Professional Documents
Culture Documents
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Module 2: Foreign Exchange Markets I. II. III. IV. V. VI. VII. VIII. IX.
Introduction Need for Foreign Currencies Spot Markets versus Forward Markets Direct Quotes versus Indirect Quotes Computing Percent Change for a Foreign Currency Bid, Ask Prices and Bid/Ask Percent Spread Cross Exchange Rates Currency Forward Contracts and Forward Premium/Discount Currency Futures
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Module 6: The Nature and Control of Foreign Exchange Risk I. II. III. IV.
Foreign Exchange Risk and Types of Foreign Exchange Risk Relevance of Exchange Rate Risk Types of Foreign Exchange Risk Managing Transaction Exposure A. Identification of Net Transaction Exposure B. Forecast of Exchange Rates and the Decision to Hedge or not to Hedge C. Techniques for Managing Transaction Exposure D. Comprehensive Examples of Hedging Transaction Exposure 1. Hedging Payables a. Forward Contract Hedge b. Money Market Hedge c. Currency Call Option Hedge d. No Hedge 2. Hedging Receivables a. Forward Contract Hedge b. Money Market Hedge c. Currency Put Option Hedge d. No Hedge E. Managing Long-term Transaction Exposure F. Other techniques to Manage Transaction Exposure Managing Economic Exposure A. Diversifying Operations B. Diversifying Financing Globally Questions and Problems
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Module 8: Corporate Use of Innovative Foreign Exchange Risk Management Products I. II. III. IV. V. VI.
Characteristics of Respondent Corporations Use of Foreign Exchange Risk Management Products Differences Across Industries Influence of Firm Size and Degree of International Involvement Summary Questions for Fxrisk News Group Discussion
interest and currency swaps, and floating rate notes. Technological innovations in telecommunications, information dissemination, and computers have accelerated and reinforced this trend toward globalization
in a penthouse suite overlooking the Hudson river, install plush carpeting, or hire a pretty secretary. These problems are called agency problems, and the costs are called agency costs. These agency costs affect the cash flows and, therefore, the stock price. Because MNCs have subsidiaries around the globe and often have several layers of management, the agency costs of an MNC are higher than for purely domestic corporations. Constraints: The constraints in implementing the goal of the MNC are: 1. Environmental: Each country imposes its own environmental regulations, 2. Regulatory: Each host country can enforce taxes, earnings remittance restriction, job protection, and 3. Ethical: There is no consensus standard of business conduct that applies to all countries. A business practice that is considered to be unethical in the U.S. may be totally ethical in another country. All of these constraints add additional costs to the MNC and increase the cost of doing business. These constraints can act as a drag on the goal of maximizing stockholder wealth.
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright 2000 by West Publishing Company. All Rights Reserved.
Question: Do you think that the three theories of international business, Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory, are complementary or competitive? Provide justification for your answer.
Disadvantages: 1) The local firm in the host country may attempt to export the goods to another country, which may reduce sales of the licensing corporation, 2) It is difficult to ensure quality control of the local firm's production process, and 3) Technology secrets provided to the local firm may leak out to competitive firms in that country. Joint Venture: In the case of joint venture, two or many firms combine to create a subsidiary. Usually, each firm provides the resources in which it has the advantage. For example, a corporation in a developing country can combine with a US based MNC to gain technological advantages. The US firm, in turn, gains a foothold in the country and gains a market share.
FIGURE 2
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright 2000 by West Publishing Company. All Rights Reserved.
Note that the marginal return (MR) is higher, but the marginal cost of capital (MCC) is lower for a MNC compared to a DC. The intersection of the MR and MCC curves determines the projects that will get accepted. As long as the MR is greater than or equal to the MCC, the projects will be accepted. Question: Do you know why the marginal cost of capital curve (MCC) is upward sloping?
The optimal size of an MNC will be determined by a variety of factors, such as the economic and political environment of the foreign governments, MNC's product line, operating characteristics, risk-return preference, and industry type, etc.
In this case, ABC Corporation paid $ 8.9 million more than it anticipated to pay at time=0; the DM appreciated, thereby increasing the $ cost of the payables in DM. This is the exchange rate risk that the MNCs face in handling their foreign currency flows. This risk arises from the need to convert the cash flows from one currency to another. If there is no need to convert the currency, MNCs will not face exchange rate risk. Question for interactive table above Please change the t=+90 days exchange rate from $0.75 per DM to: 1. $0.50 per DM 2. $1.00 per DM What happens to the $ outflow cost in 1 and 2 above? Does what unfolds in scenario #1 above constitute an exchange rate risk? Question: If there were a single Currency through out the globe, MNCs would not face the daunting problem of exchange rate risk. What do you think of this idea? Is it feasible? Could it create other problems? Political Risk: Some examples of political risk include: 1) nationalization or being taken-over without receiving adequate compensation 2) Restrictions by host country governments on remittances to the parent company, 3) Change in taxation policies in mid-stream. In addition, the form of the government, its stability and the form of the legal system etc. will affect the political risk of a country.
Business Risk: Business risk arises from host country business and economic conditions. Slowing or weakening Japanese and European markets often leads to reduced demand for products of U.S. MNCs in these markets, thereby, contributing to the business risk of the U. S. MNCs.
Summary
In this module, we learned about some features of the World of International Finance and we noted the increasing globalization trend sweeping the markets. In addition, we looked at the characteristics of the Multinational Corporation and its objective; in the context of the MNC, we discussed the theories of international business: Theory of Comparative Advantage, Imperfect Markets Theory, and Product Cycle Theory. In addition, we also compared and contrasted multinational corporations with purely domestic corporations with regard to return and risk; it turns out that multinational corporations enjoy higher possible returns, but they also face more risks. Answers to Questions Raised in the Lecture 1. How does the objective of stock price or stockholder wealth maximization consider the time value of money? Stock price is the present value of all expected future cash flows of the corporation. Therefore, maximizing stock price automatically considers the time value of money. 2. How does the objective of stock price or stockholder wealth maximization consider the riskiness of cash flows as well? In finding the present value of the cash flows to arrive at the stock price of the corporation, depending on the riskiness of the cash flows, one can use different discount rates: if the risk is higher, one can use a higher discount rate, and if the risk is lower, one can use a lower discount rate. Thus, the objective of stock price maximization considers the riskiness of cash flows as well. 3. Are the three theories of international business complementary or competitive? The three theories are more complementary rather than competitive. The three theories address different dimensions of international business. 4. If there were a single currency throughout the globe, there would not be exchange rate risk. What do you think about its feasibility ? What other problems could that create? If we had a single currency, the sovereignty of each country as we know it today would be violated. The ability of the Central Bank of each country to control monetary policy and affect exchange rates, and inflation etc. would be affected as well. We are already witnessing these kinds of problems with the European integration and its single currency ECU evolution. 5. Why is the marginal cost of capital (MCC) upward sloping? If a corporation has debt in its capital structure, it is inherently risky, and, therefore, the banks will be willing to lend additional money only at higher interest rates. That is why the MCC is upward sloping. END OF MODULE 1
Objectives and Theme: This segment introduces foreign exchange markets. The first objective here is to learn the characteristics of Spot Markets and the Forward Markets; the second objective is to study the pricing of one currency relative to another in terms of direct and indirect quotes. Thirdly, bid and ask prices are introduced and explained. Finally, the concept of buying and selling currencies for future needs using Forward contracts, Futures contracts, and Options are briefly explained. Introduction: Unlike stock markets, which have a physical location of their own, there is no one place where currencies trade. In fact, currencies trade around the globe on a 24-hour basis. According to Zaheer (1995), the foreign exchange market consists of: 1. a primary network of about 150 major international banks with 1000 affiliates spread around the globe; these major banks act as market makers by buying and selling various currencies, and by quoting two-way bid-ask prices all the time. These banks also do speculative trading based on "privately informed opinion about market expectations of price trends." 2. a secondary network of 4000 or so second tier banks, which are involved both in speculative trading and trading with customers. 3. tertiary network of corporations, central banks, fund managers, and customers. The participants in this group buy and sell currencies essentially for their liquidity needs arising from trade and investment transactions. As of April 1998, the net turnover in the global foreign exchange market amounted to 1.5 trillion dollars a day!1. This compares with a market turnover of $820 billion in 1992 and 590 billion in 1989, representing an annual growth rate of 12 percent and 14 percent per year respectively. To understand the enormity of this market, it would be helpful to know that the US annual real GDP is about 6.82 trillion dollars! London, New York and Tokyo dominate the currency markets. The US dollar accounts for 83 percent of all global foreign exchange transactions, followed by the German mark, which accounts for 30 percent of all transactions, and the Japanese yen with a share of 24 percent of all transactions.
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Bank for International Settlements: Central Bank Summary of Foreign Exchange and Derivatives Market Activity, 1998
Foreign currency needs also arise for travel, education, and charitable giving needs, as well. For example, if Korean nationals want to go to a US university for furthering their educations, they must convert their Korean Won to US dollars to do so. Likewise, if someone from the US wants to travel in London for entertainment and shopping, he or she has to pay for the trip in British pounds, and, therefore, the US resident has to convert the US dollars to British pounds.
Wednesday 2/7/2001 0.9999 1.8310 14.810 0.3770 43.416 2.0025 0.6875 0.6876 0.6880 0.6886 1.5090 1.5089 1.5085
6-months forward Chile (Peso) China (Renminbi) Colombia (Peso) Czech. Rep. (Koruna) Denmark (Krone) Ecuador (US Dollar) -e Finland (Markka) France (Franc) 1-month forward 3-months forward 6-months forward Germany (Mark) 1-month forward 3-months forward 6-months forward Greece (Drachma) Hong Kong (Dollar) Hungary (Forint) India (Rupee) Indonesia (Rupiah) Ireland (Punt) Israel (Shekel) Italy (Lira) Japan (Yen) 1-month forward 3-months forward 6-months forward Jordan (Dinar) Kuwait (Dinar) Lebanon (Pound) Malaysia (Ringgit-b) Malta (Lira) Mexico (Peso) Float Netherland (Guilder) New Zealand (Dollar) Norway (Krone) Pakistan (Rupee) Peru (new Sol) Philippines (Peso)
0.6623 0.001787 0.1208 0.0004455 0.02656 0.1231 1.0000 0.1545 0.1400 0.1401 0.1403 0.1404 0.4696 0.4699 0.4704 0.4710 0.002696 0.1282 0.003460 0.02155 0.0001036 1.1663 0.2420 0.0004744 0.008572 0.008607 0.008678 0.008781 1.4065 3.2616 0.0006605 0.2632 2.2589 0.1033 0.4168 0.4351 0.1125 0.01695 0.2833 0.02075
0.6632 0.001778 0.1208 0.0004461 0.02682 0.1251 1.0000 0.1563 0.1416 0.1417 0.1419 0.1421 0.4751 0.4754 0.4758 0.4764 0.002727 0.1282 0.003501 0.02155 0.0001036 1.1798 0.2416 0.0004799 0.008596 0.008631 0.008701 0.008805 1.4065 3.2680 0.0006605 0.2632 2.2758 0.1033 0.4216 0.4442 0.1137 0.01698 0.2831 0.02060
1.5098 559.65 8.2763 2244.50 37.652 8.1245 1.0000 6.4730 7.1412 7.1370 7.1300 7.1211 2.1293 2.1280 2.1259 2.1233 370.87 7.7994 289.01 46.405 9651.00 0.8574 4.1330 2107.96 116.66 116.19 115.23 113.89 0.7110 0.3066 1514.00 3.8000 0.4427 9.6835 2.3991 2.2983 8.8873 59.000 3.5303 48.200
1.5079 562.35 8.2765 2241.88 37.288 7.9920 1.0000 6.3991 7.0598 7.0555 7.0486 7.0396 2.1050 2.1037 2.1016 2.0990 366.73 7.7999 285.63 46.400 9651.00 0.8476 4.1396 2083.92 116.33 115.86 114.93 113.57 0.7110 0.3060 1514.00 3.8000 0.4394 9.6835 2.3717 2.2512 8.7955 58.895 3.5320 48.550
Poland (Zloty) [d] Portugal (Escudo) Russia (Ruble) [a] Saudi Arabia (Riyal) Singapore (Dollar) Slovak Rep. (Koruna) South Africa (Rand) South Korea (Won) Spain (Peseta) Sweden (Krona) Switzerland (Franc) 1-month forward 3-months forward 6-months forward Taiwan (Dollar) Thailand (Baht) Turkey (Lira) United Arab (Dirham) Uruguay (New Peso) Financial Venezuela (Bolivar) SDR Euro
0.2431 0.004582 0.03501 0.2666 0.5722 0.02106 0.1252 0.0007899 0.005521 0.1035 0.5988 0.5998 0.6016 0.6042 0.03104 0.02346 0.00000147 0.2723 0.07957 0.001425 1.2932 0.9186
0.2468 0.004635 0.03509 0.2666 0.5720 0.02125 0.1267 0.0007915 0.005584 0.1047 0.6047 0.6057 0.6076 0.6102 0.03104 0.02343 0.00000147 0.2723 0.07958 0.001426 1.2990 0.9292
4.1135 218.26 28.562 3.7506 1.7475 47.483 7.9850 1266.00 181.14 9.6610 1.6700 1.6673 1.6622 1.6550 32.220 42.620 682170.00 3.6730 12.568 701.75 0.7733 1.0886
4.0520 215.77 28.497 3.7506 1.7483 47.059 7.8900 1263.50 179.07 9.5550 1.6536 1.6510 1.6459 1.6387 32.220 42.685 678130.00 3.6730 12.566 701.51 0.7698 1.0762
1. The quotes are given for Wednesday, February 7th and Thursday, February 8th. In the first column, the country name appears. In the second and third columns, US $ Equivalents, or Direct Quotes are given. Let us consider Germany (Mark): The very first line for Germany represents the Spot quote. Recall that Spot quotes represent the prices quoted for immediate conversion and delivery. The Quote of 0.4696 in US $ Equivalent for Thursday translates to US $ 0.4696 per Mark. This means one Mark equals US $ 0.4696. Likewise, the quote of 0.4751 in US $ Equivalent for Wednesday should be read as US $0.4751 per Mark. For another example, let us examine the French Franc. Once again, the very first line for that country represents the Spot Quote. Whenever a given country quote appears more than once, the very first line always represents the Spot Quote. A quote of 0.1400 for France on Thursday should be read as US $ 0.1400 per French Franc. This means one French Franc is worth 0.1400 US dollar. Likewise, considering the Direct Quotes for the British pound, a quote of US $ Equivalent of 1.4445 on Thursday should be read as US $ 1.4445 per British pound. This means one British pound equals US $ 1.4445. 2. The Indirect Quotes are presented in columns 4 and 5 of the Currency Trading: Exchange Rates table, under the heading Currency per US $. Once again, consider the Spot Quotes for Germany. The quote of 2.1293 appearing across Germany (Marks) for Thursday under column 4 should be read as 2.1293 Mark (DM) per US dollar: this means one US dollar is worth 2.1293 DMs. The indirect quote of 2.1050 of the DM for Wednesday, read as 2.1050 DMs per US dollar, translates into a value of 2.1050 DMs for one US dollar. In a similar fashion, the indirect Thursday quote of 7.1412 for France, read as Franc (FF) 7.1412/US$, means one US $ is worth 7.1412 French Francs. A quote of 7.0598 for the FF on Wednesday means that one US $ is worth 7.0598 FF. For the British pound, the Thursday Indirect Quote is 0.6923, read as BP 0.6923 per US $, implying one US $ equals BP 0.6923.
