Midterm Two - November 7, 2007
1. (20 pts) In trying to forecast the Canadian dollar price of the U.S. dollar in the next three
months, what is your conclusion with respect to trend and volatility? Use fundamental
analysis to support your conclusion?
It is difficult to get a good read on what the U.S. dollar is going to do with relation to the
Canadian dollar. Nearly all of the fundamentals would support further appreciation. For
example, the Canada’s BOP is in surplus and the U.S. BOP is in deficit. However, that could
change since the Canadian dollar has appreciated by 20% already this year. This is making
Canadian products in the U.S. much more expensive and will reduce our exports there. On the
other hand everything sold in the U.S. is now cheaper to Canadians. While the U.S. BOP deficit
will moderate, until China appreciates the Yuan Chinese will still be selling the U.S. However,
the Canadian BOP surplus could be reversed in the next three months, putting pressure on the
cd to depreciate.
Other fundamentals such as relative monetary policy favors the cd appreciating. While the
Bank of Canada is targeting inflation with its monetary policy, it looks more and more that the
U.S. has adopted an interest rate policy, at least for the short term. That could trigger higher
inflation in the U.S. and further appreciation of the cd.
Fiscal policy also favors Canadian dollar appreciation. Canada has a budgetary surplus and each
year is paying off more debt while the Bush administration has accrued large deficits and, as a
result, will double the nation’s debt load by the time he leaves office. The Fed is going to be
under increasing pressure to monetize this debt which will further exacerbate inflation.
Relative regulatory policies also favor cd appreciation. The U.S. seems to be becoming more
protectionistic by the day. Further intrusion in the market place will increase the probability
that the U.S. dollar continue to depreciate with respect to all the world’s currencies.
All of what has been discussed above adds to the risk of holding U.S. dollar denominated assets.
In addition there other external sources of risk such as the war in Iraq, the sub-prime mortgage
meltdown, and the huge amount of U.S. dollar assets held by foreigners. These contribute to a
large level of risk for the U.S. dollar. It can only result in more volatility in the exchange
markets. Whether the Canadian dollar continues its strong surge increasing in value relative to
the U.S. dollar depends on whether these risk factors increase over the next three months or
abate.
2. (20pts) Explain spot and forward markets. Who are the participants in these markets
and why are they in these markets? Under the conditions of a freely-floating exchangerate regime, how are market equilibria achieved?
Spot and forward markets are very thick markets in which, if exchange rates are allowed to
float, the relative demand and supply of currencies in these markets will determine at any
single period of time what the exchange rate between two currencies will be. That equilibrium
is free to move in response to changes in supply and demand that adjust to new information in
the market. For example, the Canadian dollar price of the U.S. dollar has a very close
correlation with oil prices which are denominated in U.S. dollars. Consequently, as oil prices
have spiraled up, so has the Canadian dollar.
Participants in the market can be divided into two categories: market makers and those who
come to the market. Commercial banks are the primary market maker and handle most of the
volume of exchange transactions. The hold positions in foreign currencies and they make
money from the bid-ask spread; they buy at the bid and sell at the ask. The spread is a function
of risk. Consequently, firms which deal in volume for foreign exchange will enjoy a lower bidask spread than individuals who access the market at a foreign ATM machine. Also the longer
the term to delivery of exchange on the contract, the higher the bid-ask spread. Dealers also
hold positions and make money from the bid-ask spread. Brokers act as middle getting buyers
and sellers together and charge commission for their services.
Individuals, firms, speculators, and arbitragers come to the market to get foreign exchange.
Individuals when visiting another country will require that country’s currency. Firms that export
are normally paid in foreign exchange and will need to access the market to convert that into
their own currency. Speculators demand a foreign currency when they are making a bet about
what its price is going to do in the future. Arbitragers will employ a triangular argitrage in
which they move almost instantaneously from one currency, to a second, to a third, and then
back to the first currency to take advantage of mispricing through cross rates. Arbitrages,
unlike speculatory positions are riskless.
Central banks no longer are supposed to play a big role in exchange markets. Freely floating
exchange rates imply that the central bank has not role. However, some countries employ an
exchange rate policy attempting to fix their currency with respect to one currency or a market
basket of currencies. In that situation, they are the biggest player in the exchange of that
currency in the market place. However, with a free float, central banks intervene occasionally
only to reduce volatility in that market.
3. (10 pts) List the unique characteristics of forward, future, and option contracts that
make these instruments appealing to different market clientele.
Forward contracts are negotiable with respect to the amount, the delivery date, and to some
degree the bid-ask spread. This is a very good contract for an entity that knows that they will
receive a certain amount of foreign exchange at a specified date. It allows them to hedge the
foreign exchange transactions exposure perfectly. The one negative with this contract is that
once agreed to it cannot be backed out of.
Option and futures contracts traded on exchanges are standardized with respect to amount
(100,000 cd), term or delivery date (on the Monday preceding the 3rd Wednesday of March,
June, September, and December. The option contract stipulates an exercise price which is the
price at which foreign exchange will be delivered on the delivery date. The futures contract will
guarantee as the delivery price the spot price on the day on which the contract is purchased.
Since these contracts are standardized, every contract with the same specifications is priced
exactly the same. These contracts are used by multinationals (banks, oil companies, etc.) with
their own exchange departments to hedge net exposure. Speculators also prefer these
contracts as they are able to get out of the contract at any time: the option contract can be sold
and the futures contract can be reversed.
