The Foreign Exchange Market


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The Foreign Exchange Market

  1. 1. The Foreign Exchange Market
  2. 2. Functions of Forex Market <ul><li>Transfer of funds from one nation & currency to another. </li></ul><ul><li>Why exchange? </li></ul><ul><li># Import & Export of goods </li></ul><ul><li># Import & Export of services </li></ul><ul><li># Tourism </li></ul><ul><li># Investment </li></ul><ul><li>Eg. A US commercial bank has oversupply of pounds, then sell excess pounds, then finally a nation pays for its tourist exp. imports, investments etc. </li></ul>
  3. 3. Participants in Forex Market: <ul><li>Level 1: </li></ul><ul><li>Tourists, importers, exporters, investors- immediate users & suppliers of foreign currencies. </li></ul><ul><li>Level 2: </li></ul><ul><li>Commercial banks- they act as clearing houses between users and earners, do not actually buy & sell- Retail market </li></ul>
  4. 4. Participants in Forex Market: <ul><li>Level 3: </li></ul><ul><li>Forex brokers- They deal with commercial banks. </li></ul><ul><li>Level 4: </li></ul><ul><li>Nation’s central bank: </li></ul><ul><li>Act as Lender/ Buyer of last resort- Interbank market/ wholesale market </li></ul>
  5. 5. Entities in Forex market <ul><li>Authorised dealers-are commercial banks </li></ul><ul><li>Money changers- Buy/ sell form customers- deal in notes, coins and travelers’ cheque. </li></ul><ul><li>FEDAI- Forex Dealers’ Association of India </li></ul>
  6. 6. The Foreign Exchange Rates <ul><li>Definition- An exchange rate quotation is the price of a currency stated in terms of another. </li></ul><ul><li>For eg. Rs 50/ $ </li></ul><ul><li>This means that price of one dollar is Rs 50. </li></ul><ul><li>It is like quoting the price of a commodity. </li></ul>
  7. 7. The Foreign Exchange Rates <ul><li>Suppose there are two nations: US and UK and the exchange rate is R. </li></ul><ul><li>R=2, i.e. R= 2 $/ £ or </li></ul><ul><li>R= $/ £ = 2 </li></ul><ul><li>i.e. 2 dollars are required to buy one pound. </li></ul>
  8. 8. The Foreign Exchange Rates X axis- Quantity of pounds Y axis- exchange rate i.e. R R= $/£
  9. 9. Analysis: <ul><li>Lower exchange rate: </li></ul><ul><li>a) fewer dollars will be required to purchase one pound. </li></ul><ul><li>b) It will be cheaper for US to import funds from UK. </li></ul><ul><li>c) Better for us to invest in UK. </li></ul><ul><li>Therefore, Demand for pound increases. </li></ul>
  10. 10. Analysis: <ul><li>Higher exchange rate: </li></ul><ul><li>a) Uk gets more dollars for pound. </li></ul><ul><li>b) They find UK goods to be cheaper. </li></ul><ul><li>c) They find investing in US attractive. </li></ul><ul><li>Therefore, Supply of pound in US increases. </li></ul>
  11. 11. Analysis: <ul><li>If exchange rate becomes 3, i.e. R= 3 $/ £, means that now three dollars are required to buy a pound thus, depicting Depreciation of US dollar. </li></ul><ul><li>If exchange rate becomes 1, i.e. R= 1 $/ £, means that now one dollar is required to buy a pound thus, depicting Appreciation of US dollar. </li></ul>
  12. 12. Factors that affect the Equilibrium Exchange Rate <ul><li>1. Relative inflation rates- Eg. R= 2$ / £, If inflation in US in higher than in UK, then US goods will be costlier than that of UK goods and therefore, UK will export more goods to US and US will export less goods to UK. </li></ul><ul><li>This means that value of Dollar has Depreciated w.r.t. Pounds, or </li></ul><ul><li>Value of Pounds has Appreciated w.r.t. US dollars. </li></ul>
  13. 13. Factors that affect the Equilibrium Exchange Rate <ul><li>2. Relative interest rates </li></ul><ul><li>If real interest rates of US are higher than that of UK, then the dollar is said to have appreciated as compared to pound. </li></ul><ul><li>Real interest rate = Nominal interest rate - Inflation </li></ul><ul><li>If interest rate of US > int. rate of UK (because of inflation, then wrong picture). </li></ul><ul><li>Therefore, real interest rate should be considered. </li></ul>
  14. 14. Factors that affect the Equilibrium Exchange Rate <ul><li>3. Relative economic growth rates: </li></ul><ul><li>Strong economic growth- attract investment </li></ul><ul><li>4. Political & Economic risk: </li></ul><ul><li>High risk currency- more valuable </li></ul>
  15. 15. Exchange Rate Quotations: <ul><li>American Quote/ Direct quote: </li></ul><ul><li>No. of units of home currency for one unit of foreign currency. </li></ul><ul><li>eg. Rs 50/ $, means that 50 rupees are required to buy one unit of foreign currency/ dollar. </li></ul>
  16. 16. Exchange Rate Quotations: <ul><li>2. European Quote/ Indirect quote: </li></ul><ul><li>No. of units of foreign currency required to buy one unit of home currency. i.e. for one unit of home currency, how many units of foreign currency is required? </li></ul><ul><li>eg. $0.02/ Rs 1, means that 0.02 dollars are required to buy one unit of home currency/ rupees. </li></ul><ul><li>FF 0.1462/ Rs 1, 0.1462 French Franc per rupee. </li></ul>
  17. 17. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote UK Pound Sterling £/ GBP 66.92 US US Dollar $ 43.30 Canada Canadian Dollar Can$ 29.10
  18. 18. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote UK Pound Sterling £/ GBP 66.92 0.0149 US US Dollar $ 43.30 0.0231 Canada Canadian Dollar Can$ 29.10 0.0344
  19. 19. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Germany Deutschmark DM/DEM 22.94 Euro € 44.87 Netherlands Dutch Guilder DG/$f/ NLG 20.36
  20. 20. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Germany Deutschmark DM/DEM 22.94 0.0436 Euro € 44.87 0.0223 Netherlands Dutch Guilder DG/$f/ NLG 20.36 0.0491
