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Qualification Paper Chapter Learning Objective Template ID Source

ACCA F9 22 Types and causes of risk 295 310 CD1 F9 Blueprint, F9 syllabus

Chapter Learning Objectives


Upon completion of this chapter you will be able to: Explain the meaning and causes of translation risk Explain the meaning and causes of transaction risk Explain the meaning and causes of economic risk Describe and discuss gap exposure as a form of interest rate risk Describe and discuss basis risk as a form of interest rate risk Describe how the balance of payments can cause exchange rate fluctuations Explain the impact of purchasing power parity on exchange rate fluctuations Explain the impact of interest rate parity on exchange rate fluctuations Explain the principle of four-way equivalence and the impact on exchange rate fluctuations Use purchasing power parity theory to forecast exchange rates Use interest rate parity theory to forecast exchange rates Define the term structure of interest rates Explain the features of a yield curve Explain expectations theory and its impact on the yield curve Explain liquidity preference theory and its impact on the yield curve Explain market segmentation theory and its impact on the yield curve

Types of risk Foreign currency risk

Interest rate risk

Exchange rate systems

Reasons for currency risk

The Yield Curve

Types of currency risk

Types of interest rate risk

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1 Foreign currency risk


Qualification Paper Chapter Content Objective Content, illustration and TYU included? Source

ACCA F9 22 Types and causes of risk 295 297 yes ACCA Paper 3.7 Study notes session 20, ACCA Paper 3.7 Study Text Chp 14,

In a floating exchange rate system: the authorities allow the forces of supply and demand to continuously change the exchange rates without intervention the future value of a currency vis-a-vis other currency is uncertain the value of foreign trades will be affected unlike when trading domestically.

1.1 Depreciation and appreciation of a foreign currency

If a foreign currency depreciates it is now worth less in our home currency. Receipt adverse movement will receive less in your home currency. Payment favourable movement will end up paying less in your home currency. Receipt favourable movement will receive more in your home currency.

If a foreign currency appreciates it is simply worth more in our home currency Payment adverse movement will end up paying more in your home currency.

The Comfort Table: Sell fewer $s to get a pound Rates $/ Cash flow Receipts Payments App $1.5 6.67m (0.10) Sell more $s to get a pound $10m $1.6 6.25m 0.10 Depr $1.7 5.88m

Test your understanding 1


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What would a strong pound mean for the UK economy? UK exporters: UK importers

What would a weak euro mean for Euroland? European exporters: European importers:

Test your understanding 1 - solution


A strong pound for the UK economy i.e. the pound has appreciated therefore other foreign currencies have depreciated relative to the pound UK exporters: Bad news; receipts in currencies that are depreciating; receive less pounds. UK importers: Good news; payments in currencies that are depreciating; pay less pounds.

A weak euro for Euroland i.e. the euro has depreciated therefore other foreign currencies have appreciated relative to the euro. European exporters: more euros. Good news; receipts in currencies that are appreciating; receive

European importers: Bad news payments in currencies that are appreciating pay more euros.

The Currency Blues If a currency appreciates, companies complain that they cannot sell their goods abroad and workers agitate about losing their jobs. If a currency depreciates, consumers are unhappy because inflation is imported and their money travels less far when they go abroad.

1.2 Exchange rate systems


The worlds leading currencies e.g.: US Dollar Japenese Yen British Pound European Euro

float against each other. However only a minority of currencies use this system. Other systems include: Fixed exchange rates Local currency
Fixed XC

Single other currency e.g. US $ 3

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Freely floating exchange rates

other currencies

Local currency

other currencies

other currencies Managed floating exchange rates

Local

currency

Pre-set (often confidential) limits

Although the worlds leading trading currencies, like the US Dollar, Japanese Yen, British Pound and European Euro are floating against the other currencies. A minority of countries uses floating exchange rates. The main exchange rate systems include: a) Fixed exchange rates

This involves publishing the target parity against a single currency (or a basket of currencies), and a commitment to use monetary policy (interest rates) and official reserves of foreign exchange to hold the actual spot rate within some trading band around this target.

