Chapter 13 - Foreign Exchange Risk

models to help explain the causes of exchange rate fluctuations

- Purchasing Power Parity Theory - Interest Rate Parity Theory - International Fischer Effect - Expectations Theory

money market hedge

- alternative to a forward contract hedge, achieving similar result - money market exchange rates derived from interest rates - more complex to set up than a forward - hedges against transaction risk

foreign exchange market

- an international market in national currencies - highly competitive - virtually no differences between the prices in one market (NY stock exchange) and another (London stock exchange)

futures contract

- buyer/seller is required to deposit a sum of money with the exchange (initial margin) - if losses are incurred as a result of interest rate changes, the buyer/seller may be required to deposit further funds with the exchange (variation margin) - profits are credited to the margin a/c on a daily basis as the contract is 'marked to market' - most futures contracts are closed out before settlement date - works kind of like a bet on how the exchange rate will perform => bet that the exchange rate will depreciate: losses made from depreciated currency is offset against the futures contract

expectations theory

- claims that the current forward rate is an unbiased predictor of the spot rate at that point in the future - if trader believes that the current forward rate is < expected spot rate, buys forward which raises price until forward = market view of the expected spot rate - poor and unbiased predictor, sometimes wide of the mark on one side or the other

purchasing power parity theory (PPPT)

- claims that the rate of exchange between 2 currencies depends on the relative inflation rates between the 2 - based on 'the law of one price': equal goods must cost the same regardless of the currency - if inflation rates can be predicted so can mvmt in exchange rates - predicts that the country with the higher inflation rate will be subject to a depreciation of its currency - can be best predictor of future spot rates

matching receipts and payments as a method of combating foreign currency risk

- company matches receipts and payments in same foreign currency and any differences are dealt with on the foreign exchange market - Example: ABC a UK based company has the following transactions with the US ion 3 months: 1. Receives $16 million from a US customer 2. Pays $10 million to a US supplier 3. Unmatched exposure of $6 million is hedged by other methods on the foreign exchange market

matching assets and liabilities as a method of combating foreign currency risk

- company that expects a large amount of income in a foreign currency may want to hedge against the risk of this currency weakening by taking out a loan in the foreign currency now and repaying with customer receipts - similarly a company with a foreign subsidiary will want to hedge against this same risk by matching its foreign assets against a long-term loan in the foreign currency

similarities between a futures contract and a forward contract

- company's position is fixed by the rate of exchange in the futures contract - is a binding contract

disadvantages of using a forward exchange contract

- contractual commitment which must be completed at the due date - problems arise if payment from the overseas customer is late, as the company receiving the cash will have to settle the current forward exchange contract => bank will arrange a new forward exchange contract for a new date when the cash flow is due however - option date forward exchange contract can be arranged - eliminates any downside risk of potential adverse movement in spot rate but also any upside in favourable movement => despite what happens, the contract must be honoured

fixed exchange rate against a single currency

- country fixes its exchange rate against the currency of another country - more than 50 countries do this, mostly against USD - fixed rates are not permanently fixed - periodic revaluations and devaluations occur during periods of fluctuating inflation rates

balance of payments

- currencies are required to finance international trade, changes in trade may lead to changes in exchange rates => demand for US imports= demand for foreign currency/supply of $ => demand for US exports = demand for USD/supply of foreign currency - country where imports > exports (current account deficit) => exchange rate depreciation - any factors which alter the current a/c of the balance of payments may affect exchange rate

practical approaches to managing foreign currency risk

- deal in your home currency - do nothing - leading - lagging - matching receipts and payments - netting - hold foreign currency bank a/cs - matching assets and liabilities

international fischer effect

- difference between interest rates of two countries provides an unbiased predictor in the future changes in the spot rate - assumes that all countries will have the same real interest rate => nominal rates differ due to expected inflation - difference in interest rate should = difference in expected inflation - countries with higher inflation will have higher interest rates

interest rate parity theory

- difference between spot and forward rates = difference between interest rates of the 2 countries - predicts that the country with the higher interest rate will see the forward rate for its currency subject to depreciation of its currency - generally holds true in practice - no bargain interest rates to be had on loans/deposits in one currency rather than another

advantages of using a forward exchange contract

- flexibility with the amount to be covered - relatively straightforward both to comprehend and to organise

types of fixed exchange rate systems

- floated exchange rate - fixed exchange rate systems - freely floating exchange rate - managed floating exchange rate

currency blues

- foreign currency appreciates => companies complain that they cannot sell their goods abroad and workers worry about losing their jobs - foreign currency depreciates => consumers are unhappy because inflation is imported and their money is worth less when they go abroad

impact of a foreign currency depreciating

- foreign currency is now worth less in home country - Receipt => will receive less in home currency - Payment => will pay less in home currency

