Chapter Twelve

Managing Multinational Cash

Flow

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Chapter Outline

12.1 What is Exchange Rate?

12.2 Quotations.

12.3 Exchange Rate Regimes.

12.4 Major Foreign Exchange Instruments/Contracts/Derivatives.

12.5 Factors affecting Exchange Rate.

12.6 Forecasting Exchange Rate Movements.

12.7 Foreign Exchange Exposure.

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12.1 What is Exchange Rate?
 In finance, an exchange rate (also known as a foreign-exchange rate,
forex rate, FX rate or Agio) between two currencies is the rate at which
one currency will be exchanged for another. It is also regarded as the
value of one country’s currency in terms of another currency. For
example, an interbank exchange rate of 91 Japanese yen (JPY, ¥) to the
United States dollar (US$) means that ¥91 will be exchanged for each
US$1 or that US$1 will be exchanged for each ¥91. Exchange rates are
determined in the foreign exchange market, which is open to a wide
range of different types of buyers and sellers where currency trading is
continuous: 24 hours a day except weekends, i.e. trading from 20:15
GMT on Sunday until 22:00 GMT Friday. The spot exchange rate refers
to the current exchange rate. The forward exchange rate refers to an
exchange rate that is quoted and traded today but for delivery and
payment on a specific future date.

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12.2 Quotations.
 A currency pair is the quotation of the relative value of a currency unit
against the unit of another currency in the foreign exchange market.
The quotation EUR/USD 1.3533 means that 1 Euro is able to buy
1.3533 US dollar. In other words, this is the price of a unit of Euro in US
dollar. Here, EUR is called the “Fixed currency”, while USD is called the
“Variable currency”.
 There is a market convention that determines which is the fixed
currency and which is the variable currency. In most parts of the
world, the order is: EUR – GBP – AUD – NZD – USD – others.
Accordingly, a conversion from EUR to AUD, EUR is the fixed currency,
AUD is the variable currency and the exchange rate indicates how
many Australian dollars would be paid or received for 1 Euro. Cyprus
and Malta which were quoted as the base to the USD and others were
recently removed from this list when they joined the Eurozone.

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Quotations…….contd.

 Quotes using a country’s home currency as the price

currency (for example, EUR 0.735342 = USD 1.00 in the
Eurozone) are known as direct quotation or price
quotation (from that country’s perspective) and are used
by most countries.
 Quotes using a country’s home currency as the unit
currency (for example, USD 1.35991 = EUR 1.00 in the
Eurozone) are known as indirect quotation or quantity
quotation and are used in British newspapers and are also
common in Australia, New Zealand and the Eurozone.

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12.3 Exchange Rate Regimes.

 There are a number of methods that can be used to

determine an exchange rate:
1. A flexible or floating exchange rate is where the market
forces of supply and demand determine the exchange rate.
2. A fixed exchange rate is where the government determines
the exchange rate for a period of time based on the value of
another countries currency such as the US dollar.
3. A managed exchange rate is where the government
intervenes in the market to influence the exchange rate or
set the rate for short periods such as a day or week

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Flexible (or floating) Exchange Rates

 Under a flexible or floating exchange rate the value of a

countries currency changes frequently, even by the minute. The
market rate will depend on the demand for, and supply of, that
currency in the forex markets. When there is no intervention in
the free market operations by a government or its’ agency a
“clean float” is said to exist.

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A Currency Appreciation

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A Currency Depreciation

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Fixed Exchange Rates
 The World Bank and the IMF were both established in 1944 at a
conference of world leaders in Bretton Woods, New Hampshire
(USA). The aim of the two "Bretton Woods institutions" as they are
sometimes called, was to place the global economy on a sound
footing after World War II. To help reduce the economic instability
that existed the conference favored the use of a fixed exchange
rate system. Under a fixed exchange rate system the value of a
country’s currency is fixed by the government or one of its
agencies, for example the Reserve Bank of Australia (RBA) to
another currency for a specific time period. This method of
determining exchange rates was to dominate until the 1970s.

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Exchange Rate Determination in a Fixed
Exchange Rate

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Managed Exchange Rates
 A managed exchange rate occurs when there is official intervention
by a government or an agency, such as the RBA to determination
the value of a country’s exchange rate. Through such official
interventions, it is possible to manage both fixed and floating
exchange rates. The Australia dollar was pegged to TWI from
September 1974 to November 1976. Then in November 1976, the
government adopted a “managed flexible peg” or a “crawling peg
system”. Under this new method of determining exchange rates,
the value of the Australian dollar was changed relative to the TWI,
not just relative to a single individual currency. The exchange rate
was announced each morning by the RBA and remained at that rate
until the next morning. This system continued until the Australian
dollar was floated in December 1983.

