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More Winter ahead…
Foreign Currency
What is it? Why does it change? Risk for international managers How to manage risk
Linkage Between Currencies
World Market for Euros
World Market for DollarsPrice = $ /
€Price = € /
$S
D
S
D
$1.30 / € € .77 / $
Same “market”…different perspective.Same “market”…different perspective.
Trade, FDI, and the Economy
Increase demand for Japanese computers – trade deficittrade deficit Increase demand for computer inputs (components, labor, etc.) –
inflationaryinflationary Increase demand for Yen – appreciatesappreciates Stronger Yen increases U.S. prices – decreases demand for Japanese decreases demand for Japanese
computerscomputers
Computers
Cash $$
German Market for BMWs
Price in Euros
€ 100,000
S
D
Global Market for BMWs:Americans want to import BMWs
Price in Euros
€ 100,000
S
DD’
€ 110,000
World Market for Euros
Price in Dollars
$0.77 / €
S
D
World Market for D-Marks:Americans need to convert Dollars to Euros
Price = $ / €
$0.77 / €
S
DD’
$0.74 / €
Linkage Between Currencies
World Market for Euros
World Market for Dollars
Price =$ / €
Price =
€ / $S
D
S
D
$0.77/ € € 1.30/$
Linkage Between Currencies
World Market for Euros
World Market for Dollars
Price =$ / €
Price =
€ / $S
D
S
D
€ 1.30/$
D’
S’
$0.77/ €$0.74/ €
€ 1.35/$
Other Forces Causing Change Foreign Direct Investment Foreign Portfolio Investment
– MNCs– Government Debt Instruments
Currency Arbitrage and Speculation Governmental Intervention
– Official and Unofficial “pegs”– International Agreements (e.g., G-7, the Euro)– Posturing (e.g., “talking” the dollar down)
Index of Swiss Franc vs. Dollar1990 = 100
60
70
80
90
100
110
120
19901980 2000
Depreciating Peso
0
1000
2000
3000
4000
5000
6000
7000
8000
9000
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999
Pesos per $
The Big Mac Index
Big Mac: Local F/X
Actual
F/X Rate
Big Mac: in
US$
Implied
PPP Rate
% Under/ Over Value
U.S. $2.55 – $2.55 – –
EU ℮ 2.44 ℮ 1.08/$ $ 2.26 ℮ .96/$ - 11%
Japan Y 253 Y 118.2/$ $ 2.14 Y 99.2/$ - 16%
England ₤ 2.99 ₤ .69/$ $ 4.33 ₤ 1.17/$ + 70%
Poland Z 1.34 Z 4.12/$ $ .32 Z .52/$ - 87%
www.economist.com
Short-term F/X Management Currency Hedges
– Forward Contracts– Options– Negotiation of Ratcheted Pricing Schedule
Adjustment of Prices and Target Profits– Lower foreign prices to keep market share when
home currency appreciates … lowers profit margin– Raise foreign prices to keep profit margins when
home currency depreciates … less price competitive
Today: US Dealer to Import BMWs
Sales Contract:– Quantity: 100 BMW 750s– Price: € 100,000 each– Payment: Due in 3 months
Value of Sales Contract = – € 10.0 million– Spot Rate = $1.30 / €– $13.0 million$13.0 million
In Three Months: Payment is DueUncovered Transaction
Euro appreciates– New spot rate = $1.35 / €– € 10.0 million
Adjusted Value of Sales Contract– “Risk penalty” = $0.05 per € traded– $13.5 million$13.5 million
US Dealer’s Loss = $500,000
Today: US Dealer to Import BMWsHedged Transaction
Sales Contract:– Quantity: 100 BMW 535s– Price: € 100,000 each– Payment: Due in 3 months
Value of Sales Contract = – € 10 million– at 90-day Forward Rate = $1.305 / €– “Insurance premium” = $0.005 per € traded – $13.05 million$13.05 million
In Three Months: Payment is Due Hedged Transaction
Euro appreciates– New spot rate = $ 1.35 / € (Doesn’t matter!!!) – € 10 million
Adjusted Value of Sales Contract– Locked-in Forward Rate = $ 1.305 / €– $13.05 million$13.05 million
Cost of Hedge (insurance premium) = $50,000
In Three Months: Payment is Due Hedged Transaction
Euro Depreciates– New spot rate = $ 1.25 / € – € 10 million
Adjusted Value of Sales Contract– Locked-in Forward Rate = $ 1.305 / € (Spot better!!) – $12.5 million$12.5 million
Currency Windfall Currency Windfall -- Cost of Hedge = $450,000 Cost of Hedge = $450,000
Medium-Term F/X Management Balance sheet hedge
– Match foreign assets with same level of foreign liabilities in same currency
Cash flow hedge– Match foreign A/P with A/R in same currency
Long-Term F/X Management
Shift sourcing and procurementShift production Cut costs / improve productivity
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