fischer effect

- formula: (1 + i) = (1 + h)(1 + r) - states that money rate (nominal rate) is made up of two parts: required return and a premium to allow for inflation - countries with high inflation will be expected to have nominal rates of interest to ensure investors can get a high enough real return

differences between a futures contract and a forward contract

- futures can be traded on futures exchange => contract which guarantees the price (futures contract) is separated from the transaction itself allowing contracts to be traded easily - settlement takes place in 3-month cycles - futures are standardised contracts for standard amounts - only whole multiple numbers can be bought/sold - price of a futures contract is the exchange rate for the currencies specified - always a buy and sell element in a futures contract

limitations of IRPT

- government controls on capital markets - controls on currency trading - intervention in foreign market exchanges

economic risk exposure for an exporter

- home currency strengthens against the currency in which it trades - competitor's home currency weakens against the currency in which it trades

limitations to PPPT

- ignores effects of capital movements on the exchange rate - exchange rates will only reflect the prices of good which enter into international trade and not the general price level as this incls. non-tradeables - future inflation rates are only estimates - market is dominated by speculative transactions (98%) as opposed to trade transactions, breaking down purchasing power theory - government may manage exchange rate which denies the forces pressing towards PPPT

law of one price

- in a free market with no barriers to trade, no transport/transaction costs, competitive process ensures that only 1 price given for 1 good - price differences would be removed by arbitrage - entrepreneurs would buy in low market, sell in high market, eradicating price difference

doing nothing as a method of combating foreign currency risk

- in the long run, win some and lose some scenario - works for small occasional transactions - saves in transaction costs - is dangerous

dealing in your home currency as a method of combating foreign currency risk

- insists that all customers pay in your home currency and pay for all imports in home currency - transfers risk to the customer - may not be commercially acceptable

statement of financial position hedge

- involves hedging foreign currency assets against an equal amount of exposed liabilities - idea: => loan in same currency used to finance assets in same foreign currency => when exchange rate fluctuates both the asset and liability affected equally - method may create transaction exposure but eliminates translation risk

fixed exchange rate system

- involves publishing the target home currency equivalent against either a single currency or a basket of currencies, and a commitment to use monetary policy and official reserves of a foreign exchange to hold the actual spot rate within some trading band around this target - types of fixed exchange rate systems: 1. fixed against a single currency 2. fixed against a basket of currencies

money market

- markets for wholesale lending, borrowing, and trading in short-term financial instruments - companies are able to borrow/deposit funds through their bank in the money markets

forward exchange contract

- method of hedging against foreign exchange transaction risk - most frequently used form of hedging - enables a business to fix a currency price now for a future transaction - quoted as a margin on the spot rate - forward exchange rates derived from spot rates

netting as a method of combating foreign currency risk

- not technically a method of managing foreign exchange risk - objective is to save transaction costs by netting off inter-company balances before arranging payment between group companies

types of options

- over the counter options from banks => these are tailored to the specific needs of the customer and can be used by small-medium sized banks - exchange-traded options => traded on the same exchange as futures which can be used by larger companies

options

- similar to forwards but with one key difference: => they give the right but not the obligation to buy/sell currency at some point in the future at a predetermined rate - a company can therefore: => exercise the option if it is favourable to do so => let if lapse if the spot rate is more favourable or there is no longer a need to exchange currency - most useful when: => uncertainty over timing of transaction => when exchange rates are volatile - premium must be paid to purchase an option whether it is ever used or not

freely floating exchange rate system

- sometimes called a 'clean float' - a genuine free float would involve: => leaving exchange rates to the forces of supply and demand on foreign exchange markets => no intervention using reserves of foreign exchange => no taking exchange rates into account when making interest rate decisions - UK is not a genuinely free float as they take into account external value of sterling in their decision-making process

managed float exchange rate system

- sometimes called a dirty float - countries attempt to keep currency within a predetermined range of values compared to others, which are not usually public - they will often intervene in foreign markets by buying/selling their currency to remain within the range

capital movements between economies

- switching bank deposits from one country to another - supply/demand of a currency may reflect event on the capital account - factors leading to inflows/outflows of capital: => changes in interest rates: higher rates = capital inflow and demand for currency => inflation: asset holders wont want assets in a currency whose value is falling due to inflation

a firm may decide to hedge against transaction risk if

- the amount is material - settlement period is a material amount of time - its is thought that exchange rates will significantly change

transaction risk

- the risk of an exchange rate changing between the transaction date and the date of settlement - arises on any future transaction involving conversion between 2 currencies - most common area where transaction risk is prevalent is imports and exports - focuses on relatively short-term cash flow effects

economic risk

- the variation in the value of the business due to unexpected exchange rates => value of business = PV of future cash flows - long-term version of transaction risk

types of foreign currency risk

- transaction risk - economic risk - translation risk

fixed exchange rate against a basket of currencies

- used to fix a currency against a more stable base than a single economy - basket is often created to reflect the major trading links of the country concerned

using foreign currency bank accounts as a method of combating foreign currency risk