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Fixed against a single currency This is where a country fixes its exchange rate against the currency of another countrys currency. More than 50 countries fix their rates in this way, mostly against the US dollar. Fixed rates are not permanently fixed and periodic revaluations and devaluations occur when the economic fundamentals of the country concerned strongly diverge (e.g. inflation rates). Fixed against a basket of currencies Using a basket of currencies is aimed at fixing the exchange rate against a more stable currency base than would occur with a single currency fix. The basket is often devised to reflect the major trading links of the country concerned. Historical Perspective: British pound previously used a fixed rate system. The pound was fixed against the US dollar from 1945 to 1972, and more recently was part of the European Exchange Rate Mechanism (ERM) between 1990 and 1992. The rules of the ERM were complicated, UK membership of the ERM involved a target rate of 2.95 DM against the DM with a +/- 6% trading band: in other words, a minimum spot rate of around 2.77 DM. To hold sterling above this rate in 1992, the government used a significant amount of the UKs foreign currency reserves and a high interest rate policy. Following its failure to defend the pound within the system, the UK left the ERM in September 1992. b) Freely floating exchange rates (sometimes called a clean float)

A genuine free float would involve leaving exchange rates entirely to the vagaries of supply and demand on the foreign exchange markets, and neither intervening on the market using official reserves of foreign exchange nor taking exchange rates into account when making interest rate decisions. The Monetary Policy Committee of the Bank of England clearly takes account of the external value of sterling in its decision-making process, so that although the pound is no longer in a fixed exchange rate system, it would not be correct to argue it is on a genuinely free float. c) Managed floating exchange rates (sometimes called a dirty float)

The central bank of countries using a managed float will attempt to keep currency relationships within a predetermined range of values (not usually publicly announced), and will often intervene in the foreign exchange markets by buying or selling their currency to remain within the range.

2 Types of foreign currency risk


Since firms regularly trade with firms operating in countries with different currencies, and may operate internationally themselves, it is essential to understand the impact that foreign exchange changes can have on the business.

2.1 Transaction risk

Transaction risk is the risk of an exchange rate changing between the transaction date and the subsequent settlement date i.e. it is the gain or loss arising on conversion. It arises primarily on imports and exports.

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Illustration 1
On 1 January a UK firm enters into a contract to buy a piece of equipment from the US for st $300,000. The invoice is to be settled on 31 March. The exchange rate on 1 January is $1.6/ (i.e. $1.6 = 1)
st st

However by 31 March, the pound may have 1 2 strengthened to $1.75/ or depreciated to $1.45/

st

Explain the risk faced by the UK firm

Solution
The UK firm faces uncertainty over the amount of sterling they will need to use to settle the US dollar invoice. The cost of the equipment on 1 January is However on settlement, the cost may be 1 2
st

$300,000 = 187,500 1.6

$300,000 = $171,429 1.75 $300,000 = $206,897 1.45

This uncertainty is the transaction risk. A firm may decide to hedge take action to minimise the risk if it is: a material amount over a material time period thought likely exchange rates will change significantly.

See Chapter 23 for details of hedging strategies.

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This type of risk is primarily associated with imports and exports. If a company exports goods on credit then it has a figure for receivables in its accounts. The amount it will finally receive depends on the foreign exchange movement from the transaction date to the settlement date. As transaction risk has a potential impact on the cash flows of a company, most companies choose to hedge against such exposure. Measuring and monitoring transaction risk is normally an important component of treasury management. The degree of exposure involved, which is dependent on: The size of the transaction, is it material? The hedge period, the time period before the expected cash flows occurs. The anticipated volatility of the exchange rates during the hedge period. The corporate risk management policy should state what degree of exposure is acceptable. This will probably be dependent on whether the Treasury Department is been established as a cost or profit centre.

2.2 Economic risk

Economic risk is the variations in the value of the business (i.e. the present value of future cash flows) due to unexpected changes in exchange rates. It is the long-term version of transaction risk. For an export company it could occur because: the home currency strengthens against the currency in which it trades a competitors home currency weakens against the currency in which it trades.

Illustration 2
An UK exporter sells one product in Europe on a cost plus basis. The selling price is based on a UK price of 16 to cover costs and provide a profit margin. The current exchange rate is 1.56/ What would be the effect on the exporters business if sterling strengthened to 1.71/?

