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Alex smith8-16 Chapter 8: Currency of Payment (Managing Transaction Risks)
Chapter 8: Currency of Payment (Managing Transaction Risks) 8- 15
Chapter 8
Currency of Payment (Managing Transaction Risks)
lEARNING oBJECTIVES
At the end of this chapter, YOU SHOULD:
Identify the risks that currency exchange rates pose for both the importer and exporter.
Identify the system of currency exchange rates.
Identify theories of exchange rate determination.
Identify means of exchange rate forecasting.
Identify means of managing transaction exposure.
Identify international banking institutions.
Preview
This chapter looks at some of the risks exporters take in dealing with currencies of different nations. It also discusses ways currency fluctuations can be predicted and how participants in international trade can protect themselves from currency valuation swings that may be against them. Some of the more technical aspects of the chapter can be omitted if they are too complex for the level at which the course is offered.
Chapter Outline
Introduction
I. Previous chapters have shown that exporters and importers must agree on:
a. Terms of trade
b. Terms of sale
II. Another issue of concern is currency for the transaction
a. Exporter country’s currency?
b. Importer country’s currency?
c. Third country’s currency?
8-1 Sales Contracts’ Currency of Quote
I. Risk of currency fluctuation
II. Convertibility of currency
8-1-1 Exporter’s Currency
I. Exchange rate fluctuation risk is nil for exporter
II. Exchange rate risks borne by importer
8-1-2 Importer’s Currency
I. Exchange rate fluctuation risk is nil for importer
II. Exchange rate risks borne by exporter
8-1-3 Third Country’s Currency
I. Exporter and importer responsible for fluctuations of their country’s currency against that of third country
II. Artificial currency such as Special Drawing Rights (SDRs) on International Monetary Fund (IMF) can be used
8-1-4 The Special Status of the Euro
I. Originally an artificial currency
II. Began circulation in 2002
III. Truly an international currency designed to challenge international status of U.S. dollar
8-2 The System of Currency Exchange Rates
8-2-1 Types of Exchange Rate Quotes
I. The exchange rate of two currencies is the value of one currency expressed in units of the second
a. The first way to value a currency is the direct quote, or the value of the foreign currency expressed in units of the domestic currency
b. The second way to value a currency is the indirect quote, that is the value of the domestic currency expressed in units of foreign currency
c. Direct quote = _____1_____
Indirect quote
II. Spot exchange rate—the exchange rate for a foreign currency for immediate delivery (at foreign exchange kiosks and banks worldwide)
III. Forward exchange rate—the exchange rate for a foreign currency to be delivered 30, 90, or 180 days from date of quote
a. Outright rate—the rate at which a commercial customer would purchase the currency
b. It has to be differentiated from the swap rate, which is the method used by banks and other financial institutions to express a forward exchange rate and is expressed in points
IV. Currency futures
a. Currencies are traded on futures’ market as “commodities” (Chicago Mercantile Exchange in U.S.)
b. Currency options’ market:
i. U.S.-style option gives a company the right to exercise its option at any time until the expiration date
ii. European-style option allows exercising of option only on that date
V. Current options
c. Two types of options:
i. Call option is a right to buy, but not an obligation to buy
ii. Put option is a right to sell, but not an obligation to sell
iii. An option is priced by the “market” between companies wanting to purchase options and speculators and other companies who are selling options
8-2-2 Types of Currencies
I. Floating currencies—foreign currencies whose value changes (or can change) daily against other currencies
a. Countries most involved in world trade have floating currencies
b. Some countries attempt to control the floating ability of their currencies
II. Pegged currencies
a. Countries with very volatile currencies may try to peg their currency to currency that is more stable
b. Pegging currency to a stable currency will make exchange rate predictable
c. Country may replace currency with that of another country—Panama and Ecuador adopted U.S. dollar or were involved in dollarization of their economies
III. Floating currency blocs—European Monetary System
a. Countries may trade so much with each other that they develop a currency bloc
b. European Monetary System (EMS) gave rise to the euro
c. Blocs can eventually develop into a fixed exchange rate among all the internal currencies of involved countries.
8-3 Theories of Exchange Rate Determinations
8-3-1 Purchasing Power Parity
I. Theory holds that exchange rates should reflect the price differences of all products. Big Mac Index should illustrate this (Table 8-5).
