OUTLINE Module 1: The World of International Finance and the Multinational Corporation I.
II.
The World of International Finance and the Globalization of International Financial Markets: A. The World of International Finance B. Globalization of Capital Markets The Multinational Corporation A. The Multinational Corporation and its Goal B. Conflicts and Constraints in Implementing the Goal
III.
Theories of International Business A. Theory of Comparative Advantage B. Imperfect Markets Theory C. Product Cycle Theory
IV.
Methods of International Business A. International Trade B. Direct Foreign Investment C. Licensing D. Franchising E. Joint Ventures
V.
VI.
VII.
Multinational Firm versus Domestic Firm A. Marginal Return on Projects B. Marginal Cost of Capital C. Size of the Firm Risks of International Business A. Exchange Rate Risk B. Business Risk C. Political Risk Answers to Questions Raised in the Lecture
Module 2: Foreign Exchange Markets I. II. III. IV. V. VI. VII. VIII. IX.
Introduction Need for Foreign Currencies Spot Markets versus Forward Markets Direct Quotes versus Indirect Quotes Computing Percent Change for a Foreign Currency Bid, Ask Prices and Bid/Ask Percent Spread Cross Exchange Rates Currency Forward Contracts and Forward Premium/Discount Currency Futures
X. XI.
Currency Options Questions and Problems
Module 3: Arbitrage and the Theory of Interest Rate Parity I.
II. III.
International Arbitrage and Interest Parity A. International Arbitrage 1. Locational Arbitrage 2. Triangular Arbitrage 3. Covered Interest Arbitrage B. Theory of Interest Rate Parity Purchasing Power Parity International Fisher Effect
Module 4: Forecasting Exchange Rates I. II.
III. IV. V. VI. VII.
Why Multinationals Forecast Exchange Rates? Forecasting Techniques A. Technical Forecasting B. Fundamental Forecasting: Regression Approach C. Market Based Forecasting D. Mixed Forecasting Forecast Performance of Consulting Firms Assessment of Forecast Accuracy Over Time A Comprehensive Regression Example Forecasting Performance and Market Efficiency Questions and Problems
Module 5: Currency Futures, Forward Contracts, and Options I.
II. III.
Currency Futures A. Interpreting Currency Futures Quotes B. Speculating with Currency Futures C. Hedging with Currency Futures Forward Contracts and Hedging Currency Options A. Call Options 1. Interpreting Currency Call Option Information 2. Speculating with Call Options 3. Hedging Payables with Call Options 4. Factors Affecting Call Option Premium B. Put Options 1. Interpreting Currency Put Option Information 2. Speculating with Put Options 3. Hedging Receivables with Put Options
4.
Factors Affecting Put Option Premium
Module 6: The Nature and Control of Foreign Exchange Risk I. II.
Foreign Exchange Risk and Types of Foreign Exchange Risk Relevance of Exchange Rate Risk
III.
Types of Foreign Exchange Risk
IV.
Managing Transaction Exposure A. Identification of Net Transaction Exposure B. Forecast of Exchange Rates and the Decision to Hedge or not to Hedge C. Techniques for Managing Transaction Exposure D. Comprehensive Examples of Hedging Transaction Exposure 1. Hedging Payables a. Forward Contract Hedge b. Money Market Hedge c. Currency Call Option Hedge d. No Hedge 2. Hedging Receivables a. Forward Contract Hedge b. Money Market Hedge c. Currency Put Option Hedge d. No Hedge E. Managing Long-term Transaction Exposure F. Other techniques to Manage Transaction Exposure
V.
VI.
Managing Economic Exposure A. Diversifying Operations B. Diversifying Financing Globally Questions and Problems
Module 7: Case Analysis of Foreign Exchange Risk Management: Lufthansa I.
II.
Evaluation of Hedging Alternatives A. Remaining Uncovered B. Full Forward Cover C. Partial Forward Cover D. Foreign Currency Options E. Buy Dollars Now The Decision A. The Rise of DM B. The Fall of DM C. How It Came Out?
D.
Questions
Module 8: Corporate Use of Innovative Foreign Exchange Risk Management Products I. II. III. IV. V. VI.
Characteristics of Respondent Corporations Use of Foreign Exchange Risk Management Products Differences Across Industries Influence of Firm Size and Degree of International Involvement Summary Questions for Fxrisk News Group Discussion
Module 1 : The World of International Finance and Multinational Corporations "What is prudence in the conduct of every private family can scarcely be folly in that of great kingdom. If a foreign country can supply us with a commodity cheaper than we ourselves can make it, better buy it of them with some part of the produce of our own industry employed in way in which we have some advantage" (Smith, The Wealth of Nations, 1776). Objectives and Theme: Our first objective is to discuss the exciting world of Global Financial Markets; our second objective is to learn the Characteristics of the Multinational Corporation (MNC); we find that MNCs have goals similar to that of the purely Domestic Corporation (DC); however, they have a wider variety of opportunities around the globe. With additional opportunities come increased potential returns and other forms of risk to consider. The potential benefits and risks are introduced and explained
Globalization of Financial Markets For more than 25 years, there has been an increasing globalization of the world financial markets. A worldwide financial network of financial centers consisting of London, New York, Tokyo, Frankfurt, Zurich, Hong-Kong, Paris, Amsterdam etc., has evolved. This has led to the global presence of international financial institutions, increased financial integration, and a rapid evolution of innovative new financial products. Increased flows of world capital intensifies competition among nations, leading to deregulation of domestic financial markets and further liberalization of capital movements around the globe. Financial integration refers to the elimination of barriers between domestic and international financial markets and the development of many linkages between these market sectors. As a result, financial capital flows unrestricted between the two markets, enhancing various borrowing, lending, and investing activities. On the innovative side, there has been the creation of new financial instruments and technologies. Some of these instruments include Eurodollar CDs, zero-coupon Eurobonds, syndicated Eurocurrency loans,
interest and currency swaps, and floating rate notes. Technological innovations in telecommunications, information dissemination, and computers have accelerated and reinforced this trend toward globalization
The Multinational Corporation Multinational Corporation (MNC) and its goal: We can define an MNC simply as a corporation operating in more than one country. The goal or objective of the MNC should be the maximization of stockholders' wealth or the stock price. This objective is the same for purely domestic corporations as well. Stockholder Wealth equals Stock Price * # of Shares Outstanding. Maximizing the Shareholders' Wealth confers the following Advantages: 1. It considers the Time Value of Money. How does the stock price maximization objective consider the time value of money ? The answer to this question is at the end of this Module. 2. It also considers the riskiness of the cash flows of the MNC. How does maximizing stock price consider the riskiness of cash flows ? The answer to this question is at the end of this Module as well. An idea of the biggest Fortune 500 global industrial and service companies ranked by various criteria can be obtained from visiting Fortune. The global 500 corporations have been ranked by revenues; there is also a country wide ranking available using various criteria. Based on the information from the Fortune list of Global 500, please check your knowledge by answering the following questions. 1. Can you name the company that recorded the highest profit increase within the lastest year or quarter? 2. Which company headed the list in terms of revenues? And how much was the revenue of that company? 3. Which US company had the highest revenue within the lastest year or quarter? What was its rank in terms of revenue in the previous year or quarter? 4. In the Pharmaceuticals industry, which company led the list in terms of revenues for the latest year or quarter? And what was its revenue?
Conflicts and Constraints in Implementing the Goal Conflicts: In the corporate form of organization, stockholders are the true owners of the corporation. There are often millions of stockholders for a given corporation, and, therefore, stockholders select managers to operate and manage the corporation from day-to-day. In this setup, the stockholders are the principals, and the managers are the agents. Thus, there is an agency relationship between the stockholders and the managers. Sometimes the managers, instead of acting in the best interests of stockholders, may act to maximize their own interests. For example, the top manager may go for a corporate jet, install his office
in a penthouse suite overlooking the Hudson river, install plush carpeting, or hire a pretty secretary. These problems are called agency problems, and the costs are called agency costs. These agency costs affect the cash flows and, therefore, the stock price. Because MNCs have subsidiaries around the globe and often have several layers of management, the agency costs of an MNC are higher than for purely domestic corporations. Constraints: The constraints in implementing the goal of the MNC are: 1. Environmental: Each country imposes its own environmental regulations, 2. Regulatory: Each host country can enforce taxes, earnings remittance restriction, job protection, and 3. Ethical: There is no consensus standard of business conduct that applies to all countries. A business practice that is considered to be unethical in the U.S. may be totally ethical in another country. All of these constraints add additional costs to the MNC and increase the cost of doing business. These constraints can act as a drag on the goal of maximizing stockholder wealth.
Theories of International Business Theory of Comparative Advantage - Specialization: Specialization of products and services can increase both individual and global efficiency. Since specialization in some products may result in no production of some goods in a given country, there is a need for international business or trade. For example, consider a two country world of the USA and Japan. Let us assume that Japan can produce television sets of comparable quality at a cheaper price than the US. Let us also assume that the US has cost advantages in the production of automobiles. In this setup, the US will import television sets from Japan, while Japan will import automobiles from the US. Since both products are produced at the lowest possible cost, global efficiency is enhanced. Imperfect Markets Theory: Due to imperfect markets and the resulting immobility of resources, resources cannot be easily and freely retrieved by the MNC. Consequently, the MNC must sometimes go to the resources rather than retrieve resources such as low cost land, labor etc. An example would be US auto manufactures setting-up factories in Mexico to take advantage of the lowcost labor there. Product Cycle Theory: A firm is likely to market its product first in the home country due to the ready availability of information about markets and competitors. As the market in the home country matures, the corporation, seeking foreign demand, initially exports its product. After learning more about the foreign country and how to gain advantage over competitors in foreign countries, the firm opens production facilities overseas. Figure # 1 provides a flow chart of Product Cycle Theory.
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
Question: Do you think that the three theories of international business, Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory, are complementary or competitive? Provide justification for your answer.
Methods of International Business International Trade: Exporting: A business firm may maintain its production facilities within the territory of its home nation and export its products to foreign countries. Exporting is a safer way to break into a new market since there is less to lose if the strategy fails. The advantage of this approach is lower fixed production costs; but, the disadvantage is higher transportation costs. Direct Foreign Investment (DFI): A business firm located in one country may acquire facilities that enable it to produce a product or render a business service within the territory of another country. An MNC may initiate DFI by either establishing a new subsidiary, opening a factory or purchasing an existing company in that country. An essential element of DFI is the investor's involvement in the management of the productive assets. The investor has total managerial control. Licensing: In a licensing arrangement, one business firm, the licensor, makes certain resources or "inputs" available to another business firm, the licensee. The availability of these inputs makes it possible for the licensee to produce and market a product or service similar to that which the licensor has been producing. As the goods are sold, or services rendered, a portion of the revenues, as specified by the agreement, are sent to the licensor. Franchising is a form of licensing that has spread rapidly throughout the world in recent years. The best-known and most successful international franchisors have been the fast-food chains such as Kentucky Fried Chicken, Burger King, and McDonald's. Advantages: 1) Low cost and 2) low risk.
Disadvantages: 1) The local firm in the host country may attempt to export the goods to another country, which may reduce sales of the licensing corporation, 2) It is difficult to ensure quality control of the local firm's production process, and 3) Technology secrets provided to the local firm may leak out to competitive firms in that country. Joint Venture: In the case of joint venture, two or many firms combine to create a subsidiary. Usually, each firm provides the resources in which it has the advantage. For example, a corporation in a developing country can combine with a US based MNC to gain technological advantages. The US firm, in turn, gains a foothold in the country and gains a market share.
Impact of Foreign Opportunities on Firm Size MNCs have cost advantages over domestic corporations, and, therefore, the cost of capital for MNCs is cheaper than that for domestic corporations (DCs). Also, MNCs have greater opportunities for more profitable projects; that is, the marginal rate of return from a project is higher for the MNC as opposed to the DC. Besides, MNCs have additional opportunities. With higher return, lower cost, and additional opportunities, an MNC is likely to attain a larger size compared to a DC. Figure # 2 provides information on the marginal return and marginal cost for MNC and DC.
FIGURE 2
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
Note that the marginal return (MR) is higher, but the marginal cost of capital (MCC) is lower for a MNC compared to a DC. The intersection of the MR and MCC curves determines the projects that will get accepted. As long as the MR is greater than or equal to the MCC, the projects will be accepted. Question: Do you know why the marginal cost of capital curve (MCC) is upward sloping?
The optimal size of an MNC will be determined by a variety of factors, such as the economic and political environment of the foreign governments, MNC's product line, operating characteristics, risk-return preference, and industry type, etc.
Risks of International Business Exchange Rate Risk: Exchange Rate Risk is defined as the variability in home-country cash flows due to the fluctuations in the host-country exchange rates. This risk can affect both the revenues and costs of an MNC negatively. For example, consider the following example: ABC Corporation (US based MNC) has DM 100 million in 90-day payables owed to a German firm for imports from the firm. Suppose, the exchange rate right now (t=0) = $0.661 per DM. Based on this exchange rate, ABC anticipated an outflow of $66.1 million. The exchange rate at t=+90 days when the payable bill was paid, turned out to be $0.75 per DM. Given: ABC Corporation (US-based MNC) has DM 100 million in 90-day Payables 90-day Payables
DM
100 Million
Time=t
0
Plus 90 days
Spot Exchange Rate $/DM
0.661
0.75
$ Cost
66.1
75
Extra Cost
8.9
In this case, ABC Corporation paid $ 8.9 million more than it anticipated to pay at time=0; the DM appreciated, thereby increasing the $ cost of the payables in DM. This is the exchange rate risk that the MNCs face in handling their foreign currency flows. This risk arises from the need to convert the cash flows from one currency to another. If there is no need to convert the currency, MNCs will not face exchange rate risk. Question for interactive table above Please change the t=+90 days exchange rate from $0.75 per DM to: 1. $0.50 per DM 2. $1.00 per DM What happens to the $ outflow cost in 1 and 2 above? Does what unfolds in scenario #1 above constitute an exchange rate risk? Question: If there were a single Currency through out the globe, MNCs would not face the daunting problem of exchange rate risk. What do you think of this idea? Is it feasible? Could it create other problems? Political Risk: Some examples of political risk include: 1) nationalization or being taken-over without receiving adequate compensation 2) Restrictions by host country governments on remittances to the parent company, 3) Change in taxation policies in mid-stream. In addition, the form of the government, its stability and the form of the legal system etc. will affect the political risk of a country.
Business Risk: Business risk arises from host country business and economic conditions. Slowing or weakening Japanese and European markets often leads to reduced demand for products of U.S. MNCs in these markets, thereby, contributing to the business risk of the U. S. MNCs.
Summary In this module, we learned about some features of the World of International Finance and we noted the increasing globalization trend sweeping the markets. In addition, we looked at the characteristics of the Multinational Corporation and its objective; in the context of the MNC, we discussed the theories of international business: Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory. In addition, we also compared and contrasted multinational corporations with purely domestic corporations with regard to return and risk; it turns out that multinational corporations enjoy higher possible returns, but they also face more risks. Answers to Questions Raised in the Lecture 1. How does the objective of stock price or stockholder wealth maximization consider the time value of money? Stock price is the present value of all expected future cash flows of the corporation. Therefore, maximizing stock price automatically considers the time value of money. 2. How does the objective of stock price or stockholder wealth maximization consider the riskiness of cash flows as well? In finding the present value of the cash flows to arrive at the stock price of the corporation, depending on the riskiness of the cash flows, one can use different discount rates: if the risk is higher, one can use a higher discount rate, and if the risk is lower, one can use a lower discount rate. Thus, the objective of stock price maximization considers the riskiness of cash flows as well. 3. Are the three theories of international business complementary or competitive? The three theories are more complementary rather than competitive. The three theories address different dimensions of international business. 4. If there were a single currency throughout the globe, there would not be exchange rate risk. What do you think about its feasibility ? What other problems could that create? If we had a single currency, the sovereignty of each country as we know it today would be violated. The ability of the Central Bank of each country to control monetary policy and affect exchange rates, and inflation etc. would be affected as well. We are already witnessing these kinds of problems with the European integration and its single currency ECU evolution. 5. Why is the marginal cost of capital (MCC) upward sloping? If a corporation has debt in its capital structure, it is inherently risky, and, therefore, the banks will be willing to lend additional money only at higher interest rates. That is why the MCC is upward sloping. END OF MODULE 1
Module 2: Foreign Exchange Markets
Objectives and Theme: This segment introduces foreign exchange markets. The first objective here is to learn the characteristics of Spot Markets and the Forward Markets; the second objective is to study the pricing of one currency relative to another in terms of direct and indirect quotes. Thirdly, bid and ask prices are introduced and explained. Finally, the concept of buying and selling currencies for future needs using Forward contracts, Futures contracts, and Options are briefly explained. Introduction: Unlike stock markets, which have a physical location of their own, there is no one place where currencies trade. In fact, currencies trade around the globe on a 24-hour basis. According to Zaheer (1995), the foreign exchange market consists of: 1. a primary network of about 150 major international banks with 1000 affiliates spread around the globe; these major banks act as market makers by buying and selling various currencies, and by quoting two-way bid-ask prices all the time. These banks also do speculative trading based on "privately informed opinion about market expectations of price trends." 2. a secondary network of 4000 or so second tier banks, which are involved both in speculative trading and trading with customers. 3. tertiary network of corporations, central banks, fund managers, and customers. The participants in this group buy and sell currencies essentially for their liquidity needs arising from trade and investment transactions. As of April 1998, the net turnover in the global foreign exchange market amounted to 1.5 trillion dollars a day!1. This compares with a market turnover of $820 billion in 1992 and 590 billion in 1989, representing an annual growth rate of 12 percent and 14 percent per year respectively. To understand the enormity of this market, it would be helpful to know that the US annual real GDP is about 6.82 trillion dollars! London, New York and Tokyo dominate the currency markets. The US dollar accounts for 83 percent of all global foreign exchange transactions, followed by the German mark, which accounts for 30 percent of all transactions, and the Japanese yen with a share of 24 percent of all transactions. 1
Bank for International Settlements: Central Bank Summary of Foreign Exchange and Derivatives Market Activity, 1998
Need for Foreign Currencies The need for foreign currency arises in the context of trade and investment needs of individuals, corporations, governments, and open market operations of central banks. Let us first consider a trade related foreign currency need. Consider for example, ABC Corporation, a US based MNC, which has imported merchandise from a German firm; let us assume that these imports are denominated in German marks. ABC Corporation has to resort to the foreign exchange market to buy the German marks to pay for its imports. Similarly, XYZ Corporation located in London exported merchandise to an Indian company; these exports are denominated in British pounds. The Indian importer has to buy British pounds to pay for its imports. Now, let us look at an investment based need for foreign currencies. If Japanese individuals and institutional investors want to invest in US bond market securities like T-bills, and T-bonds etc., they need to convert the home currency, the Japanese yen, to US dollars before they can invest in the US. Likewise, if US individuals or institutional investors want to invest in Japanese stock markets, they have to convert the US dollar to the Japanese yen to do so.
Foreign currency needs also arise for travel, education, and charitable giving needs, as well. For example, if Korean nationals want to go to a US university for furthering their educations, they must convert their Korean Won to US dollars to do so. Likewise, if someone from the US wants to travel in London for entertainment and shopping, he or she has to pay for the trip in British pounds, and, therefore, the US resident has to convert the US dollars to British pounds.
Spot Markets versus Forward Markets In Spot transactions, currencies are bought and sold for immediate conversion and delivery. The market where Spot transactions occur is called the Spot market. Currencies can also be bought and sold for deferred delivery in the future. The markets where such deferred transactions occur are referred to as Forward markets. Obviously, these markets are identified by the nature of transactions. In other words, they do not trade in separate places ! You may wonder why anybody would want to buy or sell currencies in the future. Buying and selling currencies in the future is done based on future foreign currency needs. The prices at which currencies are bought and sold for spot transactions in the Spot markets are called Spot prices, or quotes, while the prices at which currencies are bought and sold for future needs in the forward markets are called Forward prices, or quotes.
Direct Quotes versus Indirect Quotes There are two ways in which the price of one currency can be quoted relative to another currency. For the US, the home currency is the US dollar; with respect to the US dollar, the two types of Quotes are: 1. Direct Quote, also called US $ Equivalent, refers to the # of units of US dollar per one unit of the Foreign Currency. To understand the Direct Quote, please look at the table Currency Trading: Exchange Rates. This table is a reproduction of Exchange Rate Quotes from the Wall Street Journal of February 8, 2001.
Table 2.1: Exchange Rate Quotes from WSJ, 2/8/2001 U.S. $ equiv.
Currency
per
U.S.
