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Devaluing the currency

A country may reduce its trade deficit by devaluating its currency against the currencies of major trading partners. A currency devaluation may improve the trade balance because a weak currency makes imported goods more expensive and exported goods less expensive. However, currency devaluation might not correct a trade deficit (1) if foreign markets do not buy more goods in response to lower prices (2) if domestic companies do not have the capacity to produce more goods for export (3) if domestic residents continue to import foreign goods regardless of their higher prices and (4) if middlemen do not pass on changes in prices to their customers.

The European Currency Unit

The European Currency Unit (ECU) was also introduced as a forerunner to creating a single European currency. The ECU was a currency based on the weighted average of the currencies of the common market. The ECU also served to provide a measure of relative value for each currency in the EMS. such trading activity served to stabilize the currency and interest markets and was, therefore, valuable. Throughout the 1980s, the EMS suffered occasional periods of stress in the system, with speculative runs on the weak currencies of the system resulting in frequent realignments. The German Bundesbank's conservative anti-inflationary policies were out of step with the more inflation-prone, loose money policies of Italy, France, Spain, Portugal and the Scandinavian countries. Devaluation of those currencies versus the Deutschemark was often associated with large speculative positions, which were taken by banks, hedge funds and other market participants, almost always at the expense of currency...

Currency values and terminology

A foreign-exchange rate is the price of one currency expressed in terms of another currency. A fixed exchange rate is an exchange rate that does not fluctuate or that changes within a predetermined band. The rate at which the currency is fixed or pegged is called the par value. A floating or flexible exchange rate is an exchange rate that fluctuates according to market forces. Although governments do not attempt to prevent fundamental changes in the exchange rate between their own currency and other currency, they typically attempt to maintain orderly trading conditions in the market. A flexible exchange system has a number of advantages Four concepts appreciation, depreciation, revaluation (upvaluation), and devaluation are all related to changing the value of a currency. An appreciation is a rise in the value of a currency against other currencies under a floating-rate system. A depreciation is a decrease in the value of a currency against other currencies under a floating-rate...

From the European Currency Unit to the euro

The EU's decision to switch their monetary union from the ECU to the euro came about in December 1991, when EU leaders met at Maastricht, in the Netherlands, and signed the Maastricht Treaty. The Maastricht Treaty specified a timetable for the creation of a monetary union. Under their accord, EU leaders agreed to establish a single European currency, called the euro, by January 1, 1999, with a common monetary policy established by an independent European Central Bank.

Market risk currency risk political risk high purchase price

BCP paid US 2.5 billion, an unexpectedly high price, for its cellular telephone licence in Sao Paulo, Brazil, and financed it with a high level of debt. Although operating performance, and earnings before interest, taxes, depreciation and amortisation (EBITDA), exceeded its business plan, BCP had difficulty rolling over its local-currency paper every two years and servicing its US dollar-denominated debt as the value of the Brazilian real declined. Debt restructuring was impeded by a disagreement between two deadlocked 47-per-cent shareholders.

Widely Traded Currency Pairs

The most widely traded currency pairs are In general, EUR USD is by far the most traded currency pair and has captured approximately 30 of the global turnover. It is followed by USD JPY with 20 and GBP USD with 11 (see Tables 3.1 and 3.2). Of course, most national currencies are represented in the foreign 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2001 exchange rates. 3 Non-US dollar legs of foreign currency transactions were converted into original currency amounts at average exchange rates for April of each survey year and then reconverted into US dollar amounts at average April 2001 exchange rates. Table 3.2 Reported foreign exchange turnover by currency pairs1 (Daily averages in April, in billions of US dollars and percentages) Table 3.2 Reported foreign exchange turnover by currency pairs1 (Daily averages in...

Reflexivity In The Currency Market

The traditional view of the currency market is that it tends toward equilibrium. An overvalued exchange rate Sncourages imports and discourages exports until equilibrium is reestablished. Similarly, an improvement in competitive position is reflected in an appreciating exchange rate that reduces the trade surplus so that equilibrium is again reestablished. Speculation cannot disrupt the trend toward equilibrium if speculators anticipate the future correctly, they accelerate the trend if they misjudge it, they will be penalized by the underlying trend that may be delayed but will inexorably assert itself. appreciation of its currency, as Germany demonstrated in the 1970s. The fact is that the relationship between the domestic inflation rate and the international exchange rate is not unidirectional but circular. Changes in one may precede changes in the other, but it does not make sense to describe one as the cause and the other as the effect because they mutually reinforce each other....

The July 1993 currency crisis in Europe

On July 1, 1993, wave after wave of currency selling by investors forced European governments to all but abandon their system of managing exchange rates. The economics ministers of the EU rushed off to the EU headquarters in Brussels that weekend, scrambling to save the EMS. This crisis had been triggered by the German central bank's decision not to lower its discount rate. The ministers debated all manner of possible solutions, including devaluing most of the curren cies, or even removing the mark from the EMS. By July 4 (Monday), they finally agreed to drastically widen the bands within which member currencies could fluctuate against other member currencies, to 15 percent of a central value, from 2.25 percent, in most cases. The net effect of their decision was essentially a free float that meant that European central banks were no longer forced to prop up their currencies every time speculators pushed a currency to the limits of the narrower fluctuation band. Pundits assumed that...

More Bang for Your Buck in Currency Trading

The potential of CME foreign-currency futures and options on futures is easy to understand. Most important, CME currency contracts trend well, year after year. And they respond to familiar, fundamental economic factors - the kind of information you follow every day in the news. What is more, with CME foreign-currency options, you can take advantage of opportunities in the market with limited risk. Of course, trading foreign-currency futures and options at the CME does involve risk. But if you can afford to assume it, they offer everything a speculator could want. O 6.1 The Currency Futures Market The Chicago Mercantile Exchange (CME), known as The Merc, was founded in 1919 as a nonprofit organization to trade spot and futures commodity contracts. In 1972, the CME introduced futures trading in foreign currencies through the International Monetary Market (IMM) as an alternative to regular forward contracts offered by commercial banks. Most major exchanges around the world have added...

Currency call options

A currency call option is a contract that gives the buyer the right to buy a foreign currency at a specified price during the prescribed period. People buy currency call options because they anticipate that the spot rate of the underlying currency will appreciate. Currency option trading can take place for hedging or speculation. Hedging in the call options market MNCs with open positions in foreign currencies can utilize currency call options. Suppose that an American firm orders industrial equipment from a German company, and its payment is to be made in euros upon delivery. A euro call option locks in the rate at which the US company can purchase euros for dollars. Such an exchange between these two currencies at the specified strike price can take place before the settlement date. Thus, the call option specifies the maximum price that the US company must pay to obtain euros. If the spot rate falls below the strike price by the delivery date, the American firm can buy euros at the...

Valuation Of Currency Swaps

In the absence of default risk, a currency swap can be decomposed into a position in two bonds in a similar way to an interest rate swap. Consider the position of company B in Figure 5.6. It is long a sterling bond that pays interest at 12.0 percent per annum and short a dollar bond that pays interest at 9.4 percent per annum. In general, if V is the value of a swap such as the one in Figure 5.6 to the party paying U.S. dollar interest rates, where Bp is the value, measured in the foreign currency, of the foreign denominated bond underlying the swap, BD is the value of the U.S. dollar bond underlying the swap, and S is the spot exchange rate (expressed as number of units of domestic currency per unit of foreign currency). The value of a swap can therefore be determined from the term structure of interest rates in the domestic currency, the term structure of interest rates in the foreign currency, and the spot exchange rate. Suppose that the term structure of interest rates is flat in...

How to read currency option quotes

To explain how to read currency option quotes, we will focus on the Swiss franc option traded on the Philadelphia Stock Exchange. Table 6.6 reflects typical quotes in The Wall Street Journal for options on the Swiss franc. Although the table does not show them, there are two sets of figures for each of most currencies. One set consists of quotes for European-style options and another set of quotes for American-style options. A European-style option can be exercised only at the time of expiration. An American-style option can be exercised at any time between the date the option is written and its maturity date. Because American-style options are more flexible than European-style options, American-style options are typically more valuable than European-style options for a given strike price, exchange rate volatility, and period to maturity. There are also a number of cross rate options contracts available for several sets of two currencies, such as Euro Japanese yen. The first column...