4. (20 pts) Define transaction exposure. How do forward and money market hedges work?
Explain the mechanics of these positions from the point of view of the firm. If secondary
markets in banker’s acceptances exist, firms can also discount their banker’s
acceptances in these markets. How does this hedge work? Which of these three
possible approaches leaves the firm with the least risk?
Transaction exposure exists when firms enter into contracts that will be paid sometime in the
future denominated in a foreign currency. Because there is a lag between the time the contract
is entered into and the contract is paid, there is time for the exchange rate to move in such a
way that the firm will receive less than they thought they contracted for. For this reason a firm
will hedge that exposure (risk).
Forward contracts a good way to hedge. Once you are long a contract (bill of exchange) that
will deliver foreign exchange sometime in the future, you buy (go long) in a contract that will
exchange that foreign exchange for a fixed amount of your domestic currency for delivery on
the day that you are to get paid., for example March 12, 2008. Thus you collect your payment
on March 12 and go to your bank and collect on the forward contact on the same day
converting foreign exchange for your domestic currency. You have some default risk on the bill
of exchange which is often is guaranteed by the buyer’s bank (banker’s acceptance) and there is
a little default risk on the forward contact, but overall this is pretty risk free. Your cost of the
hedge is a function of the bid-ask spread,.
One could also enter into a Money market hedge. In this instance, you borrow (go short) the
discounted value of the value of the bill of exchange. You exchange the discounted value
immediately in the exchange market. On March 12 you collect on the bill of exchange and pay
off the loan with what you have been paid. You have default risk on the bill of exchange. On
the books you are short the loan and long the bill of exchange which cancel each other out.
Your transaction exposure is eliminated when you exchange what you borrowed for domestic
currency on the day you borrow the money.
If secondary markets for bills of exchange (and banker’s acceptances) exist. The easiest way to
hedge your exposure is to sell you bill of exchange at discount to a third party. Once you sell it
any default risk is transferred to the buyer. Wth the proceeds of your sale you go to the foreign
exchange market to get your domestic currency. This is the safest way (least risky) to go in that
you eliminate the receivable (bill of exchange & banker’s acceptanct) from you books today
rather than hold it to March 12 and you eliminate transaction exposure when you convert to
your domestic currency by going to the exchange market.
5. (20 pts) The U.S. dollar and Canadian dollar are moving in opposite directions
internationally and with respect to each other. Explain what operating exposure is and
how Canadian exporters might try to hedge their operating exposure in the current
economic environment.
Operating exposure arises from the possibility that the real exchange rate will change. PPP
theorizes that relative inflation will be adjusted for through a change in the exchange rate.
However, when the exchange rate changes more than enough to compensate for relative
inflation, real exchange rates change. This has been the case between Canada and the United
States over the last five years. On average the relative inflation has been approximately 1%
higher in the U.S. than in Canada which would imply that the Canadian dollar should have
appreciate about 5% in that time period. Instead, the exchange rate has appreciated nearly
50%, which means that the real exchange rate has appreciated approximately 45%. Any
company that exports to the U.S. then has faced the situation in which their product, assuming
the U.S. dollar price remains unchanged are generating 45% less revenue in Canadian dollar
terms for the same amount of goods sold. Unless the firm is able to reduce their costs by 45%,
their profits have been eliminated.
Hedges for operating exposure, particularly on this scale, are difficult. There are no contractual
hedges that can be used as with transaction exposure. If the exposure is with one particular
currency (the U.S. dollar) than the firm can try to diversify the customer base to include
customers in monetary regimes in which the Canadian dollar has not appreciated or has
appreciated considerable less. European and South American markets are places where on
might look.
The firm can also try to reduce costs. They can outsource their production. In the case of the
U.S., they can move their production facilities to the U.S. While that would reduce operating
exposure, it still leaves translation and transaction exposure when they try to repatriate their
profits from the U.S. A lot of production is being moved to Mexico and other very low cost
labor markets. In most instances the primary reason for outsourcing is to reduce or eliminate
operating exposure.
Finally, if your product has low elasticity of own demand increasing prices will not affect
demand very much. Since many of the goods being bought by Americans from Canada are
resources with a low own elasticity of demand such as commodities, firms might have a large
latitude in the price that they charge for their goods.
6. (10 pts) The current and temporal methods describe different accounting procedures
for translating the values of balance sheet items from a foreign subsidiary to be put into
a consolidated balance sheet. What balance sheet items are translated differently
(using either current or historical exchange rates) and why?
The current and temporal methods treat long-term assets and liabilities differently. If you
translate using the current method you translate all items on the balance sheet at the current
rate. This does not discriminate in any way. Income statement items are translated using the
weighted average of the exchange rate found over the period covered by the cash flows being
followed on the income statement. The reasoning in using the current method is that PPP
holds so that the exchange rate is accommodating relative inflation.
The temporal method discriminates based on whether assets and liabilities are long or short
term. All assets and liabilities considered to be short-term are translated at the current rate.
All assets and liabilities considered to be long-term are translated using the historical exchange
rate that existed when the asset was purchased or the debt liability incurred. On the income
statement again most items are translated using the weighted average of the exchange rate
except for depreciation which is translated at the historical rate again. When PPP doesn’t hold
as in the case of Canada and the U.S. over the last few years, the temporal method would have
given a better value for U.S. affiliates of Canadian firms. However, you cannot choose to
change you accounting methods back and forth. So if you are using one or the other, you will
have to stick with it.