FX Markets and Exchange Rates

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FX MARKETS AND EXCHANGE RATES

Corporations with significant foreign operations are often called international


corporations or multinationals. Such corporations must consider many financial
factors that do not directly affect purely domestic firms. These include foreign
exchange rates, differing interest rates from country to country, complex
accounting methods for foreign operations, foreign tax rates, and foreign
government intervention.
The basic principles of corporate finance still apply to international corporations;
like domestic companies, these firms seek to invest in projects that create more
value for the shareholders than they cost and to arrange financing that raises cash
at the lowest possible cost. In other words, the net present value principle holds for
both foreign and domestic operations, although it is usually more complicated to
apply the NPV rule to foreign investments.
One of the most significant complications of international finance is foreign
exchange. The foreign exchange markets provide important information and
opportunities for an international corporation when it undertakes capital
budgeting and financing decisions.
The first step in learning about the globalization of financial markets is to learn the
commonly used terminologies. As with any specialty, international finance is rich
in jargon. These are particular ones because they appear frequently in financial
books or because they illustrate the colorful nature of the language of international
finance.

1. American Depositary Receipt (ADR). It is a security issued in the United


States that represents shares of a foreign stock, allowing that stock to be traded
in the United States. Foreign companies use ADRs, which are issued in U.S.
dollars, to expand the pool of potential U.S. investors.
2. Cross-rate is the implicit exchange rate between two currencies (usually
non-U.S.) when both are quoted in some third currency, usually the U.S. dollar.

3. A Eurobond is a bond issued in multiple countries but denominated in a


single currency, usually the issuer’s home currency. Eurobonds are issued
outside the restrictions that apply to domestic offerings and are syndicated and
traded mostly from London.

4. Eurocurrency is money deposited in a financial center outside of the


country whose currency is involved. For instance, Eurodollars—the most
widely used Euro currency—are U.S. dollars deposited in banks outside the
U.S. banking system.

5. Foreign bonds, unlike Eurobonds, are issued in a single country and are


usually denominated in that country’s currency. Foreign bonds often are
nicknamed for the country where they are issued: Yankee bonds (United
States), Samurai bonds (Japan), Rembrandt bonds (the Netherlands), Bulldog
bonds (Britain).
6. Gilts technically are British and Irish government securities, although the
term also includes issues of local British authorities and some overseas public
sector offerings.
7. London Interbank Offered Rate (LIBOR) is the rate that most
international banks charge one another for loans of Eurodollars overnight in the
London market.

8. Swaps are agreements to exchange two securities or currencies. There are


two basic kinds of swaps; interest rate and An interest rate swap occurs when
two parties exchange a floating-rate payment for a fixed-rate payment or vice
versa. Currency swaps are agreements to deliver one currency in exchange for
another. Often, both types of swaps are used in the same transaction when debt
denominated in different currencies is swapped.

Foreign Exchange Markets and Exchange Rates


The foreign exchange market is undoubtedly the world’s largest financial market.
It is the market where one country’s currency is traded for another’s. Most of the
trading takes place in a few currencies: the U.S. dollar ($), the British pound
sterling (£), the Japanese yen (¥), and the euro (€).
The foreign exchange market is an over-the-counter market, so there is no single
location where traders get together. Instead, market participants are located in the
major commercial and investment banks around the world. They communicate
using computer terminals, telephones, and other telecommunications devices.
For example, one communications network for foreign transactions is maintained
by the Society for Worldwide Interbank Financial Telecommunication
(SWIFT), a Belgian not-for-profit cooperative. Using data transmission lines, a
bank in New York can send messages to a bank in London via SWIFT regional
processing centers.
List of some of the more common currencies and their symbols
Source: Ross, Stephen, et al. (2010). Fundamentals of Corporate Finance. (9 th Edition). New York, NY:
McGraw-Hill Irwin. p. 683

The many different types of participants in the foreign exchange market include
the following:

1. Importers who pay for goods using foreign currencies.


2. Exporters who receive foreign currency and may want to convert to
domestic currency.
3. Portfolio managers who buy or sell foreign stocks and bonds.
4. Foreign exchange brokers who match buy and sell orders.
5. Traders who “make a market” in foreign currencies.
6. Speculators who try to profit from changes in exchange rates.

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.