Currency Forward Rates

Currency forward rates are a variation on Result 7.2. In the absence of arbitrage, the forward currency rate Fo (for example, Euros dollar) is related to the current exchange rate (or spot rate), S0, by the equation r the return (unannualized) on a domestic or foreign risk-free security over the life of the forward agreement, as measured in the respective country's currency which represents the percentage discount at which one buys foreign currency in the forward market relative to the spot market, is approximately the same as the interest rate differential, rforeign - rdomestic. For example, if the one-year interest rate in Switzerland is 10 percent and the one-year interest rate in the United States is 8 percent, then a U.S. company can purchase Swiss francs forward for approximately 2 percent less than the spot rate, which is reflected by F0 being about 2 percent larger than S0. 19It is a discount instead of a premium because exchange rates are measured as units of foreign currency...

Currency risk management

Companies use currency swaps to eliminate currency risks arising from overseas commercial operations. A currency swap can take many forms. One type of currency swap accommodates two companies that have long-term needs in two different currencies. Assume the following two things first, a US firm, hired to build several power plants in Canada, expects to receive payment in Canadian dollars in 3 years and, second, a Canadian firm has bought machinery from the USA and will make payment in US dollars in 3 years. These two companies could arrange a currency swap that allows for an exchange of Canadian dollars for US dollars in 3 years at a predetermined exchange rate. In this way, the US firm could lock in the number of US dollars it will receive in exchange for the Canadian dollar payment in 3 years. By the same token, the Canadian firm could lock in the number of Canadian dollars it will receive in exchange for the US dollar payment in 3 years.

Currency Choices and NPV

A company in a high inflation economy has asked for your advice regarding which currency to use for investment analysis. The company believes that using the local currency to estimate the NPV will yield too low a value, because domestic interest rates are very high - this, in turn, would push up the discount rate. Is this true

Foreign currency exchange

Whenever a company has global operations, it's certain to have some costs related to moving currency from one country to another. The U.S. dollar, as well as currencies from other countries, experiences changes in currency exchange rates sometimes 100 times a day or more. Each time the dollar exchange rate between two countries changes, moving currency between those countries can result in a loss or a gain. Any losses or gains related to foreign currency exchanges are shown on a special line item on the statement of cash flows called Effect of currency exchange rate changes on cash. Both Mattel and Hasbro show the effects of currency exchange on their statements in 2007 Hasbro's net cash increased by 3.6 million and Mattel's increased by 8.1 million.

Exhibit 8 Currency Arbitrage when F Ser fT t

In practice, arbitrage opportunities do not occur as obviously as our example. Currency prices may be out of balance for only a short period of time. It is the nimble hedge fund manager that can take advantage of pricing discrepancies. Further, more famous hedge fund managers engage in currency speculation as opposed to currency arbitrage. In currency speculation, the hedge fund manager takes an unhedged position on one side of the market. Cash is committed to establish the position. The best example of this is George Soros' bet against the British pound sterling in 1992.

Blackscholes Equation Applies To Currency Options Hidden Symmetry

The formalism here applies to currency options. Interpret the stock price S as the exchange rate to another currency, say euros more precisely S is the value of 1 euro, in (instead of the value of one share in ). Then, the right but not the obligation to buy 1 euro at some exchange rate K, that is, exchange K for 1 euro, is known as a call on euros. The payoff is the same as for a stock option. This seemingly paradoxical first glance is resolved by noting that the two different traders track their risk in different currencies and Ito's lemma kicks off an extra drift term due to this. One values their portfolio in dollars and the other values their portfolio in euros the same (stochastic) portfolio has a different average drift when measured in a different currency. Mathematically the chain rule ensures the two deltas are different.

Caseroblem 6 Mercks Use of Currency Options

The effect of foreign-currency fluctuations on a company depends on a company's business structure, its industry profile, and its competitive environment. This case recounts how Merck assessed its foreign-exchange exposure and decided to hedge those exposures. Foreign subsidiaries of pharmaceutical companies are typically importers of product at some stage of production. And these subsidiaries are responsible for completing, marketing, and distributing the product within the country of incorporation. Sales are denominated in local currency, but costs are denominated in a combination of local currency and the parent-country currency. multinational company in three ways. First, the dollar value of net assets held in foreign currencies may be changed. This type of exposure is called translation or accounting exposure it measures the effect of an exchange rate change on published financial statements of a firm. Second, the expected results of outstanding transactions, such as accounts...

Translation of foreigncurrency financial statements

Under FASB 52, the current exchange rate method is used to translate foreign-currency balance sheets from their functional currency into the reporting currency. The current exchange rate method is the easiest to apply because under this method, all assets and liabilities are translated at the current exchange rate. Only owners' equity is translated at the historical exchange rate. Unlike the controversial FASB 8, FASB 52 does not require companies to include translation adjustments in net income. Instead, a company will report these translation adjustments separately and accumulate them in a separate component of equity until it sells or substantially liquidates the foreign net investment.

How to read currency futures quotes

The Wall Street Journal and other major newspapers carry currency futures quotations, though they do not list the newest or least active contracts. To explain how to read currency futures quotes, we will focus on the Australian dollar futures traded on the CME. Table 6.2 presents the Australian dollar futures prices reported in The Wall Street Journal on July 1, 2004. Because there is a one-day time lag between the transactions of foreign exchange and the report of these transactions, we obtained the June 30 quotations from the July 1 issue of The Wall Street Journal. The top, bold-faced line gives the name of the currency, in this case the Australian dollar (AUD) the exchange on which it is traded according to a key in the table, such as the Table 6.2 Currency futures quotations in the CME the Australian dollar Table 6.2 Currency futures quotations in the CME the Australian dollar

An overview of the Eurocurrency interbank market

The functions of the interbank market The Eurocurrency interbank market has at least four related functions. First, the interbank market is an efficient market system through which funds move from banks in one country to banks in other countries. Second, the interbank market gives banks an efficient mechanism to buy or sell foreign-currency assets and liabilities of different maturities in order to hedge their exposure to interest rate and foreign-exchange risks. Third, the interbank market is a convenient source of additional loans when banks need to adjust their balance sheets either domestically or internationally. Fourth, because of this market, banks sidestep regulations on capital adequacy and interest rates prevalent in many domestic banking markets.

Managed Futures in Currency Markets

The currency markets are the most liquid and efficient markets in the world. The reason is simple, every other commodity, financial asset, household good, cheeseburger, etc. must be denominated in a currency. As the numeraire, currency is the commodity in which all other commodities and assets are denominated. Daily trading volume in exchange listed and forward markets for currency contracts is in the hundreds of billions of dollars. Given the liquidity, depth, and efficiency of the currency markets, we would expect the ability of managed futures traders to derive value to be small. Exhibit 2 provides the distribution of returns for actively managed currency futures. We can see from this graph and Exhibit 5, that CTAs produced a distribution of returns with a very large positive skew of 1.39. This is considerably greater than that for the MLMI, and presents a strong case for skill. In addition, the average monthly return for CTAs trading in currency futures is 0.8 per month, an...

The international bond market size and its currency denomination

International bonds are denominated in various currencies British pounds, euros, Japanese yen, Swiss francs, US dollars, and composite units of currencies. These multiple-currency bonds may be classified as currency option bonds and currency cocktail bonds. Table 11.4 shows the currency composition of international bond issues from 1996 to 2003. In 2003, 28 percent was denominated in US dollars, 41 percent was denominated in euros, and the remaining 31 percent was denominated in either other single currencies or composite units of currencies. International

Example 73 Payments in a Currency Swap

Currency Swap Example

Describe the exchange of payments in a fixed-for-fixed dollar-yen currency swap with annual payments and a 100 notional amount as shown in Exhibit 7.6. The dollar bond has an interest rate of 7 percent, the yen bond has an interest rate of 5 percent, and the current exchange rate is 80 . Answer Here, the interest rates of both bonds are fixed, but each is denominated in a different currency. Thus, counterparty A will exchange its 7 (7 ) 100 fixed payments with counterparty B's fixed payments of 400 (5 ) 100(80 ) , as illustrated in Exhibit 7.6. Exhibit 7.6 The Cash Flows of a Five-Year Annual Yen-Dollar Fixed-Rate Currency Swap 100 Notional Exhibit 7.6 The Cash Flows of a Five-Year Annual Yen-Dollar Fixed-Rate Currency Swap 100 Notional

Remeasured Financial Statements Foreign Currency to Functional Currency

The previous illustrations of the translation process assumed that the currency of the foreign entity was the functional currency. However, there are certain instances when the functional currency is not the currency of the foreign entity. In these instances, the financial statements of the foreign entity must be remeasured into the functional currency before the financial statements can be translated. The remeasurement process is intended to produce financial statements that are the same as if the entity's transactions had been originally recorded in the functional currency. Generally speaking, the remeasurement process is based on the temporal method. The temporal method was originally adopted by FASB Statement No. 8, which has been superseded by Statement No. 52. In essence, the historical exchange rates between the functional currency and the foreign currency are used to remeasure certain accounts. The adjustment resulting from the remeasurement process is referred to as a...

