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The Foreign Exchange Market

This is by far the largest market in the world, with an estimated 1.6 trillion average daily turnover. It is distinguished from the commodity or equity markets by having no fixed base. In other words, the foreign exchange market exists at the end of a telephone, the Internet or other means of instant communication it is not located in a building, nor is it limited by fixed trading hours. The foreign exchange market is truly a 24-hour global trading system. It knows no barriers and trading activity in general moves with the sun from one major financial centre to the next. The foreign exchange market is an over-the-counter market where buyers and sellers conduct business. The foreign exchange market is a global network of buyers and sellers of currencies. 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...

Foreign Exchange Notes

Foreign exchange gains and losses can result from both transaction and translation exposure. Transaction gains and losses result from either unhedged or partially hedged foreign-currency exposure.37 This exposure is created by items such as accounts receivable and accounts payable resulting from sales and purchases denominated in foreign currencies. As foreign-currency exchange rates change, the value of the foreign-currency assets and liabilities will expand and contract. This results, in turn, in foreign currency transaction gains and losses. This is the essence of the concept of currency exposure. Foreign-currency gains and losses can also result from the use of various currency contracts, such as forwards, futures, options, and swaps, entered into for both hedging and speculation. It is not uncommon to observe foreign exchange gains and losses year after year in a company's income statement. The amounts of these items, however, as well as whether they are gains or losses are often...

Foreign exchange trading

Straight through processing (STP) is the complete streamlining and automation of an entire foreign-exchange trade cycle, i.e. the removal of all manual intervention.5 E-forex portals have focused on streamlining the middle and back offices. Sara Lee de, the 6 billion subsidiary of the consumer goods firm, are running a project with Currenex to improve the way internal forex trade requests are collected and managed. It plans to automate the front, middle and back offices by building an interface with the treasury management system, which will automate the settlement of trades.

Foreign Exchange Gains and Losses

Information on foreign exchange gains and losses was disclosed in the statement of cash flows (Exhibit 2.28) and in the MD& A (Exhibit 2.30). The statement of cash flows disclosed foreign-currency losses of 1.9 million in 1995 and 8.9 million in 1996. A 6.1 million gain was disclosed in 1997. However, the MD& A disclosed a foreign-currency loss of 11.4 million for 1996 and a gain of 4.1 million for 1997. The foreign-currency items in the statement of cash flows represent recognized but unrealized gains and losses. As such, there are no associated cash inflows and outflows. However, the disclosures in the MD& A represent all of the net foreign-exchange gains and losses, both realized and unrealized. These are the totals that would have been added or deducted in arriving at net income and also represent the nonrecurring foreign currency gains and losses.

Direct and indirect quotes for foreign exchange

Foreign-exchange quotes are frequently given as a direct quote or as an indirect quote. In this pair of definitions, the home or reference currency is critical. A direct quote is a home currency price per unit of a foreign currency, such as 0.2300 per Saudi Arabian riyal (SR) for a US resident. An indirect quote is a foreign-currency price per unit of a home currency, such as SR4.3478 per US dollar for a US resident. In Saudi Arabia, the foreign-exchange quote, 0.2300, is an indirect quotation, while the foreign-exchange quote, SR4.3478, is a direct quotation. In the USA, both quotes are reported daily in The Wall Street Journal and other financial press.

Foreign Exchange Exposure

As mentioned previously, many organizations are at risk to the financial impact of the market due to changes in foreign exchange rates. In particular, there are three types of foreign exchange exposure Foreign exchange exposure is the risk of financial impact due to changes in foreign exchange rates. Of course, this exposure could be eliminated or mitigated through the use of foreign exchange products, such as a forward contract, which could lock in a specific exchange rate for settlement at the time the payment is due. Again, this exposure can be eliminated or mitigated through the use of foreign exchange products such as a forward contract or a currency option. Economic exposure relates to a company's exposure to foreign markets and suppliers. It can also be referred to as competitive, strategic or operational exposure and is more difficult to identify. In fact, identification of economic exposure involves in-depth forecasting to determine how sensitive the company's business is to...

Spot Foreign Exchange

Foreign exchange rates are a means of expressing the value and worth of an economy by its currency vis-a-vis that of another. Normal market usage is to quote the exchange rate for spot value, i.e. for delivery two business days from the trade date (except Canadian transactions against the dollar, when the spot date is only one day). The two business days are normally required in order to enable the trade information between the counterparties involved to be agreed and to process the funds through the local clearing systems. The two payments are made on the same date, regardless of the time zone difference (see Figure 7.1). Figure 7.1 Example of a foreign exchange transaction Figure 7.1 Example of a foreign exchange transaction

Foreign exchange and gold risk

Alternatively, subject to approval by national regulators, banks can employ a simulation method. The exchange rate movements over a past period are used to revalue the bank's present foreign exchange positions. The revaluations are, in turn, used to calculate simulated profits losses if the positions had been fixed for a given period, and based on this, a capital charge imposed.

Foreign Exchange Swaps

A foreign exchange swap is the simultaneous purchase and sale of one currency against another for two different value dates. One of the value dates is usually the spot date and the other is a date in the future. In a typical swap transaction, one currency amount is held constant for both dates of the transaction. Most foreign exchange swaps have a maturity of less than one year.

The Value Of Foreign Exchange Swaps

Swaps are used primarily by investors and borrowers, and for cash management purposes. They are valuable to those who have liquidity in one currency but need liquidity in another currency. Typically, a client will buy spot and sell forward to generate liquidity in the currency purchased at spot. That is, if a client exchanges dollars for francs at spot and simultaneously exchanges francs forward for dollars, the client has created liquidity in francs (i.e. has them to spend) until the forward date. A foreign exchange swap is an alternative to straight borrowing in a foreign currency. A swap allows the two parties involved to use a currency for a period in exchange for another currency not needed at that time. For example, companies can access foreign currency to finance foreign currency denominated assets, such as those of a foreign subsidiary. Hence, foreign exchange swaps can help clients to diversify their investments, to fund intracompany loans, to fund a position rather than use...

Should You Hedge Foreign Exchange Risk

Since foreign exchange risk does add to the dollar risk of holding foreign securities, it could be desirable for an investor in foreign markets to hedge against currency movements. Currency hedging means entering into a currency contract that offsets unexpected changes in the price of foreign currency relative to the dollar.

Foreign Exchange Options

The currency options market shares its origins with the new markets in derivative products, which have blossomed in recent years. They were developed to cope with the rise in volatility in the financial markets world wide. In the foreign exchange markets, the dramatic rise (1983-1985) and the subsequent fall (1985-1987) in the dollar caused major problems for central banks, corporate treasurers, and international investors alike. Windfall foreign exchange losses became enormous for the treasurer who failed to hedge, or who hedged too soon, or who borrowed money in the wrong currency. The investors in the international bond market soon discovered that the risk on their bond positions could appear insignificant relative to their currency exposure. Therefore, currency options were developed, not as another interesting off-balance-sheet trading vehicle but as an alternative risk management tool to the spot and forward foreign exchange markets. They are a product of currency market...

