THE FOREIGN EXCHANGE MARKET
What is the foreign exchange market?
Except in a few European centers, there is no central marketplace for the foreign exchange market. Rather, business is carried out over telephone or telex. The major dealers are large banks. A company that wants to buy or sell currency typically uses a commercial bank. International transactions and investments involve more than one currency. For example, when a U.S. company sells merchandise to a Japanese firm, the former wants to be paid in dollars but the Japanese company typically expects to pay yen. Due to the foreign exchange market, the buyer may pay in one currency while the seller can receive payment in another currency.
Although currencies can be supported by various means for short periods, the primary determinant of exchange rates is the supply of and demand for the various currencies. Under current international agreements, exchange rates are allowed to "float." During periods of extreme fluctuations, however, governments and control banks may intervene to maintain stability in the market. The U.S. dollar is the most widely used currency in international markets today. It is considered much more stable than any of the third-world currencies. Thus, many third-world countries rely on the U.S. dollar for foreign trade.
What are spot and forward foreign exchange rates?
An exchange rate is the ratio of one unit of currency to another. An exchange rate is established between the different currencies. The conversion rate between currencies depends on the demand/supply relationship. Because of the change in exchange rates, companies are susceptible to exchange rate fluctuation risks because of a net asset or net liability position in a foreign currency.
Exchange rates may be in terms of dollars per foreign currency unit (called a direct quote) or units of foreign currency per dollar (called an indirect quote). Therefore, an indirect quote is the reciprocal of a direct quote and vice versa.
An indirect quote = 1/direct quote
Pound/$ = 1/($/pound)
Figure 6.1 presents a sample of indirect and direct quotes for selected currencies. A rate of 1.617/British pound means each pound costs the U.S. company $1.617. In other words, the U.S. company gets 1/1.617 = .6184 pounds for each dollar.
The spot rate is the exchange rate for immediate delivery of currencies exchanged, while the forward rate is the exchange rate for later delivery of currencies exchanged. For example, there
may be a 90 day exchange rate. The forward exchange rate of a currency will be slightly different from the spot rate at the current date because of future expectations and uncertainties.
FOREIGN EXCHANGE RATES (A SAMPLE)
AUGUST 5, 20x3
U.S. Dollar Currency
Country Contract Equivalent per U.S. $
Britain Spot 1.6124 .6202
(Pound) 30-day future 1.6091 .6215
90-day future 1.6030 .6238
180-day future 1.5934 .6276
Japan Spot .008341 119.89
(Yen) 30-day future .008349 119.77
90-day future .008366 119.53
180-day future .008394 119.13
Forward rates may be greater than the current spot rate (premium) or less than the current spot rate (discount).
Note: The amount of appreciation or depreciation is computed as the fractional increase or decrease in the home currency value of the foreign currency or in the foreign currency value of the home currency:
With direct quotes:
Percent change = ((Ending rate - beginning rate) / beginning rate) * 100
With indirect quotes:
Percent change = (Beginning rate - ending rate) / ending rate) * 100
For example, An increase in the exchange rate from $0.00909 (or ¥110/$) to $0.00926 (or ¥108/$) is equivalent to a Yen appreciation of 1.87% [($0.00926 - $0.00909)/ $0.00909 = 0.0187] (direct quote) or [(¥110 - ¥108)/ ¥108= 0.0187] (indirect quote). This also means a dollar depreciation of 1.82% [(¥108- ¥110)/ ¥110 = -0.0182]
What are cross rates?
A cross rate is the indirect calculation of the exchange rate of one currency from the exchange rates of two other currencies. It is the exchange rate between two currencies derived by dividing each currency`s exchange rate with a third currency.
Hypothetical dollar per pound and the yen per dollar rates are given in Figure 6.1. For example, if dollars per pound is $1.6124/£ and yens per dollar is ¥119.89/$, the cross rate between Japanese yen and British pounds is
Cross rate between yen and pound = (Dollars / pound) * (Yen / Dollar) = Yen / Pound
= $/£ x ¥/$ = ¥/£
= 1.6124 dollars per pound x 119.89 yens per dollar
= 193.31 yens per pound
Because most currencies are quoted against the dollar, it may be necessary to work out the cross rates for currencies other than the dollar. The cross rate is needed to consummate financial transactions between two countries.
EXAMPLE OF CURRENCY CROSS RATES
British Euro Japan U.S.
British --- .7054 .05770 .62020
Euro 1.4176 --- .00733 .87920
Japan 193.31 136.36 --- 119.89
U.S. 1.6124 1.1374 .00834 ---
Note: The Wall Street Journal routinely publishes key currency cross rates, as shown in the hypothetical rates. They are also available on www.bloomberg.com. The cross currency table calculator can be accessed by www.xe.net/currency/table.htm.
On August 5, 20x3, forward rates on the British pound were at a discount in relation to the spot rate, while the forward rates for the Japanese yen were at a premium from the spot rate. This means that participants in the foreign exchange market anticipated that the British pound would depreciate relative to the U.S. dollar in the future but the Japanese yen would appreciate against the dollar.
The percentage premium (P) or discount (D) is computed as follows.
P (or D) = ((F-S) / S) x (12 months / n) * 100
where F, S = the forward and spot rates and n = length of the forward contract in months.
If F>S, the result is the annualized premium in percent; otherwise, it is the annualized discount in percent.
On August 5, 20X3, a 30 day forward contract in Japanese yens (see Figure 6.1) was selling at a 1.15 percent premium:
((.008349 - .008341) / .008341) x (12 months / 1 month) x 100 = 1.15%
How do you control foreign exchange risk?
Foreign exchange rate risk exists when the contract is written in terms of the foreign currency or denominated in foreign currency. The exchange rate fluctuations increase the riskiness of the investment and incur cash losses. The controllers must not only seek the highest return on temporary investments but must also be concerned about changing values of the currencies invested. You do not necessarily eliminate foreign exchange risk. You may only try to contain it.