II. This is essentially impossible to achieve and measure, given disparity of goods and services purchased worldwide
III. Theory holds that exchange rates should reflect differences in inflation rates between countries
IV. Mathematical illustrations:
Spot value of Currency F at time t in Country D_ (1+ inflation rate in Country D)t
Spot value of Currency F at time 0 in Country D = (1+ inflation rate in Country F)t
or
S(et) = (1 + infD)t
S(e0) (1 + infF)t
8-3-2 Fisher Effect
I. Observation that a country’s nominal interest rate comprises inflation rate in country and real interest rate borrowers are paying
II. Such real interest rate is expected to be “uniform” throughout the world
III. Mathematical representations:
(1 + real interest rate) × (1 + inflation rate) = 1 + nominal interest rate
or
(1 + rir)(1 + inf) = 1 + nir or nir = inf + rir + (inf × rir) ≈ inf + rir
8-3-3 International Fisher Effect
I. Observation that exchange rates reflect the differences between nominal interest rates in different countries
II. It posits that, if nominal interest rates are higher in country F than in country D, then country F’s currency should be expected to decrease in value relative to country D’s currency
III. Conceptually, the expected spot rate reflects the fact that an investor would get the same yield on an investment, whether it is made in country D or country F
IV. Mathematical representations:
Spot value of Currency F at time (t+1) in country D
Spot value of Currency F at time t in country D =
(1 + nominal interest rate in country D)
(1 + nominal interest rate in country F)
or
S(et+1) = (1 + nirD)
S(et) (1 + nirF)
8-3-4 Interest Rate Parity
I. This theory links the forward exchange rate of a foreign currency to its spot rate, using the differences in nominal interest rates between the foreign country and the domestic country
II. The principle is that the forward exchange rate should be expressed as a discount if the foreign country is experiencing higher nominal interest rates than the domestic country, and should reflect a premium if the foreign nominal interest rates are lower
III. In other words, at time t, the forward exchange rate F {t + 1}(et) for delivering currency F n days from t—that is, at time t + 1—reflects the difference between the nominal interest rate in Country D and the nominal interest rate in Country F, adjusted for the length of n days
IV. Mathematical representations:
Fn(et) – S(et) × 360 = nirD – nirF
S(et) n
8-3-5 Forward Rate as Unbiased Predictor of Spot Rate
I. This theory holds that forward exchange rates for currencies are good predictors of the future spot exchange rates of that currency
II. In other words, if the forward rate for a currency shows a discount of 2 percent for a maturity date of n days, then the spot rate in n days should be 2 percent lower than it is today
III. Conceptually, the relationship is that the forward exchange rate of currency F at time t in Country D for delivery at time t + 1 is the expected (average) spot value of currency F at time t + 1 in Country D
IV. Mathematical representation:
Ft+1(et) = S(et+1)
8-3-6 Entire Predictive Model
I. The five relationships can be combined to understand how each can be used to forecast expected spot exchange rates
II. See Figure 8-3 in text, page 282
8-4 Exchange Rate Forecasting
8-4-1 Technical Forecasting
I. So-called technical forecasting methods are essentially all based upon time-series analysis
a. Simple moving averages
b. Sophisticated ARIMA (auto-regressive integrated moving average; also called Box-Jenkins) methods
c. Neural-network models which require dedicated software packages and pretty powerful computers
d. Several possible sources on technical forecasting are listed in this chapter’s bibliography
II. Technical forecasting is based on the premise that future movements in the value of a currency are “mathematically” linked to its past movements
III. Patterns are then duplicated with very recent data to forecast the future exchange rates of the currency
IV. Such technical forecasts are valuable in determining the possible variations of a currency’s exchange rate in the short-run
V. In the long run, they tend to accumulate errors fairly quickly, as they ignore the economic fundamentals of exchange rate determination
8-4-2 Fundamental Forecasting
I. Development of a causal model
a. Exchange rate of a specific currency is dependent variable
b. Expected inflation rates, nominal interest rates, forward interest rates, and real interest rates as independent variables
c. Use of large multiple linear regression and analysis of variance (ANOVA) techniques
II. Problem with causal models is:
a. Difficulty in accounting for all possible influences on a currency’s exchange rate
b. Limiting inevitable collinearity of independent variables
8-4-3 Market-Based Forecasting
I. Based on premise that “market knows best”
II. Market’s “wisdom” may be skewed by objectives of speculators
III. Does not account for government interventions
8-5 Managing Transaction Exposure
I. Exposure to risk of using foreign country’s currency is called transaction exposure
II. Transaction exposure can be retained by the firm or hedged
III. Transaction exposure strategy is dependent on:
a. Company’s forecast of exchange rate