Given a Direct Quote, one can get the Indirect Quote by taking the reciprocal of the Direct Quote and vice-versa. For example, we already know that the Direct Quote for the Mark on Thursday is 0.4696; if we take 1/0.4696, we get 2.1293, the Indirect Quote of the Mark for Thursday. Similarly, if we take the reciprocal of the Indirect Quote of the FF for Thursday: 1/7.1412, we get 0.1400 , the Direct Quote for FF for the same day
Bouvet Island Brazil Brunei Bulgaria Burkina Faso Burma Burundi Cambodia Cameroon Canada Cape Verde Isl Cayman Islands Centrl African Rp Chad Chile Chile China Colombia Commnwlth Ind Sts Comoros Congo Dem Rep Congo, People Rp Costa Rica Croatia Cuba Cyprus Czech Denmark Djibouti Dominica Dominican Rep Ecuador Egypt El Salvador Equatorial Guinea Estonia Ethiopia
Norweg. Krone Real Dollar Lev C.F.A. Franc Kyat Franc Riel C.F.A. Franc Dollar Escudo Dollar C.F.A. Franc C.F.A. Franc Peso Peso Peso Rouble Franc Congolese Fr C.F.A. Franc Colon Kuna Peso Pound * Koruna Danish Krone DjiboutiFranc E Caribbean $ Peso Sucre Pound Colon C.F.A. Franc Kroon Birr
9.0083 1.9885 1.7409 2.14 714.8226 6.5899 734.067 3835.00 714.8226 1.5334 119.984 0.82 714.8226 714.8226 518.37 562.825 2238.50 28.688 536.117 4.4999 714.8226 321.13 8.489 1.00 1.5703 37.833 8.2005 173.00 2.70 16.30 25000.00 3.8843 8.75 714.8226 17.1866 8.10
8.8631 1.9905 1.7485 2.1195 713.9124 6.5949 734.063 3835.00 713.9124 1.5099 119.989 0.82 713.9124 713.9124 518.37 559.95 8.2764 2242.00 28.671 535.4343 4.4999 713.9124 320.68 8.3718 1.00 1.5902 37.575 8.0943 175.50 2.70 16.30 25000.00 3.8843 8.75 713.9124 16.9777 8.25
Euro Monetary Union EURO * Faeroe Islands Falkland Islands Fiji Finland France French Guiana French Pacific Isl Gabon Gambia Georgia Germany Ghana Gibraltar Greece Greenland Grenada Guadeloupe Guam Guatemala Guinea Bissau Guinea Rep Guyana Haiti Honduras Rep Hong Kong Hungary Iceland India Indonesia Iran Iraq Ireland Israel Italy Ivory Coast Jamaica Danish Krone Pound * Dollar Markka Franc Franc C.F.P. Franc C.F.A. Franc Dalasi Lari Mark Cedi Pound * Drachma Danish Krone E Caribbean $ Franc U.S. $ Quetzal C.F.A. Franc Franc Dollar Gourde Lempira Dollar Forint Krona Rupee Rupiah Rial Dinar Punt * New Shekel Lira C.F.A. Franc Dollar
0.9177 8.2005 1.4541 2.2346 6.4793 7.1482 7.1482 129.9676 714.8226 15.40 1.97 2.1314 7300.00 1.4541 371.3289 8.2005 2.70 7.1482 1.00 7.8065 714.8226 1865.00 180.50 23.00 15.19 7.7997 291.815 86.40 46.515 9600.00 1752.50 0.3124 1.1652 4.106 714.8226 45.20
0.9188 8.0943 1.4449 2.2284 6.4711 7.1391 7.1391 129.8021 713.9124 15.40 1.967 2.1286 7100.00 1.4449 369.64 8.0943 2.70 7.1391 1.00 7.8215 713.9124 1865.00 180.50 23.00 15.19 7.7992 288.04 85.91 46.4575 9650.09 1752.50 0.3124 1.1667 4.118 713.9124 45.20
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Japan Jordan Kazakhstan Kenya Kiribati Korea, North Korea, South Kuwait Kyrgyzstan Laos, People DR Latvia Lebanon Lesotho Liberia Libya Liechtenstein Lithuania Luxembourg Macao Madagascar DR Malawi Malaysia Maldive Mali Rep Malta Martinique Mauritania Mauritius Mexico Moldova Monaco Mongolia Montserrat Morocco Mozambique Namibia Nauru Islands
Yen Dinar Tenge Shilling Australia $ Won Won Dinar Som Kip Lat Pound Maloti Dollar Dinar Franc Litas Lux.Franc Pataca Franc Kwacha Ringgit Rufiyaa C.F.A. Franc Lira * Franc Ouguiya Rupee New Peso Lei Franc Tugrik E Caribbean $ Dirham Metical Dollar Australia $
116.468 0.711 145.35 78.285 1.8948 2.20 1251.50 0.3066 48.304 7600.00 0.6199 1514.25 7.8863 1.00 0.5357 1.687 3.999 43.96 8.0571 6400.00 80.30 3.80 11.77 714.8226 2.2456 7.1482 251.695 27.985 9.7005 12.3833 7.1482 1063.00 2.70 10.7625 16900.00 7.862 1.8948
116.683 0.711 145.35 78.06 1.8645 2.20 1266.00 0.3067 49.221 7600.00 0.6209 1514.00 7.95 1.00 0.5357 1.6649 3.9991 43.904 8.0566 6400.00 80.80 3.80 11.77 713.9124 2.2571 7.1391 250.70 27.975 9.684 12.3436 7.1391 1099.00 2.70 10.6995 17050.00 7.9675 1.8645
Nepal Netherlands Netherlands Ant'les Netherlands Ant'les New Zealand Nicaragua Niger Rep Nigeria Norway Oman, Sultanate of Pakistan Panama Papua N.G. Paraguay Peru Philippines Pitcairn Island Poland Portugal Puerto Rico Qatar Repub of Macedonia Republic of Yemen Reunion, Ile de la Romania Russia Rwanda Saint Christopher Saint Helena Saint Lucia Saint Pierre Saint Vincent Samoa, American Samoa, Western San Marino Saudi Arabia
Rupee Guilder Guilder Florin N.Z.Dollar Gold Cordoba C.F.A. Franc Naira Norweg. Krone Rial Rupee Balboa Kina Guarani New Sol Peso N.Z.Dollar Zloty Escudo U.S. $ Riyal Denar Rial Franc Leu Rouble Franc E Caribbean $ E Caribbean $ Franc E Caribbean $ U.S. $ Tala Lira Riyal
74.4677 2.4015 1.79 1.79 2.3345 12.90 714.8226 111.50 9.0083 0.385 59.5125 1.00 3.1496 3700.00 3.5268 48.00 2.3345 4.1005 218.4733 1.00 3.6408 64.045 161.458 7.1482 26864.00 28.688 359.0281 2.70 2.70 7.1482 2.70 1.00 3.3478 2390.98 3.7504
74.1637 2.3984 1.79 1.79 2.2991 12.90 713.9124 111.80 8.8631 0.385 59.195 1.00 3.0628 3670.00 3.5303 48.20 2.2991 4.108 218.1951 1.00 3.6408 64.045 161.458 7.1391 26722.50 28.671 359.0281 2.70 1.4449 2.70 7.1391 2.70 1.00 3.3478 2390.98 3.7504
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Senegal Seychelles Sierra Leone Singapore Slovak Slovenia Solomon Islands Somali Rep South Africa Spain Sri Lanka Sudan Rep Sudan Rep Surinam Swaziland Sweden Switzerland Syria Taiwan Tanzania Thailand Togo, Rep Tonga Islands Trinidad & Tobago Tunisia Turkey Turks & Caicos Tuvalu Uganda Ukraine United Arab Emir United Kingdom Uruguay Uzbekistan Vanuatu Vatican City Venezuela
C.F.A. Franc Rupee Leone Dollar Koruna Tolar Solomon $ Shilling Rand Peseta Rupee Dinar Pound Guilder Lilangeni Krona Franc Pound Dollar Shilling Baht C.F.A. Franc Pa'anga Dollar Dinar Lira U.S. $ Australia $ Shilling Hryvnia Dirham
714.8226 6.49 1899.095 1.7409 48.017 236.81 5.1099 2620.00 7.8863 181.3175 86.09 256.00 2560.00 981.00 7.8863 9.841 1.687 52.7064 32.274 815.50 42.465 714.8226 2.0101 6.22 1.3949 1.00 1.8948 1815.00 5.4289 3.6729
713.9124 6.45 1899.095 1.7485 47.3125 233.89 5.1099 2620.00 7.95 181.0866 86.81 256.00 2560.00 981.00 7.95 9.663 1.6649 52.7064 32.285 812.00 42.595 713.9124 2.0096 6.24 1.3878 1.00 1.8645 1815.00 5.4298 3.6729 1.4449 11.3925 775.00 141.80 701.75
686255.00 681280.00
Pound Sterling * 1.4541 Peso Uruguayo 11.3925 Sum Vatu Lira Bolivar 775.00 141.80 702.90
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The rates given are in terms of # of Units of Foreign Currency per one US dollar. The values are given for two different dates: one for Friday, February 16th, and another for Friday, February 9th, 2001. For example, for the South Korean Won, the rate given for February 16th is 1251.50, which should be read as South Korean Won 1251.50 per one US dollar. Please note the fact that this quote is in indirect form. Can you compare the value of South Korean Won on February 16th with its value on February 9th, and figure out whether or not the Won appreciated or depreciated with respect to the US $? Remember to use direct quotes to do that; you can get the direct quotes for the Won by taking the reciprocals of the indirect quotes in this table. Further, take a few minutes to read and learn the currencies of the countries around the globe! Do you know the name of the Currency for Reunion, Ille de la? Or for that matter, can you name the currencies for Algeria, Bolivia, Chile, Denmark, Egypt, Finland, Germany, Holland, India, Jordan, Kenya, Libya, Madagascar, Nepal, Oman, Panama, Qatar, Singapore, Taiwan, Uganda, Vatican City, and Zaire? By visiting the Foreign Exchange Rates site, you can convert one currency to another currency using the latest quotes. Be sure to visit the site. Can you tell me the value or price of the Indian Rupee in terms of South Korean Won? That is, figure out how many Won equal one Indian Rupee? Then, get the value of South Korean Won in Rupees. That is, get the value of # of Indian Rupees per South Korean Won
[(0.4696-0.4751) / 0.4751] * 100 = -1.1577 percent. This means, the DM depreciated by 1.1577 percent with respect to the US $, over a one day period. If we were to compute the percent change in the US $ with respect to the DM for the same period, we should be using the indirect quotes for the same period: Percent change in the US $ with respect to the Mark from Wednesday to Thursday = [(2.1293-2.1050) / 2.1050] * 100 = + 1.1544 percent.
Suppose for example, the following are the Bid, Ask Prices quoted for the Mark: Bid = $ 0.4664/DM Ask= $ 0.4724/DM If you want to purchase 100 Marks, it will cost you: Ask Price * # of Marks being bought = 0.4724 * 100 = US $ 47.24 If you want to sell 100 marks, you will receive = Bid price of 0.4664 * # Marks being bought = US $ 46.64 The Bid/Ask Percent Spread is given by: [ (Ask - Bid) / Ask ] * 100 = [(0.4724 - 0.4664)/0.4724] * 100 = 1.2701 percent. This should be read as the Ask price being at a premium of 1.2701 percent with respect to the Bid price. Obviously, one can compute the discount with respect to the Ask price, by dividing by the Bid price. It is customary to express the Bid/Ask Percent spread as a premium with respect to the Bid Price
Key Currency Cross Rates Wall Street Journal, February 08, 2001
Dollar Canada France Germany Italy Japan Mexico 1.5110 7.1412 2.1293 2108.0 116.66 9.6835 Euro Pound SFranc Guilder Peso Yen Lira D-Mark FFranc CdnDlr 4.7261
1.3880 2.1826 1.9560 3.0758 1936.4 3045.0 107.16 168.52 8.8953 13.988 2.2038 3.4655 1.5341 2.4123 .6359 .9186 .... 1.5725 1.4445
0.9048 .62982 .15604 .01295 .00072 .70962 .21159 .... 1.2750 .88754 .21989 .01825 .00101 .... 1262.3 878.65 217.69 18.069 .... 69.856 48.627 12.047 .... 5.7985 4.0363 .... 1.4366 .... .... .4145 .29817 1.4092
.69609 .17246 .01432 .00079 .78430 .23385 1.1052 .28856 .07149 .00593 .00033 .32512 .09694 .45816
1.08860 ....
.65186 .45376 .11242 .00933 .00052 .51125 .15244 .72046 .59880 .41682 .10327 .00857 .00047 .46964 .14003 .66181
The very first column refers to the US dollar. If we read across France and down the Dollar column, the value given is 7.1412; this should be read as FF 7.1412 per US dollar. Likewise, if we read across Germany and down the Dollar column, the quote given is 2.1293; this should be read as Marks 2.1293 per US dollar. Both the FF and DM are in indirect form. The value of DM in terms of FF, that is the # of FFs per DM is calculated as: [FF / US $] : [DM / US $] = 7.1412 / 2.1293= FF 3.3538 per DM = [FF / US $] * [US $ / DM] = FF / DM ! If we refer to the Currency Cross Rates Table and look across France and down D-Mark, you will see a Cross Exchange Rate of 3.3538, the same rate we calculated just now! To look at yet another example of the cross exchange rate, let us examine the rates for Germany and U.K. If we look across Germany and down the Dollar column, we note a quote of 2.1293, which stands for DM 2.1293 per US dollar. Likewise, for the pound the rate is 0.69230, which should be read as 0.69230 pound per US dollar. The cross exchange rate of the pound with respect to DM, that is, # of DMs per pound, is calculated as: 2.1293 / 0.69230 = Marks 3.0758 per pound
If we look across Germany and down Pound in Table 5, we get the value of 3.0758 DMs per pound as well, the same # as we calculated just now. In these Cross Exchange Rate computations, we used Indirect Quotes. Note the fact that the order in which the currencies are plugged in the numerator and denominator to arrive at the cross exchange rate is in the same order as the currencies appear in the pricing of currencies. However, if we are using the Direct Quotes, the order of currencies in the numerator and denominator will be reversed.
