Exchange Rates
Currency Conversion
Spot Rates
Forward Rates
Hedging Strategies
Exchange Rates
Through a real life example we will explain the following:
Spot and Forward Exchange Rates
How to convert currencies from one type to another given an exchange rate
How to protect yourself from currency fluctuations
Hedging Strategies
Answer 2 textbook questions assigned
Scenario
Mary is planning to spend two months in the U.S. next year (2016).
She will need approximately $10,000 U.S. for her stay.
She has been looking at the exchange rates to see how much Canadian
Dollars she will need to save.
You let Mary know that exchange rates fluctuate (change) and she will not
know with 100% certainty what the rate will be a year from now.
Your job is to help Mary hedge (insure) against any fluctuate.
Before you do that we need to educate Mary on exchange rates.
Spot Rate vs Forward Rates
The spot rate is the price quoted for immediate settlement on a
commodity, a security or a currency. Simply put it is the current or
todays exchange rate.
You look up the exchange rate between U.S. and Cdn Dollars and
let Mary know the current or spot rate is $1.25 Cdn dollars for
every $1 U.S. dollar.
Mary wants to know how much Cdn Dollars she would need to get
her $10,000 U.S. right now.
Converting Currency Using Ratios
If Mary knows someone who needs to convert U.S. dollars
to Cdn dollars they can agree to exchange at the spot rate.
They can facilitate the transaction on their own.
In most cases this is unlikely and here is where banks and
financial intermediaries step in to facilitate the exchange.
They act like a match maker.
Converting Currency Using Ratios
Assume Mary does not know anyone and she will likely have
to go through a bank or financial intermediary to convert her
money.
The bank or match maker will need to take a fee for their
service.
They will likely quote Mary a higher price for example $1.26
Cdn dollars for every $1 U.S. dollar and the difference will be
revenue or the fee for the financial institution.
Spot Rate vs Forward Rates
In order to calculate how much Cdn dollars she will need to get
$10,000 U.S. you set up the ratio and solve for the unknown.
What you know:
• $1 U.S. = $1.26 Cdn
• You need $10,000 U.S.
Unknown:
How much Cdn dollars do you need to get $10,000 U.S..
Converting Currency Using Ratios
To convert currencies set up the ratios and solve for the unknown.
In Mary’s case the ratios would look like this
$1 U.S.
: $1.26 Cdn
$10,000 U.S. : $x Cdn
Solve for x by cross multiplication.
$x = $1.26 * 10,000
x = 12,600
If Mary’s vacation was today she could take $12,600 Cdn and convert it at the
spot rate and receive $10,000 U.S.
Forward Markets
Mary asks if the exchange rate will stay the same a year from now.
You let her know that exchange rates fluctuate and there is no way of knowing.
She than proceeds to ask what she can do to protect herself from these
changes.
You tell her about forward rates or futures markets.
The Forward Rate is the rate that appears in a contract to exchange a currency
in the future. The Forward Rates cover different forward expiration periods.
Financial institutions which exchange currencies at current rates also provide a
service which allows people to enter into contracts to agree to exchange rates in
the future. The futures markets are the markets which facilitate the transactions.
Forward Markets
You let Mary know the following are the futures rates including
fees quoted from financial institution X.
Timing
Rate
Spot
1.26
1 month
1.26
3 month
1.28
6 months
1.30
1 year
1.29
2 years
1.27
Forward Markets
If Mary choose to enter into the forward contract 1 year from
know she can get a guaranteed rate of $1.30 Cdn for $1 U.S.
Mary would now need to save $13,000 Cdn dollars to get the
$10,000 dollars a year from now.
She eliminates the need to worry about changes in rate between
now and a year from now.
Mary wants you to review her options and advise her on what to
do.
Options
1. Convert the money to U.S. dollars now and hold it for a year. Assumes she
has the money right now. She can also borrow and pay interest.
2. Negotiate with her suppliers (hotels, restaurants etc.) in the U.S. to quote
her costs in Cdn dollars. They would take the risk of fluctuations in rates.
3. Enter into the forward contract. This would cost her more than the
current rate but eliminates risk.
4. Let the rates fluctuate and hope she gets a good rate a year from now or
convert amounts between now and the trip.
What to Do? It Depends
You let Mary know that her decision is not a clear one and depends mostly on
how much risk she is willing to take on and her current financial situration.
If she is comfortable with the risk she can just wait and see but if she is really
concerned and is on a tight budget than it may be a good idea to lock in even
though it will be more expensive.
Finally if she is willing to take on a little risk and can afford it she can convert
some money now and go for the forward rate the remainder.
Note although it is possible to negotiate with suppliers in your own currency
it is not likely to occur and if it does they will likely ask for more money and
enter into the forward contract to hedge their risk. In effect you would be
paying the forward costs either way.
How does all this work?
You explain to her that in order for their to be a market to facilitate
currency transactions you need a buyer and a seller.
In the spot and forward markets we have an intermediary (middle man
or match maker) who brings people together who want to buy and sell
currencies. For a fee of course.
Mary is looking for U.S. dollars in the future and wants to eliminate
risk and the intermediary finds someone who has U.S. dollars is
looking for Cdn dollars in the future the only thing which needs to be
negotiated is the price.
How does all this work?
You explain that it is rare for individuals to use forward markets
businesses use them often to manage risk. Fees vary depending on
the amount of currency you want to convert.
For example if you need to order product or supplies which will not
be ready for months or years from foreign suppliers you may wish to
enter into forward contracts.
There are rules for entering into forward markets since you are
guaranteeing a future commitment.
Questions
Solution Problem #23
a) $100 Japan 8,816.01 yen
$350 Mexico 4,160.03 pesos
$1,250 South Korea 2,189,537.50 won
$2,520 India 165,225.56 rupees
$5,600 United States 5,004.02 dollars
$15,850 Kenya 1,724,273.95 shillings
$120,500 United Kingdom 66,510.58 pounds
$1,400,000 European Union 895,815.20 dollars
Solution Problem #23
b) Japan
100 yen
$1.13
Mexico
3,000 pesos
$252.40
South Korea
5,700 won
$3.25
India
10,500 rupees
$160.14
United States
75,000 dollars
$83,932.52
Kenya
140,000 shillings
$1,286.92
United Kingdom 1,600,000 pounds
$2,898,787.04
European Union 7,500,000 euros
$11,721,167.49
Solution Problem #24
Vivek owns a business in Ontario, but 90 percent of his business is
exported to the United States. He has a contract with an American
company to sell USD$500,000 worth of product. Delivery is in
sixty days. Vivek knows the CAD is at $0.92 today, but is expected
to drop to $0.89 in sixty days.
a) Calculate the price of the shipment in CAD if the American
company paid today when it ordered.
$500,000/$0.92=$543,478.26
Solution Problem #24
b) Calculate the price of the shipment in CAD if the American company
pays on delivery in sixty days.
$500,000/$0.89=$561,797.75
c) What is it called when the value of a currency goes down?
Currency devaluation
d) When should Vivek ask for the payment? How much more does he
make if he receives the highest possible payment?
He should ask for payment in sixty days. He’ll make over $18,000
more. $561,797.75 - $543,478.26 = $18,319.49
Solution Problem #24
e) Why would Vivek quote his price in USD?
To attract American customers
f) What are the risks of quoting in USD?
The currency will fluctuate.
g) If Vivek had asked for payment in CAD, what could the American
company do to save money?
Convert the money and keep it in a CAD bank account
h) What is this called?
Speculating