Solution
The product was previously selling at 16 x 1.56 = 24.96 After the movement in exchange rates the exporter has an unhappy choice: Either they must BUSINESSCH22ACCAPAPERF9V1JA.doc 7

raise the price of the product to maintain their profits: 16 x 1.71= 27.36 but risk losing sales as the product is more expensive and less competitive, or maintain the price to keep sales volume but risk eroding profit margins.

The exporter is facing economic risk. A favoured but long term solution is to diversify all aspects of the business internationally.

Economic risk Transaction exposure focuses on relatively short-term cash flows effects; economic exposure encompasses these plus the longer-term effects of changes in exchange rates on the market value of a company. Basically this means a change in the present value of the future after tax cash flows due to changes in exchange rates. There are two ways in which a company is exposed to economic risk Directly: If your firms home currency strengthens then foreign competitors are able to gain sales at your expense because your products have become more expensive (or you have reduced your margins) in the eyes of customers both abroad and at home. Indirectly: Even if your home currency does not move vis--vis your customers currency you may lose competitive position. For example suppose a South African firm is selling into Hong Kong and its main competitor is a New Zealand firm. If the New Zealand dollar weakens against the Hong Kong dollar the South African firm has lost some competitive position. Economic risk is difficult to quantify but a favoured strategy is to diversity internationally, in terms of sales, location of production facilities, raw materials and financing. Such diversification is likely to significantly reduce the impact of economic exposure relative to a purely domestic company, and provide much greater flexibility to react to real exchange rate changes.

2.3 Translation risk

Where the reported performance of an overseas subsidiary in home-based currency terms is distorted in consolidated financial statements because of a change in exchange rates. N.B. This is an accounting risk rather that a cash based one.

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The financial statements of overseas subsidiaries are usually translated into the home currency in order that they can be consolidated into the groups financial statements. Note that this is purely a paper-based exercise it is the translation not the conversion of real money from one currency to another. The reported performance of an overseas subsidiary in home-based currency terms can be severely distorted if there has been a significant foreign exchange movement. If initially the exchange rate is given by $/ 1.00 and an American subsidiary is worth $500,000, then the UK parent company will anticipate a balance sheet value of 500,000 for the subsidiary. A depreciation of the US dollar to $/ 2.00 would result in only 250,000 being translated. Unless managers believe that the company's share price will fall as a result of showing a translation exposure loss in the company's accounts, translation exposure will not normally be hedged. The company's share price, in an efficient market, should only react to exposure that is likely to have an impact on cash flows.

3 Why exchange rates fluctuate


Qualification Paper Chapter Content Objective Content, illustration and TYU included? Source

ACCA F9 22 Types and causes of risk 300 305 yes ACCA Paper 3.7 Study notes session 21, ACCA Paper 3.7 Study Text Chp 20

Changes in exchange rates result from changes in the demand for and supply of the currency. These changes may occur for a variety of reasons:

3.1 Balance of payments


Since currencies are required to finance international trade, changes in trade may lead to changes in exchange rates. In principle: demand for imports in the UK represents a demand for foreign currency or a supply of sterling overseas demand for UK exports represents a demand for sterling or a supply of the currency.

Thus a country with a current account deficit where imports exceed exports may expect to see its exchange rate depreciate since the supply of the currency (imports) will exceed the demand for the currency (exports). Any factors which are likely to alter the state of the current account of the balance of payments may ultimately affect the exchange rate.

3.2 Capital movements between economies

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There are also capital movements between economies. These transactions are effectively switching bank deposits from one currency to another. These flows are now more important than the volume of trade in goods and services. Thus supply/demand for a currency may reflect events on the capital account. Several factors may lead to inflows or outflows of capital: changes in interest rates: rising (falling) interest rates will attract a capital inflow (outflow) and a demand (supply) for the currency inflation: asset holders will not wish to hold financial assets in a currency whose value is falling because of inflation.

These forces which affect the demand and supply of currencies and hence exchange rates have been incorporated into a number of formal models.

3.3 Purchasing Power Parity Theory (PPPT)

PPPT claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries. PPPT is based on: The Law of One Price: In equilibrium, identical goods must cost the same regardless of the currency in which they are sold.

