The Foreign Exchange Market
Exchange Rate QuotationsForecasting Foreign Exchange RatesForeign Exchange Risk ExposureManaging Foreign Exchange Risk
Exchange Rate Quotations
Direct QuoteQuote is a home currency price for a unit of
foreign currency. For example, $0.989986/€ is a direct quote of about $0.99 for one Euro in the United States. The base currency is the foreign currency.
Indirect QuoteQuote is a foreign currency price for a unit of
home currency. For example, ¥122.481/$ is an indirect quote of 122.481 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 (Xh) to foreign currency (Xf) the following rules apply:
Direct Rate (Eh) Indirect Rate (Ef)
Xh Xf(Eh) Xf / Ef
Xf Xh / Eh 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 EnglandOn an indirect basis in the US (except £)On a direct basis throughout the rest of the
worldStandardization avoids complications
Exchange Rate Quotations
Rates are quoted in various forms Outright rates
Rates are quoted in full terms, including currency signs, such as: ¥122.481/$
Short form rates Generally used by banks and FX dealers Outright rates are not used in the market Example: 122.481
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 (£)
Bid Offer
EUR (€) 1.5765 1.5790
GBP
EUR 1.5765 - 90
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
EUR Bid Offer
Spot rate: 1.5765 1.5790
3-month forward rate: 1.5195 1.5240
Deviation: 0.0570 0.0550
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:
EUR GBP
Spot: 1.5765 - 90
3-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
EUR Bid Offer
Spot rate: 1.5765 1.5790
Deviation: -.0570 -.0550
Outright forward rate: 1.5195 1.5240
Forward Rates
Base currency is at a discount:Bid points are greater than offer pointsSubtract forward points from spot rateForward rate = spot rate – forward points
Base currency is at a premium:Bid points are less than offer pointsAdd forward points to the spot rateForward rate = spot rate + forward points
Forward Rates
Determine the bid and offer rates from the quotes for the following currencies:
Spot 1-month forward
FF / $ 9.7550 - 850 90 / 105
$ / £ 1.7315 - 50 175 / 195
Rin / $ 2.6035 - 140 59 / 52
Forward Rates
To calculate forward premium or discount in percent per annum the following abbreviations are used:
Indirect DirectOutright spot rate Ef Eh
Outright forward rate for n period Ffn Fh
n
Forward premium or discount in % per annum
Ffn,% Fh
n,%
Forward Rates
Given E and F, the forward premium or discount in percent per annum (Fn,%) is calculated as follows:
Direct basis:Fh
n,% = [(Fh – Eh) / Eh] x 12 / n x 100 = + or - %
Indirect basis:Ff
n,% = [(Ff – Ef) / Ef] x 12 / n x 100 = + or - %
Forward Rates
Given E and Fn,%, the outright forward rate (Fn) is calculated as follows:
Direct basis:Fh
n = Eh(1 + Ffn,%) x n / 12
Indirect basis:Ff
n = Ef / [1 + (Ffn,% x n / 12)]
Forecasting the Exchange Rate
Environmental factors influencing the exchange rate:
Demand and supply of goods and services
Rate of inflationInterest 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 tradingEconomies of countries are free-marketNo import/export duties or taxesExchange rate is floatingNo 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 Ef = Ef x [1 + (If - Ih)]
Expected Eh = Eh x [1 + (Ih - If)]
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:
(E1 – E2) / E2 x 100 = Ix – Iy
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 / £
US UKExpected 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 currencyMeasuring currencyFunctional currencyReporting 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 assetsForeign liabilitiesValue of foreign equityOn-going transactions and contractsExpected cash flows in foreign currenciesForeign 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 exposureTranslation exposureOperating exposureTax 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
Assets Liabilities and Equity
Cash £ 4,000 AP £ 8,000
AR 12,000 Accrued expenses 3,000
Inventory 14,000 Net Working Capital 19,000
£ 30,000 £ 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
Current Temporal
Monetary Assets & Liabilities
Current Rate Current Rate
Non-monetary Assets & Liabilities
Current Rate Historic Rate
Monetary Income & Expenses
Rate in EffectWeighted Average
Other Income & Expenses
Rate in Effect Rate in Effect
Equity Historic Rate Historic Rate
Dividends Rate in Effect Rate in Effect
Managing Risk Exposure
Short-term Optimize operating cash flowsHedge translation and transaction
exposuresLong-term
Maximize net present value and the overall value of the firm
Diversify operating and tax exposures internationally
Managing Risk Exposure
Forward market hedgingMoney market hedgingOption hedgingFutures hedgingBalance sheet hedgingLeading and LaggingSwapsDiversification