Slide 1

FX Concepts

1Foreign Exchange (FX)

Conversion of one currency into another eg EUR into USD2What 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 GBPA$ worth in terms of a basket of currenciesVideo - https://www.youtube.com/watch?v=72fAp1yq4HQ3What determines a currencys 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:

Differences of inflation rates in countriesDifferences of interest rates in countriesDifferent current-account deficits of countriesDifferent public deficits in countriesDifferent balance of payments between countriesDifferent political stability and economic performance in countries(Source: http://www.investopedia.com/articles/basics/04/050704.asp)

4FX Markets in Different Cities Across the World

International CompaniesRisk ManagersBrokersDealers/TradersFunds ManagersTreasury-staffFunds Mgt staffTreasury-staffFunds Mgt staffCorporate Finance-staff

FX TradingWhat is Forex? (1.53m) Video - https://www.youtube.com/watch?v=zdGFmifODbs ; https://www.youtube.com/watch?v=72fAp1yq4HQ 5Functions of FX Markets

Currency BuyersCurrency SellersTransaction PurposesCurrency conversion Currency hedging (conversion value risk reduction)Currency arbitrage (profit taking without conversion losses)Currency speculation (speculative profit taking)

6What is a FX Hedge?

2NOW- Contract AgreementSettlement date in the future5(b)Agree to lock in a fixed FX rateAUDJPY3Buyer has to pay in AUD in the future. If there is no FX hedge (insurance), buyer could be:

Paying more if JPY/AUD rate decreases (AUD is worth more)Paying less if JPY/AUD rate increases (AUD is worth less)

Can result in loss5 (a)Buyer purchases a hedge contract against an unfavourable JPY/AUD movement on settlement date

4Buyer is worried of worst case1TransactDealAlso see http://ibankcoin.com/chessnwine/2012/06/13/what-is-hedging-infographic/ for more examples7FX Hedging ProcessExamples of the different types of hedging strategies:Forward exchange contract for currenciesCurrency future contractsMoney Market Operations for currenciesForward Exchange Contract for interestMoney Market Operations for interestFuture contracts for interestDerivatives eg risk reversal, delta neutral instruments What are Derivatives? (4.18 m)

Sources: http://www.cambridgefx.com/services.aspx ; http://en.wikipedia.org/wiki/Hedge_%28finance%29 ; https://www.youtube.com/watch?v=FLGRPYAtReo 8History of Gold Standard1870sWW1 (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 transactionsGold standard ended at first of WW2Gold was a powerful tool for achieving balance of trade equilibrium between countries evolution of international monetary policy development

9International Monetary Funds (IMF)

188 countries working together to:

foster global monetary cooperation,

secure financial stability,

facilitate international trade,

promote high employment and sustainable economic growth,

reduce poverty around the world(Source: http://www.imf.org/external/about.htm)Also lend $ to countries (governments) subject to resolve in:

Implementing governmental reforms to stabilize monetary policy and

Fostering economic growth eg encourage FDI in developing countries

10Fixed & Floating FX Rate Regimes

FIXED FX RateA currencys FX is pegged to anotherAims to:Ensure governments do not expand $upply at inflationary ratesIncreases certainty in terms of uncertainty

Negative:No clear correlation between FX rate and trade balance

Watch video - https://www.youtube.com/watch?v=72DYtXLZOvI to better understand11Fixed & Floating FX Rate RegimesFloating FX RateA currencys FX is pegged to anotherAims to:Give monetary policy autonomy to countriesAutomatic trade balance adjustments

Negative:Trade deficit depreciation of a currency currency is worth lessTrade surplus currency appreciates worth more

China to re-engage the managed floating exchange rate (19 Jun 2010) - 2.06mObama: China currency undervalued (13 Apr 2010) 1.51 m 12Caterpillar Case

International business

The worlds 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 Services13Caterpillar Case

Business Transactions inmultiple currenciesContract 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 moveUsually payable in another currency

14Caterpillar Case

Business Transactions inmultiple currenciesContract Transaction GBP 000 000 000.Contract Transaction USD 000 000 000.Contract Transaction JPY 000 000 000.Translation exposure = General Ledgers book values of foreign currencies payments & receivables converted to the currency used in a firms financial statement reporting at corporate and other international branch levelsUsually payable in another currency

General Ledger15Caterpillar Case

In the 1980s a stronger dollar hurt Caterpillars competitive position, but in 2008, a stronger dollar did not seem to have the same effect

How did Caterpillar use strategy as a real hedge to reduce its exposure to FX risk? What is the downside of this approach?

Explain the difference between transaction exposure and translation exposure using material in the Caterpillar Tractor case to illustrate your answer.

16