  21. 21. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Switzerland Swiss franc sFr 0.0358 France French franc FF/ FRF 0.1462 Italy Swedish krona SKr 0.1931
  22. 22. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Switzerland Swiss franc sFr 27.97 0.0358 France French franc FF/ FRF 6.84 0.1462 Italy Swedish krona SKr 5.18 0.1931
  23. 23. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Italy Italian lira Lira/ Lit/ ITL 43.2901 Japan Japanese Yen ¥ 2.4994 Australia Australian dollar AU$ 0.0360
  24. 24. Exchange Rate Quotations: Spot rates for a number of currencies (in Rupees) Country Currency Symbol Direct quote Indirect quote Italy Italian lira Lira/ Lit /ITL 0.0231 43.2901 Japan Japanese Yen ¥ 0.4001 2.4994 Australia Australian dollar AU$ 27.76 0.0360
  25. 25. Numerator and Denominator <ul><li>The higher fraction is supposed to be the numerator and the Denominator corresponds to its lower part. </li></ul><ul><li>Eg. EUR / USD, </li></ul><ul><li>EUR is the basic currency (Numerator) & USD is the counter currency (Denominator). </li></ul>
  26. 26. Buying and selling a currency <ul><li>Buy/ Long EUR/ USD, means that you want to buy EUR and sell USD. </li></ul><ul><li>Sell / Short EUR/ USD, means that you want to sell the basic currency and buy the counter currency i.e. sell EUR and buy USD. </li></ul><ul><li>Short sell </li></ul>
  27. 27. Bid and Ask Rates <ul><li>A bank is ready to buy and sell a currency at different prices. </li></ul><ul><li>Buy price- Bid rate </li></ul><ul><li>Sell price- Ask rate </li></ul><ul><li>Spread- Difference between Bid and Ask rate is called Bid- ask Spread. </li></ul><ul><li>It is more in retail market and less in interbank market as there is more volume, greater liquidity and lower counterparty risk in interbank transactions. </li></ul>
  28. 28. Causes of spread are: <ul><li>Transaction cost </li></ul><ul><li>Return on capital employed </li></ul><ul><li>Reward / Compensation for taking risk </li></ul><ul><li>Mid rate- Arithmetic mean of bid and ask rates i.e. when one rate is mentioned. </li></ul>
  29. 29. Important conventions regarding quotes: <ul><li>a) The bid rate always precedes the ask rate. </li></ul><ul><li>E.g Rs/$ 45.45 / 45.50 </li></ul><ul><li>b) The bid and ask rates are always separated either by slash(/) or (-). </li></ul><ul><li>c) The quote is always from the banker’s point of view. Rs/$ 45.45 / 45.50 </li></ul><ul><li>E.g The banker is ready to buy dollar at 45.45 and sell at 45.50. i.e. Banker’s buy rate= Customer’s sell rate. </li></ul><ul><li>d) The Bid is always lower than the ask. (ask rate- Bid rate = profit) </li></ul>
  30. 30. Interbank quote vs Merchant quote <ul><li>Merchant quote is by bank to its retail customers. </li></ul><ul><li>Interbank quote is given by one bank to another bank. </li></ul><ul><li>Since, both the parties are banks, then whose quote will be considered. The bank requesting the quote will is the customer and the other bank’s quote will be considered. </li></ul>
  31. 31. Basis Point (BPS) <ul><li>A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly used for calculating changes in interest rates, equity indexes and the yield of a fixed-income security. </li></ul><ul><li>The relationship between percentage changes and basis points can be summarized as follows: 1% change = 100 basis points, and  0.01% = 1 basis point. </li></ul>
  32. 32. Basis Point (BPS) <ul><li>So, a bond whose yield increases from 5% to 5.5% is said to increase by 50 basis points; or interest rates that have risen 1% are said to have increased by 100 basis points. </li></ul>
  33. 33. Cross Rates / Synthetic rates <ul><li>When we calculate the exchange rates between other currencies with the dollar (or any other currency) as the intermediate currency. </li></ul><ul><li>The € / £ rate will be calculated through the € / $ quote and the $/ £ quote. </li></ul>
  34. 34. Cross Rates <ul><li>Eg. We need to calculate the Switzerland franc / Canadian Dollar (sFr/ Can$) rate from given sFr / $ and $/ Can$ quotes. </li></ul><ul><li>sFr / $ : 5.5971 / 5.5978 </li></ul><ul><li>$/ Can$ : 0.7555 / 0.7562 </li></ul><ul><li>Synthetic (sFr/ Can$)bid rate </li></ul><ul><li>= 5.5971 * 0.7555 </li></ul><ul><li>= (sFr / $)bid * ($/ Can$)bid </li></ul><ul><li>= 4.2286 </li></ul>
  35. 35. Cross Rates <ul><li>Eg. We need to calculate the Switzerland franc / Canadian Dollar (sFr/ Can$) rate from given sFr / $ and $/ Can$ quotes. </li></ul><ul><li>sFr / $ : 5.5971 / 5.5978 </li></ul><ul><li>$/ Can$ : 0.7555 / 0.7562 </li></ul><ul><li>Synthetic (sFr/ Can$)ask rate </li></ul><ul><li>= 5.5978 * 0.7562 </li></ul><ul><li>= (sFr / $)ask * ($/ Can$)ask </li></ul><ul><li>= 4.2330 </li></ul>
  36. 36. Appreciation & Depreciation <ul><li>Q1. During 2002, the yen went from $0.0074074 to $0.0084746. </li></ul><ul><li>By how much did the yen appreciate against the dollar? </li></ul><ul><li>By how much has the dollar depreciated against the yen? </li></ul>
  37. 37. Appreciation & Depreciation <ul><li>Solution: </li></ul><ul><li>The yen has appreciated against the dollar by an amount equal to (0.0084746 – 0.0074074)/ 0.0074074 = 14.41%. </li></ul><ul><li>An exchange rate of ¥ 1= 0.0074074 translates into an exchange rate of $ 1 = ¥135 (1/ 0.0074074 =135). Similarly, the exchange rate of ¥ 1= $0.0084746 is equivalent to an exchange rate of $ 1 = ¥118. Therefore, the dollar has depreciated (against the yen) by an amount equal to (118-135)/ 135 = -12.59%. </li></ul>
  38. 38. The Foreign Exchange Market <ul><li>Types of Transactions </li></ul><ul><li>Spot- Spot quotes- Prices in spot market </li></ul><ul><li>Forward- Forward quote- Prices in Forward market </li></ul>
