foreign exchange: what is it, and why does it matter?
TRANSCRIPT
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
www.blueskyconsultingservices.com
Francia Harris
Partner O. 312.757.6459M. [email protected]
www.bbgfx.com
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