Similarly, the Premium P for the BP 90-day and 180-day forward rates will be computed as : Premium for 90-day forward rate: [ (1.4435-1.4445) / 1.4445] * (360/90) * 100 = -0.2769 %
Premium for 180-day forward Rate: = [ (1.4422-1.4445) / 1.4445] * (360/180) * 100 = -0.3184 %
In some sense, forward rates convey information about the spot rates in the future. Under certain conditions and assumptions, forward rates can act as predictors of spot rates in the future.
Currency Futures
Currency Futures are legal contracts which enable individuals, institutions, and MNCs to buy or sell currencies in the future at a specific price and for a specific period of time. Currency futures are available in the Chicago Mercantile Exchange for the Japanese Yen, DMark, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, and Euro. Unlike the Forward contacts, these futures are standardized with respect to size and delivery. These futures are used in hedging and speculation. We will learn more about these futures in Module 5. Can you visit the Chicago Mercantile Exchange and find out what futures are and options are currently traded at the exchange? Who trades them? And why?
Currency Options
Currency options are rights which enable individuals, institutions, and MNCs to buy and sell currencies in the future at a specific price for a specified period of time. These options are available for various currencies and trade in the Philadelphia Exchange. These options can be used for hedging and speculation. We will learn a lot about these instruments later in Module 5. Please visit the Introduction to Options site: Learn about Options Basics. Also, learn about the classification types, classes, and series! So, what are European Options? And what are American Options? What are calls, and what are puts? Summary: In this module, we learned about the pricing of foreign currencies; the currencies can be quoted in direct form as # of US $ per one unit of foreign currency and in indirect form as # of units of foreign currency per US $. We also learned about the ask and bid prices: the prices at which currencies are bought and sold, respectively. There was a discussion on computing percent change of a given currency. Also, we studied forward contracts and forward rates; forward rates are the rates at which contracts are entered into to buy and sell currencies in the future to meet future needs.
12. Please refer to the Currency Trading: Exchange Rates table. Using the information on Thursday's spot and forward rates for the French Franc, compute a) 30-day forward premium b) 90-day forward premium and c)180-day forward premium. 13. Using the exchange rate information for Thursday in Table 2.1, compute the following: a. Cross Exchange Rate of the BP with respect to FF: # of FF per BP b. Cross Exchange Rate of the FF with respect to Canadian Dollar: # of Canadian Dollar per FF c. Cross Exchange Rate of the SF with Respect to Swedish Krona: # of Krona per SF d. Cross Exchange Rate of the Italian Lira with Respect to Japanese Yen: # of Japanese Yen per Italian Lira 2. The following are the Ask and Bid Prices of the DM quoted by a bank: 3. Bid $ 0.6645 Per DM Ask $ 0.6745 Per DM
a. If you have DM 2,000 how many US $, you will get? b. If you want to buy DM 3,000 to visit Germany, how many US Dollars you need?
END OF MODULE 2
Module 3: Arbitrage and the Theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect
Objectives and Theme: In this module, our objective is to study arbitrage and examine why and how three types of arbitrage take place in the foreign currency markets; we also explore the realignment of exchange rates due to arbitrage transactions. Our second objective is to learn about the theories of Interest Rate Parity (IRP), Purchasing Power Parity (PPP), and International Fisher Effect (IFE). International Arbitrage and the Theory of Interest Rate Parity: Whenever there are discrepancies between quoted-rates and observed market rates in the foreign exchange markets, currency realignments will take place. Market forces bring about the realignment of currencies through arbitrage. Loosely, arbitrage can be defined as capitalizing on market discrepancies in the prices quoted in the foreign exchange markets by simultaneous buying and selling. It can also involve simultaneous lending and borrowing in different currencies to take advantage of the higher interest rates.
International Arbitrage
Types of Arbitrage Variables in the Discrepencies Locational Triangular Covered Interest Foreign exchange rate among banks Cross exchange rates Differential in interest rate and forward rate
Locational Arbitrage: Usually, locational arbitrage takes place when a particular currency can be sold at a higher price compared to its buying price; undertaking such transactions yields profits. In addition, locational arbitrage leads to the realignment of currency exchange rates as well. Example: Bank C Bid Price DM Ask Price DM $0.6405/DM $0.6500/DM Bank D $0.6610/DM $0.6710/DM
Since Bid price of $0.6610 at Bank D > Ask price of $0.6500 at Bank C, there is an opportunity to engage in locational arbitrage. Arbitrageurs will buy at $0.650 from Bank C and sell to Bank D at $ 0.6610 per DM. Recall one buys at the ask price and sells at the bid price.
If you have $ 10,000 and execute locational arbitrage, the following steps are involved: Buy DM at $ 0.650 from Bank C = $ 10,000/$ 0.650 = DM 15384.6 Sell DM at $ 0.6610 to Bank D = DM 15384.6 * $ 0.6610 = $ 10169.23 Net Profit = $ 10,169.23 - $ 10,000 = $ 169.23 As a result of this locational arbitrage, the asked price at bank C will go up, and the bid price at bank D will go down. The locational arbitrage concept explains why prices between banks at different locations will not normally differ by a significant amount.
Triangular Arbitrage
Foreign exchange quotations are typically expressed in US $ regardless of the country where the quotation is provided. Cross exchange rates are used to determine the relationship between two nondollar currencies. If a quoted actual or market cross exchange rate differs from the appropriate theoretical or should be rate, triangular arbitrage becomes feasible. Example: DM Value = $2 per DM FF Value = $0.20 Per FF The appropriate/theoretical cross exchange of DM with respect to FF, that is # of FF per DM = 2/0.2 = 10 FF/DM
Suppose a bank quotes cross exchange of DM with respect to DM = 11 FF/DM Since 1 DM = 11 FF at the bank (1 FF more than the theoretical cross exchange rate of 10 FF/DM), you can buy DM with US $, convert DM to FF, then sell FF for US $. There are three steps to follow: Step 1: Determine amount of the DM to be received or sell US $ to get DM Since 1 DM = $2 =====> $10,000 = 5000 DM Step 2: Determine how much FF you will receive in exchange for DM based on banks= quote of 1 DM = 11 FF 5,000 DM * 11 FF = 55,000 FF Step 3: Determine US $ amounts you will receive in exchange for FF or you sell FF and buy US $ based on 1 FF => $0.2 55,000 FF * $0.2 => $11,000 The triangular arbitrage strategy generates a profit of $1,000. Also note that triangular arbitrage is a riskfree strategy since there is no uncertainty about the prices at which you will buy and sell the currencies, and of course all the three steps should be executed simultaneously. Triangular arbitrage forces a quoted cross exchange rate to be appropriately priced vis--vis the rates of the given two currency values with respect to the dollar. Because of these triangular arbitrage transactions, the exchange rates are affected as follows: $2/DM ====> Since DMs are being bought, this rate goes up. ===> Since FFs are being bought, this rate goes down. ===> Since $s are being bought, this rate goes down
11 FF/DM $0.20/FF
1. Sell US $ and buy DM at the Spot rate of $2/DM $1,000,000 /2= DM500,000 2. Invest in German T-Bill @ 4 % 90-day interest rate in Germany Maturity Value of Investment in German Marks=500,000 (1 +0.04) = DM520,000 3. Sell 520,000 DM forward @ 90-day Forward Rate of $2.1/DM Time= +90-days 4. Get the Matured Investment of DM520,000, convert DM at the earlier agreed-up on $2.1/DM DM 520,000 DM x $2.1/DM = $1,092,000 The rate of return on this investment is computed as: ( $1,092,000 - $1,000,000)/ $1,000,000 x 100 = 9.2% The 9.2 % rate of return for investing in Germany has two components: a. German Interest Rate of 4 % b. DM Forward Premium of 5 % Recall that the Forward Premium is computed as : (Forward Rate - Spot Rate)/Spot Rate * 100 =(2.1-2.0)/2.0 * 100 = 5 % Note that since interest rates are given for 90-day period, we computed the forward premium also for the 90-day period. Normally, the forward premium is usually annualized, in which case, we would have used annualized interest rates. The sum of the 4 % interest rate and the forward premium adds up to 9.0 % which approximates the 9.2 % return on CIA we computed earlier. Because we are using an approximation here, we observe the 0.20 % difference. Later, we will be using the exact version to get the exact return. In this case, since US investors are earning a 7.2 % extra return from investing in Germany, US investors will be better off investing there. Let us further develop the example on CIA we just now saw: Covered Interest Rate Arbitrage Under Varying Forward Rate Regimes 90-day 90-day 90-day Foreign Spot Forward Home (US) Forward State (Germany) DM $ Premium or Interest Rate -DM $ Interest Rate per DM Discount (P) Rate per DM Appropriate Return on Covered Interest Arbitrage
1 2 3 4
2% 2% 2% 2%
4% 4% 4% 4%
$2 $2 $2 $2
5% 2.5% 0% -2.0%
4 + 5 = 9% 4+2.5 = 6.5% 4 + 0 = 4% 4 - 2 = 2%
In states 1 through 3, CIA (investing in Germany) is profitable. In all those instances, the forward premium of the DM was positive or 0, either adding to or maintaining the foreign interest rate of 4 %. But, in scenario # 4, when the forward rate shows a discount of -2%, the return on CIA is the same as the return from investing in the US. In this case, the interest rate advantage of 2 % for investing in Germany is exactly offset by the discount of -2% in the forward rate of the DM.
Recall that p is computed as: (Fj - Sj)/Sj x 100 If the (Home Interest Rate - Foreign Interest Rate) interest differential exactly equals the forward premium or discount, then there is Interest Rate Parity. At that point, the interest advantage is offset by the forward discount. In scenario #4 above, US investors earn 2% return regardless of where they choose to invest. Note that IRP does not imply that all country investors earn the same return at the point of IRP. In scenarios 1 through 3, US investors have an advantage in investing in Germany by CIA. The concept of IRP is further explained in Figure # 3.
Note: This Figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright 2000 by West Publishing Company. All Rights Reserved.
On the horizontal axis, the Forward premium or discount is given. On the vertical axis, (Home Interest Rate - Foreign Interest Rate) interest rate difference is plotted. Point #1 corresponds to scenario # 1 from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table. As we already know, US investors make 4% on interest income and 5% by exchange gain as the forward rate shows a premium of 5%. Likewise, in point #2 corresponding to scenario #2, US investors make 2 % more than what is available in the US, solely on the interest rate front. Points #1 and #2 lie to the right of the IRP line and therefore we can generalize and conclude that at the points to the right of IRP line, it will be advantageous for US investors to invest overseas. Similarly, at the points to the left of the IRP line, it will be advantageous for the foreign investors to invest in the US. At all points on the IRP line, there is interest rate parity. This means that a given country investor will get the same rate of return regardless of which country he chooses to invest in. The exact version of IRP equation is given by: (1+ih)/(1+if) - 1 = p Where, ih = Home Interest Rate if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency The only difference here is that the interaction term (p*if) adds an extra component to the interest rate difference between home and foreign country. Recall that in our State 1 example from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table, we had a 0.20 % difference on return to CIA in the approximate method in scenario #4. Given the German interest rate of 0.04 and premium of 0.05, (p*if) works out to 0.20 %, the difference we observed earlier. IRP holds true in the real world especially in the Eurocurrency markets. Arbitrage transactions ensure that interest differentials in different segments of the Eurocurrency markets are off-set by corresponding
forward premiums or discounts. IRP impacts on instruments of similar maturity and risk. However, if capital controls and such are imposed, IRP may not hold true in the real world.
Example: Home: US Real Interest Rate Inflation Rate Nominal Interest Rate PPP will predict, Ef (% Change, Spot, Foreign Currency) of 2%, equal to the inflation differential of (Ih - If) = 5-3 = 2 % . IFE will predict, Ef (% Change, Spot, Foreign Currency) of 2%, = the interest differential of (8-6) = 2%. According to both theories, the foreign currency should appreciate by 2%. While IFE looks at the nominal interest rate (total picture), PPP looks at the inflation rate. Both provide the same result; it is the same wine in different bottles! This means that if an American investor invests in the US, he or she will get 8% in nominal return. And if the investor invests abroad, he or she will get 6% return from interest income and an additional 2% return from the appreciation of the foreign currency. Summary: In this Module, we studied the concept of arbitrage and the types of arbitrage: 1) Locational, 2) Triangular and, 3) Covered Interest. Arbitrage helps to bring about the re-alignment of the exchange rates. We also discussed the theories of Interest Rate Parity, Purchasing Power Parity, and International Fisher Effect. END OF MODULE 3 3% 5% 8% Foreign: Japan 3% 3% 6%
currency reduces the effective return on a foreign currency. Therefore, before venturing into foreign currency borrowing or investing, it is a good idea to get the forecasts of the exchange rates. 3. Capital budgeting decisions: Capital investments call for initial foreign currency outflows for the investment cost followed by foreign currency inflows during the life of the project; furthermore, those flows need to be converted to the home currency. For this purpose, one also has to forecast the exchange rates and 4. Earnings assessment: In the preparation of consolidated financial statements, a forecast of the exchange rates is required. Therefore, such operations can be carried out more effectively if exchange rates are forecasted accurately.
Forecasting Techniques
Forecasting will depend on the type of exchange rate regimes, like fixed rate system versus free-floating regime; it will also depend on the period of future forecast like short-term horizon versus long-term horizon. Here, some methods are outlined without regard to those considerations. Technical Forecasting: Technical forecasting involves the review of historical exchange rates to search for repetitive patterns which may occur in the future. This pattern would be the basis for future exchange rate movements. If the exchange rate of the dollar has decreased over the last week period, it may provide an indication of how the currency will move tomorrow. Technical analysts often use time series models: "three steps and stumble" means that the currency tends to decline in value after a rise in the moving average over three consecutive periods! Computer programs can be used to detect patterns and to compute moving averages etc.