Illustration 3
An item costs $3,000 in the US Assuming the sterling and the US dollar are at PPPT equilibrium at the current spot rate of $/ 1.50 i.e. the sterling price x current spot rate of $1.50 = dollar price. The US market Cost of item now Estimated inflation Cost in one year $3,000 5% $3,150 $1.50 The UK market 2,000 3% 2,060

The Law of One Price states that the item must always cost the same. Therefore in one year:

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$3,150 must equal 2,060 and so the expected future spot rate can be calculated:

$3,150 )) $ 1.5291 2,060

Rule: The country with the higher inflation will be subject to a depreciation of its currency. If you need to estimate the expected future spot rates, simply apply the following formula:
1 infl Current spot rate x 1 infl

1st Future expected spot rate in one year's time 2nd

Where: 1 infl

1st

= Inflation rate in country for which the spot is quoted

1 infl = Inflation rate in the other country 2nd

Illustration 4
So where inflation in the US is expected to be 5% and in the UK 3%, the future expected spot is 1.05 1.50 x ( )) $ 1.5291 1.03

Test your understanding 2


The dollar and sterling are currently trading at $1.72/ Inflation in the US is expected to grow at 3%pa, but at 4%pa in the UK. Required: Predict the future spot rate in a years time.

Test your understanding 2 solution


1.72 x ( 1.03 )) $ 1.7035 1.04

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Purchasing power theory can be used as our best predictor of future spot rates, however it suffers from the following major limitations: the future inflation rates are only estimates. the market is dominated by speculative transactions (98%) as opposed to trade transactions; therefore purchasing power theory breaks down. government intervention: governments may manage exchange rates, thus defying the forces pressing towards PPPT.

The main function of an exchange rate is to provide a means of translating prices expressed in one currency into another currency. The implication is that the exchange will be determined in some way by the relationship between these prices. This arises from the law of one price. The law of one price states that in a free market with no barriers to trade no transport or transactions costs, the competitive process will ensure that there will only be one price for any given good. If price differences occurred they would be removed by arbitrage; entrepreneurs would buy in the low market and resell in the high market. This would eradicate the price difference. If this law is applied to international transactions, it suggests that exchange rates will always adjust to ensure that only one price exists between countries where there is relatively free trade. Thus if a typical set of goods cost $1,000 in the USA and the same set cost 500 in the UK, free trade would produce an exchange rate of 1 to $2. How does this result come about? Let us suppose that the rate of exchange was $1.5 to 1: the sequence of events would be: US purchasers could buy UK goods more cheaply (500 at $1.5 to 1 is $750). There would be flow of UK exports to the US: this would represent demand for sterling. The sterling exchange rate would rise. When the exchange rate reached $2 to 1, there would be no extra US demand for UK exports since prices would have been equalised: purchasing power parity would have been established.

The clear prediction of the purchasing power parity model of exchange rate determination is that if a country experiences a faster rate of inflation than its trading partners, it will experience a depreciation in its exchange rate. It follows that if inflation rates can be predicted, so can movements in exchange rates. The purchasing power parity model can be stated as

1 i f 1+ in
where if in F

F S
= = = expected foreign inflation rate expected home inflation rate expected future spot rate

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current spot rate.

In practice the purchasing power parity model has shown some weaknesses and is a poor predictor of short term changes in exchange rates: It ignores the effects of capital movements on the exchange rate. Trade and therefore exchange rates will only reflect the prices of goods which enter into international trade and not the general price level since this includes non-tradeables (e.g. inland transport). Governments may manage exchange rates, e.g. by interest rate policy. It is likely that the purchasing power parity model may be more useful for predicting long run changes in exchange rates since these are more likely to be determined by the underlying competitiveness of economies as measured by the model.

3.4 Interest rate parity theory (IRPT)

The Interest Rate Parity theory claims that the difference between the spot and the forward exchange rates is equal to the differential between interest rates available in the two currencies.

