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Module 1: The World of International Finance and the Multinational Corporation I.
The World of International Finance and the Globalization of International Financial Markets: A. The World of International Finance B. Globalization of Capital Markets The Multinational Corporation A. The Multinational Corporation and its Goal B. Conflicts and Constraints in Implementing the Goal Theories of International Business A. Theory of Comparative Advantage B. Imperfect Markets Theory C. Product Cycle Theory Methods of International Business A. International Trade B. Direct Foreign Investment C. Licensing D. Franchising E. Joint Ventures Multinational Firm versus Domestic Firm A. Marginal Return on Projects B. Marginal Cost of Capital C. Size of the Firm Risks of International Business A. Exchange Rate Risk B. Business Risk C. Political Risk Answers to Questions Raised in the Lecture
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
Currency Options Questions and Problems
Module 3: Arbitrage and the Theory of Interest Rate Parity I.
International Arbitrage and Interest Parity A. International Arbitrage 1. Locational Arbitrage 2. Triangular Arbitrage 3. Covered Interest Arbitrage B. Theory of Interest Rate Parity Purchasing Power Parity International Fisher Effect
Module 4: Forecasting Exchange Rates I. II.
Why Multinationals Forecast Exchange Rates? Forecasting Techniques A. Technical Forecasting B. Fundamental Forecasting: Regression Approach C. Market Based Forecasting D. Mixed Forecasting Forecast Performance of Consulting Firms Assessment of Forecast Accuracy Over Time A Comprehensive Regression Example Forecasting Performance and Market Efficiency Questions and Problems
III. IV. V. VI. VII.
Module 5: Currency Futures, Forward Contracts, and Options I.
Currency Futures A. Interpreting Currency Futures Quotes B. Speculating with Currency Futures C. Hedging with Currency Futures Forward Contracts and Hedging Currency Options A. Call Options 1. Interpreting Currency Call Option Information 2. Speculating with Call Options 3. Hedging Payables with Call Options 4. Factors Affecting Call Option Premium B. Put Options 1. Interpreting Currency Put Option Information 2. Speculating with Put Options 3. Hedging Receivables with Put Options
Factors Affecting Put Option Premium
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
Module 7: Case Analysis of Foreign Exchange Risk Management: Lufthansa I.
Evaluation of Hedging Alternatives A. Remaining Uncovered B. Full Forward Cover C. Partial Forward Cover D. Foreign Currency Options E. Buy Dollars Now The Decision A. The Rise of DM B. The Fall of DM C. How It Came Out?
and a rapid evolution of innovative new financial products. On the innovative side. they have a wider variety of opportunities around the globe. The Wealth of Nations. New York. With additional opportunities come increased potential returns and other forms of risk to consider. Amsterdam etc.. If a foreign country can supply us with a commodity cheaper than we ourselves can make it. V. Paris. Frankfurt. 1776). and investing activities. The potential benefits and risks are introduced and explained Globalization of Financial Markets For more than 25 years. enhancing various borrowing. Financial integration refers to the elimination of barriers between domestic and international financial markets and the development of many linkages between these market sectors. however. Objectives and Theme: Our first objective is to discuss the exciting world of Global Financial Markets. there has been the creation of new financial instruments and technologies. II. Tokyo. syndicated Eurocurrency loans. Hong-Kong. better buy it of them with some part of the produce of our own industry employed in way in which we have some advantage" (Smith. zero-coupon Eurobonds. leading to deregulation of domestic financial markets and further liberalization of capital movements around the globe. Questions Module 8: Corporate Use of Innovative Foreign Exchange Risk Management Products I. . IV. Zurich. VI. Increased flows of world capital intensifies competition among nations. our second objective is to learn the Characteristics of the Multinational Corporation (MNC). Some of these instruments include Eurodollar CDs. III.D. This has led to the global presence of international financial institutions. A worldwide financial network of financial centers consisting of London. financial capital flows unrestricted between the two markets. lending. has evolved. increased financial integration. 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 Module 1 : The World of International Finance and Multinational Corporations "What is prudence in the conduct of every private family can scarcely be folly in that of great kingdom. we find that MNCs have goals similar to that of the purely Domestic Corporation (DC). As a result. there has been an increasing globalization of the world financial markets.
stockholders are the true owners of the corporation. which company led the list in terms of revenues for the latest year or quarter? And what was its revenue? Conflicts and Constraints in Implementing the Goal Conflicts: In the corporate form of organization. the stockholders are the principals. How does the stock price maximization objective consider the time value of money ? The answer to this question is at the end of this Module. Can you name the company that recorded the highest profit increase within the lastest year or quarter? 2. How does maximizing stock price consider the riskiness of cash flows ? The answer to this question is at the end of this Module as well. It also considers the riskiness of the cash flows of the MNC. Thus. please check your knowledge by answering the following questions. 1. The global 500 corporations have been ranked by revenues. stockholders select managers to operate and manage the corporation from day-to-day. Maximizing the Shareholders' Wealth confers the following Advantages: 1.interest and currency swaps. In this setup. Which US company had the highest revenue within the lastest year or quarter? What was its rank in terms of revenue in the previous year or quarter? 4. information dissemination. Stockholder Wealth equals Stock Price * # of Shares Outstanding. the top manager may go for a corporate jet. There are often millions of stockholders for a given corporation. An idea of the biggest Fortune 500 global industrial and service companies ranked by various criteria can be obtained from visiting Fortune. Technological innovations in telecommunications. therefore. For example. and the managers are the agents. Sometimes the managers. instead of acting in the best interests of stockholders. install his office . The goal or objective of the MNC should be the maximization of stockholders' wealth or the stock price. there is an agency relationship between the stockholders and the managers. may act to maximize their own interests. It considers the Time Value of Money. This objective is the same for purely domestic corporations as well. Which company headed the list in terms of revenues? And how much was the revenue of that company? 3. 2. there is also a country wide ranking available using various criteria. and computers have accelerated and reinforced this trend toward globalization The Multinational Corporation Multinational Corporation (MNC) and its goal: We can define an MNC simply as a corporation operating in more than one country. and floating rate notes. Based on the information from the Fortune list of Global 500. In the Pharmaceuticals industry. and.
the agency costs of an MNC are higher than for purely domestic corporations. . earnings remittance restriction. Regulatory: Each host country can enforce taxes. These constraints can act as a drag on the goal of maximizing stockholder wealth. Imperfect Markets Theory: Due to imperfect markets and the resulting immobility of resources. Product Cycle Theory: A firm is likely to market its product first in the home country due to the ready availability of information about markets and competitors. In this setup. labor etc. seeking foreign demand. consider a two country world of the USA and Japan. initially exports its product. These problems are called agency problems. Environmental: Each country imposes its own environmental regulations. Let us also assume that the US has cost advantages in the production of automobiles. and the costs are called agency costs. Ethical: There is no consensus standard of business conduct that applies to all countries. Since both products are produced at the lowest possible cost. install plush carpeting. All of these constraints add additional costs to the MNC and increase the cost of doing business. Theories of International Business Theory of Comparative Advantage . and 3. resources cannot be easily and freely retrieved by the MNC. there is a need for international business or trade.in a penthouse suite overlooking the Hudson river.S. Since specialization in some products may result in no production of some goods in a given country. Constraints: The constraints in implementing the goal of the MNC are: 1. job protection. A business practice that is considered to be unethical in the U. may be totally ethical in another country. Consequently. the MNC must sometimes go to the resources rather than retrieve resources such as low cost land. As the market in the home country matures. Figure # 1 provides a flow chart of Product Cycle Theory. Because MNCs have subsidiaries around the globe and often have several layers of management. These agency costs affect the cash flows and. the corporation. therefore. Let us assume that Japan can produce television sets of comparable quality at a cheaper price than the US. or hire a pretty secretary. An example would be US auto manufactures setting-up factories in Mexico to take advantage of the lowcost labor there.Specialization: Specialization of products and services can increase both individual and global efficiency. After learning more about the foreign country and how to gain advantage over competitors in foreign countries. the US will import television sets from Japan. while Japan will import automobiles from the US. For example. 2. the firm opens production facilities overseas. global efficiency is enhanced. the stock price.
All Rights Reserved. and Product Cycle Theory. the disadvantage is higher transportation costs. The best-known and most successful international franchisors have been the fast-food chains such as Kentucky Fried Chicken.Note: This Figure is reproduced from permission from International Financial Management. Question: Do you think that the three theories of international business. Imperfect Markets Theory. or services rendered. Methods of International Business International Trade: Exporting: A business firm may maintain its production facilities within the territory of its home nation and export its products to foreign countries. Copyright © 2000 by West Publishing Company. Theory of Comparative Advantage. a portion of the revenues. The availability of these inputs makes it possible for the licensee to produce and market a product or service similar to that which the licensor has been producing. one business firm. Direct Foreign Investment (DFI): A business firm located in one country may acquire facilities that enable it to produce a product or render a business service within the territory of another country. The advantage of this approach is lower fixed production costs. the licensor. are complementary or competitive? Provide justification for your answer. An essential element of DFI is the investor's involvement in the management of the productive assets. makes certain resources or "inputs" available to another business firm. are sent to the licensor. Exporting is a safer way to break into a new market since there is less to lose if the strategy fails. Burger King. Sixth Edition. Jeff Madura. as specified by the agreement. Advantages: 1) Low cost and 2) low risk. Licensing: In a licensing arrangement. Franchising is a form of licensing that has spread rapidly throughout the world in recent years. the licensee. . As the goods are sold. The investor has total managerial control. An MNC may initiate DFI by either establishing a new subsidiary. opening a factory or purchasing an existing company in that country. but. and McDonald's.
MNCs have additional opportunities. Copyright © 2000 by West Publishing Company. an MNC is likely to attain a larger size compared to a DC. in turn. Question: Do you know why the marginal cost of capital curve (MCC) is upward sloping? . lower cost. gains a foothold in the country and gains a market share. two or many firms combine to create a subsidiary. and. the marginal rate of return from a project is higher for the MNC as opposed to the DC. As long as the MR is greater than or equal to the MCC.Disadvantages: 1) The local firm in the host country may attempt to export the goods to another country. that is. With higher return. Sixth Edition. The intersection of the MR and MCC curves determines the projects that will get accepted. For example. Figure # 2 provides information on the marginal return and marginal cost for MNC and DC. Besides. the cost of capital for MNCs is cheaper than that for domestic corporations (DCs). Note that the marginal return (MR) is higher. Jeff Madura. therefore. Also. Usually. Impact of Foreign Opportunities on Firm Size MNCs have cost advantages over domestic corporations. but the marginal cost of capital (MCC) is lower for a MNC compared to a DC. All Rights Reserved. and 3) Technology secrets provided to the local firm may leak out to competitive firms in that country. MNCs have greater opportunities for more profitable projects. a corporation in a developing country can combine with a US based MNC to gain technological advantages. and additional opportunities. FIGURE 2 Note: This Figure is reproduced from permission from International Financial Management. Joint Venture: In the case of joint venture. which may reduce sales of the licensing corporation. 2) It is difficult to ensure quality control of the local firm's production process. each firm provides the resources in which it has the advantage. the projects will be accepted. The US firm.
This is the exchange rate risk that the MNCs face in handling their foreign currency flows. Based on this exchange rate. In addition. Risks of International Business Exchange Rate Risk: Exchange Rate Risk is defined as the variability in home-country cash flows due to the fluctuations in the host-country exchange rates.9 million more than it anticipated to pay at time=0. $0. its stability and the form of the legal system etc. the DM appreciated. 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. The exchange rate at t=+90 days when the payable bill was paid. .50 per DM 2. Question for interactive table above Please change the t=+90 days exchange rate from $0. For example.9 Extra Cost In this case.1 million.661 per DM.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.The optimal size of an MNC will be determined by a variety of factors.75 per DM. and industry type. such as the economic and political environment of the foreign governments. operating characteristics. $1.661 66. etc. the form of the government. turned out to be $0. This risk can affect both the revenues and costs of an MNC negatively. risk-return preference.75 75 8. 3) Change in taxation policies in mid-stream. will affect the political risk of a country. This risk arises from the need to convert the cash flows from one currency to another. ABC anticipated an outflow of $66.1 100 Million Plus 90 days 0. Suppose. thereby increasing the $ cost of the payables in DM. MNCs would not face the daunting problem of exchange rate risk. consider the following example: ABC Corporation (US based MNC) has DM 100 million in 90-day payables owed to a German firm for imports from the firm. the exchange rate right now (t=0) = $0. MNCs will not face exchange rate risk.75 per DM to: 1. ABC Corporation paid $ 8. Given: ABC Corporation (US-based MNC) has DM 100 million in 90-day Payables 90-day Payables Time=t Spot Exchange Rate $/DM $ Cost DM 0 0. If there is no need to convert the currency. MNC's product line.
S. we learned about some features of the World of International Finance and we noted the increasing globalization trend sweeping the markets. Thus. the sovereignty of each country as we know it today would be violated. therefore. Why is the marginal cost of capital (MCC) upward sloping? If a corporation has debt in its capital structure. 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. In addition. it is inherently risky. The three theories address different dimensions of international business. Imperfect Markets Theory. END OF MODULE 1 Module 2: Foreign Exchange Markets . the objective of stock price maximization considers the riskiness of cash flows as well. If there were a single currency throughout the globe. 2. we looked at the characteristics of the Multinational Corporation and its objective. 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. maximizing stock price automatically considers the time value of money. it turns out that multinational corporations enjoy higher possible returns. would be affected as well. Are the three theories of international business complementary or competitive? The three theories are more complementary rather than competitive. thereby. Answers to Questions Raised in the Lecture 1. and inflation etc. Summary In this module. 5. and. and Product Cycle Theory. What do you think about its feasibility ? What other problems could that create? If we had a single currency. there would not be exchange rate risk. but they also face more risks. 3. one can use a higher discount rate. MNCs in these markets.Business Risk: Business risk arises from host country business and economic conditions. we also compared and contrasted multinational corporations with purely domestic corporations with regard to return and risk. depending on the riskiness of the cash flows. the banks will be willing to lend additional money only at higher interest rates. We are already witnessing these kinds of problems with the European integration and its single currency ECU evolution. 4. MNCs. we discussed the theories of international business: Theory of Comparative Advantage. That is why the MCC is upward sloping. Therefore. S. Slowing or weakening Japanese and European markets often leads to reduced demand for products of U. in the context of the MNC. In addition. one can use a lower discount rate. The ability of the Central Bank of each country to control monetary policy and affect exchange rates. one can use different discount rates: if the risk is higher. and if the risk is lower. contributing to the business risk of the U.
currencies trade around the globe on a 24-hour basis. the net turnover in the global foreign exchange market amounted to 1. they have to convert the US dollar to the Japanese yen to do so. these exports are denominated in British pounds. which has imported merchandise from a German firm. Futures contracts. The participants in this group buy and sell currencies essentially for their liquidity needs arising from trade and investment transactions. let us assume that these imports are denominated in German marks. Introduction: Unlike stock markets. a US based MNC. These banks also do speculative trading based on "privately informed opinion about market expectations of price trends. there is no one place where currencies trade. ABC Corporation has to resort to the foreign exchange market to buy the German marks to pay for its imports. central banks. they need to convert the home currency. which accounts for 30 percent of all transactions. followed by the German mark. As of April 1998. The US dollar accounts for 83 percent of all global foreign exchange transactions.5 trillion dollars a day!1. ABC Corporation. Now. and T-bonds etc. and the Japanese yen with a share of 24 percent of all transactions. Similarly. the second objective is to study the pricing of one currency relative to another in terms of direct and indirect quotes. and customers. and Options are briefly explained. . a secondary network of 4000 or so second tier banks. In fact. 3.. corporations. 1 Bank for International Settlements: Central Bank Summary of Foreign Exchange and Derivatives Market Activity. the Japanese yen. these major banks act as market makers by buying and selling various currencies. and open market operations of central banks. tertiary network of corporations. XYZ Corporation located in London exported merchandise to an Indian company. which have a physical location of their own. fund managers. a primary network of about 150 major international banks with 1000 affiliates spread around the globe. to US dollars before they can invest in the US.Objectives and Theme: This segment introduces foreign exchange markets. This compares with a market turnover of $820 billion in 1992 and 590 billion in 1989. According to Zaheer (1995). Likewise.82 trillion dollars! London. governments. bid and ask prices are introduced and explained. it would be helpful to know that the US annual real GDP is about 6. the concept of buying and selling currencies for future needs using Forward contracts. Thirdly. New York and Tokyo dominate the currency markets. Let us first consider a trade related foreign currency need. To understand the enormity of this market. let us look at an investment based need for foreign currencies. The first objective here is to learn the characteristics of Spot Markets and the Forward Markets. representing an annual growth rate of 12 percent and 14 percent per year respectively. The Indian importer has to buy British pounds to pay for its imports. the foreign exchange market consists of: 1. and by quoting two-way bid-ask prices all the time." 2. Finally. which are involved both in speculative trading and trading with customers. Consider for example. If Japanese individuals and institutional investors want to invest in US bond market securities like T-bills. if US individuals or institutional investors want to invest in Japanese stock markets. 1998 Need for Foreign Currencies The need for foreign currency arises in the context of trade and investment needs of individuals.
or quotes.4422 0.416 2.6924 0.6880 0. these markets are identified by the nature of transactions. and. $ equiv. Table 2.0001 0.6627 0.5108 1. currencies are bought and sold for immediate conversion and delivery.6627 0. This table is a reproduction of Exchange Rate Quotes from the Wall Street Journal of February 8. the two types of Quotes are: 1. Currencies can also be bought and sold for deferred delivery in the future. 2001.5461 0. Country Argentina (Peso) Australia (Dollar) Austria (Schilling) Bahrain (Dinar) Belgium (Franc) Brazil (Real) Britain (Pound) 1-month forward 3-months forward 6-months forward Canada (Dollar) 1-month forward 3-months forward Thursday 2/8/2001 1.Foreign currency needs also arise for travel. $ Wednesday 2/7/2001 0.6629 Currency Thursday 2/8/2001 0.5352 0.4543 1.06675 2.3770 43. therefore.0228 0. The market where Spot transactions occur is called the Spot market. Spot Markets versus Forward Markets In Spot transactions. Direct Quote. please look at the table Currency Trading: Exchange Rates.5085 .0025 0.6525 0.6876 0. if someone from the US wants to travel in London for entertainment and shopping.4994 1. or quotes.3770 43. as well.5090 1. and charitable giving needs. Direct Quotes versus Indirect Quotes There are two ways in which the price of one currency can be quoted relative to another currency.0230 0.6620 Wednesday 2/7/2001 1.5110 1.5089 1.4523 0. Likewise.9915 0. with respect to the US dollar.981 0.5021 1.9999 1.6875 0.0001 0.S.6923 0.S.1: Exchange Rate Quotes from WSJ. also called US $ Equivalent.5105 per U. To understand the Direct Quote. while the prices at which currencies are bought and sold for future needs in the forward markets are called Forward prices. education. Obviously.917 1. The markets where such deferred transactions occur are referred to as Forward markets.8686 14.4443 1.810 0.9999 1. The prices at which currencies are bought and sold for spot transactions in the Spot markets are called Spot prices.8310 14. 2/8/2001 U. he or she has to pay for the trip in British pounds.4435 1. they must convert their Korean Won to US dollars to do so. the US resident has to convert the US dollars to British pounds. For the US.4445 1.6934 1. if Korean nationals want to go to a US university for furthering their educations. they do not trade in separate places ! You may wonder why anybody would want to buy or sell currencies in the future. In other words.6525 0. Buying and selling currencies in the future is done based on future foreign currency needs.4545 1. refers to the # of units of US dollar per one unit of the Foreign Currency.6886 1.6928 0. the home currency is the US dollar.06752 2. For example.6619 0.6618 0.4535 1.
