1. FX Concepts

2. Foreign Exchange (FX)
Conversion of one currency into another eg EUR into USD

3. BUT this definition is in a mathematic formula context!
What is FX/FOREX?
Conversion of one currency into another eg EUR into USD
BUT this definition is in a mathematic formula context! A$
A$ worth in terms of GBP
A$ worth in terms of a basket of currencies
Video -
BUT Why convert?
A currency, say AUD, is measured in another currency or basket of currencies to understand what is its worth (value) according to factors of supply and demand for that currency (AUD)

4. What determines a currency’s FX rate?
A currency, say AUD, is measured in another currency or basket of currencies to understand what is its worth (value) according to factors of supply and demand for that currency (AUD)
Influences of FX Rates:
Differences of inflation rates in countries
Differences of interest rates in countries
Different current-account deficits of countries
Different public deficits in countries
Different balance of payments between countries
Different political stability and economic performance in countries
(Source:

5. FX Markets in Different Cities Across the World
Treasury-staff
Funds Mgt staff
Risk Managers
Brokers
International Companies
FX Trading
Video - ;
Corporate Finance-staff
Funds Mgt staff
Treasury-staff
Dealers/Traders
Funds Managers
What is Forex? (1.53m)

6. Functions of FX Markets
Transaction Purposes
Currency conversion
Currency hedging (conversion value risk reduction)
Currency arbitrage (profit taking without conversion losses)
Currency speculation (speculative profit taking)
Currency Buyers
Currency Sellers

7. NOW- Contract Agreement4
Buyer is worried of worst case
What is a FX Hedge? 3
Buyer has to pay in AUD in the future. If there is no FX hedge (insurance), buyer could be:
Paying more if JPY/AUD rate decreases (AUD is worth more)
Paying less if JPY/AUD rate increases (AUD is worth less) 1
Transact
Deal
AUD
JPY
Can result in loss
Also see for more examples 2
NOW- Contract Agreement
Settlement date in the future
5(b)
Agree to lock in a fixed FX rate
5 (a)
Buyer purchases a hedge contract against an unfavourable JPY/AUD movement on settlement date

8. FX Hedging Process
Examples of the different types of hedging strategies:
Forward exchange contract for currencies
Currency future contracts
Money Market Operations for currencies
Forward Exchange Contract for interest
Money Market Operations for interest
Future contracts for interest
Derivatives eg risk reversal, delta neutral instruments – What are Derivatives? (4.18 m)
Sources: ; ;

9. History of Gold Standard
WW1 ( )
WW2 ( )
1870s
Currencies valued against gold
Governments started printing $
Inflation & collapse of gold standard when people used gold as a commodity for transactions
Gold standard ended at first of WW2
Gold was a powerful tool for achieving balance of trade equilibrium between countries  evolution of international monetary policy development

10. International Monetary Funds (IMF)
188 countries working together to:
foster global monetary cooperation,
secure financial stability,
facilitate international trade,
promote high employment and sustainable economic growth,
reduce poverty around the world
(Source:
Also lend $ to countries (governments) subject to resolve in:
Implementing governmental reforms to stabilize monetary policy and
Fostering economic growth eg encourage FDI in developing countries

11. Fixed & Floating FX Rate Regimes
FIXED FX Rate
A currency’s FX is pegged to another
Aims to:
Ensure governments do not expand $upply at inflationary rates
Increases certainty in terms of uncertainty
Negative:
No clear correlation between FX rate and trade balance
Watch video - to better understand

12. Fixed & Floating FX Rate Regimes
A currency’s FX is pegged to another
Aims to:
Give monetary policy autonomy to countries
Automatic trade balance adjustments
Negative:
Trade deficit  depreciation of a currency  currency is worth less
Trade surplus  currency appreciates  worth more
Obama: China currency undervalued (13 Apr 2010) – 1.51 m
China to re-engage the managed floating exchange rate (19 Jun 2010) m

13. Caterpillar Case The world’s leading manufacturer of:
Construction & mining equipment,
diesel & natural gas engines,
industrial turbines &
diesel-electric locomotives.
Is also a leading financial services provider via Caterpillar Financial Services.
International business
Manufacturing & Financial Services

14. Caterpillar Case
Usually payable in another currency
Business Transactions in
multiple currencies
Contract Transaction GBP ….
Contract Transaction USD ….
Contract Transaction JPY ….
Transaction exposure = payment currency value (+ worth changes) when FX rates move

15. Caterpillar Case General Ledger
Usually payable in another currency
Business Transactions in
multiple currencies
Contract Transaction GBP ….
Contract Transaction USD ….
Contract Transaction JPY ….
Translation exposure = General Ledger’s book values of foreign currencies’ payments & receivables converted to the currency used in a firm’s financial statement reporting at corporate and other international branch levels
General Ledger

16. Caterpillar Case
In the 1980s a stronger dollar hurt Caterpillar’s competitive position, but in 2008, a stronger dollar did not seem to have the same effect
How did Caterpillar use strategy as a “real hedge” to reduce its exposure to FX risk? What is the downside of this approach?
Explain the difference between transaction exposure and translation exposure using material in the Caterpillar Tractor case to illustrate your answer.