Fundamental Forecasting
Fundamental forecasting is based on underlying relationships between the currency's value and one or more economic factors like relative interest rates, inflation differentials, trade deficits, budget deficits, real GDP, money supply etc. Exchange rate forecasting is available at the Financial Forecast Center. What is the Bank of America medium term forecast for the U.S. dollar-Yen exchange rate? How about the U.S. dollar-Deutsche Mark exchange rate? Often regression analysis is used in fundamental forecasting. In a regression set-up, a dependent variable (effect) is forecast using an independent variable (cause); constant and slope coefficients for the straight line equation of the estimate of the dependent variable are obtained. From the regression equation, one can forecast the dependent variable for a given time-period. If you want to forecast the value of the British Pound relative to the US $, the regression analysis will involve the following steps: Steps: 1. Specification of the model: ERPD$t = a + b * INTDIFFt where, ERPD$t = Value of the Pound in dollars
INTDIFFt = Interest rate differential between U.K. and U.S. interest rates (U.K. rate - U.S. rate) a = Constant or Intercept b = Slope. This measures the responsiveness of exchange rate change of the pound (dependent variable) for any given change in the INTDIFF. In this model, we assume that interest rate differential is the only factor affecting the value of pound. 2. Collect data on the above variables for a suitable number of periods like 20 or so quarters. 3. Run the regression equation and get the estimate of "a" and "b" 4. From the estimate of the equation, plug in the value of future (forecasted) interest rate differential and arrive at the value of pound for the future period. Suppose, we obtained the following Regression Equation Model above. ERPD$t = 1.78 + 0.80 * INTDIFFt Then, given the value of INTDIFF for the next period, we can forecast ERPD$. If the INTDIFF were 5% for the next period, then what is the forecasted value of ERPD$? Can you tell? Problems in fundamental forecasting: 1. Uncertain timing of the impact of any given variable on the forecasted variable: The impact might be felt with a lag, and if so the regression equation specified is incorrect, 2. Omission of some relevant variables. 3. Possible changes in the sensitivity or value of the coefficients over time, and 4. Forecasts are needed for factors with instantaneous impact.
Mixed Forecasting
Mixed forecasting involves a combination of two or more techniques. Different weights adding up to 1 can be assigned. For example, if the following forecasts were obtained: Technical Forecast of the BP for the next quarter: Fundamental Forecast of the BP for next quarter: $ 1.50 per Pound. $ 1.55 per Pound.
If we assign a weight of 0.50 for each outcome, then the weighted average forecast will be:
1.55(0.50) + 1.50 (0.5) = $ 1.525 per pound. Obviously, these weights are subjective
Forecasting accuracy can be further analyzed by plotting the bias over time and also looking at the positive (+) and negative (-) deviations of forecasted rates from the actual rates. If we observe consistent over or under forecasting, we can correct our forecast suitably. If for example, we consistently overforecast on an average by 5%, we can improve our forecast accuracy by subtracting 5% from our forecast every time. A Comprehensive Regression Example: A Regression Example for forecasting Spot BP using lagged 30-day forward rate of the BP is presented in the following tables. Regression Data contains 21 daily data: the dependent variable is the Spot BP, and the independent variable is the 30-day lagged forward rate of BP. The lagging has been done based on trading day. Using data for the first fifteen (observations # 1-15) days, a regression is run; the results are shown in Regression Results. The resulting regression equation is of the form:
Future Spot Ratet = 0.481698 + [0.6994*30-day Forward Rate t-30] The slope of 0.6994 means that for every 1% change in the forward rate, the spot rate of the BP changes by 0.6994% in the same direction. This equation is used to forecast the spot BP for days 17-21, and the predicted spot, absolute error, and average error appear in Prediction
If you have US $100,000 how would you go about executing a locational arbitrage? Outline the steps and show the results. 4. Triangular Arbitrage: Consider the information on Cross Exchange Rates (Table 2.1) in Module 2. The cross exchange rate of the FF per SF is 4.2762; that is the rate given across France, and under SFRANC is 4.2762, read as FF 4.2762 per SF. This is the theoretical rate. Suppose, in the Market, this cross rate is FF 4.2993 per SF. If you have $100,000, how would you go about executing triangular arbitrage? Outline the steps, profits, and compute the rate of return. 5. Define Covered interest arbitrage. 6. Covered interest arbitrage: Consider the following information: Spot Exchange Rate 180-days Forward Rate 180-days Interest Rate $1.535/Pound $1.566/Pound 6% 8% (UK) (USA)
i. ii.
If you are a US investor with $1,000,000 on hand, how would you go about executing covered interest arbitrage ? Outline the steps, compute the profit, and return on investment. As a result of the covered interest arbitrage above, what will happen to: a. The spot exchange rate of $1.535 ? b. The forward exchange rate of $1.566 ? c. To the interest rates in the USA and Britain ?
7. Identify and explain the reasons for forecasting exchange rates. 8. What is fundamental forecasting ? What variables are used in fundamental forecasting ? 9. Explain regression approach to forecasting exchange rates. Outline the method, state and explain the steps. Provide suitable examples. 10. In early 2001, a consultant was hired to forecast the Japanese yen for the four quarters of 2001. His forecasts and the actual or realized exchange rates are given below: Forecast Error for Japanese Yen Quarter Forecasted Value $ per Yen 0.009091 0.009524 Realized $ per Yen 0.009023 0.009534 Value Absolute Value the Deviation of
1 2
3 4
0.009334 0.009346
Fill-in the missing values in the last column and compute the average forecast error. Do you think that the consultant did a good job ? END OF MODULE 4
LIFETIME OPEN MAR 0.8764 JUNE 0.8850 SEPT . . . . DEC .... HIGH 0.8796 0.8876 .... .... LOW 0.8726 0.8845 .... .... SETTLE CHANGE HIGH 0.8765 0.8870 0.8968 0.9066 +.0003 +.0004 +.0004 +.0004 1.0300 1.0219 1.0050 0.9880 LOW 0.8414 0.8590 0.8769 0.8873 JAPANESE YEN (CME)-12.5 MILLION YEN; $ PER YEN (.00)
EST VOL 11,539; VOL MON 12,941; OPEN INT 93,017, +503. DEUTSCHEMARK (CME)-125,000 MARKS; $ PER MARK MAR 0.4785 0.4785 0.4752 0.4759 -.0046 0.4925 0.4225 322 EST VOL 3; VOL MON 1; OPEN INT 331, UNCH CANADIAN DOLLAR (CME)-100,000 DOLLARS; $ PER CAN $ MAR 0.6621 JUNE 0.6625 SEPT 0.6626 DEC 0.6632 0.6640 0.6637 0.6640 0.6645 0.6615 0.6615 0.6623 0.6632 0.6619 0.6623 0.6627 0.6631 -.0021 -.0021 -.0021 -.0021 0.7040 0.6990 0.6906 0.6825 0.6415 0.6425 0.6445 0.6452 46,671 4,846 1,545 680
EST VOL 5,857; VOL MON 9,955; OPEN INT 53,773, -1,902. BRITISH POUND (CME)-62,500 PDS.; $ PER POUND MAR 1.4750 1.4750 1.4570 1.4584 -.0168 1.6050 1.4010 28,681 EST VOL 30,974; VOL TH 10,792; OPEN INT 74,908, +781. SWISS FRANC (CME)-125,000 FRANCS; $ PER FRANC MAR 0.6119 JUNE 0.6100 0.6119 0.6107 0.6042 0.6073 0.6050 0.6078 -.0069 -.0070 0.6326 0.6358 0.5541 0.5585 47,387 451
EST VOL 11,255; VOL MON 8,076; OPEN INT 47,854, -1,532 AUSTRALIAN DOLLAR (CME)-100,000 DLRS.; $ PER A.$ MAR 0.5496 0.5512 0.5468 0.5488 -.0009 0.6390 0.5100 23,106 EST VOL 493; VOL MON 1,092; OPEN INT 20,205, -200. MEXICAN PESO (CME)-500,000 NEW MEX PESO, $ PER MP MAR 0.10110 0.10200 0.10110 0.10165 +00067 APR 0.10085 0.10085 0.10085 0.10065 +00067 .... .09870 .... .... .... .09830 .... .... 0.09965 +00067 0.09860 +00062 0.09685 +00067 0.09603 +00067 MAY . . . . JUNE .09830 AUG . . . . SEPT . . . . 0.10425 0.09120 16,031 0.10170 0.09730 1,000 0.10070 0.09900 202 0.10160 0.09070 3,388 0.09800 0.09800 100 0.09880 0.09300 297
EST VOL 4,370; VOL MON 555; OPEN INT 21,125 +97. EURO FX (CME)-EURO 125,000; $ PER EURO MAR 0.9393 JUNE 0.9351 SEPT . . . . 0.9400 0.9351 .... 0.9292 0.9314 .... 0.9308 0.9321 0.9334 -.0089 -.0089 -.0089 0.9999 0.9784 0.9634 0.8333 0.8358 0.8379 89,251 1,951 851
EST VOL 13,310; VOL MON 18,079; OPEN INT 92,109, -264.
Futures are available for the Japanese Yen, Deutsche Mark, Canadian Dollar, British Pound, Swiss Franc, Australian Dollar, Mexican Peso, and the Euro. Right next to each currency, the standardized units of a given currency per one futures contract are also given: For example, each Japanese futures contract has 12.5 million units; the numbers of units for one futures contract for other currencies are presented below: Currency D-Mark Canadian Dollar British Pound Swiss Franc Australian Dollar Mexican Peso Euro # of units in one futures contract 125,000 100,000 62,500 125,000 100,000 500,000 125,000
These futures trade for March through December 2001, and they expire on the third Wednesday of the given month. For illustrative purposes, if we examine the June 2001 Swiss Franc contracts further, we find the open price of $0.6100 per SF; further, the intra-day high and low respectively were $0.6107 and $0.6073. The closing price of $0.6078 represents the price when the CME closed for business on February 8th, 2001. If we were to buy the June 2001 SF futures at the closing price, the cost would have been: $0.6078*125,000 ( # of units of SF in one SF futures contract) = $75,975. One only needs to post a small margin of about 5% of the cost rather than pay the whole amount. The margin requirement varies from one currency to another; it also depends on whether the contract is for speculation or hedging. Therefore, there is enormous leverage involved here. You can find information on current futures margin requirements at the Chicago Mercentile Exchange web site.
Day Traders Take a Fast and Costly Route By Stanley W. Angrist Wall Street Journal, Aug. 31, 1993 Every day is not payday for most day traders. Day traders are investors who open and close market positions within the same trading day. They hope their market insights, trading skills and speed of action will allow them to take some profits home each day. In reality, most day traders find that what looks easy on paper is hard to do in the market.
Consider Jeffrey Needleman, a wholesale stamp dealer from Ann Arbor, Mich., who has been investing for 25 years, most of that as a day trader. He says that during the past 10 years he has run a $10,000 account into more than $100,000 in a few months "seven or eight times" but always manages to collapse it back to below its starting value in a few weeks. "When you have 30 or 40 winning trades in a row you begin to believe you are onto something and so you start to overtrade and the market takes it all back," explains Mr. Needleman. Most market professionals shun day trading, arguing that the costs of getting in and out of trades that usually produce only small profits and some inevitable losses will eventually deplete the equity in the accounts of all but the most skilled. But traders like Mr. Needleman don't much care about expert opinion. He says he is neither a high liver nor consumed with a desire to have great wealth. What he likes, he says, are the "big video game aspects" of day trading. When brokerage firms ask what his goals are, his stock response is that "I just want to have a wonderful time losing my equity." Other investors explain their affection for day trading in more expected ways. Kent Taylor, an Austin, Texas, investor who traded stock options before he began day trading futures full time in August 1992, says, "I like to go to sleep at night and not worry about the market 'gapping open' against me." An opening gap is when market prices begin the day at a substantially higher or lower level than the previous day's close. Day traders can play in all the financial markets, but most of them deal in futures contracts, especially financial futures such as the contracts based on the Standard and Poor's 500 stock index or on currencies such as the Swiss franc. A futures contract is an agreement to buy or sell something in the future, say 62,500 British pounds for each contract, at whatever price then prevails on the exchange. Investors who believe prices are going lower sell futures contracts, while those who believe prices are going to rise buy futures contracts. Two things determine whether an investment is attractive to day traders. One is liquidity, or the volume of trading. The other is volatility, or the size of price moves. When the volume of trading is heavy the bid-ask spread for an investment is small, meaning day traders can profit on small price moves. For example, the S&P 500 contract usually trades with only a $25 to $50 difference between what sellers will accept-the "bid price"-and what buyers will pay-the "ask price." The second requirement, volatility, means the investments must move enough during the day so that traders will be able to overcome their costs and still be left with a profit. Linda Raschke, a full-time trader and a sometime day trader, says day trading isn't something that can be done every day. "You do it when the volatility is there," she says. More than any other individual investors, day traders see their activity as a business. They believe that if they do their homework they will spot a significant move in the market before the rest of the trading world, capture a part of that move, and then exit with a profit. Anthony Eck, 39 years old, who trades out of his home in Austin, says that getting out quickly is an absolute necessity. So is a strict control system that limits both profits and losses. Trading mostly currency contracts he will risk no more that $125 a contract. His average loss generally is no more than $50 and his average profit is a minuscule $62 per contract. While many traders would scoff at such numbers, Mr. Eck says that 71% of his trades have been profitable since he
started trading about a year ago, making his trading profitable overall. Tom Meadows, who has been day trading full time only since March, hopes he can make a living doing it, but so far his losses exceed his profits. Mr. Meadows, 50, a former software manager in Austin, says day trading is appealing to him because "I like the idea of having my finger on the pulse of American economy." Day trading requires constant attention. In addition to the frequently changing bid-ask spread, day traders also must cope with the time differential required for brokers to fill their orders. It's a business where seconds count. Mr. Taylor, who trades mostly currency and the S&P stock futures, says he places his orders by phoning clerks stationed in booths along the periphery of the trading pit. He says the clerks can execute an order and report the price to him in less than a minute from the time he picks up the phone to place his order. Although all day traders claim they kiss the losers good-bye fast, the general lack of success for most suggests they might be a bit slow on the exit. David Morse, who trades from his home in Atlantic City, N.J., says he has been far more successful at the blackjack tables, which he visits after the markets close, than he has been in day trading. After 10 years of trading, "I would give a pint of blood to be able to trade successfully," he laments. Brokers love day traders because they can generate huge commissions. But few brokers openly encourage clients to day trade. "If I saw more success stories I might be more willing to encourage people to try," says William Mallers Jr., president of First American Discount Corp., a futures broker in Chicago. An active day trader can generate as much as $1,000 a day in commissions, he says.
