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FOREIGN EXCHANGE MARKET AND
MANAGEMENT OF FOREIGN EXCHANGE RISK
Prepared by
Edson Mbedzi
Topic Objectives
To describe the fundamental operations of the foreign exchange
market.
at
an
Forward Rates (F) - Buyer and Seller agree on P and Q for delivery in
the future - 1 month, 3 month, 6 months or more in the future.
Market forces determine both spot and forward rates.
NB: When a currency is expected to appreciate, it sells at a forward
premium (%), and when it is expected to depreciate, it sells at a forward
discount (%).
Example 1
If the = 100/$ and the 1 year F = 105/$, the dollar is selling a 5%
F S0
105 100
S0
forward premium.
5%
100
Forward Premium
=S 0
=
This tells us that the dollar is expected to appreciate by 5% over the next
year.
5
Are the most difficult to predict and are often determined based on bandwagon
effects, overreaction to news, and speculation.
a) Trend-Following Behaviour is the tendency for the market to follow a trend. In
other words an increase in the exchange rate is more likely to be followed by
another increase.
b) Investor Sentiment is based on the consensus of the market. For example if
the market is bullish on the dollar, then the dollar is likely to strengthen versus
other currencies.
c) Order Flow - there is evidence of a positive correlation between spot exchange
rate movements and, order flows in the inter-dealer market and customer currency
order flows.
6
States that since the prices should be the same across countries, the
exchange rate between two countries should be the ratio of the prices
in each country. Also known as the law of equal prices.
PPP :
PA
where, the spot rate (S ) is B
P
Relative PPP states that the exchange rate will change to offset
differences in national inflation rates.
i.e. if Country A has higher inflation than Country B, you can expect
Country As currency to depreciate versus Country Bs currency if
parity is to be maintained.
7
Ph (1 I h ) Pf (1 I f )
PPP theory suggests that when inflation rates differ between countries,
the percentage change in foreign
e f currency ( ) should necessarily
vary to maintain parity in purchasing power.
If inflation occurs in the foreign country, then exchange rate of foreign
currency has to change and the foreign price index becomes as
followseto maintain parity:
Ph (1 I h ) Pf (1 I f )(1 e f )
Solving
, we obtain
P (1for
Ih )
ef h
1
Pf (1 I f )
(1 0.05)
(1 I h )
1
1 e f
(1 0.03)
(1 I f )
= 0.0194 or 1.94%
Thus the foreign currency should appreciate by 1.94% in response to the higher
inflation rate of the home country relative to that of the foreign country.
The estimated future spot rate becomes:
E ( S t 1 ) S t (1 e f )
E ( S t 1 ) $1.50(1 0.0194)
E ( S t 1 ) $1.53
As a results of the exchange rate effect, price indexes of both countries rise by 5%
from the home country perspective, thus the purchasing power is the same for
foreign and home goods.
rh
rf
h
Where
and
respectively.
ef
(1 r f )
(1 0.11)
1
(1 0.12)
= -0.0089 or -0.89%
Thus the foreign currency should depreciate by 0.89% to make the
actual return of 12% on the foreign deposit equal the 11% from the
perspective of the investors in the home country. This would make the
return on the foreign country equal to the return on a domestic
investment.
11
Fdays
days
i
x
f 360
S0
days
1 id x 360
Where, S 0 is the spot rate and are the annual foreign and domestic interest rates
respectively.
Forward rates are unbiased predictors of future exchange rates.
An unbiased predictor means that on average the estimation will be wrong on
the up side or the downside with equal frequency and degree. In other words, the
errors are normally distributed
12
Fdays
days
1 i f x
360
S0
days
1 id x 360
{1 0.05
{1 0.06
180
360
180
360
13
{1 0.04
{1 0.08
180
}
360
1
180
}
360
= -0.019.
This means the should depreciate by 0.019 to 103.96/$. This means the 180
days forward rate of 103.50 in the FX market is slightly undervalued and therefore
there exist an arbitrage opportunity.
