FX Concepts
Foreign Exchange (FX)
Conversion of one currency into another eg EUR into USD
What is FX/FOREX?
Conversion of one currency into another eg EUR into USD
BUT this definition is in a
mathematic formula context!
A$ worth in
terms of GBP
A$ worth in terms
of a basket of
currencies
BUT Why convert?
A currency, say AUD, is measured in another currency or basket of currencies to
understand what is its worth (value) according to factors of supply and demand
for that currency (AUD)
What determines a currency’s FX rate?
A currency, say AUD, is measured in another currency or basket of currencies to
understand what is its worth (value) according to factors of supply and demand
for that currency (AUD)
Influences of FX Rates:
1. Differences of inflation rates in countries
2. Differences of interest rates in countries
3. Different current-account deficits of countries
4. Different public deficits in countries
5. Different balance of payments between countries
6. Different political stability and economic performance in countries
(Source: http://www.investopedia.com/articles/basics/04/050704.asp)
FX Markets in Different Cities Across the World
Treasury-staff
Funds Mgt staff
Risk Managers
Brokers
International Companies
Treasury-staff
Funds Mgt staff
Dealers/Traders
Funds Managers
What is Forex? (1.53m)
Corporate Finance-staff
FX Trading
Functions of FX Markets
•
•
•
•
Transaction Purposes
Currency conversion
Currency hedging (conversion value risk
reduction)
Currency arbitrage (profit taking without
conversion losses)
Currency speculation (speculative profit
taking)
Currency
Buyers
Currency
Sellers
4
Buyer is worried of
worst case
What is a FX Hedge?
3
Buyer has to pay in AUD in the future. If
there is no FX hedge (insurance), buyer
could be:
Can result in loss
1. Paying more if JPY/AUD rate
decreases (AUD is worth more)
2. Paying less if JPY/AUD rate increases
(AUD is worth less)
5 (a)
Buyer purchases a hedge contract against an
unfavourable JPY/AUD movement on settlement date
1
Transact
AUD Deal JPY
2
NOW- Contract Agreement
Settlement date in the future
5(b)
Agree to lock in a fixed FX rate
FX Hedging Process
Examples of the different types of hedging strategies:
• Forward exchange contract for currencies
• Currency future contracts
• Money Market Operations for currencies
• Forward Exchange Contract for interest
• Money Market Operations for interest
• Future contracts for interest
• Derivatives eg risk reversal, delta neutral instruments – What are Derivatives? (4.18 m)
History of Gold Standard
1870s
Currencies valued against gold
WW1
(1914-18)
Governments
started printing $
Inflation &
collapse of gold
standard when
people used gold
as a commodity
for transactions
WW2
(1939-45)
Gold standard
ended at first of
WW2
Gold was a powerful tool for achieving
balance of trade equilibrium between
countries  evolution of international
monetary policy development
International Monetary Funds (IMF)
188 countries working together to:
1. foster global monetary cooperation,
2. secure financial stability,
3. facilitate international trade,
4. promote high employment and sustainable economic growth,
5. reduce poverty around the world
(Source: http://www.imf.org/external/about.htm)
Also lend $ to countries (governments) subject to
resolve in:
1. Implementing governmental reforms to stabilize
monetary policy and
2. Fostering economic growth eg encourage FDI in
developing countries
Fixed & Floating FX Rate Regimes
FIXED FX Rate
A currency’s FX is pegged to another
Aims to:
• Ensure governments do not expand
$upply at inflationary rates
• Increases certainty in terms of uncertainty
Negative:
• No clear correlation between FX rate and
trade balance
Fixed & Floating FX Rate Regimes
Floating FX Rate
A currency’s FX is pegged to another
Aims to:
• Give monetary policy autonomy to countries
• Automatic trade balance adjustments
Negative:
• Trade deficit  depreciation of a currency  currency is worth less
• Trade surplus  currency appreciates  worth more
Obama: China currency undervalued (13 Apr 2010) – 1.51 m
China to re-engage the managed floating exchange rate (19 Jun 2010) - 2.06m
Caterpillar Case
The world’s leading manufacturer
of:
• Construction & mining equipment,
• diesel & natural gas engines,
• industrial turbines &
• diesel-electric locomotives.
International business
Is also a leading financial services
provider via Caterpillar Financial
Services.
Manufacturing & Financial Services
Caterpillar Case
Business Transactions in
multiple currencies
Usually
payable in
another
currency
Contract Transaction GBP 000 000 000….
Contract Transaction USD 000 000 000….
Contract Transaction JPY 000 000 000….
Transaction exposure = payment currency value
(+ worth changes) when FX rates move
Caterpillar Case
Business Transactions in
multiple currencies
Usually
payable in
another
currency
Contract Transaction GBP 000 000 000….
Contract Transaction USD 000 000 000….
Contract Transaction JPY 000 000 000….
Translation exposure = General Ledger’s book
values of foreign currencies’ payments & receivables
converted to the currency used in a firm’s financial
statement reporting at corporate and other
international branch levels
Caterpillar Case
1. In the 1980s a stronger dollar hurt Caterpillar’s competitive
position, but in 2008, a stronger dollar did not seem to have
the same effect
2. How did Caterpillar use strategy as a “real hedge” to reduce
its exposure to FX risk? What is the downside of this
approach?
3. Explain the difference between transaction exposure and
translation exposure using material in the Caterpillar Tractor
case to illustrate your answer.