Discuss whether financial management theory suggests that Droxfol Co can

reduce its weighted average cost of capital to a minimum level.

Droxfol Co has long-term finance provided by ordinary shares, preference
shares and loan notes. The rate of return required by each source of
finance depends on its risk from an investor point of view, with equity
(ordinary shares) being seen as the most risky and debt (in this case loan
notes) seen as the least risky. Ignoring taxation, the weighted average
cost of capital (WACC) would therefore be expected to decrease as equity
is replaced by debt, since debt is cheaper than equity, i.e. the cost of debt
is less than the cost of equity.
In the traditional view of capital structure, ordinary shareholders are
relatively indifferent to the addition of small amounts of debt in terms
of increasing financial risk and so the WACC falls as a company gears
up. As gearing up continues, the cost of equity increases to include a
financial risk premium and the WACC reaches a minimum value. Beyond
this minimum point, the WACC increases due to the effect of increasing
financial risk on the cost of equity and, at higher levels of gearing, due to
the effect of increasing bankruptcy risk on both the cost of equity and the
cost of debt. On this traditional view, therefore, Droxfol Co can gear up
using debt and reduce its WACC to a minimum, at which point its market
value (the present value of future corporate cash flows) will be
maximised.
In contrast to the traditional view, continuing to ignore taxation but
assuming a perfect capital market, Miller and Modigliani demonstrated
that the WACC remained constant as a company geared up, with the
increase in the cost of equity due to financial risk exactly balancing
the decrease in the WACC caused by the lower before-tax cost of debt.
Since in a prefect capital market the possibility of bankruptcy risk does
not arise, the WACC is constant at all gearing levels and the market value
of the company is also constant. Miller and Modigliani showed, therefore,
that the market value of a company depends on its business risk alone,
and not on its financial risk. On this view, therefore, Droxfol Co cannot
reduce its WACC to a minimum.
When corporate tax was admitted into the analysis of Miller and
Modigliani, a different picture emerged. The interest payments on debt
reduced tax liability, which meant that the WACC fell as gearing increased,
due to the tax shield given to profits. On this view, Droxfol Co could
reduce its WACC to a minimum by taking on as much debt as possible.
However, a perfect capital market is not available in the real world and at
high levels of gearing the tax shield offered by interest payments is more
than offset by the effects of bankruptcy risk and other costs associated
with the need to service large amounts of debt. Droxfol Co should
therefore be able to reduce its WACC by gearing up, although it may be
difficult to determine whether it has reached a capital structure giving a
minimum WACC.


Discuss the differences between transaction risk, translation risk and economic
risk.
Transaction risk
This is the risk arising on short-term foreign currency transactions that
the actual income or cost may be different from the income or cost
expected when the transaction was agreed. For example, a sale worth
$10,000 when the exchange rate is $1.79 per has an expected sterling
value is $5,587. If the dollar has depreciated against sterling to $1.84 per
when the transaction is settled, the sterling receipt will have fallen to
$5,435. Transaction risk therefore affects cash flows and for this reason
most companies choose to hedge or protect themselves against
transaction risk.
Translation risk
This risk arises on consolidation of financial statements prior to reporting
financial results and for this reason is also known as accounting exposure.
Consider an asset worth 14 million, acquired when the exchange rate
was 1.4 per $. One year later, when financial statements are being
prepared, the exchange rate has moved to 1.5 per $ and the balance
sheet value of the asset has changed from $10 million to $9.3 million,
resulting an unrealised (paper) loss of $0.7 million. Translation risk does
not involve cash flows and so does not directly affect shareholder wealth.
However, investor perception may be affected by the changing values of
assets and liabilities, and so a company may choose to hedge translation
risk through, for example, matching the currency of assets and liabilities
(eg a euro-denominated asset financed by a euro-denominated loan).
Economic risk
Transaction risk is seen as the short-term manifestation of economic risk,
which could be defined as the risk of the present value of a companys
expected future cash flows being affected by exchange rate movements
over time. It is difficult to measure economic risk, although its effects can
be described, and it is also difficult to hedge against it.

Explain how inflation rates can be used to forecast exchange rates.