Illustration 5
UK investor invests in a one-year US bond with a 9.2% interest rate as this compares well with similar risk UK bonds offering 7.12%. The current spot rate is $1.5/ When the investment matures and the dollars are converted into sterling IRPT states that the investor will have achieved the same return as if the money had been invested in UK government bonds. The UK market Spot $/ 1.5 Start 1m $1.5m The US market

x 1.0712
End 1.0712m

x 1.092
$1.638m

What you gain in extra interest you lose on an adverse movement in exchange rates. BUSINESSCH22ACCAPAPERF9V1JA.doc 13

Any attempt to fix the future exchange rate by locking into an agreed rate now (for example by buying a forward (see Chapter 13 for details)), will also fail: The forward rates moves to bring about interest rate parity amongst different currencies.

1.50 x (

1.092 )) $ 1.5291 1.0712

If you need to calculate the forward rate in one years time:


1 i st 1 Forward rate in one year' s time 1 i nd 2

Current spot rate x

Where: i = interest rate

Illustration 6
Using the formula in the above example:

1.50 x (

1.092 )) $ 1.5291 1.0712

The IRPT generally holds true in practice. There are no bargain interest rates to be had on loans/deposits in one currency rather than another. However it suffers from the following limitations: government controls on capital markets controls on currency trading intervention in foreign exchange markets.

Test your understanding 3


An treasurer can borrow in Swiss Francs at a rate of 3% pa or in the UK at a rate of 7% pa. The current rate of exchange is 10SF/ BUSINESSCH22ACCAPAPERF9V1JA.doc 14

What is the likely rate of exchange in a years time?

Test your understanding 3 solution


10 x ( 1.03 )) $ 9.6262 1.07

The interest rate parity model shows that it may be possible to predict exchange rate movements by referring to differences in nominal exchange rates. If the forward exchange rate for sterling against the dollar were no higher than the spot rate but US nominal interest rates were higher, the following would happen:

UK investors would shift funds to the US in order to secure the higher interest rates since they would suffer no exchange losses when they converted $ back into the flow of capital from the UK to the US would raise UK interest rates and force up the spot rate for the US $.

3.5 Expectations theory


The expectations theory claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future. If a trader takes the view that the forward rate is lower than the expected future spot price there is an incentive to buy forward. The buying pressure on the forward raises the price until the forward price equals the market consensus view on the expected future spot price. It is a poor unbiased predictor sometimes it is wide of the mark in one direction and sometimes wide of the mark in the other.

3.6 The International Fisher Effect


The International Fisher Effect claims that the interest rate differentials between two countries provide an unbiased predictor of future changes in the spot rate of exchange. International Fisher Effect assumes that all countries will have the same real interest rate, although nominal or money rates may differ due to expected inflation rates. It is a poor unbiased predictor of future exchange rates. Factors other than interest differentials influence exchange rates such as government intervention in foreign exchange markets.

3.7 Four-way equivalence

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The four theories can be pulled together to show the overall relationship between spot rates, interest rates, inflation rates and the forward and expected future spot rates. As shown above, these relationships can be used to forecast exchange rates.

Difference in interest rates 1 + infl1st 1 + infl2nd

EQUAL International Fisher Effect

Expected difference in inflation rates 1 + i1st 1 + i2nd

EQUAL Interest Rate Parity Theory

EQUAL Purchasing Power Parity Theory

Difference between forward and spot rates

EQUAL Expectations theory

Expected change in spot rates

spot forward

spot expected future spot

4 Interest rate risk


Qualification Paper Chapter Content Objective Content, illustration and TYU included? Source

ACCA F9 22 Types and causes of risk 298 299 yes ACCA Paper 3.7 Study notes session 19, ACCA Paper 3.7 Study Text Chp 15

Financial managers face risk arising from changes in interest rates as well as exchange rates, i.e. a lack of certainty about the amounts or timings of cash payments and receipts. Managers are normally risk-averse, so they will look for techniques to manage and reduce these risks.

4.1 Gap / interest rate exposure

Interest rate risk refers to the risk of an adverse movement in interest rates and thus a reduction in the companys net cash flow. Adverse Interest Rate Movements

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Loan Interest Rate

Deposit Interest Rate

Compared to currency exchange rates, interest rates do not change continually: currency rates change throughout the day interest rates can be stable for much longer periods

but changes in interest rates occur frequently, and the size of the changes can be substantial. It is the duty of the corporate treasurer (to hedge) to reduce the companys exposure to the interest rate risk.

