The Foreign Exchange Market

Exchange Rate Quotations

Forecasting Foreign Exchange Rates
Foreign Exchange Risk Exposure
Managing Foreign Exchange Risk
Exchange Rate Quotations
 Direct Quote
Quote is a home currency price for a unit of
foreign currency. For example, $0.989986/€ is a
direct quote of about $0.99 for one Euro in the
United States. The base currency is the foreign
currency.
 Indirect Quote
Quote is a foreign currency price for a unit of
home currency. For example, ¥122.481/$ is an
indirect quote of 122.481 Yen for one US dollar.
The base currency is the home currency.
Exchange Rate Quotations
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)
Exchange Rate Quotations

 Rates may be quoted either directly, or

indirectly, as may be suitable
 The convention is to quote all currencies:
 On an indirect basis in England
 On an indirect basis in the US (except £)

 On a direct basis throughout the rest of the

world
 Standardization avoids complications
Exchange Rate Quotations
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
Exchange Rate Quotations

Bid and Ask Quotes

 The FX market quotes buying and
selling rates for all currencies traded
GBP (£)
 For example: Bid Offer
EUR (€) 1.5765 1.5790

GBP
 Or in shortest form: 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 points
 Subtract forward points from spot rate

 Forward rate = spot rate – forward points

 Base currency is at a premium:

 Bid points are less than offer points
 Add forward points to the spot rate

 Forward 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 Direct
Outright spot rate Ef Eh
Outright forward rate for n period Ff n Fhn
Forward premium or discount in Ffn,% Fhn,%
% per annum
Forward Rates

Given E and F, the forward premium or

discount in percent per annum (Fn,%) is
calculated as follows:

 Direct basis:
Fhn,% = [(Fh – Eh) / Eh] x 12 / n x 100 = + or - %
 Indirect basis:
Ffn,% = [(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:
Fhn = Eh(1 + Ffn,%) x n / 12
 Indirect basis:
Ffn = 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 inflation
 Interest rate
Forecasting the Exchange Rate

Demand and
Supply of
Goods and
Services
Change in
Change in Demand Change in
Imports, and Exchange
Rate of Inflation Exports and Supply of Rate
Investment Currency

Interest Rate
Forecasting the 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 trading
 Economies of countries are free-market
 No import/export duties or taxes
 Exchange rate is floating
 No transaction costs
Purchasing Power Parity Theory

 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)]
Purchasing Power Parity Theory

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
Forecasting the Exchange 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 UK
Expected rate of inflation: 7% 12%
Interest rate on 1-year notes: 10% ?
Forecasting the Exchange Rate

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.
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 currency
 Measuring currency

 Functional currency

 Reporting currency
Exchange Risk Exposure

 Denominating currency
-the currency in which the terms and
conditions of transactions are expressed
without accounting for the effects of
changes in rates.
Exchange Risk Exposure

 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.
Exchange Risk Exposure

 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.
Exchange Risk Exposure

 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.
Exchange Risk Exposure

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.
Exchange Risk Exposure

In particular, the following aspects of

multinational business are exposed to
the changes in exchange rates:
 Foreign based assets
 Foreign liabilities
 Value of foreign equity
 On-going transactions and contracts
 Expected cash flows in foreign currencies
 Foreign tax liabilities
Exchange Risk Exposure

Based on the nature of foreign

transactions each type of foreign
exchange exposure can be classified as
one of:
 Transaction exposure
 Translation exposure

 Operating exposure

 Tax exposure
Exchange Risk 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?
Exchange Risk Exposure

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
Exchange Risk Exposure

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 &
Current Rate Current Rate
Liabilities
Non-monetary
Current Rate Historic Rate
Assets & Liabilities
Monetary Income & Weighted
Rate in Effect
Expenses Average
Other Income &
Rate in Effect Rate in Effect
Expenses
Equity Historic Rate Historic Rate
Dividends Rate in Effect Rate in Effect
Managing Risk Exposure
 Short-term
 Optimize operating cash flows
 Hedge translation and transaction
exposures
 Long-term
 Maximize net present value and the overall
value of the firm
 Diversify operating and tax exposures
internationally
Managing Risk Exposure
 Forward market hedging
 Money market hedging
 Option hedging
 Futures hedging
 Balance sheet hedging
 Leading and Lagging
 Swaps
 Diversification