Discuss whether the dividend growth model or the Capital asset pricing model
should be used to calculate the cost of equity

The dividend growth model calculates the apparent cost of equity in the capital
market, provided that the current market price of the share, the current dividend
and the future dividend growth rate are known. While the current market price
and the current dividend are readily available, it is very difficult to find an
accurate value for the future dividend growth rate. A common approach to
finding the future dividend growth rate is to calculate the average historic
dividend growth rate and then to assume that the future dividend growth rate
will be similar. There is no reason why this assumption should be true.
The capital asset pricing model tends to be preferred to the dividend growth
model as a way of calculating the cost of equity as it has a sound theoretical
basis, relating the cost of equity or required return of well-diversified
shareholders to the systematic risk they face through owning the shares of a
company. However, finding suitable values for the variables used by the capital
asset pricing model (risk-free rate of return, equity beta and equity risk
premium) can be difficult.

Discuss the attractions of leasing as a source of both short-term and long-term
finance

Operating leasing can act as a source of short-term finance, while finance leasing
can act as a source of long-term finance.

Operating leasing offers a solution to the obsolescence problem, whereby
rapidly aging assets can decrease competitive advantage. Where keeping up-to-
date with the latest technology is essential for business operations, operating
leasing provides equipment on short-term contracts which can usually be
cancelled without penalty to the lessee. Operating leasing can also provide
access to skilled maintenance, which might otherwise need to be bought in by
the lessee, although there will be a charge for this service.

Both operating leasing and finance leasing provide access to non-current assets
in cases where borrowing may be difficult or even not possible for a company.
For example, the company may lack assets to offer as security, or it may be seen
as too risky to lend to. Since ownership of the leased asset remains with the
lessor, it can be retrieved if lease rental payments are not forthcoming.

In Islamic finance, explain briefly the concept of riba(interest) and how returns
are made by Islamic financial instruments

Interest (riba) is the predetermined amount received by a provider of finance,
over and above the principal amount of finance provided. Riba is absolutely
forbidden in Islamic finance. Riba can be seen as unfair from the perspective of
the borrower, the lender and the economy. For the borrower, riba can turn a
profit into a loss when profitability is low. For the lender, riba can provide an
inadequate return when unanticipated inflation arises. In the economy, riba can
lead to allocational inefficiency, directing economic resources to sub-optimal
investments.
Islamic financial instruments require that an active role be played by the
provider of funds, so that the risks and rewards of ownership are shared. In a
Mudaraba contract, for example, profits are shared between the partners in the
proportions agreed in the contract, while losses are borne by the provider of
finance. In a Musharaka contract, profits are shared between the partners in the
proportions agreed in the contract, while losses are shared between the partners
according to their capital contributions. With Sukuk, certificates are issued
which are linked to an underlying tangible asset and which also transfer the risk
and rewards of ownership. The underlying asset is managed on behalf of the
Sukuk holders.
In a Murabaha contract, payment by the buyer is made on a deferred or
instalment basis. Returns are made by the supplier as a mark-up is paid by the
buyer in exchange for the right to pay after the delivery date. In an Ijara contract,
which is equivalent to a lease agreement, returns are made through the payment
of fixed or variable lease rental payments.

Explain the reasons why interest rates may differ between loans of different
maturity.

Liquidity preference theory
This theory suggests that investors prefer to have cash now and so require
compensation for lending money. The longer the period for which money is lent,
the higher will be the interest rate to compensate the lender for deferring their
use of the loaned cash. The higher interest rate for long-term debt over short-
term debt will also compensate lenders for increasing risk over time, for
example, the increasing risk of default with increasing maturity. Liquidity
preference theory can therefore explain why the yield curve is normally upward
sloping.
Expectations theory
This theory suggests that the relationship between short-term and long-term
interest rates can be explained by expectations regarding interest rate
movements. Where future interest rates are expected to rise compared to short-
term interest rates, the yield curve will slope upwards. Where future interest
rates are expected to fall compared to short-term interest rates, the yield curve
will slope downwards.
Market segmentation theory
The reason why interest rates may differ between loans of different maturity
could be because the balance between supply and demand differs between
markets for loans of different maturity. If demand for long-term loans is greater
than the supply, for example, because of a high public sector borrowing
requirement, interest rates in the long-term loan market will increase to restore
equilibrium between demand and supply. Differing interest rates between
markets for loans of different maturity can also explain why the yield curve may
not be smooth, but kinked.
Fiscal policy
Governments may use fiscal policy to support the achievement of economic
objectives. For example, the government or central bank may act to increase
short-term interest rates in order to reduce inflation. This can result in short-
term interest rates being higher than long-term interest rates, an effect which
can be compounded if there is a decrease in the anticipated inflation reflected in
long-term interest rates.

