Question

1. Describe Interest Rate Parity (IRP).

2. Compare and contrast forward and futures contracts.

3. Explain how firms can benefit from forecasting exchanges rates.

4. Describe the common techniques used for forecasting exchange rates.

5. Explain the concepts of transaction exposure, economic exposure, and translation exposure. How each of the exposure could be measured?

6. Describe the commonly used techniques to hedge payables and receivables.

7. Suggest other methods of reducing exchange rate risk when hedging techniques are not available.

8. Explain how a firm can hedge its translation exposure and the limitations of hedging translation exposure.

Answer 1

1) Interest Rate Perity: Interest rate perity is a no arbritage condition representing an equilibrium state in which inesters will be indifferent to interest rates available on bank deposits in two countries.There are two basic assumption behind Interest rate perity (a) Capital mobility and (b) perfect substitutablity of domestic and foreighn assets. Under this Interest rate differential between the two countries equals to the differential between the forward exchange rates and spot exchange rtaes.

2)Following are some points to highlight the main difference between the forward and future contracts:

• Platform for trading: The future contracta are traded on exchanges but forwards are traded over the counter. future contracts carries more legal boundations with them . forward are generally between two or more counterparties in which exchanges or other legal body does not involv.
• Setelments of contract: For forward contarct, settelment of contract occurs at the end of the contract.On the other hand settlement of futures happens over a range of dates.
• Speculation and hedging: future contracts are often used to cover the counterparty risk . it is mainly used for speculation and hedging. On the other hand forward contracts are merely a contract for the future date.

3) Following are some points describing how fimrs can be benifited by forcasting exchange rates:

• hedging decisions: forcasting exchange rates can be helpful in taking the hedging decisions.
• Short term financing decisions: companies specially MNCs face a variety of problems for their short term financings. forcasting exchange rates can be helpfull in this.
• Investment decisions: it enables to showcase every aspects of investment outcomes.
• Capital budgeting decisions: This assist in taking capital budgeting decisions of the company. The firm may periodically needs exchange of currency
• Earning assesments: Helpful in overall assisment of earnings and its usage. It helps in taking decisions like whether the whole earnig is to be reinvested or to be remit back to the parent company.
• Long term financing : corporations that issues bonds, to secure long term funds may prefer that the currency borrowed, depriciated over a time against the currency they are receiving from sales.

4) Common techniques used for forcasing exchange rates:

(a) technical forcasting

(b) fundamental forcasting

(c) market based forcasting

• Technical forcasting: Thechnical forcasting involves use of historical exchange rate data to predict future values.This assumes that there may be a trend of successive exchange rate adjustment in the same direction. this includes statistical analysis and time series models.
• Fundamental analysis: This is based on fundamental relationship between economical variable and exchange rates. This includes the subjective assesment of the factors of economy which effects the exchange rates.
• Market Based Forcast: The process of developing forcast from market is usually based on Spot rates and Forward rate.Speculation should push the rate to that leve which reflects the market expection of the future exchange rate