Country
Thursday 2/8/2001
Wednesday 2/7/2001
Thursday 2/8/2001
Wednesday 2/7/2001
Argentina (Peso)
1.0001
1.0001
0.9999
0.9999
Australia (Dollar)
0.5352
0.5461
1.8686
1.8310
Austria (Schilling)
0.06675
0.06752
14.981
14.810
Bahrain (Dinar)
2.6525
2.6525
0.3770
0.3770
Belgium (Franc)
0.0228
0.0230
43.917
43.416
Brazil (Real)
0.5021
0.4994
1.9915
2.0025
Britain (Pound)
1.4445
1.4545
0.6923
0.6875
1-month forward
1.4443
1.4543
0.6924
0.6876
3-months forward
1.4435
1.4535
0.6928
0.6880
6-months forward
1.4422
1.4523
0.6934
0.6886
0.6618
0.6627
1.5110
1.5090
1-month forward
0.6619
0.6627
1.5108
1.5089
3-months forward
0.6620
0.6629
1.5105
1.5085
Canada (Dollar)
$
6-months forward
0.6623
0.6632
1.5098
1.5079
Chile (Peso)
0.001787
0.001778
559.65
562.35
China (Renminbi)
0.1208
0.1208
8.2763
8.2765
Colombia (Peso)
0.0004455
0.0004461
2244.50
2241.88
Czech. Rep. (Koruna)
0.02656
0.02682
37.652
37.288
Denmark (Krone)
0.1231
0.1251
8.1245
7.9920
Ecuador (US Dollar) -e
1.0000
1.0000
1.0000
1.0000
Finland (Markka)
0.1545
0.1563
6.4730
6.3991
France (Franc)
0.1400
0.1416
7.1412
7.0598
1-month forward
0.1401
0.1417
7.1370
7.0555
3-months forward
0.1403
0.1419
7.1300
7.0486
6-months forward
0.1404
0.1421
7.1211
7.0396
0.4696
0.4751
2.1293
2.1050
1-month forward
0.4699
0.4754
2.1280
2.1037
3-months forward
0.4704
0.4758
2.1259
2.1016
6-months forward
0.4710
0.4764
2.1233
2.0990
Greece (Drachma)
0.002696
0.002727
370.87
366.73
Hong Kong (Dollar)
0.1282
0.1282
7.7994
7.7999
Hungary (Forint)
0.003460
0.003501
289.01
285.63
India (Rupee)
0.02155
0.02155
46.405
46.400
Indonesia (Rupiah)
0.0001036
0.0001036
9651.00
9651.00
Ireland (Punt)
1.1663
1.1798
0.8574
0.8476
Israel (Shekel)
0.2420
0.2416
4.1330
4.1396
Italy (Lira)
0.0004744
0.0004799
2107.96
2083.92
Japan (Yen)
0.008572
0.008596
116.66
116.33
1-month forward
0.008607
0.008631
116.19
115.86
3-months forward
0.008678
0.008701
115.23
114.93
6-months forward
0.008781
0.008805
113.89
113.57
Jordan (Dinar)
1.4065
1.4065
0.7110
0.7110
Kuwait (Dinar)
3.2616
3.2680
0.3066
0.3060
Lebanon (Pound)
0.0006605
0.0006605
1514.00
1514.00
Malaysia (Ringgit-b)
0.2632
0.2632
3.8000
3.8000
Malta (Lira)
2.2589
2.2758
0.4427
0.4394
Mexico (Peso) Float
0.1033
0.1033
9.6835
9.6835
Netherland (Guilder)
0.4168
0.4216
2.3991
2.3717
New Zealand (Dollar)
0.4351
0.4442
2.2983
2.2512
Norway (Krone)
0.1125
0.1137
8.8873
8.7955
Pakistan (Rupee)
0.01695
0.01698
59.000
58.895
Peru (new Sol)
0.2833
0.2831
3.5303
3.5320
Philippines (Peso)
0.02075
0.02060
48.200
48.550
Germany (Mark)
Poland (Zloty) [d]
0.2431
0.2468
4.1135
4.0520
Portugal (Escudo)
0.004582
0.004635
218.26
215.77
Russia (Ruble) [a]
0.03501
0.03509
28.562
28.497
Saudi Arabia (Riyal)
0.2666
0.2666
3.7506
3.7506
Singapore (Dollar)
0.5722
0.5720
1.7475
1.7483
Slovak Rep. (Koruna)
0.02106
0.02125
47.483
47.059
South Africa (Rand)
0.1252
0.1267
7.9850
7.8900
South Korea (Won)
0.0007899
0.0007915
1266.00
1263.50
Spain (Peseta)
0.005521
0.005584
181.14
179.07
Sweden (Krona)
0.1035
0.1047
9.6610
9.5550
Switzerland (Franc)
0.5988
0.6047
1.6700
1.6536
1-month forward
0.5998
0.6057
1.6673
1.6510
3-months forward
0.6016
0.6076
1.6622
1.6459
6-months forward
0.6042
0.6102
1.6550
1.6387
Taiwan (Dollar)
0.03104
0.03104
32.220
32.220
Thailand (Baht)
0.02346
0.02343
42.620
42.685
Turkey (Lira)
0.00000147
0.00000147
682170.00
678130.00
United Arab (Dirham)
0.2723
0.2723
3.6730
3.6730
Uruguay (New Peso) Financial
0.07957
0.07958
12.568
12.566
Venezuela (Bolivar)
0.001425
0.001426
701.75
701.51
SDR
1.2932
1.2990
0.7733
0.7698
Euro
0.9186
0.9292
1.0886
1.0762
1. The quotes are given for Wednesday, February 7th and Thursday, February 8th. In the first column, the country name appears. In the second and third columns, US $ Equivalents, or Direct Quotes are given. Let us consider Germany (Mark): The very first line for Germany represents the Spot quote. Recall that Spot quotes represent the prices quoted for immediate conversion and delivery. The Quote of 0.4696 in US $ Equivalent for Thursday translates to US $ 0.4696 per Mark. This means one Mark equals US $ 0.4696. Likewise, the quote of 0.4751 in US $ Equivalent for Wednesday should be read as US $0.4751 per Mark. For another example, let us examine the French Franc. Once again, the very first line for that country represents the Spot Quote. Whenever a given country quote appears more than once, the very first line always represents the Spot Quote. A quote of 0.1400 for France on Thursday should be read as US $ 0.1400 per French Franc. This means one French Franc is worth 0.1400 US dollar. Likewise, considering the Direct Quotes for the British pound, a quote of US $ Equivalent of 1.4445 on Thursday should be read as US $ 1.4445 per British pound. This means one British pound equals US $ 1.4445. 2. The Indirect Quotes are presented in columns 4 and 5 of the Currency Trading: Exchange Rates table, under the heading Currency per US $. Once again, consider the Spot Quotes for Germany. The quote of 2.1293 appearing across Germany (Marks) for Thursday under column 4 should be read as 2.1293 Mark (DM) per US dollar: this means one US dollar is worth 2.1293 DMs. The indirect quote of 2.1050 of the DM for Wednesday, read as 2.1050 DMs per US dollar, translates into a value of 2.1050 DMs for one US dollar. In a similar fashion, the indirect Thursday quote of 7.1412 for France, read as Franc (FF) 7.1412/US$, means one US $ is worth 7.1412 French Francs. A quote of 7.0598 for the FF on Wednesday means that one US $ is worth 7.0598 FF. For the British pound, the Thursday Indirect Quote is 0.6923, read as BP 0.6923 per US $, implying one US $ equals BP 0.6923.
Given a Direct Quote, one can get the Indirect Quote by taking the reciprocal of the Direct Quote and vice-versa. For example, we already know that the Direct Quote for the Mark on Thursday is 0.4696; if we take 1/0.4696, we get 2.1293, the Indirect Quote of the Mark for Thursday. Similarly, if we take the reciprocal of the Indirect Quote of the FF for Thursday: 1/7.1412, we get 0.1400 , the Direct Quote for FF for the same day
The World Value of the US Dollar The World Value of the US dollar for several global currencies are presented below. Source: Wall Street Journal, February 16, 2001.
Table 2.2: World Value of the US Dollar from WSJ, 2/16/2001 Country
Currency
2/16
2/9
Afghanistan
Afghani
4750.00
4750.00
Albania
Lek
143.00
142.70
Algeria
Dinar
73.93
74.00
Andorra
Peseta
181.3175
181.0866
Andorra
Franc
7.1482
7.1391
Angola
Readj Kwanza
18.2458
18.2458
Antigua
E Caribbean $
2.70
2.70
Argentina
Peso
1.00
1.00
Armenia
Dram
552.18
553.97
Aruba
Florin
1.79
1.79
Australia
Australia $
1.8948
1.8645
Austria
Schilling
14.9952
14.9761
Azerbaijan
Manat
4558.00
4558.00
Bahamas
Dollar
1.00
1.00
Bahrain
Dinar
0.377
0.377
Bangladesh
Taka
54.10
54.13
Barbados
Dollar
2.00
2.00
Belarus
Ruble
1210.00
1210.00
Belgium
Franc
43.96
43.904
Belize
Dollar
2.00
2.00
Benin
C.F.A. Franc
714.8226
713.9124
Bermuda
Dollar
1.00
1.00
Bhutan
Ngultrum
46.515
46.4575
Bolivia
Boliviano
6.43
6.395
Bolivia
Boliviano
6.07
6.07
Bosnia Herzegovina
Convtbl Mark
2.1314
2.1286
Botswana
Pula
5.5233
5.5556
Bouvet Island
Norweg. Krone
9.0083
8.8631
Brazil
Real
1.9885
1.9905
Brunei
Dollar
1.7409
1.7485
Bulgaria
Lev
2.14
2.1195
Burkina Faso
C.F.A. Franc
714.8226
713.9124
Burma
Kyat
6.5899
6.5949
Burundi
Franc
734.067
734.063
Cambodia
Riel
3835.00
3835.00
Cameroon
C.F.A. Franc
714.8226
713.9124
Canada
Dollar
1.5334
1.5099
Cape Verde Isl
Escudo
119.984
119.989
Cayman Islands
Dollar
0.82
0.82
Centrl African Rp
C.F.A. Franc
714.8226
713.9124
Chad
C.F.A. Franc
714.8226
713.9124
Chile
Peso
518.37
518.37
Chile
Peso
562.825
559.95
China
Renminbi Yuan 8.277
8.2764
Colombia
Peso
2238.50
2242.00
Commnwlth Ind Sts
Rouble
28.688
28.671
Comoros
Franc
536.117
535.4343
Congo Dem Rep
Congolese Fr
4.4999
4.4999
Congo, People Rp
C.F.A. Franc
714.8226
713.9124
Costa Rica
Colon
321.13
320.68
Croatia
Kuna
8.489
8.3718
Cuba
Peso
1.00
1.00
Cyprus
Pound *
1.5703
1.5902
Czech
Koruna
37.833
37.575
Denmark
Danish Krone
8.2005
8.0943
Djibouti
DjiboutiFranc
173.00
175.50
Dominica
E Caribbean $
2.70
2.70
Dominican Rep
Peso
16.30
16.30
Ecuador
Sucre
25000.00
25000.00
Egypt
Pound
3.8843
3.8843
El Salvador
Colon
8.75
8.75
Equatorial Guinea
C.F.A. Franc
714.8226
713.9124
Estonia
Kroon
17.1866
16.9777
Ethiopia
Birr
8.10
8.25
Euro Monetary Union EURO *
0.9177
0.9188
Faeroe Islands
Danish Krone
8.2005
8.0943
Falkland Islands
Pound *
1.4541
1.4449
Fiji
Dollar
2.2346
2.2284
Finland
Markka
6.4793
6.4711
France
Franc
7.1482
7.1391
French Guiana
Franc
7.1482
7.1391
French Pacific Isl
C.F.P. Franc
129.9676
129.8021
Gabon
C.F.A. Franc
714.8226
713.9124
Gambia
Dalasi
15.40
15.40
Georgia
Lari
1.97
1.967
Germany
Mark
2.1314
2.1286
Ghana
Cedi
7300.00
7100.00
Gibraltar
Pound *
1.4541
1.4449
Greece
Drachma
371.3289
369.64
Greenland
Danish Krone
8.2005
8.0943
Grenada
E Caribbean $
2.70
2.70
Guadeloupe
Franc
7.1482
7.1391
Guam
U.S. $
1.00
1.00
Guatemala
Quetzal
7.8065
7.8215
Guinea Bissau
C.F.A. Franc
714.8226
713.9124
Guinea Rep
Franc
1865.00
1865.00
Guyana
Dollar
180.50
180.50
Haiti
Gourde
23.00
23.00
Honduras Rep
Lempira
15.19
15.19
Hong Kong
Dollar
7.7997
7.7992
Hungary
Forint
291.815
288.04
Iceland
Krona
86.40
85.91
India
Rupee
46.515
46.4575
Indonesia
Rupiah
9600.00
9650.09
Iran
Rial
1752.50
1752.50
Iraq
Dinar
0.3124
0.3124
Ireland
Punt *
1.1652
1.1667
Israel
New Shekel
4.106
4.118
Italy
Lira
2110.0311 2107.3442
Ivory Coast
C.F.A. Franc
714.8226
713.9124
Jamaica
Dollar
45.20
45.20
Japan
Yen
116.468
116.683
Jordan
Dinar
0.711
0.711
Kazakhstan
Tenge
145.35
145.35
Kenya
Shilling
78.285
78.06
Kiribati
Australia $
1.8948
1.8645
Korea, North
Won
2.20
2.20
Korea, South
Won
1251.50
1266.00
Kuwait
Dinar
0.3066
0.3067
Kyrgyzstan
Som
48.304
49.221
Laos, People DR
Kip
7600.00
7600.00
Latvia
Lat
0.6199
0.6209
Lebanon
Pound
1514.25
1514.00
Lesotho
Maloti
7.8863
7.95
Liberia
Dollar
1.00
1.00
Libya
Dinar
0.5357
0.5357
Liechtenstein
Franc
1.687
1.6649
Lithuania
Litas
3.999
3.9991
Luxembourg
Lux.Franc
43.96
43.904
Macao
Pataca
8.0571
8.0566
Madagascar DR
Franc
6400.00
6400.00
Malawi
Kwacha
80.30
80.80
Malaysia
Ringgit
3.80
3.80
Maldive
Rufiyaa
11.77
11.77
Mali Rep
C.F.A. Franc
714.8226
713.9124
Malta
Lira *
2.2456
2.2571
Martinique
Franc
7.1482
7.1391
Mauritania
Ouguiya
251.695
250.70
Mauritius
Rupee
27.985
27.975
Mexico
New Peso
9.7005
9.684
Moldova
Lei
12.3833
12.3436
Monaco
Franc
7.1482
7.1391
Mongolia
Tugrik
1063.00
1099.00
Montserrat
E Caribbean $
2.70
2.70
Morocco
Dirham
10.7625
10.6995
Mozambique
Metical
16900.00
17050.00
Namibia
Dollar
7.862
7.9675
Nauru Islands
Australia $
1.8948
1.8645
Nepal
Rupee
74.4677
74.1637
Netherlands
Guilder
2.4015
2.3984
Netherlands Ant'les
Guilder
1.79
1.79
Netherlands Ant'les
Florin
1.79
1.79
New Zealand
N.Z.Dollar
2.3345
2.2991
Nicaragua
Gold Cordoba
12.90
12.90
Niger Rep
C.F.A. Franc
714.8226
713.9124
Nigeria
Naira
111.50
111.80
Norway
Norweg. Krone
9.0083
8.8631
Oman, Sultanate of
Rial
0.385
0.385
Pakistan
Rupee
59.5125
59.195
Panama
Balboa
1.00
1.00
Papua N.G.
Kina
3.1496
3.0628
Paraguay
Guarani
3700.00
3670.00
Peru
New Sol
3.5268
3.5303
Philippines
Peso
48.00
48.20
Pitcairn Island
N.Z.Dollar
2.3345
2.2991
Poland
Zloty
4.1005
4.108
Portugal
Escudo
218.4733
218.1951
Puerto Rico
U.S. $
1.00
1.00
Qatar
Riyal
3.6408
3.6408
Repub of Macedonia
Denar
64.045
64.045
Republic of Yemen
Rial
161.458
161.458
Reunion, Ile de la
Franc
7.1482
7.1391
Romania
Leu
26864.00
26722.50
Russia
Rouble
28.688
28.671
Rwanda
Franc
359.0281
359.0281
Saint Christopher
E Caribbean $
2.70
2.70
Saint Helena
Pound Sterling * 1.4541
1.4449
Saint Lucia
E Caribbean $
2.70
2.70
Saint Pierre
Franc
7.1482
7.1391
Saint Vincent
E Caribbean $
2.70
2.70
Samoa, American
U.S. $
1.00
1.00
Samoa, Western
Tala
3.3478
3.3478
San Marino
Lira
2110.0311 2107.3442
Sao Tome & Principe Dobra
2390.98
2390.98
Saudi Arabia
3.7504
3.7504
Riyal
Senegal
C.F.A. Franc
714.8226
713.9124
Seychelles
Rupee
6.49
6.45
Sierra Leone
Leone
1899.095
1899.095
Singapore
Dollar
1.7409
1.7485
Slovak
Koruna
48.017
47.3125
Slovenia
Tolar
236.81
233.89
Solomon Islands
Solomon $
5.1099
5.1099
Somali Rep
Shilling
2620.00
2620.00
South Africa
Rand
7.8863
7.95
Spain
Peseta
181.3175
181.0866
Sri Lanka
Rupee
86.09
86.81
Sudan Rep
Dinar
256.00
256.00
Sudan Rep
Pound
2560.00
2560.00
Surinam
Guilder
981.00
981.00
Swaziland
Lilangeni
7.8863
7.95
Sweden
Krona
9.841
9.663
Switzerland
Franc
1.687
1.6649
Syria
Pound
52.7064
52.7064
Taiwan
Dollar
32.274
32.285
Tanzania
Shilling
815.50
812.00
Thailand
Baht
42.465
42.595
Togo, Rep
C.F.A. Franc
714.8226
713.9124
Tonga Islands
Pa'anga
2.0101
2.0096
Trinidad & Tobago
Dollar
6.22
6.24
Tunisia
Dinar
1.3949
1.3878
Turkey
Lira
686255.00 681280.00
Turks & Caicos
U.S. $
1.00
1.00
Tuvalu
Australia $
1.8948
1.8645
Uganda
Shilling
1815.00
1815.00
Ukraine
Hryvnia
5.4289
5.4298
United Arab Emir
Dirham
3.6729
3.6729
United Kingdom
Pound Sterling * 1.4541
1.4449
Uruguay
Peso Uruguayo 11.3925
11.3925
Uzbekistan
Sum
775.00
775.00
Vanuatu
Vatu
141.80
141.80
Vatican City
Lira
2110.0311 2107.3442
Venezuela
Bolivar
702.90
701.75
Vietnam
Dong
14582.50
14578.00
Virgin Is, Br
U.S. $
1.00
1.00
Virgin Is, US
U.S. $
1.00
1.00
Yugoslavia
New Dinar
64.4696
63.6537
Zambia
Kwacha
3675.00
3525.00
Zimbabwe
Dollar
55.10
55.00
The rates given are in terms of # of Units of Foreign Currency per one US dollar. The values are given for two different dates: one for Friday, February 16th, and another for Friday, February 9th, 2001. For example, for the South Korean Won, the rate given for February 16th is 1251.50, which should be read as South Korean Won 1251.50 per one US dollar. Please note the fact that this quote is in indirect form. Can you compare the value of South Korean Won on February 16th with its value on February 9th, and figure out whether or not the Won appreciated or depreciated with respect to the US $? Remember to use direct quotes to do that; you can get the direct quotes for the Won by taking the reciprocals of the indirect quotes in this table. Further, take a few minutes to read and learn the currencies of the countries around the globe! Do you know the name of the Currency for Reunion, Ille de la? Or for that matter, can you name the currencies for Algeria, Bolivia, Chile, Denmark, Egypt, Finland, Germany, Holland, India, Jordan, Kenya, Libya, Madagascar, Nepal, Oman, Panama, Qatar, Singapore, Taiwan, Uganda, Vatican City, and Zaire? By visiting the Foreign Exchange Rates site, you can convert one currency to another currency using the latest quotes. Be sure to visit the site. Can you tell me the value or price of the Indian Rupee in terms of South Korean Won? That is, figure out how many Won equal one Indian Rupee? Then, get the value of South Korean Won in Rupees. That is, get the value of # of Indian Rupees per South Korean Won
Computing Percent Change for a Foreign Currency One can compute the Percent Change for a currency as follows: Percentage Change for a Currency = (St - St-1 ) / St-1 * 100 , Where, St = Spot Rate for more recent period t, St-1 = Spot Rate for last period t-1. If percent change were positive, then it implies appreciation of the currency over time; and, If percent change were negative, then it implies depreciation of the currency over time. In computing the percent change for a foreign currency from the US perspective, always use the direct quote. Let us compute the percent change for the DM from Wednesday (t-1) to Thursday (t) : Percent change in DM from Wednesday to Thursday from the WSJ (Table 2.1) =
[(0.4696-0.4751) / 0.4751] * 100 = -1.1577 percent. This means, the DM depreciated by 1.1577 percent with respect to the US $, over a one day period. If we were to compute the percent change in the US $ with respect to the DM for the same period, we should be using the indirect quotes for the same period: Percent change in the US $ with respect to the Mark from Wednesday to Thursday = [(2.1293-2.1050) / 2.1050] * 100 = + 1.1544 percent.
Bid, Ask Prices, and Bid / Ask Percent Spread At any given point in time, there are two separate prices quoted for currencies: one for buying and the other for selling. Every time you buy a given currency, its buying price is always greater than its asking price. Every time the currencies are bought and sold, the foreign exchange dealers make a profit. The bid and ask prices are further explained below: BID-ASK PRICES Foreign Currency
Bank Quotation
Bank/Foreign You/MNC Exchange Dealer Buy
Sells
Ask = Mininum price the bank will accept for the currency in question
Sell
Buys
Bid = Maximum price the bank will pay for the currency in question
Suppose for example, the following are the Bid, Ask Prices quoted for the Mark: Bid = $ 0.4664/DM Ask= $ 0.4724/DM If you want to purchase 100 Marks, it will cost you: Ask Price * # of Marks being bought = 0.4724 * 100 = US $ 47.24 If you want to sell 100 marks, you will receive = Bid price of 0.4664 * # Marks being bought = US $ 46.64 The Bid/Ask Percent Spread is given by: [ (Ask - Bid) / Ask ] * 100 = [(0.4724 - 0.4664)/0.4724] * 100 = 1.2701 percent. This should be read as the Ask price being at a premium of 1.2701 percent with respect to the Bid price. Obviously, one can compute the discount with respect to the Ask price, by dividing by the Bid price. It is customary to express the Bid/Ask Percent spread as a premium with respect to the Bid Price
Cross Exchange Rates Given the value of any two currencies in terms of the US dollar, one can calculate the value of those two currencies with respect to one another without the intervening dollar. Important Cross Currency Rates are given below:
Key Currency Cross Rates Wall Street Journal, February 08, 2001 Dollar
Euro
Canada
1.5110
1.3880 2.1826
France
7.1412
6.5599 10.3155 4.2762 2.9766 .73746 .06121 .00339 3.3538 ....