Discuss how the capital asset pricing model can be used to calculate a project-
specific cost of capital for AMH co, referring in your discussion to the key
concepts of systematic risk, business risk and financial risk.

The capital asset pricing model (CAPM) assumes that investors hold diversified
portfolios, so that unsystematic risk has been diversified away. Companies using
the CAPM to calculate a project-specific discount rate are therefore concerned
only with determining the minimum return that must be generated by an
investment project as compensation for its systematic risk.
The CAPM is useful where the business risk of an investment project is different
from the business risk of the investing companys existing business operations.
In such a situation, one or more proxy companies are identified that have similar
business risk to the investment project. The equity beta of the proxy company
represents the systematic risk of the proxy company, and reflects both the
business risk of the proxy companys business operations and the financial risk
arising from the proxy companys capital structure.
Since the investing company is only interested in the business risk of the proxy
company, the proxy companys equity beta is ungeared to remove the effect of
its capital structure. Ungearing converts the proxy companys equity beta into
an asset beta, which represents business risk alone. The asset betas of several
proxy companies can be averaged in order to remove any small differences in
business operations.
The asset beta can then be regeared, giving an equity beta whose systematic
risk takes account of the financial risk of the investing company as well as the
business risk of an investment project. Both ungearing and regearing use the
weighted average beta formula, which equates the asset beta with the weighted
average of the equity beta and the debt beta.
The project-specific equity beta resulting from the regearing process can then be
used to calculate a project-specific cost of equity using the CAPM. This can be
used as the discount rate when evaluating the investment project with a
discounted cash (DCF) flow investment appraisal method such as net present
value or internal rate of return. Alternatively, the project-specific cost of equity
can be used in calculating a project-specific weighted average cost of capital,
which can also be used in a DCF evaluation.

Explain why the cost of equity is greater than the cost of debt.

The cost of equity is the return required by ordinary shareholders (equity
investors), in order to compensate them for the risk associated with their
equity investment, i.e. their investment in the ordinary shares of a company. If
the risk of an investment increases, the return expected by the investor also
increases. If the risk of a company increases, therefore, its cost of equity also
increases.
If a company is liquidated, the order in which the claims of creditors are settled
is a factor in determining their relative risk. The claims of providers of debt
finance (debt holders) must be paid off before any cash can be distributed to
ordinary shareholders (the owners). The risk faced by shareholders is therefore
greater than the risk faced by debt holders, and the cost of equity is therefore
greater than the cost of debt.
Interest on debt finance must be paid before dividends can be paid to ordinary
shareholders, so the risk faced by ordinary shareholders is greater than the risk
faced by debt holders, since the necessity of paying interest may mean that
dividends have to be reduced.

Discuss the key elements of a trade receivables management policy.

Credit analysis
Credit analysis helps a company to minimise the possibility of bad debts by
offering credit only to customers who are likely to pay the money they owe.
Credit analysis also helps a company to minimise the likelihood of customers
paying late, causing the company to incur additional costs on the money owed,
by indicating which customers are likely to settle their accounts as they fall due.
Credit analysis, or the assessment of creditworthiness, is undertaken by
analysing and evaluating information relating to a customers financial history.
This information may be provided by trade references, bank references, the
annual accounts of a company or credit reports provided by a credit reference
agency. The depth of the credit analysis will depend on the potential value of
sales to the client, in terms of both order size and expected future trading. As a
result of credit analysis, a company will decide on whether to extend credit to a
customer.
Credit control
Having granted credit to customers, a company needs to ensure that the agreed
terms are being followed. The trade receivables management policy will
stipulate the content of the initial sales invoice that is raised. It will also advise
on the frequency with which statements are sent to remind customers of
outstanding amounts and when they are due to be paid. It will be useful to
prepare an aged receivables analysis at regular intervals (e.g. monthly), in order
to focus management attention on areas where action needs to be taken to
encourage payment by clients.
Receivables collection
Ideally, all customers will settle their outstanding accounts as and when they fall
due. Any payments not received electronically should be banked quickly in order
to decrease costs and increase profitability. If accounts become overdue, steps
should be taken to recover the outstanding amount by sending reminders,
making customer visits and so on. Legal action could be taken if necessary,
although only as a last resort.