1330 2107.003460 0.0004461 0.50 37.4168 0.0486 7.6-months forward Chile (Peso) China (Renminbi) Colombia (Peso) Czech.200 1.2758 0.008678 0.008805 1.5303 48.1208 0.1293 2.9920 1.3717 2.4754 0.4730 7.4710 0.87 7.008781 1.7110 0.0990 366.86 114.93 113.4704 0.7994 289.7955 58.6835 2.405 9651.1037 2.4442 0.4065 3.0555 7.1401 0.23 113.4216 0.02155 0.1798 0.57 0.4758 0.00 3.4065 3.8873 59.2616 0.008572 0.1282 0.4351 0.7110 0.73 7.2983 8.6623 0.2831 0.002727 0.1231 1.5079 562.02060 1.001778 0.3991 2.1050 2.2420 0.1245 1.92 116.0000 6.89 0.02656 0.895 3.1563 0.0004455 0.1400 0.1421 0.02682 0.2763 2244.01695 0.1370 7.2680 0.63 46.00 0.1396 2083.0000 6.1403 0. Rep.7999 285.1419 0.1251 1.4427 9.5098 559.0001036 1.0004799 0.2833 0.8000 0.1016 2.02155 0.1033 0.4764 0.0001036 1.0006605 0.02075 0.2416 0.0396 2.3991 7.19 115.4751 0.1416 0.2589 0.1137 0.1280 2.1417 0.008701 0.3060 1514.1033 0.1545 0.00 3.2765 2241.2632 2.1233 370.652 8.4394 9.008607 0.1663 0.8476 4.0000 0.1404 0.1282 0.002696 0.4696 0.8574 4.5320 48.400 9651.8000 0.4699 0.0004744 0.1211 2.33 115.288 7.01698 0.1300 7.6632 0.1125 0.001787 0.008631 0.0000 0. (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) 0.1412 7.0598 7.1259 2.2512 8.66 116.6835 2.1208 0.000 3.2632 2.0006605 0.88 37.35 8.01 46.00 0.008596 0.003501 0.550 .3066 1514.65 8.96 116.
1293 DMs.001425 1.02106 0.005584 0.4445 per British pound.7475 47. means one US $ is worth 7.7506 1.03104 0.4445 on Thursday should be read as US $ 1. A quote of 0.7506 1.03509 0. considering the Direct Quotes for the British pound.4696.2666 0.4445. the Thursday Indirect Quote is 0.0598 for the FF on Wednesday means that one US $ is worth 7.07958 0. Likewise. US $ Equivalents.6923 per US $.562 3.6047 0.14 9.4696 per Mark.51 0.9292 4.005521 0.6700 1.2932 0.2431 0. The indirect quote of 2.1050 of the DM for Wednesday.7698 1.220 42.6076 0. Whenever a given country quote appears more than once.6536 1.5988 0.9850 1266.0520 215. the country name appears.0762 1.620 682170.03104 0.0007899 0.2723 0.8900 1263.6016 0.26 28.1252 0.0598 FF. For the British pound. Let us consider Germany (Mark): The very first line for Germany represents the Spot quote.4751 in US $ Equivalent for Wednesday should be read as US $0.1400 per French Franc.02343 0. the quote of 0. read as 2. .1293 appearing across Germany (Marks) for Thursday under column 4 should be read as 2.6459 1.2666 0.00 3. read as Franc (FF) 7.5550 1.2990 0.07 9.1035 0. Likewise. Once again.004582 0.1050 DMs per US dollar.6673 1. Recall that Spot quotes represent the prices quoted for immediate conversion and delivery.00 181.6923.9186 0. This means one Mark equals US $ 0.5722 0.2468 0. read as BP 0. or Direct Quotes are given. This means one French Franc is worth 0.1412 French Francs.483 7.77 28.6550 32.6730 12. let us examine the French Franc. In the first column.001426 1.004635 0.7483 47. The Quote of 0. the indirect Thursday quote of 7.4696 in US $ Equivalent for Thursday translates to US $ 0.566 701.0886 4. (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 0.5998 0.00000147 0.75 0. For another example.6610 1.7733 1.1400 for France on Thursday should be read as US $ 0.1412 for France.6387 32.50 179.1293 Mark (DM) per US dollar: this means one US dollar is worth 2.Poland (Zloty) [d] Portugal (Escudo) Russia (Ruble) [a] Saudi Arabia (Riyal) Singapore (Dollar) Slovak Rep.0007915 0.03501 0.4751 per Mark. The quotes are given for Wednesday.1267 0.568 701. the very first line always represents the Spot Quote.6042 0. 2. The quote of 2. A quote of 7.1412/US$. under the heading Currency per US $.6510 1. Once again.6622 1.1135 218.6923. February 8th.1050 DMs for one US dollar.6730 12. In the second and third columns. implying one US $ equals BP 0.6102 0.497 3.02346 0. In a similar fashion. translates into a value of 2. February 7th and Thursday.02125 0. the very first line for that country represents the Spot Quote. consider the Spot Quotes for Germany.07957 0.059 7. This means one British pound equals US $ 1.2723 0.685 678130.1047 0.00000147 0.6057 0.5720 0.1400 US dollar.00 3.220 42. The Indirect Quotes are presented in columns 4 and 5 of the Currency Trading: Exchange Rates table. a quote of US $ Equivalent of 1.
00 0.2458 2.00 552.70 1.F.00 1210.8948 14. Franc Dollar Ngultrum Boliviano Boliviano Convtbl Mark Pula 2/16 4750.0866 7.07 2. February 16.00 713. Table 2.4696. the Direct Quote for FF for the same day The World Value of the US Dollar The World Value of the US dollar for several global currencies are presented below.43 6.A. we already know that the Direct Quote for the Mark on Thursday is 0.00 1.1314 5.8226 1. 2001.Given a Direct Quote.377 54.1391 18.00 73.07 2.00 714.18 1.1286 5.00 43.00 43.1293.00 46.2458 2.10 2. For example.00 181.9952 4558.9124 1.8645 14.97 1.1482 18. Source: Wall Street Journal.5233 2/9 4750. we get 0.4696.9761 4558.00 553.93 181. we get 2.79 1.70 1.1400 .395 6.4575 6. the Indirect Quote of the Mark for Thursday.1412.79 1.00 142.00 143.00 1210.3175 7. Similarly.00 0.377 54.904 2.13 2. if we take 1/0.00 1. if we take the reciprocal of the Indirect Quote of the FF for Thursday: 1/7.96 2.70 74. 2/16/2001 Country Afghanistan Albania Algeria Andorra Andorra Angola Antigua Argentina Armenia Aruba Australia Austria Azerbaijan Bahamas Bahrain Bangladesh Barbados Belarus Belgium Belize Benin Bermuda Bhutan Bolivia Bolivia Bosnia Herzegovina Botswana Currency Afghani Lek Dinar Peseta Franc Readj Kwanza E Caribbean $ Peso Dram Florin Australia $ Schilling Manat Dollar Dinar Taka Dollar Ruble Franc Dollar C.515 6.5556 .2: World Value of the US Dollar from WSJ. one can get the Indirect Quote by taking the reciprocal of the Direct Quote and vice-versa.00 46.
95 8.4999 713.00 28.75 713.A.F.F.30 25000.F.F.067 3835.00 713.75 714.671 535.9124 320.9905 1.489 1. People Rp Costa Rica Croatia Cuba Cyprus Czech Denmark Djibouti Dominica Dominican Rep Ecuador Egypt El Salvador Equatorial Guinea Estonia Ethiopia Norweg.4999 714.82 713.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.25 Renminbi Yuan 8.8843 8.00 2.14 714.A.00 3.5902 37.5899 734.117 4.984 0.A. Franc C.82 714.9124 6.575 8.A.A.5099 119.9124 1.8226 518.0943 175.8226 17.833 8. Krone Real Dollar Lev C.063 3835.10 8.8631 1.70 16.68 8.50 28.50 2.989 0.8226 714.2005 173.5334 119.2764 2242.8226 1.4343 4.1866 8.00 714.F.00 1.37 559.5703 37.688 536.1195 713.30 25000.7485 2.00 1.9124 713.9777 8.70 16.9885 1.0083 1.7409 2.277 .37 562.00 3.8226 6.A.8843 8.9124 518. Franc Peso Peso Peso Rouble Franc Congolese Fr C. Franc Colon Kuna Peso Pound * Koruna Danish Krone DjiboutiFranc E Caribbean $ Peso Sucre Pound Colon C.F. Franc Kroon Birr 9. Franc Dollar Escudo Dollar C.9124 16.13 8.825 2238.5949 734. Franc Kyat Franc Riel C.8226 321.3718 1.
00 180.19 7.8021 713.4793 7.00 15.2005 1.1482 1.F.97 2.1391 1.4575 9650.70 7. Franc Dalasi Lari Mark Cedi Pound * Drachma Danish Krone E Caribbean $ Franc U.40 1.7997 291.8065 714.9124 15.00 7.50 23.40 46.40 1.8215 713.815 86. Franc Dollar 0.F.20 0.9676 714.00 180.3124 1.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.7992 288.00 1752.1391 7.4449 369.3124 1. Franc Franc Dollar Gourde Lempira Dollar Forint Krona Rupee Rupiah Rial Dinar Punt * New Shekel Lira C.04 85.8226 45.9124 45.0943 1.A.1391 129.9177 8.8226 1865.S.0943 2.00 15.2346 6.91 46.515 9600.3442 .00 1.4541 371.00 1.09 1752.19 7.967 2.00 7.4711 7.64 8.F.A.8226 15.4541 2.2284 6.50 0.70 7.1286 7100.1314 7300.50 23.118 713.1667 4.20 2110. Franc C.1652 4.106 714.A.2005 2.P.9124 1865.1482 7.0311 2107.4449 2.F.3289 8.50 0.9188 8. $ Quetzal C.1482 129.
00 0.00 80.8645 .6199 1514.684 12.25 7.80 3.8948 2.1391 250.30 3.0566 6400.711 145.1482 1063.711 145.00 2.8226 2. South Kuwait Kyrgyzstan Laos.20 1251. North Korea.35 78.9991 43.77 713.00 7.50 0.3833 7.F.8645 2.00 0.904 8.8863 1.1482 251.985 9.70 10.70 10.221 7600.00 7.35 78.00 2.80 11.1391 1099. 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.06 1.2571 7.77 714.304 7600.00 7.2456 7.3066 48.5357 1.285 1.862 1. Franc Lira * Franc Ouguiya Rupee New Peso Lei Franc Tugrik E Caribbean $ Dirham Metical Dollar Australia $ 116.683 0.687 3.3436 7.999 43.6995 17050.5357 1.96 8.80 11.468 0.9675 1.00 0.3067 49.00 80.8948 116.7005 12.975 9.9124 2.Japan Jordan Kazakhstan Kenya Kiribati Korea.95 1.695 27.20 1266.6649 3.70 27.7625 16900.0571 6400.00 0.6209 1514.Franc Pataca Franc Kwacha Ringgit Rufiyaa C.A.00 0.
S.Nepal Netherlands Netherlands Ant'les Netherlands Ant'les New Zealand Nicaragua Niger Rep Nigeria Norway Oman.7504 74.00 3.00 3.F.00 3.Z.1005 218. $ Tala Lira Riyal 74.70 1.4449 2.S.Z.00 2. American Samoa.8631 0.70 7.1951 1.9124 111.6408 64. Sultanate of Pakistan Panama Papua N.1391 2.3442 Sao Tome & Principe Dobra .4015 1.90 713.385 59.3478 2390.0311 2107.671 359.79 1.Dollar Gold Cordoba C.90 714.8226 111.1496 3700.Dollar Zloty Escudo U.0281 2.458 7.3345 4.00 3.2991 4.045 161.0628 3670.98 3.5268 48. Paraguay Peru Philippines Pitcairn Island Poland Portugal Puerto Rico Qatar Repub of Macedonia Republic of Yemen Reunion.3984 1.0281 2.50 28.3345 12.4733 1.045 161.70 7.1637 2.1482 2.688 359.00 3.00 3.G.00 28.80 8.1482 26864.79 2.5125 1.00 3.A.4677 2.79 1.00 3.108 218.0083 0.458 7.50 9.1391 26722.4541 2110.20 2.70 1.3478 2390. $ Riyal Denar Rial Franc Leu Rouble Franc E Caribbean $ E Caribbean $ Franc E Caribbean $ U. Franc Naira Norweg. Western San Marino Saudi Arabia Rupee Guilder Guilder Florin N.79 2.6408 64.2991 12.5303 48.70 2.98 3. Krone Rial Rupee Balboa Kina Guarani New Sol Peso N.385 59.70 1.7504 Pound Sterling * 1. Ile de la Romania Russia Rwanda Saint Christopher Saint Helena Saint Lucia Saint Pierre Saint Vincent Samoa.195 1.
00 7.S.95 9. Franc Pa'anga Dollar Dinar Lira U.3442 .8863 181. Franc Rupee Leone Dollar Koruna Tolar Solomon $ Shilling Rand Peseta Rupee Dinar Pound Guilder Lilangeni Krona Franc Pound Dollar Shilling Baht C.F.00 981.6649 52.6729 1.1099 2620.50 42.00 141.22 1.3175 86.00 7.7485 47.1099 2620.8226 2.89 5.6729 713.0311 2107.80 701.00 5.00 1.49 1899.687 52.663 1.0101 6.4298 3.595 713.465 714.00 681280.4541 Peso Uruguayo 11.F.3949 1.8226 6.3925 Sum Vatu Lira Bolivar 775.09 256.00 1.7064 32.A.8863 9.4289 3.95 181.9124 6.00 981.8645 1815.00 141.285 812.24 1.3125 233.095 1.00 5.81 5.3925 775.0096 6.00 7.00 7.3878 1.75 686255.8948 1815.A.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.00 2560.0866 86.90 2110.80 702. $ Australia $ Shilling Hryvnia Dirham 714.00 42.81 256.45 1899.274 815.00 2560.7064 32.9124 2.7409 48.4449 11.017 236.00 Pound Sterling * 1.841 1.095 1. Rep Tonga Islands Trinidad & Tobago Tunisia Turkey Turks & Caicos Tuvalu Uganda Ukraine United Arab Emir United Kingdom Uruguay Uzbekistan Vanuatu Vatican City Venezuela C.
00 1.Vietnam Virgin Is. Ille de la? Or for that matter. then it implies appreciation of the currency over time. Can you compare the value of South Korean Won on February 16th with its value on February 9th.1) = . Kenya. you can get the direct quotes for the Won by taking the reciprocals of the indirect quotes in this table.00 55. and. for the South Korean Won. Jordan. get the value of South Korean Won in Rupees. If percent change were negative. Holland. Egypt. Vatican City. Further. Germany. Bolivia. the rate given for February 16th is 1251. Finland. $ U. US Yugoslavia Zambia Zimbabwe Dong U.00 1. figure out how many Won equal one Indian Rupee? Then. which should be read as South Korean Won 1251. 2001.4696 3675. If percent change were positive. and another for Friday.50 per one US dollar. and figure out whether or not the Won appreciated or depreciated with respect to the US $? Remember to use direct quotes to do that.50 1.00 55.00 64. Singapore. get the value of # of Indian Rupees per South Korean Won Computing Percent Change for a Foreign Currency One can compute the Percent Change for a currency as follows: Percentage Change for a Currency = (St . and Zaire? By visiting the Foreign Exchange Rates site. For example. Taiwan. Panama. Can you tell me the value or price of the Indian Rupee in terms of South Korean Won? That is. St = Spot Rate for more recent period t. February 9th. Chile. Nepal. Br Virgin Is. Qatar. Where. February 16th. you can convert one currency to another currency using the latest quotes. Be sure to visit the site. Uganda. Oman. $ New Dinar Kwacha Dollar 14582. That is. Denmark.50.S. Libya.00 The rates given are in terms of # of Units of Foreign Currency per one US dollar.00 63. In computing the percent change for a foreign currency from the US perspective. The values are given for two different dates: one for Friday. India. can you name the currencies for Algeria. Madagascar.S.6537 3525. 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. Please note the fact that this quote is in indirect form. St-1 = Spot Rate for last period t-1.00 1. then it implies depreciation of the currency over time.St-1 ) / St-1 * 100 .10 14578. always use the direct quote. Let us compute the percent change for the DM from Wednesday (t-1) to Thursday (t) : Percent change in DM from Wednesday to Thursday from the WSJ (Table 2.
by dividing by the Bid price.1050] * 100 = + 1. Ask Prices quoted for the Mark: Bid = $ 0. Ask Prices. it will cost you: Ask Price * # of Marks being bought = 0. Every time the currencies are bought and sold.1544 percent. Every time you buy a given currency.1293-2. The bid and ask prices are further explained below: BID-ASK PRICES Foreign Currency Bank/Foreign You/MNC Exchange Dealer Buy Sell Sells Buys Ask = Mininum price the bank will accept for the currency in question Bid = Maximum price the bank will pay for the currency in question Bank Quotation Suppose for example.2701 percent.4724 * 100 = US $ 47.4664)/0.4664 * # Marks being bought = US $ 46. there are two separate prices quoted for currencies: one for buying and the other for selling.0.4724 . If we were to compute the percent change in the US $ with respect to the DM for the same period.24 If you want to sell 100 marks.1577 percent. and Bid / Ask Percent Spread At any given point in time. Bid. the foreign exchange dealers make a profit. one can compute the discount with respect to the Ask price.2701 percent with respect to the Bid price. This means. This should be read as the Ask price being at a premium of 1.4696-0. over a one day period.4724/DM If you want to purchase 100 Marks.64 The Bid/Ask Percent Spread is given by: [ (Ask . It is customary to express the Bid/Ask Percent spread as a premium with respect to the Bid Price . the following are the Bid.Bid) / Ask ] * 100 = [(0.1050) / 2.4751] * 100 = -1.4751) / 0.1577 percent with respect to the US $. its buying price is always greater than its asking price.[(0. Obviously. 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 = [(2.4724] * 100 = 1. the DM depreciated by 1. you will receive = Bid price of 0.4664/DM Ask= $ 0.