b. Size of firm
c. Ability of firm to weather risk
d. Size of invoice
e. Company’s sophistication in international finance
IV. Usually better to hedge foreign exchange risk
8-5-1 Risk Retention
I. Large traders tend to retain their risks
II. Exporters/exporters with little exposure tend to retain their risks
III. Some firms do not evaluate risks, so, rightly or wrongly, they retain their risks
8-5-2 Forward Market Hedges
I. Company sells forward a future receivable in a foreign currency
II. Company purchases forward currency necessary to cover foreign payment
III. Hedge means company knows how much it would collect or pay
8-5-3 Money Market Hedges
I. Use of banking system of the country of the currency in which the receivable or the payable is going to be paid
II. Is effective since it allows the firm to use the exchange rate as of the date of the transaction rather than speculate on the value of the exchange rate at the date of payment
III. Minimizes the risks of currency fluctuations
8-5-4 Options Market Hedges
I. It is also possible to hedge a foreign currency fluctuation risk with options. This is a yet more sophisticated alternative, which is essentially equivalent to remaining unhedged (retaining the risk), and to purchasing an insurance policy to protect against unfavorable exchange rate fluctuations. If the exchange rate turns unfavorably, the firm can exercise its option—its insurance policy—and is covered. If the exchange rate turns favorably, the firm can still benefit from this situation by not exercising its option, albeit while losing the cost of the option
II. This strategy involves purchasing put or call options, or the option to sell or purchase certain currencies at a certain exchange rate on (European-style options) or before (U.S.-style options) a certain date. This agreed upon exchange rate is called the strike price
III. Options are very expensive
IV. Options are only commonly traded for a limited number of currencies
V. Amounts are not as flexible as in forward markets
VI. Some banks will write options that are tailored to their customers’ needs
VII. For firms sophisticated in international trade, this strategy has great potential
8-6 International Banking Institutions
8-6-1 Central National Banks
I. Central banks create and control monetary supply:
a. Through market operations
b. Through control of currency
II. Function as a check clearinghouse
III. In some countries, they also try to “manage” exchange rate of the national currency and the national foreign exchange reserves
8-6-2 International Monetary Fund
I. Created in 1944 at the Bretton Woods Conference
II. Designed to oversee the fixed exchange rate system that conference had started
III. With end of gold standard in 1971, IMF changed its focus to helping countries manage balance of payments
IV. IMF lends money to countries that experience difficulties with their balance of payments—loans usually accompanied by conditions to which the country has to agree: inflation control and money supply growth are often on the list
V. IMF is also curator of artificial currency called a “Special Drawing Rights” (SDRs)
a. Designed to supplement the U.S. dollar in its role as the international currency
b. SDR’s value is determined by a basket of four currencies (U.S. dollar, European euro, British pound, and Japanese yen)
c. SDR not often used by businesses
d. Often used by governments to settle their debts with each other
e. Also used in the settlement of disputes under the liability conventions of ocean cargo shipping
8-6-3 Bank for International Settlements
I. Initially designed to handle Germany’s World War I reparation payments
II. Evolved into major supporter of central banks (which make up its membership)
8-6-4 International Bank for Reconstruction and Development—World Bank
I. Created in 1945 after Bretton Woods Conference
II. Designed to help countries rebuild their infrastructure after World War II
III. Now finances large infrastructure projects
8-6-5 Export-Import Bank
I. Export-Import (Ex-Im) Bank is U.S. government agency
II. Makes loans to large exporters
III. Makes loan guarantees to banks financing exporters
IV. Makes political risk insurance policies available through Foreign Credit Insurance Associations (FCIA)
8-6-6 Society for Worldwide Interbank Financial Telecommunication
I. SWIFT is bank-created agency to support Electronic Data Interchange (EDI) network
II. Allows communication of letters of credit and miscellaneous fund transfers
III. High security gives it same value as original paper documents
8-7 Currency of Payment as a Marketing Tool
I. Flexibility is primarily important
II. Importer’s currency is generally preferred by importers, and currency exchange risk can be hedged
Key terms
artificial currency
A currency that is not in circulation. After the euro was changed into a circulating currency on January 1, 2002, the only artificial currency left was the Special Drawing Rights of the International Monetary Fund. Its value is determined by the value of a basket of four currencies: the euro (approximately 34 percent of the SDRs value), the Japanese yen (approximately 11 percent), the U.S. dollar (approximately 44 percent), and the British pound (approximately 11 percent).