                                                 Argentinia (Peso)     US Dollars  


                                          1 ARS                 =  $.3290 (in US 2nd column)
                                          To get the value of $1 in ARS: divide 1ARS by $.3290 =
3.0395,
                                          Therefore       $1 = ARS3.03
 

Cross-Rates and Triangle Arbitrage


Using the U.S. dollar as the common denominator in quoting exchange rates
greatly reduces the number of possible cross-currency quotes. For example, with
five major currencies, there would potentially be 10 exchange rates instead of just
4.  Also, the fact that the dollar is used throughout decreases inconsistencies in the
exchange rate quotations.
Example: A Yen for Euros
Suppose you have $1,000. Based on the rates in Figure 21.1, how many Japanese
yen can you get? Alternatively, if a Porsche costs €100,000 (recall that € is the
symbol for the euro), how many dollars will you need to buy it? The exchange rate
in terms of yen per dollar (third column) is 108.21. Your $1,000 will thus get you:
                            $1,000 x 108.21 yen per $1 = 108,210 yen
Because the exchange rate in terms of dollars per euro (second column) is 1.5363,
you will need:
                            €100,000 x $1.5363 per € = $153,630
According to Ross (2010), cross-rate is defined as the exchange rate for a non-U.S.
currency expressed in terms of another non-U.S. currency. For example, suppose
we observe the following for the euro (€) and the Swiss franc (SF):
                            € per $1 = 1.00
                            SF per $1 = 2.00
Suppose the cross-rate is quoted as:
                            € per SF = .40
The cross-rate here is inconsistent with the exchange rates. To see this, suppose
you have $100. If you convert this to Swiss francs, you will receive:
                             $100 x SF 2 per $1 = SF 200
If you convert this to euros at the cross-rate, you will have:
                             SF 200 x €.4 per SF 1 = €80
However, if you just convert your dollars to euros without going through Swiss
francs, you will have:  
                             $100 x €1 per $1 = €100
What we see is that the euro has two prices, €1 per $1 and €.80 per $1, with the
price we pay depending on how we get the euros.
To make money, we want to buy low and sell high. The important thing to note is
that euros are cheaper if you buy them with dollars because you get 1 euro instead
of just .8.
You should proceed as follows:

1. Buy 100 euros for $100.


2. Use the 100 euros to buy Swiss francs at the cross-rate. Because it takes .4
euros to buy a Swiss franc, you will receive €100/.4 = SF 250.
3. Use the SF 250 to buy dollars. Because the exchange rate is SF 2 per dollar,
you receive SF 250/2 = $125, for a round-trip profit of $25.
4. Repeat steps 1 through 3.

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. Exchange dollars for francs: $100 x 2 = SF 200.


2. Exchange francs for pounds: SF 200/3 = £66.67.
3. Exchange pounds for dollars: £66.67/.60 = $111.12.

This would result in an $11.12 round-trip profit.


Types of Transactions
There are two basic types of trades in the foreign exchange market: spot trades and
forward trades.
A spot trade is an agreement to exchange currency “on the spot,” which actually
means that the transaction will be completed or settled within two business days.
The exchange rate on a spot trade is called the spot exchange rate.
A forward trade is an agreement to exchange currency at some time in the future.
The exchange rate that will be used is agreed upon today and is called the forward
exchange rate. A forward trade will normally be settled sometime in the next 12
months.
If you look back at Figure 21.1, you will see forward exchange rates quoted for
some of the major currencies. For example, the spot exchange rate for the Swiss
franc is SF 1 = $.9531. The 180-day (6-month) forward exchange rate is SF 1 =
$.9544. This means you can buy a Swiss franc today for $.9531, or you can agree
to take delivery of a Swiss franc in 180 days and pay $.9544 at that time.
Notice that the Swiss franc is more expensive in the forward market ($.9544 versus
$.9531). Because the Swiss franc is more expensive in the future than it is today, it
is said to be selling at a premium relative to the dollar. For the same reason, the
dollar is said to be selling at a discount relative to the Swiss franc.
 