Figure 1: Covered Interest Arbitrage diagrammatical illustration
$4,638.
00
15
$83,333.
33
$87,500.
00
16
$1.6
0
$1.5
5
$1.5
0
Quantity
of
17
Example
Imagine D and S schedule in figure 4 below and if US inflation suddenly increased
while the British inflation remains the same. The sudden jump in US inflation
causes an increase in US DD for British goods and therefore an increase in US DD
for British . In addition, increase in US inflation reduces the British DD for US
goods and thus reduce SS of for sale in the international market. The increased
US DD for and reduced SS of for sale place pressure on value of shifting the
equilibrium to $1.57 as shown on figure 4 below.
Figure 4: Impact of rising US inflation on Equilibrium value of British
Value
of
$1.60
S1
S
$1.57
$1.5
5
D1
D
$1.50
Quantity
18
Example
Assume US interest rates rise while the British interest rates remain the same. US
investors will reduce their DD for British since US interest rates are now more
attractive, and therefore less desire for British bank deposits. In addition, US
rates are more attractive to British investors with excess cash, the supply of for
sale by British investors increases as they establish more deposits in US. Due to
inward DD for and an outward SS of , the equilibrium exchange rate should
decrease to; say $1.53 as shown on figure 5 below.
Figure 5: Impact of rising US interest on Equilibrium value of British
S
$1.60
Value
S
of
1
$1.55
$1.5
3
$1.50
D
D1
Quantity
19
Relative income levels affect the amount of imports demanded, it also influences
exchange rates.
Example
Assume US income levels rise substantially while the British income rates remain
unchanged. First, the DD for will shift outward, reflecting the US increase in
income and therefore increased demand for British goods through the MPM
effect. Second, the SS schedule of pounds is not expected to change as there is
no corresponding change in income in Britain. Therefore, equilibrium exchange
rate of the pound is expected to rise to; say $1.56 as shown on figure 6 below.
Figure 6: Impact of rising US income levels on Equilibrium Value of British
Value
of
S
$1.6
0
$1.57
$1.55
D1
D
$1.5
0
Quantity
20
Financing Decisions
Investment Decisions
Hedging Decisions
21
Forecasting Techniques
a)
Technical Forecasting
22
Forecasting Techniques
Fundamental Forecasting
b)
t 1
t 1
Forecasting Techniques
2)
Recall the theory of PPP specifies the fundamental relationship between inflation
differential and exchange rate, meaning this theory can be used to forecast
future exchange rates.
Example
Assume US inflation is expected to be 1% while the Australian one is 6% in the
next year. According to PPP, the Australian dollar (A$) exchange rate will adjust
as follows:
ef
(1 I h )
1
(1 I f )
ef
(1 0.01)
1
(1 0.06)
= -0.047 or - 4.7%
St
S t 1
This forecast of the percentage change
in the A$ can be applied to its existing spot rate to
forecast
future spot rate
end of one period. If the existing spot rate ( ) of the A$
E ( S t 1 ) Sthe
E (at
S t the
t (1 e f )
1 ) $0.20[1 ( 0.047 )]
E ( S t 1 ) $0.1906
is $0.20, the expected spot rate E ( ) at the end of one period will be:
This is the forecasted exchange rate at the end of period t. NB the same principle can be
applied on other international parity conditions such as the IFE and the IRP theories
24 to
Forecasting Techniques
3.
Market-Based Forecasting
The process of developing forecasts from market indicators and usually uses either the spot
rate or the forward rate as its basis.
Example
The US annualised five-year interest rate is currently 10% p.a. while the British one is 13%
p.a. and the current British spot rate is $0.856. Based on these current rates, the five-year
compounded returns on investments in each of these countries are compounded as follows:
Country
1 0.10 5 1 61%
1 0.13 5 1 84%
United States
United Kingdom
Thus the five-year forward rate premium or discount of the British pound will be:
(1.61)
(1 i F )
e P 5 0.125 or 12.5%
eP5
1
eP5
1
(1 i H )
(1.84)
The spot rate is expected to depreciate by 12.5% in 5 years period to give the expected
forward rate of:
E ( S t 5 ) S t (1 e f )
E ( S t 5 ) $0.856[1 (0.125)]
E ( S t 5 ) $0.749
25
Forecasting Techniques
4.