72046 . Likewise. 5. If we read across France and down the Dollar column.6835 Euro Pound SFranc Guilder Peso Yen Lira D-Mark FFranc CdnDlr 4.46964 .09694 .05534 54.14003 .3 878.21989 .7261 1.3538 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..069 .1293 per US dollar.6359 .33595 1.15604 .0758 per pound .70962 .65186 .29817 1.45816 1.65 217.00339 3.73746 ..3880 2.17246 .15244 .1293 per US dollar.S.3560 6. this should be read as FF 7.. 1.78430 ... 1.00459 4.4087 Netherlands 2.1412...28856 .69 18...69609 . .32512 . .00101 .3538 .K.3538.2762 2.00047 .1412 / 2. that is the # of FFs per DM is calculated as: [FF / US $] : [DM / US $] = 7..3155 4.4 3045.7985 4.336 77.51125 .08860 .1293 2108.88754 . 989..45376 . The cross exchange rate of the pound with respect to DM. the quote given is 2..00593 .59880 .00933 .08301 . # of DMs per pound.2750 .5878 . the same rate we calculated just now! To look at yet another example of the cross exchange rate.. this should be read as Marks 2.1052 . Likewise..1412 2.01295 .06121 ....00114 1.66 9.5477 1.69230.1293.69230 = Marks 3.3991 Switzerland 1.4655 1.9766 .0 116..4123 .1293. you will see a Cross Exchange Rate of 3.. 69.1293 / 0.Cross Exchange Rates Given the value of any two currencies in terms of the US dollar.00857 ..1267 .66181 The very first column refers to the US dollar. one can calculate the value of those two currencies with respect to one another without the intervening dollar.4092 6.9560 3. 2001 Dollar Canada France Germany Italy Japan Mexico 1.9186 . .8953 13. .4145 ..00072 .69230 .11242 .69230 pound per US dollar.41682 .0758 1936. which stands for DM 2.1826 1. 1262.01432 . . February 08. for the pound the rate is 0.21159 .047 . that is.16 168.00052 .4445 0.10327 .18 1395.K. The value of DM in terms of FF. Important Cross Currency Rates are given below: Key Currency Cross Rates Wall Street Journal.23385 1.67 U...01825 .988 2. we note a quote of 2. which should be read as 0..62982 .856 48..5599 10.00079 ... Euro U..98 295.. If we look across Germany and down the Dollar column.07149 . let us examine the rates for Germany and U.788 16.00033 .02056 ..24775 . the value given is 7.627 12.. Both the FF and DM are in indirect form. 1.1412 per US dollar.5110 7..5725 1.207 .1293= FF 3. is calculated as: 2.5341 2.0363 ..0 107.52 8.1 .9048 .4366 .2038 3. if we read across Germany and down the Dollar column.
Rather. The currency exchange does not take place when the contract is bought or sold.0758 DMs per pound as well. thereby avoiding the exchange rate risk. Forward rates for some currencies appear in Table 2. Similarly. In these Cross Exchange Rate computations. forward market rates are at a discount with respect to the spot market rates. if we are using the Direct Quotes. and therefore. the 90-day and 180-day forward rates are BP 1. MNCs face future foreign currency outflow needs or receive foreign currency inflows in the future. all the three forward rates are below the spot rate.1661 percent means that the 30-day forward rate is at a discount of 0. In this instance. The spot rate is 1. We can calculate the Forward Market Premium or Discount P as follows: P = Forward Market Premium or Discount Percent = = [( Forward . and Forward Premium The currencies can be bought and sold in Forward Markets. the order of currencies in the numerator and denominator will be reversed.1661 % The premium of . A forward contract specifies the foreign currency to be bought or sold at a specified known rate today for a future settlement date. the quoted 30-day forward rate is British pound 1.4445 US $ per BP.Spot) / Spot ] * (360/# of Days of the Contract) * 100 The multiplier (360/# of Days of the Contract) converts the P to an annual rate ! For example. However. we get the value of 3. 90-day.4445) / 1.4443 per US dollar. the Premium P for the BP 90-day and 180-day forward rates will be computed as : Premium for 90-day forward rate: [ (1.4422 per US $.1. Currency Forward Contracts.2769 % Premium for 180-day forward Rate: = [ (1.4435 per US $ and BP 1. Forward Rates. and 180-day.4443-1. the exchange occurs later. When MNCs expect future outflow needs like Bills Payable. the P for the 30-Day BP Rate will be computed as follows: [ (1.4445] * (360/180) * 100 = -0.4445) / 1. they can buy the foreign currency at t=0 at the then prevailing forward rate and lock-in that rate. The Forward Rate is the rate at which currencies are bought or sold for future delivery at an agreed upon price today.If we look across Germany and down Pound in Table 5. we used Indirect Quotes. the same # as we calculated just now.4435-1. Often.3184 % .4422-1.4445) / 1.4445 ] * (360/30)* 100 = -0. For the British pound (BP).0. 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. The most common maturities are 30-day.4445] * (360/90) * 100 = -0. respectively.1661 percent with respect to the spot rate.
institutions. State and explain the different methods of international business. 4. 7. What is an agency problem? What are agency costs? Are they higher or lower for MNCs ? And why? 3. What do bid and ask prices mean? Which is higher? And why? . There was a discussion on computing percent change of a given currency. classes. State and explain the three theories of international business. Swiss Franc. Australian Dollar. We will learn more about these futures in Module 5. 8. we learned about the pricing of foreign currencies. Also. 11. forward rates are the rates at which contracts are entered into to buy and sell currencies in the future to meet future needs. and MNCs to buy or sell currencies in the future at a specific price and for a specific period of time. Define forward markets and forward rates. Why is it important to manage it for an MNC? 6. which quote would you use and why? 9. These futures are used in hedging and speculation. 10. These options can be used for hedging and speculation. respectively. Mexican Peso. forward rates can act as predictors of spot rates in the future. Distinguish between spot and forward foreign currency markets. 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 $. and what are puts? Summary: In this module. We also learned about the ask and bid prices: the prices at which currencies are bought and sold. Identify the participants in the foreign exchange market and explain their roles. British Pound. forward rates convey information about the spot rates in the future. Canadian Dollar. institutions. and MNCs to buy and sell currencies in the future at a specific price for a specified period of time. DMark. For what purposes and needs do the foreign exchange markets serve? Give suitable examples. and Euro. and series! So. Currency futures are available in the Chicago Mercantile Exchange for the Japanese Yen. Unlike the Forward contacts. What is the difference between direct and indirect quotes? If you were to compute the percent change in a foreign currency. learn about the classification types. 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. these futures are standardized with respect to size and delivery. 5. Also. Currency Futures Currency Futures are legal contracts which enable individuals. Questions and Problems 1.In some sense. we studied forward contracts and forward rates. What is exchange rate risk? Illustrate your answer with a suitable example. Under certain conditions and assumptions. We will learn a lot about these instruments later in Module 5. What are the advantages of that objective? 2. what are European Options? And what are American Options? What are calls. State and explain the right objective for a multinational corporation. These options are available for various currencies and trade in the Philadelphia Exchange. Please visit the Introduction to Options site: Learn about Options Basics.
Cross Exchange Rate of the SF with Respect to Swedish Krona: # of Krona per SF d. how many US Dollars you need? END OF MODULE 2 Module 3: Arbitrage and the Theories of Interest Rate Parity. 13. Using the information on Thursday's spot and forward rates for the French Franc.12. If you want to buy DM 3. you will get? b. compute the following: a. Our second objective is to learn about the theories of Interest Rate Parity (IRP). compute a) 30-day forward premium b) 90-day forward premium and c)180-day forward premium. Purchasing Power Parity (PPP). Cross Exchange Rate of the FF with respect to Canadian Dollar: # of Canadian Dollar per FF c.6645 Per DM Ask $ 0. Bid $ 0. and International Fisher Effect Objectives and Theme: In this module. arbitrage can be defined as capitalizing on market discrepancies in the prices quoted in the foreign exchange markets by simultaneous buying and selling.000 to visit Germany. Cross Exchange Rate of the BP with respect to FF: # of FF per BP b. our objective is to study arbitrage and examine why and how three types of arbitrage take place in the foreign currency markets. 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 . Loosely. Market forces bring about the realignment of currencies through arbitrage. The following are the Ask and Bid Prices of the DM quoted by a bank: 3. Using the exchange rate information for Thursday in Table 2. we also explore the realignment of exchange rates due to arbitrage transactions.000 how many US $. Cross Exchange Rate of the Italian Lira with Respect to Japanese Yen: # of Japanese Yen per Italian Lira 2. Purchasing Power Parity.1. It can also involve simultaneous lending and borrowing in different currencies to take advantage of the higher interest rates. International Arbitrage and the Theory of Interest Rate Parity: Whenever there are discrepancies between quoted-rates and observed market rates in the foreign exchange markets. Please refer to the Currency Trading: Exchange Rates table. currency realignments will take place. and International Fisher Effect (IFE).6745 Per DM a. If you have DM 2.
23 .20 Per FF The appropriate/theoretical cross exchange of DM with respect to FF.000/$ 0.23 As a result of this locational arbitrage. Cross exchange rates are used to determine the relationship between two nondollar currencies. Arbitrageurs will buy at $0. undertaking such transactions yields profits. the following steps are involved: Buy DM at $ 0.650 = DM 15384.6610 at Bank D > Ask price of $0.6610/DM $0.$ 10. and the bid price at bank D will go down.6610 = $ 10169. Recall one buys at the ask price and sells at the bid price.169.6 * $ 0.6610 to Bank D = DM 15384. Example: Bank C Bid Price DM Ask Price DM $0. locational arbitrage takes place when a particular currency can be sold at a higher price compared to its buying price.23 Net Profit = $ 10.6610 per DM. If you have $ 10.6500 at Bank C.Locational Arbitrage: Usually.000 and execute locational arbitrage.2 = 10 FF/DM .6500/DM Bank D $0. Example: DM Value = $2 per DM FF Value = $0. Triangular Arbitrage Foreign exchange quotations are typically expressed in US $ regardless of the country where the quotation is provided.650 from Bank C and sell to Bank D at $ 0. the asked price at bank C will go up. there is an opportunity to engage in locational arbitrage.650 from Bank C = $ 10. locational arbitrage leads to the realignment of currency exchange rates as well.6710/DM Since Bid price of $0.6 Sell DM at $ 0. triangular arbitrage becomes feasible.6405/DM $0. In addition. The locational arbitrage concept explains why prices between banks at different locations will not normally differ by a significant amount. that is # of FF per DM = 2/0. If a quoted actual or market cross exchange rate differs from the appropriate theoretical or should be rate.000 = $ 169.
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.000 The triangular arbitrage strategy generates a profit of $1. ===> Since FFs are being bought. the exchange rates are affected as follows: $2/DM ====> Since DMs are being bought. Covered interest arbitrage then involves interest arbitrage to take advantage of higher overseas interest rates and covering the foreign investment position by selling forward the maturity value of the investment. this rate goes down 11 FF/DM $0. 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 =====> $10.2 55.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). this rate goes down. investing in foreign currency and covering against exchange rate risk by selling forward the maturity value of the investment thereby locking-in a rate.000. Triangular arbitrage forces a quoted cross exchange rate to be appropriately priced vis-à-vis the rates of the given two currency values with respect to the dollar.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. Example: Amount to invest $1.000 = 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. Because of these triangular arbitrage transactions.20/FF Covered Interest Arbitrage (CIA) The opportunity to engage in Covered Interest Arbitrage arises when the interest rate difference between the home interest rate and foreign interest rate is not off-set by the forward premium or discount of the foreign currency in the forward market. this rate goes up.2 => $11.000 DM * 11 FF = 55. Covered interest arbitrage involves converting the home currency to the foreign currency. ===> Since $s are being bought. then sell FF for US $.000 Current spot rate of DM = $2/DM 90-day forward rate of DM = $2.000.000 FF * $0.1/DM 90-day interest rate in the USA = 2% 90-day interest rate in Germany = 4% Time=0: . you can buy DM with US $. convert DM to FF.
DM Forward Premium of 5 % Recall that the Forward Premium is computed as : (Forward Rate . we would have used annualized interest rates.092. The sum of the 4 % interest rate and the forward premium adds up to 9. Because we are using an approximation here.000 DM x $2. in which case.$1.000 .0 % which approximates the 9. In this case.0 * 100 = 5 % Note that since interest rates are given for 90-day period.000 DM forward @ 90-day Forward Rate of $2.Spot Rate)/Spot Rate * 100 =(2.000 3. we observe the 0.04) = DM520.1. Sell US $ and buy DM at the Spot rate of $2/DM $1.000 x 100 = 9. Normally.000. we computed the forward premium also for the 90-day period.1/DM DM 520. US investors will be better off investing there.000 The rate of return on this investment is computed as: ( $1.2 % return on CIA we computed earlier.20 % difference.000 /2= DM500.000.000.000)/ $1. Later. the forward premium is usually annualized.1/DM Time= +90-days 4.2 % rate of return for investing in Germany has two components: a.1/DM = $1.000 2. Invest in German T-Bill @ 4 % 90-day interest rate in Germany Maturity Value of Investment in German Marks=500. since US investors are earning a 7. convert DM at the earlier agreed-up on $2. we will be using the exact version to get the exact return.1-2. 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 .000. German Interest Rate of 4 % b.0)/2.2% The 9. Get the Matured Investment of DM520.092. Sell 520.2 % extra return from investing in Germany.000 (1 +0.
then there is Interest Rate Parity. The concept of IRP is further explained in Figure # 3.96 5% 2.1 2 3 4 2% 2% 2% 2% 4% 4% 4% 4% $2 $2 $2 $2 $2. when the forward rate shows a discount of -2%. CIA (investing in Germany) is profitable. the interest advantage is offset by the forward discount.2 = 2% In states 1 through 3.5% 4 + 0 = 4% 4 . At that point. either adding to or maintaining the foreign interest rate of 4 %. US investors have an advantage in investing in Germany by CIA.Sj)/Sj x 100 If the (Home Interest Rate .5 = 6. In all those instances. But. In scenarios 1 through 3.5% 0% -2. Note that IRP does not imply that all country investors earn the same return at the point of IRP.if = p where. In scenario #4 above. the forward premium of the DM was positive or 0. ih = Home Interest Rate if = Foreign Interest Rate p = Forward Premium or discount of the foreign currency Recall that p is computed as: (Fj .05 $2 $1. . Theory of Interest Rate Parity (IRP) The Interest Rate Parity Theorem examines the impact of nominal interest rate differentials between two countries on the forward rate of the foreign currency. US investors earn 2% return regardless of where they choose to invest. 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. The approximate IRP equation is: ih . the return on CIA is the same as the return from investing in the US. in scenario # 4.10 $2.0% 4 + 5 = 9% 4+2. In this case.Foreign Interest Rate) interest differential exactly equals the forward premium or discount.
This means that a given country investor will get the same rate of return regardless of which country he chooses to invest in. Likewise. On the horizontal axis.04 and premium of 0. Similarly. there is interest rate parity. it will be advantageous for US investors to invest overseas. All Rights Reserved. Point #1 corresponds to scenario # 1 from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table. Copyright © 2000 by West Publishing Company. the difference we observed earlier. it will be advantageous for the foreign investors to invest in the US. Given the German interest rate of 0. As we already know. IRP holds true in the real world especially in the Eurocurrency markets. solely on the interest rate front.20 %. 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. Recall that in our State 1 example from the Covered Interest Arbitrage Under Varying Forward Rate Regimes table.20 % difference on return to CIA in the approximate method in scenario #4. 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. in point #2 corresponding to scenario #2. (Home Interest Rate . Jeff Madura. At all points on the IRP line.05. at the points to the left of the IRP line. On the vertical axis.Note: This Figure is reproduced by permission from International Financial Management. (p*if) works out to 0.Foreign Interest Rate) interest rate difference is plotted. the Forward premium or discount is given. The exact version of IRP equation is given by: (1+ih)/(1+if) . we had a 0. Arbitrage transactions ensure that interest differentials in different segments of the Eurocurrency markets are off-set by corresponding . US investors make 2 % more than what is available in the US. Sixth Edition.1 = p Where. US investors make 4% on interest income and 5% by exchange gain as the forward rate shows a premium of 5%.
Purchasing Power Parity (PPP) PPP suggests that the purchasing power of a consumer will be similar when purchasing goods in a foreign country or in the home country. it may anticipate high inflation. However. Thus. ih = Nominal interest rate in the home country. foreign demand for goods in that country will decrease. that country's demand for foreign goods should increase. Ih = Inflation rate in the home country. IRP may not hold true in the real world. if capital controls and such are imposed. International Fisher Effect (IFE) IFE predicts the same magnitude and direction in the spot rate of a currency as PPP does. while currencies of countries having low inflation will appreciate by the inflation differential. According to PPP. IRP impacts on instruments of similar maturity and risk. If . In addition. currencies in highly-inflated countries will be weaker causing the purchasing power of goods in the home country versus these countries to be similar. Note: Nominal Interest Rate = Real Interest rate + Inflation Premium (approximate version) The approximate version of IFE equation is given by if . If = Inflation rate in the foreign country.forward premiums or discounts. Ef = % Change in the Spot Rate of the Foreign Currency. the home currency of that country will weaken. Thus the inflation will put pressure on the currency's value causing a depreciation. currencies of countries with high inflation will depreciate by the inflation differential. but IFE looks at the nominal interest rate rather than inflation rate. Ef = % Change in the Spot Rate of the Foreign Currency. When inflation is high in a particular country. if = Nominal interest rate in the foreign country. the exchange rate will adjust to maintain equal purchasing power.ih = Ef Where. If inflation in the foreign country differs from inflation in the home country. Inflation differentials are offset by exchange rate change. The approximate version of PPP equation is given by.Ih = E f Where. this tendency should continue until the currency has weakened to the extent that a foreign country's goods are no more attractive than the home country's goods. IFE argues that a currency's value will adjust to reflect the difference in nominal interest rates between countries. The rationale behind IFE is that if a currency exhibits a high nominal interest rate. Thus. .
