Foreign Exchange: Dealing with Currencies

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Foreign Exchange Dealing with Currencies

• with a basic introduction to the International
  Monetary System

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Foreign Exchange Terms

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

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Basic questions

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

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What is money?

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

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

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How should you convert money from one currency
into another?

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

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

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How are the values of currencies set?

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

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The major developed-country currencies float
against each other

• Supply and demand sets values
• This is how exchange rates are set for the US
  dollar vs.
• Euro,
• Japanese yen,
• British pound,
• Swiss franc, etc.

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Fixed exchange rates have important benefits

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

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The gold standard made the benefits of fixed
rates clear

• Before WW I, all major currencies were
  convertible into gold
• UK 1113 grains gold (.2354 oz)
• US 1 23.22 grains (.0484 oz)
• So, 14.87
• Everyone knew what everything was and would be
  worth

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

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

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

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

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When an economy has recently grown, it may be
hard to spend

• There is poor transportation infrastructure
• People live in the countryside or in tiny urban
  apartments, so they have little space for things
• So more money may come in from exports than
  people want to spend

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

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

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Most international business involves currencies
with floating rates

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

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Foreign-Exchange Trading Terms

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

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Market Rhythms
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Insuring Against Foreign Exchange Risk

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

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Insuring Against Foreign Exchange Risk

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

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Insuring Against Foreign Exchange Risk

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

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Insuring Against Foreign Exchange Risk

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

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How can you predict when currency values will
change?

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

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Fundamental analysis involves examining basic
economic data

• How fast are prices rising in the country?
• Is there a trade surplus or deficit?
• Is the government running budget deficits? How
  much?
• How do interest rates in the countries compare?
• How has the government been managing the
  currency?

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Technical analysis involves examining trends in
exchange rates

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

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Foreign exchange can be the difference between
profit and loss

• HSBC Bank in Argentina
• They entered Argentina at a time when it appeared
  the government was starting to manage the economy
  effectively
• But they continued investing as government became
  more irresponsible
• They lost big

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• Material below here is not required

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Foreign-Exchange Convertibility

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

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