4.2 Basis risk

There are a number of ways in which a corporate treasurer can hedge exposure to interest rate risk. One method (discussed further in Chapter 23) is to lock the company into an agreed interest rate by buying futures. However, normally these futures do not completely eliminate interest rate exposure, and the remaining exposure is known as basis risk.

Even non-bank companies can have substantial exposures to interest rate risk. Many companies borrow at a floating rate of interest (or variable rate of interest). For example, a company might borrow at a variable rate of interest, with interest payable every six months and the amount of the interest charged each time varying according to whether shortterm interest rates have risen or fallen since the previous payment. Some companies also budget to receive large amounts of cash, and so budget large temporary cash surpluses that can be invested short-term. Income from those temporary investments will depend on what the interest rate happens to be when the money is available for depositing.

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Some investments earn interest at a variable rate of interest (for example money in bank deposit accounts) and some short-term investments go up or down in value with changes in interest rates (for example, Treasury bills and other bills). Some companies hold investments in marketable bonds, either government bonds or corporate bonds. These change in value with movements in long-term interest rates. Some companies borrow by issuing bonds. If a company foresees a future requirement to borrow by issuing bonds, it will have an exposure to interest rate risk until the bonds are eventually issued. Many companies borrow, and if they do they have to choose between borrowing at a fixed rate of interest (usually by issuing bonds) or borrow at a floating rate (possibly through bank loans). There is some risk in deciding the balance or mix between floating rate and fixed rate debt. Too much fixed rate debt creates an exposure to falling long-term interest rates and too much floating rate debt creates an exposure to a rise in short-term interest rates. Interest rate risk can be significant. For example, suppose that a company wants to borrow $10 million for one year, but does not need the money for another three weeks. It would be expensive to borrow money before it is needed, because there will be an interest cost. On the other hand, a rise in interest rates in the time before the money is actually borrowed could also add to interest costs. For example, a rise of just 0.25% (25 basis points) in the interest rate on a one-year loan of $10 million would cost an extra $25,000 in interest.

5 Why interest rates fluctuate


Qualification Paper Chapter Content Objective Content, illustration and TYU included? Source

ACCA F9 22 Types and causes of risk 306 310 yes ACCA Paper 3.7 Study notes session 18, ACCA Paper 3.7 Study Text Chp 6

5.1 The Yield Curve


The term structure of interest rates refers to the way in which the yield of a debt security or bond varies according to the term of the security, i.e. to the length of time before the borrowing will be repaid. The yield curve is an analysis of the relationship between the yields on debt with different periods to maturity

Gross redemption

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yield

12

16

20

24

28

Term to maturity 30 (years)

The shape of the yield curve at any point in time is the result of the three following theories acting together: expectations theory liquidity preference theory market segmentation theory.

5.2 Expectations theory

The normal upward sloping yield curve reflects the expectation that inflation levels, and therefore interest rates will increase in the future. Note: Downward sloping yield curve: In the early 1990s interest rates were high to counter act high inflation, everybody expected interest rates to fall in the future, which they did. Expectations that interest rates would fall meant it was cheaper to borrow long term than short term.

5.3 Liquidity preference theory

Always pushes up

Investors have a natural preference for more liquid (shorter maturity) investments. They will need to be compensated if they are deprived of cash for a longer period. Therefore the longer the maturity period, the higher the yield required leading to an upward sloping curve, assuming that the interest rates were not expected to fall in the future.

5.4 Market segmentation theory

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The market segmentation theory suggests that there are different players in the short-term end of the market and the long-term end of the market: investors are assumed to be risk averse and to invest in segments of the market that match their liability commitments. E.g.: o o banks tend to be active in the short term end of the market pension funds would tend to invest in long term maturities to match the long term nature of their liabilities.

the supply and demand forces in various segments of the market in part influence the shape of the yield curve: If there is an increased supply in the long-term end of the market because the government needs to borrow more, this may cause the price to fall and the yield to rise and may result in an upward sloping yield curve

5.5 The significance of the yield curve


Financial managers should inspect the current shape of the yield curve when deciding on the term of borrowings or deposits, since the curve encapsulates the market's expectations of future movements in interest rates. For example, a yield curve sloping steeply upwards suggests that interest rates will rise in the future. The manager may therefore: wish to avoid borrowing long-term on variable rates, since the interest charge may increase considerably over the term of the loan short-term variable rate borrowing or long-term fixed rate borrowing may instead be more appropriate.

