Impact of globalization Convertibility with open or closed borders Fixed rate of exchange Floating rate of exchange Managed rate of exchange Practical means of forecasting foreign exchange rates Introduction
Speculative trading Balance of payments position and trends Inflation rate compared to trading partners Investor confidence in economics, politics and business Intervention in the foreign exchange market Market Drivers
Transaction exposure Translation exposure Economic exposure Measuring Foreign Exchange Exposure
Accounts Payable and Accounts receivable in a foreign currency Wide array Balance sheet hedging Assets: Plant and equipment, market share, investments, etc. Liabilities: Loans, bonds, etc. Acquisition activity Business Needs for Foreign Currency
The Currency Market a Continuous Market
An exchange of one currency for another currency Dollars (USD) for Japanese Yen (JPY) Indirect Quote Currency rate USD = JPY Direct Quote Currency rate JPY = USD FX Trading
Spot - buy now, pay now Forwards - buy now, pay later ( up to 1 year) NDF (non-deliverable forwards) Swaps Options Alternatives Instruments used to offset risk
Purchase or sale of one currency for another Delivery taking place on a specific future date or within a specific window of time Unlike futures traded over-the-counter Any convertible currency Any maturity (typically less than a year) Any amount (typically with a $50,000 min) Forward Contracts
Price is based on: Current spot rate plus or minus a discount or premium for interest rate differentials Example: One year forward sale of Japanese Yen: Spot rate 117 Yen per US$ Interest rate differential 4.70% US interest rates (1 yr.) 4.80% Japanese interest rates (1 yr.) 0.10% 1 Year Forward: (117*4.70%=5.50) = Forward Contracts Example
The right but not the obligation to convert one currency for another on a specific future date. Difference between European and American Style is OTC and Exchange Traded (flexibility) Any convertible currency Any strike price (typically +-5% of spot) Any maturity (typically below 1 year) Amount typically is a large amount Options
Price is based on: current spot price strike price volatility factor The right to buy Japanese Yen at a specific rate one year out in the future. If the Yen weakens a conversion will be made in the open market Options Example
Forward Contract Eliminates up and downside potential Good tool when company has firm commitments in the future Mark-to-market offset against A/R or A/P No initial cost 10% risk assessment Option Eliminates “downside” but leaves “upside” Good tool for company involved in projects with uncertainty “Naked hedge” for commitments not yet recognized on the balance sheet 1-5% premium up front a tough sale Options vs. Forwards
Settlement Participation Technique Datein Price Movement HIGH SpotPresent100% OptionsFuture DateParticipating in certain or positive price RISKmovements with adverse price movements defined ForwardFuture date certainNone LOWWindowPeriod certainNone specific date uncertain Foreign Exchange Spectrum of Choice
The Australian Dollar
The Euro
The Japanese Yen
Japan (interest rates)
China