International Financial System

International Financial System • Market for converting currency of one country into

that of other is Foreign Exchange Market

• Demand and supply of currencies is influenced by

respective countries relative inflation rates and

interest rates

• Foreign exchange market serves two main functions

- to convert currency of one country into currency of another- to provide some insurance against foreign exchange risk

Exchange rate • The rate at which one currency is traded against the

other Example

• USD 1 = NRs 90; IRs 1 = NRs 1.6 (to acquire 1 unit of USD, you have to afford 90 units of NRs)

• It is important to understand how and exchange rate is initially set and why it changes over time• To anticipate exchange rate changes• To make appropriate response to situations

affected by such changes• The foreign exchange market is made up of all the

institutions that buy and sell foreign currencies

Spot exchange rate • When two parties agrees to exchange currency and

execute the deal immediately the transaction is refereed to as spot exchange and rate at which deal is carried out is Spot Exchange Rate

• In other words, rate at which foreign exchange dealer converts one currency into another on particular day is Spot Exchange Rate

• Spot exchange rates are reported daily in financial pages of newspapers

• Value of currency of determined by the interaction between the demand and supply of that currency relative to demand and supply of other currencies

Forward exchange rate

• It occurs when two parties agree to exchange

currency and execute deal at some specific date in

the future

• Exchange rate governing such future transaction are

referred to as Forward Exchange Rate

• For major currencies, forward exchange rate are

quoted for 30 days, 90 days and 180 days in the

future

Currency swaps

• A simultaneous purchase and sale of given amount

of foreign exchange for two different value dates

• Swaps are transacted between international

businesses and their banks, between banks and

between governments when it is desirable to move

out of one currency into another for a limited period

without incurring foreign exchange risk

Currency swapsExample: Apple Computers • Apple assembles laptops in US but screens are made in Japan• Also Apple sells laptop to Japan Suppose:• Apple need to exchange $ 1 million into ¥ to pay to its Japanese

suppliers of laptop screens today• Apple knows that in 90 days it will be paid ¥ 120 million by Japanese

importer of laptops • Say: Spot exchange rate toady is $1= ¥ 120; Apple change $ 1

million and paid ¥120 million to its supplier today• Same time Apple made forward contract with rate of $ 1= ¥110 (90

day forward exchange deal) • In 90 days Apple receives ¥ 120 million that is $ 1.09 million

(120/110)

Exchange rate system Floating exchange rate system• In this system foreign exchange market (i.e. demand

and supply of currency) determines that relative value of currency (exchange rate) . World`s four major currencies are US dollar, Pound Sterling, Yen and Euro are free to float against each other

• Market forces determines exchange rates

• Trade flows and capital flows are the main factors affecting the exchange rate

• No pre-determined official target for the exchange rate is set by the Government

Exchange rate system Pegged exchange rate system• A value of currency is fixed relative to a reference currency,

such as U.S. dollar and then exchange rate between that currency and other currencies is determined by the reference currency

• Commitment to a single fixed exchange rate• No permitted fluctuations from the central rate • Achieves exchange rate stability but perhaps at the expense

of domestic economic stabilityWhile some countries not adopt a formal pegged rate,try to hold value of their currency within a some rangeagainst an important reference currency as US $referred as Dirty Float

• When firms are trading internationally, they are exposed to risks as the exchange rates change. Generally, there are three types of foreign exchange risk exposures: • Asset exposure, • Operating exposure, • Transaction exposure and Translation exposure

• Note that asset exposure and operating exposure are together called economic exposure referring to the fact that in both an unanticipated changes in exchange rates affects the value of the firm

• Asset Exposure The risk a firm faces when the value of firm’s assets denominated in foreign currency is subject to an unanticipated change in exchange rates

Types of foreign exchange risk

Asset ExposureAsset Exposure• For example, a US firm has a vacation home for employees

in the UK, which is worth £100,000. If the spot rate is $1.80, the value translates into $180,000

• As the pound depreciates, say, to $1.70, the value of the vacation home falls by $10,000

• By contrast, assume that, for unknown reason, the pound price of the vacation home and the pound price of the dollar always move together. That is, when the pound depreciates from $1.80 to $1.70 (i.e., from £0.56/$ to £0.59/$), the price of the vacation home rises to £105,882. The dollar value of the home is still $ 180,000 (£105,882×$1.70). As long as the pound price of the asset and the pound price of the dollar vary together, there is no change in the dollar value of the asset. Thus, the risk exposure depends crucially on the sensitivity of the value of the asset to the changes in exchange rates