Germany
2.1293
1.9560 3.0758
1.2750 .88754 .21989 .01825 .00101 ....
Italy
2108.0
1936.4 3045.0
1262.3 878.65 217.69 18.069 ....
Japan
116.66
107.16 168.52
69.856 48.627 12.047 ....
Mexico
9.6835
8.8953 13.988
5.7985 4.0363 ....
Netherlands 2.3991
2.2038 3.4655
1.4366 ....
Switzerland 1.67
1.5341 2.4123
....
.69609 .17246 .01432 .00079 .78430 .23385 1.1052
U.K.
.69230
.6359
....
.4145
.28856 .07149 .00593 .00033 .32512 .09694 .45816
Euro
1.08860 ....
1.5725
.65186 .45376 .11242 .00933 .00052 .51125 .15244 .72046
U.S.
....
1.4445
.59880 .41682 .10327 .00857 .00047 .46964 .14003 .66181
.9186
Pound
SFranc Guilder Peso
Yen
Lira
D-Mark FFranc CdnDlr
0.9048 .62982 .15604 .01295 .00072 .70962 .21159 .... 4.7261
.29817 1.4092
989.98 295.18 1395.1
.05534 54.788 16.336 77.207
.08301 .00459 4.5477 1.3560 6.4087
.24775 .02056 .00114 1.1267 .33595 1.5878
The very first column refers to the US dollar. If we read across France and down the Dollar column, the value given is 7.1412; this should be read as FF 7.1412 per US dollar. Likewise, if we read across Germany and down the Dollar column, the quote given is 2.1293; this should be read as Marks 2.1293 per US dollar. Both the FF and DM are in indirect form. The value of DM in terms of FF, that is the # of FFs per DM is calculated as: [FF / US $] : [DM / US $] = 7.1412 / 2.1293= FF 3.3538 per DM = [FF / US $] * [US $ / DM] = FF / DM ! If we refer to the Currency Cross Rates Table and look across France and down D-Mark, you will see a Cross Exchange Rate of 3.3538, the same rate we calculated just now! To look at yet another example of the cross exchange rate, let us examine the rates for Germany and U.K. If we look across Germany and down the Dollar column, we note a quote of 2.1293, which stands for DM 2.1293 per US dollar. Likewise, for the pound the rate is 0.69230, which should be read as 0.69230 pound per US dollar. The cross exchange rate of the pound with respect to DM, that is, # of DMs per pound, is calculated as: 2.1293 / 0.69230 = Marks 3.0758 per pound
If we look across Germany and down Pound in Table 5, we get the value of 3.0758 DMs per pound as well, the same # as we calculated just now. In these Cross Exchange Rate computations, we used Indirect Quotes. Note the fact that the order in which the currencies are plugged in the numerator and denominator to arrive at the cross exchange rate is in the same order as the currencies appear in the pricing of currencies. However, if we are using the Direct Quotes, the order of currencies in the numerator and denominator will be reversed.
Currency Forward Contracts, Forward Rates, and Forward Premium The currencies can be bought and sold in Forward Markets. The Forward Rate is the rate at which currencies are bought or sold for future delivery at an agreed upon price today. The currency exchange does not take place when the contract is bought or sold. Rather, the exchange occurs later. Often, MNCs face future foreign currency outflow needs or receive foreign currency inflows in the future. When MNCs expect future outflow needs like Bills Payable, they can buy the foreign currency at t=0 at the then prevailing forward rate and lock-in that rate, thereby avoiding the exchange rate risk. A forward contract specifies the foreign currency to be bought or sold at a specified known rate today for a future settlement date. Forward rates for some currencies appear in Table 2.1. The most common maturities are 30-day, 90-day, and 180-day. For the British pound (BP), the quoted 30-day forward rate is British pound 1.4443 per US dollar; the 90-day and 180-day forward rates are BP 1.4435 per US $ and BP 1.4422 per US $, respectively. The spot rate is 1.4445 US $ per BP. In this instance, all the three forward rates are below the spot rate, and therefore, forward market rates are at a discount with respect to the spot market rates. We can calculate the Forward Market Premium or Discount P as follows: P = Forward Market Premium or Discount Percent = = [( Forward - Spot) / Spot ] * (360/# of Days of the Contract) * 100 The multiplier (360/# of Days of the Contract) converts the P to an annual rate ! For example, the P for the 30-Day BP Rate will be computed as follows: [ (1.4443-1.4445) / 1.4445 ] * (360/30)* 100 = -0.1661 % The premium of - 0.1661 percent means that the 30-day forward rate is at a discount of 0.1661 percent with respect to the spot rate.
Similarly, the Premium P for the BP 90-day and 180-day forward rates will be computed as : Premium for 90-day forward rate: [ (1.4435-1.4445) / 1.4445] * (360/90) * 100 = -0.2769 %
Premium for 180-day forward Rate: = [ (1.4422-1.4445) / 1.4445] * (360/180) * 100 = -0.3184 %
In some sense, forward rates convey information about the spot rates in the future. Under certain conditions and assumptions, forward rates can act as predictors of spot rates in the future.
Currency Futures Currency Futures are legal contracts which enable individuals, institutions, and MNCs to buy or sell currencies in the future at a specific price and for a specific period of time. Currency futures are available in the Chicago Mercantile Exchange for the Japanese Yen, DMark, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, and Euro. Unlike the Forward contacts, these futures are standardized with respect to size and delivery. These futures are used in hedging and speculation. We will learn more about these futures in Module 5. Can you visit the Chicago Mercantile Exchange and find out what futures are and options are currently traded at the exchange? Who trades them? And why?
Currency Options Currency options are rights which enable individuals, institutions, and MNCs to buy and sell currencies in the future at a specific price for a specified period of time. These options are available for various currencies and trade in the Philadelphia Exchange. These options can be used for hedging and speculation. We will learn a lot about these instruments later in Module 5. Please visit the Introduction to Options site: Learn about Options Basics. Also, learn about the classification types, classes, and series! So, what are European Options? And what are American Options? What are calls, and what are puts? Summary: In this module, we learned about the pricing of foreign currencies; the currencies can be quoted in direct form as # of US $ per one unit of foreign currency and in indirect form as # of units of foreign currency per US $. We also learned about the ask and bid prices: the prices at which currencies are bought and sold, respectively. There was a discussion on computing percent change of a given currency. Also, we studied forward contracts and forward rates; forward rates are the rates at which contracts are entered into to buy and sell currencies in the future to meet future needs.
Questions and Problems 1. State and explain the right objective for a multinational corporation. What are the advantages of that objective? 2. What is an agency problem? What are agency costs? Are they higher or lower for MNCs ? And why? 3. State and explain the three theories of international business. 4. State and explain the different methods of international business. 5. What is exchange rate risk? Illustrate your answer with a suitable example. Why is it important to manage it for an MNC? 6. Distinguish between spot and forward foreign currency markets. 7. Identify the participants in the foreign exchange market and explain their roles. 8. What is the difference between direct and indirect quotes? If you were to compute the percent change in a foreign currency, which quote would you use and why? 9. Define forward markets and forward rates. 10. For what purposes and needs do the foreign exchange markets serve? Give suitable examples. 11. What do bid and ask prices mean? Which is higher? And why?
12. Please refer to the Currency Trading: Exchange Rates table. Using the information on Thursday's spot and forward rates for the French Franc, compute a) 30-day forward premium b) 90-day forward premium and c)180-day forward premium. 13. Using the exchange rate information for Thursday in Table 2.1, compute the following: a. Cross Exchange Rate of the BP with respect to FF: # of FF per BP b. Cross Exchange Rate of the FF with respect to Canadian Dollar: # of Canadian Dollar per FF c. Cross Exchange Rate of the SF with Respect to Swedish Krona: # of Krona per SF d. Cross Exchange Rate of the Italian Lira with Respect to Japanese Yen: # of Japanese Yen per Italian Lira 2. The following are the Ask and Bid Prices of the DM quoted by a bank: 3. Bid $ 0.6645 Per DM Ask $ 0.6745 Per DM
a. If you have DM 2,000 how many US $, you will get? b. If you want to buy DM 3,000 to visit Germany, how many US Dollars you need? END OF MODULE 2
Module 3: Arbitrage and the Theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect Objectives and Theme: In this module, our objective is to study arbitrage and examine why and how three types of arbitrage take place in the foreign currency markets; we also explore the realignment of exchange rates due to arbitrage transactions. Our second objective is to learn about the theories of Interest Rate Parity (IRP), Purchasing Power Parity (PPP), and International Fisher Effect (IFE). International Arbitrage and the Theory of Interest Rate Parity: Whenever there are discrepancies between quoted-rates and observed market rates in the foreign exchange markets, currency realignments will take place. Market forces bring about the realignment of currencies through arbitrage. Loosely, arbitrage can be defined as capitalizing on market discrepancies in the prices quoted in the foreign exchange markets by simultaneous buying and selling. It can also involve simultaneous lending and borrowing in different currencies to take advantage of the higher interest rates.
International Arbitrage Types of Arbitrage Variables in the Discrepencies Locational
Foreign exchange rate among banks
Triangular
Cross exchange rates
Covered Interest
Differential in interest rate and forward rate
Locational Arbitrage: Usually, locational arbitrage takes place when a particular currency can be sold at a higher price compared to its buying price; undertaking such transactions yields profits. In addition, locational arbitrage leads to the realignment of currency exchange rates as well. Example: Bank C
Bank D
Bid Price DM
$0.6405/DM
$0.6610/DM
Ask Price DM
$0.6500/DM
$0.6710/DM
Since Bid price of $0.6610 at Bank D > Ask price of $0.6500 at Bank C, there is an opportunity to engage in locational arbitrage. Arbitrageurs will buy at $0.650 from Bank C and sell to Bank D at $ 0.6610 per DM. Recall one buys at the ask price and sells at the bid price.
If you have $ 10,000 and execute locational arbitrage, the following steps are involved: Buy DM at $ 0.650 from Bank C = $ 10,000/$ 0.650 = DM 15384.6 Sell DM at $ 0.6610 to Bank D = DM 15384.6 * $ 0.6610 = $ 10169.23 Net Profit = $ 10,169.23 - $ 10,000 = $ 169.23 As a result of this locational arbitrage, the asked price at bank C will go up, and the bid price at bank D will go down. The locational arbitrage concept explains why prices between banks at different locations will not normally differ by a significant amount.
Triangular Arbitrage Foreign exchange quotations are typically expressed in US $ regardless of the country where the quotation is provided. Cross exchange rates are used to determine the relationship between two nondollar currencies. If a quoted actual or market cross exchange rate differs from the appropriate theoretical or should be rate, triangular arbitrage becomes feasible. Example: DM Value = $2 per DM FF Value = $0.20 Per FF The appropriate/theoretical cross exchange of DM with respect to FF, that is # of FF per DM = 2/0.2 = 10 FF/DM
Suppose a bank quotes cross exchange of DM with respect to DM = 11 FF/DM Since 1 DM = 11 FF at the bank (1 FF more than the theoretical cross exchange rate of 10 FF/DM), you can buy DM with US $, convert DM to FF, then sell FF for US $. There are three steps to follow: Step 1: Determine amount of the DM to be received or sell US $ to get DM Since 1 DM = $2 =====> $10,000 = 5000 DM Step 2: Determine how much FF you will receive in exchange for DM based on banks= quote of 1 DM = 11 FF 5,000 DM * 11 FF = 55,000 FF Step 3: Determine US $ amounts you will receive in exchange for FF or you sell FF and buy US $ based on 1 FF => $0.2 55,000 FF * $0.2 => $11,000 The triangular arbitrage strategy generates a profit of $1,000. Also note that triangular arbitrage is a riskfree strategy since there is no uncertainty about the prices at which you will buy and sell the currencies, and of course all the three steps should be executed simultaneously. Triangular arbitrage forces a quoted cross exchange rate to be appropriately priced vis-à-vis the rates of the given two currency values with respect to the dollar. Because of these triangular arbitrage transactions, the exchange rates are affected as follows: $2/DM
====> Since DMs are being bought, this rate goes up.
11 FF/DM $0.20/FF
===> Since FFs are being bought, this rate goes down. ===> Since $s are being bought, this rate goes down
Covered Interest Arbitrage (CIA) The opportunity to engage in Covered Interest Arbitrage arises when the interest rate difference between the home interest rate and foreign interest rate is not off-set by the forward premium or discount of the foreign currency in the forward market. Covered interest arbitrage involves converting the home currency to the foreign currency, investing in foreign currency and covering against exchange rate risk by selling forward the maturity value of the investment thereby locking-in a rate. Covered interest arbitrage then involves interest arbitrage to take advantage of higher overseas interest rates and covering the foreign investment position by selling forward the maturity value of the investment. Example: Amount to invest $1,000,000 Current spot rate of DM = $2/DM 90-day forward rate of DM = $2.1/DM 90-day interest rate in the USA = 2% 90-day interest rate in Germany = 4% Time=0:
1. Sell US $ and buy DM at the Spot rate of $2/DM $1,000,000 /2= DM500,000 2. Invest in German T-Bill @ 4 % 90-day interest rate in Germany Maturity Value of Investment in German Marks=500,000 (1 +0.04) = DM520,000 3. Sell 520,000 DM forward @ 90-day Forward Rate of $2.1/DM Time= +90-days 4. Get the Matured Investment of DM520,000, convert DM at the earlier agreed-up on $2.1/DM DM 520,000 DM x $2.1/DM = $1,092,000 The rate of return on this investment is computed as: ( $1,092,000 - $1,000,000)/ $1,000,000 x 100 = 9.2% The 9.2 % rate of return for investing in Germany has two components: a. German Interest Rate of 4 % b. DM Forward Premium of 5 % Recall that the Forward Premium is computed as : (Forward Rate - Spot Rate)/Spot Rate * 100 =(2.1-2.0)/2.0 * 100 = 5 % Note that since interest rates are given for 90-day period, we computed the forward premium also for the 90-day period. Normally, the forward premium is usually annualized, in which case, we would have used annualized interest rates. The sum of the 4 % interest rate and the forward premium adds up to 9.0 % which approximates the 9.2 % return on CIA we computed earlier. Because we are using an approximation here, we observe the 0.20 % difference. Later, we will be using the exact version to get the exact return. In this case, since US investors are earning a 7.2 % extra return from investing in Germany, US investors will be better off investing there. Let us further develop the example on CIA we just now saw: Covered Interest Rate Arbitrage Under Varying Forward Rate Regimes 90-day 90-day 90-day Foreign Spot Forward Home (US) Forward State (Germany) DM $ Premium or Interest Rate -DM $ Interest Rate per DM Discount (P) Rate per DM
Appropriate Return on Covered Interest Arbitrage
1
2%
4%
$2
$2.10
5%
4 + 5 = 9%
2
2%
4%
$2
$2.05
2.5%
4+2.5 = 6.5%
3
2%
4%
$2
$2
0%
4 + 0 = 4%
4
2%
4%
$2
$1.96
-2.0%
4 - 2 = 2%
In states 1 through 3, CIA (investing in Germany) is profitable. In all those instances, the forward premium of the DM was positive or 0, either adding to or maintaining the foreign interest rate of 4 %. But, in scenario # 4, when the forward rate shows a discount of -2%, the return on CIA is the same as the return from investing in the US. In this case, the interest rate advantage of 2 % for investing in Germany is exactly offset by the discount of -2% in the forward rate of the DM.
Theory of Interest Rate Parity (IRP) The Interest Rate Parity Theorem examines the impact of nominal interest rate differentials between two countries on the forward rate of the foreign currency. The approximate IRP equation is: ih - if = p where, ih = Home Interest Rate if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency
Recall that p is computed as: (Fj - Sj)/Sj x 100 If the (Home Interest Rate - Foreign Interest Rate) interest differential exactly equals the forward premium or discount, then there is Interest Rate Parity. At that point, the interest advantage is offset by the forward discount. In scenario #4 above, US investors earn 2% return regardless of where they choose to invest. Note that IRP does not imply that all country investors earn the same return at the point of IRP. In scenarios 1 through 3, US investors have an advantage in investing in Germany by CIA. The concept of IRP is further explained in Figure # 3.
Note: This Figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
On the horizontal axis, the Forward premium or discount is given. On the vertical axis, (Home Interest Rate - Foreign Interest Rate) interest rate difference is plotted. Point #1 corresponds to scenario # 1 from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table. As we already know, US investors make 4% on interest income and 5% by exchange gain as the forward rate shows a premium of 5%. Likewise, in point #2 corresponding to scenario #2, US investors make 2 % more than what is available in the US, solely on the interest rate front. Points #1 and #2 lie to the right of the IRP line and therefore we can generalize and conclude that at the points to the right of IRP line, it will be advantageous for US investors to invest overseas. Similarly, at the points to the left of the IRP line, it will be advantageous for the foreign investors to invest in the US. At all points on the IRP line, there is interest rate parity. This means that a given country investor will get the same rate of return regardless of which country he chooses to invest in. The exact version of IRP equation is given by: (1+ih)/(1+if) - 1 = p Where, ih = Home Interest Rate if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency The only difference here is that the interaction term (p*if) adds an extra component to the interest rate difference between home and foreign country. Recall that in our State 1 example from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table, we had a 0.20 % difference on return to CIA in the approximate method in scenario #4. Given the German interest rate of 0.04 and premium of 0.05, (p*if) works out to 0.20 %, the difference we observed earlier. IRP holds true in the real world especially in the Eurocurrency markets. Arbitrage transactions ensure that interest differentials in different segments of the Eurocurrency markets are off-set by corresponding
forward premiums or discounts. IRP impacts on instruments of similar maturity and risk. However, if capital controls and such are imposed, IRP may not hold true in the real world.
Purchasing Power Parity (PPP) PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. If inflation in the foreign country differs from inflation in the home country, the exchange rate will adjust to maintain equal purchasing power. According to PPP, currencies in highly-inflated countries will be weaker causing the purchasing power of goods in the home country versus these countries to be similar. When inflation is high in a particular country, foreign demand for goods in that country will decrease. In addition, that country's demand for foreign goods should increase. Thus, the home currency of that country will weaken; this tendency should continue until the currency has weakened to the extent that a foreign country's goods are no more attractive than the home country's goods. Inflation differentials are offset by exchange rate change. The approximate version of PPP equation is given by, If - Ih = E f Where, If = Inflation rate in the foreign country, Ih = Inflation rate in the home country, Ef = % Change in the Spot Rate of the Foreign Currency. Thus, currencies of countries with high inflation will depreciate by the inflation differential, while currencies of countries having low inflation will appreciate by the inflation differential.
International Fisher Effect (IFE) IFE predicts the same magnitude and direction in the spot rate of a currency as PPP does, but IFE looks at the nominal interest rate rather than inflation rate. IFE argues that a currency's value will adjust to reflect the difference in nominal interest rates between countries. The rationale behind IFE is that if a currency exhibits a high nominal interest rate, it may anticipate high inflation. Thus the inflation will put pressure on the currency's value causing a depreciation. Note: Nominal Interest Rate = Real Interest rate + Inflation Premium (approximate version) The approximate version of IFE equation is given by if - ih = Ef Where, if = Nominal interest rate in the foreign country, ih = Nominal interest rate in the home country, Ef = % Change in the Spot Rate of the Foreign Currency.
Example: Home: US
Foreign: Japan
Real Interest Rate
3%
3%
Inflation Rate
5%
3%
Nominal Interest Rate
8%
6%
PPP will predict, Ef (% Change, Spot, Foreign Currency) of 2%, equal to the inflation differential of (Ih - If) = 5-3 = 2 % . IFE will predict, Ef (% Change, Spot, Foreign Currency) of 2%, = the interest differential of (8-6) = 2%. According to both theories, the foreign currency should appreciate by 2%. While IFE looks at the nominal interest rate (total picture), PPP looks at the inflation rate. Both provide the same result; it is the same wine in different bottles! This means that if an American investor invests in the US, he or she will get 8% in nominal return. And if the investor invests abroad, he or she will get 6% return from interest income and an additional 2% return from the appreciation of the foreign currency. Summary: In this Module, we studied the concept of arbitrage and the types of arbitrage: 1) Locational, 2) Triangular and, 3) Covered Interest. Arbitrage helps to bring about the re-alignment of the exchange rates. We also discussed the theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect. END OF MODULE 3
Module 4: Forecasting Exchange Rates Why Multinationals Forecast Exchange Rates ? An assessment of the future exchange rates is required for several decisions of the MNCs. Future exchange rates will affect all critical characteristics of the firm such as costs and revenues. To be more specific, various operations of MNCs use exchange rate projections including: 1. Hedging: Hedging involves taking protective steps to safe-guard open currency positions from exchange rate risk. The decision to hedge or not to hedge will depend on the forecast of the spot rate in the future. 2. Short-term financing and investing and long-term financing and investing decisions: When borrowing in foreign currencies, either short or long-term, one would need a forecast of the exchange rates. An appreciating foreign currency adds to the cost of borrowing; on the other hand, a depreciating foreign currency reduces the cost of borrowing. When investing in foreign currency investments, one needs a forecast of the future spot exchange rate as well. While an appreciating foreign currency adds a bonus to the foreign country return, a depreciating foreign
currency reduces the effective return on a foreign currency. Therefore, before venturing into foreign currency borrowing or investing, it is a good idea to get the forecasts of the exchange rates. 3. Capital budgeting decisions: Capital investments call for initial foreign currency outflows for the investment cost followed by foreign currency inflows during the life of the project; furthermore, those flows need to be converted to the home currency. For this purpose, one also has to forecast the exchange rates and 4. Earnings assessment: In the preparation of consolidated financial statements, a forecast of the exchange rates is required. Therefore, such operations can be carried out more effectively if exchange rates are forecasted accurately.