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Major Foreign Exchange Instruments

 Spot transaction.
 Forward transaction.
 Options.
 Futures.
 Swaps.

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The Spot Market/Spot Rate/Spot Transaction

 The duration of the Spot transaction is 2 working

days.
 The spot rate will be fixed/remain constant for 2
working days.
 The volume of transaction is relatively small.
 Usually tourist, overseas students & the dealer are
the main participants of this market

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The Forward Market/Forward Rate/Forward
Transaction

 The duration of the forward transaction is 180 working days.

 The seller of the currency determines the forward rate by
analyzing the trend of movements of that currency.
 The forward rate will remain constant for maximum 180
working days.
 The volume of transaction is relatively large.
 Usually importers, exporters & other business peoples & the
dealer are the main participants of this market.
 A forward premium is charged at the time of transaction.

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Options

 An option is the right but not the obligation to

buy or sell a foreign currency within a certain
time period or on a specific exchange rate. An
option can be purchased from both the OTC &
ETM. The option provides the company
flexibility, because it can walk away from the
option if the strike price is not a good price.

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Futures

 A foreign currency future resembles a forward

contract insofar as it specifies an exchange rate
sometime in advance of the actual exchange of
currency. However a future is traded on an
ETM, not an OTC. Instead of working with
bankers, company likes to work with the
exchange brokers when purchasing future
contracts.

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Swaps

 A currency swap involves exchanging principal and

fixed rate interest payments on a loan in one currency
for principal and fixed rate interest payments on an
equal loan in another currency. Just like interest rate
swaps, the currency swaps are also motivated by
comparative advantage. Currency swaps entail
swapping both principal and interest between the
parties, with the cash flows in one direction being in a
different currency than those in the opposite
direction. It is also a very crucial uniform pattern in
individuals and customers.

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Foreign-Exchange Convertibility
 Hard currencies are those that governments allow both residents and
nonresidents to purchase in unlimited amounts, i.e., currencies freely
traded and accepted in international business. Hard currencies are fully
convertible, relatively stable and tend to be comparatively strong. Soft
(weak) currencies are not fully convertible and tend to be the currencies
of developing countries. To conserve scarce foreign exchange,
governments may impose exchange restrictions on individuals and/or
companies. Under a multiple exchange-rate system the government sets
different rates for different types of transactions. If the government
imposes an advance import deposit, importers will be required to make
a deposit with the central bank, often for as long as one year, to cover the
full price of the products being sourced from abroad. With quantity
controls, the government limits the amount of foreign currency that can
be used for a given transaction. Such currency controls significantly add to
the cost of doing business and can serve as serious impediments to trade.

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12.5 Factors Affecting Exchange Rates.
1. Inflation,
2. Interest Rates,
3. Speculation,
4. Change in Competitiveness,
5. Relative strength of other currencies,
6. Balance of Payments,
7. Government Debt,
8. Government intervention, &
9. Economic growth/recession.

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Example Fall in Value of Sterling 2007 – Jan 2009

During this period, the value of Sterling fell over 20%. This was due to:
1. Restoring UK’s lost competitiveness. UK had large current account deficit in 2007
2. Bank of England cut interest rates to 0.5% in 2008.
3. Recession hit UK economy hard. Markets expected interest rates in UK to stay low
for a considerable time.
4. Bank of England pursued quantitative easing (increasing money supply). This
raised prospect of future inflation, making UK bonds less attractive.

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12.6 Forecasting Exchange Rate Movements.

 Purchasing Power Parity (PPP)

 Relative Economic Strength Approach
 Econometric Models
 Time Series Model

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12.7 Foreign Exchange Exposure.
 When a company has cash flows that are denominated in a
foreign currency, it becomes exposed to foreign exchange
risk, or in other words, has foreign exchange exposure.
Foreign exchange exposure can also arise when a firm has
assets denominated in a foreign currency, because the
value of those assets will fluctuate with the exchange rate.
Four types of exposure are:
1. Transaction exposure,
2. Economic exposure,
3. Translation exposure, &
4. Contingent exposure.

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