Application Of Foreign Exchange Options

The users of the option market are widespread and varied, but the main users are organizations whose business involves foreign exchange risk. Options may be a suitable means of removing that risk and are an alternative to forward foreign exchange transactions. In general, the exchange-traded options markets will be accessed by the professional market makers and currency risk managers. The standardization of options contracts promotes tradability, but this is at the expense of flexibility. 2. Forward forex contract no potential loss or gain Figure 14.1 Foreign exchange considerations If foreign exchange rates are expected to Forward foreign exchange contract In general, the applications of foreign exchange options can be summarized as follows. To cover foreign exchange exposure Table 14.1 Forex options versus forex forwards Options Table 14.2 Forex options versus forex open positions

Foreign Exchange Market Efficiency

This chapter is an introduction to the economics of foreign exchange market efficiency. We begin with an evaluation of the simplest model of international currency and money-market equilibrium uncovered interest parity. Econometric analyses show that it is strongly rejected by We cover three possible explanations. The first is that the forward foreign exchange rate contains a risk premium. This argument is developed using the Lucas model of chapter 4. The second explanation is that the true underlying structure of the economy is subject to change occasionally but economic agents only learn about these structural changes over time. During this transitional learning period in which market participants have an incomplete understanding of the economy and make systematic prediction errors even though they are behaving rationally. This is called the 'peso-problem' approach. The third explanation is that some market participants are actually irrational in the sense that they believe that the...

Users Of Foreign Exchange Options

Writing options on exchanges tends to be simpler as the credit risks are controlled by a margin system. The margin is a small percentage of the value of the contract, which must be deposited to cover losses up to a certain limit. The margin is usually adjusted on each trading day and, on occasions, more frequently to take account of market movements. However, the greater flexibility available in the OTC market allows some of the credit difficulties to be pursued and overcome. Participants in the foreign exchange currency options market include Banks - who provide a service for their clients, to manage their own foreign exchange risk, and in order to take a directional and or volatility view. Multinational companies - multinationals and their subsidiaries will have funds and cross-border transactions in several currencies and so will be subject to foreign exchange risk.

Interest rate risk and foreign exchange risk

Interest rate risk and foreign currency exchange (forex) risk are two of the principal market risks that can hit an industrial firm, bank, insurance company, pension fund or asset management entity. All sorts of organizations have cash flow obligations to meet, and part of the investments they make as a 'war chest' are exposed to volatility of these two (and more) market risk factors In practice, market anomalies see to it that they are not hence they are vulnerable to arbitrage exploiting interest rate differentials and or forex differentials for profit. The model that addresses simultaneously interest rate and forex rate risk must be sophisticated. A British investor will earn more on a US investment than on a comparable investment in his or her country as long as a US interest rate advantage is not neutralized by a depreciation of the American dollar against the British pound. Under these circumstances With many instruments, mismatch risk should be a focal point. Also known as...

Case Study Australian Forex Market

In the following, we present a case study to forecast six different currency rates, namely, the U.S. dollar (USD), Great British pound (GBP), Japanese yen (JPY), Singapore dollar (SGD), New Zealand dollar (NZD) and Swiss franc (CHF) against the Australian dollar using their historical exchange rate data. The case study is based on our previous study (Kamruzzaman & Sarker, 2004). In most of the previous studies related to forex forecasting, the neural network algorithms used were Standard Backpropation (SBP), Radial Basis Function (RBF), or Generalized Regression Neural Network (GRNN). In this case study, we used two other improved feed-forward learning algorithms, namely the Scaled Conjugated Gradient (SCG) and Bayesian Reguralization (BR) algorithms, to build the model and investigate how the algorithms performed compared to standard backpropagation in terms of prediction accuracy and profitability. Dataset. The data used in this study is the foreign exchange rate of six different...

Monetary and Foreign Exchange Operations Instruments and Effectiveness

The prevailing monetary operations framework is based on monetary policy instruments and operating procedures, money and foreign exchange markets, and payment settlement system. Its design bears directly on banks' ability to manage short-term liquidity. The three structural components are closely interlinked, and they strongly influence and reinforce each other so that the design and framework of one will affect the characteristics that need to be given to the others. Usually banks operate in more than one currency and must, therefore, include foreign exchange considerations in their liquidity management. Access to liquidity in foreign exchange is affected by a number of factors that are different from those affecting liquidity in domestic currency. In this regard, banks operating in highly dollarized economies are faced with particular challenges. For example, deposits in domestic currency may prove less stable than those denominated in dollars. In addition, specific market and...

Monetary and Foreign Exchange Markets Microstructure and Functioning

The microstructure and functioning of money and foreign exchange markets differ from that of other financial markets because of the singular role of the central bank.7 The central bank is usually the regulator of those markets and is responsible for the development of market institutions. The central bank frequently serves as market maker and dominant supplier of liquidity, particularly in less-developed markets. In a context of shallow markets, the central bank faces the challenge of establishing operating procedures to guide its interventions that balance the need to achieve its policy objectives with the need to promote market development. Transmission of Policy. The effectiveness of market makers, be they the central bank or primary dealers, is a key component for the implementation of monetary policy using indirect instruments and for effective intervention in the foreign exchange market.

Foreign Exchange Reserve Management

Specifically, reserves play a key role in preventing the cascading of sectoral liquidity problems into national liquidity and even solvency problems (through the effect on interest rates). Claims on reserves can arise from public and private sector risk and liquidity management. The size of short-term (by remaining maturity), economy-wide, external debt in relation to available international reserves is typically the starting point in determining reserve adequacy for emerging market countries. However, in the absence of effective capital controls, short-term foreign currency debt between residents can also result in pressures on reserves. Therefore, with flexible exchange rates, overall maturity mismatches in foreign currency are the chief concern as they can spill over into claims on reserves and national liquidity problems (see IMF 2004). When exchange rates are fixed and capital controls are weak, all domestic private sector liquidity problems can spill over into national liquidity...

Electronic Foreign Exchange Trading

For the past few decades, the telephone has been the near universal means of communication between the banks and their clients for the executions of foreign exchange. The telephone has served the needs of the market well but now, with the advent of Internet trading, it is a moot point as to whether deal execution is significantly easier and more efficient using a computer instead of the telephone. Some would offer this as an argument against the introduction of e-commerce solutions to the foreign exchange markets. Some fear that a consequent reduction of personal contact between salesperson and client could undermine valued relationships.

