Foreign Exchange

INTRODUCTION

In this study unit we will be looking at the workings of the foreign exchange market, and examining the more practical aspects of the subject, such as the different exchange rate systems, the calculation of exchange rates, the impact of international trade on an organisation, various methods of expansion overseas, exchange risk and the various techniques used to reduce this risk.

Exchange Rates

An exchange rate is the rate at which a unit of one currency can be exchanged for another – for any currency there is an exchange rate for each currency it can be traded with.

Foreign Exchange Market (Forex)

The foreign exchange market is a world market and competition is freely applied.  However, governments do intervene in the market to influence prices, and some currencies are not freely dealt in the market. The largest dealing centre is London followed by New York and Tokyo.  The main dealers on forex markets are banks.

 

Some countries have strict exchange control regulations and fix the exchange rate, often in an arbitrary manner.  Nevertheless the foreign exchange market exists to buy and sell currencies and this it does efficiently and effectively.

Exchange Rate Systems

Governments have a choice of exchange rate policies that they can adopt in order to achieve their economic (and political) aims.

 

The main exchange rate policies are:

• Fixed exchange rates, where governments which are members of the international monetary system use their official reserves (which comprise foreign currency and gold) to maintain a fixed exchange rate. By adding to, or using, the official reserves the government ensures that the demand for, and the supply of, their currency are balanced (thus maintaining its price).  The exchange rate of each member currency is generally set against a standard – which could be gold, a major currency (e.g. the US $) or a basket of currencies.  It is also possible for each currency in the system to be set against each other.  Fixed exchange rate systems encourage international trade by removing uncertainty.  However, they restrict member states’ independence in setting domestic economic policies by requiring them to take appropriate action to maintain their exchange rate.
• Floating exchange rate systems are those whereby exchange rates are left to, and are determined by, market forces, there being no use of the official reserves in maintaining the exchange rate level. Floating exchange rate systems may be either free floating or, more commonly, managed floating.  Wide fluctuations of exchange rate values can occur under floating exchange rate systems creating problems of uncertainty for international trade.  However, it is likely that the underlying economic conditions creating these fluctuations would have created severe problems for the working of a fixed exchange rate system – even creating instability.
• Adjustable (or moveable) peg system is a fixed exchange rate system which has provisions for the devaluation and revaluation of currencies for countries with persistent balance of payments’ deficits or surpluses. Adjustable peg systems allow more flexibility than a fixed exchange rate system but still limit the choice of government action to either maintaining the exchange rate or devaluing/revaluing the currency.  The ERM (Exchange Rate Mechanism – see below) is an example of such a system.                           FACTORS TO CONSIDER – INTERNATIONAL TRADE

Risk Factors

Apart from the normal problems which occur in any type of business there are further complications when the organisation is involved in international trade.  Among these are:

• Credit Risk – usually higher risk for foreign trade
• Physical Risk – there is a greater risk of goods in transit being lost, stolen or destroyed.
• Exchange Controls – may hinder movement of funds.
• Foreign Laws & Customs – different practices in certain countries.
• Taxation – different tax rates/rules. Double Taxation Treaty may apply.
• Political Risk – actions of a foreign government may prevent/delay payment being made. This can take many forms, ranging from bureaucratic delays to war (e.g.

Iran/Iraq).

• Exchange Rate Risk – losses due to unforeseen movement in currency exchange rates.

Some forms of risk may be reduced/eliminated by insurance – e.g. normal commercial insurance (physical risk), export credit insurance (credit risk).  Credit risk may also be reduced by screening customers or by the terms of trade (e.g. irrevocable letter of credit).

Methods of Expansion Overseas

Overseas expansion may be achieved by:

• Exporting – often used as a first step to direct investment.
  • Advantages: uses spare capacity at existing plants; safe way to enter new market as costs are relatively low if strategy fails.
  • Disadvantages: high transportation costs; may be difficult or expensive due to imposition of tariffs, quotas, taxes etc; consumers may prefer locally produced goods; service, spare parts etc. normally less reliable with exports.

• Foreign Direct Investment (FDI) – establish a new subsidiary or acquire existing local company.
  • Advantages: establish new markets & demand;  benefit from economies of scale;  take advantage of relatively cheap labour or land;  avoid tariffs and restrictions;  international diversification;  highly skilled or educated workforce;  use foreign

raw materials & avoid high transport costs;  take advantage of undervalued foreign currency;  exploit monopolistic or competitive advantage;  react to overseas investment by competitors.

• Disadvantages: commitment of substantial capital; significant risk.

 

• Licensing – local company manufactures in return for a royalty. Often used where countries have high import barriers.
  • Advantages: penetration of foreign markets without large capital outlay;  political risk reduced as product is manufactured locally;  transportation costs avoided
  • Disadvantages: difficult to ensure quality control; local company might export and compete with multinational’s exports; problems of technology transfer or licensee may become a significant competitor when licence expires.

• Joint Venture – two or more independent companies cooperate in an agreed manner in a project/projects.
  • Advantages: access to new markets at relatively low cost; use of joint venture partner’s knowledge of the local environment, distribution network, technology, patents, brands, marketing or other skills; risk and cost shared; easier access to local capital markets/tax incentives/ grants in overseas country; may be the only way to enter some markets – host government may impose requirements that any direct investment must be a joint venture.
  • Disadvantages: agreement on terms – percentage ownership of each partner, transfer pricing rules, reinvestment decisions, nationality of key managers, where raw materials and components are to be purchased etc; may be time consuming and difficult to find a reliable partner;  managerial freedom may be reduced.

Classification of Exposure

Transaction Exposure – The above exposure is known as Transaction Exposure, which exists because of the time lag between the initiation of the transaction and the actual payment/receipt of the foreign currency.