Scalping the Market British futures contracts are being used for speculative purposes here. As the article illustrates, the speculator buys or goes long on the British futures contract expecting the pound to appreciate in value. Initially, he buys 2 BP futures contracts at $1.5424 per pound; he closes out one contract at $ 1.5442 initially, and another contract at $ 1.5426. $ Outflows: Purchase cost of 2 futures $1.5424 / pound at Round-trip commission at $25.00 / trade
$1.5424 * $25.00
62,500
* *
2 2
Total Cost $ Inflows: Close out one contract at $1.5442 Close out the second $1.5426 contract at $1.5442 * $1.5426 * 62,500 62,500 Total Profit * * 1 1
In the second trade, Mr. Eck trailed the rising pound price with an order to sell as soon as the upward trend stalled. He was out of the trade with a profit within an hour and 15 minutes. Chicago TIme 7:47am 9:02am Action Buy contracts Sell contracts Price per Pound 2 $ 1.5134 2 $ 1.5206 Gross Profit Commission Net Profit
$900
$50 $850.00
*Each contract consists of 62,500 pounds In this situation, the speculator expected the pound to appreciate; therefore, he bought the futures contract first, and then sold it, or closed it out, after the pound depreciated. If the speculator expected the pound to depreciate, he would have sold the pound first and then bought it back after the pound has depreciated. Questions for interactive table above (use the available Excel spreadsheet): 1. Close out (sell) contract 1 at a price higher than $1.5442 and see what happens to the net profit. 2. Close out contract 2 at a price higher than $1.5426 and see what happens to the net profit. 3. Close out contract 2 at a price lower than $1.5426 and see what happens to the net profit.
$/DM Cost in the Spot Market 44.12 90-day Futures Cost of Futures # of Futures Needed Savings from Futures This table is available as an Excel spreadsheet. In this case, Coca-Cola is, say,concerned about the possible rise in DM value which could lead to higher future $ costs than expected at time 0. To avoid this exchange rate risk, Coca-Cola can buy a DM June Futures contract at $0.4560 per DM , thereby locking-in the rate. Regardless of what happens to the spot DM in the future, Coca-Cola is now guaranteed a price of $0.4560 per DM. Since there are 125,000 units per DM futures contract, Coca-Cola has to buy 100,000,000/125,000 = 800 contracts. Note that at time 0, Coca-Cola only has to pay a 5% margin or so. When the bills are due in 90-days, Coca-Cola will execute the purchase of DM 100 ml @ $0.4560 per DM and remit the proceeds of DM 100 ml to pay-off its payables. Questions for interactive table above (use the available Excel spreadsheet): 1. Please change the exchange rate at t=+90 days from $0.75 to $0.85. What is the $ cost of savings from the use of futures here? 2. Please change the spot exchange rate at t=+90 days from $0.75 to $0.60. Was the use of futures worthwhile? If Coca-Cola had open accounts receivable in a foreign currency, Coca-Cola would sell futures contract at the agreed upon price, thereby guaranteeing that rate regardless of what would happen to the spot rate in the future. Summary information with regard to hedging payables and receivables, in terms of what to do with the futures and when to do it, appears below: What to do? Foreign Currency Accounts Payable Accounts Receivable Future Contract in that Currency Buy Sell 0.456 45.6 800 6.9 52.5 8.38
======> ======>
When to do it? Payables: If the spot rate in the future is expected to be less than the current futures rate ===> Do not enter into futures contract. If the spot rate in the future is going to be greater than the current futures rate ===> Enter into the futures contract.
======>
If spot rate in the future is expected to be greater than futures rate ===> Do not enter into the futures contract. If the spot rate in the future is going to be less than the current futures rate ===> Enter into the futures contract. Foreign Currency Depreciate Future Contract in that Currency Sell
======>
Banks, brokers, and multinational Banks, brokers, and multinational companies. Public speculation not companies. Qualified public encouraged. speculation encouraged. None as such, but compensating Small security deposit required. bank balance or lines of credit are required. Handling contingent on individual Handled by exchange clearinghouse. banks and brokers. No separate Daily settlements to the market price. clearinghouse function. Over the telephone worldwide. Central exchange floor with worldwide communications.
Security deposit
Clearing operation
Marketplace
Regulation
Self-regulating.
Futures National
Trading Futures
Most settled by actual delivery. Some Most by offset, very few by delivery. by offset, at a cost. Set by "spread" between bank's buy Negotiated brokerage fees. and sell prices.
Currency Options
Currency options are an alternative type of contracts that can be purchased or sold by speculators and firms. Currency options are available for seven major currencies on the Philadelphia Exchange. The volume for currency represented in each currency option contract on the Philadelphia Exchange is half size of the currency's volume in the IMM futures contract. For example, one DM option contract contains 62,500 German Marks, half of the 125,000 units per one German mark futures contract. There are two types of options with regard to their exercisability: a) American options can be exercised at any time on or before the date of maturity and b) European options can be exercised only on the day of expiration. Obviously, American options are far more flexible than European options.
Call Option
It is right, but not an obligation, to buy a currency at a specified price called the strike price, or exercise price, for a specified period of time for which the purchaser pays an option premium to the seller or writer of the call. A currency call option is bought for speculative purposes when one expects the underlying currency to appreciate in value. The idea is to buy the currency low at the strike price and then turn around and sell the currency high. A currency call option is also used to hedge foreign currency payables; by buying call options at the appropriate strike price, one is able to lock-in a rate.
BPound 31,250 Brit. Pound-cents per unit. 142 BPound 31,250 Brit. Pound-cents per unit. 155 163 CDollr 50,000 Canadian Dollars-cents per unit 67 67 Euro 62,500 Euro-European style 94 Euro 62,500 Euro-European style. 82 Euro 62,500 Euro-cents per unit. 88 90 92 94 SFranc 62,500 Swiss Francs-European Style 60 SFranc 62,500 Swiss Francs-cents per unit. 60 Sep 5 2.20 ... Mar ... ... 60 Mar Apr Mar Mar ... ... 2 3 Mar 5 8.67 ... Jun 10 1.51 ... Mar Jun ... ... ... ... 10 100 Apr Mar 100 ... 0.10 ... ... 100 Jun ... ... 5
147.69 2.38 147.69 ... 0.33 91.61 2.00 2.15 88.15 ... 88.15 ... 88.15
...
... 0.73 0.31
3 10 ... ...
697 1,204
Our focus will be on American style options. Please refer the last of Swiss Francs-cents per unit information in the middle column. The 62,500 found to the left of the Swiss Francs refers to the # of units of Swiss Francs in one Swiss Franc option. The first column of #s below the last 62,500 refers to the strike price: the strike price is 60, which stands for a strike price of US $0.60 per SF. The strike price is also called the exercise price and, in the case of the call option, represents the purchase price. Right next to the strike price is the month of expiration; options expire on the Friday before the third Wednesday of a given month. The next two columns provide information on calls: vol refers to the volume of calls traded for the day and the last refers to the last option premium quoted for a given call strike and month. The last two columns contain information on put option volume, etc.
t=0
Buy 1 DM September call at $0.60 per SF Assumed spot rate: $0.6109 per SF Option Premium (Outflow) ($0.0220) SF per ($1,375)
t = +1
Exercise call and buy DM 62,500 at $0.60 per SF Purchase price (Outflow) Assumed spot rate now: $0.65 ($0.60) per SF ($37,500)
t = +1
Sell SF 62,500 at the spot rate of $0.65 $0.65 per SF (Inflow) Net profit = $0.02700
$40,625 $1,750
Note: We assume a spot rate of $0.6109 per SF at t=0 and $0.65 per SF at t=+1. The table is self-explanatory. Here, since the SF appreciated, the speculator exercises his right to buy the SF at the original agreed upon strike price and turns around and sells it at a higher price. The results are shown both for per unit and for 1 option. Unlike the futures, which are legal obligations, one can walk away from the options if things are not working in favor of the speculator. Further, with the higher spot price at time=t+1, as shown in the above Speculating with Call Option interactive table, the premium of the June 60 SF call will be higher, and the speculator could close out his call by selling to other speculators in the marketplace without having to exercise the options. Thus options can be bought and sold in their own rights as stand-alone securities. Another interesting point about options is that, for the purchaser of an option, the maximum loss is the premium amount paid originally and no more.
Questions for interactive table above (use the Change the spot rate at t=+1 from $0.65 per Swiss Franc to: 1. $0.75 per SF 2. $0.50 per SF
available
Excel
spreadsheet):
Note what happens to net profit in each case. A contingency graph of a British call option from the buyer's perspective is shown in Figure # 4. On the horizontal axis, the spot rate appears, and the vertical axis shows the net profit. The break-even point for the call equals the strike price plus the premium; in this case, the purchase (strike) price is $1.50 and the premium is $ 0.02; therefore, the break-even point occurs at $1.52 (spot price). The call buyer benefits when the spot price increases; for example, if the spot price in the future were $1.60, the net profit will be $ 0.08. The maximum loss from the buyer's perspective is the premium of $0.02. Figure #4
Note: This Figure is reproduced from permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright 2000 by West Publishing Company. All Rights Reserved.
This makes sense since the call buyer will benefit if the spot price goes up. Therefore, the premium will correspondingly increases as it is more attractive. Time to maturity: For any given strike price, the longer the maturity, the higher the premium. Here, there simply is more time for the spot price to go up in value. Potential volatility or variability of the currency: The higher the variability as measured by the standard deviation or fluctuation of a currency, the higher the option premium. Higher variability increases the chances of the currency going up in value. The higher the risk free rate, the higher the option premium. This is because of the higher opportunity cost for the writers of calls who will demand a higher premium.
Put Option
It is a right to sell a given currency at a price called the strike or exercise price for a given specified period of time for which the buyer pays a premium to the writer or the seller of the put option. Currency put options are bought for speculative purposes when one expects the underlying currency to depreciate in value. The idea is to sell the currency high at the strike price and turn around and buy the currency back low. Currency put options are also used to hedge foreign currency receivables; by buying put options at the appropriate strike price, one is able to lock-in a rate. Any subsequent depreciation of the foreign currency will not affect the $ inflows since the rate is locked-in.
Speculating with Put Option Time Action Per Unit of Euro Per 1 Euro Option 62,500 units per contract
t=0
Buy 1 Euro July put at $0.900 Assumed spot rate: $0.9000 per Mark Option Premium (Outflow) ($0.0120) Euro per ($750)
t = +1
Exercise put and sell Euro 62,500 at $0.900 per Euro Selling price (Inflow) Assumed spot rate now: $0.85 ($0.900) per Euro ($56,250)
t = +1
Buy Euro 62,500 at the spot rate of $0.85 ($0.85) per Euro per Euro (Outflow) Net profit =
($53,125)
This chart is available as an Excel spreadsheet. Note: We assume a spot rate of $0.90 per Euro at t=0 and $0.85 per Euro at t=+1. The table is self-explanatory. Here, since the Euro depreciated, the speculator exercises his right to sell the Euro at the original agreed upon strike price and turns around and buys it back at a lower price. The results are shown for both per unit and per option. Unlike futures, which are legal obligations, one can walk away from the options if things are not working in favor of the speculator. Further, with the new lower spot price at time=+1, as shown in the Speculating with Put Option interactive table above, the premium of the April 90 Euro put will be higher, and the speculator could close out his put position by selling to other speculators in the market place without having to exercise the option. Thus, options can be bought and sold, in their own right, as stand-alone securities. Another feature of options is that, for the purchaser of an option, the maximum loss is the premium amount paid originally and no more. Questions for interactive table above (use Change the spot rate at t=+1 from $0.85 per Euro to: 1. $0.60 per Euro 2. $0.90 per Euro the available Excel spreadsheet):
Note what happens to net profit in each case. A contingency graph of a British put option from the buyer's perspective is shown in Figure # 5. On the horizontal axis the spot rate appears, and the vertical axis shows the net profit. The break-even point for a put equals the strike price less the premium; in this case, the selling (strike) price is $1.50, and the premium is $ 0.03; therefore, the break-even point occurs at $1.47 ($1.50-$ 0.03). The put buyer benefits
when the spot price decreases; for example, if the spot price in the future were $1.40, the net profit would be $ 0.07. The maximum loss from the buyer's perspective is the premium of $0.03. Figure # 5
Note: This Figure is reproduced from permission from International Financial Management, Fourth Edition, Jeff Madura. Copyright 1995 by West Publishing Company. All Rights Reserved.
Summary of Information on Hedging with options: Accounts Payable ===> Outflow Minimization ===> Buy the Currency in the Future ===> Buy Call Option Accounts Receivable Inflow maximization ===> Sell the Currency in the Future ===> Buy Put Option
Summary: In this Module, we studied the nature and characteristics of currency futures, forward contracts, and options. In addition, we discussed their use in speculation and hedging. END OF MODULE 5
Foreign Exchange Risk and Types of Foreign Exchange Risk: Foreign Exchange Risk refers to the effect of fluctuating exchange rates on the revenues, costs, profits, cash flows and firm value of an MNC. It is very important to measure and manage exchange risk. Managing foreign exchange risk reduces the variability of both the earnings and the cash flows of a firm. It also helps in more accurate forecast of receipts and payments and leads to improved cash budgeting as well. Quite a few MNCs like Sony, Merck, Eastman Kodak, and Colgate practice effective foreign exchange management techniques to stabilize their earnings and cash flows
The effect of changing foreign exchange rates on a firm can be classified into the following three categories: 1. Economic Exposure: This is defined as the effect of exchange rate changes on a firm's cashflows and therefore its value. 2. Transaction Exposure: This exposure is defined as the variabilty of the cashflows arising from the fluctuations in exchange rates affecting the transactions already entered into and denominated in one or more foreign currencies. Consider the following Example on Transaction Exposure type exchange rate risk in Module 1: AN EXAMPLE ON FOREIGN EXCHANGE RATE RISK Given: ABC Corporation ( US based MNC ) has DM 100 million in 90-day Payables Time=t 0 Plus 90 Days Extra Cost Spot Exchange Rate $/DM $ Cost 0.661 66.1 0.75 75 8.9
This table is available as an Excel spreadsheet. In this case, ABC paid $8.9 Million more than it anticipated to pay at time=0; the DM appreciated, thereby, increasing the US dollar cost of the payables in DM. This is the exchange rate risk MNCs face in handling their foreign currency flows. The risk arises from the need to convert the cash flows from one currency to another. If there is no need to convert the currency, MNCs will not face exchange rate risk. This is an example of transaction exposure: the exchange risk arose in the context of foreign currency payables for imports made by the US based MNC from Germany. This example has been built on foreign currency outflows being affected by changing exchange rate; the transaction exposure can affect foreign currency inflows as well. Questions for the interactive table above (use the available Excel spreadsheet): Change the exchange rate at t=+90 days from $0.75 per DM to: 1. $0.95 per DM 2. $0.65 per DM What is the measure of transaction exposure in each scenario above?