Foreign Exchange Markets And Exchange Rates

The foreign exchange market is undoubtedly the world's largest financial market. It is the market where one country's currency is traded for another's. Most of the trading takes place in a few currencies the U.S. dollar ( ), the German deutsche mark (DM), the British pound sterling ( ), the Japanese yen ( ), the Swiss franc (SF), and the French franc (FF). Of course, with the introduction of the euro (see our chapter opener), some of these currencies have disappeared. Table 22.1 lists some of the more common currencies and their symbols. The foreign exchange market is an over-the-counter market, so there is no single location where traders get together. Instead, market participants are located in the major commercial and investment banks around the world. They communicate using computer terminals, telephones, and other telecommunications devices. For example, one communications network for foreign transactions is maintained by the Society for Worldwide Interbank Financial...

Applications of ARCH to foreign exchange rate data

Such as their contiguous periods of volatility and stability together with their leptokurtic unconditional distributions see, e.g., Mussa (1979) and Friedman and Vandersteel (1982). As discussed above, the ARCH class of models is ideally suited to modeling such behavior. Whereas stock returns have been found to exhibit some degree of asymmetry in their conditional variances, the two-sided nature of the foreign exchange market makes such asymmetries less likely. In the absence of any structural model for the conditional variances, the linear GARCH(p,q) model in (7) therefore is a natural candidate for modeling exchange rate dynamics. In accordance with the findings for stock returns and interest rates, the persistence of volatility shocks in the foreign exchange market is also very A growing body of literature has found that the forward rate is not an unbiased predictor of the corresponding future spot rate see, e.g., Hakkio (1981), Hsieh (1984), Baillie (1989), and McCurdy and Morgan...

Trading in Foreign Exchange

Importers, exporters, tourists, and governments buy and sell currencies in the foreign exchange market. For example, when a U.S. trader imports automobiles from Japan, payment will probably be made in Japanese yen. The importer buys yen (through its bank) in the foreign exchange market, much as one buys common stocks on the New York Stock Exchange or pork bellies on the Chicago Mercantile Exchange. However, whereas stock and commodity exchanges have organized trading floors, the foreign exchange market consists of a network of brokers and banks based in New York, London, Tokyo, and other financial centers. Most buy and sell orders are conducted by computer and telephone.5

Fixed income Foreign exchange and Equities Trading

Case of a sale) and offer (when the asset is bought) prices for equities, bonds, foreign exchange or commodities. The firm is exposed to price or market risk because it is quoting bid and offer prices for the asset in question. The market risk is hedged through deals with other market makers. The trader profits from the difference between the bid and offer price. Given the small margins, the trader relies on large volumes to make a reasonable profit on the small margin between the bid and offer price for each transaction. Traders are backed up by a sales team, whose job it is to find clients for the equities, bonds, foreign exchange or commodities. A bank such as Goldman Sachs will also use its large client base from other parts of the firm (e.g. investment banking) to provide business for this trading.

Foreign Exchange Markets

An American company that imports goods from Switzerland may need to exchange its dollars for Swiss francs in order to pay for its purchases. An American company exporting to Switzerland may receive Swiss francs, which it sells in exchange for dollars. Both firms must make use of the foreign exchange market, where currencies are traded. The foreign exchange market has no central marketplace. All business is conducted by computer and telephone. The principal dealers are the large commercial banks, and Turnover in the foreign exchange markets is huge. In London alone about 640 billion of currency changes hands each day. That is equivalent to an annual turnover of 159 trillion ( 159,000,000,000,000). New York and Tokyo together account for a further 500 billion of turnover per day. Compare this to trading volume of the New York Stock Exchange, where no more than 30 billion of stock might change hands on a typical day. Suppose you ask someone the price of bread. He may tell you that you...

Foreign Exchange Rate Intervention and the IMF

When capital account outflows occur, investors sell the domestic currency and buy foreign currency, which puts downward pressure on the exchange rate. In order to avoid a depreciation, a government can raise interest rates in an effort to persuade investors to keep their money in the country. But as our discussion of second-generation models suggests, there may be limits to this policy, due to the weakness of the domestic economy or the banking system. Another option is for the government to instruct its central bank to engage in foreign exchange intervention, namely to buy the domestic currency being sold by selling the central bank's foreign currency reserves.

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. The main participants in the foreign exchange market are These banks usually have large foreign exchange sales and trading departments that not only handle the requests from their clients but also take positions...

Preface and Acknowledgments

In chapter 5, The Foreign-Exchange Market and Parity Conditions, we have replaced both the opening case and the ending cases with new ones, shortened our discussion on the overview of the foreign-exchange market, and, in a box, examined the effectiveness of official exchange intervention. Chapter 6, Currency Futures and Options, discusses the risk of financial derivatives more explicitly and analyzes the reasons for the decline in the importance of currency futures. We have substantially revised chapter 7, Financial Swaps, to reflect new information in the opening case, to describe the US accounting scandal of 2002, and to explain the motives for the use of financial swaps. Chapter 8, Exchange Rate Forecasting, tracks the fluctuation of the US dollar in a box and discusses the reasons for central bank intervention in currency markets. The fifth edition of this book had only one chapter about foreign-exchange risk management, but the sixth edition discusses this important topic in two...

The Bretton Woods System

Convertibility ended with the Great Depression, and the major powers left the Gold Standard and fostered protectionism. As the political climate deteriorated and the world headed for war, the foreign exchange markets all but ceased to exist. With the end of World War II, reconstruction for Europe and the Far East had as its base the Bretton Woods system.

The balance of payments as a whole

1 Predict pressures on foreign-exchange rates. The transactions of cases (a) (e) in example 3.1 represent autonomous transactions. In case (a), the export of US machinery earns a foreign exchange of 30,000 and is thus a credit. Transactions of cases (b) (e) cause the USA to expend a foreign exchange of 40,000 and are therefore debits. Consequently, the USA has an overall deficit of 10,000 in its balance of payments and must undertake 10,000 worth of compensating transactions to make up the difference. In this case, the compensating transactions of the USA involve sales of its gold, reductions in its balance of convertible foreign currencies, or increases in the balance of the US dollars held by other nations.

Reserves and related items group E

Foreign currencies account for approximately 90 percent of the total reserve assets held by IMF member countries. Among foreign exchanges, the US dollar has been, and still is, the most important asset. Table 3.2 shows that the dollar share of world foreign-exchange reserves declined from 1987 to 1990, increased from 1993 to 1998, and has been relatively flat at around 68 percent since 1998.

Establishing public control

In general, there are two types of public controls foreign-exchange controls and trade controls. Think, for a moment, of a case in which increased Mexican imports create a shortage in its foreign exchange. Under exchange controls, the Mexican government would force its exporters and other recipients to sell their foreign exchange to the government or to designated banks. Then, the government would allocate this foreign exchange among the various users of foreign exchange. In this way, the Mexican government could restrict Mexican imports to a certain amount of foreign exchange earned by Mexican exports. Thus, imports under exchange controls would be less than they would be under free market conditions.

