Ema Questions 2022

1
Topic
EMA

2
Index
Question No. Page No.
Question 1...................................................................... 2
Question 2...................................................................... 5
Question 3...................................................................... 5
Question 4...................................................................... 6
Question 5...................................................................... 8
References..................................................................... 10

3
Question
1.)
i) What types of foreign exchange risk is the parent company exposed to and in what
ways can it hedge these risks? (12 marks)
Answer:
Suppose the parent firm buys (imports) from subsidiary firm located in Austria, and parent
company’s accounts payable are denominated in Euros. The current dollar–euro rate as $1.25,
but suppose that each day the dollar depreciates. Assume an exchange rate of $1.31 a month
from now, when you make your payment. In this way instead of paying $1.25 for every Euro,
the importer will have to pay 1.31.dollar for every Euro (WealthHow. 2018).
Hence, importer incurred loss of $ 1.31- $1.25 = $ 0.06 per Euro.
Exchange rate hedging can be done in following ways:
a) Forwards:
Informal way of hedging traded over the counter. Forward contracts specify an
amount, exchange rate and date for a currency exchange between two parties. It
permits participating player to wind-up the contact at prevailing prices. It does not
associate any cost; however, there is all the time an issue of compliance by any of the
two parties involved in contract.
Consider a case, where Japanese is selling camera to an Indian buyer and will ship
monthly for a year. They sign a forward stating that the buyer will pay at the end of
the year at today's exchange rate. Any changes in the exchange rate will not change
the contract guarantees that the buyer will still spend the same amount of yen and the
company will still receive the same amount of rupee.
b) Futures:
Formalised way of hedging traded in more formalised market. Futures contracts are
financial instruments with conditions for a currency exchange, including the amount,
rate and expiry date. Futures eliminate the non-compliance risk, like in forwards, so
they are common when there are credit risks. But it is only available in major
currencies of the world. By selling futures, investors might hedge currencies falling
value. By buying futures, they hedge currencies increasing value.
c) Option:
Give buyer right to buy or sell but not obligation. An options contract is an agreement
between a buyer and seller that gives the buyer of the option the right to buy or sell a
particular asset at a later date at an agreed price. Options contracts are often used in
all types of financial instruments mainly for the hedging purpose.
d) SWAPS:
In brief, currency swapping between two parties with interest rate is called Swaps.
Swaps are contracts between two parties that need foreign currency, but don't want to
borrow from a foreign bank.

4
What will be the type and strategy of currency hedging will be decided as per the
expectations and requirements of the importer. If importer does not need very fixed or rigid
type of strategy, he may go for swaps and options. Whereas, if both parties are familiar to
each other they may wanted to go for forward contracts as per both parties requirements and
suitability. Just opposite to forward, future contracts are more formal in nature, because,
future contract is very regulated and standardised kind of hedging strategy than forward.
ii. Using the forward margin methodology, calculate what rate of exchange between
EUR and USD the parent company could hedge the exposure arising from the
commitment of the parent company to pay EUR 100m in 6 months’ time. For this
question the ‘base’ currency is the EUR and the ‘terms’ currency is the USD. Note that
both currencies use a 360-day convention for one year. (4 marks)
Answer:
Forward Margin =
(Spot rate * forward period in days * difference in interest) / (100 * no. of days in year)
After putting data from given question answer will be
Forward margin = 0.005
They could hedge 0.005 cent above the given rate.
That is, Eur 1 = USD 1.3
iii. Define the factors determining the prices of the options. (6 marks)
Answer:
Factor which decides the pricing of option are as given below:
Volatility in Option and Pricing:
Volatility is inherent feature of market any expected news, news, or any fear factor causes
premium to rise or cause the effect in rise of premium of option (Singh, 2019).
Underlying prices of Currency:
Any change in underlying prices of security, changes the premium of call or put option. If
security prices rises call premium rises same way a fall in security price could lead to fall in
premium of put option.
Strike Price of option