FX Markets and Exchange Rates
FX Markets and Exchange Rates
FX Markets and Exchange Rates
The many different types of participants in the foreign exchange market include
the following:
Exchange Rates
An exchange rate is simply the price of one country’s currency expressed in terms
of another country’s currency. In practice, almost all trading of currencies takes
place in terms of the U.S. dollar. For example, both the Swiss franc and the
Japanese yen are traded with their prices quoted in U.S. dollars. Exchange rates are
constantly changing.
Exchange Rate Quotations
Figure 21.1 reproduces exchange rate quotations as they appeared in The Wall
Street Journal in 2008. The second column (labeled “in US$”) gives the number of
dollars it takes to buy one unit of foreign currency. Because this is the price in
dollars of a foreign currency, it is called a direct or American quote (remember that
“Americans are direct”). For example, the Australian dollar is quoted at .9388,
which means you can buy one Australian dollar with U.S. $.9388.
The third column shows the indirect, or European, the exchange rate (even though
the currency may not be European). This is the amount of foreign currency per
U.S. dollar. The Australian dollar is quoted here at 1.0652, so you can get 1.0652
Australian dollars for one U.S. dollar. Naturally, this second exchange rate is just
the reciprocal of the first one (possibly with a little rounding error), 1/.9388 =
1.0652.
Source: Ross, Stephen, et al. (2010). Fundamentals of Corporate Finance. (9 th Edition). New York, NY:
McGraw-Hill Irwin. p. 685.
This particular activity is called triangle arbitrage because the arbitrage involves
moving through three different exchange rates:
To prevent such opportunities, it is not difficult to see that because a dollar will
buy you either 1 euro or 2 Swiss francs, the cross-rate must be:
(€1/$1)/(SF 2/$1) = €1/SF 2
That is, the cross-rate must be one euro per two Swiss francs. If it were anything
else, there would be a triangle arbitrage opportunity.
Suppose the exchange rates for the British pound and Swiss franc are:
Pounds per $1 = .60
SF per $1 = 2.00
The cross-rate is three francs per pound. Is this consistent? Explain how to make
some money. The cross-rate should be SF 2.00/£.60 = SF 3.33 per pound. You can
buy a pound for SF 3 in one market, and you can sell a pound for SF 3.33 in
another. So, we want to first get some francs, then use the francs to buy some
pounds, and then sell the pounds.
Assuming you have $100, you could:
1. What is the appropriate exchange rate to use for translating each balance
sheet account?
2. How should balance sheet accounting gains and losses from foreign
currency translation be handled?
Lilliputia is a quiet place, and nothing at all actually happened during the year. As
a result, net income was zero (before consideration of exchange rate changes).
However, the exchange rate did change to 4 Gullivers = $1 purely because the
Lilliputian inflation rate is much higher than the U.S. inflation rate. Because
nothing happened, the accounting ending balance sheet in Gullivers is the same as
the beginning one. However, if we convert it to dollars at the new exchange rate,
we get:
Notice that the value of the equity has gone down by $125, even though net
income was exactly zero. Despite the fact that absolutely nothing really happened,
there is a $125 accounting loss. How to handle this $125 loss has been a
controversial accounting question.
Managing Exchange Rate Risk
For a large multinational firm, the management of exchange rate risk is
complicated by the fact that there can be many different currencies involved in
many different subsidiaries. A change in some exchange rate will likely benefit
some subsidiaries and hurt others. The net effect on the overall firm depends on its
net exposure.
For example, suppose a firm has two divisions. Division A buys goods in the
United States for dollars and sells them in Britain for pounds. Division B buys
goods in Britain for pounds and sells them in the United States for dollars. If these
two divisions are of roughly equal size in terms of their inflows and outflows, then
the overall firm obviously has little exchange rate risk.
In our example, the firm’s net position in pounds (the amount coming in less the
amount going out) is small, so the exchange rate risk is small. However, if one
division, acting on its own, were to start hedging its exchange rate risk, then the
overall firm’s exchange rate risk would go up. The moral of the story is that
multinational firms have to be conscious of their overall positions in a foreign
currency. For this reason, the management of exchange rate risk is probably best
handled on a centralized basis.
Political Risk
One final element of risk in international investing is political risk. Political risk
refers to changes in value that arise as a consequence of political actions. This is
not a problem faced exclusively by international firms. For example, changes in
U.S. tax laws and regulations may benefit some U.S. firms and hurt others, so
political risk exists nationally as well as internationally.
Some countries do have more political risk than others, however. When firms
operate in these riskier countries, the extra political risk may lead the firms to
require higher returns on overseas investments to compensate for the possibility
that funds may be blocked, critical operations interrupted, and contracts abrogated.
In the most extreme case, the possibility of outright confiscation may be a concern
in countries with relatively unstable political environments.
Political risk also depends on the nature of the business; some businesses are less
likely to be confiscated because they are not particularly valuable in the hands of a
different owner. An assembly operation supplying subcomponents that only the
parent company uses would not be an attractive “takeover” target, for example.