O 41 A Successful Foreign Exchange System

Theoretically, continuous balance-of-payments deficits and surpluses cannot exist around the world. Under a system of freely flexible exchange rates, a foreign-exchange market clears itself in the same way a competitive market for goods does. Just like every commodity price, each exchange rate moves to a level at which demand and supply are equal. Under a system of fixed exchange rates, central banks or other designated agencies buy and sell on the open market to absorb surpluses and to eliminate deficiencies of foreign currencies at the fixed exchange rates.

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. A revaluation is an official increase in the value of a currency by the government of that currency under a fixed-rate system. A devaluation is an official reduction in the par value of a currency by the government of that currency under a fixed-rate system. Under a system of fixed rates, a country may devalue its exchange rate by setting a lower intervention price at which it will intervene in the foreign-exchange market. It may revalue or upvalue its exchange rate by setting a higher intervention price.

Company Goals And Functions Of Financial Management

The foreign-exchange market and international accounting play a key role when an MNC attempts to perform its planning and control function. For example, once a company crosses national boundaries, its return on investment depends on not only its trade gains or losses from normal business operations but also on exchange gains or losses from currency fluctuations. For example, Thailand's chemical giant Siam Cement PCL incurred a foreign-exchange loss of 517 million in the third quarter of 1997 due to currency turmoil in Asia during the second half of 1997. The company had 4.2 billion in foreign loans, and none of it was hedged. The exchange loss wiped out all the profits that the company earned between 1994 and 1996 (Glain 1997). The risk return trade-off does not apply to 100 percent of all cases, but in a free enterprise system, it probably comes close. Thus, the financial manager must attempt to determine the optimal balance between risk and profitability that will maximize the...

Is Official Exchange Intervention Effective

Many governments have intervened in foreign-exchange markets to try to dampen volatility and to slow or reverse currency movements. Their concern is that excessive short-term volatility and long-term swings in exchange rates may hurt their economy, particularly sectors heavily involved in international trade. And the foreign-exchange market certainly has been volatile recently. For example, one euro cost about 1.15 in January 1999, dropped to only 0.85 by the end of 2000, and climbed to over 1.18 by March 2003. Over this same period, one US dollar bought as much as 133 Japanese yen and as little as 102, a 30 percent fluctuation. Many other currencies have also experienced similarly large price swings in recent years.

Speculation in the foreignexchange market

Foreign-exchange markets facilitate both commercial and private transactions such as foreign trade, loans, and investments. In addition, they give rise to exchange speculation. The purpose of speculation in the foreign-exchange market is to make a profit from exchange rate fluctuations by deliberately taking an uncovered position. Speculation can be undertaken in both the spot market and the forward market.

Trade And Financial Flows

The foreign exchange market provides the liquidity for all these market participants to convert their trade and financial flows from the currency of one money centre to the currency of another. These participants buy and sell foreign exchange directly or indirectly from the interbank market, which comprises professional foreign exchange traders who operate in every financial centre of the world. These flows and the products available to facilitate these conversions are shown in Figure 4.6. The products - the majority of which have been developed for the clients of the foreign exchange market rather than for professional traders - are also used to hedge or protect the values of cash flows, as these can be affected by the potential changes in the relationships of the currencies involved. The funds borrowed or invested in the money markets may also need to be hedged for the same reasons.

Coveredinterest arbitrage

Figure 5.5 presents a graphic representation of the theoretical relationship between the forward premium or discount and the interest rate differential. The vertical axis represents the interest differential in favor of the foreign currency and the horizontal axis shows the forward premium or discount on that currency. The interest parity line shows the equilibrium state. This chapter ignores transaction costs for simplicity. However, it is important to recognize the fact that transaction costs cause the interest parity line to be a band rather than a thin line. Transaction costs include the foreign-exchange brokerage costs on spot and forward contracts as well as the investment brokerage cost on buying and selling securities. Point A of figure 5.5 shows that the forward discount for foreign exchange is 1 percent and that the foreign interest rate is 2 percent higher than the domestic interest rate. In this case, the arbitrageur could employ the so-called covered-interest arbitrage to...

Futures market participants

The currency futures market was created for those who use foreign exchange in business. Businesses, which deal with international transactions, routinely buy and sell foreign exchange in the spot market. They enter the futures market only to protect themselves against risks from volatile exchange rates. The currency futures contract is like an insurance policy against changes in exchange rates. In practice, most currency futures contracts are nullified by opposing trades, so futures traders rarely take delivery of a foreign currency in fact, nearly 98 percent of them are terminated before delivery.

Case Problem 4 The Mexican Peso Crisis of December 1994

Mexico Peso Crisis

Before the December 1994 devaluation, the Mexican government had essentially pegged the peso to the US dollar through its exchange rate stabilization program. Mexico permitted its exchange rate to fluctuate within a band of 2 percent. However, in December 1994 Mexico faced a balance-of-payments crisis. Investors lost confidence in Mexico's ability to maintain the exchange rate of the peso within its trading band, in part because of Mexico's large current-account deficit, which had reached almost 28 billion in that year. Intense pressure on the peso in foreign-exchange markets threatened to exhaust Mexico's international reserves. This pressure eventually compelled the Mexican government to float the peso and led to the now-famous peso crisis between December 1994 and early 1995.

Concluding Remarks

Today, there are products available in the foreign exchange market that can address all types of foreign exchange exposures and purposes. As mentioned in an earlier chapter, there are six basic foreign exchange products foreign exchange swaps foreign exchange futures contracts. Foreign Exchange Products

The origins of the swap market

The structure of a typical parallel loan is illustrated in figure 7.1. Assume that (1) a parent corporation (IBM) in the United States with a subsidiary in Australia wants to obtain a 1-year Australian dollar loan and (2) a parent corporation (WMC Western Mining Company) in Australia with a subsidiary in the USA wishes to obtain a 1-year US dollar loan. In other words, each parent wants to lend to its subsidiary in the subsidiary's currency. These loans can be arranged without using the foreign-exchange market. IBM lends the agreed amount in US dollars to the American subsidiary of WMC. In return for this loan, WMC lends the same amount of money in Australian dollars to the Australian subsidiary of IBM. Parallel loan agreements involve the same loan amount and the same loan maturity. Of course, each loan is repaid in the subsidiary's currency. The parallel loan arrangement avoids foreign-exchange risk because each loan is made and repaid in one currency.

Uses For Spot Transactions

Client groups, such as corporations, investors, funds and institutions, will use spot transactions as part of their foreign exchange management programmes. Speculators will also, use this market because it is extremely active and liquid with roughly two-thirds of all foreign exchange It must be remembered that there are risks with spot transactions. Firstly, there is a credit risk. Like the risk a bank incurs when making a loan, a foreign exchange contract poses the risk that the client will not perform according to the terms of the contract (i.e. will not deliver the appropriate currency on time). In a foreign exchange transaction, the market maker and the client agree that each will deliver to the other a specified amount of a currency on a specific date, at an agreed rate. Trading the currencies of countries that are in different time zones compounds the risk. Secondly, there is a market price risk. Trading in any currency has a degree of risk. Exchange rate risk is inevitable...