O 113 The Asian Currency Market

In 1968, an Asian version of the Eurodollar came into existence with the acceptance of dollar-denominated deposits by commercial banks in Singapore. Singapore was an ideal location for the birth of the Asian currency market. It had an excellent communication network, important banks, and a stable government. Because the US dollar accounts for most of the foreign-currency transactions in Singapore, the term Asian dollar market can be used to represent the Asian currency market. The Asian currency market developed when the Singapore branch of the Bank of America proposed that the monetary authority of Singapore relax taxes and restrictions. The monetary authority accepted these proposals and extended a number of important incentives to foreign banks so that dollar accounts could be held in Singapore. They included (1) the removal of an existing 40 percent tax on interest payments on foreign-currency deposits (2) the reduction of the tax rate on interest earned from offshore loans (3)...

Foreign Currency Adjustments

These adjustments to stockholders' equity are commonly made by multinational corporations. Multinationals are companies that operate in both foreign and domestic (U.S.) markets. Some of their operations are conducted in foreign currency British pounds or Japanese yen, for example. When preparing financial statements in the United States, multinationals translate their foreign operations into U.S. dollars. Foreign currency translation is the process of converting the financial results of operations in a foreign currency into U.S. dollars for financial-reporting purposes. A translation adjustment is the gain or loss that results when the operations of a company's foreign subsidiaries are translated from foreign to U.S. currency for reporting consolidated financial statements. These adjustments may result in gains or losses depending on whether the dollar has gained or lost value relative to other currencies. Translation adjustments are reported in the stockholders' equity section of the...

Credit risk in a currency swap

Schematics of a cross-currency swap Schematics of a cross-currency swap The Basel regulators recognised that somewhat higher capital limits were required for swaps that involved an exchange-rate risk. These are so-called interest-rate and currency swaps, whereby one party notion-ally, or actually, borrows in, say, dollars and exchanges that obligation with another party which has notionally, or actually, borrowed the same principal amount in, say, yen. The two parties agree to service each other's debt, including an exchange of the borrowed amount at the end of the deal. For example, Ziggurat borrows i00m at 6 and Agora borrows 12 billion at a floating rate, which happens to be 1.5 . Both Everything goes well until year three is nearly up, when Agora goes bust. At this point Agora owes Ziggurat an interest payment of 6m, but this is offset by the fact that the yen has appreciated to 100 to the dollar and interest rates are at 2 . Ziggurat owes Agora 24om, which at today's exchange...

The September 1992 currency crisis in Europe

However, Europe's plans for economic union experienced a setback in September 1992, because turbulent trading amid the chaos surrounding an apparent breakdown of the European Monetary System (EMS) racked world currency markets. Although the roots of the currency crisis lay in Germany's high interest rates, the UK took center stage. The crisis began when Norman Lamont, Chancellor of the Exchequer, announced on September 16 that the UK would withdraw from the EMS. Pressures leading to this turmoil had built up for several months since the Danes, in a referendum in May 1992, narrowly opposed ratification of the Maastricht Treaty. Europe's once-solid monetary system was suddenly plunged into turmoil. On September 17, 1992, the UK and Italy both suspended their currencies from the EMS, after the values of the pound and the lira fell below the floor set by that system. The UK, Italy, and Spain then devalued their currencies. Ireland, Spain, and Portugal reimposed limited controls on capital...

Foreign Currency Risk

Some CDO transactions, particularly those issued out of Europe, allow for a bucket of assets denominated in a currency different from that of the notes issued. The currency mismatch introduced is best hedged with a balance-guaranteed foreign exchange swap, but the cost of entering into these swaps is often prohibitive. The most common way to address this risk is to use a natural hedge or asset-specific foreign exchange swaps based on set notional balances. In both of these cases, the foreign exchange risk is not fully hedged throughout the life of the transaction, thus necessitating additional cash flow stresses to capture the foreign exchange risk. A natural foreign exchange hedge exists when both the assets and liabilities denominated in each currency make up the same proportion of a given pool. For instance, the collateral pool may have 70 percent euro-denominated and 30 percent U.S. dollar-denominated assets matched to 70 percent euro-denominated and 30 percent U.S....

Foreign Currency Transactions

Account for a foreign currency transaction, including the measurement of exchange gain or loss. 4. Identify the contexts in which a company may be exposed to foreign currency exchange risk. 5. Explain the accounting treatment given various types of foreign currency hedges. As discussed in the previous chapter, modern businesses often find themselves affected by a global economy that presents a variety of challenges and opportunities. This chapter focuses on how a domestic entity should account for transactions which are denominated or settled in a foreign currency. For example, a U.S. company may purchase raw materials from a French vendor and pay for the goods with French francs. Such transactions may expose the U.S. entity to risks or opportunities depending on how exchange rates change over time. Strategies to manage the exposure to exchange rate fluctuations are also presented in this chapter. Chapter 11 will describe the issues associated with a domestic entity having an...

Forecast Cash Flow in the Subsidiarys Home Currency

As mentioned at the beginning of this chapter, it is best to value a foreign subsidiary in its home currency. But first, you should forecast the components of cash flow in their most relevant currency. This means forecasting the British pound cash flows in British pounds, the Swiss franc cash flows in Swiss francs, and so on, before combining them into a set of Financials for the foreign subsidiary. In practice, this is an iterative process you cannot forecast the individual line items without considering how they affect the other line items in the forecast. You need a coherent integrated forecast that reflects the competitive dynamics of the business unit. Once all cash flow has been forecasted in terms of its most relevant currency, it should be converted into the currency of the subsidiary before discounting using the forward-rate method. In our example, forward foreign exchange rates are used to convert forecasted French Euro revenues to British pound cash flow on a year-by-year...

The difference between conversion and translation and the definition of a foreign currency transaction

Conversion is the exchange of one currency for another while translation is the expression of another currency in the terms of the currency of the reporting operation. Only in the case of conversion is there a foreign currency transaction, which IAS 21 A foreign transaction is a transaction, which is denominated in or requires settlement in a foreign currency, including transactions arising when an entity (a) buys or sells goods or services whose price is denominated in a foreign currency (b) borrows or lends funds when the amounts payable or receivable are denominated in a foreign currency (c) otherwise acquires or disposes of assets, or incurs or settles liabilities, denominated in a foreign currency.

The functional currency

The functional currency is the currency of the primary economic environment in which the entity operates. IAS 21 sets out the factors which a reporting entity (a company preparing financial statements) will consider in determining its functional currency.2 These are (a) the currency (b) the currency that mainly influences labour, material, and other costs of providing goods and services. The following factors may also provide evidence of an entity's functional currency 3 (a) the currency in which funds from financing activities are generated (b) the currency in which the receipts from operating activities are usually retained. A company must also decide whether or not any of its foreign operations, such as a branch or subsidiary, has the same functional currency. In doing so the following factors will be considered 4 (a) Whether the activities of the foreign operation are carried out as an extension of the reporting entity, rather than being carried out with a significant degree of...

The rules on the recording of foreign currency transactions

All transactions are entered in the books at the spot currency exchange rate between the foreign currency and the functional currency on the transaction date. An average rate may be used for a period where it is appropriate. It will be inappropriate where exchange rates fluctuate significantly. Amounts paid or received in settlement of foreign currency monetary items during an accounting period are translated at the date of settlement.

