More Winter ahead… Foreign Currency What is it? Why does it change? Risk for international managers How to manage risk Linkage Between Currencies World Market for Euros Price = $ / € Price = € / $ World Market for Dollars S S € .77 / $ $1.30 / € D Same “market”…different perspective. D Trade, FDI, and the Economy Computers Cash $$ Increase demand for Japanese computers – trade deficit Increase demand for computer inputs (components, labor, etc.) – inflationary Increase demand for Yen – appreciates Stronger Yen increases U.S. prices – decreases demand for Japanese computers German Market for BMWs Price in Euros S € 100,000 D Global Market for BMWs: Americans want to import BMWs Price in Euros S € 110,000 € 100,000 D D’ World Market for Euros Price in Dollars S $0.77 / € D World Market for D-Marks: Americans need to convert Dollars to Euros Price = $ / € S $0.74 / € $0.77 / € D D’ Linkage Between Currencies Price = $/€ World Market for Euros Price = S $0.77/ € € /$ World Market for Dollars S € 1.30/$ D D Linkage Between Currencies Price = $/€ World Market for Euros Price = € /$ S $0.74/ € $0.77/ € World Market for Dollars S S’ € 1.30/$ € 1.35/$ D D’ D Other Forces Causing Change Foreign Direct Investment Foreign Portfolio Investment – – MNCs Government Debt Instruments Currency Arbitrage and Speculation Governmental Intervention – – – Official and Unofficial “pegs” International Agreements (e.g., G-7, the Euro) Posturing (e.g., “talking” the dollar down) Index of Swiss Franc vs. Dollar 1990 = 100 120 110 100 90 80 70 60 1980 1990 2000 Depreciating Peso 9000 8000 7000 Pesos per $ 6000 5000 4000 3000 2000 1000 0 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 The Big Mac Index Big Mac: in Implied US$ PPP Rate % Under/ Over Value Big Mac: Local F/X Actual F/X Rate U.S. $2.55 – $2.55 – – EU ℮ 2.44 ℮ 1.08/$ $ 2.26 ℮ .96/$ - 11% Japan Y 253 Y 118.2/$ $ 2.14 Y 99.2/$ - 16% England ₤ 2.99 ₤ .69/$ $ 4.33 ₤ 1.17/$ + 70% Poland Z 1.34 Z 4.12/$ $ .32 Z .52/$ - 87% www.economist.com Short-term F/X Management Currency – – – Hedges Forward Contracts Options Negotiation of Ratcheted Pricing Schedule Adjustment – – of Prices and Target Profits Lower foreign prices to keep market share when home currency appreciates … lowers profit margin Raise foreign prices to keep profit margins when home currency depreciates … less price competitive Today: US Dealer to Import BMWs Sales – – – Quantity: 100 BMW 750s Price: € 100,000 each Payment: Due in 3 months Value – – – Contract: of Sales Contract = € 10.0 million Spot Rate = $1.30 / € $13.0 million In Three Months: Payment is Due Uncovered Transaction Euro – – appreciates New spot rate = $1.35 / € € 10.0 million Adjusted Value – – of Sales Contract “Risk penalty” = $0.05 per € traded $13.5 million US Dealer’s Loss = $500,000 Today: US Dealer to Import BMWs Hedged Transaction Sales – – – Quantity: 100 BMW 535s Price: € 100,000 each Payment: Due in 3 months Value – – – – Contract: of Sales Contract = € 10 million at 90-day Forward Rate = $1.305 / € “Insurance premium” = $0.005 per € traded $13.05 million In Three Months: Payment is Due Hedged Transaction Euro – – appreciates New spot rate = $ 1.35 / € (Doesn’t matter!!!) € 10 million Adjusted Value – – of Sales Contract Locked-in Forward Rate = $ 1.305 / € $13.05 million Cost of Hedge (insurance premium) = $50,000 In Three Months: Payment is Due Hedged Transaction Euro – – Depreciates New spot rate = $ 1.25 / € € 10 million Adjusted Value – – of Sales Contract Locked-in Forward Rate = $ 1.305 / € (Spot better!!) $12.5 million Currency Windfall - Cost of Hedge = $450,000 Medium-Term F/X Management Balance – Match foreign assets with same level of foreign liabilities in same currency Cash – sheet hedge flow hedge Match foreign A/P with A/R in same currency Long-Term F/X Management Shift sourcing and procurement Shift production Cut costs / improve productivity