Tracking the US Dollar

Each day, more than 1 trillion in currency trades in the foreign-exchange market. Many participants and factors affect the value of one currency versus another. The market consists of a worldwide cast of businesses, investors, speculators, governments, and central banks, acting and reacting on the basis of a mix of forces such as trade patterns, interest rate differentials, capital flows, and international relations.

Step one assessing the balanceofpayments outlook

Step one is an early warning system that will assist the forecaster in identifying those countries whose currencies are likely to be adjusted. Currencies are rarely devalued without prior indication of weakness. Many researchers in this area have attempted to forecast currency devaluation on the basis of key economic indicators that are critical in assessing a country's balance-of-pay-ments outlook. Some of these indicators are the international monetary reserves, international trade, inflation, monetary supply, and exchange spread between official versus market rates. These economic indicators are also used to forecast foreign-exchange controls. Money supply Money supply consists of currency in circulation and demand deposits. Simply stated, inflation is the consequence of a country's spending beyond its capacity to produce. As an economy approaches full employment, any additional increase in money supply can serve only to make prices spiral upward. Some foreign-exchange forecasters...

Step four the nature of the adjustment

Under foreign-exchange controls, a country would force its exporters and other recipients to sell their foreign exchange proceeds to the central bank. Then, the government would allocate this foreign exchange only to the various users of foreign exchange. In this way, the government restricts the country's imports to an amount of foreign exchange earned by the country's exports. Thus, imports under exchange controls are less than they would be under free market conditions.

Why and how central banks intervene in currency markets

In a system of fixed exchange rates, central banks frequently intervene in the foreign-exchange market to maintain the par value system. Even within the flexible exchange rate system, central banks intervene in the foreign-exchange market to maintain orderly trading conditions. Monetary authorities normally intervene in the foreign-exchange market (1) to smooth exchange rate movements, (2) to establish implicit exchange rate boundaries, and (3) to respond to temporary disturbances. Depending on market conditions, a central bank may In 1999, the Bank for International Settlements (BIS) sent a questionnaire on the practice of exchange market intervention to 44 central banks, including the European Central Bank. Of 44 institutions, 22 responded to some or all of the questions asked. The Reserve Bank of New Zealand was the only authority to report that it had not intervened in the past 10 years. Table 8.1 shows summary statistics of the intervention survey responses. The survey of central...

Coca Colas Exposure Management

Coca Cola is a good example of how MNCs use operational techniques and financial instruments for their foreign-exchange exposure management. Because Coca Cola earns about 80 percent of its operating income from foreign operations, foreign-currency changes can have a major impact on reported earning. The company manages its currency exposures on a consolidated basis, which allows it to net exposures from different operations around the world and takes advantage of natural offsets - for example, cases in which Japanese yen receivables offset Japanese yen payables. It also uses financial contracts to further reduce its net exposure to currency fluctuations. Coca Cola enters into currency forward contracts and purchases currency options in several countries, most notably the euro and Japanese yen, to hedge firm sales commitments. It also buys currency options to hedge certain anticipated sales.

A comparison of the three exposures

The management of foreign-exchange risk based on translation exposure is basically static and historically oriented. By definition, translation exposure does not look to the future impact of an exchange rate change that has occurred or may occur. In addition, it does not involve actual cash flows. In contrast, both transaction and economic exposures look to the future impact of an exchange rate change that has occurred or may occur. These exposures also involve actual or potential cash flow changes.

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. As Merck became increasingly global, it continued to establish and enhance strategic alliances here in the USA and abroad, in order to discover, develop, and market innovative products. Moreover, Merck understands that future competition will be more global in nature. To prepare its managers for this broader challenge, Merck continues to expand the international nature of its management training. Programs focus increasingly on international issues such as foreign-exchange risk management, and training program participants reflect the worldwide nature of the company's businesses. For example, the senior-level managers who attended its Executive Development Programs in recent years came from 30 countries. Every company faces...

O 92 Transaction Exposure Management

An action that removes transaction risk is said to cover that risk. A cover involves the use of forward contracts, a combination of spot market and money market transactions, and other techniques to protect a foreign-exchange loss in the conversion from one currency to another. The term conversion relates to transaction exposure because the transaction exposure involves the actual conversion of exposed assets and liabilities from one currency to another. If MNCs decide to cover their transaction exposure, they may select from a variety of financial instruments and operational techniques. Operational techniques, such as exposure netting, leading and lagging, and price adjustments through transfer prices, will be discussed in chapter 10. This chapter will focus on the following four financial instruments.

The forward market hedge

A forward-exchange market hedge involves the exchange of one currency for another at a fixed rate on some future date to hedge transaction exposure. The purchase of a forward contract substitutes a known cost for the uncertain cost due to foreign-exchange risk caused by the possible devaluation of one currency in terms of another. Although the cost of a forward contract is usually smaller than the uncertain cost, the forward contract does not always assure the lowest cost due to foreign-exchange rate change. The forward contract simply fixes this cost in advance, thus eliminating the uncertainty caused by foreign-exchange rate changes. For example, an American company may have a euro import payable in 9 months. The American company can cover this risk by purchasing euros at a certain price for the same date forward as the payment maturity.

The money market hedge

Hedge transaction exposure from this import payable, the American company may borrow in dollars (loan contract), convert the proceeds into British pounds, buy a 90-day British Treasury bill, and pay the import bill with the funds derived from the sale of the Treasury bill (source of funds). Of course, it can buy British pounds in the foreign-exchange spot market when the import bill becomes due, but this approach involves transaction risk. A money market hedge is similar to a forward market hedge. The difference is that the cost of the money market hedge is determined by differential interest rates, while the cost of the forward market approach is determined by the forward premium or discount. If foreign-exchange markets and money markets are in equilibrium, the forward market approach and the money market approach incur the same cost.

The use of hedging techniques by MNCs

Burston-Marsteller, a consulting firm in currency risk management, conducted a survey of 110 chief financial officers at a November 1997 CFO forum in Manila, Philippines. Figure 9.1 shows that these CFOs consider foreign-exchange risk (38 percent) as the most important one among the many risks that they face. The next most frequently cited risks are interest rate risk (32 percent) and political risk (10 percent). Other risks (20 percent) consist of credit risk at 9 percent, liquidity risk at 7 percent, and inflation risk at 4 percent. Figure 9.1 also shows that the traditional forward contract was the most commonly used instrument to manage foreign-exchange risks. Of all respondents, 42 percent used the forward contract as the primary hedging instrument. Four other hedging techniques discussed in part II of this book currency swaps, interest rate swaps, currency options, and futures were almost equally used by these respondents. Another recent survey by Jesswein et al. (1995) also...