3. Operating Exposure: This is another type of exchange rate risk; it is defined as a measure of the changes in firm value resulting from changes in future operating cash flows of a firm, which in turn are caused by unexpected exchange rate changes. This type of exposure is also called competitive or strategic exposure. Actually, transaction exposure is a subset of economic exposure. The concept of operating exposure is examined using an example. Madison Inc. is a US based MNC with a portion of its business located in Canada. Its US sales are in US dollars, and its Canadian sales are in Canadian dollars. Its pro forma income statement for next year is presented below: Impact of Possible Exchange Rate Movements on Earnings (in millions)
Exchange Rate Scenerio C$=$.75 Sales (1) U.S. (2) Canadian (3) Total Cost of goods sold (4) U.S. (5) Canadian (6) Total (7) Gross Profit Operating Expenses (8) U.S.: Fixed (9) U.S.: Variable (10% of total sales) (10) Total (11) EBIT Interest expense (12) U.S. (13) Canadian (14) Total (15) EBT $3 C$10= $ 7.5 $ 10.5 $ 32.2 C$10= $3 $8 $ 11 $ 25.48 C$=10 $3 $ 8.5 $ 11.5 $ 17.86 $ 30.3 $ 60.3 $ 42.7 $ 30.72 $ 60.72 $ 36.48 $ 31.04 $ 61.04 $ 29.36 $ 30 $ 30 $ 30 $ 50 C$200= $150 $200 $103 C$200= $ 50 $160 $210 $ 97.2 C$=200 $ 50 $170 $220 $ 90.4 C$4= $300 $3 $303 C$4= $304 $ 3.2 $307.2 C$=4 $307 $ 3.4 $310.4 C$=$.80 C$=$.85
The impact of three different exchange rate changes on the income statement is shown below; here, the US sales are assumed to be higher when the Canadian dollar is stronger. The reason is that Canadian competitors will be priced out when the Canadian dollar is stronger. Impact of Possible Exchange Rate Movements on Earnings (in millions) The table is self-explanatory; basically, it is a combined statement of income with the Canadian revenues and costs converted at the different exchange rate scenarios. A stronger Canadian dollar results in an increase in the US dollar value of sales; it also increases the US dollar sales in the US due to Canadian competitors being priced out. The stronger Canadian dollar also leads to a higher cost of goods sold since Canadian cost of goods sold exposure is greater than the Canadian sales exposure. Thus, there is a negative overall impact on the Earnings Before Interest and
Taxes (EBIT). Thus, Madison Inc., with its higher Canadian costs, is affected by a stronger Canadian dollar. In general, firms with more foreign costs than foreign revenues will be unfavorably affected by a stronger foreign currency; but, a weaker foreign currency will have a positive impact on these firms. On the other hand, firms with more foreign revenues than costs will be favorably affected by a stronger currency; but, these firms will be unfavorably affected by a weaker foreign currency since, with the weak currency, translated US dollar revenues will be lowered. Operating exposure thus affects the local currency inflows and outflows. These flows can be 1) operating cash flows like inter and intra-firm receivables and payables, rent and lease payments, royalty and license fees, and management fees, and 2) financing cash flows like interest on loans and dividends on stockholders' equity. The concept of Operating Exposure is further explained in the context of a Swiss subsidiary remitting cash flows from a capital investment in Switzerland to its parent in the USA. The very first line gives the after-tax incremental cash flows remitted; year 0 cash flows represent cost or outflows for the investment project. The forecast of the SF called for its steady appreciation as shown in the Strong-franc scenario of $0.54 per in year 1 to $0.65 in year 4. With a steady appreciation forecast, the $ cash inflows increase resulting in a net present value of $4,875,754. But, in reality, the SF weakened, and the exchange rate, as shown in weak-Franc scenario, unfolded: the result was a steep decline in the $ value of SF remitted, so much so that the net present value turns negative now. Economic Exposure Further Illustrated Year 0 Remitted to the parent (SF) Strong Scenario Exchange Rate $/ $Cashflows to the parent Co. PV of cashflows @ 15% discount rate Initial Investment NPV Weak Scenario Exchange rate $/ $Cashflows to the Parent Co. PV of cashflows @ 15% discount rate Initial Investment NPV ($10,000,000) ($18,757) $0.47 $2,538,000 $2,206,957 $0.45 $2,430,000 $1,837,429 $0.40 $2,736,000 $1,798,964 $0.37 $7,237,200 $4,137,893 ($10,000,000) $4,875,754 $0.54 $2,916,000 $2,535,652 $0.57 $3,078,000 $2,327,410 $0.61 $4,172,400 $2,743,421 $0.65 $12,714,000 $7,269,271 Year 1 5,400,000 Year 2 5,400,000 Year 3 6,840,000 Year 4 19,560,000
Questions about the interactive table above: Change the exchange rate under a strong Franc scenario as follows: Year 1: $0.60 Year 2: $0.65 Year 3: $0.75 What happens to the $ cash inflows and the net present value of the project? Change the exchange rate under a weak Franc scenario as follows: Year 1: $0.40 Year 2: $0.29 Year 3: $0.15 What happens to the $ cash inflows and the net present value of the project?
4. Translation Exposure: This exposure arises in the context of translating income and balance sheets from foreign currencies into the reported home currency to prepare consolidated financial statements. It affects accounting income but not cash flow. In the remaining part of this module, the management of transaction and economic exposures are explored. Since translation exposure does not affect cash flows, its management is not dealt with here.
-180
+200
-40
(+ = inflow, - = outflow) The consolidated net exposure of the MNC will be: FF + 120,000 DM - 140,000 BP - 150,000 The MNC has a net inflow position of 120,000 $ equivalent units in FF; it has a net outflow position of 140,000 $ equivalent units in DM; in BP, its net exposure is an outflow of 150,000 $ equivalent units. Questions for thought: Why do we need to identify net transaction exposure? We need to know what is at risk before we take protective steps to safe-guard the cash flows at risk. This is why we need to identify the net transaction exposure. Also, only open currency cash flows for a given time alone are at risk. This is because, if one has both inflows and outflows in the same currency for the same time horizon, any exchange rate change will result in net 0 effect on the changes in cash flow values and, therefore, in that situation, there would not be any exchange rate risk.
Should the management of transaction exposure be conducted at the subsidiary or the parent level? The management of the transaction exposure should be conducted at the parent level. That way, all subsidiaries will be able to report their net positions in all currencies. With the information on different currency flows available at the central office, the parent can come up with the overall net position for each currency for a given time; therefore, overall corporate efficiency is enhanced. It is also consistent with the objective of maximizing the stockholder wealth.
the amounts involved are small. To hedge future payables, the firm will enter into a future buying contract and, to hedge a future receivables, the firm will sell forward at the appropriate futures rate. Forward Contract Hedge: The mechanics are the same as that of the futures contracts. They are used for large amounts and are tailor made to suit the needs of the individual firm. One must always compare the costs of forward contracts or futures versus the no hedge decision and choose the alternative having the lower cost. Note: The costs of hedge or no hedge hinge on accurate forecasts; additionally, since corporations do not like risk , they may want to hedge even when the costs of hedging are higher than no hedging. Money Market Hedge: Involves taking a money market position to cover future payables or receivables. For hedging future payables, one invests in the foreign currency. For hedging the future receivables, one borrows in the foreign currency. Currency Option Hedge: Currency options not only provide the hedge but also provide the flexibility since they do not require a commitment to buy or sell a currency unlike the forward or future contracts where there is a commitment. Firms use call options to hedge future payables, and use put options to hedge future receivables.
A call option on the DM that expires in 90-days has an exercise price of $0.680 and has a premium of $0.02. A put option on DM that expires in 90-days has an exercise price of $0.660 and has a premium of $0.03. The DM spot rate in 90-days is forecasted to be: Possible Rate $0.660 per DM $0.690 per DM Probability 30 % 70 %
1. A Forward Hedge 2. A Money Market Hedge 3. An Option Hedge and 4. Remaining Unhedged You have been hired as a consultant to decide on the best possible hedge. Which one of the alternatives you will recommend, and why ? Solution: 1. Forward Hedge: Purchase DM 90 days forward at the forward rate of $0.685 per DM, thereby locking-in the rate; regardless of what happens to the spot rate in the future, ABC will be able to get the DM at $0.685 per DM. Cost = DM 200,000 * $0.685 per DM = $137,000 Note that ABC enters into a contract to purchase a DM at time 0 and the actual purchase and delivery occur 90-days later when the DM is needed to pay the payables.
3. Option Hedge
The option hedge involves buying call option to hedge payables. Recall that the call option gives the right to buy the given currency at the strike price. Also remember that an option is just that, an option; if the rates are not favorable, one can walk away from that. Buy DM call option (Exercise price = $0.68, premium = $.02)
Premium $0.02
Exercise (Y or N) NO
Cost $136,000
$0.02
YES
$0.70
$140,000
* Total Price = Purchace Price + Premium Expected cost of call option = $136,000 (0.3) +$140,000 (0.7) = $138,800
4. Remain Unhedged
Expected Spot $0.66 $0.69 Expected Cost of Remaining Unhedged = $132,000(0.3) + 138,000(0.7) = $136,200 5) Which one of the alternatives should one choose? In choosing among the hedging alternatives for payables, one has to choose a lower cost alternative; one also has to consider the risk among different alternatives and go for more certain outcome since corporations do not like uncertainty. While the expected cost of doing nothing, or remaining unhedged has the lowest cost of $136,200, there is a 70% chance that its cost might be as high as $138,000. The money market hedge has the lowest cost of $136,285.72, and it is 100% certain. Therefore, a money market hedge is recommended here. However, the forward hedge is close behind with a $137,000 cost. Total Price $132,000 $138,000 Probability 30% 70%
2. Receivables
Another US corporation (XYZ Corporation) is expecting an inflow of DM300,000 Receivables in 90-days. It is considering: 1. 2. 3. 4. A Forward hedge Money Market Hedge An Option Hedge and Remaining Unhedged
Use the other information given along with the payables to advise this firm of a suitable strategy.
1. Forward Hedge
The forward hedge to hedge receivables involves selling the currency forward at the forward rate thereby locking-in the rate. Sell DM300,000 @ the 90 days forward rate DM300,000 * $0.685 = $205,500
3. Option Hedge
This technique to hedge receivables involves buying put option. Recall put options give the right to sell a currency at the strike price. Expected Spot/ Probability $0.66 (30%) $0.69 (70%) Expected inflow from the put option= $189,000 * (0.3) + $198,000 * (0.7) = $195,300 $0.03 YES $0.66 $198,000 Premium $0.03 Exercise (Y or N) Indifferent Total Price $0.63 Cost $189,000
4. Remaining Unhedged
Expected inflow from remaining unhedged= $198,000 * (0.3) + $207,000 * (0.7) = $204,300 5) Given the three alternatives above, the choice here is to choose the one that has the highest certain cash inflow. Here, the forward hedge, with a 100% certain inflow of $205,500 is the clear winner. Although remaining unhedged has an expected value of $204,300, a number very close to that of the forward hedge amount of $205,000, the unhedged amount is only an expected amount based on forecasted exchange rate. Since it is an uncertain outcome, we will go along with the certain forward hedge amount.
management might notice changes in comparative costs among plants located in different countries. It might also observe changes in profit margins or sales volume. This will provide an opportunity for the MNC to shift its operations where the costs are lower and increase its sales where the revenues are higher or both. For example, in the Madison Inc. situation we saw earlier, its management could shift its operations to the US and take steps to increase its sales in Canada. In addition, diversifying the operations internationally will provide beneficial portfolio effects by reducing the variability of the cash flows. Some of the Japanese companies like Honda and Toyota have reduced their economic exposure stemming from rising yen by building plants in the US. When the autos were exported to the US, the appreciating yen caused a decline in demand for the Japanese autos. Therefore, the cash flows of the Japanese companies were adversely affected by the strong yen. By building plants in the US and invoicing them in US dollars, both Honda and Toyota are trying to ensure that the demand for their autos is not affected by strong yen. Still, the Japanese plants in the US import various parts from Japan. Further, the dollar earnings of these US subsidiaries have to be remitted to the parent companies in Japan. Therefore, the exchange rate risk is not totally eliminated. But, locating the plants in the US where the autos are sold has reduced the economic exposure.
END OF MODULE 6
Lufthansa
It was February 14, 1986, and Herr Heinz Ruhnau, chairman of Lufthansa (Germany) was summoned to meet with Lufthansa's board. The board's task was to determine if Herr Ruhnau's term of office should be terminated. Herr Ruhnau had already been summoned by Germany's transportation minister to explain his supposed speculative management of Lufthansa's exposure in the purchase of the Boeing aircraft. In January 1985 Lufthansa (Germany), under the chairmanship of Herr Heinz Ruhnau, purchased twenty 737 jets from Boeing (U.S.). The agreed upon price was $500,000,000, payable in U.S. dollars on delivery of the aircraft in one year (January 1986). The U.S. dollar had been rising steadily and rapidly since 1980, and was approximately DM3.2/$ in January 1985. If the dollar were to continue to rise, the cost of the jet aircraft to Lufthansa would rise substantially by the time payment was due. Herr Ruhnau had his own view or expectations regarding the direction of the exchange rate. Like many others at the time, he believed the dollar had risen about as far as it was going to go, and would probably fall by the time January 1986 rolled around. But then again, it really wasn't his money to gamble with. He compromised. He covered half the exposure ($250,000,000) at a rate of DM3.2/$, and left the remaining half ($250,000,000) uncovered.
1: Remain Uncovered
Remaining uncovered is the maximum risk approach. It therefore represents the greatest potential benefits (if the dollar weakens versus the Deutschemark), and the greatest potential cost (if the dollar continues to strengthen versus the Deutschemark). If the exchange rate were to drop to DM2.2/$ by January 1986, the purchase of the Boeing 737s would be only DM 1.1 billion. Of course if the dollar
continued to appreciate, rising to perhaps DM4.0/$ by 1986, the total cost would be DM 2.0 billion. The uncovered position's risk is therefore shown as that value line which has the steepest slope (covers the widest vertical distance) in Exhibit. This is obviously a sizable level of risk for any firm to carry. Many firms believe the decision to leave a large exposure uncovered for a long period of time to be nothing other than currency speculation.
Because he personally felt so strongly the dollar would weaken, Herr Ruhnau chose to go with partial cover. He chose to cover 50% of the exposure ($250 million) with forward contracts (the one-year forward rate was DM3.2/$) and to leave the remaining 50% ($250 million) uncovered. Because foreign currency options were as yet a relatively new tool for exposure management by many firms, and because of the sheer magnitude of the up-front premium required, the foreign currency option was not chosen. Time would tell if this was a wise decision.
The bad news was that the total Deutschemark cost with the partial forward cover was DM1.375 billion, a full DM225,000,000 more than if no hedging had been implemented at all! This was also DM129,000,000 more than what the foreign currency option hedge would have cost in total. The total cost of obtaining the needed $500 million for each alternative at the actual ending spot rate of DM2.3/$ would have been: Alternative 1: Uncovered 2: Full Forward Cover (100%) 3: Partial Forward 4: DM Call Options Relevant Rate Total DM Cost DM2.3/$ 1,150,000,000 DM3.2/$ 1,600,000,000 (DM2.3) + Cover (DM3.2) 1,375,000,000 DM3.2/$ strike 1,246,000,000
Herr Ruhnau's political rivals, both inside and outside of Lufthansa, were not so happy. Ruhnau was accused of recklessly speculating with Lufthansa's money, but the speculation was seen as the forward contract, not the amount of the dollar exposure left uncovered for the full year. It is obvious that the term speculation holds an entirely new meaning when perfect hindsight is used to evaluate performance.