Quoting Currency Futures

How are currency futures quoted Generally, in the foreign exchange market, currencies are quoted against the American dollar. For example, a rate of 1.67 Swiss francs per dollar means that it takes 1.67 Swiss francs to buy sell 1 dollar. Of course, there are the exceptions to this rule, for example sterling. However, currency futures are priced in American terms, in that it quotes how many dollars it takes to buy one unit of foreign currency. They are the reciprocal of those used in the cash market. Thus a rate of 1.67 Swiss francs per dollar would be quoted in the futures market as 0.5988 dollars per Swiss franc (1 divided by 1.67), which means that it costs 60 cents to buy one Swiss franc. For each contract, there is a specific contract size, for example one Swiss franc contract is worth 125,000 francs, the Japanese yen is worth 12,500,000 yen, sterling is worth 62,500 pounds, while the euro is worth 125,000 euros.

The treatment of exchange differences on foreign currency transactions

Note that the profits or losses on foreign currency transactions affect the cash flow and are therefore realised. In the individual annual accounts of Nemetschek AC and its subsidiaries, business transactions in a foreign currency are valued at the exchange rate at the time of their original posting. Any exchange losses from the valuation of receivables and payables are taken into account up to the balance sheet cutoff date. Profits and losses from fluctuations in the exchange rate are taken into account as affecting net income.

The translation of the accounts of foreign operations where the functional currency is the same as that of the parent

In the Boil illustration above (see section 24.8) we considered the effects of converting foreign currency in the individual company accounts. In this section we consider the situation of a subsidiary, Berlin Gmbh, which has its accounts in euros but has the pound sterling as its functional currency. Note also that the presentation currency of the reporting company, Granby Ltd, is also the pound sterling. In this situation Berlin is considered to be an extension of the parent and the translation method used is therefore exactly the same as applied to the individual company.

The use of a presentation currency other than the functional currency

Whenever the presentation currency is different from the functional currency, it is necessary to translate the financial statements into the presentation currency. In this situation there is no realisation of the exchange gain loss in the cash flows and therefore any gain loss will go to reserves. This is demonstrated in the alternative solution to Granby Ltd below, which in this case assumes that the euro is the functional currency of Berlin Gmbh and the presentation currency is the same as the functional currency of the reporting entity, i.e the pound sterling. Foreign currency translation Functional and presentation currency Items included in the financial statements of each of the Group's entities are measured using the currency of the primary economic environment in which the entity operates ('the functional currency'). The consolidated financial statements are presented in pound sterling, rounded to the nearest hundred thousand, which is the Group and Company's functional and...

Exposure Profile for Currency Swaps

Exposure profiles are substantially different for other swaps. Consider, for instance, a currency swap where the notionals are 100 million against 50 million, set at an initial exchange rate of S( ) 2. The market value of a currency swap that receives foreign currency is Following usual conventions, asterisks refer to foreign currency values.

Currency value problems

One truly unique problem area of multinational accounts receivable management has to do with the risk of currency value changes. The accounts receivable manager should understand this risk and take all necessary actions to minimize it. Multinational accounts receivable are created by two separate types of transactions, sales to customers outside the corporate group and intracompany sales. We must consider these two types of transactions separately, because their economic consequences are different. Sales to independent customers Management of accounts receivable from independent buyers involves two types of decision, the denomination of currency to be used for payment and the terms of payment. Domestic sales are always denominated in the local currency. In contrast, export sales can be denominated in the currency of the exporter, the currency of the importer, or a third-country currency. The exporter would prefer to price and to invoice in the strongest currency, while the importer...

WarmUp Domestic and Foreign Currency Returns

Earlier in the 2009 Study Notes (more specifically in Topic Reviews 18 and 19), we have used the base currency counrer currency foreign exchange quotation convention in order to remain consistent with the presentation of the material in the source curriculum. Consider the following quote on a base currencyxounrer currency basis This means that BCY is the base currency, CCY is the counter currency, and it rakes 3.25 units of CCY to buy 1.0 units of the base currency. The base is always quoted in terms of 1.0 unit, thus, keeping track of which currency is the base currency is the key to understanding the quotation. In the interbank market effectively the wholesale marker for foreign exchange trading the usual convention is to use this quotation format. However, some areas of the curriculum use the domestic currency foreign currency quotation convention (also known as the direct quotation convention). The quote given above on a DC FC basis would also be given as 3-25, bur ir implicitly...

Long Short Currency Investing

PowerShares DB G10 Currency Harvest Fund (symbol DBV) is an interesting currency interest rate ETF. The fund is benchmarked to the Deutsche Bank G10 Currency Harvest Index. The index is composed of long futures contracts on the three G10 currencies associated with the highest interest rates and short futures contracts on the three G10 currencies associated with the lowest interest rates. Cash is invested in U.S. government securities. The fund will not establish a long or short futures position in U.S. dollars because it is the fund's home currency. The index reevaluates interest rates quarterly and, based on the evaluation, reweights futures contracts. Immediately after each reweighting, the index will reflect an investment on a two-to-one leveraged basis in the three long futures contracts and in the three short futures contracts. By entering into long and short positions, the index is expected to provide more consistent and less volatile returns than could be obtained by taking...

Real exchange rates and domestic Currency Returns

'do 'fc inflation in domestic and foreign currency, respectively S spot rate (in DC FC) An investor from one country (currency DC) invests in securities in a foreign country (currency FC). The current exchange rate is DC2.00 per unit of FC. The ratio of the price levels of the domestic consumption basket to the foreign consumption basket is also equal to 2. Domestic inflation during the year was 7 , and foreign inflation was 3 . The end-of-year spot exchange rate is DC2.08 FC. Calculate the beginning of period real exchange rate and the new (i.e., end-of-period) real rate, and determine whether there was any change in the real exchange rate.

Commodity and Currency Fund List

Table 15.2 offers a list of commodity and currency ETFs and ETNs available on U.S. exchanges. It is divided into two sections. The first section lists currency funds and the second lists commodity funds. There are a growing number of currency and commodity ETFs and ETNs, and new alternative asset class funds will be introduced in the coming years. To stay on top of the news, visit the web sites listed in the ETF Resource List in Appendix B. For a current list of all commodity and currency ETFs and ETNs, including the Index Strategy Box database, and

Currency forecasting and market efficiency

Banks and independent consultants offer many currency-forecasting services. Some MNCs have in-house forecasting capabilities. Yet, no one should pay for currency-forecasting services if foreign-exchange markets are perfectly efficient. The efficient market hypothesis holds that (1) spot rates reflect all current information and adjust quickly to new information (2) it is impossible for any market analyst to consistently beat the market and (3) all currencies are fairly priced. Foreign-exchange markets are efficient if the following conditions hold First, there are many well-informed investors with ample funds for arbitrage opportunities when opportunities present themselves. Second, there are no barriers to the movement of funds from one country to another. Third, transaction costs are negligible. Under these three conditions, exchange rates reflect all available information. Thus, exchange rate changes at a given time must be due to new information alone. Because information that is...

Financial Reporting Of Foreigncurrency Denominated Transactions

When a U.S. company buys from or sells to a foreign firm, a key issue is the currency in which the transaction is to be denominated.3 In the case of Fashion-house, its purchases from Danish suppliers were invoiced to Fashionhouse in the Danish krone. This creates a risk, which is born by Fashionhouse and not its Danish supplier, of a foreign exchange transaction loss should the dollar fall in value. Alternatively, a gain would result should the dollar increase between the time the furniture is dropped on the dock in Copenhagen and the required payment date. With a fall in the value of the dollar, the Fashionhouse dollar cost for the furniture will be more than the dollar obligation it originally recorded. Fashionhouse is said to have liability exposure in the Danish krone. If, instead, Fashionhouse had been invoiced in the U.S. dollar, then it would have had no currency risk. Rather, its Danish supplier would bear the currency risk associated with a claim to U.S. dollars, in the form...

Risk Management Alternatives For Foreigncurrency Denominated Transactions

Hedging is designed to protect the dollar value of a foreign-currency asset position or to hold constant the dollar burden of a foreign-currency liability.5 At the same time, the volatility of a firm's cash flow or earnings stream is also reduced. This reduction is accomplished by maintaining an offsetting position that produces gains when the asset or liability position is creating losses, and vice versa. These offsetting positions may be created as a result of arrangements involving internal offsetting balances created through operational activities, or they may entail specialized external transactions with financial firms or markets.

Hedging with Foreign Currency Derivatives

Foreign-currency derivatives are financial instruments that derive their value from an underlying foreign-currency exchange rate. Some of the more common currency derivatives include forward contracts to buy or sell currencies in the future at fixed exchange rates, foreign-currency swaps, foreign-currency futures, and options. The forward contracts and over-the-counter options have the advantage of making it possible to tailor hedges to meet individual requirements in terms of amounts and dates. The exchange-traded futures and options have liquidity and a ready market, but a limited number of dates and contract sizes. Examples of the use of both types of instruments, privately negotiated and exchange traded, are discussed next.