The Mexican peso crisis of December 1994

In December 1994, Mexico faced a balance-of-payments crisis. Investors lost confidence in Mexico's ability to maintain the exchange rate of the peso within its trading band. Intense pressure on the peso in foreign-exchange markets threatened to exhaust Mexico's international reserves.

Differences between FASBs 8 and

FASB 52 is intended to portray foreign-currency cash flows. Companies using the functional currency approach and the current-rate method can maintain compatible income and cash flows before and after translation. Financial summary indicators, such as profit margin, gross profit, and debt-to-equity ratio, are almost the same after translation into the reporting currency as they are in the functional currency. In addition, the volatility of a company's reported earnings should be reduced under FASB 52, because its foreign-exchange gains or losses are placed directly in stockholders' equity rather than in income.

O 103 Hedging Translation Exposure

When a devaluation or upvaluation seems likely, a company must determine whether it has an unwanted net exposure to exchange risk. Management's basic objective with any exposure is to minimize the amount of probable exchange losses and the cost of protection. A hedge is an approach designed to reduce or offset a possible loss. An arrangement that eliminates translation risk is said to hedge that risk. A hedge is designed to substitute a known cost of buying protection against foreign-exchange risk for an unknown translation loss. One can use a variety of techniques to deal with translation exposure. These techniques consist of one major group of hedging devices a balance-sheet hedge.

The relative importance of different exchange exposures

Tsanacas, Hedging Preferences and Foreign Exchange Exposure Management, Multinational Business Review, Fall 1995, pp. 56-66 and D. M. Perkins, Treasury. Accounting Must Work Together to Fashion Foreign Exchange Hedging Strategy, Corporate Cashflow, Jan. 1993, pp. 34-6.

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.

Indirect fundsadjustment methods

Exposure netting MNCs can net certain exposures from different operations around the world so that they may hedge only their net exposure. For example, when an MNC has both receivables and payables in a given foreign currency, these receivables and payables can be offset through netting, which will reduce the amount of foreign-exchange exposure. Exposure netting is a method of offsetting exposures in one currency with exposures in the same or another currency in such a way that gains or losses on the first exposure will be offset by losses or gains on the second exposure. Unlike the simple case of exposure netting on a currency-by-currency basis that we discussed above, MNCs have a portfolio of currency positions. If MNCs want to apply exposure netting aggressively, it helps to centralize their exposure management function in one location. Leading and lagging Leading and lagging is another operational technique that MNCs can use to reduce foreign-exchange exposure. Leading means to...

Explain Corporate Motives For Forecasting Exchange Rates

2 If foreign-exchange markets are perfectly efficient, why should no one pay for the services of currency forecasting firms 3 Most empirical studies have found that foreign-exchange markets are at least weak-form efficient. Does this mean that investors can earn extra profits by using technical analysis 11 Why do the central banks of countries with flexible exchange rate systems intervene in the foreign-exchange market

Exposure management strategy

Most large MNCs manage their foreign-exchange risk by using a pre-established exposure management strategy. For example, Merck uses the following five steps for currency exposure management (1) projecting exchange rate volatility, (2) assessing the impact of the 5-year strategic plan, (3) deciding on hedging the exposure, (4) selecting the appropriate financial instruments, and (5) constructing a hedging program (for details, see Case Problem 6 Merck's Use of Currency Options). To protect assets adequately against risks from exchange rate fluctuations, MNCs must (1) forecast the degree of exposure, (2) develop a reporting system to monitor exposure and exchange rate movements, (3) assign responsibility for hedging exposure, and (4) select appropriate hedging tools. Assigning responsibility for hedging exposure It is important for management to decide at what level hedging strategies will be determined and implemented. Most MNCs today continue to centralize exchange exposure...

Spot And Reciprocal Rates

The spot exchange rate can be expressed in either currency, thus this price has two parts, the base currency and the equivalent number of units of the other currency. For example, a rate for the US dollar against the Swiss franc would be quoted as 1.6703. This means there are 1.6703 Swiss francs to 1 dollar. When one rate is known, the spot exchange rate expressed in the other currency (the reciprocal) is easily calculated. The price of 1 dollar, expressed in Swiss francs, is 1 0.5986 or Sfr 1.6703. Although some newspapers calculate and publish both exchange rates, it has become a standard market practice among traders to quote the foreign exchange for most currencies as the amount of foreign currency that will be exchanged for 1 dollar. For example, if a bank trader was asked to quote a rate for Swiss francs against the dollar, the response would most probably be sfr 1.6703 rather than 0.5986. In this case, 1 dollar is the

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. Risks of participating banks Participating banks in the Eurocurrency interbank market face at least five different risks (1) credit or default risk, (2) liquidity risk, (3) sovereign risk, (4) foreign-exchange risk, and (5)...

Geographical arbitrage

The basic economic principle of buy low and sell high dominates the arbitrage transaction of buying and selling currencies in two national money markets. Exchange rates in two different locations must be stated in a given currency if this principle is to be applied in foreign exchange. Thus, the arbitrage process becomes slightly more difficult to understand if exchange rates are quoted in different currencies. Let us restate our previous example in a slightly different way. The price of rands against the dollar is 0.20 in New York. The price of dollars against the rand is R4 in Johannesburg. The quotes in both locations in terms of R are as follows

Exchange vs Overthecounter Options

Foreign exchange options can be traded on an exchange on or in the over-the-counter (OTC) market, i.e. between two parties. Exchange-traded options are standardized contracts with fixed maturity dates, strike prices and contract sizes, although each exchange has its own contract specifications and trading rules. OTC option specifications are much more flexible as maturity, strike price amount, etc., can be negotiated before dealing. Exchange-traded options can be characterized by as follows

The Asian Financial Crisis and the International Monetary Fund IMF

The panic view Subscribers to the panic view admit that there were vulnerabilities increasing current-account deficits, falling foreign-exchange reserves, fragile financial systems, highly leveraged corporations, and overvaluation of the real exchange rate. Still, these vulnerabilities were not enough to explain the abruptness and depth of the crisis. They argue that economic fundamentals in Asia were essentially sound.

Other private financing

Export trading companies engage primarily in two forms of activity trade intermediation and export outlets for US manufacturing companies. In their role as trade intermediaries, export trading companies can provide small and medium-size firms with comprehensive one-stop services, such as market analysis, distribution services, documentation, financing, foreign-exchange transactions, transportation, and legal assistance. They can buy products from other US companies and export these products either through their own outlets or to outside distributors.