Bank for International Settlements
The bank that advises central banks and provides a clearinghouse for exchanges between central banks.
call options
A method used to speculate on the value of a currency in the future. A firm can purchase options to buy (called call options) or options to sell (called put options) a particular currency at a particular price, called the strike price, on a given date. Since the complexity of the options market is substantial, the reader is advised to learn a lot more about this alternative before venturing into the options market.
central bank
The entity that controls the money supply of a nation and functions as a clearinghouse for inter-bank exchanges.
convertible currency
A currency that can be converted into another currency. A convertible currency can be a hard currency (easy to convert) or a soft currency (not so easy to convert), but it can be converted.
currency
The monetary unit used in a particular country for economic transactions (e.g., the dollar in the United States, the British pound in the United Kingdom, the euro in Europe, and the yen in Japan).
currency bloc
A group of currencies whose values fluctuate in parallel fashion. The currencies within the group have a fixed exchange rate, but their exchange rates with currencies outside of the group float.
currency futures
A method used to trade currencies; the value of a fixed quantity of foreign currency for delivery at a fixed point in the future is determined by market forces. These currencies are traded as are other commodities’ futures. In the United States, they are traded on the Chicago Mercantile Exchange.
currency options
A method used to speculate on the value of a currency in the future. A firm can purchase options to buy (called call options) or options to sell (called put options) a particular currency at a particular price, called the strike price, on a given date. Since the complexity of the options market is substantial, the reader is advised to learn a lot more about this alternative before venturing into the options market.
direct quote
The value of a foreign currency expressed in units of the domestic currency; for example, the euro was worth $1.4011 as of May 25, 2009. Some currencies are traditionally expressed as direct quotes.
dollarization
A phenomenon whereby other countries decide to adopt the U.S. dollar as their circulating currency. Panama and Ecuador have gone through a “dollarization” of their respective economies.
euro
As of July 2013, the common currency of seventeen of the 27 countries of the European Union, developed in the early 1990s and placed in circulation on January 1, 2002. In July 2013, Croatia was added to the European Union, for a total of 28 countries, and Latvia adopted the euro for a total of eighteen countries using the euro.
Eurozone
The seventeen countries of Europe in which the euro is the currency. Eighteen as of January 1, 2014.
Ex-Im Bank
An agency of the U.S. federal government that provides financial assistance to U.S. exporters.
exchange rate risk
The risk represented by the fluctuation in exchange rates between the time at which two companies entered into an international contract and the time at which that contract is paid.
Fisher effect
An economic theory that holds that the interest rates that businesses and individuals pay to borrow money should be uniform throughout the world and that the nominal interest rates that they actually pay in a given country are composed of this common interest rate and the inflation rate of that country.
floating currency
A currency whose value is determined by market forces. The exchange rate of a floating currency varies frequently.
forward exchange rate
The exchange rate of a foreign currency for delivery in 30, 90, or 180 days from the date of the quote.
forward market hedge
A financial technique designed to reduce exchange rate fluctuation risks in which a business agrees to purchase (or sell) a particular currency at a predetermined exchange rate at some future time (generally 30, 60, 90, 180, or 360 days later).
hard currency
A currency that can easily be converted into another currency.
inconvertible currency
A currency that cannot be converted into another currency.
indirect quote
The value of a domestic currency expressed in units of a foreign currency; for example, the dollar was worth 94.82 yen as of May 25, 2009. Some currencies are traditionally expressed as indirect quotes.
Interest Rate Parity
An economic theory that holds that the forward exchange rate between two currencies should reflect the differences in the interest rates in those two countries.
International Fisher effect
An economic theory that holds that the spot exchange rates between two countries’ currencies should change in function of the differences between these two countries’ nominal interest rates.
International Monetary Fund
The international organization created in 1945 to oversee exchange rates and develop an international system of payments.
money market hedge
A financial technique designed to reduce exchange rate fluctuation risks. When a business has to make a payment at a future date and is pursuing a money market hedge, it invests the funds in an interest-bearing account abroad. The amount invested is the amount it owes, discounted for the interest that it will earn: At maturity, the business will have sufficient funds to cover its obligations. In the case of a business anticipating a collection, the technique calls for the business to borrow from a bank abroad and reimburse the bank with the funds provided by its creditor.
options market hedge
A financial technique designed to reduce exchange rate fluctuation risks in which a business purchases (or sells) options in a particular currency. See currency options.
outright rate
The exchange rate of a foreign currency for delivery in 30, 90, or 180 days from the date of the quote. The outright rate is the rate at which a commercial customer would purchase the currency. It has to be differentiated from the swap rate, which is the method used by banks and other financial institutions to express a forward exchange rate.
pegged currency
A currency whose value is determined by a fixed exchange rate with another, more widely traded currency. As the value of the reference currency fluctuates, so does the value of the pegged currency, but the exchange rate between the two remains constant.
points
In a forward exchange rate, the difference between the outright rate and the swap rate. Points are not fixed units; their value depends on the way a currency is expressed, but is the smallest decimal value in which that currency is traded. For example, the indirect quote for the Japanese yen/U.S. $ exchange rate was 94.82 yen as of May 25, 2009. A “point” for this currency rate is therefore worth 0.01 yen. The direct quote for the European euro/U.S. $ exchange rate was $1.4011 on the same date; a “point” for this currency is therefore worth U.S. $0.0001.