EXCHANGE RATE RISK AND POLITICAL RISK


In the previous topic, we discussed that an exchange rate is simply the price of one
country’s currency expressed in terms of another country’s currency and almost all
trading of currencies takes place in terms of the U.S. dollar.
Exchange Rate Risk
Exchange rate risk is the natural consequence of international operations in a
world where relative currency values move up and down. Managing exchange rate
risk is an important part of international finance. There are three different types of
exchange rate risk, or exposure: short-run exposure, long-run exposure, and
translation exposure.
Short-run Exposure
The day-to-day fluctuations in exchange rates create short-run risks for
international firms. Most such firms have contractual agreements to buy and sell
goods in the near future at set prices. When different currencies are involved, such
transactions have an extra element of risk.
For example, imagine that you are importing imitation pasta from Italy and
reselling it in the United States under the Impasta brand name. Your largest
customer has ordered 10,000 cases of Impasta. You place the order with your
supplier today, but you won’t pay until the goods arrive in 60 days. Your selling
price is $6 per case.
Your cost is 8.4 euros per case, and the exchange rate is currently €1.50, so it takes
1.50 euros to buy $1. At the current exchange rate, your cost in dollars of filling
the order is €8.4/1.5 = $5.60 per case, so your pretax profit on the order is 10,000 x
($6 - 5.60) = $4,000. However, the exchange rate in 60 days will probably be
different, so your profit will depend on what the future exchange rate turns out to
be.
For example, if the rate goes to €1.6, your cost is €8.4/1.6 = $5.25 per case. Your
profit goes to $7,500. If the exchange rate goes to, say, €1.4, then your cost is
€8.4/1.4 = $6, and your profit is zero.
The short-run exposure in our example can be reduced or eliminated in several
ways. The most obvious way is by entering into a forward exchange agreement to
lock in an exchange rate. For example, suppose the 60-day forward rate is €1.58.
What will be your profit if you hedge? What profit should you expect if you don’t?
If you hedge, you lock in an exchange rate of €1.58. Your cost in dollars will thus
be €8.4/1.58 = $5.32 per case, so your profit will be 10,000 x ($6 - 5.32) = $6,800.
If you don’t hedge, then, assuming that the forward rate is an unbiased predictor
(in other words, assuming the UFR condition holds), you should expect that the
exchange rate will actually be €1.58 in 60 days. You should expect to make
$6,800.
Long-run Exposure
In the long run, the value of a foreign operation can fluctuate because of
unanticipated changes in relative economic conditions. For example, imagine that
we own a labor-intensive assembly operation located in another country to take
advantage of lower wages.
Through time, unexpected changes in economic conditions can raise the foreign
wage levels to the point where the cost advantage is eliminated or even becomes
negative. The impact of changes in exchange rate levels can be substantial.
For example, during early 2008, the U.S. dollar continued to weaken against other
currencies. This meant domestic manufacturers took home more for each dollar’s
worth of sales they made, which can lead to big profit swings. For example, during
2008, Coca-Cola estimated that it gained about $972 million due to currency
swings. The dramatic effect of exchange rate movements on profitability is also
shown by the analysis done by Iluka Resources, Ltd., an Australian mining
company, which stated that a one-cent movement in the Australian dollar–U.S.
dollar exchange rate would change its net income by $5 million.
Translation Exposure
When a U.S. company calculates its accounting net income and EPS for some
period, it must “translate” everything into dollars. This can create some problems
for the accountants when there are significant foreign operations. In particular, two
issues arise:

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?

To illustrate the accounting problem, suppose we started a small foreign subsidiary


in Lilliputia a year ago. The local currency is the gulliver, abbreviated GL. At the
beginning of the year, the exchange rate was GL 2 = $1, and the balance sheet in
Gullivers looked like this:
Source: Ross, Stephen, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New
York, NY: McGraw-Hill Irwin

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:

Source: Ross, Stephen, et al. (2010). Fundamentals of Corporate Finance. (9th Edition). New


York, NY: McGraw-Hill Irwin

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

1. An exchange rate is the price of one country’s currency in terms of another


country’s currency. For example, as of November 6, 2020, one U.S. dollar
would buy 0.76 British pound, 0.85 euro, or 1.308 Canadian dollar.
2. A spot exchange rate is the quoted price for a unit of foreign currency to be
delivered “on the spot” or within a very short period of time. The pound rate
quoted, £0.76/$, is a spot rate as of the close of business on November 6, 2020.
3. A forward exchange rate is the quoted price for a unit of foreign currency
to be delivered at a specified date in the future. For example, If today was
November 6, 2020, and we wanted to know how many pounds we could expect
to receive for a dollar on May 6, 2021, we would look at the 6-month forward
rate, which was £0.77/$ versus the £0.76/$ spot rate. Thus, the dollar is
expected to appreciate relative to the British pound during the next 6 months.
Note also that the forward exchange contract on November 6 would lock in this
exchange rate but no money would change hands until May 6, 2021. The spot
rate on May 6 might be quite different from £0.76, in which case we would
have a profit or a loss on the forward purchase.
4. A fixed exchange rate for a currency is set by the government and is
allowed to fluctuate only slightly (if at all) around the desired rate, which is
called the par value. For example, Belize has fixed the exchange rate for the
Belizean dollar at BZD 2.00/$1, and it has maintained this fixed rate for the
past few years.
5. A floating or flexible exchange rate is not regulated by the government, so
supply and demand in the market determine the currency’s value. The U.S.
dollar and the euro are examples of free-floating currencies. If U.S. customers
are importing more goods from Europe than they are exporting to Europe, they
will have to make net purchases of euros and sales of dollars, which will cause
the euro to appreciate relative to the dollar. Note, though, that central banks do
intervene in the market from time to time to nudge exchange rates up or down
even though they basically float.
6. Devaluation or revaluation of a currency is the technical term referring to
the decrease or increase in the stated par value of a currency whose value is
fixed. This decision is made by the government, usually without warning.
7. Depreciation or appreciation of a currency refers to a decrease or increase,
respectively, in the foreign exchange value of a floating currency. These
changes are caused by market forces rather than by governments.

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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