Separate group exercises will be given regarding using of some of these techniques.
- Covering a Consolidation Exposure
The magnitude of exposure depends on the method of translation used by the parent
company.
Suppose an American company wants to borrow Deutschmarks at a variable rate. The
company is well placed on the American market. It borrows US$ 1 million on the
American market at a fixed rate and enters into a swap deal with its bank. On the date of
the contract, there is an exchange of the principal: the American company pays to its
bank 1 million dollars and receives 1.4 million Deutschmarks, the spot rate being DM
1.4/US$, during the contract period, the company will pay a variable rate on the
Deutschmarks while the bank will pay it a fixed rate on dollars. There will also be a re-
exchange of the principal on the maturity date.
American Company $ 1m Bank
DM 1.4 mAmerican Company Variable rate BankFixed rateAmerican Company DM 1.4 m Bank$ 1mCurrency swaps are comparable to a forward exchange transaction with a difference that
the differential of rates is calculated periodically instead of being settled just once at the
end of the contract; this feature renders the swaps more efficient and more flexible than
covering in the forward market for long periods.
- Interest Rate Risk
All banks and firms, domestic or multinational are sensitive to interest rate movements.
The interest rate risk results from a mismatch of maturity of assets and liabilities
respectively.
Financial markets have developed instruments, options and futures, on interest to cover
these risks. Likewise, banks have also evolved/devised certain mechanisms in this
regard.
Interest rate risk concerns the following: