the foreign exchange market exchange rate quotations forecasting foreign exchange rates foreign...

The Foreign Exchange Market

Exchange Rate QuotationsForecasting Foreign Exchange RatesForeign Exchange Risk ExposureManaging Foreign Exchange Risk

Exchange Rate Quotations

Direct QuoteQuote is a home currency price for a unit of

foreign currency. For example, $0.989986/€ is a direct quote of about $0.99 for one Euro in the United States. The base currency is the foreign currency.

Indirect QuoteQuote is a foreign currency price for a unit of

home currency. For example, ¥122.481/$ is an indirect quote of 122.481 Yen for one US dollar. The base currency is the home currency.


The direct and indirect rates are just the reciprocal of each other. To convert home currency (Xh) to foreign currency (Xf) the following rules apply:

Direct Rate (Eh) Indirect Rate (Ef)

Xh Xf(Eh) Xf / Ef

Xf Xh / Eh Xh( Ef)


Rates may be quoted either directly, or indirectly, as may be suitable

The convention is to quote all currencies:On an indirect basis in EnglandOn an indirect basis in the US (except £)On a direct basis throughout the rest of the

worldStandardization avoids complications


Rates are quoted in various forms Outright rates

Rates are quoted in full terms, including currency signs, such as: ¥122.481/$

Short form rates Generally used by banks and FX dealers Outright rates are not used in the market Example: 122.481

Forward premium or discount in either points or percent per annum


Bid and Ask Quotes The FX market quotes buying and

selling rates for all currencies traded

For example:

Or in shortest form:

GBP (£)

Bid Offer

EUR (€) 1.5765 1.5790

GBP

EUR 1.5765 - 90

Forward Rates

Forward rates are often quoted in terms of premium or discount in either points or percentage of premium or discount per annum

GBP

EUR Bid Offer

Spot rate: 1.5765 1.5790

3-month forward rate: 1.5195 1.5240

Deviation: 0.0570 0.0550

Forward Rates

In the preceding quotes the deviation of forward rate from spot is .0570 and .0550 for bid and offer, respectively.

In practice the bid and offer rates are quoted as:

EUR GBP

Spot: 1.5765 - 90

3-month forward rate: 570 / 550

Forward Rates

In the previous example the bid points (570) are higher than the offer points (550), indicating the base currency is at a discount. The forward points are subtracted from the spot rates in order to calculate the outright forward rates:

GBP

EUR Bid Offer

Spot rate: 1.5765 1.5790

Deviation: -.0570 -.0550

Outright forward rate: 1.5195 1.5240

Forward Rates

Base currency is at a discount:Bid points are greater than offer pointsSubtract forward points from spot rateForward rate = spot rate – forward points

Base currency is at a premium:Bid points are less than offer pointsAdd forward points to the spot rateForward rate = spot rate + forward points

Forward Rates

Determine the bid and offer rates from the quotes for the following currencies:

Spot 1-month forward

FF / $ 9.7550 - 850 90 / 105

$ / £ 1.7315 - 50 175 / 195

Rin / $ 2.6035 - 140 59 / 52

Forward Rates

To calculate forward premium or discount in percent per annum the following abbreviations are used:

Indirect DirectOutright spot rate Ef Eh

Outright forward rate for n period Ffn Fh

n

Forward premium or discount in % per annum

Ffn,% Fh

n,%

Forward Rates

Given E and F, the forward premium or discount in percent per annum (Fn,%) is calculated as follows:

Direct basis:Fh

n,% = [(Fh – Eh) / Eh] x 12 / n x 100 = + or - %

Indirect basis:Ff

n,% = [(Ff – Ef) / Ef] x 12 / n x 100 = + or - %

Forward Rates

Given E and Fn,%, the outright forward rate (Fn) is calculated as follows:

Direct basis:Fh

n = Eh(1 + Ffn,%) x n / 12

Indirect basis:Ff

n = Ef / [1 + (Ffn,% x n / 12)]

Forecasting the Exchange Rate

Environmental factors influencing the exchange rate:

Demand and supply of goods and services

Rate of inflationInterest rate


Demand and Supply of Goods and Services

Rate of Inflation

Interest Rate

Change in Imports, Exports and Investment

Change in Demand and Supply of Currency

Change in Exchange Rate


Several economic theories explain the relationship among inflation and interest rate, inflation and exchange rate and interest rate and exchange rate:

The Purchasing Power Parity Theory The Fisher Effect The International Fisher Effect The Interest Rate Parity Theory The Forward Rate as an Unbiased Predictor of

the Future Spot Rate

Purchasing Power Parity Theory

Assumes that:No restriction in cross-border tradingEconomies of countries are free-marketNo import/export duties or taxesExchange rate is floatingNo transaction costs


Establishes a direct relationship between the spot rate and inflation

The differential inflation rate between two countries is the inverse of the difference in the value of the currencies

Therefore:Expected Ef = Ef x [1 + (If - Ih)]

Expected Eh = Eh x [1 + (Ih - If)]


There are several problems associated with the theory:

The underlying concept of the one-price world is based on a fluctuating wholesale price index

It is difficult to construct a comparative basket of goods in different countries

It is difficult to measure the impact of price and income elasticity of demand for imports and exports on the price level in different countries