  39. 39. Premium / Discount <ul><li>Forward Premium- when, </li></ul><ul><li>Forward rate > Spot Rate </li></ul><ul><li>Forward Discount- when, </li></ul><ul><li>Forward rate < Spot Rate </li></ul><ul><li>The forward discount / premium is expressed in annualised percentage terms as follows: </li></ul><ul><li>Forward premium/ = Forward- Spot </li></ul><ul><li>Discount rate rate * 360 </li></ul><ul><li>Spot rate Forward contract no. of days </li></ul>
  40. 40. Arbitrage <ul><li>Simultaneous purchase and sale of the same assets / commodities on different markets to profit from price discrepancies. </li></ul><ul><li>Eg. If the dollar price of pounds were $1.98 in New York and $ 2.01 in London, an arbitrageur would purchase pounds at $1.98 in New York and immediately resell them in London for $2.01, thus realising a profit of $0.03 per pound. </li></ul>
  41. 41. Arbitrage <ul><li>As arbitrage continues, the exchange rate between the 2 currencies tends to get equalised in the two monetary centres. </li></ul><ul><li>a) Two point arbitrage- Two currencies, Two countries </li></ul><ul><li>b) Three point arbitrage- Three currencies, Three countries </li></ul>
  42. 42. Interest Arbitrage <ul><li>It refers to the International flow of short term liquid capital to earn a higher return abroad. It can be covered or uncovered. </li></ul><ul><li>1) Uncovered Interest Arbitrage </li></ul><ul><li>The transfer of funds abroad from to take advantage of higher interest rates in foreign monetary centres usually involves the conversion of the domestic currency to the foreign currency, to make the investment. At the time if maturity, the funds (principal + interest) are reconverted from the foreign currency to the domestic currency. </li></ul>
  43. 43. Uncovered Interest Arbitrage <ul><li>Low interest rate High interest rate </li></ul><ul><li>country country </li></ul><ul><li>investment </li></ul><ul><li>Eg. In Germany, the annualised interest rate is 11% whereas in London it is 15%. Suppose, a company has excess funds for 3 months. In which country one should invest? </li></ul>
  44. 44. Covered Interest Arbitrage <ul><li>Spot purchase of foreign currency to make the investment and offsetting the simultaneous the simultaneous forward sale to cover the foreign risk. </li></ul><ul><li>Net return= Positive interest differential (-) </li></ul><ul><li>Forward discount on the foreign currency </li></ul>
  45. 45. Illustration 1 <ul><li>Spot rate: Rs 42.0010 = $ 1 </li></ul><ul><li>6 month forward rate: Rs 42.8020 = $ 1 </li></ul><ul><li>Annualised interest rate on: </li></ul><ul><li>6 month rupee: 12 % </li></ul><ul><li>6 month dollar: 8% </li></ul><ul><li>Calculate the arbitrage possibilities. </li></ul>
  46. 46. Solution to Illustration1 <ul><li>The rule is that if the interest rate differential is greater than the premium or discount, place the money in the currency that has a higher rate if interest or vice –versa. </li></ul><ul><li>Given the above data: </li></ul><ul><li>Negative interest rate differential= (12-8)= 4% </li></ul><ul><li>Forward premia (annualised) = </li></ul><ul><li>Forward rate-Spot rate * 100 * 12 </li></ul><ul><li>Spot rate 6 </li></ul><ul><li>= 42.8020 – 42.0010 * 100 * 12 = 3.8141 % </li></ul><ul><li>42.0010 6 </li></ul>
  47. 47. Solution to Illustration1 <ul><li>Negative interest rate differential> forward premia, therefore, there is a possibility of arbitrage inflow in India. </li></ul><ul><li>Suppose, investment = $1000 by taking a loan @ 8% in US. Invest in India at spot rate of Rs 42.0010 @ 12 % for six months and cover the principal + interest in the six month forward rate. </li></ul><ul><li>Principal= $ 1000 = Rs 42001 </li></ul>
  48. 48. Solution to Illustration1 <ul><li>Interest on investment for six months </li></ul><ul><li>= Rs 42,001 * 12/ 100* 6/12 </li></ul><ul><li>= Rs 2520.06 </li></ul><ul><li>Amount at the end of six months = Interest + Principal </li></ul><ul><li>= Rs 42001+ 2520.06 </li></ul><ul><li>= Rs 44,521.06 </li></ul>
  49. 49. Solution to Illustration1 <ul><li>Converting the above in dollars at the forward rate = $ 44,521.06 / 42.8020 </li></ul><ul><li>= $ 1,040.16 </li></ul><ul><li>The arbitrageur will have to pay at the end of six months = $1,000+ ($1000* 8/100 *6 /12) </li></ul><ul><li>Hence, the arbitrageur gains ($1040.16 -$1040) = $ 0.16 on borrowing $1000 for six months. </li></ul>
  50. 50. Illustration 2 <ul><li>Spot rate: Rs 44.0030 = $ 1 </li></ul><ul><li>6 month forward rate: Rs 45.0010 = $ 1 </li></ul><ul><li>Annualised interest rate on: </li></ul><ul><li>6 month rupee: 12 % </li></ul><ul><li>6 month dollar: 8% </li></ul><ul><li>Calculate the arbitrage possibilities. </li></ul>
  51. 51. Solution to Illustration 2 <ul><li>The rule is that if the interest rate differential is greater than the premium or discount, place the money in the currency that has a higher rate if interest or vice –versa. </li></ul><ul><li>Given the above data: </li></ul><ul><li>Negative interest rate differential= (12-8)= 4% </li></ul><ul><li>Forward premia (annualised) = </li></ul><ul><li>Forward rate-Spot rate * 100 * 12 </li></ul><ul><li>Spot rate 6 </li></ul><ul><li>= 45.0010 – 44.0030 * 100 * 12 = 4.5361% </li></ul><ul><li>42.0030 6 </li></ul>
  52. 52. Solution to Illustration 2 <ul><li>Negative interest rate differential< forward premia, therefore, there is a possibility of arbitrage inflow in US. </li></ul><ul><li>Suppose, investment = Rs 10,000 by taking a loan @ 12% in India. </li></ul><ul><li>Invest in US at spot rate of Rs 44.0030 @ 8 % for six months (US $ 227.257) and cover the principal + interest in the six month forward rate. </li></ul>
