foreign exchange: what is it, and why does it matter?

Doris Nagel

Blue Sky Consulting Services

+1 847 984 2816

www.blueskyconsultingservices.com

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• Franica Harris, Partner, Bannockburn Global Forex

– Market leader in currency exchange

– Dealing in all foreign currencies

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• What is foreign exchange, and how does it arise?

• Who sets FX rates?

• What are some common tools for managing FX?

• Common mistakes companies make in dealing with FX

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• Also called Forex or FX

• Simply the conversion of one country’s currency into another country’s currency

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• Person or company from one country:

– Earns money in one country, but buys something in another country

– Earns money in one country, but also earns money in another country

– Needs to consolidate holdings held in another country (for financial reporting or tax returns, e.g.)

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• U.S. Manufacturer exports products to Europe– Products priced in euros

– Customer pays manufacturer in euros

– Manufacturer needs to convert euros to USD$ to calculate profit

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• Varies depending on whether exchange rates fixed or floating– Fixed: (example: China)

• Government committed to buy/sell currency at a fixed rate

– Floating: most countries (examples: U.S., Canada, Japan)• Set by supply & demand

• Still is often manipulated by countries

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• Supply and demand

• What or who is this market?

– LOTS of participants

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Examples

Pension funds Hedge funds

Private banks Non-bank financial institutions

Central banks Currency trading firms

Corporations Individuals

• Government-controlled entity responsible for overseeing a country’s monetary system

• In U.S.: the Federal Reserve System (FRS)

• All countries have at least one central bank

• Essential tool for managing inflation, money supply, export pricing, etc.

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• Direct Method

– In U.S., quoted with the US$ vis-a vis the Euro, Australian$, New Zealand$, and British £

• Indirect Method

– All other currencies quoted this way

– i.e., foreign currency per US$

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• Floating vs. Pegged Currencies

• Fixed (China, e.g.) – exchange rate set by government

• Floating (most countries) – exchange rates set by supply & demand

• Even with floating FX, central banks manipulate exchange rates

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• Every second of the day

• Market closes on Friday in New York

• Opens in New Zealand on Monday

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• Most people do not realize the size of the market

• US$ 5 TRILLION traded DAILY

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• There is NONE• It is a pure “over the counter” (OTC) market• Buyer beware!• Largest UNREGULATED financial market in the

world• This is NOT like a stock – when a bank executes a

trade, the bank does NOT reveal how much it takes from the exchange

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• LIBOR = London Interbank Offer Rate • Bank borrowing rate among the largest London banks

• Used as common borrowing reference rate around the world

• Banks found to be manipulating rates to skim more profit from trades

• LIBOR supposed to be a collective measure of bank confidence; instead, a pattern of collusion and fraud among banks

• At stake: trillions of dollars

• Demonstrates risks of unregulated currency markets

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• Everything & anything!

– Economic reports & indicators (e.g. jobless rate)

• Can swing if better than expected

• Can swing if worse than expected

– Central bank policies

– M & A transactions

– Anything that catches market off-guard

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U.S. Federal Reserve Board in 2013

• FRB was buying a lot of bonds (“Quantatitive Easing Program”) as a way to stimulate economy and pump $ into the US economy

• FRB hinted mid-2013 it was ending this & would begin to “taper” this bond purchasing

• FRB announced on 2014 that it would NOT taper or end this program

• Market assumed this meant U.S. economy was in trouble• US$/euro exchange rate before announcement: 1 euro = 1.32 USD• After the announcement: 1 euro = 1.35 USD• This was a HUGE 1-day swing

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• Public perception as stable FX• But actually quite unstable • Stability of FX rates aren’t always an

indicator of how stable a government is

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• US $ vs. Brazilian real in early 2000s– FX rates fluctuating wildly– Inflation as high as 3000%– Payment in cash demanded

• US $ vs. Iraqi dinar– From FX perspective, it is “worthless”– Means it has lost significant value

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• Exchange rate devaluation coincides closely with inflationary pressure

• High inflation means large currency fluctuations

• Currency becomes more difficult to accurately predict, and exchange rates become more unfavorable

• Can also be affected by interest rates, government debt, etc.