Mixed Forecasting
26
Forecasting Techniques
Evaluation of Forecast Performance of an MNC
MNCs that forecast exchange rates need to monitor their performance over time
to ascertain that the forecasting procedures are satisfactory.
This leads us to the calculation of the forecast error given by:
Absolute Forecast Error as % of Re alised Value
Example
Consider the following forecasted and realised values by an MNC during one period.
Forecast value
Realised Value
British Pound
$1.35
$1.50
Mexican Peso
$0.12
$0.10
The difference between the forecasted value and realised value is $0.15 for the pound and
$0.02 for the peso. This does not mean that the peso was forecasted more accurately
because when the size of what was forecasted is considered; the pound has been predicted
with more accuracy
27
Forecasting Techniques
With data given, forecast error for the pound is:
Absolute Forecast Error as % of Re alised Value
$1.35 $1.50
$1.50
$0.15
$1.50
0.10 or 10%
$0.12 $0.10
$0.10
$0.02
$0.10
0.20 or 20%
Thus, over the period under study, the peso had been forecasted with less accuracy. By
tracking its forecasting error over time, the MNC can evaluate its forecast performance over
several periods and understand whether it has good precision for short period or over long
periods.
NB: Due to the increasing corporate need to forecast currency values, there are now several
independent consulting companies which provide these services, including Business
International and Wharton Econometric Forecasting Associates among others.
28
29
Direct intervention
Refers to the direct involvement by the countrys central bank in the
foreign exchange market to push the price of the local currency to
desired levels.
Purchase and sell of foreign reserves
Buying and selling government securities e.g. Governments bonds,
OMO etc
Indirect intervention
This involves central bank influencing fundamental
determine the value of the currency to optimal levels.
Interest rate
Inflation
Income levels
factors
that
31
32
33
Types of Exposures
Exposures take three forms, namely translation (accounting) exposure,
transaction exposure and economic exposure.
35
Financial Statements Impact of Translation Methods (US000) following a 25% depreciation of local currency
LC
US$
before Monetary/
change of FX
Nonmonetary
LC4 =$1
LC5 =$1
Temporal
Current/
Noncurrent
LC5 =$1
LC4 =$1
Current
LC5 =$1
Assets
Current Assets
Cash
Inventory (at Market)
2,600
3,600
650
900
520
900
520
720
520
720
520
720
200
50
50
50
40
40
6,400
1,600
1,470
1,290
1,280
1,280
Fixed assets
Goodwill
TOTAL ASSETS
3,600
1,000
11,000
900
250
2,750
900
250
2,620
900
250
2,440
900
250
2,430
720
200
2,200
Liabilities
Current Liabilities
3,400
850
680
680
680
680
Long-term debt
3,000
750
600
600
750
600
500
125
100
100
125
100
Total Liabilities
6,900
1,725
1,380
1,380
1,555
1,380
Capital
Retained earnings
1,500
2,600
375
650
375
865
375
685
375
500
375
445
4,100
11,000
1,025
2,750
1,240
2,620
1,060
2,440
875
2,430
820
2,200
215
35
(150)
(205)
36
Prepaid expenses
Total Current Assets
Total Equity
TOTAL LIABILITIES
Translation Gain/loss
Transaction Exposure
The degree to which the value of future cash transactions (cash inflows to be
received or cash outflows to be paid) can vary due to exchange rate fluctuations
of underlying currencies is transaction exposure.
It arises when an MNC is committed to a foreign currency denominated
transaction.