  53. 53. Solution to Illustration 2 <ul><li>Amount at the end of six months = Interest + Principal </li></ul><ul><li>= $227.257* 8/ 100* 6/12 </li></ul><ul><li>= $ 236.3473 </li></ul><ul><li>Sell US $ at 6 month forward to receive 236.3473* 45.0010= Rs 10635.865 </li></ul><ul><li>Return the rupee debt borrowed at 12%. The amount to be refunded is Rs 10,600 </li></ul><ul><li>Profit= Rs 10635.865 - 10600= 35.865 </li></ul>
  54. 54. Illustration 3 <ul><li>Spot rate FFr 6.00 =$1 </li></ul><ul><li>6 month forward rate FFr 6.0020 = $1 </li></ul><ul><li>Annualised interest rate on : </li></ul><ul><li>6 month US $ = 5% </li></ul><ul><li>6 month FFr = 8% </li></ul>
  55. 55. Illustration 4 <ul><li>An American firm purchases $4,000 worth of perfume (FF 20,000) from a French firm. The American distributor must make the payment in 90 days in French francs. Given that: </li></ul><ul><li>Spot rate $ 0.2000 = 1 FF </li></ul><ul><li>90 day forward rate 0.2200 = 1 FF </li></ul><ul><li>US interest rate 15% </li></ul><ul><li>French interest rate 10% </li></ul>
  56. 56. Purchasing Power Parity (PPP) <ul><li>It focuses on inflation and exchange rate relationships. </li></ul><ul><li>There are 2 forms of PPP theory: </li></ul><ul><li>Absolute Purchasing Power Parity </li></ul><ul><li>It states that price levels should be equal worldwide when expressed in a common currency. i.e. A unit of home currency should have the same purchasing power all around the world. </li></ul>
  57. 57. Absolute Purchasing Power Parity <ul><li>Also, the exchange rate between currencies of two currencies is equal to the ratio of the price levels in the two nations. </li></ul><ul><li>i.e. Rab = Pa /Pb </li></ul><ul><li>Where, </li></ul><ul><li>Pa – General price level in Nation A </li></ul><ul><li>Pb- General price level in nation B </li></ul><ul><li>Rab – Exchange rate between currencies of Nation A & B </li></ul>
  58. 58. Absolute Purchasing Power Parity <ul><li>It does not consider: </li></ul><ul><li>a) Transportation cost, tariffs, quotas. Product differentiation. </li></ul><ul><li>b) Existence of non- traded goods and services eg Cement, bricks, doctors etc. </li></ul>
  59. 59. Relative Purchasing Power Parity <ul><li>The change in the exchange rate over a period of time should be proportional to the relative change in the price levels in the 2 nations over the same time period. </li></ul><ul><li>Rab1 = Pa1/ Pa0 * Rab0 </li></ul><ul><li>Pb1/ Pb0 </li></ul><ul><li>If the absolute PPP were to hold true, the relative PPP would also hold. However, the vice- versa will not hold true. </li></ul>
  60. 60. Problems in Relative PPP <ul><li>Ratio of prices of non- traded goods to the prices of traded goods & services is consistently higher in developed nations than in developing nations. </li></ul><ul><li>Various factors other than relative price levels can influence exchange rates in the short run. </li></ul>
  61. 61. International Fisher Effect (IFE) <ul><li>IFE uses interest rates rather than inflation rates </li></ul><ul><li>The relationship between the percentage change in the spot exchange rate over time and the differential between comparable interest rates in different national capital markets is known as “international Fisher Effect”. </li></ul>
  62. 62. International Fisher Effect (IFE) <ul><li>The IFE suggests that given two countries, the currency in the country with the higher interest rate will depreciate by the amount of interest rate differential. That is, within a country, the nominal interest rate tends to approximately equal the real interest rate plus the expected inflation rate. </li></ul><ul><li>Nominal= Real + Expected inflation rate </li></ul>
  63. 63. International Fisher Effect (IFE) <ul><li>The proportion that the nominal interest rate varies directly with the expected inflation rate, known as Fisher effect. </li></ul><ul><li>Inc. in interest rate- Inc. in exchange rate </li></ul><ul><li>It is often argued that an increase in a country’s interest rate tends to increase the exchange value of its currency by inducing capital inflows. </li></ul>
  64. 64. International Fisher Effect (IFE) <ul><li>However, the IFE argues that a rise in a country’s nominal interest rate relative to the nominal interest rate of other countries indicates that the exchange value of the country’s currency is expected to fall. This is due to the increase in the country’s expected inflation and due to the increase in the nominal interest rate. </li></ul>
  65. 65. Foreign Exchange Risk <ul><li>Foreign exchange risk is the possibility of a gain or loss to a firm that occurs due to unanticipated changes in the exchange rate. </li></ul><ul><li>The primary goal is to protect corporate profits from the negative impact of exchange rate fluctuations. </li></ul>
  66. 66. Types of Exposure <ul><li>Translation exposure </li></ul><ul><li>Transaction exposure </li></ul><ul><li>Economic exposure </li></ul>
  67. 67. 1. Translation exposure <ul><li>All financial statements of a foreign subsidiary have to be translated into the home currency for the purpose of finalising the accounts for any given period. </li></ul><ul><li>Translation exposure is the degree to which a firm’s foreign currency denominated financial statements are affected by the exchange rate changes. </li></ul>
  68. 68. 1. Translation exposure <ul><li>The changes in the asset valuation due to fluctuations in the exchange rate will affect the group’s assets, capital structure ratios, profitability ratios, solvency ratios etc. </li></ul>