Basic objectives of documentation

Documentation in foreign trade is supposed to assure that the exporter will receive the payment and the importer will receive the merchandise. More specifically, a number of documents in foreign trade are used to eliminate noncompletion risk, to reduce foreign-exchange risk, and to finance trade transactions. Foreign-exchange risk Foreign-exchange risk arises when export sales are denominated in a foreign currency and are paid at a delayed date. In international trade, the basic foreign-exchange risk is a transaction risk. Transaction risk is the potential exchange loss from outstanding obligations as a result of exchange rate fluctuations. Forward contracts, futures contracts, currency options, and currency denomination practices can be used to reduce foreign-exchange risk associated with foreign trade. Trade financing Because all foreign trade involves a time lag, funds are tied up in the shipment of goods for some period of time. Most trade transactions are free of noncompletion...

Key reasons for forward exchange transactions

Individuals and corporations buy and sell forward currencies to provide protection against future changes in exchange rates. So long as we do not have a single world currency, some degree of exchange risk exists in any system. We cannot eliminate some possibility of foreign-exchange losses in either the fixed exchange rate system or the flexible exchange rate system.

Exchange Rate Forecasting

This chapter covers four related topics (1) measuring a change in exchange rates (2) forecasting the needs of a multinational company (MNC) (3) forecasting floating exchange rates and (4) forecasting fixed exchange rates. Floating exchange rates are rates of foreign exchange determined by the market forces of supply and demand, without government intervention on how much rates can fluctuate. Fixed exchange rates are exchange rates which do not change, or they fluctuate within a predetermined band.

Edge Act and agreement corporations

Types of activities Edge Act and agreement corporations typically engage in three types of activities international banking, international financing, and holding companies. In their capacity as international banking corporations, Edge Act and agreement corporations may hold demand and time deposits of foreign parties. They can make loans, but these loans to any single borrower cannot exceed 10 percent of their capital and surplus. They can also open or confirm letters of credit, make loans or advances to finance foreign trade, create bankers' acceptances, receive items for collection, remit funds abroad, buy or sell securities, issue certain guarantees, and engage in foreign-exchange transactions.

National development banks

The Export-Import Bank (Ex-Im Bank) The Ex-Im Bank provides investment funds to MNCs. These funds include long-term direct financing to facilitate the purchase of US goods and services used in industrial projects in foreign countries. In this type of long-term direct financing, the Ex-Im Bank expects substantial equity participation by the borrower. Moreover, it provides US companies with guarantees on their engineering and feasibility studies, as well as on their technical and construction services, performed abroad. In summary, the Ex-Im Bank is a key source of financing overseas projects when private sources are not available. These projects must be economically justifiable, contribute to the economic development of the country, and improve the country's foreign-exchange position.

Sources and uses of funds

In dealing with the rest of the world, a country earns foreign exchange on some transactions and expends foreign exchange on others. Transactions that earn foreign exchange are often called Transactions that expend foreign exchange are sometimes called debit transactions and represent uses of funds. These transactions are recorded in the balance of payments as debits and are marked by minus signs ( ). The following transactions represent debit transactions

International Working Capital Management

GeoLogistics' operational guidelines for ABN outlined policies for investments, lending, funding, foreign exchange, disbursements, and financial reporting. Under these guidelines, ABN has reduced the company's idle cash by 20 million per year, with a corresponding reduction in external debt. Specifically, to improve the company treasury services, ABN centralized all intercompany lending and hedging activity

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.

Different channels to move funds

Fund flows from subsidiary to parent The major components of fund flows from subsidiary to parent consist of dividends, interest on loans, principal reduction payments, royalty payments, license fees, technical service fees, management fees, export commissions, and payments for goods received from the parent. The parent does not have total control over the size of the flow of funds because of various external factors, such as foreign-exchange controls and tax constraints. For example, many governments impose a withholding tax when dividends are remitted to foreign owners. Multilateral netting Large MNCs often require a highly coordinated interchange of material, parts, work-in-process, and finished goods among various units, because they must handle a large volume of intracorporate fund flows. These cross-border fund transfers involve the foreign-exchange spread, the opportunity cost of the float, and other transaction costs such as cable charges. Netting has been frequently suggested...

Objectives of cash management

Tive of any corporation is to minimize the cash balance within the company, with the goal of optimizing corporate fund utilization. However, the parameters within which MNCs operate are broader and more complex than those of purely domestic companies. Furthermore, the relationships among these parameters are constantly changing. Hence those responsible for cash management on an international basis must consider new variables such as tax concepts, governmental restrictions on intracompany fund flows, differences in cultures, and foreign-exchange rates.

Currency value problems

There are at least two ways in which the accounts receivable manager can alleviate currency value problems currency denomination and the use of factors. A seller may require that all payments are to be made in hard currencies. This requirement assures the seller that payments are to be made in currencies likely to face little or no devaluation on the foreign-exchange market. In certain instances, an MNC refuses credit sales denominated in foreign currencies altogether. MNCs may buy currency credit insurance. For example, American exporters can purchase protection from the Foreign Credit Insurance Association or the Export-Import Bank described in chapter 13.

Determining the amount of inventory

Despite the desire for optimizing inventory levels, many companies that rely on imported inventories maintain overstocked inventory accounts. The fears of continued inflation, raw materials shortages, and other environmental constraints induce companies to maintain high overseas inventory levels rather than risk curtailment of their overseas operations. Additional environmental constraints include anticipated import bans in foreign countries, anticipated delivery delays caused by dock strikes and slowdowns, the lack of sophisticated production and inventory control systems, and increased difficulty in obtaining foreign exchange for inventory purchases.

Protective measures against inflation and devaluation

Finally, if a subsidiary relies almost equally on imported inventories and locally purchased inventories, it should seek to reduce its locally acquired inventories and to increase its imported inventories in advance of an expected devaluation. However, if accurate forecasts of devaluation are not possible, a company should maintain the same amount of imported goods and locally purchased goods to avoid foreign-exchange risks, because a devaluation would affect both types of inventories equally, and thus the subsidiary would experience neither a gain nor a loss.

Composition Of A Dealing Room

The composition of an institution's dealing room very much depends on that institution's size, its spread of market interests and its client base (see Figure 18.1). However, in general, the majority of institutions actively involved in the foreign exchange markets will have some or all of the personnel listed below.

Case Problem 15 Navistar Internationals Netting System

Ing at that time in local currencies. The clearing center converts all amounts into dollar terms at the current spot exchange rate and sends information to those subsidiaries with net payables on how much they owe and to whom. These paying subsidiaries are responsible for informing the net receivers of funds and for obtaining and delivering the foreign exchange. Settlement is on the 25th day of the month and the funds are purchased 2 days in advance, so that they are received on the designated day. Any difference between the exchange rate used by the Swiss center on the 15th and the rate prevailing for settlement on the 25th gives rise to foreign-exchange gains or losses, and these are attributed to the subsidiary. Navistar used this original clearing system for intracompany transactions and did not use the system for its transactions with independent companies. After a decade with this system, the company introduced a scheme for foreign-exchange settlements for payments to outside...