Ignores tariffs on imports and governmental interference Does not account for transaction costs

Fisher Effect

States that the nominal interest rate (k) is equal to the real interest rate (rr) plus the rate of inflation (I), or: k = [(1 + rr)(1 + I)] - 1

Since the real rate is more or less constant it suggests that the interest rate is purely a function of inflation

Hence, an increase in the differential inflation rate in a country will lead to a proportionate increase in the differential interest rate

Empirical evidence tends to validate the theory

International Fisher Effect

States that a change in the differential interest rates in two countries (x and y) causes an inverse change in the expected spot exchange rates:

(E1 – E2) / E2 x 100 = Ix – Iy

Although it seems to bear out in the long run empirical evidence does not support the theory in the short term

Interest Rate Parity Theory

Based on the law of one rate of return on investments worldwide

States that a difference in the interest rates on the securities of similar risk and maturity in two countries should be equal to the forward exchange discount on the currency with the higher interest rate and a premium on the currency with the lower interest rate

Forward Rate As an Unbiased Predictor of Future Spot Rates

Under efficient market conditions the future spot rate is expected to positively correlate with forward rates

Assuming that the other theories hold true the forward rate can be considered as an unbiased predictor of the future spot rate


The money and foreign exchange markets in New York show the following rates:

Spot rate: $1.50 / £1-year forward rate: $1.35 / £

US UKExpected rate of inflation: 7% 12%Interest rate on 1-year notes: 10% ?


1. Calculate the theoretically expected interest rate on 1-year notes in England

2. Calculate the forward discount or premium on pounds in percentage per annum

3. What is the equilibrium forward rate based on the international market model?

Exchange Risk Exposure

Refers to the exposure of foreign based assets, liabilities and foreign currency cash flows to potential effects of changes in foreign exchange rates. To minimize losses due to future uncertainty prudent managers must learn to recognize, measure and manage such foreign exchange risk exposure.


International business transactions are settled either in terms of home currency or foreign currency. Therefore, it is necessary to distinguish the following:Denominating currencyMeasuring currencyFunctional currencyReporting currency


Denominating currency-the currency in which the terms and

conditions of transactions are expressed without accounting for the effects of changes in rates.


Measuring currency-the currency in which the financial outcomes

from transactions are measured at the exchange rate that is in effect at the time the payments are made for transactions.


Functional currency-the currency in which the operating cash

flows are generated, and assets and liabilities are denominated disregarding the effects of changes in foreign exchange rates.


Reporting currency-is normally the home currency. Firms

normally prepare periodical financial statements in home currency by translating the functional currency of subsidiaries into home currency which is reporting currency in most of the cases.


The reporting currency of foreign based subsidiaries is generally the home currency, and for most of them the denominating and functional currencies are foreign currencies. Since multinational firms are required to translate functional currencies into reporting currency for financial statements changes in exchange rates could affect the value in reporting currency.


In particular, the following aspects of multinational business are exposed to the changes in exchange rates:Foreign based assetsForeign liabilitiesValue of foreign equityOn-going transactions and contractsExpected cash flows in foreign currenciesForeign tax liabilities


Based on the nature of foreign transactions each type of foreign exchange exposure can be classified as one of:Transaction exposureTranslation exposureOperating exposureTax exposure


On March 15, a US firm sold goods worth $120,000 to a Manchester firm on 30 day credit. The bill is payable in Sterling Pounds at the current spot rate of $1.85. Is either party, or both, exposed to foreign

exchange risk? What type of exposure is it? What is the size of the exposure? On April 10, just before the payment due date, the

spot rate of the Pound was $1.78. Who is gaining and who is losing from this rate change?


Consider the following statement for a US subsidiary in London:

Net Working Capital

As of December 31, 200x

Assets Liabilities and Equity

Cash £ 4,000 AP £ 8,000

AR 12,000 Accrued expenses 3,000

Inventory 14,000 Net Working Capital 19,000

£ 30,000 £ 30,000


Also note that:Exchange rate (Jan 1, 200x): $2.00 / £Exchange rate (Dec 31, 200x): $1.50 / £

1. What type of exposure does the firm have?

2. For the parent firm what is the net effect to working capital caused by the change in foreign exchange rates?

Currency Translation- Balance Sheet

Current Temporal

Monetary Assets & Liabilities

Current Rate Current Rate

Non-monetary Assets & Liabilities

Current Rate Historic Rate

Monetary Income & Expenses

Rate in EffectWeighted Average

Other Income & Expenses

Rate in Effect Rate in Effect

Equity Historic Rate Historic Rate

Dividends Rate in Effect Rate in Effect

Managing Risk Exposure

Short-term Optimize operating cash flowsHedge translation and transaction

exposuresLong-term

Maximize net present value and the overall value of the firm

Diversify operating and tax exposures internationally

Managing Risk Exposure

Forward market hedgingMoney market hedgingOption hedgingFutures hedgingBalance sheet hedgingLeading and LaggingSwapsDiversification

the foreign exchange market exchange rate quotations forecasting foreign exchange rates foreign...

Documents

spot rate forward rate

spot rate forward points

outright forward rates

forward rates base currency

deviation of forward

month forward rate

spot rates

exchange rate quotations