  69. 69. 1. Translation exposure <ul><li>The following procedure has been followed: </li></ul><ul><li>Assets & Liabilities are to be translated at the current rate, i.e. the rate prevailing at the time of preparation of consolidated statements. </li></ul><ul><li>All revenues & expenses are to be translated at the actual exchange rates prevailing on the date of transactions. </li></ul><ul><li>Translation adjustments (gains or losses) are not be charged to the net income of the reporting company. (They are accumulated & reported in a separate account). </li></ul>
  70. 70. Measurement of Translation exposure <ul><li>Translation exposure = (Exposed assets – Exposed liabilities) * (Change in exchange in exchange rates) </li></ul>
  71. 71. Example <ul><li>Current exchange rate: $ 1 = Rs 47.10 </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Rs. 15,300,000 Rs 15,300,000 </li></ul><ul><li>$ 3,24,841 $ 3,24,841 </li></ul>
  72. 72. Example <ul><li>In the next period, exchange rate fluctuates to $ 1 = Rs. 47.50 </li></ul><ul><li>Assets Liabilities </li></ul><ul><li>Rs. 15,300,000 Rs 15,300,000 </li></ul><ul><li>$ 3,22,105 $ 3,22,105 </li></ul><ul><li>Decrease in the Book Value of the assets is $ 2736. </li></ul>
  73. 73. Transaction exposure <ul><li>This exposure refers to the extent to which the future value of firm’s domestic cash flow is affected by exchange rate fluctuations. It arises from thepossibility of incurring exchange rate gains or losses on transaction already entered into and denominated in a foreign currency. </li></ul><ul><li>More the transactions, more the risk. </li></ul>
  74. 74. Transaction exposure <ul><li>All transactions gains and losses should be accounted for and included in the equity’s net income for the reporting period. </li></ul><ul><li>The exposure could be interpreted either from the standpoint of the affiliate or the parent company. </li></ul>
  75. 75. Economic Exposure <ul><li>It refers to the degree to which a firm’s present value of future cash flows can be influenced by exchange rate fluctuations. </li></ul><ul><li>It is a more managerial concept than an accounting concept. </li></ul><ul><li>The risk is that a variation in the rate will affect the company’s competitive position in the market and hence its profits. </li></ul><ul><li>It cannot be hedged. </li></ul>
  76. 76. Tools & Techniques of Foreign Exchange Risk Management <ul><li>Forward contracts </li></ul><ul><li>Futures contracts </li></ul><ul><li>Option contract </li></ul><ul><li>Currency swap- It is an agreement where two parties exchange a series of cash flows in one currency for a series of cash flows in another currency, at agreed intervals over an agreed period. </li></ul>
  77. 77. Management of Translation exposure <ul><li>Accounting exposure/ translation exposure, arises because MNCs may wish to translate financial statements of foreign affiliates into their home currency in order to prepare consolidated financial statements. Or to compare financial results. </li></ul><ul><li>Translation exposure = Exposed assets – Exposed liabilities </li></ul>
  78. 78. Management of Translation exposure- Example <ul><li>A US parent company has a single wholly owned subsidiary in France. This subsidiary has monetary assets of 200 million francs & monetary liabilities of 100 million francs. The exchange rate declines from FFr 4 per dollar to FFr 5 per dollar. </li></ul>
  79. 79. Management of Translation exposure- solution <ul><li>The potential foreign exchange loss on the company’s exposed net monetary assets of 100 million francs would be $5 million. </li></ul><ul><li>Monetary assets FFr 200 million </li></ul><ul><li>Monetary liabilities FFr 100 million </li></ul><ul><li>Net exposure FFr 100 million </li></ul><ul><li>Pre-devaluation rate </li></ul><ul><li>(FFr 4= $1) FFr 100 million $ 25.0 million </li></ul><ul><li>Post-devaluation rate </li></ul><ul><li>(FFr 5= $1) FFr 100 million $ 20.0 million </li></ul><ul><li>Potential Exchange Loss $ 5.0 million </li></ul>
  80. 80. Translation Methods <ul><li>1. The current rate method </li></ul><ul><li>The monetary/ non- monetary method </li></ul><ul><li>The temporal method </li></ul><ul><li>4. The current / non- current method </li></ul>
  81. 81. 1. The Current Rate Method <ul><li>All balance sheet and income items are translated at the current rate of exchange, except for stockholders’ equity. </li></ul><ul><li>Income statement items, including depreciation and cost of goods sold, are translated at either the actual exchange rate (date of translation) or the weighted average exchange rate for the period. </li></ul>
  82. 82. 1. The Current Rate Method <ul><li>Dividends paid are translated at the exchange rate prevailing on the date the payment was made. </li></ul><ul><li>The common stock account and paid in capital accounts are translated at historical rates. </li></ul><ul><li>Gains & losses by translation adjustments- separate account – known as Cumulative Translation Adjustment (CTA). </li></ul>
  83. 83. 2. The Monetary/ Non- Monetary Method <ul><li>Monetary items- are those that represent a claim to receive or an obligation to pay fixed amount of foreign currency unit, e.g. cash, accounts receivable, current liabilities etc. </li></ul><ul><li>Monetary items- Current rate </li></ul>
  84. 84. 2. The Monetary/ Non- Monetary Method <ul><li>Non- Monetary items- are those that do not represent a claim to receive or an obligation to pay fixed amount of foreign currency items, e.g. inventory, fixed assets, long-term investments etc. </li></ul><ul><li>Monetary items- Historical rates </li></ul>
  85. 85. 3. Temporal Method <ul><li>Modified version of monetary / non- monetary method. </li></ul><ul><li>If inventory is in balance sheet at market values, then current rate otherwise historical rate. </li></ul><ul><li>Income statement items- average exchange rate </li></ul><ul><li>Cost of Goods Sold (COGS) & Depreciation-historical rates. </li></ul>