Operating exposureOperating exposure• Firm’s value depends on not only the assets it has

across the world but also its operating cash flows. In other words, the more profitable the firm is (i.e., the higher the cash flows are), the more valuable the firm is. Simple illustration helps one to realize that such cash flows can be severely affected by changes in exchange rates when the firm operates in more than one country

Operating exposureOperating exposure• Illustration: Suppose a US multinational firm sells shoes

in the UK through its UK affiliate in London. In each month, the UK affiliate imports 100 pairs of shoes for $18 each and sells them locally for £20 each, thus its monthly cost is $1,800 and the revenue is £2,000 (assume for simplicity that there is no fixed cost and local variable cost). Suppose the spot rate is £/$1.50 ($/£0.667), so that their total cost is £1,200. With that spot rate, their before-tax profit is £800 or $1,200 using the spot rate. Suppose the pound depreciates to $1.40 ($/£0.714). Intuitively, the UK affiliate has to spend more £ to pay the dollar. Their cost is now £1,286, and their profit declines to £714 (derived as £2,000 less £1,286) or $1,000 using the new spot rate. Note that the purpose of the US multinational firm is to maximize the overall profits including those of the worldwide branches as well as that of the headquarter

Operating exposureOperating exposure    CP   SP

Units   USD   Pounds

100   18   20

Monthly Cost   1800   2000

Scenario I        

  Unit Dollar Pound

 Exchange Rate 1 1.5 0.667

Cost     1200

Profits   1200 800

Scenario II        

  Unit Dollar Pound

  Exchange Rate 1 1.4 0.714

Cost     1285.7

Profits   1000   714.3

Operating exposureOperating exposure

• This example illustrates a simple case in which a small change in exchange rates negatively affects the overall cash flow of the firm (by reducing the profit of the UK affiliate without benefiting the other branches or the headquarter)

Translation ExposureTranslation Exposure• Definition: Translation exposure (a.k.a.,

accounting exposure) refers to the effect that an unanticipated change in exchange rates will have on the consolidated financial statement of a MNC. When exchange rates change, the value of a foreign subsidiary’s assets and liabilities denominated in a foreign currency change when they are viewed from the perspective of the parent firm

Economic ExposureEconomic Exposure• Extent to which a firm`s future international

earning power is affected by changes in exchange rate

• Long run effect of changes in exchange rates on future prices, sales and costs

Translation ExposureTranslation ExposureExample: A Mexican subsidiary reports cash in the bank of 900,000pesos at a time when 9.5 pesos will buy US $ 1; thus its US parentcompany translates the net in pesos into US $ 94,737. When exchangerate changes, however and 10 pesos are required to buy 1 US $ , then total of 900,000 pesos must be retranslated from US $ 94,737 into US$ 90,000

Transaction ExposureTransaction Exposure• Definition: A firm is said to have a transaction exposure

when it faces contractual cash flows that are fixed in foreign currencies

• Suppose a US firm exports goods to Japan and will receive the payment in yen after a few months. This firm is subject to transaction exposure because the value of the yen it will receive may increase or decrease

• The transaction exposure is distinguished from operating exposure because the degree of uncertainty is more narrowly defined and the firm can apply the wider range of financial contracts and operational techniques to hedge the risk it faces. These techniques include• Forward market• Options market

What Is Hedging?What Is Hedging?• The best way to understand hedging is to think of it as

insurance. • When people decide to hedge, they are insuring

themselves against a negative event. This doesn't prevent a negative event from happening, but if it does happen and you're properly hedged, the impact of the event is reduced.

• Hedging occurs almost everywhere, and we see it everyday.

• For example, if you buy house insurance, you are hedging yourself against fires, break-ins, or other unforeseen disasters

What Is Hedging? What Is Hedging?

• Portfolio managers, individual investors, and corporations use hedging techniques to reduce their exposure to various risks

• In financial markets, however, hedging becomes more complicated than simply paying an insurance company a fee every year

• For the most part, hedging techniques involve using complicated financial instruments known as derivatives, the two most common of which are options and futures

Forward MarketForward Market• A forward contract that locks-in the price an entity

can buy or sell currency on a future date• In currency forward contracts, the contract holders

are obligated to buy or sell the currency at a specified price, at a specified quantity, and on a specified future date. These contracts cannot be transferred

Options MarketOptions Market• A privilege sold by one party to another that offers the

buyer the right, but not the obligation, to buy (call) or sell (put) a security at an agreed-upon price during a certain period of time or on a specific date