Purchasing Power Parity
An economic theory that holds that exchange rates should reflect the price differences of each and every product between countries. The idea is that a set amount of money (regardless of the currency in which it is expressed) would purchase the same goods in any country of the world.
put options
A method used to speculate on the value of a currency in the future. A firm can purchase options to buy (called call options) or options to sell (called put options) a particular currency at a particular price, called the strike price, on a given date. Since the complexity of the options market is substantial, the reader is advised to learn a lot more about this alternative before venturing into the options market.
risk retention
A risk management strategy in which a company elects to retain a certain type of risk and decides not to insure that risk.
soft currency
A currency that cannot be easily converted into another currency; either it is inconvertible, it is only convertible into other soft currencies, or it has an exchange rate that differs substantially between sales of the currency and purchases of the currency.
Special Drawing Right (SDR)
An artificial currency (it does not circulate, see artificial currency) of the International Monetary Fund. Its value is determined by the value of a basket of four currencies: the euro (approximately 34 percent of the SDR’s value), the Japanese yen (approximately 11 percent), the U.S. dollar (approximately 44 percent), and the British pound (approximately 11 percent).
spot exchange rate
The exchange rate of a foreign currency for immediate delivery (within 48 hours).
strike price
A method used to speculate on the value of a currency in the future. A firm can purchase options to buy (called call options) or options to sell (called put options) a particular currency at a particular price, called the strike price, on a given date. Since the complexity of the options market is substantial, the reader is advised to learn a lot more about this alternative before venturing into the options market.
swap rate
The exchange rate of a foreign currency for delivery in 30, 90, or 180 days from the date of the quote. The swap rate is the difference between the current spot rate and the rate at which a commercial customer would purchase the currency. It is expressed in points that must be subtracted or added to the spot rate. The swap rate is the method used by banks and other financial institutions to express a forward exchange rate. The sum of the swap rate and the spot rate yields the outright rate, which is the rate paid by a commercial customer for the currency.
SWIFT- Society for Worldwide Interbank Financial Telecommunication
An interbank electronic network for the secure transfer of funds and documents.
term of sale
An element in a contract of sale that specifies the method of payment to which an exporter and an importer have agreed. Specifically, the term of sale will specify cash in advance, letter of credit, documentary collection, open account, or TradeCard transaction.
term of trade
An element in a contract of sale that specifies the responsibilities of the exporter and of the importer. Specifically, the term of trade will specify which activities must be performed by the exporter and which by the importer, which activities are paid by the exporter and which by the importer, and where in the international transportation process the transfer of responsibility for the merchandise takes place.
transaction exposure
The risk represented by the financial impact of fluctuations in exchange rates in an international transaction. A small exposure means that the firm is likely to be largely unaffected by a change in exchange rates, because the amount of the transaction is small relative to the company’s size.
World Bank
The bank that was created at Bretton-Woods in 1944 and finances large-scale infrastructure projects in the world.
PowerPoint SLIDES – STUDY THEM – PRINT THEM OUT !
· Definitions (1 slide)
· Currency of Quote (9 slides)
· Currency Exchange Rates (12 slides)
· Exchange Rate Determination (9 slides)
· Exchange Rate Forecasting (2 slides)
· Managing Transaction Exposure (19 slides)
· International Banking Institutions (3 slides)
· Currency of Payment as a Marketing Tool (1 slide)
Additional Resources
Baker, James C., International Finance: Management, Markets, and Institutions, 1998, Prentice-Hall, Upper Saddle River, New Jersey.
Eiteman, David K., Arthur I. Stonehill, and Michael H. Moffett, Multinational Business Finance, 2006, 11th Edition, Addison-Wesley Publishing Company, Reading, Massachusetts.
Madura, Jeff, International Financial Management, 10th Edition, 2009, South-Western, Cengage Learning, Cincinnati, Ohio.
Shapiro, Alan C., Multinational Financial Management, 2009, Ninth Edition, Wiley, Hoboken, New Jersey.
Edwards, Franklin R. and Cindy W. Ma, Futures and Options, 1992, McGraw-Hill, Inc., New York, New York.
Two excellent Web resources:
Exchange rates, http://www.bankofcanada.ca/en/rates/exchform.html.
Economic Research, Federal Reserve Bank of St. Louis, http://research.stlouisfed.org.
The discussion example and question;