  86. 86. 4. The Current/ Non- Current Method <ul><li>Current assets & liabilities- Current exchange rate </li></ul><ul><li>Non- Current assets & Liabilities – Historical rates </li></ul>
  87. 87. Functional vs Reporting Currency <ul><li>Functional Accounting Standard’s Board (FASB 52) differentiates between a foreign affiliate’s “functional” and “reporting” currency. </li></ul><ul><li>Functional currency is defined as the currency of the primary economic environment in which the affiliate operates and in which it generates cash flows. Generally, this is the local currency of the country in which the entity conducts most of the business. </li></ul>
  88. 88. Functional vs Reporting Currency <ul><li>The reporting currency is the currency in which the parent firm prepares its own financial statements./; This currency is normally the home country currency, i.e., the currency of the country in which the parent is located and conducts most of its business. </li></ul>
  89. 89. Conclusion <ul><li>Accounting exposure is the potential for translation losses or gains. Translation is the measurement, in a reporting currency, of assets, liabilities, revenues and expenses of a foreign operation where the foreign accounts are originally denominated and/ or measured in functional currency. </li></ul>
  90. 90. Management of Economic Exposure <ul><li>Economic exposure measures the impact of an actual conversion on the expected future cash flows as a result of an unexpected change in exchange rates. </li></ul>
  91. 91. Measuring Economic Exposure <ul><li>The degree of economic exposure to exchange rate fluctuations is significantly higher for a firm involved in international business than for a purely domestic firm. </li></ul>
  92. 92. Measuring Economic Exposure <ul><li>One method of measuring an MNCs economic exposure is to classify the cash flows into different items on the income statement and predict movement of each item in the income statement based on a forecast of exchange rates. </li></ul><ul><li>This will help in developing an alternate exchange rate scenario and the forecasts for the income statement items can be revised. </li></ul>
  93. 93. Managing Economic Exposure <ul><li>The following are some of the proactive marketing & production strategies which a firm can pursue in response to anticipated or actual real exchange rate changes. </li></ul><ul><li>1. Marketing initiatives </li></ul><ul><li>Market selection </li></ul><ul><li>Product strategy </li></ul><ul><li>Pricing strategy </li></ul><ul><li>Promotional strategy </li></ul>
  94. 94. Managing Economic Exposure <ul><li>2. Production initiatives </li></ul><ul><li>Product sourcing </li></ul><ul><li>Input mix </li></ul><ul><li>Plant location </li></ul><ul><li>Raising productivity </li></ul>
  95. 95. Market selection <ul><li>Market strategy considerations for an exporter are the markets in which to sell, i.e. market selection. It is also necessary to consider the issue of market segmentation with individual countries. </li></ul><ul><li>A firm that sells differentiated products to more affluent customers may not be harmed as much by a foreign currency devaluation as will a mass marketer. </li></ul>
  96. 96. Product strategy <ul><li>Companies can also respond to exchange rate changes by altering their product strategy, which deals in such areas as new product introduction. </li></ul><ul><li>Product line decisions </li></ul><ul><li>Product innovations </li></ul>
  97. 97. Promotional strategy <ul><li>A firm exporting its products after a domestic devaluation may well find that the return per home currency expenditure on advertising or selling is increased because of the product’s improved price positioning. </li></ul>
  98. 98. Pricing Strategy- Market Share vs Profit Margin <ul><li>To begin the analysis, a firm selling overseas should follow the standard economic proposition of setting the price that maximizes dollar profits (by equating marginal revenues and marginal costs). In making this decision, however, profits should be translated using the forward exchange rate that reflects the true expected dollar value of the receipts upon collection. </li></ul>
  99. 99. Input Mix <ul><li>Outright additions to facilities overseas accomplish a manufacturing shift. A more flexible solution is to purchase more components overseas. This practice is called as outsourcing. </li></ul>
  100. 100. Shifting production among plants <ul><li>MNCs with world wide production systems can allocate production among their several plants in line with the changing home currency cost of production, increasing production in a nation whose currency has devalued and decreasing production in a country where their has been a revaluation. </li></ul><ul><li>Assumption- Company has a portfolio of plants worldwide. </li></ul>
  101. 101. Plant location
  102. 102. Raising Productivity <ul><li>Raising productivity through closing inefficient plants, automating heavily and negotiating wage benefit cutbacks and work rule concessions is another alternative to manage economic exposure. </li></ul>
  103. 103. Corporate philosophy for Exposure Management Active trading Selective hedging All exposures hedged All exposures left unhedged High reward Low reward High risk Low risk
  104. 104. Multinational Cash Management
  105. 105. Multinational Cash Management <ul><li>Objectives of cash management </li></ul><ul><li>How to manage & control the cash resources of the company as quickly and efficiently as possible. </li></ul><ul><li>Achieve the optimum utilization and conservation of the funds. </li></ul>
