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Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All.

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Presentation on theme: "Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All."— Presentation transcript:

1 Chapter Nine Foreign Currency Transactions and Hedging Foreign Exchange Risk McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2 Exchange Rate Mechanisms Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. Since 1973, exchange rates have been allowed to fluctuate. Several valuation models exist. Prior to 1973, currency values were generally fixed. The US $ was based on the Gold Standard. Since 1973, exchange rates have been allowed to fluctuate. Several valuation models exist. 9-2

3 Different Currency Mechanisms Independent Float (the currency is allowed to fluctuate according to market forces) Pegged to another currency (the currency’s value is fixed in terms of a particular foreign currency, and the central bank will intervene to maintain the fixed value) European Monetary System – A common currency (the euro) is used in different countries. Its value floats against other world currencies. 9-3

4 Foreign Exchange Markets Countries use currencies for internal economic transactions. To make transactions in another country, units of that country’s currency may need to be acquired. The price at which a currency can be acquired is known as the “exchange rate.” Countries use currencies for internal economic transactions. To make transactions in another country, units of that country’s currency may need to be acquired. The price at which a currency can be acquired is known as the “exchange rate.” 9-4

5 Foreign Exchange Rates Exchange rates are published daily in the Wall Street Journal.  These are “end-of-day” rates, as of 4:00pm Eastern time on the day prior to publication Remember – Rates change constantly The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” Exchange rates are published daily in the Wall Street Journal.  These are “end-of-day” rates, as of 4:00pm Eastern time on the day prior to publication Remember – Rates change constantly The difference between the rates at which a bank is willing to buy and sell currency is known as the “spread.” 9-5

6 Foreign Exchange Rates As the relative strength of a country’s economy changes...... the exchange rate of the local currency relative to other currencies also fluctuates. ?¥ = $? 9-6

7 Foreign Exchange Rates Spot Rate The exchange rate that is available today. Forward Rate The exchange rate that can be locked in today for an expected future exchange transaction. The actual spot rate at the future date may differ from today’s forward rate. Spot Rate The exchange rate that is available today. Forward Rate The exchange rate that can be locked in today for an expected future exchange transaction. The actual spot rate at the future date may differ from today’s forward rate. 9-7

8 This forward contract allows us to purchase 1,000,000 ¥ at a price of $.0080 US in 30 days. But if the spot rate is $.0069 US in 30 days, we still have to pay $.0080 US and we lose $1,100!! Foreign Exchange Forward Contracts A forward contract requires the purchase (or sale) of currency units at a future date at the contracted exchange rate. 9-8

9 An alternative is an option contract to purchase 1,000,000 ¥ at $.0080 US in 30 days. But it costs $.00002 per ¥. That way, if the spot rate is $.0069 in 30 days, we only lose the $20 cost of the option contract! Foreign Exchange Options Contracts An options contract gives the holder the option of buying (or selling) the currency units at a future date at the contracted “strike” price. 9-9

10 Foreign Currency Option Contracts A “put” option allows for the sale of foreign currency by the option holder. A “call” option allows for the purchase of foreign currency by the option holder. (Remember: An option gives the holder “the right but not the obligation” to trade the foreign currency in the future.) 9-10


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