Similarly, a manufacturing operation that requires the use of specialized
components from the parent is of little value without the parent company’s
cooperation.
Political risk can be hedged in several ways, particularly when confiscation or
nationalization is a concern. The use of local financing, perhaps from the
government of the foreign country in question, reduces the possible loss because
the company can refuse to pay the debt in the event of unfavorable political
activities. Structuring the operation in such a way that it requires significant parent
company involvement to function is another way to reduce political risk.
Reference:
Ross, Stephen, et al. (2010). Fundamentals of Corporate Finance. (9th Edition).
New York, NY: McGraw-Hill Irwin
Learning Activities
According to Brigham (2010), although the same basic principles of capital
budgeting apply to both foreign and domestic operations, there are some key
differences.
First, cash flow estimation is more complex for overseas investments. Most
multinational firms set up separate subsidiaries for each foreign country in which
they operate, and the relevant cash flows for the parent company are the dividends
and royalties paid by the subsidiaries to the parent.
Second, these cash flows must be converted into the parent company’s currency,
so they are subject to exchange rate risk.
For example, General Motors’ German subsidiary may make a profit of 100
million euros in 2008, but the value of this profit to GM will depend on the
dollar/euro exchange rate.
Dividends and royalties are normally taxed by both foreign and home-country
governments. Furthermore, a foreign government may restrict the repatriation of
earnings to the parent company. For example, some governments place a ceiling,
often stated as a percentage of the company’s net worth, on the amount of cash
dividends that a subsidiary can pay to its parent.
Such restrictions are normally intended to force multinational firms to reinvest
earnings in the foreign country, although restrictions are sometimes imposed to
prevent large currency outflows that might disrupt the exchange rate.
Whatever the host country’s motivation for blocking repatriation of profits, the
result is that the parent corporation cannot use cash flows blocked in the foreign
country to pay dividends to its shareholders or to invest elsewhere in the business.
Hence, from the perspective of the parent organization, the cash flows that are
relevant for foreign investment analysis are those that the subsidiary is actually
expected to send back to the parent. The present value of those cash flows is found
by applying an appropriate discount rate, and this present value is then compared
with the parent’s required investment to determine the project’s NPV.
In addition to the complexities of the cash flow analysis, the cost of capital may be
different for a foreign project than for an equivalent domestic project because
foreign projects may be more or less risky. Higher risks might arise from (1)
exchange rate risk and (2) political risk.
A lower risk might result from the benefits of international diversification. The
foreign currency cash flows to be turned over to the parent must be converted into
U.S. dollars by translating them at expected future exchange rates.
An analysis should be conducted to ascertain the effects of exchange rate
variations; and on the basis of this analysis, an exchange rate risk premium should
be added to the domestic cost of capital to reflect this risk. It is sometimes possible
to hedge against exchange rate fluctuations; but this may not be possible,
especially on long-term projects. If hedging is used, the costs of doing so must be
subtracted from the project’s cash flows.
Political Risk
Political risk refers to potential actions by a host government that would reduce the
value of a company’s investment. It includes at one extreme the expropriation
without compensation of the subsidiary’s assets; but it also includes less drastic
actions that reduce the value of the parent firm’s investment in the foreign
subsidiary, including higher taxes, tighter repatriation or currency controls, and
restrictions on prices charged. The risk of expropriation is small in traditionally
friendly and stable countries such as Great Britain and Switzerland.
However, in Latin America, Africa, the Far East, and Eastern Europe, the risk may
be substantial. Past expropriations include those of ITT and Anaconda Copper in
Chile; Gulf Oil in Bolivia; Occidental Petroleum in Libya; and the assets of many
companies in Iraq, Iran, and Cuba. Note that companies can take several steps to
reduce the potential loss from expropriation:
(1) finance the subsidiary with local capital,
(2) structure operations so that the subsidiary has value only as a part of the
integrated corporate system, and
(3) obtain insurance against economic losses due to expropriation from a source
such as the Overseas Private Investment Corporation (OPIC).
International Monetary Terminology
Here are some important concepts and terminology that are commonly used in
international finance
FX - CROSS RATES
1. Suppose the exchange rate between the U.S. dollar and the EMU euro is €0.65 = $1.00 and the
exchange rate between the U.S. dollar and the Canadian dollar is $1.00 = C$0.98. What is the cross
rate of euros to Canadian dollars?
Here's how to calculate:
cross rate of Euros to Canadian dollars - that means Euro per Canadian dollar
2. A currency trader observes that in the spot exchange market, 1 U.S. dollar can be exchanged
for 3.50 Israeli shekels or for 104.00 Japanese yen. What is the cross exchange rate between the
yen and the shekel; that is, how many yen would you receive for every shekel exchanged?
The correct answer is 29.7143 Yen per Shekel
Please try to calculate and learn how to get the correct answer.
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