The term structure of interest rates refers to the way in which the yield of a debt security or bond varies according to the term of the security, i.e. to the length of time before the borrowing will be repaid. It is usually presented in the form of a table or a graph called a yield curve. As a graph, it shows the current gross yield earned by investing in a number of similar financial instruments with differing remaining terms to maturity. The return for each instrument is plotted on a graph where the y axis represents the annual return and the x axis represents the instruments remaining term to maturity. The points plotted on the graph are then joined up to produce a yield curve. Analysis of term structure is normally carried out by examining risk-free securities such as UK government stocks (gilts). Newspapers such as the Financial Times show the gross redemption yield (i.e. interest yield plus capital gain/loss to maturity) and time to maturity of each gilt on a daily basis. BUSINESSCH22ACCAPAPERF9V1JA.doc 20

This term structure of interest rates might be shown as a yield curve, as follows.
Gross redemption yield (%) 8

10

15

20

25 Years to maturity

The redemption yield on shorts is less than the redemption yield of mediums and longs, and there is a 'wiggle' on the curve between 5 and 10 years. A yield curve can have any shape, and can fluctuate up and down for different maturities. Generally however, yield curves fall into one of three typical patterns. Normal. A normal yield curve is upward-sloping, so that the yield is higher on instruments with a longer remaining term to maturity. The higher yield compensates the investor for tying up capital for a longer period. Although the yield curve slopes upwards, the gradient of the curve is not steep. A normal yield curve might be expected when interest rates are not expected to change. Inverse. An inverse yield curve is downward-sloping, so that the yield is lower on instruments with a longer remaining term to maturity. An inverse yield curve might be expected when interest rates are currently high but are expected to fall. Steep upward-sloping curve. When interest rates are expected to rise, the yield curve is likely to have a steep upward slope, with yields on longer-term investments much higher than the yield on shorter-dated investments. Yield curves are usually drawn for benchmark investments that are either risk-free (government securities) or low risk (such as yields on interest rate swaps). However, they are representative of the slope of the yield curve generally for all other financial instruments, such as inter-bank lending rates and corporate bond yields. The shape of the yield curve at any particular point in time is generally believed to be a combination of three theories acting together: expectations theory liquidity preference theory market segmentation theory.

Expectations theory

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This theory states that the shape of the yield curve varies according to investors' expectations of future interest rates. A curve that rises steeply from left to right indicates that rates of interest are expected to rise in future. There is more demand for short-term securities than long-term securities since investors' expectation is that they will be able to secure higher interest rates in the future so there is no point in buying long-term assets now. The price of short-term assets will be bid up, the price of long-term assets will fall, so the yields on short-term and long-term assets will consequently fall and rise. A falling yield curve (also called an inverted curve, since it represents the opposite of the usual situation) implies that interest rates are expected to fall. For much of the period of sterling's membership of the ERM, for instance, high short-term rates were maintained to support sterling and the yield curve was often inverted since the market believed that the long-term trend in interest rates should be lower than the high short-term rates. A flat yield curve indicates expectations that interest rates are not expected to change materially in the future. Liquidity preference theory Investors have a natural preference for holding cash rather than other investments, even low risk ones such as government securities. They therefore need to be compensated with a higher yield for being deprived of their cash for a longer period of time. The normal shape of the curve as being upwards sloping can be explained by liquidity preference theory. Market segmentation theory This theory states that there are different categories of investor who are interested in different segments of the curve. Typically, banks and building societies invest at the short end of the market while pension funds and insurance companies buy and sell long-term gilts. The two ends of the curve therefore have 'lives of their own', since they might react differently to the same set of new economic statistics. Market segmentation theory explains the 'wiggle' seen in the middle of the curve where the short end of the curve meets the long end it is a natural disturbance where two different curves are joining and the influence of both the short-term factors and the long-term factors are weakest. Significance of yield curves to financial managers Financial managers should inspect the current shape of the yield curve when deciding on the term of borrowings or deposits, since the curve encapsulates the market's expectations of future movements in interest rates. For example, a yield curve sloping steeply upwards suggests that interest rates will rise in the future. The manager may therefore wish to avoid borrowing long-term on variable rates, since the interest charge may increase considerably over the term of the loan. Short-term variable rate borrowing or long-term fixed rate borrowing may instead be more appropriate. A corporate treasurer might analyse a yield curve to decide for how long to borrow. For example, suppose a company wants to borrow $20 million for five years and would prefer to issue bonds at a fixed rate of interest. One option would be to issue bonds with a five-year maturity. Another option might be to borrow short term for one year, say, in the expectation that interest rates will fall, and then issue a four-year bond. When borrowing large amounts of capital, a small difference in the interest rate can have a significant effect on profit. For example, if a company borrowed $20 million, a difference of just 25 basis points (0.25% or one quarter of one per cent) would mean a difference of $50,000 each year in interest costs.