Discuss why market value weighted average cost of capital is preferred to book
value weighted average cost of capital when making investment decisions

Market values of different sources of finance are preferred to their book values
when calculating weighted average cost of capital (WACC) because market
values reflect the current conditions in the capital market. The relative
proportions of the different sources of finance in the capital structure reflect
more appropriately their relative importance to a company if market values are
used as weights. For example, the market value of equity is usually much greater
than its book value, so using book values for weights would seriously
underestimate the relative importance of the cost of equity in the weighted
average cost of capital.
If book values are used as weights, the WACC will be lower than if market values
were used, due to the understatement of the contribution of the cost of equity,
which is higher than the cost of capital of other sources of finance. This can be
seen in the case of BKB Co, where the market value after-tax WACC was found to
be 94% and the book value after-tax WACC is 87% (10% x 40 + 8% x 10 +
643% x 20/70).
If book value WACC were used as the discount rate in investment appraisal,
investment projects would be accepted that would be rejected if market value
WACC were used. Using book value WACC as the discount rate will therefore lead
to sub-optimal investment decisions.
As far as the cost of debt is concerned, using book values rather than market
values for weights may make little difference to the WACC, since bonds often
trade on the capital market at or close to their nominal (par) value. In addition,
the cost of debt is lower than the cost of equity and will therefore make a smaller
contribution to the WACC. It is still possible, however, that using book values as
weights may under- or over-estimate the contribution of the cost of debt to the
WACC.

Identify and discuss the factors to be considered in determining the optimum
level of cash to be held by a company

The following factors should be considered in determining the optimum level of
cash to be held by a company, for example, at the start of a month or other
accounting control period.
The transactions need for cash
The amount of cash needed for the next period can be forecast using a cash
budget, which will net off expected receipts against expected payments. This will
determine the transactions need for cash, which is one of the three reasons for
holding cash.
The precautionary need for cash
Although a cash budget will provide an estimate of the transactions need for
cash, it will be based on assumptions about the future and will therefore be
subject to uncertainty. The actual need for cash may be greater than the forecast
need for cash. In order to provide for any unexpected need for cash, a company
can include some spare cash (a cash buffer) in its cash balance. This is the
precautionary need for cash. In determining the optimal level of cash to be held,
a company will estimate the size of this cash buffer, for example from past
experience, because it will be keen to minimise the opportunity cost of
maintaining funds in cash form.
The speculative need for cash
There is always the possibility of an unexpected opportunity occurring in the
business world and a company may wish to be prepared to take advantage of
such a business opportunity if it arises. It may therefore wish to have some cash
available for this purpose. This is the speculative need for cash. Building a war
chest for possible company acquisitions reflects this reason for holding cash.
The availability of finance
A company may choose to hold higher levels of cash if it has difficulty gaining
access to cash when it needs it. For example, if a companys bank makes it
difficult to access overdraft finance, or if a company is refused an overdraft
facility, its precautionary need for cash will increase and its optimum cash level
will therefore also increase.

Critically discuss the similarities and differences between working capital
policies in the following areas: (1) Working capital investment (2) Working
capital financing

Working capital investment policy is concerned with the level of
investment in current assets, with one company being compared with
another. Working capital financing policy is concerned with the relative
proportions of short-term and long-term finance used by a company.
While working capital investment policy is therefore assessed on an inter-
company comparative basis, assessment of working capital financing
policy involves analysis of financial information for one company alone.
Working capital financing policy uses an analysis of current assets into
permanent current assets and fluctuating current assets. Working capital
investment policy does not require this analysis. Permanent current
assets represent the core level of investment in current assets that
supports a given level of business activity. Fluctuating current assets
represent the changes in the level of current assets that arise through, for
example, the unpredictability of business operations, such as the level of
trade receivables increasing due to some customers paying late or the
level of inventory increasing due to demand being less than predicted.
Working capital financing policy relies on the matching principle, which is
not used by working capital investment policy. The matching principle
holds that long-term assets should be financed from a long-term source of
finance. Non-current assets and permanent current assets should
therefore be financed from a long-term source, such as equity finance or
bond finance, while fluctuating current assets should be financed from a
short-term source, such as an overdraft or a short-term bank loan.
Both working capital investment policy and working capital financing
policy use the terms conservative, moderate and aggressive. In
investment policy, the terms are used to indicate the comparative level of
investment in current assets on an inter-company basis. One company has
a more aggressive approach compared to another company if it has a
lower level of investment in current assets, and vice versa for a
conservative approach to working capital investment policy. In working
capital financing policy, the terms are used to indicate the way in which
fluctuating current assets and permanent current assets are matched to
short-term and long-term finance sources.
An aggressive financing policy means that fluctuating current assets and a
portion of permanent current assets are financed from a short-term
finance source. A conservative financing policy means that permanent
current assets and a portion of fluctuating current assets are financed
from a long-term source. An aggressive financing policy will be more
profitable than a conservative financing policy because short-term
finance is cheaper than long-term finance, as indicated for debt finance by
the normal yield curve (term structure of interest rates). However, an
aggressive financing policy will be riskier than a conservative financing
policy because short-term finance is riskier than long-term finance. For
example, an overdraft is repayable on demand, while a short-term loan
may be renewed on less favourable terms than an existing loan. Provided
interest payments are made, however, long-term debt will not lead to any
pressure on a company and equity finance is permanent capital.
Overall, therefore, it can be said that while working capital investment
policy and working capital financing policy use similar terminology, the
two policies are very different in terms of their meaning and application.
It is even possible, for example, for a company to have a conservative
working capital investment policy while following an aggressive working
capital financing policy.