- useful if the firm has regular receipts/payments in foreign currency - this process operates as a permanent matching process - exposure to exchange risk is limited to the net balance on the account

translation risk

- where reported performance of an overseas subsidiary in home-based currency is distorted in consolidated FS due to change in exchange rate - accounting risk rather than cash risk - unless managers believe that the company's share price will fall as a result of translation exposure losses in the company accounts, translation exposure generally won't be hedged => share price would normally only fall if the translation risk impacted cash flows

spot market

- where you can buy and sell currency now - spot rate of exchange

impact of foreign currency appreciating

- worth more in home currency - receipt => will receive more in home currency - payment => will pay more in home currency

steps to hedge a future receipt in the money market

1 - borrow the PV of the foreign currency amount today => sell it at the spot rate => results in immediate receipt in the home currency => can be invested until the date it was due 2 - foreign loan accrues until transaction date 3 - loan is repaid with the foreign currency receipt

why exchange rates fluctuate

1. balance of payments 2. capital movements between economies

steps to hedge a future payment in the money markets

1. buy the PV of the foreign currency at the spot rate today 2. foreign currency purchased and placed on deposit to accrue interest until the transaction date 3. deposit is then used to make the foreign currency payment *remember with a future payment, the bank are selling you the foreign currency at a given rate, therefore it is necessary to use the offer price in your calculations seen as this is the price the bank makes the most money

ways a company is exposed to economic risk

1. directly - home currency appreciates and foreign competitors benefit - they are able to gain sales as they provide cheaper products in the eyes of consumers 2. indirectly - competitor currency moves favourably in the eyes of the consumer which makes the competitor more attractive than you

steps to calculate how much of the home currency is earned from the receipt

1. divide foreign currency amount by 1 + foreign currency borrowing rate 2. translate amount calc'd in 1 to home currency using the spot rate 3. take amount calc'd in 2 and multiply by 1 + home currency deposit rate

steps to calculate how much currency is needed to hedge a payment through a money market

1. divide foreign currency by 1 + foreign currency deposit rate for the time period in question 2. Take this figure and translate it to the home currency at the spot rate 3. take the figure in 2 and multiply it by 1 + home currency borrowing rate for the time period in question *deposit and borrowing rates will be normally given as annual rates, adjust by assuming that simple interest applies (3 months => divide by 4)

floating exchange rate system

1. exchange rate continuously changes without intervention due to supply and demand 2. FV of a currency compared to another is uncertain 3. value of foreign trades will be affected - world's leading currencies such as USD, Japanese Yen, Sterling, Euro use this system - these currencies float against each other - only a minority of currencies use this system

forward rate in one years time formula (IRPT)

F0 = S0 x [(1 + Ic) / (1 + Ib)] F0 = forward rate S0 = current spot rate Ic = interest rate for variable (foreign) currency Ib = interest rate for base currency

expected future spot rate formula (PPPT)

S1 = S0 x [(1 + Hc) / (1 + Hb)] S0 = current spot rate S1 = expected future spot rate Hb = inflation rate of base currency Hc = Inflation rate of variable (foreign) currency

foreign currency derivatives

another way of managing foreign currency risk. Examples: - futures - options

bid and offer

banks quote two prices for foreign currency: 1. lower price = offer - this is the rate that the dealer will sell the foreign currency in exchange for the base currency 2. higher price = bid - this is the rate at which the dealer will buy the foreign currency in exchange for the base currency

long-term solution to economic risk

diversify aspects of the company internationally, such as: - sales - location of product facilities - raw materials - financing

IRPT in action

forward rate for sterling against the dollar is no higher than the spot rate, but US interest rates are higher: - UK investors shift funds into US securities to secure higher interest rates - would suffer no exchange losses when they convert back to sterling - flow of capital from UK to US would raise UK interest rates and force up the spot rate for the dollar

forward rate

future exchange rate agreed now for buying/selling an amount of currency at an agreed future date

Leading as a method of combating foreign currency risk

if an exporter expects the currency they are supposed to receive at some point in the future will depreciate by the time the payment is due, the exporter will try to receive payment immediately => usually in the form of an early settlement discount

Lagging as a method of combating foreign currency risk

if an importer expects the currency to: - depreciate: tries to delay payment by requesting extended credit terms - appreciate: tries to settle ASAP but must take into account the cost of raising further working capital *opposite holds true for an exporter *this is not hedging, it's speculation

call option

the option to buy shares of stock at a specified time in the future

put option

the option to sell shares of stock at a specified time in the future

spot rate

the rate at which the currency can be exchanged today

forward market

where you can buy/sell currency, at a fixed future date at a predetermined rate, by entering into a forward exchange contract