Forecasting Techniques Forecasting will depend on the type of exchange rate regimes, like fixed rate system versus free-floating regime; it will also depend on the period of future forecast like short-term horizon versus long-term horizon. Here, some methods are outlined without regard to those considerations. Technical Forecasting: Technical forecasting involves the review of historical exchange rates to search for repetitive patterns which may occur in the future. This pattern would be the basis for future exchange rate movements. If the exchange rate of the dollar has decreased over the last week period, it may provide an indication of how the currency will move tomorrow. Technical analysts often use time series models: "three steps and stumble" means that the currency tends to decline in value after a rise in the moving average over three consecutive periods! Computer programs can be used to detect patterns and to compute moving averages etc.
Fundamental Forecasting Fundamental forecasting is based on underlying relationships between the currency's value and one or more economic factors like relative interest rates, inflation differentials, trade deficits, budget deficits, real GDP, money supply etc. Exchange rate forecasting is available at the Financial Forecast Center. What is the Bank of America medium term forecast for the U.S. dollar-Yen exchange rate? How about the U.S. dollar-Deutsche Mark exchange rate? Often regression analysis is used in fundamental forecasting. In a regression set-up, a dependent variable (effect) is forecast using an independent variable (cause); constant and slope coefficients for the straight line equation of the estimate of the dependent variable are obtained. From the regression equation, one can forecast the dependent variable for a given time-period. If you want to forecast the value of the British Pound relative to the US $, the regression analysis will involve the following steps: Steps: 1. Specification of the model: ERPD$t = a + b * INTDIFFt where, ERPD$t = Value of the Pound in dollars
INTDIFFt = Interest rate differential between U.K. and U.S. interest rates (U.K. rate - U.S. rate) a = Constant or Intercept b = Slope. This measures the responsiveness of exchange rate change of the pound (dependent variable) for any given change in the INTDIFF. In this model, we assume that interest rate differential is the only factor affecting the value of pound. 2. Collect data on the above variables for a suitable number of periods like 20 or so quarters. 3. Run the regression equation and get the estimate of "a" and "b" 4. From the estimate of the equation, plug in the value of future (forecasted) interest rate differential and arrive at the value of pound for the future period. Suppose, we obtained the following Regression Equation Model above. ERPD$t = 1.78 + 0.80 * INTDIFFt Then, given the value of INTDIFF for the next period, we can forecast ERPD$. If the INTDIFF were 5% for the next period, then what is the forecasted value of ERPD$? Can you tell? Problems in fundamental forecasting: 1. Uncertain timing of the impact of any given variable on the forecasted variable: The impact might be felt with a lag, and if so the regression equation specified is incorrect, 2. Omission of some relevant variables. 3. Possible changes in the sensitivity or value of the coefficients over time, and 4. Forecasts are needed for factors with instantaneous impact.
Market Based Forecasting Here, market determined spot or forward exchange rates are used to predict the future spot rates. These market based rates are good indicators of likely outcomes as otherwise, speculators will take positions to profit if deviations occur. Thus spot rates will reflect the expectation of currency value in the immediate future and the forward rates will reflect the value of a currency in the future spot markets. For example, if the 30-day forward rate of the Canadian dollar contains a 5% premium, one can predict that the Canadian spot rate 30 days from now will appreciate by 5% in 30 days time. That kind of a forecast will be unbiased in the sense that, 50% of time they will overshoot, and the remaining 50% of the forecasts will be below the actual outcomes!
Mixed Forecasting Mixed forecasting involves a combination of two or more techniques. Different weights adding up to 1 can be assigned. For example, if the following forecasts were obtained: Technical Forecast of the BP for the next quarter: Fundamental Forecast of the BP for next quarter: $ 1.50 per Pound.
$
1.55
If we assign a weight of 0.50 for each outcome, then the weighted average forecast will be:
per
Pound.
1.55(0.50) + 1.50 (0.5) = $ 1.525 per pound. Obviously, these weights are subjective
Forecast Performance of Consulting Firms Forecasting firms often use two or more techniques. They also provide other services like cash management, forecast of factors affecting exchange rates and an assessment of current and future exchange regulations. The record of forecasting services is less than perfect and in fact poor.
Assessment of Forecast Accuracy Performance can be evaluated by computing the absolute forecast error as a % of the realized value for all forecast periods. Then, an average of this type of error can be computed. This average is then compared across different forecasting techniques or among different currencies. Absolute forecast error as a % of the realized value= [|(Forecasted Value-Realized Value)/Realized Value|] * 100 An Example: The forecasted and realized values of South Korean Won for the last four quarters are given in columns 2 and 3. The absolute values of the deviations appear in column 4.
Forecast Error for the South Korean Won Quarter
Forecasted Value
Realized Value
Absolute Value of Deviation (%)
1
36.50
34.40
6.105
2
37.35
34.60
7.948
3
36.40
33.63
8.237
4
34.35
34.56
0.608
SUM=
22.897
AVERAGE=
5.724
Forecasting accuracy can be further analyzed by plotting the bias over time and also looking at the positive (+) and negative (-) deviations of forecasted rates from the actual rates. If we observe consistent over or under forecasting, we can correct our forecast suitably. If for example, we consistently overforecast on an average by 5%, we can improve our forecast accuracy by subtracting 5% from our forecast every time. A Comprehensive Regression Example: A Regression Example for forecasting Spot BP using lagged 30-day forward rate of the BP is presented in the following tables. Regression Data contains 21 daily data: the dependent variable is the Spot BP, and the independent variable is the 30-day lagged forward rate of BP. The lagging has been done based on trading day. Using data for the first fifteen (observations # 1-15) days, a regression is run; the results are shown in Regression Results. The resulting regression equation is of the form:
Future Spot Ratet = 0.481698 + [0.6994*30-day Forward Rate t-30] The slope of 0.6994 means that for every 1% change in the forward rate, the spot rate of the BP changes by 0.6994% in the same direction. This equation is used to forecast the spot BP for days 17-21, and the predicted spot, absolute error, and average error appear in Prediction
Forecasting Performance and Market Efficiency Efficiency refers to the reflection of information in the pricing of currencies. There are three forms of efficiency: 1) Weak-form, which argues that all historical pricing information, including volume and other technical factors, is reflected in currency pricing 2) Semi-strong form, which states that all publicly available information is reflected in currency pricing, and 3) Strong-form, which posits that both public and non-public private information are reflected in currency pricing. Each form of efficiency subsumes the one below it. There is evidence supporting the fact that foreign exchange markets are semi-strongly efficient and, therefore, reflect all publicly available information and historical pricing information. Still, MNCs need to forecast exchange rates and, in fact, use a variety of techniques to forecast the exchange rates under different economic scenarios. That is the only way that MNCs can assess the degree to which their performance will be affected by exchange rate movements. Also, corporations do not like uncertainty; with the exchange rate forecasts, they can estimate the cash flow estimates, thereby making the planning process easier. An anomaly called January Effect has been documented in the U.S. dollar market by Rathinasamy, Mantripragada, and Loh (1992). Summary: In this Module, we studied the reasons for and techniques of forecasting exchange rates. Specifically, we discussed technical and fundamental approaches to forecasting exchange rates. We computed forecast errors and learned about the concept of efficiency in foreign exchange markets
Questions and Problems 1. Define arbitrage. What purposes does arbitrage serve in currency markets? 2. What is locational arbitrage? Illustrate your answer with a suitable example. 3. Locational Arbitrage: Consider the following: Bank X
Bank Y
Bid price of FF per US $
5.50 FF/$
5.54 FF/$
Ask Price of FF per US $
5.52 FF/$
5.56 FF/$
If you have US $100,000 how would you go about executing a locational arbitrage? Outline the steps and show the results. 4. Triangular Arbitrage: Consider the information on Cross Exchange Rates (Table 2.1) in Module 2. The cross exchange rate of the FF per SF is 4.2762; that is the rate given across France, and under SFRANC is 4.2762, read as FF 4.2762 per SF. This is the theoretical rate. Suppose, in the Market, this cross rate is FF 4.2993 per SF. If you have $100,000, how would you go about executing triangular arbitrage? Outline the steps, profits, and compute the rate of return. 5. Define Covered interest arbitrage. 6. Covered interest arbitrage: Consider the following information: Spot Exchange Rate
$1.535/Pound
180-days Forward Rate
$1.566/Pound
180-days Interest Rate
6% 8% (UK)
i. ii.
(USA)
If you are a US investor with $1,000,000 on hand, how would you go about executing covered interest arbitrage ? Outline the steps, compute the profit, and return on investment. As a result of the covered interest arbitrage above, what will happen to: a. The spot exchange rate of $1.535 ? b. The forward exchange rate of $1.566 ? c. To the interest rates in the USA and Britain ?
7. Identify and explain the reasons for forecasting exchange rates. 8. What is fundamental forecasting ? What variables are used in fundamental forecasting ? 9. Explain regression approach to forecasting exchange rates. Outline the method, state and explain the steps. Provide suitable examples. 10. In early 2001, a consultant was hired to forecast the Japanese yen for the four quarters of 2001. His forecasts and the actual or realized exchange rates are given below: Forecast Error for Japanese Yen Quarter
Forecasted Value $ per Yen
Realized $ per Yen
1
0.009091
0.009023
2
0.009524
0.009534
Value Absolute Value the Deviation
of
3
0.009334
0.009226
4
0.009346
0.009387 Sum Average
Fill-in the missing values in the last column and compute the average forecast error. Do you think that the consultant did a good job ? END OF MODULE 4
Module 5: Currency Futures, Forward Contracts, and Options Objectives and Theme: In this module, our objectives are to study three major instruments in the foreign exchange markets: 1) currency futures contracts 2) currency forward contracts and 3) currency options and the use of these instruments for speculative and hedging purposes. The use of these instruments depends on the firm's expectation about the future value of the particular foreign currency that the firm is interested in. We also discuss the back-ground of these instruments, why a firm should use these instruments, and under what conditions they will be used. Currency Futures: Currency futures are contracts specifying a standard volume of a particular currency to be exchanged for a specific price on a specific settlement date. In 1972, the Chicago Mercantile Exchange (CME) established the International Money Market division (IMM) which allows trades in futures for some short term securities, gold, and seven widely traded foreign currencies. Visit the Future Contracts site in this link and examine the latest open, high, low, and close prices for the British Pound (BP) futures contract for the nearest month. A wealth of information on links about currency futures and options appears at this site, also.
Interpreting Currency Futures Quotes Futures page from the Wall Street Journal of February 08, 2001 are presented below:
Currency Futures Wall Street Journal -- February 08, 2001
LIFETIME OPEN
HIGH
LOW
SETTLE CHANGE HIGH
OPEN
LOW
INTEREST
JAPANESE YEN (CME)-12.5 MILLION YEN; $ PER YEN (.00) MAR 0.8764
0.8796
0.8726
0.8765
+.0003
1.0300
0.8414
89,936
JUNE 0.8850
0.8876
0.8845
0.8870
+.0004
1.0219
0.8590
2,878
SEPT . . . .
....
....
0.8968
+.0004
1.0050
0.8769
100
DEC
....
....
0.9066
+.0004
0.9880
0.8873
103
0.4225
322
....
EST VOL 11,539; VOL MON 12,941; OPEN INT 93,017, +503. DEUTSCHEMARK (CME)-125,000 MARKS; $ PER MARK MAR 0.4785
0.4785
0.4752
0.4759
-.0046
0.4925
EST VOL 3; VOL MON 1; OPEN INT 331, UNCH CANADIAN DOLLAR (CME)-100,000 DOLLARS; $ PER CAN $ MAR 0.6621
0.6640
0.6615
0.6619
-.0021
0.7040
0.6415
46,671
JUNE 0.6625
0.6637
0.6615
0.6623
-.0021
0.6990
0.6425
4,846
SEPT 0.6626
0.6640
0.6623
0.6627
-.0021
0.6906
0.6445
1,545
DEC
0.6645
0.6632
0.6631
-.0021
0.6825
0.6452
680
1.4010
28,681
0.6632
EST VOL 5,857; VOL MON 9,955; OPEN INT 53,773, -1,902. BRITISH POUND (CME)-62,500 PDS.; $ PER POUND MAR 1.4750
1.4750
1.4570
1.4584
-.0168
1.6050
EST VOL 30,974; VOL TH 10,792; OPEN INT 74,908, +781. SWISS FRANC (CME)-125,000 FRANCS; $ PER FRANC MAR 0.6119
0.6119
0.6042
0.6050
-.0069
0.6326
0.5541
47,387
JUNE 0.6100
0.6107
0.6073
0.6078
-.0070
0.6358
0.5585
451
0.5100
23,106
EST VOL 11,255; VOL MON 8,076; OPEN INT 47,854, -1,532 AUSTRALIAN DOLLAR (CME)-100,000 DLRS.; $ PER A.$ MAR 0.5496
0.5512
0.5468
0.5488
-.0009
0.6390
EST VOL 493; VOL MON 1,092; OPEN INT 20,205, -200. MEXICAN PESO (CME)-500,000 NEW MEX PESO, $ PER MP MAR 0.10110 0.10200 0.10110 0.10165 +00067
0.10425 0.09120 16,031
APR
0.10170 0.09730 1,000
0.10085 0.10085 0.10085 0.10065 +00067
MAY . . . .
....
....
0.09965 +00067
0.10070 0.09900 202
JUNE .09830
.09870
.09830
0.09860 +00062
0.10160 0.09070 3,388
AUG . . . .
....
....
0.09685 +00067
0.09800 0.09800 100
SEPT . . . .
....
....
0.09603 +00067
0.09880 0.09300 297
EST VOL 4,370; VOL MON 555; OPEN INT 21,125 +97. EURO FX (CME)-EURO 125,000; $ PER EURO MAR 0.9393
0.9400
0.9292
0.9308
-.0089
0.9999
0.8333
89,251
JUNE 0.9351
0.9351
0.9314
0.9321
-.0089
0.9784
0.8358
1,951
SEPT . . . .
....
....
0.9334
-.0089
0.9634
0.8379
851
EST VOL 13,310; VOL MON 18,079; OPEN INT 92,109, -264.
Futures are available for the Japanese Yen, Deutsche Mark, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, and the Euro. Right next to each currency, the standardized units of a given currency per one futures contract are also given: For example, each Japanese futures contract has 12.5 million units; the numbers of units for one futures contract for other currencies are presented below: Currency D-Mark Canadian Dollar British Pound Swiss Franc Australian Dollar Mexican Peso Euro
# of units in one futures contract 125,000 100,000 62,500 125,000 100,000 500,000 125,000
These futures trade for March through December 2001, and they expire on the third Wednesday of the given month. For illustrative purposes, if we examine the June 2001 Swiss Franc contracts further, we find the open price of $0.6100 per SF; further, the intra-day high and low respectively were $0.6107 and $0.6073. The closing price of $0.6078 represents the price when the CME closed for business on February 8th, 2001. If we were to buy the June 2001 SF futures at the closing price, the cost would have been: $0.6078*125,000 ( # of units of SF in one SF futures contract) = $75,975. One only needs to post a small margin of about 5% of the cost rather than pay the whole amount. The margin requirement varies from one currency to another; it also depends on whether the contract is for speculation or hedging. Therefore, there is enormous leverage involved here. You can find information on current futures margin requirements at the Chicago Mercentile Exchange web site.
Speculating with currency futures These futures contracts can be used for speculative or hedging purposes. A speculator will buy a given currency futures if he or she expects the foreign currency to appreciate or go up in price. The use of futures contracts in speculation is illustrated in the following article from the Wall Street Journal: "Day Traders Take a Fast and Costly Route."
Day Traders Take a Fast and Costly Route By Stanley W. Angrist Wall Street Journal, Aug. 31, 1993 Every day is not payday for most day traders. Day traders are investors who open and close market positions within the same trading day. They hope their market insights, trading skills and speed of action will allow them to take some profits home each day. In reality, most day traders find that what looks easy on paper is hard to do in the market.
Consider Jeffrey Needleman, a wholesale stamp dealer from Ann Arbor, Mich., who has been investing for 25 years, most of that as a day trader. He says that during the past 10 years he has run a $10,000 account into more than $100,000 in a few months "seven or eight times" but always manages to collapse it back to below its starting value in a few weeks. "When you have 30 or 40 winning trades in a row you begin to believe you are onto something and so you start to overtrade and the market takes it all back," explains Mr. Needleman. Most market professionals shun day trading, arguing that the costs of getting in and out of trades that usually produce only small profits and some inevitable losses will eventually deplete the equity in the accounts of all but the most skilled. But traders like Mr. Needleman don't much care about expert opinion. He says he is neither a high liver nor consumed with a desire to have great wealth. What he likes, he says, are the "big video game aspects" of day trading. When brokerage firms ask what his goals are, his stock response is that "I just want to have a wonderful time losing my equity." Other investors explain their affection for day trading in more expected ways. Kent Taylor, an Austin, Texas, investor who traded stock options before he began day trading futures full time in August 1992, says, "I like to go to sleep at night and not worry about the market 'gapping open' against me." An opening gap is when market prices begin the day at a substantially higher or lower level than the previous day's close. Day traders can play in all the financial markets, but most of them deal in futures contracts, especially financial futures such as the contracts based on the Standard and Poor's 500 stock index or on currencies such as the Swiss franc. A futures contract is an agreement to buy or sell something in the future, say 62,500 British pounds for each contract, at whatever price then prevails on the exchange. Investors who believe prices are going lower sell futures contracts, while those who believe prices are going to rise buy futures contracts. Two things determine whether an investment is attractive to day traders. One is liquidity, or the volume of trading. The other is volatility, or the size of price moves. When the volume of trading is heavy the bid-ask spread for an investment is small, meaning day traders can profit on small price moves. For example, the S&P 500 contract usually trades with only a $25 to $50 difference between what sellers will accept-the "bid price"-and what buyers will pay-the "ask price." The second requirement, volatility, means the investments must move enough during the day so that traders will be able to overcome their costs and still be left with a profit. Linda Raschke, a full-time trader and a sometime day trader, says day trading isn't something that can be done every day. "You do it when the volatility is there," she says. More than any other individual investors, day traders see their activity as a business. They believe that if they do their homework they will spot a significant move in the market before the rest of the trading world, capture a part of that move, and then exit with a profit. Anthony Eck, 39 years old, who trades out of his home in Austin, says that getting out quickly is an absolute necessity. So is a strict control system that limits both profits and losses. Trading mostly currency contracts he will risk no more that $125 a contract. His average loss generally is no more than $50 and his average profit is a minuscule $62 per contract. While many traders would scoff at such numbers, Mr. Eck says that 71% of his trades have been profitable since he
started trading about a year ago, making his trading profitable overall. Tom Meadows, who has been day trading full time only since March, hopes he can make a living doing it, but so far his losses exceed his profits. Mr. Meadows, 50, a former software manager in Austin, says day trading is appealing to him because "I like the idea of having my finger on the pulse of American economy." Day trading requires constant attention. In addition to the frequently changing bid-ask spread, day traders also must cope with the time differential required for brokers to fill their orders. It's a business where seconds count. Mr. Taylor, who trades mostly currency and the S&P stock futures, says he places his orders by phoning clerks stationed in booths along the periphery of the trading pit. He says the clerks can execute an order and report the price to him in less than a minute from the time he picks up the phone to place his order. Although all day traders claim they kiss the losers good-bye fast, the general lack of success for most suggests they might be a bit slow on the exit. David Morse, who trades from his home in Atlantic City, N.J., says he has been far more successful at the blackjack tables, which he visits after the markets close, than he has been in day trading. After 10 years of trading, "I would give a pint of blood to be able to trade successfully," he laments. Brokers love day traders because they can generate huge commissions. But few brokers openly encourage clients to day trade. "If I saw more success stories I might be more willing to encourage people to try," says William Mallers Jr., president of First American Discount Corp., a futures broker in Chicago. An active day trader can generate as much as $1,000 a day in commissions, he says.
Scalping the Market British futures contracts are being used for speculative purposes here. As the article illustrates, the speculator buys or goes long on the British futures contract expecting the pound to appreciate in value. Initially, he buys 2 BP futures contracts at $1.5424 per pound; he closes out one contract at $ 1.5442 initially, and another contract at $ 1.5426. $ Outflows: Purchase cost of 2 futures $1.5424 / pound at Round-trip commission at $25.00 / trade
$1.5424 *
62,500
$25.00
*
2
= $192,800.00
*
2
= $50.00
Total Cost
= $192,850.00
$ Inflows: Close out one contract at $1.5442 Close out the second $1.5426 contract at
$1.5442 * $1.5426 *
62,500 62,500 Total
Profit
* *
1 1
= $96,512.50 = $96,412.50 = $192,925.00 75
This table is available as an Excel spreadsheet.
In the second trade, Mr. Eck trailed the rising pound price with an order to sell as soon as the upward trend stalled. He was out of the trade with a profit within an hour and 15 minutes. Chicago TIme 7:47am 9:02am
Action Buy contracts Sell contracts
Price per Pound 2 $ 1.5134
Gross Profit
Commission
2 $ 1.5206
$900
$50
Net Profit
$850.00 *Each contract consists of 62,500 pounds In this situation, the speculator expected the pound to appreciate; therefore, he bought the futures contract first, and then sold it, or closed it out, after the pound depreciated. If the speculator expected the pound to depreciate, he would have sold the pound first and then bought it back after the pound has depreciated. Questions for interactive table above (use the available Excel spreadsheet): 1. Close out (sell) contract 1 at a price higher than $1.5442 and see what happens to the net profit. 2. Close out contract 2 at a price higher than $1.5426 and see what happens to the net profit. 3. Close out contract 2 at a price lower than $1.5426 and see what happens to the net profit.