Explain the following risks and explain how each of these risks can be
managed.

Nature and assessment of business risk
Business risk arises due to the nature of a companys business operations,
which determines the business sector into which it is classified, and to the
way in which a company conducts its business operations. Business risk is the
variability in shareholder returns that arises as a result of business operations. It
can therefore be related to the way in which profit before interest and tax (PBIT
or operating profit) changes as revenue or turnover changes. This can be
assessed from a shareholder perspective by calculating operational gearing,
which essentially looks at the relative proportions of fixed operating costs to
variable operating costs. One measure of operational gearing that can be used is
(100 x contribution/PBIT), although other measures are also used.
Nature and assessment of financial risk
Financial risk arises due to the use of debt as a source of finance, and hence is
related to the capital structure of a company. Financial risk is the variability in
shareholder returns that arises due to the need to pay interest on debt.
Financial risk can be assessed from a shareholder perspective in two ways.
Firstly, balance sheet gearing can be calculated. There are a number of gearing
measures that can be used, such as the debt/equity ratio, the debt ratio and
financial gearing, and the calculation can be based on either market values or
book values. Secondly, the interest coverage ratio can be calculated.
Nature and assessment of systematic risk
From a shareholder perspective, systematic risk is the sum of business risk and
financial risk. Systematic risk is the risk that remains after a shareholder has
diversified investments in a portfolio, so that the risk specific to individual
companies has been diversified away and the shareholder is faced with risk
relating to the market as a whole. Market risk and undiversifiable risk are
therefore other names for systematic risk.
From a shareholder perspective, the systematic risk of a company can be
assessed by the equity beta of the company. If the company has debt in its
capital structure, the systematic risk reflected by the equity beta will include
both business risk and financial risk. If a company is financed entirely by equity,
the systematic risk reflected by the equity beta will be business risk alone, in
which case the equity beta will be the same as the asset beta.

Explain the meaning of the term cash operating cycle and discuss the
relationship between the cash operatin cycle and the level of investment in
working capital. Your answer should include a discussion of relevant working
capital policy and the nature of business operations.

The cash operating cycle is the average length of time between paying trade
payables and receiving cash from trade receivables. It is the sum of the average
inventory holding period, the average production period and the average trade
receivables credit period, less the average trade payables credit period. Using
working capital ratios, the cash operating cycle is the sum of the inventory
turnover period and the accounts receivable days, less the accounts payable
days.
The relationship between the cash operating cycle and the level of investment in
working capital is that an increase in the length of the cash operating cycle will
increase the level of investment in working capital. The length of the cash
operating cycle depends on working capital policy in relation to the level of
investment in working capital, and on the nature of the business operations of a
company.
Working capital policy
Companies with the same business operations may have different levels of
investment in working capital as a result of adopting different working capital
policies. An aggressive policy uses lower levels of inventory and trade
receivables than a conservative policy, and so will lead to a shorter cash
operating cycle. A conservative policy on the level of investment in working
capital, in contrast, with higher levels of inventory and trade receivables, will
lead to a longer cash operating cycle. The higher cost of the longer cash operating
cycle will lead to a decrease in profitability while also decreasing risk, for
example the risk of running out of inventory.
Nature of business operations
Companies with different business operations will have different cash operating
cycles. There may be little need for inventory, for example, in a company
supplying business services, while a company selling consumer goods may have
very high levels of inventory. Some companies may operate primarily with cash
sales, especially if they sell direct to the consumer, while other companies may
have substantial levels of trade receivables as a result of offering trade credit to
other companies.

