FX Concepts

Foreign Exchange (FX)Conversion of one currency into another eg EUR into USD

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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sury

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nds

Mgt

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.