Currency Option Contracts

A common feature of option contracts is that they provide the right, but not the obligation, to either acquire or to sell the contracted items at an agreed price. The agreed price is called the strike price. In addition, options are considered to be in the money or out of the money based upon the relationship between the strike price and the current price. The prices in the case of currency options are currency exchange rates. For example, a currency option contract is out of the money if the option provides the right to buy the Irish Punt at 1.12 when its spot price is 1.10. Conversely, an option is in the money if it provides the right to sell the German Mark at 0.45 when its spot value is 0.43. An option contract that gives the holder the right to sell a currency at an agreed rate, the strike price, is called a put option. The contract that provides the right to purchase the currency at an agreed rate is termed a call option. The cost of acquiring an option is termed the option...

Summary of Currency Exposure and Hedging Positions

It is common for firms to first attempt to reduce currency exposure by using their own operating activities and other internal actions. This point is made in the following comments from the disclosures of JLG Industries The Company manages its exposure to these risks (interest and foreign-currency rates) principally through its regular operating and financing activities. 20 These approaches to reducing currency exposure are usually referred to as natural hedges. A number of examples of natural hedges were provided in Exhibit 12.2. When natural hedges do not close out sufficient currency exposure, it is common for firms to turn to currency derivatives to reduce exposure still further. Based upon the previous discussion of selected currency derivatives, the positions to be taken in the face of asset versus liability exposure are summarized in Exhibit 12.9. The information in Exhibit 12.9 indicates how a number of different instruments can be used to hedge currency risk. However,...

Is Currency Exposure Material

A common disclosure made by firms with currency exposure is the effect that a 10 change in exchange rates would have on results. For example, Titan International, Inc. has currency exposure from its net investment in foreign subsidiaries. Titan discloses the potential loss associated with an adverse movement in the exchange rates of these subsidiaries EXHIBIT 12.9 Foreign currency exposure and hedging EXHIBIT 12.9 Foreign currency exposure and hedging

Translation Of Foreign Currency Financial Statements

Foreign subsidiaries of U.S. firms usually prepare their financial statements in the currencies in which they transact their business, which is referred to as their functional currency. The U.S. parent firm prepares its financial reports in U.S. dollars and, as a consequence, the financial statements of the foreign subsidiaries must be translated into U.S. dollars in order to be consolidated with those of the parent company. To illustrate the process of translating foreign currency financial statements, consider the balance sheets and income statements of Perot, Inc., a subsidiary of a U.S. company, at the end of 2001, as shown in Exhibit 13-5. Perot, Inc., operates in Taiwan and prepares its financial statements in New Taiwan dollars, or NT . Because Perot, EXHIBIT 13-5 Translation of Foreign Currency Financial Statements Foreign exchange rates between U.S. and New Taiwan dollars must be used to translate the various elements of Perot's financial statements into U.S. dollars....

Supra National Currency

In the early 1990s, the European Union (EU) agreed to introduce a single European currency in an effort to create a European Monetary Union.The euro, which was introduced in early 1999, will coexist with existing national currencies for three years. After that time,the national currencies of EU members will no longer be legal tender. The expected advantages of this single currency include the elimination of risks due to foreign currency fluctuations, savings in transactions costs with a resulting stimulation of trade and investment, and the potential of lower inflation and interest rates for some member nations.A single currency, however, implies a coordination of the monetary policies of the member countries. Because monetary policy is very closely tied to fiscal (taxation and government spending) policy, this also implies an evolving similarity across nations in terms of political and social policies. The introduction of the euro will have various direct and indirect effects on...

Managing The Currency Risk Of Foreign Subsidiaries

The reduced level of currency risk-management in the case of translation exposure is explained largely by the absence of direct cash flow and earnings risk. There is a somewhat greater effort to manage remeasurement-related risk because, unlike under the all-current method, remeasurement gains and losses are included in net income. Some companies do hedge translation exposure even though the translation adjustments are only included in other comprehensive income, with this element generally going straight to shareholders' equity. However, the absence of an impact on earnings under all-current translation makes it less likely that this exposure will be hedged. Prior to the issuance of SFAS No. 52, Foreign Currency Translation, SFAS No. 8, Accounting for the Translation of Foreign Currency Transactions and Foreign Financial Statements, required all firms to use the temporal method and to include all translation gains and losses in the computation of net income.35 As a result, one would...

Currency Forward Contracts

Recall from our introduction to financial derivatives in Chapter 4 that a forward contract is one in which one party agrees to buy the underlying asset, and another party agrees to sell that same underlying asset at a designated price and date in the future. Forward contracts in which the underlying asset is foreign exchange is called a currency forward contract. Most currency forward contracts have a maturity of less than two years. For longer-dated forward contracts, the bid-ask spread for a forward contract increases that is, the size of the spread for a given currency increases with the maturity. Consequently, forward contracts become less attractive for hedging long-dated foreign currency exposure.

Interpreting Financial Statements Foreign Currency Translation

Does the firm's treatment of foreign currency translations seem to have any significant effect on its balance sheet On its income statement c. What other impact might foreign currency translations have on the long-term success or failure of this firm On other aspects of its financial statements On other aspects of the firm's performance

Foreign Currency Effects

13-57 Kimberly-Clark is a global corporation whose primary product is diapers and tissues.Access the EDGAR archives ( edaux searches.htm) to locate Kimberly-Clark's 1995 10-K.Answer the following questions based on its Note on Foreign Currency Related Issues. a. What is the dollar impact of foreign currency transactions included in consolidated net income

Subsidiary Characterization and Functional Currency

For a multinational company based outside the United States, its foreign subsidiaries' type of operations will determine the translation method the firm will use. For U.S.-based MNCs, the determining factor is the functional currency of each subsidiary. Table 18.2 on page 816 provides further details on these points. Subsidiary Currency Operations and Translation Method Integrated foreign enriry (international practice) Self-sustaining foreign entity (international practice) Functional currency approach (used by U.S. MNCs) Operates as an extension of the parent MNC temporal method is the primary translation tool Operates independent of the parent multinational the current-rate method is the primary approach The dominant currency in which the foreign subsidiary conducts its activities it may be the same as the parent's (in which case, the temporal method is applied), the subsidiary's (the current-rate method), or a third currency (temporal, then current) Statement issued by the FASB...

The forward exchange rate of a currency is based on the spot price and the interest rate differential between the

Currency (the euro in our example), and investing in a low-yielding currency (the dollar in our example) up to the moment when the transaction is unwound. More generally, if the benchmark currency offers a lower interest rate than the foreign currency, the forward rate will be below the spot rate. Currency A is said to be at discount vis- -vis currency B if A offers higher interest rates than B during the period concerned. Similarly, currency A is said to be at premium vis- -vis currency B if interest rates on A are below interest rates on B during the period concerned.

Example 235 Measuring Currency Gains

The financial manager of Universal Waffle is proud of his acumen. Instead of keeping his cash in U.S. dollars, he for many years invested it in German deutschemark deposits. He calculates that between the end of 1980 and 1998, the deutschemark increased in value by nearly 47 percent, or about 2.1 percent a year. But did the manager really gain from investing in foreign currency Let's check. The interest rate differential (which by interest rate parity is equal to the forward premium) is a measure of the market's expectation of the change in the value of the currency. The difference between the German and United States interest rates during this period suggests that the market was expecting the deutschemark to appreciate by just over 2 percent a year,5 and that is almost exactly what happened.

Currency Hedging and Speculation

Currency trading using ETFs is a growing area. Hedging currencies using ETFs and ETNs can reduce the financial risk for global travelers and small companies doing business abroad. Currency speculation has also been made much easier for individual investors because of the trading flexibility of ETFs and ETNs. The securities pay a money market rate of interest based on the currency they are in while hedging against a decline in the U.S. dollar. Are you planning a trip abroad and want to hedge the U.S. dollars you have saved for the event Or perhaps you are saving for a villa in Italy For a small annual fee, you can lock in the value of the currency you will be using for the event and receive interest on your money based on the interest rates prevailing in that region. Before leaving for the trip or closing on your villa, simply sell the ETF or ETN and withdraw U.S. dollars.