Hedging with Currency Futures When a corporation has an open currency position (accounts receivable or accounts payable without an offsetting entry) in a foreign currency, it can lock in an exchange rate through futures contracts. This eliminates the risk of fluctuation in the value of the currency at the future date of transaction. Hedging allows a firm to avoid any unfavorable future exchange rate effect. *If the firm is receiving currencies ===> it must sell currency futures *If the firm is buying currencies ===> it must buy currency futures Hedging refers to taking protective positions to safe-guard the open currency positions. Suppose Coca-Cola Company, a US MNC has DM 100 million in 90-days payables for merchandise imported from Germany, as illustrated in the interactive Table below. Coca-Cola is concerned about the rising DM value which could lead to higher costs than anticipated. AN EXAMPLE ON EXCHANGE RATE RISK Given: Coca-Cola Corporation ( US based MNC ) has DM 100 million in 90-day Payables Time=t Spot
0 Exchange
Rate 0.4412
Plus 90 Days 0.525
Extra Cost
$/DM Cost in the Spot Market 44.12 90-day Futures
0.456
Cost of Futures
45.6
# of Futures Needed
800
Savings from Futures
52.5
8.38
6.9
This table is available as an Excel spreadsheet. In this case, Coca-Cola is, say,concerned about the possible rise in DM value which could lead to higher future $ costs than expected at time 0. To avoid this exchange rate risk, Coca-Cola can buy a DM June Futures contract at $0.4560 per DM , thereby locking-in the rate. Regardless of what happens to the spot DM in the future, Coca-Cola is now guaranteed a price of $0.4560 per DM. Since there are 125,000 units per DM futures contract, Coca-Cola has to buy 100,000,000/125,000 = 800 contracts. Note that at time 0, Coca-Cola only has to pay a 5% margin or so. When the bills are due in 90-days, Coca-Cola will execute the purchase of DM 100 ml @ $0.4560 per DM and remit the proceeds of DM 100 ml to pay-off its payables. Questions for interactive table above (use the available Excel spreadsheet): 1. Please change the exchange rate at t=+90 days from $0.75 to $0.85. What is the $ cost of savings from the use of futures here? 2. Please change the spot exchange rate at t=+90 days from $0.75 to $0.60. Was the use of futures worthwhile? If Coca-Cola had open accounts receivable in a foreign currency, Coca-Cola would sell futures contract at the agreed upon price, thereby guaranteeing that rate regardless of what would happen to the spot rate in the future. Summary information with regard to hedging payables and receivables, in terms of what to do with the futures and when to do it, appears below: What to do? Foreign Currency Accounts Payable Accounts Receivable
======> ======>
Future Contract in that Currency Buy Sell
When to do it? Payables: If the spot rate in the future is expected to be less than the current futures rate ===> Do not enter into futures contract. If the spot rate in the future is going to be greater than the current futures rate ===> Enter into the futures contract.
Foreign Currency Appreciate
======>
Future Contract in that Currency Buy
Receivables: If spot rate in the future is expected to be greater than futures rate ===> Do not enter into the futures contract. If the spot rate in the future is going to be less than the current futures rate ===> Enter into the futures contract. Foreign Currency Depreciate
======>
Future Contract in that Currency Sell
Forward Contracts and Hedging The hedging of DM payables by Coca-Cola using the June futures contract could also have been accomplished via forward contracts in forward markets. In module 2, we learned about the forward markets and forward rates. For example, Coca-Cola might easily have hedged its DM 100 million payables by buying a DM 90-day Forward contract at $ 0.4590 per DM for DM 100 million. Forward rates are shown in the following table: Exchange Rates: Currency Trading Forward contracts are explained in plain English at this site! Please visit this site. What are the advantages and disadvantages of forward contracts? However, there are quite a few differences between currency futures and forward contracts. Currency futures are traded face to face on a trading floor. They are standardized and require a small security deposit, whereas forward contracts are negotiated over the phone, tailored to individual needs, and require no security deposit. The differences between the forward contracts and futures are illustrated below: Comparison of Forward and Futures Markets Forward Contracts
Futures
Size of contract
Tailored to individual needs.
Standardized.
Delivery date
Tailored to individual needs.
Standardized.
Participants
Banks, brokers, and multinational Banks, brokers, and multinational companies. Public speculation not companies. Qualified public encouraged. speculation encouraged.
Security deposit
None as such, but compensating Small security deposit required. bank balance or lines of credit are required.
Clearing operation
Handling contingent on individual Handled by exchange clearinghouse. banks and brokers. No separate Daily settlements to the market price. clearinghouse function.
Marketplace
Over the telephone worldwide.
Central exchange floor with worldwide communications.
Regulation
Self-regulating.
Commodity Commission; Association.
Futures National
Trading Futures
Liquidation
Most settled by actual delivery. Some Most by offset, very few by delivery. by offset, at a cost.
Transaction costs
Set by "spread" between bank's buy Negotiated brokerage fees. and sell prices.
® Reproduced with permission from Chicago Mercantile Exchange, Chicago
Currency Options Currency options are an alternative type of contracts that can be purchased or sold by speculators and firms. Currency options are available for seven major currencies on the Philadelphia Exchange. The volume for currency represented in each currency option contract on the Philadelphia Exchange is half size of the currency's volume in the IMM futures contract. For example, one DM option contract contains 62,500 German Marks, half of the 125,000 units per one German mark futures contract. There are two types of options with regard to their exercisability: a) American options can be exercised at any time on or before the date of maturity and b) European options can be exercised only on the day of expiration. Obviously, American options are far more flexible than European options.
Call Option It is right, but not an obligation, to buy a currency at a specified price called the strike price, or exercise price, for a specified period of time for which the purchaser pays an option premium to the seller or writer of the call. A currency call option is bought for speculative purposes when one expects the underlying currency to appreciate in value. The idea is to buy the currency low at the strike price and then turn around and sell the currency high. A currency call option is also used to hedge foreign currency payables; by buying call options at the appropriate strike price, one is able to lock-in a rate.
Interpreting Currency Call Option Information The features of call option are found in Philadelphia Options.
Philadelphia Options Wall Street Journal, February 21, 2001 Calls Vol.
Puts Last
Vol.
Last
BPound
147.69
31,250 Brit. Pound-cents per unit. 142
Jun
...
...
5
BPound
2.38 147.69
31,250 Brit. Pound-cents per unit. 155
Apr
100
0.10
...
...
163
Mar
...
...
100
0.33
CDollr
91.61
50,000 Canadian Dollars-cents per unit 67
Mar
...
...
10
2.00
67
Jun
...
...
100
2.15
Euro
88.15
62,500 Euro-European style 94
Jun
10
1.51
...
Euro
... 88.15
62,500 Euro-European style. 82
Mar
5
8.67
...
Euro
... 88.15
62,500 Euro-cents per unit. 88
Mar
...
...
3
0.35
90
Apr
...
...
10
1.27
92
Mar
2
0.73
...
...
94
Mar
3
0.31
...
...
SFranc
57.83
62,500 Swiss Francs-European Style 60
Mar
...
...
60
SFranc
1.17 57.83
62,500 Swiss Francs-cents per unit. 60
Sep
5
2.20
...
...
Call Vol.
697
Open Int.
15, 523
Put Vol.
1,204
Open Int.
13, 523
Our focus will be on American style options. Please refer the last of Swiss Francs-cents per unit information in the middle column. The 62,500 found to the left of the Swiss Francs refers to the # of units of Swiss Francs in one Swiss Franc option. The first column of #s below the last 62,500 refers to the strike price: the strike price is 60, which stands for a strike price of US $0.60 per SF. The strike price is also called the exercise price and, in the case of the call option, represents the purchase price. Right next to the strike price is the month of expiration; options expire on the Friday before the third Wednesday of a given month. The next two columns provide information on calls: vol refers to the volume of calls traded for the day and the last refers to the last option premium quoted for a given call strike and month. The last two columns contain information on put option volume, etc.
Speculating with Call Options A speculator will buy a call option if he expects the currency to go up in value or appreciate. Suppose a speculator buys 1 Swiss Franc September 60 call with a premium of 2.20 cents per Franc. The 60 stands for a purchase price of $0.60 per Swiss Franc; the following Table illustrates a hypothetical situation. Please refer to Speculating with Call Option table below: Speculating with Call Option Time
Action
t=0
Buy 1 DM September call at $0.60 per SF
Per Unit of SF
Per 1 62,500 contract
SF Option units per
Assumed spot rate: $0.6109 per SF Option Premium (Outflow) t = +1
($0.0220) SF
per ($1,375)
Exercise call and buy DM 62,500 at $0.60 per SF Purchase price (Outflow)
($0.60) per SF
($37,500)
Assumed spot rate now: $0.65 t = +1
Sell SF 62,500 at the spot rate of $0.65 $0.65 per SF (Inflow)
$40,625
Net profit =
$1,750
$0.02700
This table is available as an Excel spreadsheet.
Note: We assume a spot rate of $0.6109 per SF at t=0 and $0.65 per SF at t=+1. The table is self-explanatory. Here, since the SF appreciated, the speculator exercises his right to buy the SF at the original agreed upon strike price and turns around and sells it at a higher price. The results are shown both for per unit and for 1 option. Unlike the futures, which are legal obligations, one can walk away from the options if things are not working in favor of the speculator. Further, with the higher spot price at time=t+1, as shown in the above Speculating with Call Option interactive table, the premium of the June 60 SF call will be higher, and the speculator could close out his call by selling to other speculators in the marketplace without having to exercise the options. Thus options can be bought and sold in their own rights as stand-alone securities. Another interesting point about options is that, for the purchaser of an option, the maximum loss is the premium amount paid originally and no more.
Questions for interactive table above (use the Change the spot rate at t=+1 from $0.65 per Swiss Franc to:
available
Excel
spreadsheet):
1. $0.75 per SF 2. $0.50 per SF
Note what happens to net profit in each case. A contingency graph of a British call option from the buyer's perspective is shown in Figure # 4. On the horizontal axis, the spot rate appears, and the vertical axis shows the net profit. The break-even point for the call equals the strike price plus the premium; in this case, the purchase (strike) price is $1.50 and the premium is $ 0.02; therefore, the break-even point occurs at $1.52 (spot price). The call buyer benefits when the spot price increases; for example, if the spot price in the future were $1.60, the net profit will be $ 0.08. The maximum loss from the buyer's perspective is the premium of $0.02. Figure #4
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
Hedging Payables with Call Option Call options can be used to hedge payables. Basically, one buys the required number of calls at the selected strike price and month. In the example above, if the calls were being bought for hedging payables, the corporation would buy the currency at the strike price and there would not be any resale of the currency. The foreign currency bought would be used to pay off the payables. The number of calls to be bought to hedge the payables would depend on the amount of payables and its currency of denomination.
Factors Affecting Call Option Premium The following factors have a bearing on the call option premium: Spot price relative to strike price: The higher the spot rate, the higher the premium.
This makes sense since the call buyer will benefit if the spot price goes up. Therefore, the premium will correspondingly increases as it is more attractive. Time to maturity: For any given strike price, the longer the maturity, the higher the premium. Here, there simply is more time for the spot price to go up in value. Potential volatility or variability of the currency: The higher the variability as measured by the standard deviation or fluctuation of a currency, the higher the option premium. Higher variability increases the chances of the currency going up in value. The higher the risk free rate, the higher the option premium. This is because of the higher opportunity cost for the writers of calls who will demand a higher premium.
Put Option It is a right to sell a given currency at a price called the strike or exercise price for a given specified period of time for which the buyer pays a premium to the writer or the seller of the put option. Currency put options are bought for speculative purposes when one expects the underlying currency to depreciate in value. The idea is to sell the currency high at the strike price and turn around and buy the currency back low. Currency put options are also used to hedge foreign currency receivables; by buying put options at the appropriate strike price, one is able to lock-in a rate. Any subsequent depreciation of the foreign currency will not affect the $ inflows since the rate is locked-in.
Interpreting Currency Put Option Information The features of the put option are found in Philadelphia Options table. Our focus once again will be on American style options. Please refer the last of Euro-cents per unit information in the middle column. The 62,500 found to the left of the Euro refers to the # of units of Euro in one Euro option. The first column of numbers below the last 62,500 refers to the strike price: the first strike price is 88, which stands for a strike price of US $ 0.88 per Euro, while the 90 below that represents a strike price of $ 0.90 per Euro and so on. The strike price, also called the exercise price, in the case of the put option, represents the sale price. Right next to the strike price is the month of expiration; options expire on the Friday before the third Wednesday of a given month. The last two columns provide information on puts: vol refers to the volume of puts traded for the day, and the last refers to the last option premium quoted for a given put strike and month.
Speculating with Put Options A speculator will buy a put option if he expects the currency to go down in value or depreciate. Suppose a speculator buys one Euro April 90 put with a premium of 1.27 cents per Euro. The information on this put option appears at the very bottom of column 2 of the Philadelphia Options table. The 90 here stands for a selling price of $0.90 per Euro; a hypothetical situation is illustrated in Speculating with Put Options table below:
Speculating with Put Option Time
Action
t=0
Buy 1 Euro July put at $0.900
Per Unit of Euro
Per 1 Euro Option 62,500 units per contract
Assumed spot rate: $0.9000 per Mark Option Premium (Outflow) t = +1
($0.0120) Euro
per ($750)
Exercise put and sell Euro 62,500 at $0.900 per Euro Selling price (Inflow)
($0.900) per Euro ($56,250)
Assumed spot rate now: $0.85 t = +1
Buy Euro 62,500 at the spot rate of $0.85 ($0.85) per Euro per Euro (Outflow) Net profit =
($53,125)
$0.0380 per Euro $2,375
This chart is available as an Excel spreadsheet. Note: We assume a spot rate of $0.90 per Euro at t=0 and $0.85 per Euro at t=+1. The table is self-explanatory. Here, since the Euro depreciated, the speculator exercises his right to sell the Euro at the original agreed upon strike price and turns around and buys it back at a lower price. The results are shown for both per unit and per option. Unlike futures, which are legal obligations, one can walk away from the options if things are not working in favor of the speculator. Further, with the new lower spot price at time=+1, as shown in the Speculating with Put Option interactive table above, the premium of the April 90 Euro put will be higher, and the speculator could close out his put position by selling to other speculators in the market place without having to exercise the option. Thus, options can be bought and sold, in their own right, as stand-alone securities. Another feature of options is that, for the purchaser of an option, the maximum loss is the premium amount paid originally and no more. Questions for interactive table above (use Change the spot rate at t=+1 from $0.85 per Euro to:
the
available
Excel
spreadsheet):
1. $0.60 per Euro 2. $0.90 per Euro
Note what happens to net profit in each case. A contingency graph of a British put option from the buyer's perspective is shown in Figure # 5. On the horizontal axis the spot rate appears, and the vertical axis shows the net profit. The break-even point for a put equals the strike price less the premium; in this case, the selling (strike) price is $1.50, and the premium is $ 0.03; therefore, the break-even point occurs at $1.47 ($1.50-$ 0.03). The put buyer benefits
when the spot price decreases; for example, if the spot price in the future were $1.40, the net profit would be $ 0.07. The maximum loss from the buyer's perspective is the premium of $0.03. Figure # 5
Note: This Figure is reproduced from permission from International Financial Management, Fourth Edition, Jeff Madura. Copyright © 1995 by West Publishing Company. All Rights Reserved.
Hedging Receivables with Put Option Put options can be used to hedge receivables. Basically, one buys the required number of puts for a selected strike price and month. In the example above, if the put were being bought for hedging receivables, the corporation would sell the currency at the strike price and there would not be any buyback of the currency. The number of puts to be bought to hedge the receivables would depend on the amount of receivables and its currency of denomination.
Factors Affecting Put Option Premium The following factors affect the premium in the put option: Spot price relative to strike price: The lower the spot rate, the higher the premium. This makes sense since the put buyer will benefit if the spot price goes down. Therefore, the premium will correspondingly increases as it becomes more attractive. Time to maturity: For any given strike price, the longer the maturity, the higher the premium. Here, there simply is more time for the spot price to go down in value. Potential volatility or variability of the currency: The higher the variability, as measured by the standard deviation or fluctuation of a currency, higher the option premium. Higher variability increases the chances of the currency going-down in value as well. The higher the risk free rate, the lower the put option premium.
Summary of Information on Hedging with options: Accounts Payable ===> Outflow Minimization ===> Buy the Currency in the Future ===> Buy Call Option Accounts Receivable Inflow maximization ===> Sell the Currency in the Future ===> Buy Put Option
Summary: In this Module, we studied the nature and characteristics of currency futures, forward contracts, and options. In addition, we discussed their use in speculation and hedging. END OF MODULE 5
Module 6: The Nature and Control of Foreign Exchange Risk Objectives and Theme: In this module, we study the nature of Foreign Exchange risk and its management. Our objectives are to define foreign exchange risk, review categories, or types of exchange rate risk, and examine various techniques available for managing exchange risk. Specifically, we analyze two types of exchange rate risk in depth : 1) Transaction Exposure and 2) Operating Exposure and study techniques to manage them.
Foreign Exchange Risk and Types of Foreign Exchange Risk: Foreign Exchange Risk refers to the effect of fluctuating exchange rates on the revenues, costs, profits, cash flows and firm value of an MNC. It is very important to measure and manage exchange risk. Managing foreign exchange risk reduces the variability of both the earnings and the cash flows of a firm. It also helps in more accurate forecast of receipts and payments and leads to improved cash budgeting as well. Quite a few MNCs like Sony, Merck, Eastman Kodak, and Colgate practice effective foreign exchange management techniques to stabilize their earnings and cash flows
Relevance of Exchange Rate Risk Some people have argued that in a world of purchasing power parity where movements in exchange rates are expected to be offset by price movements, the exchange rate risk is not relevant. However, purchasing power parity often does not hold in the real world, especially during the shorter time horizon of 2 to 5 years. Another argument for the irrelevance of exchange rate risk is that stockholders of MNCs can hedge their own risk by substituting homemade hedges for corporate hedges. But, the investors do not have access to the information that managers have access to; managers simply have an advantage in the depth and breath of the risks and returns of MNCs. Further, the investors may not be very knowledgeable in various hedging techniques, and the transactions costs for individual investors might be prohibitive.
Types of Foreign Exchange Risk
The effect of changing foreign exchange rates on a firm can be classified into the following three categories: 1. Economic Exposure: This is defined as the effect of exchange rate changes on a firm's cashflows and therefore its value. 2. Transaction Exposure: This exposure is defined as the variabilty of the cashflows arising from the fluctuations in exchange rates affecting the transactions already entered into and denominated in one or more foreign currencies. Consider the following Example on Transaction Exposure type exchange rate risk in Module 1: AN EXAMPLE ON FOREIGN EXCHANGE RATE RISK Given: ABC Corporation ( US based MNC ) has DM 100 million in 90-day Payables Time=t 0 Plus 90 Days Extra Cost Spot Exchange Rate $/DM
0.661
0.75
$ Cost
66.1
75
8.9
This table is available as an Excel spreadsheet. In this case, ABC paid $8.9 Million more than it anticipated to pay at time=0; the DM appreciated, thereby, increasing the US dollar cost of the payables in DM. This is the exchange rate risk MNCs face in handling their foreign currency flows. The risk arises from the need to convert the cash flows from one currency to another. If there is no need to convert the currency, MNCs will not face exchange rate risk. This is an example of transaction exposure: the exchange risk arose in the context of foreign currency payables for imports made by the US based MNC from Germany. This example has been built on foreign currency outflows being affected by changing exchange rate; the transaction exposure can affect foreign currency inflows as well. Questions for the interactive table above (use the available Excel spreadsheet): Change the exchange rate at t=+90 days from $0.75 per DM to: 1. $0.95 per DM 2. $0.65 per DM What is the measure of transaction exposure in each scenario above?