PPP looks at the inflation rate. Purchasing Power Parity. We also discussed the theories of Interest Rate Parity. it is the same wine in different bottles! This means that if an American investor invests in the US. 3) Covered Interest. either short or long-term. on the other hand. Arbitrage helps to bring about the re-alignment of the exchange rates.Example: Home: US Real Interest Rate Inflation Rate Nominal Interest Rate PPP will predict. According to both theories. a depreciating foreign . While IFE looks at the nominal interest rate (total picture). and International Fisher Effect. To be more specific. = the interest differential of (8-6) = 2%. the foreign currency should appreciate by 2%. IFE will predict. An appreciating foreign currency adds to the cost of borrowing. While an appreciating foreign currency adds a bonus to the foreign country return. Short-term financing and investing and long-term financing and investing decisions: When borrowing in foreign currencies. 2. Spot. one needs a forecast of the future spot exchange rate as well. Summary: In this Module. Ef (% Change. When investing in foreign currency investments. The decision to hedge or not to hedge will depend on the forecast of the spot rate in the future. equal to the inflation differential of (Ih . Future exchange rates will affect all critical characteristics of the firm such as costs and revenues. Spot. a depreciating foreign currency reduces the cost of borrowing. Both provide the same result. Foreign Currency) of 2%. various operations of MNCs use exchange rate projections including: 1. Hedging: Hedging involves taking protective steps to safe-guard open currency positions from exchange rate risk. END OF MODULE 3 3% 5% 8% Foreign: Japan 3% 3% 6% Module 4: Forecasting Exchange Rates Why Multinationals Forecast Exchange Rates ? An assessment of the future exchange rates is required for several decisions of the MNCs. 2) Triangular and. he or she will get 8% in nominal return. we studied the concept of arbitrage and the types of arbitrage: 1) Locational. Foreign Currency) of 2%.If) = 5-3 = 2 % . And if the investor invests abroad. Ef (% Change. he or she will get 6% return from interest income and an additional 2% return from the appreciation of the foreign currency. one would need a forecast of the exchange rates.
Earnings assessment: In the preparation of consolidated financial statements. inflation differentials. Technical Forecasting: Technical forecasting involves the review of historical exchange rates to search for repetitive patterns which may occur in the future. the regression analysis will involve the following steps: Steps: 1. before venturing into foreign currency borrowing or investing.S. one also has to forecast the exchange rates and 4. Exchange rate forecasting is available at the Financial Forecast Center. What is the Bank of America medium term forecast for the U. it is a good idea to get the forecasts of the exchange rates. real GDP. budget deficits. Specification of the model: ERPD$t = a + b * INTDIFFt where. a forecast of the exchange rates is required. some methods are outlined without regard to those considerations. Here. like fixed rate system versus free-floating regime. money supply etc. a dependent variable (effect) is forecast using an independent variable (cause). In a regression set-up.S. trade deficits. it may provide an indication of how the currency will move tomorrow. Therefore. those flows need to be converted to the home currency. furthermore. This pattern would be the basis for future exchange rate movements. Fundamental Forecasting Fundamental forecasting is based on underlying relationships between the currency's value and one or more economic factors like relative interest rates. dollar-Deutsche Mark exchange rate? Often regression analysis is used in fundamental forecasting. Therefore. it will also depend on the period of future forecast like short-term horizon versus long-term horizon. one can forecast the dependent variable for a given time-period. ERPD$t = Value of the Pound in dollars . Forecasting Techniques Forecasting will depend on the type of exchange rate regimes. dollar-Yen exchange rate? How about the U. 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. constant and slope coefficients for the straight line equation of the estimate of the dependent variable are obtained. 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.currency reduces the effective return on a foreign currency. For this purpose. If you want to forecast the value of the British Pound relative to the US $. such operations can be carried out more effectively if exchange rates are forecasted accurately. If the exchange rate of the dollar has decreased over the last week period. 3. From the regression equation.
rate) a = Constant or Intercept b = Slope. $ 1. Run the regression equation and get the estimate of "a" and "b" 4. and if so the regression equation specified is incorrect.S. ERPD$t = 1. if the 30-day forward rate of the Canadian dollar contains a 5% premium. Different weights adding up to 1 can be assigned. Thus spot rates will reflect the expectation of currency value in the immediate future and the forward rates will reflect the value of a currency in the future spot markets. If the INTDIFF were 5% for the next period.K. speculators will take positions to profit if deviations occur.55 per Pound.50 for each outcome. 2. then what is the forecasted value of ERPD$? Can you tell? Problems in fundamental forecasting: 1.S. 3.50 per Pound. Forecasts are needed for factors with instantaneous impact.K. Suppose. For example. 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. Uncertain timing of the impact of any given variable on the forecasted variable: The impact might be felt with a lag. interest rates (U. 2. This measures the responsiveness of exchange rate change of the pound (dependent variable) for any given change in the INTDIFF. If we assign a weight of 0. 50% of time they will overshoot. if the following forecasts were obtained: Technical Forecast of the BP for the next quarter: Fundamental Forecast of the BP for next quarter: $ 1. For example. These market based rates are good indicators of likely outcomes as otherwise. Possible changes in the sensitivity or value of the coefficients over time. given the value of INTDIFF for the next period.78 + 0. That kind of a forecast will be unbiased in the sense that. In this model. market determined spot or forward exchange rates are used to predict the future spot rates. Omission of some relevant variables. one can predict that the Canadian spot rate 30 days from now will appreciate by 5% in 30 days time. 3. Collect data on the above variables for a suitable number of periods like 20 or so quarters.INTDIFFt = Interest rate differential between U. we can forecast ERPD$. and 4. and U. rate . we assume that interest rate differential is the only factor affecting the value of pound.U. and the remaining 50% of the forecasts will be below the actual outcomes! Mixed Forecasting Mixed forecasting involves a combination of two or more techniques. we obtained the following Regression Equation Model above. then the weighted average forecast will be: .80 * INTDIFFt Then. Market Based Forecasting Here.
If for example. a regression is run. The lagging has been done based on trading day.50) + 1. This average is then compared across different forecasting techniques or among different currencies. Using data for the first fifteen (observations # 1-15) days.35 36. the results are shown in Regression Results. we can improve our forecast accuracy by subtracting 5% from our forecast every time. They also provide other services like cash management.5) = $ 1. Assessment of Forecast Accuracy Performance can be evaluated by computing the absolute forecast error as a % of the realized value for all forecast periods.724 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.60 33.948 8. The resulting regression equation is of the form: .56 SUM= AVERAGE= Absolute Value of Deviation (%) 6. 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.50 37. and the independent variable is the 30-day lagged forward rate of BP. an average of this type of error can be computed. we can correct our forecast suitably. Regression Data contains 21 daily data: the dependent variable is the Spot BP. If we observe consistent over or under forecasting. Forecast Error for the South Korean Won Quarter 1 2 3 4 Forecasted Value 36. Absolute forecast error as a % of the realized value= [|(Forecasted Value-Realized Value)/Realized Value|] * 100 An Example: The forecasted and realized values of South Korean Won for the last four quarters are given in columns 2 and 3.525 per pound. forecast of factors affecting exchange rates and an assessment of current and future exchange regulations.50 (0.63 34.1.608 22. these weights are subjective Forecast Performance of Consulting Firms Forecasting firms often use two or more techniques.897 5. we consistently overforecast on an average by 5%.40 34. The absolute values of the deviations appear in column 4.40 34.55(0. Then. The record of forecasting services is less than perfect and in fact poor.237 0.105 7.35 Realized Value 34. Obviously.
Each form of efficiency subsumes the one below it. Still. therefore.Future Spot Ratet = 0. we studied the reasons for and techniques of forecasting exchange rates. with the exchange rate forecasts. Mantripragada. we discussed technical and fundamental approaches to forecasting exchange rates. What is locational arbitrage? Illustrate your answer with a suitable example. and 3) Strong-form.S. Summary: In this Module. use a variety of techniques to forecast the exchange rates under different economic scenarios.6994*30-day Forward Rate t-30] The slope of 0. the spot rate of the BP changes by 0. What purposes does arbitrage serve in currency markets? 2. which posits that both public and non-public private information are reflected in currency pricing. We computed forecast errors and learned about the concept of efficiency in foreign exchange markets Questions and Problems 1.6994 means that for every 1% change in the forward rate.52 FF/$ Bank Y 5.6994% in the same direction. and Loh (1992). thereby making the planning process easier. Define arbitrage. and average error appear in Prediction Forecasting Performance and Market Efficiency Efficiency refers to the reflection of information in the pricing of currencies.54 FF/$ 5.56 FF/$ . they can estimate the cash flow estimates. and the predicted spot. 3. Specifically. dollar market by Rathinasamy. absolute error. An anomaly called January Effect has been documented in the U. which argues that all historical pricing information. There is evidence supporting the fact that foreign exchange markets are semi-strongly efficient and. This equation is used to forecast the spot BP for days 17-21. including volume and other technical factors. MNCs need to forecast exchange rates and. which states that all publicly available information is reflected in currency pricing. There are three forms of efficiency: 1) Weak-form. is reflected in currency pricing 2) Semi-strong form.481698 + [0. Also. reflect all publicly available information and historical pricing information. That is the only way that MNCs can assess the degree to which their performance will be affected by exchange rate movements. in fact.50 FF/$ 5. Locational Arbitrage: Consider the following: Bank X Bid price of FF per US $ Ask Price of FF per US $ 5. corporations do not like uncertainty.
how would you go about executing triangular arbitrage? Outline the steps. 5.2762 per SF.009091 0. His forecasts and the actual or realized exchange rates are given below: Forecast Error for Japanese Yen Quarter Forecasted Value $ per Yen 0. Outline the method. profits. Triangular Arbitrage: Consider the information on Cross Exchange Rates (Table 2.009524 Realized $ per Yen 0.566/Pound 6% 8% (UK) (USA) i. To the interest rates in the USA and Britain ? 7.535/Pound $1. If you have $100. The forward exchange rate of $1. Identify and explain the reasons for forecasting exchange rates. Covered interest arbitrage: Consider the following information: Spot Exchange Rate 180-days Forward Rate 180-days Interest Rate $1. a consultant was hired to forecast the Japanese yen for the four quarters of 2001. 4. what will happen to: a. state and explain the steps.1) in Module 2. in the Market. how would you go about executing covered interest arbitrage ? Outline the steps. compute the profit.000 how would you go about executing a locational arbitrage? Outline the steps and show the results. 10. and under SFRANC is 4. The cross exchange rate of the FF per SF is 4.009534 Value Absolute Value the Deviation of 1 2 . This is the theoretical rate.000 on hand. 6. 8. The spot exchange rate of $1. Explain regression approach to forecasting exchange rates.535 ? b. As a result of the covered interest arbitrage above.000. Define Covered interest arbitrage. Provide suitable examples. read as FF 4. Suppose. If you are a US investor with $1.2993 per SF. that is the rate given across France. this cross rate is FF 4.566 ? c.2762. ii. What is fundamental forecasting ? What variables are used in fundamental forecasting ? 9. and compute the rate of return.2762.009023 0.000. and return on investment. In early 2001.If you have US $100.
Currency Futures: Currency futures are contracts specifying a standard volume of a particular currency to be exchanged for a specific price on a specific settlement date. 2001 .February 08. and close prices for the British Pound (BP) futures contract for the nearest month. and under what conditions they will be used. We also discuss the back-ground of these instruments. In 1972. Interpreting Currency Futures Quotes Futures page from the Wall Street Journal of February 08.3 4 0.009334 0.009387 Sum Average Fill-in the missing values in the last column and compute the average forecast error. A wealth of information on links about currency futures and options appears at this site. our objectives are to study three major instruments in the foreign exchange markets: 1) currency futures contracts 2) currency forward contracts and 3) currency options and the use of these instruments for speculative and hedging purposes. 2001 are presented below: Currency Futures Wall Street Journal -. The use of these instruments depends on the firm's expectation about the future value of the particular foreign currency that the firm is interested in. high. Do you think that the consultant did a good job ? END OF MODULE 4 Module 5: Currency Futures. and seven widely traded foreign currencies.009226 0. low. the Chicago Mercantile Exchange (CME) established the International Money Market division (IMM) which allows trades in futures for some short term securities. Forward Contracts. Visit the Future Contracts site in this link and examine the latest open.009346 0. also. gold. and Options Objectives and Theme: In this module. why a firm should use these instruments.
9999 0. .0009 0.387 451 EST VOL 11.0050 0.6621 JUNE 0.. EURO FX (CME)-EURO 125.017.09860 +00062 0.0089 -. JUNE .205..6050 1.792.8876 .9880 LOW 0..4750 1.6358 0.6452 46. .0021 -. $ PER A.0004 +. VOL TH 10.. $ PER EURO MAR 0. . 0.6042 0.000 0.9634 0.6390 0.902.941.09900 202 0. $ PER YEN (.09800 0.251 1.10085 0.6615 0. VOL MON 1.000 DOLLARS.0021 -.09870 . DEUTSCHEMARK (CME)-125. -1.6445 0.846 1...LIFETIME OPEN MAR 0.. VOL MON 1.6631 -.8850 SEPT . .0003 +.0168 1..000 NEW MEX PESO. SWISS FRANC (CME)-125.4752 0.0219 1. VOL MON 555. BRITISH POUND (CME)-62.5488 -.6615 0. SETTLE CHANGE HIGH 0. ..5468 0. $ PER POUND MAR 1.7040 0.0021 0.10110 0.4925 0.00) OPEN INTEREST 89..5 MILLION YEN...10065 +00067 . -264. OPEN INT 20..854.8870 0.539.9393 JUNE 0.6078 -.09685 +00067 0.9066 +...6627 0. $ PER FRANC MAR 0. ..9314 . OPEN INT 93.671 4. .0021 -..6632 0.09070 3. ... .000 DLRS. .8379 89.6119 JUNE 0.000 MARKS.532 AUSTRALIAN DOLLAR (CME)-100. .6640 0.4570 1.. OPEN INT 74.8333 0.6050 0.6632 0. 0.0089 -.0046 0.6906 0.4785 0.8358 0.10085 0..6640 0.9400 0.6619 0.109.. $ PER CAN $ MAR 0.773.936 2.10110 0.6637 0. OPEN INT 47.5541 0.8968 0.076. . OPEN INT 331.09830 AUG ..0004 +.10170 0.5512 0.6990 0.500 PDS.8764 JUNE 0.000.9321 0.9292 0.9334 -.8414 0. 0.681 EST VOL 30.955.09830 .908.6425 0. -1. . . VOL MON 18.5100 23.6626 DEC 0.09965 +00067 0.545 680 EST VOL 5...09603 +00067 MAY .6119 0. .9784 0.0004 1. MEXICAN PESO (CME)-500. .310..4785 0. OPEN INT 92.4010 28.878 100 103 EST VOL 11.5585 47.10070 0.6107 0.125 +97.8845 .0070 0.974.09730 1. .092. .09120 16.388 0.09880 0.. -200. HIGH 0..6100 0..10425 0. UNCH CANADIAN DOLLAR (CME)-100.4750 1.. LOW 0.9351 .9308 0..000 FRANCS.5496 0. ... +781. DEC .10160 0.8873 JAPANESE YEN (CME)-12. VOL MON 8.6326 0. OPEN INT 53.6623 0. 0.. .6073 0.255. SEPT .. VOL MON 12..857.09800 100 0.8590 0.9351 SEPT . OPEN INT 21.4759 -.10165 +00067 APR 0. 0.. .09300 297 EST VOL 4.8726 0.8769 0.8796 0. ..951 851 EST VOL 13.031 0.4584 -.10200 0.10085 0. $ PER MP MAR 0.4225 322 EST VOL 3. $ PER MARK MAR 0...6825 0. .370.106 EST VOL 493..0069 -.6623 0.6645 0.079.0089 0. VOL MON 9.0300 1.$ MAR 0. +503.6625 SEPT 0.6415 0.8765 0.
" Day Traders Take a Fast and Costly Route By Stanley W. British Pound. the cost would have been: $0. 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. Australian Dollar. If we were to buy the June 2001 SF futures at the closing price.6100 per SF.975.000 125. it also depends on whether the contract is for speculation or hedging. we find the open price of $0.000 100. They hope their market insights.6078*125. Right next to each currency. A speculator will buy a given currency futures if he or she expects the foreign currency to appreciate or go up in price.6078 represents the price when the CME closed for business on February 8th. there is enormous leverage involved here.000 100.6073. and the Euro. Angrist Wall Street Journal. 1993 Every day is not payday for most day traders. The margin requirement varies from one currency to another.500 125.000 These futures trade for March through December 2001. For illustrative purposes. Aug.6107 and $0. most day traders find that what looks easy on paper is hard to do in the market. In reality. trading skills and speed of action will allow them to take some profits home each day. Deutsche Mark.000 ( # of units of SF in one SF futures contract) = $75. if we examine the June 2001 Swiss Franc contracts further. and they expire on the third Wednesday of the given month. 31. . 2001. The use of futures contracts in speculation is illustrated in the following article from the Wall Street Journal: "Day Traders Take a Fast and Costly Route. Therefore. Speculating with currency futures These futures contracts can be used for speculative or hedging purposes.000 500. Canadian Dollar. Mexican Peso. The closing price of $0. the standardized units of a given currency per one futures contract are also given: For example.000 62. Swiss Franc. each Japanese futures contract has 12. the intra-day high and low respectively were $0. Day traders are investors who open and close market positions within the same trading day.Futures are available for the Japanese Yen.5 million units. further. You can find information on current futures margin requirements at the Chicago Mercentile Exchange web site. One only needs to post a small margin of about 5% of the cost rather than pay the whole amount.
While many traders would scoff at such numbers." Other investors explain their affection for day trading in more expected ways. who trades out of his home in Austin. and then exit with a profit." she says. while those who believe prices are going to rise buy futures contracts. Trading mostly currency contracts he will risk no more that $125 a contract. 39 years old. What he likes. his stock response is that "I just want to have a wonderful time losing my equity. 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. They believe that if they do their homework they will spot a significant move in the market before the rest of the trading world. volatility. "I like to go to sleep at night and not worry about the market 'gapping open' against me. who has been investing for 25 years. 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. 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.500 British pounds for each contract. He says he is neither a high liver nor consumed with a desire to have great wealth. or the volume of trading. But traders like Mr.. a wholesale stamp dealer from Ann Arbor. day traders see their activity as a business. A futures contract is an agreement to buy or sell something in the future. When brokerage firms ask what his goals are. When the volume of trading is heavy the bid-ask spread for an investment is small. Needleman. So is a strict control system that limits both profits and losses. or the size of price moves. says that getting out quickly is an absolute necessity. Eck says that 71% of his trades have been profitable since he . His average loss generally is no more than $50 and his average profit is a minuscule $62 per contract. meaning day traders can profit on small price moves. Mich. Investors who believe prices are going lower sell 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. Day traders can play in all the financial markets. says. are the "big video game aspects" of day trading. The other is volatility. investor who traded stock options before he began day trading futures full time in August 1992. he says.000 account into more than $100." An opening gap is when market prices begin the day at a substantially higher or lower level than the previous day's close." The second requirement. Linda Raschke. an Austin. One is liquidity. at whatever price then prevails on the exchange. Needleman don't much care about expert opinion.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. most of that as a day trader. Texas. "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. but most of them deal in futures contracts. Two things determine whether an investment is attractive to day traders." explains Mr. He says that during the past 10 years he has run a $10. "You do it when the volatility is there. Kent Taylor. a full-time trader and a sometime day trader. capture a part of that move. Mr. say 62. Most market professionals shun day trading. More than any other individual investors. For example. Anthony Eck. says day trading isn't something that can be done every day.Consider Jeffrey Needleman.
