FX Concepts
What is FX/FOREX?Conversion of one currency into another eg EUR into USD
BUT this definition is in a mathematic formula context!
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)
A$
A$ worth in terms of GBP
A$ worth in terms of a basket of
currencies
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 countries2. Differences of interest rates in countries3. Different current-account deficits of countries4. Different public deficits in countries5. Different balance of payments between countries6. 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
International Companies
Risk ManagersBrokers
Dealers/TradersFunds Managers
Treasury-staffFunds Mgt staff
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staff
Corporate Finance-staff
FX Trading
What is Forex? (1.53m)
Functions of FX Markets
Currency Buyers
Currency Sellers
Transaction Purposes• Currency conversion • Currency hedging (conversion value risk
reduction)• Currency arbitrage (profit taking without
conversion losses)• Currency speculation (speculative profit
taking)
What is a FX Hedge?
2NOW- Contract Agreement
Settlement date in the future5(b)
Agree to lock in a fixed FX rate
AUD JPY
3Buyer has to pay in AUD in the future. If there is no FX hedge (insurance), buyer could be:
1. Paying more if JPY/AUD rate decreases (AUD is worth more)
2. Paying less if JPY/AUD rate increases (AUD is worth less)
Can result in loss
5 (a)Buyer purchases a hedge contract against an
unfavourable JPY/AUD movement on settlement date
4Buyer is worried of
worst case
1Transact
Deal
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
WW1 (1914-18)
WW2 (1939-45)
Currencies valued against gold Governments started printing $
Inflation & collapse of gold standard when
people used gold as a commodity for transactions
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 RateA 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 RateA 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
China to re-engage the managed floating exchange rate (19 Jun 2010) - 2.06m
Obama: China currency undervalued (13 Apr 2010) – 1.51 m
Caterpillar Case
International business
The world’s leading manufacturer of:• Construction & mining equipment, • diesel & natural gas engines, • industrial turbines &• diesel-electric locomotives.
Is also a leading financial services provider via Caterpillar Financial Services.
Manufacturing & Financial Services
Caterpillar Case
Business Transactions inmultiple currencies
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
Usually payable in another currency
Caterpillar Case
Business Transactions inmultiple currencies
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
Usually payable in another currency
General Ledger
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.