3. Operating Exposure: This is another type of exchange rate risk; it is defined as a measure of the changes in firm value resulting from changes in future operating cash flows of a firm, which in turn are caused by unexpected exchange rate changes. This type of exposure is also called competitive or strategic exposure. Actually, transaction exposure is a subset of economic exposure. The concept of operating exposure is examined using an example. Madison Inc. is a US based MNC with a portion of its business located in Canada. Its US sales are in US dollars, and its Canadian sales are in Canadian dollars. Its pro forma income statement for next year is presented below: Impact of Possible Exchange Rate Movements on Earnings (in millions)
Exchange Rate Scenerio C$=$.75
C$=$.80
C$=$.85
Sales (1) U.S. (2) Canadian (3) Total
C$4=
$300 $3
C$4=
$303
$304 $ 3.2
C$=4
$307.2
$307 $ 3.4 $310.4
Cost of goods sold (4) U.S. (5) Canadian
$ 50 C$200= $150
C$200=
$ 50 $160
C$=200
$ 50 $170
(6) Total
$200
$210
$220
(7) Gross Profit
$103
$ 97.2
$ 90.4
$ 30
$ 30
$ 30
(10% of total sales)
$ 30.3
$ 30.72
$ 31.04
(10) Total
$ 60.3
$ 60.72
$ 61.04
(11) EBIT
$ 42.7
$ 36.48
$ 29.36
Operating Expenses (8) U.S.: Fixed (9) U.S.: Variable
Interest expense (12) U.S. (13) Canadian
$3 C$10= $ 7.5
C$10=
$3 $8
C$=10
$3 $ 8.5
(14) Total
$ 10.5
$ 11
$ 11.5
(15) EBT
$ 32.2
$ 25.48
$ 17.86
This table is available as an Excel spreadsheet. Note: This figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
The impact of three different exchange rate changes on the income statement is shown below; here, the US sales are assumed to be higher when the Canadian dollar is stronger. The reason is that Canadian competitors will be priced out when the Canadian dollar is stronger. Impact of Possible Exchange Rate Movements on Earnings (in millions) The table is self-explanatory; basically, it is a combined statement of income with the Canadian revenues and costs converted at the different exchange rate scenarios. A stronger Canadian dollar results in an increase in the US dollar value of sales; it also increases the US dollar sales in the US due to Canadian competitors being priced out. The stronger Canadian dollar also leads to a higher cost of goods sold since Canadian cost of goods sold exposure is greater than the Canadian sales exposure. Thus, there is a negative overall impact on the Earnings Before Interest and
Taxes (EBIT). Thus, Madison Inc., with its higher Canadian costs, is affected by a stronger Canadian dollar. In general, firms with more foreign costs than foreign revenues will be unfavorably affected by a stronger foreign currency; but, a weaker foreign currency will have a positive impact on these firms. On the other hand, firms with more foreign revenues than costs will be favorably affected by a stronger currency; but, these firms will be unfavorably affected by a weaker foreign currency since, with the weak currency, translated US dollar revenues will be lowered. Operating exposure thus affects the local currency inflows and outflows. These flows can be 1) operating cash flows like inter and intra-firm receivables and payables, rent and lease payments, royalty and license fees, and management fees, and 2) financing cash flows like interest on loans and dividends on stockholders' equity. The concept of Operating Exposure is further explained in the context of a Swiss subsidiary remitting cash flows from a capital investment in Switzerland to its parent in the USA. The very first line gives the after-tax incremental cash flows remitted; year 0 cash flows represent cost or outflows for the investment project. The forecast of the SF called for its steady appreciation as shown in the Strong-franc scenario of $0.54 per in year 1 to $0.65 in year 4. With a steady appreciation forecast, the $ cash inflows increase resulting in a net present value of $4,875,754. But, in reality, the SF weakened, and the exchange rate, as shown in weak-Franc scenario, unfolded: the result was a steep decline in the $ value of SF remitted, so much so that the net present value turns negative now. Economic Exposure Further Illustrated Year 0
Year 1
Year 2
Year 3
Year 4
5,400,000
5,400,000
6,840,000
19,560,000
Exchange Rate $/ $Cashflows to the parent Co.
$0.54 $2,916,000
$0.57 $3,078,000
$0.61 $4,172,400
$0.65 $12,714,000
PV of cashflows @ 15% discount rate
$2,535,652
$2,327,410
$2,743,421
$7,269,271
Remitted to the parent (SF) Strong Scenario
Initial Investment
($10,000,000)
NPV
$4,875,754
Weak Scenario Exchange rate $/ $Cashflows to the Parent Co.
$0.47 $2,538,000
$0.45 $2,430,000
$0.40 $2,736,000
$0.37 $7,237,200
PV of cashflows @ 15% discount rate
$2,206,957
$1,837,429
$1,798,964
$4,137,893
Initial Investment NPV
($10,000,000) ($18,757)
Questions about the interactive table above: Change the exchange rate under a strong Franc scenario as follows: Year 1: $0.60 Year 2: $0.65 Year 3: $0.75 What happens to the $ cash inflows and the net present value of the project? Change the exchange rate under a weak Franc scenario as follows: Year 1: $0.40 Year 2: $0.29 Year 3: $0.15 What happens to the $ cash inflows and the net present value of the project?
4. Translation Exposure: This exposure arises in the context of translating income and balance sheets from foreign currencies into the reported home currency to prepare consolidated financial statements. It affects accounting income but not cash flow. In the remaining part of this module, the management of transaction and economic exposures are explored. Since translation exposure does not affect cash flows, its management is not dealt with here.
Transaction Exposure Management Once again, recall that transaction exposure refers to the exchange rate induced changes in the future inflows and outflows of a firm; it affects transactions already entered into and denominated in foreign currencies. To manage the transaction exposure effectively, one should: 1) Identify the degree of transaction exposure 2) Decide whether to hedge or not, and 3) Choose among various hedging techniques if the decision is to hedge.
Identifying Net Transaction Exposure All expected inflows and outflows for a particular currency and time should be consolidated to measure the net transaction exposure. The MNC should identify each subsidiary's position in all currencies. The subsidiaries will send reports to the centralized cash management office of the parent company. Consider the following example: Quincy Corporation estimates the following cash flows in 90 days at its subsidiaries: Net Position in each currency measured in parent's currency (in 1000s of Units) Subsidiary
FF
DM
BP
A
+200
-300
-100
B
+100
-40
-10
C
-180
+200
-40
(+ = inflow, - = outflow) The consolidated net exposure of the MNC will be: FF + 120,000 DM - 140,000 BP - 150,000 The MNC has a net inflow position of 120,000 $ equivalent units in FF; it has a net outflow position of 140,000 $ equivalent units in DM; in BP, its net exposure is an outflow of 150,000 $ equivalent units. Questions for thought: Why do we need to identify net transaction exposure? We need to know what is at risk before we take protective steps to safe-guard the cash flows at risk. This is why we need to identify the net transaction exposure. Also, only open currency cash flows for a given time alone are at risk. This is because, if one has both inflows and outflows in the same currency for the same time horizon, any exchange rate change will result in net 0 effect on the changes in cash flow values and, therefore, in that situation, there would not be any exchange rate risk.
Should the management of transaction exposure be conducted at the subsidiary or the parent level? The management of the transaction exposure should be conducted at the parent level. That way, all subsidiaries will be able to report their net positions in all currencies. With the information on different currency flows available at the central office, the parent can come up with the overall net position for each currency for a given time; therefore, overall corporate efficiency is enhanced. It is also consistent with the objective of maximizing the stockholder wealth.
Forecast of Exchange Rates and the Decision to Hedge or not to Hedge Obviously, the hedging decision will depend on the forecast of the exchange rates. If you anticipate receivables sometime in the future in a foreign currency and the forecast calls for appreciation of the foreign currency in the interim, hedging the receivables by selling forward at the forward rate may not be worthwhile. Similarly, if payables in a foreign currency are due in the future and the forecast of exchange rates calls for the depreciation of the foreign currency involved, hedging would also not be worthwhile. Since nobody can foretell the future of the exchange rate movements and businesses are conservative and dislike uncertainty, most MNCs do hedge.
Techniques to Hedge Transaction Exposure Futures Contract Hedge: Future contracts enable firms to buy or sell a specified amount of a given currency at a pre-determined price on a specific future date. This is the preferred choice by firms when
the amounts involved are small. To hedge future payables, the firm will enter into a future buying contract and, to hedge a future receivables, the firm will sell forward at the appropriate futures rate. Forward Contract Hedge: The mechanics are the same as that of the futures contracts. They are used for large amounts and are tailor made to suit the needs of the individual firm. One must always compare the costs of forward contracts or futures versus the no hedge decision and choose the alternative having the lower cost. Note: The costs of hedge or no hedge hinge on accurate forecasts; additionally, since corporations do not like risk , they may want to hedge even when the costs of hedging are higher than no hedging. Money Market Hedge: Involves taking a money market position to cover future payables or receivables. For hedging future payables, one invests in the foreign currency. For hedging the future receivables, one borrows in the foreign currency. Currency Option Hedge: Currency options not only provide the hedge but also provide the flexibility since they do not require a commitment to buy or sell a currency unlike the forward or future contracts where there is a commitment. Firms use call options to hedge future payables, and use put options to hedge future receivables.
Comprehensive Examples on Hedging Transaction Exposure Different techniques to hedge transactions exposure are illustrated through comprehensive examples here: I. Payables outstanding in foreign currency: With the payables, the corporation is concerned about a rising value of the foreign currency which would lead to higher dollar costs. Hedging these payables is done to minimize dollar outflow costs in the future. ABC corporation has an outstanding DM 200,000 90-day payables. The following information is available: Spot rate of the DM : $ 0.675 per DM 90-day Forward Rate : $0.685 per DM 90-day Interest rates are as follows: US 5.0 % 6.0 %
90-day deposit rate 90-day borrowing rate
Germany 5.0 % 6.0 %
A call option on the DM that expires in 90-days has an exercise price of $0.680 and has a premium of $0.02. A put option on DM that expires in 90-days has an exercise price of $0.660 and has a premium of $0.03. The DM spot rate in 90-days is forecasted to be: Possible Rate $0.660 per DM $0.690 per DM
Probability 30 % 70 %
ABC corporation is considering:
1. A Forward Hedge 2. A Money Market Hedge 3. An Option Hedge and 4. Remaining Unhedged You have been hired as a consultant to decide on the best possible hedge. Which one of the alternatives you will recommend, and why ? Solution: 1. Forward Hedge: Purchase DM 90 days forward at the forward rate of $0.685 per DM, thereby locking-in the rate; regardless of what happens to the spot rate in the future, ABC will be able to get the DM at $0.685 per DM. Cost = DM 200,000 * $0.685 per DM = $137,000 Note that ABC enters into a contract to purchase a DM at time 0 and the actual purchase and delivery occur 90-days later when the DM is needed to pay the payables.
2. Money Market Hedge A money market hedge works on the general principle of creating an opposite sign currency cash flow for the same duration as that of the payables. For hedging payables, the steps include borrowing in dollars, converting to DM at the spot rate, investing DM in a German money market instrument at the German deposit rate, and repaying the dollar loan with interest at the US borrowing rate in 90 days. When the German investment matures in 90-days, the proceeds are used to pay the payables. Steps: 1. Find amount of DM to be invested = Payables Amount /(1+Foreign Interest Rate) DM200,000 / (1+0.05) = DM190,476.19 Since foreign investment generates interest income, one needs to only invest the net amount which will grow into an amount equal to the payables amount. 2. Calculate amount of $ to be borrowed = DM190,476.19 * 0.675 = $128,571.43 3. Borrow $128,571.43 @ 6% 4. Convert $128,571.43 to DM at exchange rate of $0.675 per DM $ 128, 571.43 * 0.675 = DM190,476.19 5. Invest in Germany @ 5% = DM190,476.19 * 1.05 = DM200,000 6. Repay loan in 90 days plus interest $128,571.43 * 1.06 = $136,285.72 When the German investment proceeds of DM200,000 are received in 90-days, the proceeds will be used to pay off the payables.
3. Option Hedge The option hedge involves buying call option to hedge payables. Recall that the call option gives the right to buy the given currency at the strike price. Also remember that an option is just that, an option; if the rates are not favorable, one can walk away from that. Buy DM call option (Exercise price = $0.68, premium = $.02)
Expected Spot/ Probability $0.66 (30% )
Premium
Exercise (Y or N)
Total Price*
Cost
$0.02
NO
$0.68
$136,000
$0.69 (70%)
$0.02
YES
$0.70
$140,000
* Total Price = Purchace Price + Premium Expected cost of call option = $136,000 (0.3) +$140,000 (0.7) = $138,800
4. Remain Unhedged Expected Spot $0.66 $0.69
Total Price $132,000 $138,000
Probability 30% 70%
Expected Cost of Remaining Unhedged = $132,000(0.3) + 138,000(0.7) = $136,200 5) Which one of the alternatives should one choose? In choosing among the hedging alternatives for payables, one has to choose a lower cost alternative; one also has to consider the risk among different alternatives and go for more certain outcome since corporations do not like uncertainty. While the expected cost of doing nothing, or remaining unhedged has the lowest cost of $136,200, there is a 70% chance that its cost might be as high as $138,000. The money market hedge has the lowest cost of $136,285.72, and it is 100% certain. Therefore, a money market hedge is recommended here. However, the forward hedge is close behind with a $137,000 cost.
2. Receivables Another US corporation (XYZ Corporation) is expecting an inflow of DM300,000 Receivables in 90-days. It is considering: 1. 2. 3. 4.
A Forward hedge Money Market Hedge An Option Hedge and Remaining Unhedged
Use the other information given along with the payables to advise this firm of a suitable strategy.
1. Forward Hedge The forward hedge to hedge receivables involves selling the currency forward at the forward rate thereby locking-in the rate. Sell DM300,000 @ the 90 days forward rate DM300,000 * $0.685 = $205,500
2. Money Market Hedge As before,the Money Market Hedge is built on the principle of building an opposite currency flow for the same amount to the flow that is being hedged: in this case, since the receivables being hedged is an inflow of DM300,000 to be received 90-days from now, we need to create a DM300,00 outflow in 90-days. We can accomplish this by borrowing in DMs, converting to US dollars, investing those dollars in the US; when the proceeds from the receivables are received, the corporation will use those proceeds to pay off the DM loan. Amount to be borrowed in DM = Receivables/(1+Foreign Interest Rate) = DM 300,000/(1+0.06) = DM 283,018.27 US dollars Received after converting to the DM at the Spot Rate = DM 283,018.27 * 0.675 = $ 191,037.74 Invest the US dollars in the US at the US deposit rate Amount accumulated after 180 days = $ 191,037.74 *(1+0.05) = $ 200,589.62
3. Option Hedge This technique to hedge receivables involves buying put option. Recall put options give the right to sell a currency at the strike price. Expected Spot/ Probability
Premium
Exercise (Y or N)
Total Price
Cost
$0.66
$0.03
Indifferent
$0.63
$189,000
$0.03
YES
$0.66
$198,000
(30%) $0.69 (70%) Expected inflow from the put option= $189,000 * (0.3) + $198,000 * (0.7) = $195,300
4. Remaining Unhedged
Expected Spot
Total Price
Probability
$0.66
$198,000
30%
$0.69
$207,000
70%
Expected inflow from remaining unhedged= $198,000 * (0.3) + $207,000 * (0.7) = $204,300 5) Given the three alternatives above, the choice here is to choose the one that has the highest certain cash inflow. Here, the forward hedge, with a 100% certain inflow of $205,500 is the clear winner. Although remaining unhedged has an expected value of $204,300, a number very close to that of the forward hedge amount of $205,000, the unhedged amount is only an expected amount based on forecasted exchange rate. Since it is an uncertain outcome, we will go along with the certain forward hedge amount.
Managing Long-term Transaction Exposure Long-term forward hedge: Use of long-term forward contracts for extended 5 to 10 year periods; firms that have set up fixed-price export or import contracts over long periods of time use long forwards. Currency Swap: Exchange of currencies between firms having different long term needs. Arrangement is made for two firms to swap currencies for a specified future time period at a specified exchange rate. Banks often act as middlemen to link firms . Example: Consider an MNC called ABC Corporation, which is based in U.S. and is expecting payment of contract work done in Germany in DM 5 years into the future. At the same time, a German firm, Hamburg International, is expecting payment from a U.S. firm for its exports in U.S. dollars 5 years into the future also. ABC and Hamburg can arrange for a currency swap at a negotiated exchange rate. Parallel Loan: Exchange of currencies and a re-exchange at later date.
Other Techniques to Reduce Transaction Exposure Leading and Lagging: Lead payments in a foreign currency if the foreign currency is expected to appreciate and lag the payments if the foreign currency is expected to depreciate. Cross Hedging: If a firm cannot hedge a specific currency, it can use a forward contract on a currency that is highly correlated with the currency of concern. If a firm has net inflows in a currency that is highly correlated with a net outflow currency, it is in a sense hedged. If the net outflow currency appreciates, so should the net inflow currency, such that the firm will not be affected by this exposure. Currency Diversification: If a firm has net inflows or outflows in a variety of currencies which are not highly correlated with one another, exposure is not as great as if the equivalent amount of funds were denominated in a single currency. This is because not all currencies will depreciate or appreciate against the firm's home currency simultaneously by the same degree. There may be a partial offsetting effect due to a diversified set of inflow or outflow currencies.
Managing Economic Exposure The objective of economic exposure management is to anticipate and influence the effect of unexpected exchange rate changes on firm's future cash flows. Economic exposure can be managed by diversifying operations and financing. Diversifying Operations: If operations are diversified internationally, an MNC can recognize disequilibrium conditions and react competitively. For example, if purchasing power parity does not hold up, the
management might notice changes in comparative costs among plants located in different countries. It might also observe changes in profit margins or sales volume. This will provide an opportunity for the MNC to shift its operations where the costs are lower and increase its sales where the revenues are higher or both. For example, in the Madison Inc. situation we saw earlier, its management could shift its operations to the US and take steps to increase its sales in Canada. In addition, diversifying the operations internationally will provide beneficial portfolio effects by reducing the variability of the cash flows. Some of the Japanese companies like Honda and Toyota have reduced their economic exposure stemming from rising yen by building plants in the US. When the autos were exported to the US, the appreciating yen caused a decline in demand for the Japanese autos. Therefore, the cash flows of the Japanese companies were adversely affected by the strong yen. By building plants in the US and invoicing them in US dollars, both Honda and Toyota are trying to ensure that the demand for their autos is not affected by strong yen. Still, the Japanese plants in the US import various parts from Japan. Further, the dollar earnings of these US subsidiaries have to be remitted to the parent companies in Japan. Therefore, the exchange rate risk is not totally eliminated. But, locating the plants in the US where the autos are sold has reduced the economic exposure.
Diversifying Financing Globally If a firm diversifies its financing sources, it can take advantage of any deviations from the International Fisher effect: if interest rate differentials do not equal the expected changes in the (spot) exchange rates, there is an opportunity to lower the cost of financing is available. In addition, diversifying financing sources reduces the variability of future cash flows from domestic business cycles as well. Summary: In this Module, we examined the nature and types of foreign exchange rate risk. We studied the relevance of exchange rate risk and discussed the three types of exchange rate risk: 1) Transaction Exposure 2) Economic Exposure and 3) Translation Exposure. In addition, we reviewed various techniques to manage transaction exposure effectively. A good review of Foreign Exchange Risk Management is provided by Professors Gunther and Dufey. Questions and Problems 1. What are currency futures? Discuss their characteristics, the participants, and their use in speculation and hedging. Use suitable illustrations. 2. Compare currency forward contracts with currency futures with regard to their characteristics, participants, and their use in hedging and speculation. 3. A speculator bought a BP call option with a strike price of $1.55 per pound; the premium paid was $0.02 per unit. When he exercised the option, the spot price was $1.61. If there are 31,250 units in one BP option, compute the net profit to the speculator from this transaction. 4. A speculator bought a DM put option with a strike price of $ 0.675 per DM; the premium paid was $0.01 per unit. On the day when the put option was exercised, the spot price of DM was $0.625 per unit. If there are 62,500 units for each DM option, compute the net profit from this transaction. 5. What is foreign exchange risk? Why is it important to manage foreign exchange risk? 6. What are the three types of exchange rate risk? Define each type and explain whether each type affects the cash flows or not. 7. What is transaction exposure? What methods are available to hedge payables or receivables to manage transaction exposure? Explain each method in derail by providing suitable illustrations as necessary. 8. What is economic exposure? How would one manage economic exposure?
END OF MODULE 6
Module 7: Case on Exchange Rate Risk Management ® Reproduced with permission from Multinational Business Finance by Eiteman, Stonehill, and Moffett. 7th Edition, 1995, Addison Wesley Publishing Company, New York. All rights reserved.
Lufthansa It was February 14, 1986, and Herr Heinz Ruhnau, chairman of Lufthansa (Germany) was summoned to meet with Lufthansa's board. The board's task was to determine if Herr Ruhnau's term of office should be terminated. Herr Ruhnau had already been summoned by Germany's transportation minister to explain his supposed speculative management of Lufthansa's exposure in the purchase of the Boeing aircraft. In January 1985 Lufthansa (Germany), under the chairmanship of Herr Heinz Ruhnau, purchased twenty 737 jets from Boeing (U.S.). The agreed upon price was $500,000,000, payable in U.S. dollars on delivery of the aircraft in one year (January 1986). The U.S. dollar had been rising steadily and rapidly since 1980, and was approximately DM3.2/$ in January 1985. If the dollar were to continue to rise, the cost of the jet aircraft to Lufthansa would rise substantially by the time payment was due. Herr Ruhnau had his own view or expectations regarding the direction of the exchange rate. Like many others at the time, he believed the dollar had risen about as far as it was going to go, and would probably fall by the time January 1986 rolled around. But then again, it really wasn't his money to gamble with. He compromised. He covered half the exposure ($250,000,000) at a rate of DM3.2/$, and left the remaining half ($250,000,000) uncovered.
Evaluation of the Hedging Alternatives Lufthansa and Herr Ruhnau had the same basic hedging alternatives available to all firms. 1. Remain uncovered; 2. Cover the entire exposure with forward contracts; 3. Cover some proportion of the exposure, leaving the balance uncovered; 4. Cover the exposure with foreign currency options; 5. Obtain U.S. dollars now and hold them until payment is due. Although the final expense of each alternative could not be known beforehand, each alternative's outcome could be simulated over a range of potential ending exchange rates. Exhibit 7.7 illustrates the final net cost of the first four alternatives over a wide range of potential end-of-period (January 1986) spot exchange rates.
1: Remain Uncovered Remaining uncovered is the maximum risk approach. It therefore represents the greatest potential benefits (if the dollar weakens versus the Deutschemark), and the greatest potential cost (if the dollar continues to strengthen versus the Deutschemark). If the exchange rate were to drop to DM2.2/$ by January 1986, the purchase of the Boeing 737s would be only DM 1.1 billion. Of course if the dollar
continued to appreciate, rising to perhaps DM4.0/$ by 1986, the total cost would be DM 2.0 billion. The uncovered position's risk is therefore shown as that value line which has the steepest slope (covers the widest vertical distance) in Exhibit. This is obviously a sizable level of risk for any firm to carry. Many firms believe the decision to leave a large exposure uncovered for a long period of time to be nothing other than currency speculation.
2: Full Forward Cover If Lufthansa were very risk adverse and wished to eliminate fully its currency exposure, it could buy forward contracts for the purchase of U.S. dollars for the entire amount. This would have locked in an exchange rate of DM3.2/$, with a known final cost of DM 1.6 billion. This alternative is represented by the horizontal value line in Exhibit 7.7; the total cost of the Boeing 737s no longer has any risk or sensitivity to the ending spot exchange rate. Most firms believe they should accept or tolerate risk in their line of business, not in the process of payment. The 100% forward cover alternative is often used by firms as their benchmark, their comparison measure for actual currency costs when all is said and done.
