The Foreign Exchange Market Exchange Rate Quotations Forecasting Foreign Exchange Rates Foreign Exchange Risk Exposure Managing Foreign Exchange Risk

Exchange Rate Quotations Direct Quote Quote is a home currency price for a unit of foreign currency. For example, $ /€ is a direct quote of about $0.99 for one Euro in the United States. The base currency is the foreign currency. Indirect Quote Quote is a foreign currency price for a unit of home currency. For example, ¥ /$ is an indirect quote of Yen for one US dollar. The base currency is the home currency.

Exchange Rate Quotations The direct and indirect rates are just the reciprocal of each other. To convert home currency (X h ) to foreign currency (X f ) the following rules apply: Direct Rate (E h )Indirect Rate (E f ) XhXh Xf(Eh)Xf(Eh) Xf / EfXf / Ef XfXf Xh / EhXh / Eh Xh( Ef)Xh( Ef)

Exchange Rate Quotations Rates may be quoted either directly, or indirectly, as may be suitable The convention is to quote all currencies: On an indirect basis in England On an indirect basis in the US (except £) On a direct basis throughout the rest of the world Standardization avoids complications

Exchange Rate Quotations Rates are quoted in various forms Outright rates Rates are quoted in full terms, including currency signs, such as: ¥ /$ Short form rates Generally used by banks and FX dealers Outright rates are not used in the market Example: Forward premium or discount in either points or percent per annum

Exchange Rate Quotations Bid and Ask Quotes The FX market quotes buying and selling rates for all currencies traded For example: Or in shortest form: GBP (£) BidOffer EUR (€) GBP EUR

Forward Rates Forward rates are often quoted in terms of premium or discount in either points or percentage of premium or discount per annum GBP EURBidOffer Spot rate: month forward rate: Deviation:

Forward Rates In the preceding quotes the deviation of forward rate from spot is.0570 and.0550 for bid and offer, respectively. In practice the bid and offer rates are quoted as: EURGBP Spot: month forward rate:570 / 550

Forward Rates In the previous example the bid points (570) are higher than the offer points (550), indicating the base currency is at a discount. The forward points are subtracted from the spot rates in order to calculate the outright forward rates: GBP EURBidOffer Spot rate: Deviation: Outright forward rate:

Forward Rates Base currency is at a discount: Bid points are greater than offer points Subtract forward points from spot rate Forward rate = spot rate – forward points Base currency is at a premium: Bid points are less than offer points Add forward points to the spot rate Forward rate = spot rate + forward points

Forward Rates Determine the bid and offer rates from the quotes for the following currencies: Spot1-month forward FF / $ / 105 $ / £ / 195 Rin / $ / 52

Forward Rates To calculate forward premium or discount in percent per annum the following abbreviations are used: IndirectDirect Outright spot rate EfEf EhEh Outright forward rate for n period FfnFfn FhnFhn Forward premium or discount in % per annum Ffn,%Ffn,% Fhn,%Fhn,%

Forward Rates Given E and F, the forward premium or discount in percent per annum (F n, % ) is calculated as follows: Direct basis: F h n, % = [(F h – E h ) / E h ] x 12 / n x 100 = + or - % Indirect basis: F f n, % = [(F f – E f ) / E f ] x 12 / n x 100 = + or - %

Forward Rates Given E and F n, %, the outright forward rate (F n ) is calculated as follows: Direct basis: F h n = E h (1 + F f n, % ) x n / 12 Indirect basis: F f n = E f / [1 + (F f n, % x n / 12)]

Forecasting the Exchange Rate Environmental factors influencing the exchange rate: Demand and supply of goods and services Rate of inflation Interest rate

Forecasting the Exchange Rate Demand and Supply of Goods and Services Rate of Inflation Interest Rate Change in Imports, Exports and Investment Change in Demand and Supply of Currency Change in Exchange Rate

Forecasting the Exchange Rate Several economic theories explain the relationship among inflation and interest rate, inflation and exchange rate and interest rate and exchange rate: The Purchasing Power Parity Theory The Fisher Effect The International Fisher Effect The Interest Rate Parity Theory The Forward Rate as an Unbiased Predictor of the Future Spot Rate

Purchasing Power Parity Theory Assumes that: No restriction in cross-border trading Economies of countries are free-market No import/export duties or taxes Exchange rate is floating No transaction costs

Purchasing Power Parity Theory Establishes a direct relationship between the spot rate and inflation The differential inflation rate between two countries is the inverse of the difference in the value of the currencies Therefore: Expected E f = E f x [1 + (I f - I h )] Expected E h = E h x [1 + (I h - I f )]

Purchasing Power Parity Theory There are several problems associated with the theory: The underlying concept of the one-price world is based on a fluctuating wholesale price index It is difficult to construct a comparative basket of goods in different countries It is difficult to measure the impact of price and income elasticity of demand for imports and exports on the price level in different countries Ignores tariffs on imports and governmental interference Does not account for transaction costs