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Expectations of future interest rate movements are monitored closely by the financial markets, and are important for any organisation that intends to borrow heavily or invest heavily in interestbearing instruments. A company might use a forward yield curve to predict what interest rates might be in the future. For example, if we know the current interest rate on a two-month and a sixmonth investment, it is possible to work out what the market expects the four-month interest rate to be in two months time.

Test your understanding 4


Answer the following question: 1 2 What is gap exposure? What are the three determinants of the yield curve?

Test your understanding 4 solution


1 Gap exposure refers to the risk of an adverse movement in interest rates and thus a reduction in the companys net cash flow. The shape of the yield curve at any point in time is the result of the three following theories acting together: expectations theory liquidity preference theory market segmentation theory.

Chapter summary
Qualification Paper Chapter Template ID Source

ACCA F9 22 Types and causes of risk CS1 ACCA Paper 3.7 Study notes session 18 21, ACCA Paper 3.7 Study Text chapter 6, 14 15.

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Types of risk Foreign currency risk


Movement of one currency against another Affects value of foreign trades

Interest rate risk

Gap Exchange rate systems


Fixed against one other Fixed against a basket Free floating Managed floating Adverse movements in interest rates

Basis
Cannot create a perfect hedge

Reasons for currency risk


See summary below

The Yield Curve

Types of currency risk Transaction


XC rate change between transaction and settlement

Inflation & interest rates expected to rise

Expectations theory

Liquidity preference
Natural preference for short term investments

Translation
Accounting risk on consolidation of a foreign subsidiary

Economic
Long term movements Changes in business value

Market segmentation
Different preferences apply supply & demand forces

Reasons for currency risk Balance of payments


Demand for imports=demand for foreign currency Demand for exports=demand for home currency

Capital movements between economies

Interest Rate Parity Theory


Current spot x 1 + i1st =Expected forward 1 + i2nd

Expectations theory
Forward predictor of spot

Purchasing Power Parity Theory


Current spot x 1 + infl1st =Expected future spot 1 + infl2nd

International Fisher Effect


Inflation causes interest rate differencesexpected inflation can predict spot

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Checklist submit with each chapter


NGLM CHECKLIST 1 Table completed per content objective 2 Icons 3 Followed blueprint 4 Read and followed the house style document 5 Content, illustrations, TYUs included 6 Legacy material used and referenced, although text must be up to date with current standards. 7 Activities etc. taken from legacy material (please list): 8 9 10 11 12 13 No bullet after heading begin with some explanatory text Bullets used, max. 9 bullets per heading, 70 words per bullet Any exceptions to rule 9 as per the syllabus Expandable text, 500 words max per paragraph Main content Arial 10, headings bold 14, subheadings bold 12, correctly numbered with 1, 1.1, 1.2, etc. Diagrams/tables used Tick

14 Tables are 15 cm across and rules on text followed (more info on balance sheets etc., layout in the house style guide) 15 Varied style for illustrations 16 Reviewed pilot 17 Chapter overview, summary and checklist completed 18 Saved correctly

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