After 10 years of trading.500 Total Profit * * 1 1 = $96. which he visits after the markets close. An active day trader can generate as much as $1.00 = $192. who trades from his home in Atlantic City. he buys 2 BP futures contracts at $1.00 75 ." he laments..5442 Close out the second $1. Scalping the Market British futures contracts are being used for speculative purposes here. Although all day traders claim they kiss the losers good-bye fast. says day trading is appealing to him because "I like the idea of having my finger on the pulse of American economy. and another contract at $ 1." says William Mallers Jr.5426 * 62. It's a business where seconds count. making his trading profitable overall.412.5424 per pound. David Morse. president of First American Discount Corp. 50.500 62. $ Outflows: Purchase cost of 2 futures $1.. who trades mostly currency and the S&P stock futures. the general lack of success for most suggests they might be a bit slow on the exit. a futures broker in Chicago. 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.925. "I would give a pint of blood to be able to trade successfully.512.00 = $50. but so far his losses exceed his profits. the speculator buys or goes long on the British futures contract expecting the pound to appreciate in value. In addition to the frequently changing bid-ask spread..50 = $96.5424 / pound at Round-trip commission at $25. Tom Meadows. As the article illustrates. day traders also must cope with the time differential required for brokers to fill their orders. But few brokers openly encourage clients to day trade. he says.5442 initially.800.850.000 a day in commissions. who has been day trading full time only since March.00 Total Cost $ Inflows: Close out one contract at $1. Meadows.5426. a former software manager in Austin.5424 * $25. hopes he can make a living doing it.50 = $192. says he places his orders by phoning clerks stationed in booths along the periphery of the trading pit. Mr. he closes out one contract at $ 1. Mr.00 / trade $1.500 * * 2 2 = $192. Taylor.00 62.5442 * $1. than he has been in day trading.J." Day trading requires constant attention. N. Initially. says he has been far more successful at the blackjack tables. Brokers love day traders because they can generate huge commissions.5426 contract at $1. "If I saw more success stories I might be more willing to encourage people to try.started trading about a year ago.
Close out contract 2 at a price lower than $1. Hedging with Currency Futures When a corporation has an open currency position (accounts receivable or accounts payable without an offsetting entry) in a foreign currency. Eck trailed the rising pound price with an order to sell as soon as the upward trend stalled. *If the firm is receiving currencies ===> it must sell currency futures *If the firm is buying currencies ===> it must buy currency futures Hedging refers to taking protective positions to safe-guard the open currency positions. If the speculator expected the pound to depreciate.5426 and see what happens to the net profit.525 Extra Cost . He was out of the trade with a profit within an hour and 15 minutes. Close out contract 2 at a price higher than $1. 2.500 pounds In this situation. In the second trade. Suppose Coca-Cola Company. it can lock in an exchange rate through futures contracts. 3. This eliminates the risk of fluctuation in the value of the currency at the future date of transaction. a US MNC has DM 100 million in 90-days payables for merchandise imported from Germany. he bought the futures contract first. AN EXAMPLE ON EXCHANGE RATE RISK Given: Coca-Cola Corporation ( US based MNC ) has DM 100 million in 90-day Payables Time=t Spot Exchange 0 Rate 0. as illustrated in the interactive Table below. Close out (sell) contract 1 at a price higher than $1. Questions for interactive table above (use the available Excel spreadsheet): 1.5134 2 $ 1. therefore.This table is available as an Excel spreadsheet. Coca-Cola is concerned about the rising DM value which could lead to higher costs than anticipated. Hedging allows a firm to avoid any unfavorable future exchange rate effect. or closed it out.5206 Gross Profit Commission Net Profit $900 $50 $850.00 *Each contract consists of 62.4412 Plus 90 Days 0. and then sold it.5442 and see what happens to the net profit. he would have sold the pound first and then bought it back after the pound has depreciated. the speculator expected the pound to appreciate. Mr. Chicago TIme 7:47am 9:02am Action Buy contracts Sell contracts Price per Pound 2 $ 1.5426 and see what happens to the net profit. after the pound depreciated.
Was the use of futures worthwhile? If Coca-Cola had open accounts receivable in a foreign currency. Since there are 125. .4560 per DM and remit the proceeds of DM 100 ml to pay-off its payables.$/DM Cost in the Spot Market 44.000. Note that at time 0. Coca-Cola is. Please change the exchange rate at t=+90 days from $0. When the bills are due in 90-days.12 90-day Futures Cost of Futures # of Futures Needed Savings from Futures This table is available as an Excel spreadsheet.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. in terms of what to do with the futures and when to do it. Coca-Cola is now guaranteed a price of $0.5 8.concerned about the possible rise in DM value which could lead to higher future $ costs than expected at time 0. Regardless of what happens to the spot DM in the future.4560 per DM .75 to $0.60.9 52. Summary information with regard to hedging payables and receivables. In this case.75 to $0. Coca-Cola only has to pay a 5% margin or so. appears below: What to do? Foreign Currency Accounts Payable Accounts Receivable Future Contract in that Currency Buy Sell 0. Coca-Cola will execute the purchase of DM 100 ml @ $0.000 units per DM futures contract.000/125. To avoid this exchange rate risk. If the spot rate in the future is going to be greater than the current futures rate ===> Enter into the futures contract. Coca-Cola can buy a DM June Futures contract at $0. Coca-Cola has to buy 100.85.456 45. Questions for interactive table above (use the available Excel spreadsheet): 1.4560 per DM. say.000 = 800 contracts. Please change the spot exchange rate at t=+90 days from $0. thereby guaranteeing that rate regardless of what would happen to the spot rate in the future. What is the $ cost of savings from the use of futures here? 2. thereby locking-in the rate.6 800 6. Coca-Cola would sell futures contract at the agreed upon price.
and multinational Banks. Over the telephone worldwide. Tailored to individual needs. In module 2. Security deposit Clearing operation Marketplace . For example. brokers. Central exchange floor with worldwide communications. Foreign Currency Depreciate Future Contract in that Currency Sell ======> Forward Contracts and Hedging The hedging of DM payables by Coca-Cola using the June futures contract could also have been accomplished via forward contracts in forward markets. there are quite a few differences between currency futures and forward contracts.Foreign Currency Appreciate Receivables: ======> Future Contract in that Currency Buy If spot rate in the future is expected to be greater than futures rate ===> Do not enter into the futures contract. brokers. Qualified public encouraged. Banks. None as such. Standardized. The differences between the forward contracts and futures are illustrated below: Comparison of Forward and Futures Markets Forward Contracts Size of contract Delivery date Participants Tailored to individual needs. Futures Standardized. whereas forward contracts are negotiated over the phone. banks and brokers. bank balance or lines of credit are required. speculation encouraged. They are standardized and require a small security deposit. Public speculation not companies. clearinghouse function. but compensating Small security deposit required. If the spot rate in the future is going to be less than the current futures rate ===> Enter into the futures contract. tailored to individual needs. Currency futures are traded face to face on a trading floor. we learned about the forward markets and forward rates. Handling contingent on individual Handled by exchange clearinghouse. What are the advantages and disadvantages of forward contracts? However. Forward rates are shown in the following table: Exchange Rates: Currency Trading Forward contracts are explained in plain English at this site! Please visit this site. No separate Daily settlements to the market price. Coca-Cola might easily have hedged its DM 100 million payables by buying a DM 90-day Forward contract at $ 0.4590 per DM for DM 100 million. and require no security deposit. and multinational companies.
Philadelphia Options Wall Street Journal. Set by "spread" between bank's buy Negotiated brokerage fees. to buy a currency at a specified price called the strike price. ® Reproduced with permission from Chicago Mercantile Exchange. Interpreting Currency Call Option Information The features of call option are found in Philadelphia Options. one is able to lock-in a rate. by buying call options at the appropriate strike price. by offset. Commodity Commission. The idea is to buy the currency low at the strike price and then turn around and sell the currency high. Currency options are available for seven major currencies on the Philadelphia Exchange. Obviously. and sell prices. For example. Association. American options are far more flexible than European options. 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. 2001 Calls Vol. but not an obligation. Chicago Currency Options Currency options are an alternative type of contracts that can be purchased or sold by speculators and firms. Some Most by offset.500 German Marks. 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. February 21. or exercise price. A currency call option is also used to hedge foreign currency payables. Last Puts Vol. Last . Call Option It is right. very few by delivery. A currency call option is bought for speculative purposes when one expects the underlying currency to appreciate in value. for a specified period of time for which the purchaser pays an option premium to the seller or writer of the call. at a cost. one DM option contract contains 62. half of the 125.000 units per one German mark futures contract. Futures National Trading Futures Liquidation Transaction costs Most settled by actual delivery.Regulation Self-regulating.
.500 Euro-European style 94 Euro 62. 10 100 Apr Mar 100 . Please refer the last of Swiss Francs-cents per unit information in the middle column.15 ... 142 BPound 31. 0. Put Vol..20 .204 Open Int.00 2.17 57.250 Brit..27 .... 100 Jun .38 147..500 found to the left of the Swiss Francs refers to the # of units of Swiss Francs in one Swiss Franc option. 60 Mar Apr Mar Mar . .....10 .... ....250 Brit. Pound-cents per unit. . 155 163 CDollr 50.. Jun 10 1. 523 13.60 per SF. Mar ..... 0... The first column of #s below the last 62. Mar Jun .. ...67 ... . 2 3 Mar 5 8.. Open Int.500 Euro-European style.. etc. The strike price is also called the exercise price and. .. in the case of the call option. 0...500 Euro-cents per unit.... 57.500 Swiss Francs-European Style 60 SFranc 62. Right next to the strike price is the month of expiration.000 Canadian Dollars-cents per unit 67 67 Euro 62... 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.83 . ..61 2.500 Swiss Francs-cents per unit. 60 Sep 5 2. .15 ... 697 1. 5 147.33 91.35 1. options expire on the Friday before the third Wednesday of a given month.15 . Call Vol. The last two columns contain information on put option volume.BPound 31....83 1.. 88. represents the purchase price.. The 62. ..69 .73 0. 88.500 refers to the strike price: the strike price is 60.51 .15 88. 88 90 92 94 SFranc 62. Pound-cents per unit. . 523 Our focus will be on American style options. which stands for a strike price of US $0.69 2. .. 82 Euro 62.31 3 10 . 15.. 0.
375) t = +1 Exercise call and buy DM 62. the premium of the June 60 SF call will be higher.750 This table is available as an Excel spreadsheet. with the higher spot price at time=t+1. Further.02700 $40. Please refer to Speculating with Call Option table below: Speculating with Call Option Time Action Per Unit of SF Per 1 62. 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.65 per SF at t=+1.60 per Swiss Franc. for the purchaser of an option. one can walk away from the options if things are not working in favor of the speculator.500 at $0. the maximum loss is the premium amount paid originally and no more.60 per SF Assumed spot rate: $0. which are legal obligations. since the SF appreciated.Speculating with Call Options A speculator will buy a call option if he expects the currency to go up in value or appreciate. the following Table illustrates a hypothetical situation. as shown in the above Speculating with Call Option interactive table.60 per SF Purchase price (Outflow) Assumed spot rate now: $0. The table is self-explanatory.500) t = +1 Sell SF 62. Thus options can be bought and sold in their own rights as stand-alone securities. Suppose a speculator buys 1 Swiss Franc September 60 call with a premium of 2. The 60 stands for a purchase price of $0. Unlike the futures.625 $1. The results are shown both for per unit and for 1 option.0220) SF per ($1.6109 per SF Option Premium (Outflow) ($0.6109 per SF at t=0 and $0. Another interesting point about options is that.20 cents per Franc.500 at the spot rate of $0.500 contract SF Option units per t=0 Buy 1 DM September call at $0. Note: We assume a spot rate of $0.65 $0. . Here.65 ($0.60) per SF ($37.65 per SF (Inflow) Net profit = $0. and the speculator could close out his call by selling to other speculators in the marketplace without having to exercise the options.
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
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.
Hedging Payables with Call Option
Call options can be used to hedge payables. Basically, one buys the required number of calls at the selected strike price and month. In the example above, if the calls were being bought for hedging payables, the corporation would buy the currency at the strike price and there would not be any resale of the currency. The foreign currency bought would be used to pay off the payables. The number of calls to be bought to hedge the payables would depend on the amount of payables and its currency of denomination.
Factors Affecting Call Option Premium
The following factors have a bearing on the call option premium: Spot price relative to strike price: The higher the spot rate, the higher the premium.
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.
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.
Interpreting Currency Put Option Information
The features of the put option are found in Philadelphia Options table. Our focus once again will be on American style options. Please refer the last of Euro-cents per unit information in the middle column. The 62,500 found to the left of the Euro refers to the # of units of Euro in one Euro option. The first column of numbers below the last 62,500 refers to the strike price: the first strike price is 88, which stands for a strike price of US $ 0.88 per Euro, while the 90 below that represents a strike price of $ 0.90 per Euro and so on. The strike price, also called the exercise price, in the case of the put option, represents the sale 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 last two columns provide information on puts: vol refers to the volume of puts traded for the day, and the last refers to the last option premium quoted for a given put strike and month.
Speculating with Put Options
A speculator will buy a put option if he expects the currency to go down in value or depreciate. Suppose a speculator buys one Euro April 90 put with a premium of 1.27 cents per Euro. The information on this put option appears at the very bottom of column 2 of the Philadelphia Options table. The 90 here stands for a selling price of $0.90 per Euro; a hypothetical situation is illustrated in Speculating with Put Options table below:
Speculating with Put Option Time Action Per Unit of Euro Per 1 Euro Option 62,500 units per contract
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 =
$0.0380 per Euro $2,375
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
03. . for example. Higher variability increases the chances of the currency going-down in value as well. there simply is more time for the spot price to go down in value. if the put were being bought for hedging receivables.40. Potential volatility or variability of the currency: The higher the variability.when the spot price decreases. the net profit would be $ 0. The number of puts to be bought to hedge the receivables would depend on the amount of receivables and its currency of denomination. Jeff Madura. higher the option premium. if the spot price in the future were $1. the higher the premium. Copyright © 1995 by West Publishing Company. Hedging Receivables with Put Option Put options can be used to hedge receivables. In the example above. Figure # 5 Note: This Figure is reproduced from permission from International Financial Management. This makes sense since the put buyer will benefit if the spot price goes down. the lower the put option premium. one buys the required number of puts for a selected strike price and month. The higher the risk free rate. The maximum loss from the buyer's perspective is the premium of $0. Factors Affecting Put Option Premium The following factors affect the premium in the put option: Spot price relative to strike price: The lower the spot rate. Basically. the higher the premium. Fourth Edition. Here. Time to maturity: For any given strike price. All Rights Reserved. Therefore.07. the corporation would sell the currency at the strike price and there would not be any buyback of the currency. the premium will correspondingly increases as it becomes more attractive. as measured by the standard deviation or fluctuation of a currency. the longer the maturity.
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
Module 6: The Nature and Control of Foreign Exchange Risk
Objectives and Theme: In this module, we study the nature of Foreign Exchange risk and its management. Our objectives are to define foreign exchange risk, review categories, or types of exchange rate risk, and examine various techniques available for managing exchange risk. Specifically, we analyze two types of exchange rate risk in depth : 1) Transaction Exposure and 2) Operating Exposure and study techniques to manage them.
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
Relevance of Exchange Rate Risk
Some people have argued that in a world of purchasing power parity where movements in exchange rates are expected to be offset by price movements, the exchange rate risk is not relevant. However, purchasing power parity often does not hold in the real world, especially during the shorter time horizon of 2 to 5 years. Another argument for the irrelevance of exchange rate risk is that stockholders of MNCs can hedge their own risk by substituting homemade hedges for corporate hedges. But, the investors do not have access to the information that managers have access to; managers simply have an advantage in the depth and breath of the risks and returns of MNCs. Further, the investors may not be very knowledgeable in various hedging techniques, and the transactions costs for individual investors might be prohibitive.
Types of Foreign Exchange Risk
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
This table is available as an Excel spreadsheet.
Note: This figure is reproduced by permission from International Financial Management, Sixth Edition, Jeff Madura. Copyright © 2000 by West Publishing Company. All Rights Reserved.
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
000) $4. but.429 $0.798.078. PV of cashflows @ 15% discount rate Initial Investment NPV Weak Scenario Exchange rate $/ $Cashflows to the Parent Co.45 $2.137.000) ($18. translated US dollar revenues will be lowered.61 $4.237.269.757) $0. Economic Exposure Further Illustrated Year 0 Remitted to the parent (SF) Strong Scenario Exchange Rate $/ $Cashflows to the parent Co. so much so that the net present value turns negative now.893 ($10.410 $0. rent and lease payments.560.875. these firms will be unfavorably affected by a weaker foreign currency since.000 Year 3 6..754 $0.000. Madison Inc.736.000 $2. and management fees.57 $3. but.400 $2. On the other hand. PV of cashflows @ 15% discount rate Initial Investment NPV ($10.652 $0. unfolded: the result was a steep decline in the $ value of SF remitted.743. year 0 cash flows represent cost or outflows for the investment project.54 per in year 1 to $0.400.Taxes (EBIT). and the exchange rate.65 in year 4.47 $2. and 2) financing cash flows like interest on loans and dividends on stockholders' equity.875.957 $0.37 $7.000 Year 4 19. as shown in weak-Franc scenario. firms with more foreign revenues than costs will be favorably affected by a stronger currency.538. royalty and license fees.172.400.000 $1. the $ cash inflows increase resulting in a net present value of $4.000 $2.535. the SF weakened.837.65 $12.000 $1.000 Year 2 5. The very first line gives the after-tax incremental cash flows remitted. These flows can be 1) operating cash flows like inter and intra-firm receivables and payables.327.430.000 $2. a weaker foreign currency will have a positive impact on these firms.000 $7.421 $0.271 Year 1 5. With a steady appreciation forecast. Thus.916. firms with more foreign costs than foreign revenues will be unfavorably affected by a stronger foreign currency.206.964 $0.000 .754.40 $2. in reality.000.54 $2. In general. is affected by a stronger Canadian dollar. with its higher Canadian costs.200 $4.840. But. The forecast of the SF called for its steady appreciation as shown in the Strong-franc scenario of $0. 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.714. Operating exposure thus affects the local currency inflows and outflows. with the weak currency.
