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Foreign Exchange: Dealing with Currencies


... Hedging Strategy Summary This feature examines the effects of Volkswagen s decision to not properly hedge its foreign exchange exposure in 2003. – PowerPoint PPT presentation

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Title: Foreign Exchange: Dealing with Currencies

Foreign Exchange Dealing with Currencies
  • with a basic introduction to the International
    Monetary System

Foreign Exchange Terms
  • Foreign exchange money denominated in the
    currency of another nation or group of nations
  • Cash
  • Credit
  • Bank deposits
  • Other short-term claims (e.g., bonds)
  • Exchange rate the price of a particular currency
    relative to another

Basic questions
  • What is money?
  • How should you convert money from one currency
    into another?
  • How are the values of currencies set?
  • How can you limit foreign exchange risk (the
    possibility that unpredicted changes in exchange
    rates will have adverse consequences for the
  • Can you predict when currency values will change?
    If so, how?

What is money?
  • The medium of exchange
  • that is, something widely accepted as means of
  • Usually, governments declare certain pieces of
    paper (and bank assets) to be money
  • But people must accept them
  • Alternatives are inconvenient, but possible
  • Tobacco in early American colonies
  • U.S. dollar in Russia when ruble collapsed

  • If you sell abroad, and you may receive payment
    in foreign currency
  • Buy abroad, and you may have to pay in foreign
  • Travel abroad, you must spend foreign currency
  • A foreign direct investment will have to pay
    expenses in foreign currency

How should you convert money from one currency
into another?
  • Current values of major foreign currencies are
    available on the Web
  • Most businesspeople normally buy from or sell to
    a bank
  • The bank often gives less than the rates offered
    on the Web, but handles all details
  • Banks may vary a lot in how good a deal they give
  • But they know they have to be competitive with
    other banks

  • A business with significant foreign activity
    creates a stable relationship with one or a few
  • Nowadays, you can do your own currency trading

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How are the values of currencies set?
  • There are two basic ways
  • Fixed or Pegged exchange rates
  • Governments decide the value of currency
  • Example Hong Kongs government keeps the value
    of its dollar at roughly US0.129 (US1HK7.75)
  • With a fixed rate, there is absolutely no
  • A pegged rate implies small variability

The major developed-country currencies float
against each other
  • Supply and demand sets values
  • This is how exchange rates are set for the US
    dollar vs.
  • Euro,
  • Japanese yen,
  • British pound,
  • Swiss franc, etc.

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Fixed exchange rates have important benefits
  • They make business predictable
  • In some very prosperous periods, most major
    exchange rates have been fixed
  • The late 19th century
  • 1945-1971

The gold standard made the benefits of fixed
rates clear
  • Before WW I, all major currencies were
    convertible into gold
  • UK 1113 grains gold (.2354 oz)
  • US 1 23.22 grains (.0484 oz)
  • So, 14.87
  • Everyone knew what everything was and would be

  • But a fixed exchange rate requires discipline in
    the government and a willingness to create
  • Example Suppose your nations economy is very
    prosperous, but exports are growing only slowly
  • Your people will have money to buy imports
  • Their demand for foreign currencies will put
    upward pressure on their exchange rates
  • Government has to slow the domestic economy to
    prevent change in exchange rate
  • Higher taxes, higher interest rates, lower
    government spending

  • Many economists say if a country is having
    difficulty maintaining a fixed exchange rate, the
    economy is overheated
  • They say higher interest rates or higher taxes
    might be better for the economy in the long run
    in those circumstances
  • But politicians dont like to take pain
  • U.S. abandoned fixed exchange rates when the
    Vietnam War created strong inflation

  • It seems that the more complicated an economy,
    the more difficult it is to maintain fixed/pegged
  • Many small countries succeed
  • Hong Kong, Bangladesh, Fiji
  • Few propose them for the largest developed
    countries today
  • Many developing countries including China
    restrict who can own their money
  • Hot investments in emerging currencies have
    often caused problems when foreigners changed
    their minds

  • China maintains a pegged exchange rate
  • For long periods it kept the rate at less than an
    equilibrium price
  • Its government had to buy lots of surplus dollars
    that its exports brought in
  • In June 2012 China had 3,240 billion US dollars