Foreign Currency Hedge

Suppose an American electronics manufacturer has just delivered a large shipment of finished products to a customer in France. The French buyer has agreed to pay 1 million French francs in exactly 30 days. The manufacturer is worried that the French franc may be devalued relative to the American dollar during that interval. If the franc is devalued, the dollar value of the promised payment will fall and the American manufacturer will suffer losses. The American manufacturer can shed this foreign currency exposure by going short in a franc forward contract or a franc future. The contract will specify a quantity of francs to be exchanged for dollars, at a fixed exchange rate, 30 days in the future. The contract locks in the terms at which the deferred franc revenue can be converted to dollars. No matter what happens to the franc-dollar exchange rate, the American manufacturer now knows exactly how many dollars he will receive.

Currency Boards and Crisis in Argentina

At the time of writing, there are 7 currency boards in operation Bosnia and Herzegovina, Brunei Darussalam, Bulgaria, Hong Kong SAR, Djibouti, Estonia, and Lithuania. The currency board in Dijbouti has been in place for nearly 50 years and in Hong Kong since 1985. More recently, Argentina instigated a currency board in 1991 but was forced to exit in 2001. As Figure 21.11 shows, currency boards have a good record in improving overall economic performance inflation, inflation volatility, the fiscal deficit, and growth all improve under a currency board compared to alternative regimes. Under a currency board, countries cannot print money not backed by foreign currency reserves, so the central bank can no longer finance the government's fiscal deficit. As a result, a currency board without fiscal reform is unworkable the pressure for the central bank to print money and abandon the currency board will become overwhelming. Therefore currency boards tend to be adopted as part of an overall...

Asic Translation Process Functional Currency to Reporting Currency

Before beginning the translation process, the financial statements of the foreign entity must be adjusted to conform with generally accepted accounting principles. Although this is a very important step in the accounting process, the specifics are not covered in this text. It is assumed that all of the adjustments to GAAP have already been made. The next step in the translation process is to identify the functional currency. If the functional currency is determined to be the foreign entity's local currency, the current rate method is used to translate. This is also called the functional or translation method. If the foreign entity's local currency is not the functional currency, the historical rate method is used to translate. This is also called the temporal or remeasurement method. The discussion that follows assumes that the foreign entity's currency is the functional currency. The current method requires that Apply the functional currency translation process to a trial balance,...

Currency Futures and Options

Do you know how many days it took for a son to lose 150 million in foreign-exchange trading that it had taken his father decades to accumulate The answer is just 60 days. The following story illustrates how volatile the currency derivatives market was in the 1990s. In 2 months of foreign-currency trading in 1996, Zahid wasted much of a fortune ( 250 million) that it had taken his father decades to build. The tight-knit Ashraf family estimates that Chicago-based commodities giant Refco Inc. collected about 11 million in commissions for the trades. So they sued Refco for 75 million of their losses. The Ashrafs contended that Refco brokers conspired Zahid Ashraf to execute massive unauthorized speculative trading in currency futures and options and to conceal these trades from other family members. However, after a seven-day trial in February 1999, the jury ruled against the Ashrafs, not only rejecting their claim, but also finding that the family's Eastern Trading Co. still owed Refco...

Commodity And Currency Etfs

Commodity trading or speculating has a poor public image conjuring up negative images of wild pork belly trading. Currency trading has suffered by a similar image since heretofore investing in commodities or currencies was intimidating to the average investor and carried with it the stigma of a poor image. Yet intuitively most investors know there's money to be made when dealing in both areas. The problem has been how to do it easily and minimize the perceived risks. So enter ETFs based on both commodities and currency. This is exciting because it allows investors to conveniently add these issues to their portfolios without having to join expensive and complex CPOs or using any leverage. Now average investors can truly diversify their conventional portfolios using these products. Given the lack of leverage in the ETFs some of the benefits that Lintner noted may be lessened. But the emotional craziness often associated with futures and commodity trading has also been eliminated making...

Currency Forwards

Currency forwards are very liquid instruments. Although they are elementary, they are used in a broad spectrum of financial engineering problems. A general method of engineering a (currency) forward or, for that matter, any linear instrument is as follows 1 Written as EUR USD in this quote, the base currency is the Euro.

Currency boards

A currency board is a monetary institution that only issues currency to the extent that it is fully backed by foreign reserves. In other words, a currency board is an extreme form of the fixed exchange rate regime under which local currency is fully backed by the US dollar or any other chosen currency. Its major attributes include 4 No central bank under a currency board system.

The Single Currency

In January 2002 the euro currency became the legal tender in all 12 participating countries. In January 2002, euro notes and coins were actually being circulated in the different countries and by the end of the first quarter, national notes and coins no longer existed. This change had an impact on everyone, from manufacturers, importers and exporters with trade flows to hedge, central banks with reserve asset and debt management concerns, to financial institutions and pension funds with international portfolios. In fact, even though this event was specific to Europe, the impact affected the world's currency markets from America to Japan. The single currency in Europe formed one corner of the new triangular world of the dollar, the yen, and the euro. The conversion of national legacy currencies meant that organizations had to have the ability to accept both forms of transaction. It has been quite complicated because, for instance, to convert sterling to francs you had to have a...

Currency Swaps

In a currency swap, two parties agree to swap payments based on different currencies. To illustrate a currency swap, suppose two counterparties are the High Quality Electronics Corporation (a U.S. manufacturing firm) and Citibank. The notional amount is 100 million and its Swiss franc (SF) equivalent at the time the contract was entered into is SF 127 million. The swap term is eight years. Every year for the next eight years the U.S. manufacturing firm agrees to pay Citibank Swiss francs equal to 5 of the Swiss franc notional amount, or SF 6.35 million. In turn, Citibank agrees to pay High Quality Electronics 7 of the U.S. notional principal amount of 100 million, or 7 million. Again, the motivation for the management of High Quality Electronics Corporation for using a currency swap is difficult to appreciate because we have not covered how a firm finances itself. Currency swaps are used by corporations to raise funds outside of their home currency and then swap the payments into...

Currency Exchange

SUPPLY AND DEMAND FOR FOREIGN CURRENCY Suppose you want to buy a Japanese car. To do so, you must have Japanese yen. You go to the foreign-exchange market (or your American bank). Your desire to purchase the Japanese car causes you to offer (supply) dollars to the foreign-exchange market. Your demand for Japanese yen is equivalent to your supply of U.S. dollars to the foreign-exchange market. Indeed, every U.S. import leads to a supply of dollars and a demand for some foreign currency. Likewise, every U.S. export leads to a demand for dollars and a supply of some foreign currency by the purchaser. The demand curve for Japanese yen also slopes downward. Suppose it costs you one cent to buy one yen this would be the exchange rate between dollars and yen. If tomorrow you had to pay two cents for a yen, then the exchange rate would have changed. Looking at such an increase with respect to the yen, we would say that there has been an appreciation in the value of the yen in the...

Currency Markets

The global currency markets are without a doubt the most active financial markets in the world. Their size and growth is described in Table 10-1. This trading activity dwarfs that of bond or stock markets. In comparison, the daily trading volume on the New York Stock Exchange (NYSE) is approximately 40 billion. TABLE 10-1 Activity in Global Currency Markets Average Daily Trading Volume TABLE 10-1 Activity in Global Currency Markets Average Daily Trading Volume

Currency put options

A currency put option is simply a contract that gives the holder the right to sell a foreign currency at a specified price during a prescribed period. People buy currency put options because they anticipate that the spot rate of the underlying currency will depreciate. MNCs with open positions in foreign currencies can employ currency put options to cover such positions. Consider an American company that has sold an airplane to a Japanese firm and has agreed to receive its payment in Japanese yen. The exporter may be concerned about the possibility that the yen will depreciate by the time it is scheduled to receive its payment from the importer. To protect itself against such a yen depreciation, the exporter could buy yen put options, which would enable it to sell yen at the specified strike price. In fact, the exporter would lock in the minimum exchange rate at which it could sell Japanese yen in exchange for US dollars over a specified period of time. On the other hand, if the yen...