40 Year 2: $0. To manage the transaction exposure effectively. The subsidiaries will send reports to the centralized cash management office of the parent company. In the remaining part of this module. Consider the following example: Quincy Corporation estimates the following cash flows in 90 days at its subsidiaries: Net Position in each currency measured in parent's currency (in 1000s of Units) Subsidiary A B FF +200 +100 DM -300 -40 BP -100 -10 . the management of transaction and economic exposures are explored. Since translation exposure does not affect cash flows. it affects transactions already entered into and denominated in foreign currencies. one should: 1) Identify the degree of transaction exposure 2) Decide whether to hedge or not.15 What happens to the $ cash inflows and the net present value of the project? 4. its management is not dealt with here.29 Year 3: $0. 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. Identifying Net Transaction Exposure All expected inflows and outflows for a particular currency and time should be consolidated to measure the net transaction exposure. The MNC should identify each subsidiary's position in all currencies.60 Year 2: $0. and 3) Choose among various hedging techniques if the decision is to hedge.Questions about the interactive table above: Change the exchange rate under a strong Franc scenario as follows: Year 1: $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. It affects accounting income but not cash flow. Transaction Exposure Management Once again.65 Year 3: $0. recall that transaction exposure refers to the exchange rate induced changes in the future inflows and outflows of a firm.
therefore.000 $ equivalent units in FF.150. there would not be any exchange rate risk. If you anticipate receivables sometime in the future in a foreign currency and the forecast calls for appreciation of the foreign currency in the interim. the hedging decision will depend on the forecast of the exchange rates.000 The MNC has a net inflow position of 120. This is because. It is also consistent with the objective of maximizing the stockholder wealth. Since nobody can foretell the future of the exchange rate movements and businesses are conservative and dislike uncertainty. in that situation. Forecast of Exchange Rates and the Decision to Hedge or not to Hedge Obviously. 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. it has a net outflow position of 140. hedging would also not be worthwhile. 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 the preferred choice by firms when . This is why we need to identify the net transaction exposure. its net exposure is an outflow of 150. hedging the receivables by selling forward at the forward rate may not be worthwhile. overall corporate efficiency is enhanced. if payables in a foreign currency are due in the future and the forecast of exchange rates calls for the depreciation of the foreign currency involved.140. .000 $ equivalent units. most MNCs do hedge. in BP.000 $ equivalent units in DM.C -180 +200 -40 (+ = inflow. With the information on different currency flows available at the central office. any exchange rate change will result in net 0 effect on the changes in cash flow values and. therefore. That way. the parent can come up with the overall net position for each currency for a given time.000 DM .= outflow) The consolidated net exposure of the MNC will be: FF + 120. Also. Similarly. Techniques to Hedge Transaction Exposure Futures Contract Hedge: Future contracts enable firms to buy or sell a specified amount of a given currency at a pre-determined price on a specific future date. all subsidiaries will be able to report their net positions in all currencies. only open currency cash flows for a given time alone are at risk.000 BP . if one has both inflows and outflows in the same currency for the same time horizon.
0 % Germany 5. Hedging these payables is done to minimize dollar outflow costs in the future.690 per DM Probability 30 % 70 % ABC corporation is considering: . The DM spot rate in 90-days is forecasted to be: Possible Rate $0. Forward Contract Hedge: The mechanics are the same as that of the futures contracts.02.660 per DM $0.000 90-day payables.0 % 6. and use put options to hedge future receivables. A put option on DM that expires in 90-days has an exercise price of $0. since corporations do not like risk . one borrows in the foreign currency. Note: The costs of hedge or no hedge hinge on accurate forecasts. one invests in the foreign currency. For hedging future payables. They are used for large amounts and are tailor made to suit the needs of the individual firm.680 and has a premium of $0. to hedge a future receivables.0 % 90-day deposit rate 90-day borrowing rate A call option on the DM that expires in 90-days has an exercise price of $0. 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. the corporation is concerned about a rising value of the foreign currency which would lead to higher dollar costs. For hedging the future receivables. The following information is available: Spot rate of the DM : $ 0.660 and has a premium of $0. Money Market Hedge: Involves taking a money market position to cover future payables or receivables.675 per DM 90-day Forward Rate : $0. To hedge future payables.0 % 6.685 per DM 90-day Interest rates are as follows: US 5. Payables outstanding in foreign currency: With the payables.the amounts involved are small. the firm will enter into a future buying contract and. Firms use call options to hedge future payables. additionally. the firm will sell forward at the appropriate futures rate. they may want to hedge even when the costs of hedging are higher than no hedging. Comprehensive Examples on Hedging Transaction Exposure Different techniques to hedge transactions exposure are illustrated through comprehensive examples here: I.03. ABC corporation has an outstanding DM 200. One must always compare the costs of forward contracts or futures versus the no hedge decision and choose the alternative having the lower cost.
285. Remaining Unhedged You have been hired as a consultant to decide on the best possible hedge. Convert $128. Forward Hedge: Purchase DM 90 days forward at the forward rate of $0.43 * 1. and why ? Solution: 1.571.685 per DM. Option Hedge The option hedge involves buying call option to hedge payables. thereby locking-in the rate.68. Repay loan in 90 days plus interest $128. For hedging payables.476.05) = DM190.000 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. When the German investment matures in 90-days. ABC will be able to get the DM at $0.685 per DM = $137.06 = $136.685 per DM.43 to DM at exchange rate of $0.000 / (1+0. one needs to only invest the net amount which will grow into an amount equal to the payables amount. Cost = DM 200. Which one of the alternatives you will recommend.000 are received in 90-days.571. Steps: 1. An Option Hedge and 4.000 * $0. 2. one can walk away from that. premium = $. regardless of what happens to the spot rate in the future.000 6. and repaying the dollar loan with interest at the US borrowing rate in 90 days. investing DM in a German money market instrument at the German deposit rate.19 Since foreign investment generates interest income. Calculate amount of $ to be borrowed = DM190.43 3.476. the proceeds are used to pay the payables.476.19 * 0. the steps include borrowing in dollars. converting to DM at the spot rate.571. 2. an option. Recall that the call option gives the right to buy the given currency at the strike price.675 = $128. Invest in Germany @ 5% = DM190.675 = DM190. 571.571. A Forward Hedge 2.19 5.43 * 0.675 per DM $ 128. Find amount of DM to be invested = Payables Amount /(1+Foreign Interest Rate) DM200.19 * 1.02) . Borrow $128. Money Market Hedge A money market hedge works on the general principle of creating an opposite sign currency cash flow for the same duration as that of the payables.05 = DM200.43 @ 6% 4. if the rates are not favorable. Buy DM call option (Exercise price = $0. the proceeds will be used to pay off the payables.1.72 When the German investment proceeds of DM200. Also remember that an option is just that. A Money Market Hedge 3.476.
000 cost. a money market hedge is recommended here.000 $0. 2. or remaining unhedged has the lowest cost of $136. one also has to consider the risk among different alternatives and go for more certain outcome since corporations do not like uncertainty. Total Price $132.72.3) + 138.200.69 Expected Cost of Remaining Unhedged = $132. 4.69 (70%) Premium $0.66 (30% ) $0. Therefore.285. and it is 100% certain.000 (0.66 $0. there is a 70% chance that its cost might be as high as $138.000(0.70 $140.7) = $136.02 YES $0.800 4. Remain Unhedged Expected Spot $0.000(0.000 Probability 30% 70% 2. .000 (0.02 Exercise (Y or N) NO Total Price* $0. While the expected cost of doing nothing. one has to choose a lower cost alternative.3) +$140.68 Cost $136. the forward hedge is close behind with a $137. However.200 5) Which one of the alternatives should one choose? In choosing among the hedging alternatives for payables. 3.7) = $138. The money market hedge has the lowest cost of $136. Receivables Another US corporation (XYZ Corporation) is expecting an inflow of DM300.Expected Spot/ Probability $0.000 Receivables in 90-days.000 $138.000. 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. It is considering: 1.000 * Total Price = Purchace Price + Premium Expected cost of call option = $136.
we need to create a DM300.000 * (0.000 Premium $0.3) + $198. Expected Spot/ Probability $0.62 3.74 *(1+0. Money Market Hedge As before.037.27 * 0. converting to US dollars. Remaining Unhedged .69 (70%) Expected inflow from the put option= $189. Amount to be borrowed in DM = Receivables/(1+Foreign Interest Rate) = DM 300. investing those dollars in the US.589.500 2.000 4. Recall put options give the right to sell a currency at the strike price.7) = $195.27 US dollars Received after converting to the DM at the Spot Rate = DM 283. We can accomplish this by borrowing in DMs.03 YES $0.00 outflow in 90-days.03 Exercise (Y or N) Indifferent Total Price $0.000 * (0. Option Hedge This technique to hedge receivables involves buying put option.66 (30%) $0.000/(1+0.06) = DM 283.685 = $205.018.1.66 $198. since the receivables being hedged is an inflow of DM300.74 Invest the US dollars in the US at the US deposit rate Amount accumulated after 180 days = $ 191.300 $0. Forward Hedge The forward hedge to hedge receivables involves selling the currency forward at the forward rate thereby locking-in the rate.000 to be received 90-days from now.63 Cost $189.037. the corporation will use those proceeds to pay off the DM loan.05) = $ 200.675 = $ 191. Sell DM300.018. when the proceeds from the receivables are received.the Money Market Hedge is built on the principle of building an opposite currency flow for the same amount to the flow that is being hedged: in this case.000 * $0.000 @ the 90 days forward rate DM300.
Here. an MNC can recognize disequilibrium conditions and react competitively. At the same time. firm for its exports in U. dollars 5 years into the future also. a German firm. the forward hedge.000 Probability 30% 70% Expected inflow from remaining unhedged= $198. it can use a forward contract on a currency that is highly correlated with the currency of concern. Although remaining unhedged has an expected value of $204. Example: Consider an MNC called ABC Corporation. the . Managing Long-term Transaction Exposure Long-term forward hedge: Use of long-term forward contracts for extended 5 to 10 year periods. Currency Swap: Exchange of currencies between firms having different long term needs.000 * (0. There may be a partial offsetting effect due to a diversified set of inflow or outflow currencies. which is based in U. Diversifying Operations: If operations are diversified internationally.300 5) Given the three alternatives above. Parallel Loan: Exchange of currencies and a re-exchange at later date. Managing Economic Exposure The objective of economic exposure management is to anticipate and influence the effect of unexpected exchange rate changes on firm's future cash flows. Since it is an uncertain outcome.500 is the clear winner. Other Techniques to Reduce Transaction Exposure Leading and Lagging: Lead payments in a foreign currency if the foreign currency is expected to appreciate and lag the payments if the foreign currency is expected to depreciate. and is expecting payment of contract work done in Germany in DM 5 years into the future. it is in a sense hedged. a number very close to that of the forward hedge amount of $205. we will go along with the certain forward hedge amount.000 * (0. is expecting payment from a U. the choice here is to choose the one that has the highest certain cash inflow. the unhedged amount is only an expected amount based on forecasted exchange rate. such that the firm will not be affected by this exposure.000. This is because not all currencies will depreciate or appreciate against the firm's home currency simultaneously by the same degree. If the net outflow currency appreciates. firms that have set up fixed-price export or import contracts over long periods of time use long forwards. For example. so should the net inflow currency. exposure is not as great as if the equivalent amount of funds were denominated in a single currency.S. with a 100% certain inflow of $205. Hamburg International.66 $0.7) = $204.300.S. ABC and Hamburg can arrange for a currency swap at a negotiated exchange rate. if purchasing power parity does not hold up.000 $207. Cross Hedging: If a firm cannot hedge a specific currency.69 Total Price $198. Currency Diversification: If a firm has net inflows or outflows in a variety of currencies which are not highly correlated with one another.3) + $207.S. Arrangement is made for two firms to swap currencies for a specified future time period at a specified exchange rate. If a firm has net inflows in a currency that is highly correlated with a net outflow currency.Expected Spot $0. Banks often act as middlemen to link firms . Economic exposure can be managed by diversifying operations and financing.
What are currency futures? Discuss their characteristics. diversifying the operations internationally will provide beneficial portfolio effects by reducing the variability of the cash flows.61. the appreciating yen caused a decline in demand for the Japanese autos. the spot price of DM was $0.02 per unit. 4. there is an opportunity to lower the cost of financing is available. its management could shift its operations to the US and take steps to increase its sales in Canada. 3. 8. Some of the Japanese companies like Honda and Toyota have reduced their economic exposure stemming from rising yen by building plants in the US. participants. 7. both Honda and Toyota are trying to ensure that the demand for their autos is not affected by strong yen. the premium paid was $0. in the Madison Inc. the exchange rate risk is not totally eliminated. compute the net profit from this transaction. the spot price was $1. and their use in hedging and speculation. For example. A speculator bought a DM put option with a strike price of $ 0. situation we saw earlier. the Japanese plants in the US import various parts from Japan. What is economic exposure? How would one manage economic exposure? .500 units for each DM option. A speculator bought a BP call option with a strike price of $1. In addition. the dollar earnings of these US subsidiaries have to be remitted to the parent companies in Japan. In addition. Therefore. It might also observe changes in profit margins or sales volume.management might notice changes in comparative costs among plants located in different countries. it can take advantage of any deviations from the International Fisher effect: if interest rate differentials do not equal the expected changes in the (spot) exchange rates. Questions and Problems 1. 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. When the autos were exported to the US.675 per DM. Diversifying Financing Globally If a firm diversifies its financing sources. we reviewed various techniques to manage transaction exposure effectively.55 per pound. we examined the nature and types of foreign exchange rate risk. What is transaction exposure? What methods are available to hedge payables or receivables to manage transaction exposure? Explain each method in derail by providing suitable illustrations as necessary.250 units in one BP option. locating the plants in the US where the autos are sold has reduced the economic exposure. By building plants in the US and invoicing them in US dollars. 2. the cash flows of the Japanese companies were adversely affected by the strong yen. When he exercised the option. Use suitable illustrations. Still. compute the net profit to the speculator from this transaction. A good review of Foreign Exchange Risk Management is provided by Professors Gunther and Dufey. If there are 31. But. 5. Therefore.625 per unit. We studied the relevance of exchange rate risk and discussed the three types of exchange rate risk: 1) Transaction Exposure 2) Economic Exposure and 3) Translation Exposure. the participants. On the day when the put option was exercised. the premium paid was $0. Summary: In this Module. What is foreign exchange risk? Why is it important to manage foreign exchange risk? 6. Further. diversifying financing sources reduces the variability of future cash flows from domestic business cycles as well. If there are 62.01 per unit. In addition. What are the three types of exchange rate risk? Define each type and explain whether each type affects the cash flows or not. and their use in speculation and hedging. Compare currency forward contracts with currency futures with regard to their characteristics.
and Moffett. each alternative's outcome could be simulated over a range of potential ending exchange rates. Addison Wesley Publishing Company. he believed the dollar had risen about as far as it was going to go. Although the final expense of each alternative could not be known beforehand. dollars on delivery of the aircraft in one year (January 1986).2/$ in January 1985. purchased twenty 737 jets from Boeing (U.000. Cover the exposure with foreign currency options. Evaluation of the Hedging Alternatives Lufthansa and Herr Ruhnau had the same basic hedging alternatives available to all firms.000) at a rate of DM3. All rights reserved. He compromised.2/$. Of course if the dollar . 1: Remain Uncovered Remaining uncovered is the maximum risk approach. He covered half the exposure ($250. leaving the balance uncovered. 1986. payable in U. Herr Ruhnau had his own view or expectations regarding the direction of the exchange rate. Cover some proportion of the exposure. New York.000. dollar had been rising steadily and rapidly since 1980. 2. The agreed upon price was $500.1 billion. and was approximately DM3.S. chairman of Lufthansa (Germany) was summoned to meet with Lufthansa's board.000.S. Stonehill. Exhibit 7.000. If the exchange rate were to drop to DM2. The U. 1. The board's task was to determine if Herr Ruhnau's term of office should be terminated. and Herr Heinz Ruhnau. 5. 3. If the dollar were to continue to rise. 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.END OF MODULE 6 Module 7: Case on Exchange Rate Risk Management ® Reproduced with permission from Multinational Business Finance by Eiteman. it really wasn't his money to gamble with. and the greatest potential cost (if the dollar continues to strengthen versus the Deutschemark). In January 1985 Lufthansa (Germany).S. But then again. the purchase of the Boeing 737s would be only DM 1. Cover the entire exposure with forward contracts. Obtain U. 4.). Remain uncovered. the cost of the jet aircraft to Lufthansa would rise substantially by the time payment was due. 7th Edition. and left the remaining half ($250.S. dollars now and hold them until payment is due. Like many others at the time. and would probably fall by the time January 1986 rolled around. 1995. It therefore represents the greatest potential benefits (if the dollar weakens versus the Deutschemark).2/$ by January 1986. Lufthansa It was February 14.000) uncovered.7 illustrates the final net cost of the first four alternatives over a wide range of potential end-of-period (January 1986) spot exchange rates. under the chairmanship of Herr Heinz Ruhnau.
so he expected Lufthansa would benefit from leaving more of the position uncovered (as in alternative 1). The 100% forward cover alternative is often used by firms as their benchmark.2/$. Herr Ruhnau's total potential exposure is still unlimited. and $250 million could translate into an infinite amount of Deutschemarks. 40/60. .0 billion. First.S. 2: Full Forward Cover If Lufthansa were very risk adverse and wished to eliminate fully its currency exposure. not in the process of payment.continued to appreciate. in that there are few objective methods available for determining what the proper balance (20/80. Herr Ruhnau has reduced the risk (vertical distance in Exhibit 7.) between covered/uncovered should be. The uncovered position's risk is therefore shown as that value line which has the steepest slope (covers the widest vertical distance) in Exhibit. dollars for the entire amount. their comparison measure for actual currency costs when all is said and done.0/$ by 1986.7 illustrates the total ending cost of this alternative for a partial cover of 50/50: $250 million purchased with forward contracts of DM3. This alternative is represented by the horizontal value line in Exhibit 7.2/$. the total cost of the Boeing 737s no longer has any risk or sensitivity to the ending spot exchange rate. Two principal points can be made regarding partial forward cover strategies such as this.6 billion. Note that this value line's slope is simply half that of the 100% uncovered position. The possibility that the dollar would appreciate to astronomical levels still exists. etc. however. The second point is that the first point is highly unlikely to occur. and the $250 million remaining purchased at the end-of-period spot rate.7) of the final Deutschemark outlay over a range of ending values and the benchmark value of DM3.7. Many firms believe the decision to leave a large exposure uncovered for a long period of time to be nothing other than currency speculation. the total cost would be DM 2. This strategy is somewhat arbitrary. 3: Partial Forward Cover This alternative would cover only part of the total exposure leaving the remaining exposure uncovered. it could buy forward contracts for the purchase of U. Any other partial cover strategy would similarly fall between the unhedged and 100% cover lines. rising to perhaps DM4. Exhibit 7.2/$. Therefore. with a known final cost of DM 1. for the immediate ranges of potential exchange rates on either side of the current spot rate of DM3. This is obviously a sizable level of risk for any firm to carry. Herr Ruhnau's expectations were for the dollar to fall.2/$. Most firms believe they should accept or tolerate risk in their line of business. 50/50. This would have locked in an exchange rate of DM3.