Case Questions
Herr Ruhnau was accused of making the following four mistakes: 1. Purchasing the Boeing aircraft at the wrong time. The U.S. dollar was at an all-time high at the time of the purchase in January 1985. 2. Choosing to hedge half the exposure when he expected to dollar to fall. If he had gone through with his instincts or expectations, he would have left the whole amount unhedged (which some critics have termed "whole hog"). 3. Choosing to use forward contracts as his hedging tool instead of options. The purchase of call options would have allowed Herr Ruhnau to protect himself against adverse exchange rate movements while preserving the flexibility of exchanging DM for U.S. dollars spot if the market moved in his favor.
4. Purchasing Boeing aircraft at all. Germany, as well as the other major European Economic Community countries, has a vested interest in the conglomerate Airbus. Airbus's chief rival was Boeing in the manufacture of large long-distance civil aircraft. Given these criticisms, should the board of Lufthansa retain Herr Heinz Ruhnau as chairman? How should Ruhnau justify his actions and so justify his further employment?
END OF MODULE 7
Reproduced with permission from Columbia Journal of World Business, Columbia University Press, Fall 95, pp 70-82. All rights reserved.
corporate and bank users for more sophisticated products and better variation or lower cost over existing product configurations. In this study, we examine how extensively these foreign exchange innovative products are used by U.S. corporations4. Though the above list does not exhaust all the innovations, most of the major products are already included. We are interested in a series of questions. Would the importance of old products such as the forward contract be taken over by these new entrants? Or, would these new innovations be so sophisticated that few corporations use them? How is the use of these products related to the size of a firm? Does the degree of a corporation's international involvement influence its product use? Are there variations across industries? To examine these questions, we conducted a survey. Methodology Research sample Using a mail questionnaire, we collected primary data directly from corporations. The sample includes the corporate executives most likely making decisions on the use of foreign exchange risk management products and techniques. Examples of these executives are corporate treasurers and chief financial officers. The firms chosen for the study are U.S.-based corporations that fall into two groups. The first group includes Fortune 5005 firms with sales exceeding $750 million. There are 403 firms included in this group. The second group includes 179 Fortune Service 500 firms excluding commercial banks6 and the six largest (in terms of revenue) privately-held firms7. Fourteen additional firms are included in the presurvey group, bringing the total number of survey participants to 6028. There were 173 firms which responded, of which 168 questionnaires were fully usable. The response rate was therefore 27.8%. We compared the profile of the survey respondents with the profile of the overall sample. No significant bias was found between the two groups. The sample of responding firms appeared to be sufficiently representative of the population of Fortune 500 firms assumed to be most interested in products to manage foreign exchange risks. Key Variables Several key variables are included in this study. For each of the aforementioned products, a corporation is asked whether or not and to what extent it has used the product. A composite variable, USEFX, is computed to proxy the corporation's tendency to use foreign exchange risk management products in general. The questionnaire lists 15 different products. If a corporation has used all of the 15 products, its USEFX variable will be assigned a value of "15." If the company has only tried 3 out of the 15 products, its USEFX value will be "3." Another variable TASSETS, the total amount of corporate assets, is used to proxy the firm size9. We also try to assess the degree of international involvement of the respondent firm by using three different proxies: the percentage of foreign assets, the percentage of foreign sales, and the percentage of foreign income. Empirical findings as reported in the next section show that the results are quite similar regardless of which proxy is used. Because of space constraint, we report only the results using the percentage of foreign income (FINCOME) as the proxy of international involvement. We also categorize the respondent firms under different industries according to their Standard Industrial Classification (SIC) codes. Because of the relatively small sample size, our grouping is rather broad. Using only the first digit of the codes, the firms are classified under seven categories: 1)mining and construction; 2) manufacturing (e.g., food, textile, etc.); 3) manufacturing (e.g., machinery, electronics, etc,); 4) transportation and utilities; 5) wholesale and retail trade; 6) finance, insurance and real estate; and 7) other services. Later on, in running multiple regressions to analyze the data, we use six dummy variables (I1 to I6) to represent these industries. In summary, we show in Table 1 the profile of the survey
respondents in terms of their industrial classification, total corporate assets, the percentage of foreign sales, and the percentage of foreign income10. Table 1
Table 1
Characteristics of Respondent Corporations
Total Corporate Assets (TASSETS) Less than $500 million $500 million-$1 billion $1 billion-$2 billion $2 billion-$5 billion Greater than $5 billion No response Percentage of Foreign Sales Less than 10 per cent 10-20 per cent 20-30 per cent 30-40 per cent 40-50 per cent Over 50 percent No response Percentage of Foreign Income (FINCOME) Less than 10 per cent 10-20 per cent 20-30 per cent 30-40 per cent 40-50 per cent Over 50 per cent No response Industrial Classification (Using 1st Digits of SIC Codes) 1 Mining & Construction 2 Manufacturing (e.g. Food, Textile, Lumber) 3 Manufacturing (e.g. Metal, Machinery, Electronics) 4 Transportation & Public Utilities 5 Wholesale & Retail Trade 6 Finance, Insurance & Real Estate
7-8 Other Services (e.g. Hotels, Health, Legal Services) Note: There are 173 respondents in total. The research sample is based on Fortune 500 and Fortune Service 500 firms in the United States.
3.3
Table 2
Extent of Knowledge and Use of Foreign Exchange Risk Management Products
Type of Product Forward contracts Foreign currency swaps Foreign currency futures contracts Exchange-traded currency options Exchange-traded futures option Over-the-counter currency options Cylinder options Synthetic "homemade" forwards Synthetic "homemade" options Participating forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Hindsight/lookback options, etc. Averages across products
Product Generation Heard of (Awareness) Used (Adoption) 1st 2nd 2nd 2nd 2nd 2nd 3rd 3rd 3rd 3rd 3rd 3rd 3rd 3rd 3rd 100.0% 98.8 98.8 96.4 95.8 93.5 91.2 88.0 88.0 83.6 81.7 77.7 65.3 55.8 52.1 84.4% 93.1% 52.6 20.1 17.3 8.9 48.8 28.7 22.0 18.6 15.8 14.8 4.2 4.9 3.8 5.1 23.9%
Notes: The products are ranked by the percentages of respondents who have heard of products. There are 173 respondents in total. However, awareness does not necessarily lead to adoption. Though they have heard of the products, a much smaller percentage of the corporations have adopted the new products. According to the figures under the "Used" column, the forward contract is still the most popular product (93.1%). The importance
of this old, first-generation instrument has not been overtaken by the "fancy" innovations. The next group of more commonly used products are foreign currency swaps (52.6%) and over-the-counter (OTC) currency options (48.8%). Both are second generation instruments. Overall, the average percentages of use of the first, second, and third generation products are 93.1%, 25.3%, and 14.2% respectively. The use of the third generation products is generally less than that of the second generation products, which is, in turn, generally less than the use of the first generation products11. Alternatively, the exchange-traded products of the second generation such as futures contracts, currency options and futures options show high percentages of awareness. Nevertheless, the percentages of their use are substantially less than that of OTC options (20.1%, 17.3% and 8.9% respectively, versus 48.8%). This is probably due to the fact that OTC products are more convenient and flexible to use. The corporations may simply telephone the banks to arrange for these OTC products. The products can be tailor-make to fit the specific needs of the companies. Exchange-traded products are standardized in terms of contract sizes and maturity dates and need to be bought and sold through brokers on the trading floors. They may therefore be less convenient that the OTC products. This finding is encouraging news to financial institutions such as commercial and investment banks: their tailor-make products are more attractive to most corporate customers than those offered by the open exchanges. Though the third generation products have received a lot of attention in the literature, the usage of these products is not as common as expected. Most of these products are used by less than 20% of the respondent companies. Break forwards, compound options and hindsight options are rarely used; their adoption percentages are 4.9%, 3.8% and 5.1% respectively. Even when they are used, the frequency of adoption is not high. It is not because they are not heard of. The fourth column of Table 2 shows the percentages of usage given that the products are known. Even among the corporations that are aware of these products, the use of the third generation products is not common. The possible implication of such findings is that although the sophisticated products may be interesting variations, they may not be really useful to many corporations under most circumstances. Perhaps, the simpler products such as forward contracts, currency swaps and OTC options already cover most of the business needs12.
options and exchange-traded futures are 20%, 40% and 30% respectively. The financial institutions reduce their own currency exposures by netting out financial assets and liabilities of different currencies. For the remaining exposure they cannot totally net out, they themselves go to the market to lay off the risks. One of the channels is to go through the exchange trading floor. Unlike other corporations, the financial firms are more familiar and adept in using exchange-traded products. Following the finance, insurance and real estate industry, the industry with the next highest percentage of adoption is manufacturing. In fact, both Categories (2) and (3) behave similarly and have the same percentage average of 23.7%. A slightly smaller percentage is found in the mining and construction industry, followed by the wholesale and retail trade industry. Of the seven columns, the transportation and utilities industry (4) and the "other services" industry (5) have the lowest average percentages of adoption (14.5% and 13.3% respectively). One possible reason is that the customer base of these latter industries is mainly domestic; there are relatively less foreign currency cash flows. The need for exchange risk management products may therefore be smaller. To examine the statistical significance of the industry effect, we run a multiple regression with the use of foreign exchange risk management products (USEFX) as the dependent variable and the six industry dummy variables (I1 to I6) as the independent variables. The results are shown in the third regression of Table 4.a. Overall, the industry variables explain about 12% of the variance of USEFX and the F-value is highly significant at the 0.006 level. The coefficients of the industry variables are also significantly different from one another13
Table 3
Use of Foreign Exchange Risk Management Products Across Industries Finance, Manufact. Manufact. Transp. Wholesale Insurance Mining & (e.g. (e.g. & & Retail & Real Other Manufact. Food) Electronics) Utilities Trade Estate Services Types of Products Forward contracts Foreign currency swaps Foreign currency futures contracts Exchange-traded currency options Exchange-traded futures options Over-the-counter currency options Cylinder options Synthetic "homemade" forwards Synthetic "homemade" options Participating (1) 100.0% 50.0 50.0 16.7 16.7 50.0 16.7 (2) 98.3% 48.3 18.3 18.3 6.7 55.0 31.7 (3) 100.0% 57.6 17.0 17.0 5.1 50.9 28.0 (4) 70.6% 52.9 11.7 0.0 0.0 29.4 17.7 (5) 85.7% 21.4 42.9 21.4 21.4 28.6 21.4 (6) 90.0% 80.0 20.0 40.0 30.0 50.0 60.0 (7&8) 33.1% 66.7 0.0 0.0 33.3 0.0 0.0 Overall 93.1% 52.6 20.1 17.3 8.9 48.8 28.7
16.7
20.0
28.8
5.9
14.3
40.0
0.0
22.0
16.7 0.0
16.7 18.3
22.0 10.2
5.9 11.8
14.3 28.6
40.0 30.0
0.0 0.0
18.6 15.8
forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Hindsight/lookback options, etc. Average percentages Number of respondents 0.0 0.0 0.0 16.7 0.0 23.3% 7 13.3 3.3 3.3 3.3 0.0 23.7% 60 11.9 0.0 1.7 1.7 3.4 23.7% 59 5.9 5.9 0.0 0.0 0.0 14.5% 17 28.6 7.1 0.0 0.0 0.0 22.4% 14 30.0 30.0 20.0 20.0 10.0 39.3% 10 66.7 0.0 0.0 0.0 0.0 13.3% 6 14.8 4.2 4.9 3.8 5.1 23.9% 173
Notes: The products are arranged in the same order as in Table 2. The percentages represent the proportions of respondent corporations which have used the products. There are 173 respondents in total.
Table 4.a
Firm Size, International and Industry Effects on Corporate Use of Foreign Exchange Risk Management Products Independent Variables Different Effects Intercept LASSETS FINCOME I1 I2 I3 I4 I5 I6 R2 F-Value Sign of F
1 Size Effect
2.55 (3.69)**
0.95 (1.77) 0.42 (3.75)** 0.83 0.93 0.84 0.33 1.52 4.46
0.03
3.1
0.08
2 International Effect
2.61 (7.28)**
0.09
14.1
0.0003
3 Industry Effect
2.67 (1.94)**
0.12
3.2
0.006
(0.50) (0.66) (0.6) (0.22) (0.99) (2.77)** 0.49 (0.91) 0.42 (3.39)** 0.59 0.38 0.36 0.74 1.59 3.98 0.22 4.2 0.0002
1.31 (0.90)
Furthermore, we want to see how the firm size, the international, and the industry variables affect the use of individual foreign exchange products. A regression is therefore run for each of the 15 products. The results are reported in Table 5. Of the fifteen regressions, only four do not show significant F-values at the 0.05 level. Among these four, three are exchange-traded products (futures, options, and futures options). Though most corporate managers are aware of them, these products are less frequently used than the OTC products. Conversely, high R2s are found in the regressions of the more popular products such as forward contracts and foreign currency swaps. We apply the F-test in each regression to examine whether or not the coefficients of the six industry dummy variables are the same. The results are shown in the last column of Table 5. Significant industrial variations are found at the 0.05 level of the forward contracts, exchange-traded futures options, participating forwards, foreign currency warrants, break forwards, and compound options. Significant differences are also seen in the cases of cylinder options and forward exchange agreements at the 0.01 level. In general, the firm size variable does not show significant effects on the use of individual exchange risk management products. Exceptions are found in the cases of forward contracts, foreign currency swaps, and break forwards. As the firm size increases, the use of forward contracts and foreign currency tends to increase. However, the use of break forwards tends to decrease. Among the size, international and industry effects, the international effect appears to be the most significant. Of the fifteen products, nine products show highly significant international effects. The products which do not have significant international effects are the three exchange-traded products plus forward rate agreements and hindsight options. As the degree of international involvement increases, corporate use of these exchange risk management products tends to increase. Furthermore, the use cuts across a wide spectrum of foreign exchange products.