When an economy has recently grown, it may be
hard to spend
  • There is poor transportation infrastructure
  • People live in the countryside or in tiny urban
    apartments, so they have little space for things
  • So more money may come in from exports than
    people want to spend

  • Its easier to manage a currencys level if you
    have a trade surplus than a trade deficit
  • You can simply use the surplus to buy up the
    foreign exchange that comes into the country
  • China fears that if the value of the Yuan rises,
    declining sales of manufacturers will hurt

  • US per capita GDP is 48,400
  • Chinas per capita GDP at current Yuan exchange
    rate is 5400
  • Thus, a US worker must ordinarily be 9 times as
    productive as a Chinese worker to sell
  • Chinas nominal per capita income up 46 in 3
  • For the US and Europe, a low Yuan and Chinese
    import restrictions make recovery from recession
  • But Americans get to consume more

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Most international business involves currencies
with floating rates
  • Buyers and sellers establish prices in markets
    like those for tea and wheat
  • 1,200,000,000,000 in foreign exchange is traded
    every day
  • US dollar is most widely traded
  • involved in 90 of all transactions
  • London is the main foreign-exchange market

Foreign-Exchange Trading Terms
  • Bid the rate at which a trader will buy foreign
    currency from you
  • Offer (or Ask) the rate at which a trader will
    sell foreign currency to you
  • Spread the difference between bid and offer
    rates the profit margin for the trader

Market Rhythms
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Insuring Against Foreign Exchange Risk
  • Businesses use the foreign exchange market to
    provide insurance against foreign exchange risk
  • A firm that protects itself against foreign
    exchange risk is hedging
  • You can buy or sell using
  • spot exchange rates
  • forward exchange rates
  • currency swaps

Insuring Against Foreign Exchange Risk
  • 1. Spot Exchange Rates
  • The spot exchange rate is the rate at which a
    foreign exchange dealer converts one currency
    into another currency on a particular day
  • Spot rates are determined by the interaction
    between supply and demand, and so change

Insuring Against Foreign Exchange Risk
  • 2. Forward Exchange Rates
  • A forward exchange occurs when two parties agree
    to exchange currency at some specific future date
  • Forward rates are typically quoted for 30, 90, or
    180 days into the future
  • Forward rates are typically the same as the spot
    rate plus or minus an adjustment for the interest
    the parties will pay/receive

Insuring Against Foreign Exchange Risk
  • 3. Currency Swaps
  • A currency swap is the simultaneous purchase and
    sale of an amount of foreign exchange on two
    different dates
  • Swaps are used when it is desirable to move out
    of one currency into another for a limited period
    without incurring foreign exchange rate risk
  • For example, you have accepted an order in
    Japanese yen and you must manufacture the product
    using components you must purchase in Japanese

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How can you predict when currency values will
  • Business decisions demand you look far ahead
  • If exchange rates will change and you dont hedge
    adequately, your whole calculation will be off
  • Some foreign currencies have lost 90 or more of
    their value in a year
  • Argentine peso went from 11 peso to 13.5
    pesos in one jump

Fundamental analysis involves examining basic
economic data
  • How fast are prices rising in the country?
  • Is there a trade surplus or deficit?
  • Is the government running budget deficits? How
  • How do interest rates in the countries compare?
  • How has the government been managing the

Technical analysis involves examining trends in
exchange rates
  • One principle Trends once established often tend
    to continue
  • The trend is your friend
  • But if everyone agrees something will happen,
    it may not happen
  • When everyone thinks the dollar will go down,
    everyone has already sold dollars
  • If the news changes, many may quickly change
    their minds and want to buy

Foreign exchange can be the difference between
profit and loss
  • HSBC Bank in Argentina
  • They entered Argentina at a time when it appeared
    the government was starting to manage the economy
  • But they continued investing as government became
    more irresponsible
  • They lost big

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  • Material below here is not required

Foreign-Exchange Convertibility
  • Fully convertible currencies are those that the
    government allows both residents and nonresidents
    to purchase in unlimited amounts
  • Hard currencies are fully convertible
  • Soft currencies (or weak currencies) are not
    fully convertible
  • Typically from developing countries
  • Known as exotic currencies