Fisher Effect States that the nominal interest rate (k) is equal to the real interest rate (rr) plus the rate of inflation (I), or: k = [(1 + rr)(1 + I)] - 1 Since the real rate is more or less constant it suggests that the interest rate is purely a function of inflation Hence, an increase in the differential inflation rate in a country will lead to a proportionate increase in the differential interest rate Empirical evidence tends to validate the theory

International Fisher Effect States that a change in the differential interest rates in two countries (x and y) causes an inverse change in the expected spot exchange rates: (E 1 – E 2 ) / E 2 x 100 = I x – I y Although it seems to bear out in the long run empirical evidence does not support the theory in the short term

Interest Rate Parity Theory Based on the law of one rate of return on investments worldwide States that a difference in the interest rates on the securities of similar risk and maturity in two countries should be equal to the forward exchange discount on the currency with the higher interest rate and a premium on the currency with the lower interest rate

Forward Rate As an Unbiased Predictor of Future Spot Rates Under efficient market conditions the future spot rate is expected to positively correlate with forward rates Assuming that the other theories hold true the forward rate can be considered as an unbiased predictor of the future spot rate

Forecasting the Exchange Rate The money and foreign exchange markets in New York show the following rates: Spot rate: $1.50 / £ 1-year forward rate: $1.35 / £ USUK Expected rate of inflation: 7%12% Interest rate on 1-year notes: 10%?

Forecasting the Exchange Rate 1. Calculate the theoretically expected interest rate on 1-year notes in England 2. Calculate the forward discount or premium on pounds in percentage per annum 3. What is the equilibrium forward rate based on the international market model?

Exchange Risk Exposure Refers to the exposure of foreign based assets, liabilities and foreign currency cash flows to potential effects of changes in foreign exchange rates. To minimize losses due to future uncertainty prudent managers must learn to recognize, measure and manage such foreign exchange risk exposure.

Exchange Risk Exposure International business transactions are settled either in terms of home currency or foreign currency. Therefore, it is necessary to distinguish the following: Denominating currency Measuring currency Functional currency Reporting currency

Exchange Risk Exposure Denominating currency -the currency in which the terms and conditions of transactions are expressed without accounting for the effects of changes in rates.

Exchange Risk Exposure Measuring currency -the currency in which the financial outcomes from transactions are measured at the exchange rate that is in effect at the time the payments are made for transactions.

Exchange Risk Exposure Functional currency -the currency in which the operating cash flows are generated, and assets and liabilities are denominated disregarding the effects of changes in foreign exchange rates.

Exchange Risk Exposure Reporting currency -is normally the home currency. Firms normally prepare periodical financial statements in home currency by translating the functional currency of subsidiaries into home currency which is reporting currency in most of the cases.

Exchange Risk Exposure The reporting currency of foreign based subsidiaries is generally the home currency, and for most of them the denominating and functional currencies are foreign currencies. Since multinational firms are required to translate functional currencies into reporting currency for financial statements changes in exchange rates could affect the value in reporting currency.

Exchange Risk Exposure In particular, the following aspects of multinational business are exposed to the changes in exchange rates: Foreign based assets Foreign liabilities Value of foreign equity On-going transactions and contracts Expected cash flows in foreign currencies Foreign tax liabilities

Exchange Risk Exposure Based on the nature of foreign transactions each type of foreign exchange exposure can be classified as one of: Transaction exposure Translation exposure Operating exposure Tax exposure

Exchange Risk Exposure On March 15, a US firm sold goods worth $120,000 to a Manchester firm on 30 day credit. The bill is payable in Sterling Pounds at the current spot rate of $1.85. Is either party, or both, exposed to foreign exchange risk? What type of exposure is it? What is the size of the exposure? On April 10, just before the payment due date, the spot rate of the Pound was $1.78. Who is gaining and who is losing from this rate change?

Exchange Risk Exposure Consider the following statement for a US subsidiary in London: Net Working Capital As of December 31, 200x AssetsLiabilities and Equity Cash£ 4,000AP£ 8,000 AR12,000Accrued expenses3,000 Inventory14,000Net Working Capital19,000 £ 30,000

Exchange Risk Exposure Also note that: Exchange rate (Jan 1, 200x):$2.00 / £ Exchange rate (Dec 31, 200x):$1.50 / £ 1. What type of exposure does the firm have? 2. For the parent firm what is the net effect to working capital caused by the change in foreign exchange rates?

Currency Translation- Balance Sheet CurrentTemporal Monetary Assets & Liabilities Current Rate Non-monetary Assets & Liabilities Current RateHistoric Rate Monetary Income & Expenses Rate in Effect Weighted Average Other Income & Expenses Rate in Effect EquityHistoric Rate DividendsRate in Effect

Managing Risk Exposure Short-term Optimize operating cash flows Hedge translation and transaction exposures Long-term Maximize net present value and the overall value of the firm Diversify operating and tax exposures internationally

Managing Risk Exposure Forward market hedging Money market hedging Option hedging Futures hedging Balance sheet hedging Leading and Lagging Swaps Diversification