Discuss the circumstances under which the weighted average cost of capital
(WACC) can be used as a discount rate in investment appraisal. Briefly indicate
alternative approaches that could be adopted when using the WACC is not
appropriate.

The weighted average cost of capital (WACC) is the average return required by
current providers of finance. The WACC therefore reflects the current risk of a
companys business operations (business risk) and way in which the company is
currently financed (financial risk). When the WACC is used as discount rate to
appraise an investment project, an assumption is being made that the projects
business risk and financial risk are the same as those currently faced by the
investing company. If this is not the case, a marginal cost of capital or a project-
specific discount rate must be used to assess the acceptability of an investment
project.

The business risk of an investment project will be the same as current business
operations if the project is an extension of existing business operations, and if it
is small in comparison with current business operations. If this is the case,
existing providers of finance will not change their current required rates of
return. If these conditions are not met, a project-specific discount rate should be
calculated, for example by using the capital asset pricing model.
The financial risk of an investment project will be the same as the financial risk
currently faced by a company if debt and equity are raised in the same
proportions as currently used, thus preserving the existing capital structure. If
this is the case, the current WACC can be used to appraise a new investment
project. It may still be appropriate to use the current WACC as a discount rate
even when the incremental finance raised does not preserve the existing capital
structure, providing that the existing capital structure is preserved on an average
basis over time via subsequent finance-raising decisions.
Where the capital structure is changed by finance raised for an investment
project, it may be appropriate to use the marginal cost of capital rather than the
WACC.

Hedging against exchange risksHow to do so.

Boluje receives peso income from its export sales and makes annual peso-
denominated interest payments to bond-holders. It could consider opening a
peso account in the overseas country and using this as a natural hedge against
peso exchange rate risk.
Boluje Co could consider using lead payments to settle foreign currency
liabilities. This would not be beneficial as far as peso- denominated liabilities are
concerned, as the peso is depreciating against the dollar. It is inadvisable to lag
payments to foreign suppliers, since this would breach sales agreements and
lead to loss of goodwill.
Foreign currency derivatives available to Boluje Co could include currency
futures, currency options and currency swaps.
Currency futures are standardised contracts for the purchase or sale of a
specified quantity of a foreign currency. These contracts are settled on a
quarterly cycle, but a futures position can be closed out any time by undertaking
the opposite transaction to the one that opened the futures position. Currency
futures provide a hedge that theoretically eliminates both upside and downside
risk by effectively locking the holder into a given exchange rate, since any gains
in the currency futures market are offset by exchange rate losses in the cash
market, and vice versa. In practice however, movements in the two markets are
not perfectly correlated and basis risk exists if maturities are not perfectly
matched. Imperfect hedges can also arise if the standardised size of currency
futures does not match the exchange rate exposure of the hedging company.
Initial margin must be provided when a currency futures position is opened and
variation margin may also be subsequently required. Boluje Co could use
currency futures to hedge both its regular foreign currency receipts and its
annual interest payment.
Currency options give holders the right, but not the obligation, to buy or sell
foreign currency. Over-the-counter (OTC) currency options are tailored to
individual client needs, while exchange-traded currency options are
standardised in the same way as currency futures in terms of exchange rate,
amount of currency, exercise date and settlement cycle. An advantage of
currency options over currency futures is that currency options do not need to
be exercised if it is disadvantageous for the holder to do so. Holders of currency
options can take advantage of favourable exchange rate movements in the cash
market and allow their options to lapse. The initial fee paid for the options will
still have been incurred, however.
Currency swaps are appropriate for hedging exchange rate risk over a longer
period of time than currency futures or currency options. A currency swap is an
interest rate swap where the debt positions of the counterparties and the
associated interest payments are in different currencies. A currency swap begins
with an exchange of principal, although this may be a notional exchange rather
than a physical exchange. During the life of the swap agreement, the
counterparties undertake to service each others foreign currency interest
payments. At the end of the swap, the initial exchange of principal is reversed.