  106. 106. Objective of an efficient system: <ul><li>Minimise the currency exposure risk. </li></ul><ul><li>Minimise the country and political risk. </li></ul><ul><li>Minimise the overall cash requirements of the company. </li></ul><ul><li>Minimise the transaction costs. </li></ul><ul><li>Full benefits of economies of scale as well as the benefit of superior knowledge. </li></ul>
  107. 107. Techniques to Optimise Cash Flows <ul><li>Accelerating cash inflows. </li></ul><ul><li>Managing blocked funds. </li></ul><ul><li>Leading and lagging strategy. </li></ul><ul><li>Using netting to reduce overall transaction costs by eliminating a no. of unnecessary conversions and transfer of currencies. </li></ul><ul><li>Minimising the tax on cash flow through international transfer pricing. </li></ul>
  108. 108. Accelerating cash inflows <ul><li>Quicker recovery of inflows by </li></ul><ul><li># establishing lockboxes </li></ul><ul><li># Pre-authorising payments- It allows an organisation to charge a customer’s bank account up to some limit. </li></ul>
  109. 109. Managing blocked funds <ul><li>The host country may block funds that the subsidiary attempts to send to the parent. For eg. The host country may ask the company to re-invest the funds for few years and create jobs. </li></ul><ul><li>Prior to making a capital investment in a foreign subsidiary, the parent firm should investigate the potential of future funds blockage. </li></ul>
  110. 110. Leading and Lagging <ul><li>MNCs can accelerate (lead) or delay (lag) the timing of foreign currency payments by modifying the credit terms extended by one unit to another. </li></ul>
  111. 111. Leading & Lagging- advantages <ul><li>It is used for minimising foreign exchange exposure and helps in shifting liquidity among affiliates by changing credit terms. </li></ul><ul><li>It helps in taking advantage of expected revaluations and devaluations of currency movements. </li></ul><ul><li>No formal note of indebtedness is required and credit terms can be changed by increasing & decreasing the terms on the account. </li></ul>
  112. 112. Example <ul><li>An MNC faces the after tax borrowing and lending rates in UK and the US as shown below: </li></ul><ul><li>Borrowing rate Lending rate </li></ul><ul><li>% % </li></ul><ul><li>US 3.6 2.8 </li></ul><ul><li>UK 3.4 2.6 </li></ul><ul><li>+ - </li></ul>
  113. 113. Example- solution <ul><li>UK </li></ul><ul><li>+ - </li></ul><ul><li>2.8% / 2.6% (0.2%) 2.8% / 3.4% (-0.6%) </li></ul><ul><li>3.6% / 2.6% (1.0%) 3.6% / 3.4% (0.2%) </li></ul>
  114. 114. Netting <ul><li>Netting is a technique of optimising cash flow movements with the joint efforts of subsidiaries. </li></ul><ul><li>The process involves the reduction of administration and transaction costs that result from currency conversion. </li></ul><ul><li>Netting helps in minimising the total volume of inter company fund flow. </li></ul>
  115. 115. Advantages of Netting <ul><li>It reduces the no. of cross border transactions between subsidiaries, thereby reducing the overall costs of such cash transfers. </li></ul><ul><li>There is a more co-ordinated effort among all the subsidiaries to accurately report and settle various accounts </li></ul><ul><li>It reduces the need for foreign exchange conversion and hence, reduces transaction costs </li></ul><ul><li>It helps improved cash flow forecasting since, only net cash transfers are made at the end of each period. </li></ul>
  116. 116. Types of Netting <ul><li>Bilateral netting system </li></ul><ul><li>Multinational netting system </li></ul>
  117. 117. Bilateral Netting System <ul><li>Example: </li></ul><ul><li>Suppose, The US parent and the German Affiliate have to receive net $ 40,000 and $ 30,000 from one another. Then, under a bilateral netting system, only one payment will be made – the German affiliate pays the US parent an amount equal to $ 10,000. </li></ul>
  118. 118. Bilateral Netting System US Parent German Affiliate US Parent German Affiliate Pay $ 30,000 Pay $ 40,000 Pay $ 10,000 After Bilateral Netting
  119. 119. Multinational Netting System <ul><li>In this system, each affiliate nets all its inter affiliate receipts against all its disbursements. It then transfers or receives the balance, depending upon whether it is the net receiver or a payer. </li></ul><ul><li>To be really effective, it needs centralised and effective communication system and discipline. </li></ul>
  120. 120. Multinational Netting System X Y Z $ 20 m $ 20 m $ 20 m
  121. 121. Country Risk Analysis
  122. 122. Political Risk Indicators <ul><li>It is very difficult to measure political risk associated with a particular country or a borrower. Assessing political risk is a continuous problem. </li></ul><ul><li>Stability of the local political environment </li></ul><ul><li>Consensus regarding priorities </li></ul><ul><li>Attitude of the host government </li></ul><ul><li>War </li></ul><ul><li>Mechanisms for expressions of discontent </li></ul>
  123. 123. Economic Risk Indicators <ul><li>Inflation rate </li></ul><ul><li>Current and potential state of the country’s economy </li></ul><ul><li>Resource base </li></ul><ul><li>Adjustment to external shocks </li></ul><ul><li>Other factors include exports and imports as a proportion of GDP etc. </li></ul>
  124. 124. Techniques to assess Country Risk <ul><li>1. Debt related factors: </li></ul><ul><li>For eg, countries with a high export growth rate are more likely to be able to service their debt and are expected t enjoy better credit worthiness rating since exporters are the main source of foreign exchange earnings for most of the countries. </li></ul>