Currency
Total Inflows
Total outflows
Expected
Net Exposure of
Exchange rate at cash flow in US$
end of period
British
17,000,000
7,000,000
10,000,000
$1.50
$15,000,000
Canadian $
C$12,000,000
C$2,000,000
C$10,000,000
$0.80
$8,000,000
Swedish
Kronor
SK20,000,000
SK120,000,000
(SK100,000,000)
$0.15
($15,000,000)
Mexican Peso
MXP90,000,000
MXP10,000,000
MXP80,000,000
$0.10
$8,000,000
37
British
Range
of
expected Range of possible net cash flows
exchange rate at end of in US$
period
10,000,000
$1.40 to $1.60
$14,000,000 to $16,000,000
C$10,000,000
$0.79 to $0.81
$7,900,000 to $8,100,000
Swedish
Kronor
(SK100,000,000)
$0.14 to $0.16
($14,000,000) to ($16,000,000)
Mexican
Peso
MXP80,000,000
$0.06 to $0.11
$4,800,000 to $8,800,00
Canadian $
38
1981-1993
1994-2006
British
0.0109
0.0148
Canadian $
0.0100
0.0110
Swedish Kronor
0.0287
0.0195
Mexican Peso
0.0330
0.0246
For example, standard deviations for the British and Canadian $ are much lower
than those of the Swedish and Mexican currencies.
This information is important to the MNC to identify which currencies are likely to
be stable or highly variable in future.
In practice currencies which exhibit lower levels of variability tend to also exhibit
lower forecast error.
39
Currency
Y
Currency
Z
-2.5
-5.0
Time
40
We will use
transaction
exposure. Assume a USs General Electrical (GE)s Deutsche Mark (DM)
exposure. On 1 January, GE is awarded a contract to supply turbine blades to
Lufthansa, the Germany Airline and GE will receive DM25 million on 31
December the same year. The current spot rate for deutsche mark is
DM1=$0.40 and the one-year forward rate is DM1=$0.3828. The following are
potential exchange rate exposure management options.
a) Forward Market Hedge
In forward market hedge a company that expect to receive a foreign currency sells foreign
currency forward and one that expect to pay (short position) a foreign currency buys the
currency forward. In our case, GE sell the proceeds of the sale forward and transforms the
currency denomination of its expected DM25 million into dollars, thereby eliminating all
currency risk on the sale.
Spot Exchange rate
DM1=$0.40
Flow
$10,000,000
($430,000)
$9,570,000
DM1=$0.3828
$9,570,000
$9,570,000
DM1=$0.36
$9,000,000
570,000
$9,570,000
41
43
It is a trade transaction with a price clause whereby base price is adjusted for
certain foreign rate changes beyond the neutral zone.
The neutral zone is the currency range within which risk is not shared,
supposedly incurred by one party.
Suppose we specify our neutral zone as $0.39-$0.41: DM1, with the base rate
of spot rate $0.40. Therefore, for any future rate within the neutral zone, GE
receives DM25 million at the base rate of $0.40 or $10 million. Thus
Lufthansas cost in this case varies from DM24.39 million to DM25.64 million
(10,000,000/0.41 to 10,000,000/0.39).
Should the DM depreciates from $0.40, to say $0.35, the actual rate would
have moved $0.04 from the lower limit of the neutral zone, and this change is
shared equally. Thus the applied rate in settling the transaction is $0.38
($0.40-$0.04/2) and GE receives $9.5 million (DM25, 000,000x$0.38) but
Lufthansas cost rises to DM27.14 ($9,500,000x$0.35).
In the absence of risk sharing agreement, GE would have received only $8.75
million (DM25, 000,000x$0.35).
44
No Risk
Sharing
11
Neutra
l
Zone
10
Risk Sharing
Contract
9.5
7
9
Forward
Contract
7
0.3
4
0.36
0.3
8
0.4
0.42
0.44
0.46
At any point below the lower boundary of neutral zone, say at rate of $0.35, GEs
loss is reduced from $8.75 million dollars to $9.5 million due to risk sharing.