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• Are significant even on “purely” domestic operations– Iraqi earns salary in dinari, pays rent and food in dinari

• But… – Any imported goods because much more expensive to buy or use in

local manufacturing process

– End result is that it becomes extremely expensive to produce and imports become unattractive

– May mean that purely domestic Iraqi goods are effectively cheaper/more attractive

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Japan: * long-term manipulation of ¥* Pumping money into economy to make Japanese goods less expensive to foreign buyers

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There are tools to manage FX

Can make FX rates more predictable

Allow companies to plan

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Common tools to manage FX: Spot transactionsForward contracts (90% of companies use this)

Outright forwardForward window

SwapsOptions

Let’s look at each of these in more detail.

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Spot Transaction:

Immediate delivery of a currency at the current market exchange rate

Average settlement takes 2 business days

i.e., You lock in a rate & your supplier receives the funds at that exchange rate in 2 days

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Forward Contract: Several types

Most common (90% of companies use these)

Most common types:

Outright forward: Allows a company to lock in a rate on a specific date

Window forward: Allows a company to lock in a rate or over a range of dates

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Outright forward:Use when you know the exact date you need to pay someone in a foreign currency, or that you’ll be receiving foreign currency

Example: You are a U.S. company and you are acquiring a Canadian company. You know the close date is December 31st, and you will need a specific amount of Canadian $ to purchase this company

This removes any exchange uncertainty out of the amount of Canadian $ you will need to do the transaction.

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Forward window:Use when you know the you will need to pay a foreign currency or be receiving a foreign currency during a range of dates (a “window” of time)Example: You are a U.S. company and you are selling products into Canada, and receiving monthly payments from customers in Canadian $.

A forward window will provide much less volatility than a spot rate.

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Forward window:Use when you know the you will need to pay a foreign currency or be receiving a foreign currency during a range of dates (a “window” of time)Example: You are a U.S. company and you are selling products into Canada, and receiving monthly payments from customers in Canadian $. A forward window will provide much less volatility than a spot rate.

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Currency Swap:

Simultaneous buying and selling a fixed amount of the same currency on 2 different dates

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Currency Option:

Gives you the right, but not the obligation, to buy a foreign currency on a specific day or range of days at a pre-determined rate

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FX Order:

You can order to buy a specific foreign currency at a specifically-agree exchange rate

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• Virtually ANY company who buys or sells products or services from another country

• Forward contracts very simple– Spot rate +/- “forward points”

– Derived from the interest rate differential between the 2 countries involved

– Rates tend to be fairly predictable

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• Supply & distribution contracts

– Often multi-year agreements

– Exchange rates will vary over that time

– Deal may not be as good for 1 company as originally envisioned

– Before you sign, do a 3-year look-back

– Mark up that risk into the contract

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• Companies making acquisitions– Even small FX shifts can kill a deal

– Termination payments

• Companies sourcing from overseas

• Companies exporting products or services

• FX should always be part of the planning process

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• There is ALWAYS FX when dealing with 2 currencies

• Refusing to address exchange rate volatility is not realistic – you are just pushing all of it onto your business partner

• Are you an attractive partner if you continually do this?

• FX is a REAL cost of business, just like transportation

• How many sales are you losing to competitors?

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• Global competition increasing

• You can still sell in US$, but accept foreign payables

• You can also be billed in both currencies

– There can be significant advantages to do this

– The rate your supplier/distributor is quoted may be VERY different, so you can take advantage of that

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• YES!– Depends on your bank expertise

– Depends on currencies involved

• BUT…– Be sure your bank has direct experience

– Make sure they truly have this capability & aren’t just using “middleman” or ignoring the issues because they don’t have the expertise

– Is transparent

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• Companies SHOULD:

– Consider pricing in foreign currency

– Understand competitive advantage/disadvantage

– Hedge at least part of their exchange risks

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• Financial Times

• Bloomberg (app)

• Wall Street Journal

• Get an FX forensic study/audit (often free)

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• Analysis of past trades

• Look back at high/low

• If the rate you paid is outside the range, you’ve paid too much!

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Doris Nagel

Principal

Blue Sky Consulting Services

+1 847 984 2816

doris.nagel@blueskyconsultingservices.com

www.blueskyconsultingservices.com

Francia Harris

Partner O. 312.757.6459M. 513.748.1690Francia.Harris@bbgfx.com

www.bbgfx.com

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