  125. 125. Techniques to assess Country Risk <ul><li>1. Debt related factors: </li></ul><ul><li>The debt service indicators include: </li></ul><ul><li>Debt / GDP (to rank countries according to external debt) </li></ul><ul><li>Debt- service ratio (relates debt service requirements to export incomes) </li></ul><ul><li>Short term debt/ Total exports </li></ul>
  126. 126. Techniques to assess Country Risk <ul><li>1. Debt related factors: </li></ul><ul><li>The debt service indicators include: </li></ul><ul><li>Imports/ GDP (Sensitivity of domestic economy to external development) </li></ul><ul><li>Net interest payment / Export of goods and services </li></ul>
  127. 127. Techniques to assess Country Risk <ul><li>2. Balance of Payments </li></ul><ul><li>The balance of payment indicators include: </li></ul><ul><li>%age increase in imports / %age increase in GDP (this ratio shows the income elasticity of demand for exports) </li></ul><ul><li>Current Account/ GNP (a measure of the country’s net external borrowings relative to country size) </li></ul>
  128. 128. Techniques to assess Country Risk <ul><li>2. Balance of Payments </li></ul><ul><li>The balance of payment indicators include: </li></ul><ul><li>Imports of goods and services / GDP </li></ul><ul><li>Effective exchange rate Index (measures the relative movements in domestic and international prices) </li></ul>
  129. 129. Techniques to assess Country Risk <ul><li>3. Economic Performance </li></ul><ul><li>It can be measured in terms of a country’s rate of growth and its rate of inflation. The inflation can be regarded as a proxy for the quality of economic management. Thus, the higher the inflation rate, the lower the creditworthiness rating. </li></ul>
  130. 130. Techniques to assess Country Risk <ul><li>3. Economic Performance </li></ul><ul><li>Ratios that can be used are: </li></ul><ul><li>GNP per capita </li></ul><ul><li>Money supply (serves as an early indicator for future inflation) </li></ul><ul><li>Gross Domestic Savings / Gross National Product </li></ul><ul><li>Gross Investment / GDP. This ratio is called propensity to invest ratio and captures a country’s prospects for future growth. </li></ul>
  131. 131. Techniques to assess Country Risk <ul><li>4. Political Instability undermines the economic capacity of a country to service its debt. </li></ul><ul><li>Political instability generates adverse consequences for economic growth, inflation, domestic supply, level of import dependency and creates foreign exchange shortage from imbalance between exports and imports. </li></ul>
  132. 132. Techniques to assess Country Risk <ul><li>4. Political instability: </li></ul><ul><li>The political instability indicators which can be considered are: </li></ul><ul><li>The political protest, for example, protest demonstrations, political strikes, riots, political assassination etc. </li></ul><ul><li>Successful and unsuccessful irregular transfer. </li></ul>
  133. 133. Techniques to assess Country Risk <ul><li>5. Check list approach </li></ul><ul><li>A number of relevant indicators that contribute to a firm’s assessment of country risk are chosen and a weight is attached to it. </li></ul><ul><li>Factors having greater influence on country risk are assigned greater weights. </li></ul><ul><li>It employs a combination of statistical and judgmental factors. </li></ul>
  134. 134. Techniques to assess Country Risk <ul><li>5. Check list approach </li></ul><ul><li>Statistical factors try and assess the performance of a country’s economy. (study past to judge the future) </li></ul><ul><li>Judgmental factors – give some indication of a country’s future ability and willingness to repay. </li></ul><ul><li>The weighting of the judgmental and statistical factors could then be done to arrive at thea risk ranking for countries. </li></ul>
  135. 135. Cost of Capital & Capital Structure
  136. 136. Cost of capital <ul><li>Cost of capital for a firm is the rate that must be earned in order to satisfy the required rate of return of the firm’s investors. </li></ul><ul><li>It has a major impact on firm’s value. </li></ul><ul><li>Lesser the cost of capital, the better it is. </li></ul>
  137. 137. Cost of capital for MNCs vs Domestic firms <ul><li>There is a difference between Cost of capital for MNCs and Domestic firms because of the following: </li></ul><ul><li>1. Size of the firm: Firms that operate internationally are usually much bigger in size than firms that operate only in the domestic market. MNCs generally borrow substantial amount of funds by virtue of their size and are in a position to get it at cheaper rates. </li></ul>
  138. 138. Cost of capital for MNCs vs Domestic firms <ul><li>2. Foreign exchange risk: An exceptionally volatile exchange rate is not much appreciated as it leads to wide fluctuations in in the cash flows of an MNC. It would be difficult for the firm to meet its fixed commitments and therefore, the shareholders and creditors demand a higher return which, in turn, would increase the cost of capital of the firm. </li></ul>
  139. 139. Cost of capital for MNCs vs Domestic firms <ul><li>3. Access to international capital markets: MNCs can access to international capital markets helps them to attract funds at lower cost than domestic companies. </li></ul><ul><li>4. International diversification effect: If a firm’s cash flows come from sources all over the world, there might be more stability in them. </li></ul>
  140. 140. Cost of capital for MNCs vs Domestic firms
  141. 141. Cost of capital for MNCs vs Domestic firms
  142. 142. Cost of capital for MNCs vs Domestic firms
  143. 143. Cost of capital for MNCs vs Domestic firms
  144. 145. <ul><li> </li></ul>