Also, beyond the upper boundary, say at $0.45 exchange rate, GEs transaction
gain is also reduced from $11.25 million to $10.5 million as the full potential
45
gain is shared
The extent to which a firms present value of future cash flows (firm value)
can be influenced by exchange rate movements.
NB, all transactions that cause transaction exposure also cause economic
exposure.
Decrease
Increase
Decrease
Increase
Decrease
Increase
Decrease
Increase
No change
No change
Decrease
Increase
Decrease
Increase
46
Economic exposure of the MNC results in two ways, which ultimately affect
firm value:
MNCs must assess the level of economic exposure that exist and try to
minimise it.
Madison, a US based MNC has businesses in the US and Canada both sales
denominated in local currencies, i.e. US$ and C$ respectively. The business
income statements are as follows.
Revenue and Cost of Madison (Millions of US$ and C$)
Item
US Business
Canadian Business
Sales
$304.00
C$4.00
50.00
C$200.00
$254.00
-C$196.00
fixed
30.00
30.30
Total
60.30
$193.70
-C$196.00
3.00
10.00
$190.70
-C$206.00
Interest expenses
Earnings before tax (EBT)
48
Sales
US
Canadian
C$=$0.75
C$=$0.80
C$=$0.85
$300.00
3.0
$304.00
$3.20
$307.00
$3.40
Total
Cost of goods sold
$303.00
$307.20
$310.40
US
Canadian
$50.00
$150.00
$50.00
$160.00
$50.00
$170.00
$200.00
$103.00
$210.00
$97.20
$220.00
$90.40
US Fixed
$30.00
$30.00
$30.00
$30.30
$30.72
$31.04
Total
EBIT
Interest Expenses
$60.30
$42.70
$60.72
$36.48
$61.04
$29.36
$3.00
$7.50
$3.00
$8.00
$3.00
$8.50
$10.50
$32.20
$11.00
$25.48
$11.50
$17.86
C$4=
C$200=
Total
Gross profit
Operating expenses
US
Canadian
Total
EBT
C$10=
49
50
This may involve shifting the sources of revenues or costs to other locations
in order to match cash inflows with outflows in foreign currencies.
In the above case, Madison has more cash outflows than cash inflows in
Canada and therefore can balance by increasing Canadian sales and reducing
Canadian Costs.
Sales
US
Canadian
Total
Cost of goods sold
C$=$0.85
Old
New
Structure
Structure
$300
C$4 = 3
$303
300
C$20=15
$315
$304
$3.2
$307.2
$304
C$20=16
$320
$307
$3.40
$310.40
$307
C$20=17
$324
$50
$140
C$100=$75
$50
$160
$140
C$100=80
$50
$170
$140
C$100=85
$200
$103
$215
$100
$210
$97.2
$220
$100
$220
$90.40
$225
$99.00
US Fixed
variable (10% sales)
$30
$30.3
$32
31.50
$30
$30.72
$32
32
$30
$31.04
$32
32.40
Total
EBIT
Interest Expenses
$60.30
$42.70
63.50
36.50
$60.72
$36.48
64.00
36.00
$61.04
$29.36
64.40
34.60
$3
C$10=$7.5
7
C$5=$3.75
$3
$8
C$5=$4
$3
$8.5
C$5=$4.25
$10.5
$32.20
10.75
$25.75
$11
$25.48
11
$25.00
$11.5
$17.86
11.25
$23.35
US
Canadian
Total
Gross profit
C$200=$150
Operating expenses
US
Canadian
Total
EBT
52
Earning
s before
Taxes
(in
Millions)
$3
0
$2
5
Proposed Operating
Structure
$2
0
Original Operating
Structure
$1
5
C$=$0.7
5
C$=$0.8
0
C$=$0.8
5
Exchange Rate
Scenario
53
54
Proportion of debt structure Restructure debt to increase Restructure debt to reduce debt
representing foreign debts
debt payments in foreign payments in foreign currency
currency
55
END
56