3: Partial Forward Cover This alternative would cover only part of the total exposure leaving the remaining exposure uncovered. Herr Ruhnau's expectations were for the dollar to fall, so he expected Lufthansa would benefit from leaving more of the position uncovered (as in alternative 1). This strategy is somewhat arbitrary, however, in that there are few objective methods available for determining what the proper balance (20/80, 40/60, 50/50; etc.) between covered/uncovered should be. Exhibit 7.7 illustrates the total ending cost of this alternative for a partial cover of 50/50: $250 million purchased with forward contracts of DM3.2/$, and the $250 million remaining purchased at the end-of-period spot rate. Note that this value line's slope is simply half that of the 100% uncovered position. Any other partial cover strategy would similarly fall between the unhedged and 100% cover lines. Two principal points can be made regarding partial forward cover strategies such as this. First, Herr Ruhnau's total potential exposure is still unlimited. The possibility that the dollar would appreciate to astronomical levels still exists, and $250 million could translate into an infinite amount of Deutschemarks. The second point is that the first point is highly unlikely to occur. Therefore, for the immediate ranges of potential exchange rates on either side of the current spot rate of DM3.2/$, Herr Ruhnau has reduced the risk (vertical distance in Exhibit 7.7) of the final Deutschemark outlay over a range of ending values and the benchmark value of DM3.2/$.
4: Foreign Currency Options The foreign currency option is unique among the hedging alternatives due to its kinked-shape value line. If Herr Ruhnau had purchased a call option on marks at DM3.2/$, he could have obtained what many people believe is the best of both worlds. If the dollar had continued to strengthen above DM3.2/$, the total cost of obtaining $500 million could be locked in at DM1.6 billion plus the cost of the option premium, as illustrated by the flat portion of the option alternative to the right of DM3.2/$. If, however, the dollar fell as Herr Ruhnau had expected, Lufthansa would be free to let the option expire and purchase the dollars at lower cost on the spot market. This alternative is shown by the falling value line to the left of DM3.2/$. Note that the call option line falls at the same rate (same slope) as the uncovered position, but is higher by the cost of purchasing the option. In this instance Herr Ruhnau would have had to buy call options for DM 1.6 billion given an exercise price of DM3.2/$. In January 1985 when Herr Heinz Ruhnau was thinking over these alternatives, the option premium on Deutschemark call options was about 6%, equal to DM96,000,000 or $30,000,000! The total cost of the purchase in the event the call option was exercised would be DM1,696,000 (exercise plus premium). It is important to understand what Herr Ruhnau would be hoping to happen if he had decided to purchase the call options. He would be expecting the dollar to weaken (ending up to the left of DM3.2/$ in Exhibit , therefore he would expect the option to expire without value. In the eyes of many corporate treasurers, DM96,000,000 is a lot of money for the purchase of an instrument that the hedger expects or hopes not to use!
5: Buy Dollars Now The fifth alternative is a money market hedge for an account payable: Obtain the $500 million now and hold those funds in an interest-bearing account or asset until payment was due. Although this would eliminate the currency exposure, it required that Lufthansa have all the capital in hand now. The purchase of the Boeing jets had been made in conjunction with the ongoing financing plans of Lufthansa, and these did not call for the capital to be available until January 1986. An added concern (and what ultimately eliminated this alternative from consideration) was that Lufthansa had several relatively strict covenants in place that limited the types, amounts, and currencies of denomination of the debt it could carry on its balance sheet.
Herr Ruhnau's Decision Although Herr Ruhnau truly expected the dollar to weaken over the coming year, he believed remaining completely uncovered was too risky for Lufthansa. Few would argue this, particularly given the strong upward trend of the DM/$ exchange rate as seen in Exhibit 7.8. The dollar had shown a consistent threeyear trend of appreciation versus the Deutschemark, and that trend seemed to be accelerating over the most recent year.
Because he personally felt so strongly the dollar would weaken, Herr Ruhnau chose to go with partial cover. He chose to cover 50% of the exposure ($250 million) with forward contracts (the one-year forward rate was DM3.2/$) and to leave the remaining 50% ($250 million) uncovered. Because foreign currency options were as yet a relatively new tool for exposure management by many firms, and because of the sheer magnitude of the up-front premium required, the foreign currency option was not chosen. Time would tell if this was a wise decision.
How It Came Out Herr Ruhnau was both right and wrong. He was definitely right in his expectations. The dollar appreciated for one more month, and then weakened over the coming year. In fact, it did not simply weaken, it plummeted. By January 1986 when payment was due to Boeing, the spot rate had fallen to DM 2.3/$ from the previous year's DM3.2/$ as shown in Exhibit . This was a spot exchange rate movement in Lufthansa's favor.
The bad news was that the total Deutschemark cost with the partial forward cover was DM1.375 billion, a full DM225,000,000 more than if no hedging had been implemented at all! This was also DM129,000,000 more than what the foreign currency option hedge would have cost in total. The total cost of obtaining the needed $500 million for each alternative at the actual ending spot rate of DM2.3/$ would have been: Alternative 1: Uncovered 2: Full Forward Cover (100%) 3: Partial Forward 4: DM Call Options
Relevant Rate Total DM Cost DM2.3/$ 1,150,000,000 DM3.2/$ 1,600,000,000 ½ (DM2.3) + Cover ½ (DM3.2) 1,375,000,000 DM3.2/$ strike 1,246,000,000
Herr Ruhnau's political rivals, both inside and outside of Lufthansa, were not so happy. Ruhnau was accused of recklessly speculating with Lufthansa's money, but the speculation was seen as the forward contract, not the amount of the dollar exposure left uncovered for the full year. It is obvious that the term speculation holds an entirely new meaning when perfect hindsight is used to evaluate performance.
Case Questions Herr Ruhnau was accused of making the following four mistakes: 1. Purchasing the Boeing aircraft at the wrong time. The U.S. dollar was at an all-time high at the time of the purchase in January 1985. 2. Choosing to hedge half the exposure when he expected to dollar to fall. If he had gone through with his instincts or expectations, he would have left the whole amount unhedged (which some critics have termed "whole hog"). 3. Choosing to use forward contracts as his hedging tool instead of options. The purchase of call options would have allowed Herr Ruhnau to protect himself against adverse exchange rate movements while preserving the flexibility of exchanging DM for U.S. dollars spot if the market moved in his favor.
4. Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, has a vested interest in the conglomerate Airbus. Airbus's chief rival was Boeing in the manufacture of large long-distance civil aircraft. Given these criticisms, should the board of Lufthansa retain Herr Heinz Ruhnau as chairman? How should Ruhnau justify his actions and so justify his further employment?
END OF MODULE 7 Reproduced with permission from Columbia Journal of World Business, Columbia University Press, Fall 95, pp 70-82. All rights reserved.
Kurt R. Jesswein, Chuck C.Y. Kwok, and William R. Folks, Jr.
Corporate Use of Innovative Foreign Exchange Risk Management Products In today's competitive global markets, firms are threatened by the increasing exchange rate volatility. Over the last two decades, a plethora of new financial products has been introduced in the marketplace to help multinational corporate managers handle currency risks. In this study, the authors examine how extensive are the various major innovative foreign exchange products used by U.S. corporations, and categorize these products into three generations. They find that the popularity of the simpler, firstgeneration product (forward contracts) has not been overtaken by the sophisticated new entrants, and that the adoption of innovative foreign exchange risk management products is not as common as expected. In today's competitive global markets, the effective strategic management of a firm must include an analysis of the impact of exchange rate changes on the firm's operating exposures. Firms are threatened by exchange rate volatility and its impact on their competitive position. They are also threatened more subtly by the potential for management error due to illusions associated with short-run movements in exchange rates. Financial managers, with their knowledge of the dynamics of foreign exchange, can assist operating managers in configuring operations to cope with such exchange rate volatility and responding to shifts as they occur1. Given their specialized knowledge and competitive advantage in these imperfect product and factor markets, the major burden of such exchange risk management should fall on the shoulders of marketing (market selection, pricing, promotional and product strategies) and production (input mix, plant location, and long range planning) executives. Nevertheless, there will usually be residual operating exposures, if large enough, can be hedged using various financial products and techniques2. Over the last two decades, a large variety of new foreign exchange risk management products have been introduced in the financial marketplace to help managers handle risks in the increasingly volatile foreign exchange environment. These products may be roughly categorized under three generations3: 1. First generation: Forward contracts; this product was used under the fixed rate regime. 2. Second generation: Futures, options, futures options, warrants and swaps; these products arose out of the post-Bretton Woods volatility and the need for more variety in hedging tools. 3. Third generation: Range, participating and break forwards, compound options, synthetic products, foreign exchange agreements, and hindsight options; these products arose from the demands of
corporate and bank users for more sophisticated products and better variation or lower cost over existing product configurations. In this study, we examine how extensively these foreign exchange innovative products are used by U.S. corporations4. Though the above list does not exhaust all the innovations, most of the major products are already included. We are interested in a series of questions. Would the importance of old products such as the forward contract be taken over by these new entrants? Or, would these new innovations be so sophisticated that few corporations use them? How is the use of these products related to the size of a firm? Does the degree of a corporation's international involvement influence its product use? Are there variations across industries? To examine these questions, we conducted a survey. Methodology Research sample Using a mail questionnaire, we collected primary data directly from corporations. The sample includes the corporate executives most likely making decisions on the use of foreign exchange risk management products and techniques. Examples of these executives are corporate treasurers and chief financial officers. The firms chosen for the study are U.S.-based corporations that fall into two groups. The first group includes Fortune 5005 firms with sales exceeding $750 million. There are 403 firms included in this group. The second group includes 179 Fortune Service 500 firms excluding commercial banks6 and the six largest (in terms of revenue) privately-held firms7. Fourteen additional firms are included in the presurvey group, bringing the total number of survey participants to 6028. There were 173 firms which responded, of which 168 questionnaires were fully usable. The response rate was therefore 27.8%. We compared the profile of the survey respondents with the profile of the overall sample. No significant bias was found between the two groups. The sample of responding firms appeared to be sufficiently representative of the population of Fortune 500 firms assumed to be most interested in products to manage foreign exchange risks. Key Variables Several key variables are included in this study. For each of the aforementioned products, a corporation is asked whether or not and to what extent it has used the product. A composite variable, USEFX, is computed to proxy the corporation's tendency to use foreign exchange risk management products in general. The questionnaire lists 15 different products. If a corporation has used all of the 15 products, its USEFX variable will be assigned a value of "15." If the company has only tried 3 out of the 15 products, its USEFX value will be "3." Another variable TASSETS, the total amount of corporate assets, is used to proxy the firm size9. We also try to assess the degree of international involvement of the respondent firm by using three different proxies: the percentage of foreign assets, the percentage of foreign sales, and the percentage of foreign income. Empirical findings as reported in the next section show that the results are quite similar regardless of which proxy is used. Because of space constraint, we report only the results using the percentage of foreign income (FINCOME) as the proxy of international involvement. We also categorize the respondent firms under different industries according to their Standard Industrial Classification (SIC) codes. Because of the relatively small sample size, our grouping is rather broad. Using only the first digit of the codes, the firms are classified under seven categories: 1)mining and construction; 2) manufacturing (e.g., food, textile, etc.); 3) manufacturing (e.g., machinery, electronics, etc,); 4) transportation and utilities; 5) wholesale and retail trade; 6) finance, insurance and real estate; and 7) other services. Later on, in running multiple regressions to analyze the data, we use six dummy variables (I1 to I6) to represent these industries. In summary, we show in Table 1 the profile of the survey
respondents in terms of their industrial classification, total corporate assets, the percentage of foreign sales, and the percentage of foreign income10. Table 1
Table 1 Characteristics of Respondent Corporations
Total Corporate Assets (TASSETS)
Frequency
Percentage
Less than $500 million $500 million-$1 billion $1 billion-$2 billion $2 billion-$5 billion Greater than $5 billion
7 20 35 40 49
4.6% 13.2 23.2 26.5 32.5
No response
22
Percentage of Foreign Sales Less than 10 per cent 10-20 per cent 20-30 per cent 30-40 per cent 40-50 per cent Over 50 percent No response Percentage of Foreign Income (FINCOME) Less than 10 per cent 10-20 per cent 20-30 per cent 30-40 per cent 40-50 per cent Over 50 per cent No response Industrial Classification (Using 1st Digits of SIC Codes) 1 Mining & Construction 2 Manufacturing (e.g. Food, Textile, Lumber) 3 Manufacturing (e.g. Metal, Machinery, Electronics) 4 Transportation & Public Utilities 5 Wholesale & Retail Trade 6 Finance, Insurance & Real Estate
Frequency
Percentage
53 32 36 17 20 13
31.0% 18.7 21.1 9.9 11.7 7.6
2 Frequency
Percentage
66 31 19 19 16 17
39.3% 18.5 11.3 11.3 9.5 10.1
5 Frequency
Percentage
7 60 59 17 14 10
31.0% 34.7 34.1 9.8 8.1 5.7
7-8 Other Services (e.g. Hotels, Health, Legal Services)
6
3.3
Note: There are 173 respondents in total. The research sample is based on Fortune 500 and Fortune Service 500 firms in the United States.
Use of Foreign Exchange Risk Management Products We report the extent of knowledge and use of foreign exchange risk management products by the U.S. corporations in Table 2. The products are arranged in a descending order according to the percentages of respondents who have heard of the products. It is no surprise that all of the respondent companies have heard of the forward contract, which is a simple, popular product of the first generation. The least heard of product is the third-generation hindsight/lookback options; the percentage of awareness is 52.1%. As expected, corporations are more aware of the first and second generation products than those of the third generation. Nevertheless, even the lowest ranked product of hindsight/lookback options has been heard of by over half of the respondents. Overall, the average percentage of awareness across all products is 84.4%. It indicates that U.S. corporations in general are well aware of the existence of these innovative instruments.
Table 2 Extent of Knowledge and Use of Foreign Exchange Risk Management Products
Type of Product Forward contracts Foreign currency swaps Foreign currency futures contracts Exchange-traded currency options Exchange-traded futures option Over-the-counter currency options Cylinder options Synthetic "homemade" forwards Synthetic "homemade" options Participating forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Hindsight/lookback options, etc. Averages across products
Product Generation Heard of (Awareness) Used (Adoption) 1st 2nd 2nd 2nd 2nd 2nd 3rd 3rd 3rd 3rd 3rd 3rd 3rd 3rd 3rd
100.0% 98.8 98.8 96.4 95.8 93.5 91.2 88.0 88.0 83.6 81.7 77.7 65.3 55.8 52.1
93.1% 52.6 20.1 17.3 8.9 48.8 28.7 22.0 18.6 15.8 14.8 4.2 4.9 3.8 5.1
84.4%
23.9%
Notes: The products are ranked by the percentages of respondents who have heard of products. There are 173 respondents in total. However, awareness does not necessarily lead to adoption. Though they have heard of the products, a much smaller percentage of the corporations have adopted the new products. According to the figures under the "Used" column, the forward contract is still the most popular product (93.1%). The importance
of this old, first-generation instrument has not been overtaken by the "fancy" innovations. The next group of more commonly used products are foreign currency swaps (52.6%) and over-the-counter (OTC) currency options (48.8%). Both are second generation instruments. Overall, the average percentages of use of the first, second, and third generation products are 93.1%, 25.3%, and 14.2% respectively. The use of the third generation products is generally less than that of the second generation products, which is, in turn, generally less than the use of the first generation products11. Alternatively, the exchange-traded products of the second generation such as futures contracts, currency options and futures options show high percentages of awareness. Nevertheless, the percentages of their use are substantially less than that of OTC options (20.1%, 17.3% and 8.9% respectively, versus 48.8%). This is probably due to the fact that OTC products are more convenient and flexible to use. The corporations may simply telephone the banks to arrange for these OTC products. The products can be tailor-make to fit the specific needs of the companies. Exchange-traded products are standardized in terms of contract sizes and maturity dates and need to be bought and sold through brokers on the trading floors. They may therefore be less convenient that the OTC products. This finding is encouraging news to financial institutions such as commercial and investment banks: their tailor-make products are more attractive to most corporate customers than those offered by the open exchanges. Though the third generation products have received a lot of attention in the literature, the usage of these products is not as common as expected. Most of these products are used by less than 20% of the respondent companies. Break forwards, compound options and hindsight options are rarely used; their adoption percentages are 4.9%, 3.8% and 5.1% respectively. Even when they are used, the frequency of adoption is not high. It is not because they are not heard of. The fourth column of Table 2 shows the percentages of usage given that the products are known. Even among the corporations that are aware of these products, the use of the third generation products is not common. The possible implication of such findings is that although the sophisticated products may be interesting variations, they may not be really useful to many corporations under most circumstances. Perhaps, the simpler products such as forward contracts, currency swaps and OTC options already cover most of the business needs12.
Differences Across Industries For further analysis, we break down the use of foreign exchange risk management products under seven industrial categories as shown in Table 3. The rankings of the product use are generally alike across industries. The first and second generation OTC products such as forward contracts, currency swaps and OTC options are generally very popular. Though being widely heard of, exchange-traded products such as futures contracts, currency options and futures options are less utilized by corporations. The use of the third generation products are generally limited. Among the various industries, the finance, insurance and real estate industry of Category (6) stands out to be the most frequent user of exchange risk management products. The average percentage of adoption across the different products is 39.3%, 15.6% higher than the next highest industry, manufacturing, which has an adoption rate of 23.7%. This finding comes as no surprise. There are substantially more finance experts in this industry who are skillful at using financial products. The assets these firms handle daily are mainly financial assets; they have more need to utilize financial instruments to offset financial risks. While the use of most products is higher in the finance industry, its ranking is still quite similar to those of there industries. Forward contracts, currency swaps and options stand out to be most popular. Some of the third generation products such as break forwards, compound options, and hindsight options are seldom utilized even by these finance experts. The message seems to be the same: the popularity of the simpler products has not been overtaken by the sophisticated new instruments. Interestingly, the use of exchange-traded products also shows higher percentages in the finance, insurance and real estate industry. The adoption percentages for futures contracts, exchange-traded
options and exchange-traded futures are 20%, 40% and 30% respectively. The financial institutions reduce their own currency exposures by netting out financial assets and liabilities of different currencies. For the remaining exposure they cannot totally net out, they themselves go to the market to lay off the risks. One of the channels is to go through the exchange trading floor. Unlike other corporations, the financial firms are more familiar and adept in using exchange-traded products. Following the finance, insurance and real estate industry, the industry with the next highest percentage of adoption is manufacturing. In fact, both Categories (2) and (3) behave similarly and have the same percentage average of 23.7%. A slightly smaller percentage is found in the mining and construction industry, followed by the wholesale and retail trade industry. Of the seven columns, the transportation and utilities industry (4) and the "other services" industry (5) have the lowest average percentages of adoption (14.5% and 13.3% respectively). One possible reason is that the customer base of these latter industries is mainly domestic; there are relatively less foreign currency cash flows. The need for exchange risk management products may therefore be smaller. To examine the statistical significance of the industry effect, we run a multiple regression with the use of foreign exchange risk management products (USEFX) as the dependent variable and the six industry dummy variables (I1 to I6) as the independent variables. The results are shown in the third regression of Table 4.a. Overall, the industry variables explain about 12% of the variance of USEFX and the F-value is highly significant at the 0.006 level. The coefficients of the industry variables are also significantly different from one another13
Table 3 Use of Foreign Exchange Risk Management Products Across Industries Finance, Manufact. Manufact. Transp. Wholesale Insurance Mining & (e.g. (e.g. & & Retail & Real Other Manufact. Food) Electronics) Utilities Trade Estate Services Types of Products
(1)
(2)
(3)
(4)
(5)
(6)
(7&8)
Overall
Forward contracts
100.0%
98.3%
100.0%
70.6%
85.7%
90.0%
33.1%
93.1%
Foreign currency swaps
50.0
48.3
57.6
52.9
21.4
80.0
66.7
52.6
Foreign currency futures contracts
50.0
18.3
17.0
11.7
42.9
20.0
0.0
20.1
Exchange-traded currency options
16.7
18.3
17.0
0.0
21.4
40.0
0.0
17.3
Exchange-traded futures options
16.7
6.7
5.1
0.0
21.4
30.0
33.3
8.9
Over-the-counter currency options
50.0
55.0
50.9
29.4
28.6
50.0
0.0
48.8
Cylinder options
16.7
31.7
28.0
17.7
21.4
60.0
0.0
28.7
Synthetic "homemade" forwards
16.7
20.0
28.8
5.9
14.3
40.0
0.0
22.0
Synthetic "homemade" options
16.7
16.7
22.0
5.9
14.3
40.0
0.0
18.6
Participating
0.0
18.3
10.2
11.8
28.6
30.0
0.0
15.8
forwards, etc. Forward exchange agreements, etc.
0.0
13.3
11.9
5.9
28.6
30.0
66.7
14.8
Foreign currency warrants
0.0
3.3
0.0
5.9
7.1
30.0
0.0
4.2
Break forwards, etc.
0.0
3.3
1.7
0.0
0.0
20.0
0.0
4.9
Compound options
16.7
3.3
1.7
0.0
0.0
20.0
0.0
3.8
Hindsight/lookback options, etc.
0.0
0.0
3.4
0.0
0.0
10.0
0.0
5.1
Average percentages
23.3%
23.7%
23.7%
14.5%
22.4%
39.3%
13.3%
23.9%
Number of respondents
7
60
59
17
14
10
6
173
Notes: The products are arranged in the same order as in Table 2. The percentages represent the proportions of respondent corporations which have used the products. There are 173 respondents in total.
