Question

1. Identify an investment that you could reduce Exchange Rate risks through spreading. Carefully explain why this would spread your risk.

Answer 1

Answer :- The various investment opportunities by which exchange rate risks can be reduced (through spreading the risks across) are as follows :-

1). Derivatives: - A derivative transaction is a bilateral contract or payment exchange agreement whose value depends on - derives from - the value of an underlying asset, reference rate or index. Every derivative transaction is constructed from two simple building blocks that are fundamental to all derivatives :- Forwards and options. They include :- a). Forward-based derivatives and (b) Options.

  (a) Forward-based derivatives :- There are three divisions of forward-based derivatives :- i). Forward contract. (ii). Swaps and (iii) Future contracts.

  (b). Options : They offer, in exchange for a premium, the right - but not the obligation - to buy (call option) or sell (put option) the underlying at the exercise price (strike price) during a period or on a specific date.

2). Netting :- It involves associated companies, which trade with each other. The technique is simple. Group companies merely settle inter affiliate indebtedness for the net amount owing. Gross intra-group trade, receivables and payables are netted out.

3). Price variation :- It involves increasing selling prices to counter the adverse effects of foreign exchange rate change.

4). Leading and Lagging :- Leading means paying an obligation in advance of the due date. Lagging means delaying payment of an obligation beyond its due date. Leading and Lagging are foreign exchange management tactics designed to take advantage of expected devaluations and revaluations of currencies.

5). Invoicing in foreign currencies :- Sellers usually wish to sell in their own currency or the currency in which they incur cost. This avoids foreign exchange exposure. For the buyer, the ideal currency is usually its own or one that is stable relative to it, or it may be a currency of which the purchaser has reserves.

6). Arbitrage :- The simple notion in arbitrage is to purchase and sell a currency simultaneously in more than one foreign exchange markets. Arbitrage profits are the result of the difference in exchange rates at two different exchange centers and the difference, due to interest yield which can be earned at different exchanges.