Table 5
Firm Size, International, and Industry Effects on Corporate Use of Individual Products
Industry Effect Types of Products Intercept LASSETS FINCOME Forward contracts Foreign currency swaps Foreign currency futures contracts Exchange-traded currency options Exchange-traded futures options Over-the-counter currency options Cylinder options Synthetic "homemade" forwards Synthetic 0.85 (2.19)* -0.05 (-0.10) 0.19 (0.43) -0.20 (-0.60) -0.12 (-0.43) -0.08 (-0.13) -0.43 (-1.01) 0.40 (2.39)* -0.72 (3.14)** -0.18 (-0.93) 0.14 (0.95) 0.05 (0.48) 0.38 (1.53) 0.25 (1.34) 0.08 (2.04)* 0.19 (3.59)** 0.01 (0.01) 0.04 (1.11) 0.04 (0.15) 0.18 (3.12)** 0.12 (2.76)** I1 1.06 I2 1.17 I3 1.22 I4 0.13 I5 0.69 I6 1.05 FSign. R2 Value of F 0.27 6.5 0.0001 Significant? Yes
(2.36)* (3.23)** (3.36)** (0.31) (1.71) (2.47)** -0.53 -0.43 -0.16 -0.27 -0.68 0.42 0.21 4.7 0.0001 No
(-0.33) (-0.49) (-1.23) (0.71) 0.33 (0.80) 0.10 0.34 0.77 0.58 (1.20) 0.61 (1.64) 0.44 (1.51) 0.28 (0.43) 0.99 0.14 2.8 0.01 No 0.11 2.1 0.04 No 0.1 1.8 0.08 Yes 0.08 1.5 0.16 No 0.06 1.1 0.37 No
(2.00)* (0.98) 0.24 (0.62) 0.10 (0.33) 0.20 (0.29) 0.01 (0.03) 0.23 (0.74) 0.07 (0.29) 0.20 (0.36) 0.41 (1.02)
(-0.01) (-0.04) (1.56) 0.24 0.19 (0.48) -0.02 0.18 0.04 0.45
0.14 0.14
0.11 0.10
0.12 0.14
2.4 2.7
0.02 0.01
No No
(0.39) (0.28)
"homemade" options (-0.43) Participating forwards, etc. Forward exchange agreements, etc. Foreign currency warrants Break forwards, etc. Compound options Hindsight/lookback options, etc. -0.03 (-0.09) 0.21 (0.63) -0.23 (-1.02) 0.10 (0.65) -0.04 (-0.26) -0.03 (-0.29) Notes: Sample size is 173. The numbers in the parentheses are statistics. *Significant at the 0.05 level. **Significant at the 0.01 level. Industry effects are tested to examine whether or not they are significant at the 0.05 level. Dependent variables: Use of individual foreign exchange risk management products. (-0.17) -0.12 (-0.72) -0.03 (-0.18) 0.13 (1.38) -0.14 (-2.15)* -0.05 (-0.66) 0.01 (0.17) (3.64)** 0.12 (3.10)** 0.02 (0.50) 0.06 (2.62)** 0.04 (2.59)** 0.07 (4.11)** 0.01 (1.48) (0.44) 0.05 (0.12) -0.21 (0.42) 0.23 (0.65) -0.11 (0.37) -0.04 (-0.11) 0.02 (0.39) (0.28) 0.36 0.62 (1.88) 0.56 (1.36) 0.50 (1.40) 0.79 0.33 0.41 0.25 0.12 0.19 5.7 2.4 4.1 0.0001 0.02 0.0003 Yes Yes Yes 0.07 1.4 0.21 No 0.12 2.5 0.01 Yes
(-0.56) (-0.39) -0.07 -0.02 (-0.12) 0.09 -0.03 0.01 (0.09) -0.03
(0.08) (-0.33) (0.74) -0.09 (-0.44) -0.03 (-0.17) -0.06 0.02 0.09 -0.06 0.11 -0.02 -0.04
(-0.26) (-0.14)
(-0.36) (-0.32) (-0.26) (2.20)* 0.02 (0.19) 0.01 -0.01 0.18 0.08 1.5 0.17 No
(-0.12) (-0.23)
Notes: Independent variables: LASSETS Log of total corporate assets FINCOME Percentage of foreign income Industry dummy variables I1 Mining and construction I2 Manufacturing (e.g. food, textile, etc.) I3 Manufacturing (e.g. machinery, electronics, etc.) I4 Transportation and public utilities I5 Wholesale and retail trade I6 Finance, insurance and real estate
References
Batten, Jonathan, Robert Mellor and Victor Wan. "Foreign Exchange Risk Management Practices and Products Used by Australian Firms." Journal of International Business Studies, (3rd quarter 1993): 55773. Belk, Penny A. and Martin Glaum. "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation." Accounting and Business Research 21 (1990): 3-13.
Cornell, Bradford and Alan Shapiro. "Managing Foreign Exchange Risks." In Joel M. Stern and Donald H. Chew, eds. New Developments in International Finance (New York: Basil Blackwell, 1988) 44-59. Dufey, Gunter and Ian H. Giddy "Innovations in the International Financial Markets." Journal of International Business Studies, (Fall 1981): 33-51. Finnerty, John D. "Financial Engineering in Corporate Finance: An Overview." Financial Management, (Winter 1988): 14-33. Jesswein, Kurt R. "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implications for Financial Innovation Theory." Unpublished Ph.D. dissertation, University of South Carolina, 1992. Khoury, Sarkis J. and K. Hung Chan. "Hedging Foreign Exchange Risk: Selecting the Optimal Tool." Midland Corporate Finance Journal, (Winter 1988): 40-52. Lessard, Donald R. "Financial and Global Competition: Exploring Financial Scope and Coping with Volatile Exchange Rates." In Michael Porter, ed. Competition in Global Industries (Boston: Harvard Business School Press, 1986) 147-84. Levich, Richard M. "Financial Innovations in International Financial Markets." In Martin Feldstein ed., The United States in the World Economy (Chicago: University of Chicago Press, 1988) 215-57. Mathur, Ike. "Managing Foreign Exchange Risk Profitability." Columbia Journal of World Business (Winter 1982): 2023-30. Priestly, Sarah and Liz Hecht. "Third Generation Risk Management: How to Use Futures, Options, and Hybrid Products to Manage Exposure." Corporate Finance (September 1986): 23-38. Smith, Clifford W. Jr., Charles W. Smithson and D. Sykes Wilford. Managing Financial Risk (Hagerstown, MD: Ballinger, 1989).
1 Donald Lessard, "Financial and Global Competition: Exploiting Financial Scope and Coping with Volatile Exchange Rates," in Michael Porter ed., Competition in Global Industries (Boston: Harvard Business School Press, 1986) 147-184. 2 Bradford Cornell and Alan Shapiro, "Managing Foreign Exchange Risks," in Joel M. Stern and Donald H. Chew, eds., New Developments in International Finance (New York: Basil Blackwell, 1988) 44-59. 3 The three generations are mentioned in Sarah Priestly and Liz Hecht, "Third Generation Risk Management: How to Use Futures, Options, and Hybrid Products to Manage Exposure," Corporate Finance (London: Euromoney Publications) September, 1986: 23-38. The classification is also used in Kurt Jesswein, "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implication for financial Innovation Theory" (Doctoral dissertation, University of South Carolina, 1992). 4 There have been empirical studies conducted in various countries to survey how companies define and manage foreign exchange risks. Ike Mathur, "Managing Foreign Exchange Risk Profitability, " Columbia Journal of World Business 17, no. 4 (Winter 1982): 23-30. Penny Belk and Martin Glaum, "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation," Accounting and Business Research 21 (1990): 3-13. Jonathan Batten, Robert Mellor and Victor Wan, "Foreign Exchange Risk Management Practices and Products Used by Australian Firms," Journal of International business
Studies 3rd quarter (1993): 557-73. Out of a random sample of fifty-five Fortune 500 firms in the U.S., Mathur found that fourteen sought to minimize transaction losses, five sought to minimize translation losses, and thirty-two sought to minimize both. Alternatively, Belk and Glaum interviewed the senior management of seventeen U.K. multinationals. While most firms saw transaction exposure management as the centerpiece of their foreign exchange risk management, a majority of firms were also prepared to manage actively their net accounting exposure. Moreover, Batten, Mellor and Wan surveyed seventy-two corporations in australia and found that 61% of the respondents considered transaction exposure was the only relevant exposure. Very few respondents (8.3%) managed both transaction and translation risks. Nevertheless, most of these previous studies did not survey how corporations utilize new foreign exchange risk management products. 5 Fortune,April 23, 1990. 6 Fortune, June 4, 1990. 7 Forbes, December 11, 1989. 8 To test the objectivity and comprehensiveness of the research instrument, a limited survey, or pretest, was made. The pretest sample included forty Fortune 500 and Fortune Service 500 firms headquartered in North Carolina, South Carolina, and Georgia. Six responses were received (a 15% response rate) with no apparent problems encountered by the respondents. 9 A related variable, LASSETS, which is the log of TASSETS, is used in the later regressions. 10 There are two groups of manufacturing firms. They constitute a major proportion of the respondent sample (34.7% and 34.1% respectively.) Manufacturing firms of Category (2) are in the area of food, tobacco, textile, lumber, paper, publishing, chemical and petroleum refining. Manufacturing companies of Category (3) are in the area of metallic products, machinery, electronics, transportation equipments, scientific instruments and others. Alternatively, since there is a small number of sample respondents in Categories (7) and (8), they are compiled under the category of "other services", including health, engineering and management, and hotels. 11 Statistical results indicate that the percentages of product adoption across the first, the second and the third generations are significantly different at the 0.01 level.
12 In this study, we examined only the use of external foreign exchange risk management products. Besides utilizing external products, companies may also employ internal foreign exchange management techniques (e.g., leading and lagging, reinvoicing centers, balance sheet hedge and so forth) to reduce exchange rate risk. This may be one factor that accounts for the large difference in awareness and adoption data. 13 The F-test is conducted to test the hypothesis that the coefficients of the industry variables are equal. It is reflected at the 0.006 level, indicating that there is a significant industry effect. 14 As alluded to earlier, besides FINCOME, FASSETS (percentage of foreign assets) and FSALES (percentage of foreign sales) are also used as alternative proxies for the degree of international involvement. Regardless of which proxy is used, the results are quite similar. Owing to space constraint, only results of FINCOME are reported in Table 4.a. 15 Higher international involvement may have two opposing effects on the use of exchange rate products. On one hand, more foreign currency cash flows lead to more need of hedging. On the other hand, firms with higher international involvement have the advantage of natural diversification; they can net out some
of the currency exposures and then worry about the non-netted exposure. Nevertheless, our findings show that, despite this advantage, the net effect is that firms with greater international involvement still tend to use foreign exchange products more. 16 The F-test is again conducted to test the hypothesis that the coefficients of the six industry dummy variables are equal. It is rejected at the 0.003 level.
The End
Glossary
Ask price: The buying price of a currency for an individual or MNC. Bid price: The selling price of a currency for an individual or MNC. Cross exchange rates: The price of one currency with respect to another without the intervening dollar. Currency forward contracts: Legal contracts that enable the purchase or sale of specified units of a given currency for a specific period of time for future delivery or settlement. Currency futures: Legal contracts that enable the purchase or sale of standardized units of a given currency for a specific period of time for future delivery or settlement and are traded on the floor of the exchange. Currency options: Rights for the purchase or sale of currencies at a specific price for a specified period of time for which the purchaser pays a premium. Derivative markets: The market for contingent claims like options, futures and forward contracts etc. Direct foreign investment: Investment in physical assets like plants, factories, subsidiaries etc., through building or buying existing company. Direct quote: Number of US dollars per one unit of foreign currency; also called US dollar equivalent. Eurocurrency markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a short-term maturity of less than one year. Eurocredit markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a medium-term maturity 1 to 5 years.
Eurobond markets: The market place for financial instruments outside the jurisdiction of the currencies in which the instruments are denominated and have a longer maturity of 5 to 25 years. Exchange rate risk: The variability in the cash flows of a firm stemming from exchange rate fluctuations. Foreign-exchange markets: The net-work of foreign exchange dealers connected by phone terminals where MNCs, individuals, central banks, speculators and arbitragers buy and sell currencies. Forward premium: The annualized percent by which the forward rate of a given currency exceeds or falls below the spot rate. Indirect quote: Number of units of the foreign currency per US dollar.
Glossary
Arbitrage: Simultaneous buying and selling of currencies or assets of comparable risk and maturity in different markets to take advantage of the price differences; also could involve simultaneous borrowing and lending in different markets to take advantage of the interest rate differences. Locational Arbitrage: Arbitrage involving bid and ask prices in different banks or locals or regions. Triangular Arbitrage: Arbitrage involving the differences in the theoretical and market exchange rates. Covered Interest Arbitrage: Arbitrage that involves investing in a foreign currency asset, followed by selling forward the maturity value of the investment generating higher return than available domestically. International Fisher Effect: The theory which predicts (home-foreign) interest rate differential. It will equal the change in the spot rate of the foreign currency. Interest Rate Parity Theory: Predicts that the (home-foreign) nominal interest differential will equal the forward premium or discount of the foreign currency. Technical Forecasting: An exchange rate forecasting approach that relies on past historical data and other related technical factors. Fundamental Forecasting: A forecasting technique that relies on fundamental economic factors; posits that the exchange rates will be impacted up-on by those factors. Market Efficiency:
The reflection of information in the pricing of currencies; semi-strong form argues that foreign exchange markets reflect historical prices and all public information. Purchasing Power Parity: The theory that predicts (home-foreign) inflative difference. It is equal to the percentage change in the spot rate of the foreign country.
Glossary
Call Option: Right to buy a standard volume of a particular currency at a specific price called strike or exercise price for a specific period of time. Currency Diversification: Holding a portfolio of currencies of inflows and outflows so as to minimize the exchange rate risk. Currency Futures: Contracts specifying a standard volume of a particular currency to be exchanged for a specific price on a specific settlement date. Currency Hedging: Taking protective positions to safe-guard open currency positions. Currency Options: Rights which enable buying or selling of a given currency for a price called strike or exercise price for a specific period of time. Forward Contracts: Contracts specifying a given volume of a particular currency to be exchanged for a specific price on a specific settlement date. Money Market: Market for short-term investments like Treasury bills with a maturity of less than one year. Operating Exposure: Exchange rate risk that affects the operating cash flows by its impact on revenues and cots of a firm. Option Premium: Price paid by the buyer to the seller of the option for the right to buy or sell a given currency at the strike price for the specified period of time. Payables: Amount owed to others for goods bought or services received. Put Option: Right to sell a standard volume of a particular currency at a specific price called strike or exercise price for a specific period of time. Receivables: Amount owed by others to your corporation for goods supplied or services rendered.
Risk-free Rate: Rate of return on a default-risk free instrument, usually measured by the return on 90-day US Treasury bill rate. Speculation: Trading for profit, with a small probability of making huge profits, and a large probability of loss. Transaction Exposure: Exchange rate risk arising from transactions already entered into and denominated in foreign currencies. Variability: Fluctuations in the value of a given currency, measured by the standard deviation of the currency for a given period