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...

Glossary of Terms for Chapter

The following lists the more popular orders used in both the foreign exchange and the futures market. Although the two markets share common orders, some are only relevant for the futures market, for example 'market on opening'. Hence, it is very important to state exactly and clearly what the order is and what, if necessary, you are trying to achieve.

The Environment Today

Today, most clients are quite sophisticated they know where the market is and what bid-offer spreads to expect for the foreign exchange deals. Banks and brokers who are uncompetitive in their pricing don't even leave the starting blocks in the race to win foreign exchange business. What distinguishes the best from the rest is the provision of high-quality information, in the way of charting and flows of relevant market information. In addition, clients are looking for systems that are Internet enabled, scalable across regions, reliable and safeguarded against crashes. Clients are also looking for Internet platforms, which offer real-time risk management systems, among other demands.

International Capital Budgeting Decisions

Foreign-exchange rates, interest rates, and inflation are three external factors that affect multinational companies (MNCs) and their markets. Changes in these three factors stem from several sources, such as economic conditions, government policies, monetary systems, and political risks. Each factor is a significant external variable that affects areas such as policy decisions, strategic planning, profit planning, and budget control. To minimize the possible negative impact of these factors, MNCs must establish and implement policies and practices that recognize and respond to their influences. These three factors - exchange rates, interest rates, and inflation - affect sales budgets, expense budgets, capital budgeting, and cash budgets. However, they are particularly useful when evaluating international capital budgeting alternatives. Foreign-exchange rates have the most significant effect on the capital budgeting process. A foreign investment project will be affected by exchange...

Translation Exposure Management

1 Because accounting exposure, commonly known as translation exposure, is based on book values only, it does not reflect the true economic value a company has at risk. By the same token, the gains and losses of foreign-exchange trading as measured by this concept bear no relationship to the real impact exchange rate changes have on the value of the firm itself. They are purely of a paper nature.

The nature of political risks

It is frequently difficult to separate political and economic risks. While government decisions are political by definition, underlying forces behind the decisions may be purely economic. For example, funds to nonresidents may be blocked because of an unexpected shortage of foreign exchange or a long-run deficiency of the foreign exchange, instead of certain types of domestic political pressures. Some government decisions are partly political and partly economic. The United Nations imposed economic sanctions against Iraq in the fall of 1990 because of Iraq's invasion of Kuwait. The Organization of American States imposed economic sanctions against Haiti in 1994 because of Haiti's human rights violations. Finally, the USA and several other Western countries have imposed a variety of economic sanctions against Afghanistan, Cuba, Iran, Libya, and North Korea for many years.

Responses to political risks

Many foreign affiliates attempt to harmonize their policies with their host-country priorities and goals. They may hire an increasing number of local persons for positions initially held by representatives of the parent-company management. They may share ownership with host-country private or public companies. They may develop and use local sources of supply for their raw materials and component requirements. They may try to export their products to bolster host-country reserves of foreign exchange.

Balance Of Payments Model

This model holds that a foreign exchange rate must be at its equilibrium level, i.e. the rate that produces a stable current account balance. For example, a nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers (depreciates) the value of its currency. The cheaper currency renders the nation's exports more affordable in the global marketplace while making imports more expensive. After an intermediate period,

Economic Influences On The Market

The trade balance is a measure of the difference between imports and exports of tangible goods and services, and is a major indicator of foreign exchange trends. Seen in isolation, measures of imports and exports are important indicators of overall economic activity in the economy. Typically, a nation that runs a substantial trade balance deficit has a weak currency due to the continued commercial selling of the currency. This can, however, be offset by financial investment flows for extended periods of time.

O 201 The Global Control System and Performance Evaluation

Financial results of profitability have traditionally provided a standard to evaluate the performance of business operations. However, as MNCs expand their operations across national boundaries, the standard itself is affected by the environment in which they operate. Inflation and foreign-exchange fluctuations affect all the financial measures of performance for MNCs. To compare the results of various affiliates of an MNC, multinational financial managers must understand the various ways in which inflation and exchange fluctuations affect operations as measured by traditional financial statements.

Key Factors Impacting Currencies

On certain occasions, foreign exchange rates immediately reflect changes in economic conditions, while, on other occasions, the market adjusts only after a period of delay. In general, foreign currency traders will tend to focus on released information that will have an impact on the market within a matter of hours this means that they will not hold very long positions as the odds of an unpredicted development effecting exchange rates increases with time. Therefore, to minimize market risk, traders tend to enter and exit the market quickly, while looking for ideas that, if sound, will produce short-term profits. The following is a guide to the essential fundamentals and practical factors impacting key foreign exchange rates against the dollar.

Organizational structure

Third, most companies centralize their foreign-exchange exposure management, because it is difficult for regional or country managers to know how their foreign-exchange exposure relates to other affiliates. Fifth, positioning funds involves paying dividends and making intracompany loans, thereby reducing consideration of total corporate tax liabilities, foreign-exchange exposure, and the availability of capital. Consequently, most companies tend to control positioning of funds from a centralized vantage point rather than from a regional viewpoint.

O 202 International Taxation

Usually, one of the most important variables in multinational operations is taxation. Perhaps no environmental variable, with the possible exception of foreign exchange, has such a pervasive influence on all aspects of multinational operations as taxation (1) the choice of location in the investment decision, (2) the form of the new enterprise, (3) the method of finance, and (4) the method of transfer pricing.

Internet resources

The website of the Federal Reserve Bank of New York takes you directly to daily noon foreign-exchange rates. You may also try other menu options on this site to obtain detailed information about the foreign exchange market in the USA. This website contains a wide variety of current and historical exchange rate data, along with stories relating to foreign exchange and links to the world's central banks. This website contains the BIS annual report, together with statistics on derivatives, external debt, foreign-exchange market activity, and so on. The Bloomberg website contains a wide variety of data on financial markets worldwide, including foreign-exchange and interest rate data. This is the home page of the Bank for International Settlements. Many interesting reports and statistics can be obtained here. The triennial report entitled Central Bank Survey of Foreign Exchange and Derivatives Market Activity can be downloaded for study.

And What Of The Future

The foreign exchange trading market is changing dramatically with the arrival of electronic trading. Today's electronic environment means that participants are looking for faster and tighter pricing with faster relevant news flows than ever before. Also, market participants are looking for trading platforms, which are Internet enabled, scalable across regions, reliable and safeguarded against crashes, and which can be integrated with various risk management systems. The future lies largely in the ability of market makers to deliver a better service to their clients, whether it is offering transaction, deal capture, trade history facilities or risk management capabilities. At the end of the day, it is all about the value chain and how it is delivered to clients. Internet trading might be here to stay, but the foreign exchange market should not expect volumes to increase significantly. At the end of the day, the foreign exchange market will always be a people-to-people marketplace. So,...

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