Table 4.a Firm Size, International and Industry Effects on Corporate Use of Foreign Exchange Risk Management Products Independent Variables Different Effects
Intercept LASSETS FINCOME
I1
I2
I3
I4
I5
I6
R2
F-Value Sign of F
1 Size Effect
2 International Effect
3 Industry Effect
2.55
0.95
(3.69)**
(1.77)
2.61
0.42
(7.28)**
(3.75)**
2.67
0.83
(1.94)** 4 International & Industry
0.93
0.84
0.33
1.52
4.46
0.03
3.1
0.08
0.09
14.1
0.0003
0.12
3.2
0.006
0.22
4.2
0.0002
(0.50) (0.66) (0.6) (0.22) (0.99) (2.77)**
1.31
0.49
0.42
(0.90)
(0.91)
(3.39)**
0.59
0.38
0.36
0.74
1.59
3.98
(0.37) (0.28) (0.26) (0.48) (1.06) (2.53)**
Influence of Firm Size and Degree of International Involvement Besides the industry effect, we also examine whether the size and the degree of international involvement of a company affect its use of foreign exchange risk management products. In Table 4.a, the first regression is run using USEFX as the dependent variable and LASSETS (log of total corporate assets) as the independent variable. Firm size explains only 2% of the variance and the F-value is not significant. The percentage of foreign income (FINCOME) is used to proxy the degree of international involvement14. The second regression results in Table 4.a show that the degree of international involvement explains 9% of the variance of USEFX, with a F-value highly significant at the 0.0003 level. The coefficient of FINCOME has a high t-value of 3.75, which is also significant at the 0.0003 level. Such findings indicate that the use of foreign exchange risk management products by a corporation is positively related to its degree of international involvement. As corporations become more internationalized, the amount of foreign currency cash flows passing through the firm increases. There may be more need for the risk management products to hedge the currency exposure15. To ensure that the international effect is not simply an indirect result of the industry effect, we run another regression including all of the independent variables mentioned above. As shown by the results of Regression 4 in Table 4.a, the two effects seem to be quite independent. When combined, the two explain 23% of the variance of USEFX, which is a significant improvement of the explanatory power. The coefficients of both FINCOME and I6 are still highly significant. The overall equation has a F-value of 4.2, which is significant at the 0.0002 level16. Thus far, the dependent variable USEFX includes the use of all foreign exchange risk management products. The results may be different if we drop the more popular, simpler products and focus on the more sophisticated, third-generation products. We therefore change the dependent variable to the use of third-generation products (USE3GEN) and return the regressions. Interestingly, the results as shown in Table 4.b are quite similar to those of Table 4.a.
Size, International and Industry Effects on the Use of Individual Products
Furthermore, we want to see how the firm size, the international, and the industry variables affect the use of individual foreign exchange products. A regression is therefore run for each of the 15 products. The results are reported in Table 5. Of the fifteen regressions, only four do not show significant F-values at the 0.05 level. Among these four, three are exchange-traded products (futures, options, and futures options). Though most corporate managers are aware of them, these products are less frequently used than the OTC products. Conversely, high R2s are found in the regressions of the more popular products such as forward contracts and foreign currency swaps. We apply the F-test in each regression to examine whether or not the coefficients of the six industry dummy variables are the same. The results are shown in the last column of Table 5. Significant industrial variations are found at the 0.05 level of the forward contracts, exchange-traded futures options, participating forwards, foreign currency warrants, break forwards, and compound options. Significant differences are also seen in the cases of cylinder options and forward exchange agreements at the 0.01 level. In general, the firm size variable does not show significant effects on the use of individual exchange risk management products. Exceptions are found in the cases of forward contracts, foreign currency swaps, and break forwards. As the firm size increases, the use of forward contracts and foreign currency tends to increase. However, the use of break forwards tends to decrease. Among the size, international and industry effects, the international effect appears to be the most significant. Of the fifteen products, nine products show highly significant international effects. The products which do not have significant international effects are the three exchange-traded products plus forward rate agreements and hindsight options. As the degree of international involvement increases, corporate use of these exchange risk management products tends to increase. Furthermore, the use cuts across a wide spectrum of foreign exchange products.
Table 5 Firm Size, International, and Industry Effects on Corporate Use of Individual Products
Industry Effect Types of Products Intercept LASSETS FINCOME Forward contracts Foreign currency swaps Foreign currency futures contracts Exchange-traded currency options Exchange-traded futures options Over-the-counter currency options Cylinder options Synthetic "homemade" forwards Synthetic
I1
I2
I3
I4
I5
I6
1.06
1.17
1.22
0.13
0.69
1.05
0.85
0.40
0.08
(2.19)*
(2.39)*
(2.04)*
-0.05
-0.72
0.19
(-0.10)
(3.14)**
(3.59)**
0.19
-0.18
0.01
(0.43)
(-0.93)
(0.01)
-0.20
0.14
0.04
0.24
0.23
(-0.60)
(0.95)
(1.11)
(0.62)
(0.74)
-0.12
0.05
0.04
0.10
0.07
(-0.43)
(0.48)
(0.15)
(0.33)
(0.29)
-0.08
0.38
0.18
0.20
0.20
(-0.13)
(1.53)
(3.12)**
(0.29)
(0.36)
-0.43
0.25
0.12
0.01
0.41
0.19
(-1.01)
(1.34)
(2.76)**
(0.03)
(1.02)
(0.48)
-.10
-0.06
0.11
0.19
0.15
0.31
(-.27)
(-0.35)
(3.09)**
(0.45)
(0.45)
(0.90)
-0.15
-0.02
0.13
0.18
0.13
0.12
FSign. R2 Value of F
Significant?
0.27
6.5
0.0001
Yes
0.21
4.7
0.0001
No
0.06
1.1
0.37
No
0.08
1.5
0.16
No
0.1
1.8
0.08
Yes
0.11
2.1
0.04
No
0.14
2.8
0.01
No
0.12
2.4
0.02
No
0.14
2.7
0.01
No
(2.36)* (3.23)** (3.36)** (0.31) (1.71) (2.47)** -0.53
-0.43
(-0.85) (-0.87) 1.01
0.40
(2.00)* (0.98)
-0.16
-0.27
-0.68
0.42
(-0.33) (-0.49) (-1.23) (0.71) 0.33 (0.80) 0.10
0.34
0.77
(0.75) (1.70) -0.05
0.43
(0.31) (-0.15) (1.24) -0.10
-0.01
0.43
(-0.01) (-0.04) (1.56) 0.24
-0.02
0.04
(0.44) (-0.03) (0.06) 0.18
0.45
0.58 (1.20) 0.61 (1.64) 0.44 (1.51) 0.28 (0.43) 0.99
(0.41) (1.02) (2.11)*
0.14
0.11
(0.39) (0.28) 0.14
0.10
0.73 (1.83) 0.71
"homemade" options Participating forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Hindsight/lookback options, etc.
(-0.43)
(-0.17)
(3.64)**
(0.44)
(0.42)
(0.37)
-0.03
-0.12
0.12
0.05
0.23
-0.04
(-0.09)
(-0.72)
(3.10)**
(0.12)
(0.65)
(-0.11)
0.21
-0.03
0.02
-0.21
-0.11
0.02
(0.63)
(-0.18)
(0.50)
-0.23
0.13
0.06
(-1.02)
(1.38)
(2.62)**
0.10
-0.14
0.04
-0.02
0.01
-0.03
(0.65)
(-2.15)*
(2.59)**
(-0.12)
(0.09)
(-0.17)
-0.04
-0.05
0.07
0.09
-0.03
-0.06
(-0.26)
(-0.66)
(4.11)**
-0.03
0.01
0.01
(-0.29)
(0.17)
(1.48)
(-0.56) (-0.39) -0.07
-0.03
(-0.26) (-0.14)
(0.48) (-0.21) -0.01
-0.02
(-0.12) (-0.23)
(0.39) (0.28) 0.36
0.62
(0.93) (1.58) -0.11
0.25
(0.08) (-0.33) (0.74) -0.09 (-0.44)
0.02
0.11
(1.88) 0.56
0.12
2.5
0.01
Yes
0.07
1.4
0.21
No
0.25
5.7
0.0001
Yes
0.12
2.4
0.02
Yes
0.19
4.1
0.0003
Yes
0.08
1.5
0.17
No
(1.36) 0.50 (1.40) 0.79
(0.10) (0.47) (3.20)** 0.09
-0.02
0.33
(0.56) (-0.15) (1.97) -0.06
-0.04
0.41
(-0.36) (-0.32) (-0.26) (2.20)* 0.02 (0.19)
0.01
-0.01
0.18
(0.03) (-0.10) (1.67)
Notes: Sample size is 173. The numbers in the parentheses are statistics. *Significant at the 0.05 level. **Significant at the 0.01 level. Industry effects are tested to examine whether or not they are significant at the 0.05 level. Dependent variables: Use of individual foreign exchange risk management products.
Notes: Independent variables: LASSETS Log of total corporate assets FINCOME Percentage of foreign income Industry dummy variables I1 Mining and construction I2 Manufacturing (e.g. food, textile, etc.) I3 Manufacturing (e.g. machinery, electronics, etc.) I4 Transportation and public utilities I5 Wholesale and retail trade I6 Finance, insurance and real estate
Summary and Conclusions The objective of this paper was to examine empirically how various major innovative foreign exchange products that are made available to multinational corporate managers in the last two decades were used by U.S. corporations. The findings showed that the use of the third generations products was generally less than that of the second generation products, which was, in turn, less than the use of the first generation products. Though companies were generally aware of the existence of the third generation products, the use of these products was not common. A similar observation was found even in the finance industry where there were plenty of finance experts who knew these innovative instruments well. The use of foreign exchange risk management products was generally not significantly related to the size of the company. Nevertheless, it was significantly related to the company's degree of international involvement. In terms of industrial variations, the finance, insurance and real estate industry stood out to be the most frequent user of the products. Significant industrial differences were found in the use of forward contracts, exchange-traded futures options, participating forwards, foreign currency warrants, break forwards, and compound options. Among the firm size, the international, and the industry effects, the international effect had the strongest impact on the corporate use of foreign exchange products. The findings of this study may have significant implications for multinational corporate managers, managers of financial institutions and members of organized futures and options exchanges. To a corporate manager who is new to the foreign exchange risk management area, he or she is better advised to focus on the more basic products of forward contracts, currency swaps and OTC options. These instruments may already cover most of their basic business needs. For special business situations where these products are inadequate, they may then approach investment bankers to help them use the more sophisticated third generation products. To finance experts in the financial industry, it is encouraging to know that their more flexible, tailor-make, OTC products are more appealing to corporate clients than the standardized products offered by organized exchanges. It is important for them to build on this competitive edge. Furthermore, emphasis should be placed on the simpler, easy-to-use, products which are more appealing to the corporate clients. On the other hand, the futures and options exchanges need to reflect on these findings and develop strategies to make their products more appealing. This paper has several limitations. The survey did not cover the use of internal foreign exchange management techniques such as leading and lagging, reinvoicing centers, balance sheet hedge and so forth. Nor did the study address how companies measured risk and how their use of products were affected by price and other considerations. These issues may be explored in future research. Further study may also examine and pinpoint the specific details of why the sophisticated, third generation products are not commonly used. Such findings may help enhance the improvement and use of these products in the future.
References
Batten, Jonathan, Robert Mellor and Victor Wan. "Foreign Exchange Risk Management Practices and Products Used by Australian Firms." Journal of International Business Studies, (3rd quarter 1993): 55773. Belk, Penny A. and Martin Glaum. "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation." Accounting and Business Research 21 (1990): 3-13.
Cornell, Bradford and Alan Shapiro. "Managing Foreign Exchange Risks." In Joel M. Stern and Donald H. Chew, eds. New Developments in International Finance (New York: Basil Blackwell, 1988) 44-59. Dufey, Gunter and Ian H. Giddy "Innovations in the International Financial Markets." Journal of International Business Studies, (Fall 1981): 33-51. Finnerty, John D. "Financial Engineering in Corporate Finance: An Overview." Financial Management, (Winter 1988): 14-33. Jesswein, Kurt R. "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implications for Financial Innovation Theory." Unpublished Ph.D. dissertation, University of South Carolina, 1992. Khoury, Sarkis J. and K. Hung Chan. "Hedging Foreign Exchange Risk: Selecting the Optimal Tool." Midland Corporate Finance Journal, (Winter 1988): 40-52. Lessard, Donald R. "Financial and Global Competition: Exploring Financial Scope and Coping with Volatile Exchange Rates." In Michael Porter, ed. Competition in Global Industries (Boston: Harvard Business School Press, 1986) 147-84. Levich, Richard M. "Financial Innovations in International Financial Markets." In Martin Feldstein ed., The United States in the World Economy (Chicago: University of Chicago Press, 1988) 215-57. Mathur, Ike. "Managing Foreign Exchange Risk Profitability." Columbia Journal of World Business (Winter 1982): 2023-30. Priestly, Sarah and Liz Hecht. "Third Generation Risk Management: How to Use Futures, Options, and Hybrid Products to Manage Exposure." Corporate Finance (September 1986): 23-38. Smith, Clifford W. Jr., Charles W. Smithson and D. Sykes Wilford. Managing Financial Risk (Hagerstown, MD: Ballinger, 1989).
1 Donald Lessard, "Financial and Global Competition: Exploiting Financial Scope and Coping with Volatile Exchange Rates," in Michael Porter ed., Competition in Global Industries (Boston: Harvard Business School Press, 1986) 147-184. 2 Bradford Cornell and Alan Shapiro, "Managing Foreign Exchange Risks," in Joel M. Stern and Donald H. Chew, eds., New Developments in International Finance (New York: Basil Blackwell, 1988) 44-59. 3 The three generations are mentioned in Sarah Priestly and Liz Hecht, "Third Generation Risk Management: How to Use Futures, Options, and Hybrid Products to Manage Exposure," Corporate Finance (London: Euromoney Publications) September, 1986: 23-38. The classification is also used in Kurt Jesswein, "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implication for financial Innovation Theory" (Doctoral dissertation, University of South Carolina, 1992). 4 There have been empirical studies conducted in various countries to survey how companies define and manage foreign exchange risks. Ike Mathur, "Managing Foreign Exchange Risk Profitability, " Columbia Journal of World Business 17, no. 4 (Winter 1982): 23-30. Penny Belk and Martin Glaum, "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation," Accounting and Business Research 21 (1990): 3-13. Jonathan Batten, Robert Mellor and Victor Wan, "Foreign Exchange Risk Management Practices and Products Used by Australian Firms," Journal of International business
Studies 3rd quarter (1993): 557-73. Out of a random sample of fifty-five Fortune 500 firms in the U.S., Mathur found that fourteen sought to minimize transaction losses, five sought to minimize translation losses, and thirty-two sought to minimize both. Alternatively, Belk and Glaum interviewed the senior management of seventeen U.K. multinationals. While most firms saw transaction exposure management as the centerpiece of their foreign exchange risk management, a majority of firms were also prepared to manage actively their net accounting exposure. Moreover, Batten, Mellor and Wan surveyed seventy-two corporations in australia and found that 61% of the respondents considered transaction exposure was the only relevant exposure. Very few respondents (8.3%) managed both transaction and translation risks. Nevertheless, most of these previous studies did not survey how corporations utilize new foreign exchange risk management products. 5 Fortune,April 23, 1990. 6 Fortune, June 4, 1990. 7 Forbes, December 11, 1989. 8 To test the objectivity and comprehensiveness of the research instrument, a limited survey, or pretest, was made. The pretest sample included forty Fortune 500 and Fortune Service 500 firms headquartered in North Carolina, South Carolina, and Georgia. Six responses were received (a 15% response rate) with no apparent problems encountered by the respondents. 9 A related variable, LASSETS, which is the log of TASSETS, is used in the later regressions. 10 There are two groups of manufacturing firms. They constitute a major proportion of the respondent sample (34.7% and 34.1% respectively.) Manufacturing firms of Category (2) are in the area of food, tobacco, textile, lumber, paper, publishing, chemical and petroleum refining. Manufacturing companies of Category (3) are in the area of metallic products, machinery, electronics, transportation equipments, scientific instruments and others. Alternatively, since there is a small number of sample respondents in Categories (7) and (8), they are compiled under the category of "other services", including health, engineering and management, and hotels. 11 Statistical results indicate that the percentages of product adoption across the first, the second and the third generations are significantly different at the 0.01 level.
12 In this study, we examined only the use of external foreign exchange risk management products. Besides utilizing external products, companies may also employ internal foreign exchange management techniques (e.g., leading and lagging, reinvoicing centers, balance sheet hedge and so forth) to reduce exchange rate risk. This may be one factor that accounts for the large difference in awareness and adoption data. 13 The F-test is conducted to test the hypothesis that the coefficients of the industry variables are equal. It is reflected at the 0.006 level, indicating that there is a significant industry effect. 14 As alluded to earlier, besides FINCOME, FASSETS (percentage of foreign assets) and FSALES (percentage of foreign sales) are also used as alternative proxies for the degree of international involvement. Regardless of which proxy is used, the results are quite similar. Owing to space constraint, only results of FINCOME are reported in Table 4.a. 15 Higher international involvement may have two opposing effects on the use of exchange rate products. On one hand, more foreign currency cash flows lead to more need of hedging. On the other hand, firms with higher international involvement have the advantage of natural diversification; they can net out some
of the currency exposures and then worry about the non-netted exposure. Nevertheless, our findings show that, despite this advantage, the net effect is that firms with greater international involvement still tend to use foreign exchange products more. 16 The F-test is again conducted to test the hypothesis that the coefficients of the six industry dummy variables are equal. It is rejected at the 0.003 level.
The End Glossary Ask price: The buying price of a currency for an individual or MNC. Bid price: The selling price of a currency for an individual or MNC. Cross exchange rates: The price of one currency with respect to another without the intervening dollar. Currency forward contracts: Legal contracts that enable the purchase or sale of specified units of a given currency for a specific period of time for future delivery or settlement. Currency futures: Legal contracts that enable the purchase or sale of standardized units of a given currency for a specific period of time for future delivery or settlement and are traded on the floor of the exchange. Currency options: Rights for the purchase or sale of currencies at a specific price for a specified period of time for which the purchaser pays a premium. Derivative markets: The market for contingent claims like options, futures and forward contracts etc. Direct foreign investment: Investment in physical assets like plants, factories, subsidiaries etc., through building or buying existing company. Direct quote: Number of US dollars per one unit of foreign currency; also called US dollar equivalent. Eurocurrency markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a short-term maturity of less than one year. Eurocredit markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a medium-term maturity 1 to 5 years.
Eurobond markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a longer maturity of 5 to 25 years. Exchange rate risk: The variability in the cash flows of a firm stemming from exchange rate fluctuations. Foreign-exchange markets: The net-work of foreign exchange dealers connected by phone terminals where MNCs, individuals, central banks, speculators and arbitragers buy and sell currencies. Forward premium: The annualized percent by which the forward rate of a given currency exceeds or falls below the spot rate. Indirect quote: Number of units of the foreign currency per US dollar.
Glossary Arbitrage: Simultaneous buying and selling of currencies or assets of comparable risk and maturity in different markets to take advantage of the price differences; also could involve simultaneous borrowing and lending in different markets to take advantage of the interest rate differences. Locational Arbitrage: Arbitrage involving bid and ask prices in different banks or locals or regions. Triangular Arbitrage: Arbitrage involving the differences in the theoretical and market exchange rates. Covered Interest Arbitrage: Arbitrage that involves investing in a foreign currency asset, followed by selling forward the maturity value of the investment generating higher return than available domestically. International Fisher Effect: The theory which predicts (home-foreign) interest rate differential. It will equal the change in the spot rate of the foreign currency. Interest Rate Parity Theory: Predicts that the (home-foreign) nominal interest differential will equal the forward premium or discount of the foreign currency. Technical Forecasting: An exchange rate forecasting approach that relies on past historical data and other related technical factors. Fundamental Forecasting: A forecasting technique that relies on fundamental economic factors; posits that the exchange rates will be impacted up-on by those factors. Market Efficiency:
The reflection of information in the pricing of currencies; semi-strong form argues that foreign exchange markets reflect historical prices and all public information. Purchasing Power Parity: The theory that predicts (home-foreign) inflative difference. It is equal to the percentage change in the spot rate of the foreign country.
Glossary Call Option: Right to buy a standard volume of a particular currency at a specific price called strike or exercise price for a specific period of time. Currency Diversification: Holding a portfolio of currencies of inflows and outflows so as to minimize the exchange rate risk. Currency Futures: Contracts specifying a standard volume of a particular currency to be exchanged for a specific price on a specific settlement date. Currency Hedging: Taking protective positions to safe-guard open currency positions. Currency Options: Rights which enable buying or selling of a given currency for a price called strike or exercise price for a specific period of time. Forward Contracts: Contracts specifying a given volume of a particular currency to be exchanged for a specific price on a specific settlement date. Money Market: Market for short-term investments like Treasury bills with a maturity of less than one year. Operating Exposure: Exchange rate risk that affects the operating cash flows by its impact on revenues and cots of a firm. Option Premium: Price paid by the buyer to the seller of the option for the right to buy or sell a given currency at the strike price for the specified period of time. Payables: Amount owed to others for goods bought or services received. Put Option: Right to sell a standard volume of a particular currency at a specific price called strike or exercise price for a specific period of time. Receivables: Amount owed by others to your corporation for goods supplied or services rendered.
Risk-free Rate: Rate of return on a default-risk free instrument, usually measured by the return on 90-day US Treasury bill rate. Speculation: Trading for profit, with a small probability of making huge profits, and a large probability of loss. Transaction Exposure: Exchange rate risk arising from transactions already entered into and denominated in foreign currencies. Variability: Fluctuations in the value of a given currency, measured by the standard deviation of the currency for a given period