000.8. In January 1985 when Herr Heinz Ruhnau was thinking over these alternatives.2/$.2/$. Few would argue this. He would be expecting the dollar to weaken (ending up to the left of DM3. Herr Ruhnau's Decision Although Herr Ruhnau truly expected the dollar to weaken over the coming year.000 (exercise plus premium). If Herr Ruhnau had purchased a call option on marks at DM3. It is important to understand what Herr Ruhnau would be hoping to happen if he had decided to purchase the call options. The dollar had shown a consistent threeyear trend of appreciation versus the Deutschemark. Lufthansa would be free to let the option expire and purchase the dollars at lower cost on the spot market.6 billion plus the cost of the option premium. Although this would eliminate the currency exposure. particularly given the strong upward trend of the DM/$ exchange rate as seen in Exhibit 7. . the total cost of obtaining $500 million could be locked in at DM1. and these did not call for the capital to be available until January 1986. he believed remaining completely uncovered was too risky for Lufthansa. as illustrated by the flat portion of the option alternative to the right of DM3. equal to DM96.000 or $30. and currencies of denomination of the debt it could carry on its balance sheet. If the dollar had continued to strengthen above DM3. DM96. An added concern (and what ultimately eliminated this alternative from consideration) was that Lufthansa had several relatively strict covenants in place that limited the types. therefore he would expect the option to expire without value. however.000 is a lot of money for the purchase of an instrument that the hedger expects or hopes not to use! 5: Buy Dollars Now The fifth alternative is a money market hedge for an account payable: Obtain the $500 million now and hold those funds in an interest-bearing account or asset until payment was due. The purchase of the Boeing jets had been made in conjunction with the ongoing financing plans of Lufthansa. the dollar fell as Herr Ruhnau had expected.000. and that trend seemed to be accelerating over the most recent year.6 billion given an exercise price of DM3. This alternative is shown by the falling value line to the left of DM3. Note that the call option line falls at the same rate (same slope) as the uncovered position. In the eyes of many corporate treasurers. but is higher by the cost of purchasing the option.2/$.000! The total cost of the purchase in the event the call option was exercised would be DM1.2/$ in Exhibit .000. If. In this instance Herr Ruhnau would have had to buy call options for DM 1. amounts. it required that Lufthansa have all the capital in hand now. he could have obtained what many people believe is the best of both worlds.2/$. the option premium on Deutschemark call options was about 6%.696.4: Foreign Currency Options The foreign currency option is unique among the hedging alternatives due to its kinked-shape value line.2/$.
and because of the sheer magnitude of the up-front premium required. . In fact. How It Came Out Herr Ruhnau was both right and wrong. the spot rate had fallen to DM 2. Because foreign currency options were as yet a relatively new tool for exposure management by many firms. He was definitely right in his expectations. it plummeted. By January 1986 when payment was due to Boeing. and then weakened over the coming year.Because he personally felt so strongly the dollar would weaken.2/$) and to leave the remaining 50% ($250 million) uncovered. Time would tell if this was a wise decision. the foreign currency option was not chosen. Herr Ruhnau chose to go with partial cover. it did not simply weaken.3/$ from the previous year's DM3.2/$ as shown in Exhibit . This was a spot exchange rate movement in Lufthansa's favor. He chose to cover 50% of the exposure ($250 million) with forward contracts (the one-year forward rate was DM3. The dollar appreciated for one more month.
150. It is obvious that the term speculation holds an entirely new meaning when perfect hindsight is used to evaluate performance.000 DM3.600.375. Ruhnau was accused of recklessly speculating with Lufthansa's money. Choosing to use forward contracts as his hedging tool instead of options. but the speculation was seen as the forward contract.375 billion. Choosing to hedge half the exposure when he expected to dollar to fall. dollar was at an all-time high at the time of the purchase in January 1985.000 ½ (DM2.2) 1.000. dollars spot if the market moved in his favor.S.2/$ strike 1.000.000.000.2/$ 1.S. Purchasing the Boeing aircraft at the wrong time. 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.000.000. not the amount of the dollar exposure left uncovered for the full year. a full DM225. 2.3) + Cover ½ (DM3.000 more than what the foreign currency option hedge would have cost in total.000 DM3. . 3.The bad news was that the total Deutschemark cost with the partial forward cover was DM1. were not so happy. Case Questions Herr Ruhnau was accused of making the following four mistakes: 1.000 more than if no hedging had been implemented at all! This was also DM129.3/$ 1. he would have left the whole amount unhedged (which some critics have termed "whole hog").3/$ would have been: Alternative 1: Uncovered 2: Full Forward Cover (100%) 3: Partial Forward 4: DM Call Options Relevant Rate Total DM Cost DM2.000 Herr Ruhnau's political rivals. both inside and outside of Lufthansa. If he had gone through with his instincts or expectations.246. The total cost of obtaining the needed $500 million for each alternative at the actual ending spot rate of DM2. The U.
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. promotional and product strategies) and production (input mix. can assist operating managers in configuring operations to cope with such exchange rate volatility and responding to shifts as they occur1. Second generation: Futures. pp 70-82. has a vested interest in the conglomerate Airbus. and William R. Given their specialized knowledge and competitive advantage in these imperfect product and factor markets. Corporate Use of Innovative Foreign Exchange Risk Management Products In today's competitive global markets. Firms are threatened by exchange rate volatility and its impact on their competitive position. and long range planning) executives. as well as the other major European Economic Community countries. can be hedged using various financial products and techniques2. These products may be roughly categorized under three generations3: 1. In this study. Chuck C. a plethora of new financial products has been introduced in the marketplace to help multinational corporate managers handle currency risks. options. synthetic products. Jr. Folks. Airbus's chief rival was Boeing in the manufacture of large long-distance civil aircraft. and that the adoption of innovative foreign exchange risk management products is not as common as expected. In today's competitive global markets. foreign exchange agreements. All rights reserved.S. firms are threatened by the increasing exchange rate volatility. Over the last two decades. participating and break forwards. compound options. First generation: Forward contracts. this product was used under the fixed rate regime. They are also threatened more subtly by the potential for management error due to illusions associated with short-run movements in exchange rates. the effective strategic management of a firm must include an analysis of the impact of exchange rate changes on the firm's operating exposures. firstgeneration product (forward contracts) has not been overtaken by the sophisticated new entrants. 2. there will usually be residual operating exposures. pricing.Y. Fall 95. warrants and swaps. Given these criticisms. Third generation: Range. Germany. Purchasing Boeing aircraft at all. Kwok. a large variety of new foreign exchange risk management products have been introduced in the financial marketplace to help managers handle risks in the increasingly volatile foreign exchange environment. with their knowledge of the dynamics of foreign exchange. these products arose out of the post-Bretton Woods volatility and the need for more variety in hedging tools. futures options. Over the last two decades. Columbia University Press. Financial managers. 3. if large enough. the authors examine how extensive are the various major innovative foreign exchange products used by U. Kurt R. They find that the popularity of the simpler. Jesswein. corporations. and hindsight options. and categorize these products into three generations. Nevertheless. plant location. these products arose from the demands of .4. the major burden of such exchange risk management should fall on the shoulders of marketing (market selection.
we collected primary data directly from corporations. We compared the profile of the survey respondents with the profile of the overall sample. of which 168 questionnaires were fully usable. The questionnaire lists 15 different products. Would the importance of old products such as the forward contract be taken over by these new entrants? Or. its USEFX value will be "3.. most of the major products are already included. In summary.-based corporations that fall into two groups. bringing the total number of survey participants to 6028.g. The first group includes Fortune 5005 firms with sales exceeding $750 million. We are interested in a series of questions. 2) manufacturing (e. A composite variable. in running multiple regressions to analyze the data. Examples of these executives are corporate treasurers and chief financial officers. its USEFX variable will be assigned a value of "15. the firms are classified under seven categories: 1)mining and construction. our grouping is rather broad. the total amount of corporate assets. No significant bias was found between the two groups. 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. Though the above list does not exhaust all the innovations. electronics. etc. 5) wholesale and retail trade.). USEFX.). We also categorize the respondent firms under different industries according to their Standard Industrial Classification (SIC) codes.corporate and bank users for more sophisticated products and better variation or lower cost over existing product configurations.S. corporations4. Because of space constraint. There are 403 firms included in this group." If the company has only tried 3 out of the 15 products. We also try to assess the degree of international involvement of the respondent firm by using three different proxies: the percentage of foreign assets. 6) finance. and the percentage of foreign income. If a corporation has used all of the 15 products. textile. Using only the first digit of the codes. 4) transportation and utilities. For each of the aforementioned products. 3) manufacturing (e. we conducted a survey. is computed to proxy the corporation's tendency to use foreign exchange risk management products in general. The second group includes 179 Fortune Service 500 firms excluding commercial banks6 and the six largest (in terms of revenue) privately-held firms7. we report only the results using the percentage of foreign income (FINCOME) as the proxy of international involvement. The firms chosen for the study are U. Empirical findings as reported in the next section show that the results are quite similar regardless of which proxy is used.. and 7) other services. a corporation is asked whether or not and to what extent it has used the product. Because of the relatively small sample size.8%. There were 173 firms which responded. Fourteen additional firms are included in the presurvey group." Another variable TASSETS. 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. The sample includes the corporate executives most likely making decisions on the use of foreign exchange risk management products and techniques. In this study. The response rate was therefore 27.g. etc. machinery. Later on.S. Methodology Research sample Using a mail questionnaire. is used to proxy the firm size9. we examine how extensively these foreign exchange innovative products are used by U. food. the percentage of foreign sales. we show in Table 1 the profile of the survey . insurance and real estate. we use six dummy variables (I1 to I6) to represent these industries.
Lumber) 3 Manufacturing (e. Insurance & Real Estate Frequency 7 20 35 40 49 22 Frequency 53 32 36 17 20 13 2 Frequency 66 31 19 19 16 17 5 Frequency 7 60 59 17 14 10 Percentage 4.7 .7 21.5 10.7 7.1 9. 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.respondents in terms of their industrial classification.9 11.6 Percentage 39.1 9.1 5. and the percentage of foreign income10. Food.8 8.3 9.3 11.g. the percentage of foreign sales.7 34.5 32.0% 34. Electronics) 4 Transportation & Public Utilities 5 Wholesale & Retail Trade 6 Finance.1 Percentage 31.5 Percentage 31.2 26.0% 18. total corporate assets.2 23.6% 13. Textile.g.3% 18.5 11. Machinery. Metal.
8 52. The products are arranged in a descending order according to the percentages of respondents who have heard of the products. which is a simple.9% Notes: The products are ranked by the percentages of respondents who have heard of products. the average percentage of awareness across all products is 84.0% 98.1 23. corporations in general are well aware of the existence of these innovative instruments.4% 93. Nevertheless. corporations in Table 2.S.7 77. a much smaller percentage of the corporations have adopted the new products.4 95. Compound options Hindsight/lookback options. There are 173 respondents in total.S.6 81.0 88.0 83. corporations are more aware of the first and second generation products than those of the third generation.2 4. 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. According to the figures under the "Used" column. the percentage of awareness is 52.3 Use of Foreign Exchange Risk Management Products We report the extent of knowledge and use of foreign exchange risk management products by the U.4%. Foreign currency warrants Break forwards.8 98.g. awareness does not necessarily lead to adoption. Legal Services) Note: There are 173 respondents in total.8 96.6 15.7 22.3 55. The least heard of product is the third-generation hindsight/lookback options.9 48. The importance . 6 3.1 17. It is no surprise that all of the respondent companies have heard of the forward contract.3 8. 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 18.8 4. etc. the forward contract is still the most popular product (93.6 20.1 84.7 65.8 5.1%). even the lowest ranked product of hindsight/lookback options has been heard of by over half of the respondents.1% 52. However.8 14. etc. popular product of the first generation. Hotels.2 88. Though they have heard of the products. As expected. Overall. Health.8 93. The research sample is based on Fortune 500 and Fortune Service 500 firms in the United States. etc. etc.1%.7-8 Other Services (e.9 3. Forward exchange agreements. It indicates that U.8 28.5 91.
and third generation products are 93. It is not because they are not heard of.1%. and 14. They may therefore be less convenient that the OTC products. Some of the third generation products such as break forwards. Overall. in turn.1% respectively.3%.of this old. Though being widely heard of. 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.1%. Interestingly. their adoption percentages are 4. The first and second generation OTC products such as forward contracts. The next group of more commonly used products are foreign currency swaps (52. Forward contracts. the exchange-traded products of the second generation such as futures contracts. This finding comes as no surprise.8% and 5. Break forwards. Both are second generation instruments. currency swaps and OTC options are generally very popular. This is probably due to the fact that OTC products are more convenient and flexible to use. currency swaps and OTC options already cover most of the business needs12. first-generation instrument has not been overtaken by the "fancy" innovations. Differences Across Industries For further analysis. Though the third generation products have received a lot of attention in the literature. Even when they are used. its ranking is still quite similar to those of there industries. The use of the third generation products is generally less than that of the second generation products. The fourth column of Table 2 shows the percentages of usage given that the products are known. currency options and futures options show high percentages of awareness. currency options and futures options are less utilized by corporations. 25. Nevertheless. currency swaps and options stand out to be most popular. which is. 17. the use of the third generation products is not common. the usage of these products is not as common as expected. The average percentage of adoption across the different products is 39.7%.9% respectively.3%. insurance and real estate industry of Category (6) stands out to be the most frequent user of exchange risk management products.6%) and over-the-counter (OTC) currency options (48. 3.9%. compound options and hindsight options are rarely used. which has an adoption rate of 23. While the use of most products is higher in the finance industry. the average percentages of use of the first.3% and 8. we break down the use of foreign exchange risk management products under seven industrial categories as shown in Table 3.2% respectively. The adoption percentages for futures contracts. The assets these firms handle daily are mainly financial assets. exchange-traded products such as futures contracts. Among the various industries. second. Perhaps.6% higher than the next highest industry. insurance and real estate industry. Even among the corporations that are aware of these products. they may not be really useful to many corporations under most circumstances. the simpler products such as forward contracts. the use of exchange-traded products also shows higher percentages in the finance. the finance. The rankings of the product use are generally alike across industries. The use of the third generation products are generally limited. exchange-traded . The products can be tailor-make to fit the specific needs of the companies. generally less than the use of the first generation products11. and hindsight options are seldom utilized even by these finance experts. The message seems to be the same: the popularity of the simpler products has not been overtaken by the sophisticated new instruments. 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. compound options. There are substantially more finance experts in this industry who are skillful at using financial products. Most of these products are used by less than 20% of the respondent companies. The corporations may simply telephone the banks to arrange for these OTC products. 15. manufacturing. the frequency of adoption is not high. Alternatively. The possible implication of such findings is that although the sophisticated products may be interesting variations. versus 48. they have more need to utilize financial instruments to offset financial risks.8%). the percentages of their use are substantially less than that of OTC options (20.8%).
0 60. & & Retail & Real Other Manufact.9 14. Following the finance.3% 48. The financial institutions reduce their own currency exposures by netting out financial assets and liabilities of different currencies.0 0.9 11.0 20.6 40.0 50.5% and 13.2 5.0% 57.4 28.0 5.8 28.006 level.0 40.7 50.7 (2) 98.3 18.7 18. One of the channels is to go through the exchange trading floor. the industry variables explain about 12% of the variance of USEFX and the F-value is highly significant at the 0.7%.0 16. One possible reason is that the customer base of these latter industries is mainly domestic.6% 52.0 22.4 17. Manufact. Unlike other corporations.0 16.1 17.a.4 21.7 0.0 0.0 31. both Categories (2) and (3) behave similarly and have the same percentage average of 23.0 17.7 16. Overall.3% respectively).0 (7&8) 33.8 14.0 50.6 17.3 40. Of the seven columns. In fact.8 5.7 0. (e. Wholesale Insurance Mining & (e.3 8.9 21.9 28.g. The results are shown in the third regression of Table 4. For the remaining exposure they cannot totally net out.3 18.7 (3) 100. Transp.0 0.6 21. 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. 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.1% 66.6 20.0 30. the transportation and utilities industry (4) and the "other services" industry (5) have the lowest average percentages of adoption (14. To examine the statistical significance of the industry effect.0 28. insurance and real estate industry.0 0.0 29.0 Overall 93.0 30.3 6.0 33. A slightly smaller percentage is found in the mining and construction industry.options and exchange-traded futures are 20%. the industry with the next highest percentage of adoption is manufacturing.0 16. followed by the wholesale and retail trade industry. 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.1 50.7 0.8 . they themselves go to the market to lay off the risks.0 (4) 70.0 0.9 48.0 16.0 0. The need for exchange risk management products may therefore be smaller.7 16.6 15.4 (6) 90. there are relatively less foreign currency cash flows.7 (5) 85.9 11.0% 50.0 10.3 22.7 20.3 28.0 18. Manufact.7% 21.1% 52.3 0.7 55. the financial firms are more familiar and adept in using exchange-traded products. 40% and 30% respectively.g.0% 80.4 42.
Forward exchange agreements.9 0.6 7.0 0.4% 14 30.4 23.0 39.7% 59 5.0 0. Compound options Hindsight/lookback options. Average percentages Number of respondents 0.0 23.0 20.0 0.9 5.0 20.8 4.0 0.7 1. etc.5% 17 28.forwards.0 14. etc.0 0. There are 173 respondents in total.1 23.0 30.0 0.9 0.7 3.3 3.0 16.7 0.0 1.1 0.3% 6 14.2 4. etc.9 3.0 10.0 0.0 22. etc.3 3.3% 7 13.3 0.0 0.0 13.8 5.7% 60 11.0 0. The percentages represent the proportions of respondent corporations which have used the products. Foreign currency warrants Break forwards.7 0.0 23.3 3.3% 10 66. .9% 173 Notes: The products are arranged in the same order as in Table 2.
Table 4. 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 .a Firm Size.