Currency Etfs DIRECT

Previous to currency linked ETFs becoming available, investing in those markets for retail investors was as difficult as with commodities. The only route for individual investors was through previously outlined expensive and leveraged commodity and futures pools. Currency trading was the domain for large banks and other institutions accustomed to dealing with large sums daily in the inter-bank market. Taking the lead in currency ETFs was Rydex Investments. They launched a series of ETFs including Rydex Euro Currency ETF FXE . Why are these important In the first place they're necessary for hedging purposes. For example, in 2005 the Nikkei 225 Index in Japan gained nearly 40 percent, but Japan ETF EWJ gained 20 percent. While a respectable return for the ETF, naturally an investor would like the return of the index more. The difference was the value of the yen, which had deteriorated by an equal amount. So if FXY had been available the investor could have shorted it in an appropriate...

Currency Risk

Currency risk arises from potential movements in the value of foreign currencies. This includes currency-specific volatility, correlations across currencies, and devaluation risk. Currency risk arises in the following environments. In a pure currency float, the external value of a currency is free to move, to depreciate or appreciate, as pushed by market forces. An example is the dollar euro exchange rate. In a fixed currency system, a currency's external value is fixed (or pegged) to another currency. An example is the Hong Kong dollar, which is fixed against the U.S. dollar. This does not mean there is no risk, however, due to possible readjustments in the parity value, called devaluations or revaluations. In a change in currency regime, a currency that was previously fixed becomes flexible, or vice versa. For instance, the Argentinian peso was fixed against the dollar until 2001, and floated thereafter. Changes in regime can also lower currency risk, as in the recent case of the...

Eurocurrency Loans

Firms can also raise funds in the Euromarkets through a Eurocurrency loan. A Eurocurrency is a major currency on deposit in a bank outside of the country of origin for the currency. Thus, when AT&T deposits dollars into the London branches of 21See Chapter 7 for additional discussion of currency swaps. Comdisco, a U.S.-based firm that leases computers, peripherals, and other high-tech equipment to customers worldwide, has subsidiaries in more than 60 countries. Naturally, customers prefer to transact in the local currency. To fund working capital needs in the early 1990s, Comdisco set up a credit facility with a syndicate of banks that included LaSalle National in Chicago, Westpac in Australia, the Union Bank of Switzerland, and three Japanese banks Yasuda Trust, Toyo Trust, and Mitsui Taiyo Kobe. The credit function is centralized in Comdisco's Chicago headquarters all the local subsidiaries have to do to borrow is make one phone call to headquarters, thus avoiding the time-consuming...

Functional currency

In this section, two terms are extensively used parent currency and functional currency. Parent currency, sometimes called reporting currency, is the currency of the country where the parent company is located. For example, the parent currency of US-based MNCs is the dollar. The functional currency, usually called foreign currency or local currency, is the currency of the country where the foreign operation of an MNC is located. The functional currency of an entity, as defined in FASB 52 (paragraph 39), is the currency of the primary economic environment in which the entity operates normally, that is the currency of the environment in which an entity primarily generates and expends cash. The term functional currency was first used in the translation literature in conjunction with FASB 52. Functional currency is, in fact, a key feature of FASB 52, because it determines the choice of translation method. This feature is very important, because the translation method employed determines...

Currency Options

The Philadelphia Exchange commenced trading in currency options in 1982. Since then the size of the market has grown very rapidly. By 1992 the currencies traded included the Australian dollar, British pound, Canadian dollar, German mark, Japanese yen, French franc, Swiss franc, and European currency unit. For most of these currencies, the Philadelphia Exchange trades both European and American options. It also trades an option German mark-Japanese yen exchange rate. A significant amount of trading in foreign currency options is also done outside the organized exchanges. Many banks and other financial institutions are prepared to sell or buy foreign currency options that have exercise prices and exercise dates tailored to meet the needs of their corporate clients. For a corporate client wishing to hedge a foreign exchange exposure, foreign currency options are an interesting alternative to forward contracts. A company due to receive sterling at a known time in the future can hedge its...

Cross Currency Swap

A cross currency swap is an agreement between two parties to exchange principal amounts in two different currencies, to pay interest based on those amounts during some period of time, and to re-exchange the principal amounts at maturity. The principal amounts in each currency remain constant throughout the transaction, and interest payments are a function of the fixed or floating rates in each currency. The currency swap market has evolved as an extension of forward currency exchange contracts. US dollars account for more than 30 per cent of all currency swap notional amounts up from one-third in 1990. Japanese yen notional amounts to one-fifth of all transactions. No other currency constitutes more than 10 per cent of the market. Cross currency swaps are generally priced at a specific rate or at some spread to a major index in both currencies. It is also possible to price a currency swap 'off-market' and compensate for the discrepancy with an up-front cash payment from one party to...

Cross Currency Swaps

A cross-currency swap has two principal amounts, one for each currency. The initial principals can be exchanged or not. The non-exchange of the initial amounts is a minor issue. But eliminating the exchange of the final amounts changes the pricing structure significantly. The exchange rate used to determine the principals is the prevailing spot rate. With an interest rate swap there is no exchange of principal at either the start or end of the transaction, as both principal amounts are the same and therefore net out. For a cross-currency swap it is essential that the parties agree to exchange principal amounts at maturity. The exchange of principal at the start is optional. Like all swaps, a cross-currency swap can be replicated using on-balance sheet instruments, in this case with money market deposits or FRNs denominated in different currencies. This explains the necessity for principal exchanges at maturity as all loans and deposits also require repayment at maturity.34 The initial...

Currency ETFs

Rydex Investments launched the first currency ETF, the Euro Currency Trust on the New York Stock Exchange in December 2005. Rydex has since added more ETFs benchmarked to other currencies. Those currencies include many of the United States' largest trading partners. Each ETF holds a different foreign currency with an overseas branch of JPMorgan Chase Bank. The funds track the price of their underlying currency based on the Federal Reserve Noon Buying Rate. Barclays Bank expanded its lineup of exchange-traded notes (ETNs) in May 2007 with the launch of three currency funds. The notes provide exposure to Euros, British pounds, and Japanese yen, respectively. The ETNs earn interest income based on the prevailing rates in the foreign country, minus 0.40 percent fee. However, you do not get the cash. Recall from Chapter 3 that ETNs do not pay dividends or any interest income. It is a total return vehicle. The note value increases over time. In contrast, the CurrencyShares pay monthly...

Currency Futures

Currency futures are exchange-traded instruments. Entering into a futures contract requires a margin deposit and a round-trip commission must also be paid. As is true of exchange-traded currency options, futures contracts come in fixed currency amounts and for a limited set of maturities. Futures contracts The Company may periodically enter into foreign currency option contracts to offset certain probable anticipated, but no firmly committed, foreign exchange transactions related to the sale of product during the ensuing nine months. The Company enters into forward sales and purchases and currency options to manage currency risk resulting from purchase and sale commitments denominated in foreign currencies (principally Euro, Canadian dollar, and Japanese yen) relating to anticipated but not yet committed purchases and sales expected to be denominated in those The Company enters into forward sales and purchase contracts and currency options to manage currency risk resulting from...

A Currency options

Currency options allow their holders to lock in an exchange rate in a particular currency, while retaining the choice of realising a transaction at the spot market rate if it is more favourable. Of course, the strike price has to be compared with the forward rate and not the spot rate. Banks can theoretically list all types of options, although European-style options are the main ones traded. Options on options are quite useful for companies bidding on a foreign project. The bid is made on the basis of a certain exchange rate, but let's say the rate has moved the wrong way by the time company wins the contract. Options on options allow the company to hedge its currency exposure as soon as it submits its bid, by giving it the right to buy a currency option with a strike price close to the benchmark rate. If the company is not chosen for the bid, it simply gives up its option on option. As the value of an option is below the value of the underlying asset, the value of an option on an...

Currency Crises

The most dramatic form of exchange rate volatility is a currency crisis when an exchange rate depreciates substantially in a short period. Such events push macroeconomics to the top of news summaries and onto the front pages of newspapers. They FIGURE 21.1 Currency crises, 1978-2003. Currency crises are a frequent occurrence. Source Authors' calculations using IMF data. can have huge political and commercial implications. In this section we will examine the frequency of currency crashes and outline theories to explain them. A currency crisis must have two features the exchange rate depreciation must be large relative to recent experience, and the nominal exchange rate depreciation must also affect the real exchange rate. In other words, the depreciation must not just reflect inflation and the operation of PPP. Even when we restrict our attention in this way, we still find that currency crashes are frequent. Figure 21.1 shows that between 1978 and 2003 nearly 250 currency crashes...