006 (0. we also examine whether the size and the degree of international involvement of a company affect its use of foreign exchange risk management products.0002 level16. The second regression results in Table 4. with a F-value highly significant at the 0. Thus far.22 4.12 3.1 0.03 3. To ensure that the international effect is not simply an indirect result of the industry effect. the two explain 23% of the variance of USEFX.95 (1.91) 0.6) (0.33 1.28)** 0.22) (0.69)** 0. Such findings indicate that the use of foreign exchange risk management products by a corporation is positively related to its degree of international involvement.42 (3. In Table 4.28) (0.53)** Influence of Firm Size and Degree of International Involvement Besides the industry effect. simpler products and focus on the more sophisticated. we run another regression including all of the independent variables mentioned above.2 0. The coefficient of FINCOME has a high t-value of 3.49 (0.77) 0.0003 level. The results may be different if we drop the more popular.2.42 (3. third-generation products. which is significant at the 0.94)** 0. which is also significant at the 0.67 (1.1 Size Effect 2.37) (0.26) (0.66) (0.59 3.99) (2.59 0.90) (0.75.77)** 0. the two effects seem to be quite independent.39)** 0. Interestingly.75)** 0.b are quite similar to those of Table 4. The overall equation has a F-value of 4.1 0.36 0.50) (0. the results as shown in Table 4.a.61 (7. There may be more need for the risk management products to hedge the currency exposure15. International and Industry Effects on the Use of Individual Products .83 0.09 14.06) (2.38 0.08 2 International Effect 2. which is a significant improvement of the explanatory power.98 0.0002 4 International & Industry 1.52 4.0003 3 Industry Effect 2. When combined. As shown by the results of Regression 4 in Table 4.55 (3.0003 level. As corporations become more internationalized. The coefficients of both FINCOME and I6 are still highly significant.31 (0.2 0. the first regression is run using USEFX as the dependent variable and LASSETS (log of total corporate assets) as the independent variable.93 0.a.46 0. Size.84 0.a. The percentage of foreign income (FINCOME) is used to proxy the degree of international involvement14.74 1.a show that the degree of international involvement explains 9% of the variance of USEFX.48) (1. the dependent variable USEFX includes the use of all foreign exchange risk management products. the amount of foreign currency cash flows passing through the firm increases. We therefore change the dependent variable to the use of third-generation products (USE3GEN) and return the regressions. Firm size explains only 2% of the variance and the F-value is not significant.
foreign currency warrants. foreign currency swaps. However. The products which do not have significant international effects are the three exchange-traded products plus forward rate agreements and hindsight options. Significant differences are also seen in the cases of cylinder options and forward exchange agreements at the 0. . and futures options). As the degree of international involvement increases. international and industry effects. As the firm size increases. The results are shown in the last column of Table 5. the international effect appears to be the most significant. the use of forward contracts and foreign currency tends to increase. and break forwards. We apply the F-test in each regression to examine whether or not the coefficients of the six industry dummy variables are the same. exchange-traded futures options. Among the size. these products are less frequently used than the OTC products. options. we want to see how the firm size.05 level of the forward contracts. the international. nine products show highly significant international effects. only four do not show significant F-values at the 0.05 level. participating forwards. the use of break forwards tends to decrease. corporate use of these exchange risk management products tends to increase. Though most corporate managers are aware of them.01 level. The results are reported in Table 5. the use cuts across a wide spectrum of foreign exchange products. Significant industrial variations are found at the 0. the firm size variable does not show significant effects on the use of individual exchange risk management products. In general. A regression is therefore run for each of the 15 products. high R2s are found in the regressions of the more popular products such as forward contracts and foreign currency swaps. three are exchange-traded products (futures. Of the fifteen products. Conversely. and compound options. break forwards. and the industry variables affect the use of individual foreign exchange products. Furthermore. Of the fifteen regressions. Exceptions are found in the cases of forward contracts.Furthermore. Among these four.
05 (-0.31) (-0.04)* 0.01 No 0.22 I4 0.19 (0.62) 0.70) -0.13 0.04) (1.01 (0.5 0.13 I5 0.48) -0.13 0.85) (-0.01) 0.09)** 0.12)** 0.71) (2.21 4.73 (1.85 (2.11 0.10 -0.75) (1.49) (-1.12 0.76)** I1 1.11)* -.39)* -0.02) (0.28 (0.37 No (2.58 (1.36)** (0.16 -0.23 (0.59)** 0.14 2.10 (-.18 (-0.45 (0.99 0.04 (1.20 (0.43) -0.12 0.18 (3.45) 0.43 (-0.19 (0.43 (-1.87) 1.7 0.43) 0.1 1.71 0.24 0.53) 0.42 0.74) 0.29) 0.44 (1.19 (0.11) 0.1 0.80) 0.5 0.41 (1.16 No 0.00)* (0.25 (1.14)** -0.72 (3.15 (0.71) 0.20 (-0.12 (-0.0001 Significant? Yes (2.08 (2.60) -0.36) 0.04 (0.34) 0.48) 0.56) 0.13) -0.1 0.35) -0.27 -0.31) (1.05 FSign.18 0.39) (0.06 1.40 (2.07 (0.02 0.08 Yes 0.40 (-0.15) (1.01) 0.Table 5 Firm Size.29) 0.19)* -0.7 0.51) 0.18 0.93) 0. R2 Value of F 0.31 (0.0001 No (-0.90) 0.01 (0.38 (1.14 0.10) 0.83) 0.53 -0.10 (0.27 6.15 -0.14 2.36)* (3.41) (1.10 0.06 I2 1.43) -0.02 0.02 0.05 (0.33) 0.28) .02) (2.95) 0.10 0. International.69 I6 1.17 I3 1.01 No No (0.14 0.19 (3.43 -0.64) 0.8 0.43 (0.33 (0.03) (0.68 0.01) (-0.45) 0.01 0.24) -0.06) (0.20 (0.23)** (3.77 0.15) 0.11 2.33) (-0.4 2.24 (0.23) (0.05 0.12 (2.34 0.27) -0.06 (-0.14 (0. 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 0.11 (3.01 0.20) 0.47)** -0.08 1.44) (-0.04 0.8 0.03) 0.04 No 0.08 (-0.98) 0.61 (1.
32) (-0.04 (2.11 (0.11) 0.12 2.19 5.09) -0.10)** 0. *Significant at the 0.39) -0.21 (0.03 (-0.38) -0.11 -0.01 0.44) -0.58) -0.01 (0.33 0.12) 0.06 0.93) (1.11 0.04 (-0.47) (3.59)** 0.02 (0. Industry effects are tested to examine whether or not they are significant at the 0.01 Yes (0.65) -0.12 (3.03 0.09 -0.12) -0.65) -0.02 -0.67) .04 (-0. Forward exchange agreements. -0.02 0.02) 0. Foreign currency warrants Break forwards.17) -0.33) (0.48) (0.36 0.66) 0.01 (1.12 (-0.50 (1. (-0.25 0.44) 0.5 0.19) 0.20)** (0.18) 0.13 (1.28) 0.4 0. Compound options Hindsight/lookback options.43) Participating forwards.62)** 0.39) (0.29) Notes: Sample size is 173.04 (-0.26) -0.4 4.01 level. **Significant at the 0.56) (-0. etc.02 0.08) (-0.88) 0.62 (1.56) (-0.12 0.17) (3.17) -0.09) 0.21 No 0.0001 0.41 0.05 (0.02 (0.03 (-0.26) (-0.0003 Yes Yes Yes 0.09 -0.14 (-2.07 -0.5 0. etc.06 0.23 (0.05 level.63) -0.08 1.01 (0.02 (-0.23 (-1.02 (-0.01 -0. etc.14) (0.21 (0.06 (2.50) 0.12) (-0.15)* -0.03 (-0.7 2.15) (1.10 (0.11)** 0.01 -0.79 0.09 (-0.02 (0.40) 0.07 (4. Dependent variables: Use of individual foreign exchange risk management products.03) (-0.03 (0.97) (0.23) (0."homemade" options (-0.20)* 0.1 0.74) -0.05 (-0.07 1.10) (1.03 (-0.56 (1.17 No (-0. The numbers in the parentheses are statistics.64)** 0.37) -0.05 level.72) -0.10) (0.18 0.21) -0.26) (2. etc.25 (-0.36) (-0.42) 0.48) (-0.36) 0.
) I4 Transportation and public utilities I5 Wholesale and retail trade I6 Finance. food. etc. insurance and real estate . electronics.) I3 Manufacturing (e.g. machinery. textile.g.Notes: Independent variables: LASSETS Log of total corporate assets FINCOME Percentage of foreign income Industry dummy variables I1 Mining and construction I2 Manufacturing (e. etc.
they may then approach investment bankers to help them use the more sophisticated third generation products. corporations. Significant industrial differences were found in the use of forward contracts. Belk. tailor-make. This paper has several limitations. On the other hand. For special business situations where these products are inadequate. it is encouraging to know that their more flexible. participating forwards. emphasis should be placed on the simpler. in turn. products which are more appealing to the corporate clients." Accounting and Business Research 21 (1990): 3-13. third generation products are not commonly used. These instruments may already cover most of their basic business needs. The findings showed that the use of the third generations products was generally less than that of the second generation products. insurance and real estate industry stood out to be the most frequent user of the products. The findings of this study may have significant implications for multinational corporate managers. Nevertheless." Journal of International Business Studies. These issues may be explored in future research. "Foreign Exchange Risk Management Practices and Products Used by Australian Firms. Furthermore. The use of foreign exchange risk management products was generally not significantly related to the size of the company.S. References Batten. he or she is better advised to focus on the more basic products of forward contracts. easy-to-use. Further study may also examine and pinpoint the specific details of why the sophisticated. it was significantly related to the company's degree of international involvement. "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation. less than the use of the first generation products. the use of these products was not common. It is important for them to build on this competitive edge. Nor did the study address how companies measured risk and how their use of products were affected by price and other considerations. and the industry effects. Penny A. the international. Though companies were generally aware of the existence of the third generation products. currency swaps and OTC options. managers of financial institutions and members of organized futures and options exchanges. the futures and options exchanges need to reflect on these findings and develop strategies to make their products more appealing. Among the firm size. and Martin Glaum. and compound options. Jonathan. reinvoicing centers. Such findings may help enhance the improvement and use of these products in the future. Robert Mellor and Victor Wan. To finance experts in the financial industry. . A similar observation was found even in the finance industry where there were plenty of finance experts who knew these innovative instruments well.Summary and Conclusions The objective of this paper was to examine empirically how various major innovative foreign exchange products that are made available to multinational corporate managers in the last two decades were used by U. the international effect had the strongest impact on the corporate use of foreign exchange products. exchange-traded futures options. foreign currency warrants. The survey did not cover the use of internal foreign exchange management techniques such as leading and lagging. OTC products are more appealing to corporate clients than the standardized products offered by organized exchanges. the finance. which was. (3rd quarter 1993): 55773. In terms of industrial variations. balance sheet hedge and so forth. To a corporate manager who is new to the foreign exchange risk management area. break forwards.
Options.. The classification is also used in Kurt Jesswein. "Financial Engineering in Corporate Finance: An Overview. University of South Carolina. Bradford and Alan Shapiro." In Martin Feldstein ed.. Kurt R. "The Management of Foreign Exchange Risk in UK Multinationals: An Empirical Investigation. Hung Chan." Financial Management." Accounting and Business Research 21 (1990): 3-13. Managing Financial Risk (Hagerstown. Options." Unpublished Ph. (Winter 1988): 40-52. Khoury. Donald R. Jr. University of South Carolina. "Managing Foreign Exchange Risks. Richard M. no." In Joel M. Giddy "Innovations in the International Financial Markets.. " Columbia Journal of World Business 17. Stern and Donald H. "Managing Foreign Exchange Risk Profitability. Gunter and Ian H. Sarkis J. Sarah and Liz Hecht. ed. and Hybrid Products to Manage Exposure. and K. 1986) 147-184." Journal of International business . (Winter 1988): 14-33. "Financial and Global Competition: Exploring Financial Scope and Coping with Volatile Exchange Rates. Lessard. (Fall 1981): 33-51. MD: Ballinger.D." In Michael Porter.Cornell. Competition in Global Industries (Boston: Harvard Business School Press. Ike Mathur. and Hybrid Products to Manage Exposure. Stern and Donald H. Competition in Global Industries (Boston: Harvard Business School Press. "Managing Foreign Exchange Risk Profitability. eds. "Financial Innovations in International Financial Markets. 1989)." Corporate Finance (September 1986): 23-38. dissertation. Dufey. 1992). Finnerty." in Michael Porter ed. 1 Donald Lessard. Priestly." Corporate Finance (London: Euromoney Publications) September. Jesswein. "Third Generation Risk Management: How to Use Futures." Columbia Journal of World Business (Winter 1982): 2023-30. 1988) 44-59. Jonathan Batten.. Charles W. Chew. New Developments in International Finance (New York: Basil Blackwell. Mathur. 2 Bradford Cornell and Alan Shapiro. Smith." Journal of International Business Studies. "Hedging Foreign Exchange Risk: Selecting the Optimal Tool. Smithson and D. Robert Mellor and Victor Wan. "Third Generation Risk Management: How to Use Futures. Sykes Wilford. "Managing Foreign Exchange Risks. 1986) 147-84. "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implication for financial Innovation Theory" (Doctoral dissertation. 1992. "Foreign Exchange Risk Management Practices and Products Used by Australian Firms. Ike. 3 The three generations are mentioned in Sarah Priestly and Liz Hecht. 1988) 44-59. John D. "Financial and Global Competition: Exploiting Financial Scope and Coping with Volatile Exchange Rates. 1988) 215-57. Clifford W. Penny Belk and Martin Glaum. The United States in the World Economy (Chicago: University of Chicago Press. Levich." Midland Corporate Finance Journal. 4 (Winter 1982): 23-30." in Joel M. eds. 1986: 23-38. 4 There have been empirical studies conducted in various countries to survey how companies define and manage foreign exchange risks. Chew. New Developments in International Finance (New York: Basil Blackwell. "Adoption Criteria for New Foreign Exchange Risk Management Products: Some Implications for Financial Innovation Theory.
006 level. leading and lagging. Regardless of which proxy is used. South Carolina. indicating that there is a significant industry effect. They constitute a major proportion of the respondent sample (34. 1989. most of these previous studies did not survey how corporations utilize new foreign exchange risk management products.Studies 3rd quarter (1993): 557-73.) Manufacturing firms of Category (2) are in the area of food. and Georgia.g. more foreign currency cash flows lead to more need of hedging. publishing. Besides utilizing external products. FASSETS (percentage of foreign assets) and FSALES (percentage of foreign sales) are also used as alternative proxies for the degree of international involvement. companies may also employ internal foreign exchange management techniques (e.S. and thirty-two sought to minimize both. Nevertheless.7% and 34. only results of FINCOME are reported in Table 4. 8 To test the objectivity and comprehensiveness of the research instrument. On the other hand. December 11. they can net out some . Belk and Glaum interviewed the senior management of seventeen U. paper. Mellor and Wan surveyed seventy-two corporations in australia and found that 61% of the respondents considered transaction exposure was the only relevant exposure. Manufacturing companies of Category (3) are in the area of metallic products.01 level. It is reflected at the 0. they are compiled under the category of "other services".a. five sought to minimize translation losses. The pretest sample included forty Fortune 500 and Fortune Service 500 firms headquartered in North Carolina. textile. tobacco.3%) managed both transaction and translation risks.K. Batten. since there is a small number of sample respondents in Categories (7) and (8). 1990. multinationals. lumber. On one hand. 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. the results are quite similar. Six responses were received (a 15% response rate) with no apparent problems encountered by the respondents. electronics. Very few respondents (8. is used in the later regressions. engineering and management. 5 Fortune. Mathur found that fourteen sought to minimize transaction losses. transportation equipments.. 13 The F-test is conducted to test the hypothesis that the coefficients of the industry variables are equal. the second and the third generations are significantly different at the 0. scientific instruments and others. including health. June 4. 9 A related variable. a majority of firms were also prepared to manage actively their net accounting exposure. was made. which is the log of TASSETS. 6 Fortune. LASSETS. reinvoicing centers. Alternatively. While most firms saw transaction exposure management as the centerpiece of their foreign exchange risk management. 7 Forbes. a limited survey. we examined only the use of external foreign exchange risk management products. chemical and petroleum refining. besides FINCOME. Owing to space constraint. or pretest. 10 There are two groups of manufacturing firms.. 15 Higher international involvement may have two opposing effects on the use of exchange rate products. 12 In this study. 11 Statistical results indicate that the percentages of product adoption across the first. Alternatively.1% respectively. Moreover. 1990. Out of a random sample of fifty-five Fortune 500 firms in the U.April 23. 14 As alluded to earlier. machinery. firms with higher international involvement have the advantage of natural diversification. and hotels.
despite this advantage. Nevertheless. 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. subsidiaries etc. futures and forward contracts etc. through building or buying existing company. also called US dollar equivalent. our findings show that.003 level. It is rejected at the 0. Cross exchange rates: The price of one currency with respect to another without the intervening dollar. factories. Derivative markets: The market for contingent claims like options. Direct foreign investment: Investment in physical assets like plants. 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. 16 The F-test is again conducted to test the hypothesis that the coefficients of the six industry dummy variables are equal. Direct quote: Number of US dollars per one unit of foreign currency.. The End Glossary Ask price: The buying price of a currency for an individual or MNC. the net effect is that firms with greater international involvement still tend to use foreign exchange products more. 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. 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. .of the currency exposures and then worry about the non-netted exposure. Bid price: The selling price of a currency for an individual or MNC. 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.
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. Interest Rate Parity Theory: Predicts that the (home-foreign) nominal interest differential will equal the forward premium or discount of the foreign currency. 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. individuals. Locational Arbitrage: Arbitrage involving bid and ask prices in different banks or locals or regions. 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. International Fisher Effect: The theory which predicts (home-foreign) interest rate differential. central banks. Triangular Arbitrage: Arbitrage involving the differences in the theoretical and market exchange rates. followed by selling forward the maturity value of the investment generating higher return than available domestically. Market Efficiency: . speculators and arbitragers buy and sell currencies. Foreign-exchange markets: The net-work of foreign exchange dealers connected by phone terminals where MNCs. Exchange rate risk: The variability in the cash flows of a firm stemming from exchange rate fluctuations. also could involve simultaneous borrowing and lending in different markets to take advantage of the interest rate differences. Covered Interest Arbitrage: Arbitrage that involves investing in a foreign currency asset. posits that the exchange rates will be impacted up-on by those factors.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. It will equal the change in the spot rate of the foreign currency.
Money Market: Market for short-term investments like Treasury bills with a maturity of less than one year. 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. Payables: Amount owed to others for goods bought or services received. semi-strong form argues that foreign exchange markets reflect historical prices and all public information. Currency Futures: Contracts specifying a standard volume of a particular currency to be exchanged for a specific price on a specific settlement date. 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. 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. 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. It is equal to the percentage change in the spot rate of the foreign country.The reflection of information in the pricing of currencies. Receivables: Amount owed by others to your corporation for goods supplied or services rendered. Currency Hedging: Taking protective positions to safe-guard open currency positions. Forward Contracts: Contracts specifying a given volume of a particular currency to be exchanged for a specific price on a specific settlement date. Purchasing Power Parity: The theory that predicts (home-foreign) inflative difference. Currency Diversification: Holding a portfolio of currencies of inflows and outflows so as to minimize the exchange rate risk.
Transaction Exposure: Exchange rate risk arising from transactions already entered into and denominated in foreign currencies. usually measured by the return on 90-day US Treasury bill rate.Risk-free Rate: Rate of return on a default-risk free instrument. and a large probability of loss. measured by the standard deviation of the currency for a given period . with a small probability of making huge profits. Variability: Fluctuations in the value of a given currency. Speculation: Trading for profit.