A3 Currency Risk

Currency positions consist of outright spot and forward positions, as well as the net delta of option positions. Gold is included in the currency risk category as it display similar volatility. Banks have the choice to use a simplified method or internal models, which better account for correlations. The first step is to value all positions in dollars or the reference currency. Define the value for currency i as Vi. Under the simplified model, we first classify all positions into long or short. The exposure is then taken as the maximum of the absolute value of the total long or short positions. To this is added the absolute value of the gold position. The market risk charge for currency risk is then obtained by applying an 8 weight to the exposure,

About the Second Edition

We have developed a second edition based on the comments of many reviewers and colleagues, producing what we think is a more reader-friendly book. The most consistent comment from users of the first edition was a request for a chapter on the key ingredients of valuation accounting, cash flows, and basic discounting. This ultimately led to an entirely new chapter in the text, Chapter 9. In almost every chapter, examples were updated, vignettes were changed, numbers were modified, statements were checked for currency, clarity, and historical accuracy, and exercises and examples were either modified or expanded. Even the introductions to the various parts of the text were modified. For example, data on capital budgeting techniques in use were liberally sprinkled into the introduction to Part III.

The Foreign Exchange Market

Foreign exchange or FX or Forex comprises all claims to foreign currency payable abroad, whether consisting of funds held in foreign currency with banks abroad, or bills or cheques payable abroad i.e. it is the exchange of one currency for another. A foreign exchange transaction is a contract to exchange one currency for another currency at an agreed rate on an agreed date.

Bibliography 509 Index 513

The past two decades saw the freeing of exchange and capital controls. This made the exchange rates significantly more variable. In the meantime, world trade grew significantly. This made the elimination of currency risk a much higher priority. It is mainly the need to hedge interest-rate and currency risks that is at the origin of the recent prolific increase in markets for derivative products. This need was partially met by financial markets. New products were developed and offered, but the conceptual understanding of the structure, functioning, and pricing of these derivative products also played an important role. Because theoretical valuation models were directly applicable to these new products, financial intermediaries were able to correctly price and successfully market them. Without such a clear understanding of the conceptual framework, it is not evident to what extent a similar development might have occurred.

International Financial Markets

During most of the post WWII period, trading of convertible currencies took place with respect to the US dollar. This meant that converting yen to deutschemarks required two trades first from yen to dollars then from dollars to deutschemarks. The dollar is said to be the vehicle currency for international transactions. In recent years cross-currency trading, that allows yen and deutschemarks to be exchanged directly, has become increasingly common. The foreign currency price of a US dollar is the exchange rate quoted in European terms. The US dollar price of one unit of the foreign currency is the exchange rate is quoted in American terms. In American terms, an increase in the exchange rate means the dollar currency has depreciated in value relative to the foreign currency. In this book, we will always refer to the exchange rate in American terms. Second, swap transactions are agreements in which a currency sold (bought) today is to be repurchased (sold) at a future date. The price of...

Continuity And Accuracy

There is more continuity over the centuries in interest rates than there is in most prices. This is because the interest rate is a ratio of like to like. Like rates produce the same mathematical result in any era, in any currency, and at any given price structure. Compound interest at x net will double principal in exactly the same number of years today as in the days of Socrates, and the net purchasing power of x interest will be increased or reduced by changes in the value of money or burden of taxes in the same proportion. Because it is such a mathematical ratio, the rate of interest is one of our closest statistical links with our economic past. This book will therefore provide a comparison of rates of interest over the ages in spite of the very unlike credit forms and economic environments. It will, however, summarize the changes in credit forms and in economic environment.

Understanding Economic Policy Issues Better

In Chapter 8 we will discuss free trade and the battle between Airbus of Europe and Boeing of the United States. For each firm, success in the marketplace requires understanding not just the products and strategy of the opposition but also the policy stance of European and American governments as well as the attitude of international organizations like the World Trade Organization. Understanding the interests and behavior of the government and its policies is therefore an important part of corporate strategy, and this requires a good understanding of macroeconomics. Any firm considering investing in Argentina would need to consider the potential for another currency crisis which is a macroeconomic question.

Spot And Forward Market

Today, foreign exchange is an integral part of our daily lives. Without foreign exchange, international trade would not be possible. For example, a Swiss watchmaker will incur expenses in Swiss francs. When the company wants to sell the watches, they want to receive Swiss francs to meet those expenses. However, if they sell to an English merchant, the English company will want to pay in sterling, the home currency. In between, a transaction has to occur that converts one currency into the other. That transaction is undertaken in the foreign exchange market. However, foreign exchange does not only involve trade. Trade, today, is only a small part of the foreign exchange market movements of international capital seeking the most profitable home for the shortest term dominates. Most participants transact in foreign currency, not only for immediate delivery but also for settlement at specific times in the future. By using the forward markets, the participant can determine today the...

Emphasis On The Futures Markets

Prior to 1972 stock traders followed only stocks, bond traders only bonds, currency traders only currencies, and commodity traders only commodities. After 1986, however, traders could pick up a chart book to include graphs on virtually every market and sector. They could see right before their eyes the daily movements in the various futures markets, including agricultural commodities, copper, gold, oil, the CRB Index, the U.S. dollar, foreign currencies, bond, and stock index futures. Traders in brokerage firms and banks could now follow on their video screens the minute-by-minute quotes and chart action in the four major sectors commodities, currencies, bonds, and stock index futures. It didn't take long for them to notice that these four sectors, which used to be looked at separately, actually fed off one another. A whole new way to look at the markets began to evolve.

The Central Banks Balance Sheet

The monetary liabilities of the central bank is called the monetary base, B. It is comprised of currency and commercial bank reserves or deposits at the central bank. The central bank's assets can be classified into two main categories. The first is domestic credit, D. In the US, domestic credit is extended to the treasury when the central bank engages in open market operations and purchases US Treasury debt and to the commercial banking system through discount lending. The second asset category is the central bank's net holdings of foreign assets, NFAcb. These are mainly foreign exchange reserves held by the central bank minus its domestic currency liabilities held by foreign central banks. Foreign exchange reserves include foreign currency, foreign government Treasury bills, and gold. We state the central bank's balance sheet identity as If, on the other hand, the Fed converts the deposit into currency, the Japanese monetary base does decline. The reason for this is that the...

New centers of global finance

The US is losing its pre-eminent position in the global capital markets due to the following reasons (a) massive financial losses caused by the 2008 economic meltdown - in the US stock market, for example stocks on the Dow Jones lost 34 of their value in 2008 (the largest drop since 1931), and in the bankruptcy of major US financial institutions (b) the rise of other capital markets and centers of wealth. The year 2007 saw a sea change in the distribution of global wealth. Largely due to the rise of China and India and investments by oil and gas producing countries, for the first time since the Second World War (1945) London displaced New York to become the center of the global capital markets. Over 40 of the world's foreign equities were traded in London, more than New York. Over 30 of the world's foreign currency trading took place in London, being larger than New York and Tokyo combined. The shift away from a US-centered global financial system can also be seen in the emergence of...

Classifying market participants

They are exposed to the market because they need to buy and sell commodities, or exchange currency. They wish to reduce these risks, and they can do so by the use of derivatives, Indeed, it has now become expected that they do so, and stock analysts will include in their reports critiques of a companies hedging strategies. Some companies even use options because of analysts' criticisms of their failure to do so.

Other Derivative Securities

In 1985, Bankers Trust developed index currency option notes or ICONs. These are bonds in which the amount received by the holder at maturity varies with a foreign exchange rate. Two exchange rates, Xi and, X2, are specified with Xi X2. If the exchange rate at the bond's maturity is above X , the bondholder receives the full face value. If it is less than X2, the bondholder receives nothing. Between X2 and Xu a portion of the full face value is received. Bankers Trust's first issue of an ICON was for the Long Term Credit Bank of Japan. The ICON specified that if the yen-U.S. dollar exchange rate, S, is greater than 169 yen per dollar at maturity (in 1995), the holder of the bond receives 1,000. If it is less than 169 yen per dollar, the amount received by holder of the bond is reduced by

Promises And Priorities

Like equities and bonds, currencies are also investment vehicles, a means to earn a return in the marketplace. Investors based in country X might choose to save local currency (U.S. dollar for the United States) holdings in something like an interest-bearing checking account or a three-month certificate of deposit (a short-term money market instrument) or they might even stuff it under a mattress. Alternatively, they might choose to spend local currency

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