Translation Exposure – The risk of profits and losses arising from the conversion of foreign currency assets and liabilities from one Balance Sheet date to the next is known as Translation Exposure.

Economic Exposure – This exists where there is the possibility that the value of the company will change due to unexpected changes in exchange rates.  Unexpected currency fluctuations can affect both the future cash flows and their riskiness.  Both of these are likely to result in a change in the value of the company.

Exchange Rates – Spot v Forward

An exchange rate is the price of a currency expressed in terms of another currency.  The spot rate is the current rate of exchange.  Two prices will be quoted by the bank – a buying rate and a selling rate.  The difference between the two prices is known as the “spread” and represents the bank’s profit or turn.

METHODS OF REDUCING RISK

Exposure can, to a certain degree, be managed by “hedging”, which is the taking of any action that protects against adverse movements in exchange/interest rates.  This “action” may take a number of forms, several of which we shall discuss.

Essentially there are three general courses of action available to the treasurer:

• Do nothing, i.e. leave exposed positions uncovered.
• Hedge everything.
• Hedge selectively.

The course taken will depend on the organisation’s philosophy, the treasurer’s perception as to future movements and the value of the potential exposure.

Remember that not all rate movements are detrimental; fortuitous gains often arise.  A company may seek to hedge or to be partially hedged in the hope of achieving high profits.

Risk management consists of the techniques and policies adopted by an organisation to minimise its exposure to risk, and takes two main forms:

• The internal management of risks, or pooling. Here risks are aggregated and offset against each other; this is the general method of dealing with normal business risks, and is also used in areas such as insurance and portfolio diversification.
• The external management of risk, or hedging. This is where two or more parties make an agreement in which their risks cancel each other out.  This is used in areas outside the company’s control, e.g. in exchange rate and interest rate risk.  The parties involved may be those facing the same risk but in opposite directions, or may include one or more speculators.

Forward Exchange Contract

With this technique we take action to-day so as to “lock-in” a rate which will apply in the future.

A Forward Exchange Contract is an agreement between two parties to exchange (buy/sell) one currency for another at some future date.  The exchange rate, amount involved, and delivery date are agreed up-front but funds do not change hands until delivery date.

It is a straightforward contract and one of the most commonly used risk hedging mechanisms.

It is one of the best means of establishing a perfect hedge – full insurance is provided against adverse rate movements. However, it is important to remember that these contracts are binding on both parties and must be carried out.  At the date that the agreement matures (the value date), if rates have moved in the customer’s favour he cannot decide that he no longer needs the forward contract.

It allows an importer/exporter to calculate up-front the precise domestic currency value of the underlying commercial transaction.

Contracts are available in most markets for maturities up to one year in all major currencies.  For large amounts some banks will contract for several years forward, if they can match buyers and sellers.

Advantages

• Facilitates perfect hedging of foreign currency payables/receivables.
• Can be tailor-made to suit a customer’s requirements (amount, currency, and timing).
• Simple implementation and standardised documentation.

Disadvantages

• Legally binding contract which must be performed. It is usually non-transferable and can only be cancelled with the consent of the counterparty and payment of a penalty.
• • At any date from contract date up to a specified future date, or
  • At any date between two specified future dates.Opportunity costs arise if rates do not move as anticipated (see example below).Close Out The Contract – if an exporter had contracted to sell $1m forward but the customer will not now make payment to the exporter (e.g. due to bankruptcy) the bank will arrange for the exporter to buy the “missing” currency at the spot rate and thus perform his part of the contract. The exporter will:
    • Buy $1m at the prevailing spot rate, and
    • Immediately sell $1m to the bank at the contracted forward rate.

     

    A loss or a gain may arise depending on current spot rate at no.1 above.

     

    Extend The Contract – if an exporter had contracted to sell $1m forward but the customer will not now make payment until say, one month later.  The bank will accept a request to extend the period of the existing contract, changing its rate to a new rate applicable to the forward date when performance is now expected.

     

    Option Dated Forward Contract – where a future cash flow is not known with certainty to the day the “fixed” forward contract, as above, may cause problems.  The option dated contract allows the customer to call for settlement:

  If, there is a cost as the bank will quote the more favourable of the two applicable rates (or  less favourable to the customer).

   Note: The option is not on the ultimate performance of the contract, it is on when it may be performed.

  Foreign Currency Option

  A currency option gives the holder the right (but not the obligation) to buy or sell an underlying currency at an agreed exchange rate (known as the “strike price”).  Depending on the terms, the option can be exercisable on a single date at expiry (European Option) or over a period of time on any day (American Option).

  Option is the key word because this particular instrument offers a good deal of flexibility.  An option is purchased for an up-front payment, known as a Premium (usually a flat percentage fee of the amount to be covered).  Thereafter, the holder exercises the option if it is in his interest to do so, or allows it to lapse if the transaction can be carried out at a more favourable rate in the spot market.

  A Call Option is the right to buy the underlying currency.

  A Put Option is the right to sell the underlying currency.

  Options differ fundamentally from traditional risk-management tools such as forward cover, as the company is not obliged to deal at an exchange rate which may turn out to be quite unfavourable depending on how rates subsequently move.  It is like a forward contract from which the holder can walk away.  Thus, it provides a mix of protection (guaranteed rate) and opportunity (to trade at the spot rate if this turns out to be more favourable).

  Note:  Currency options are not the same as Forward Exchange Option contracts, which must be completed at some date.

   

  Advantages

  • Highly flexible.
  • Suited to uncertain cash flows.
  • Does not absorb foreign exchange line, once the premium has been paid.

   

  Disadvantages

  • Cost can be relatively high and must be paid up-front (cash flow?).
  • Tailor-made options (OTC – Over The Counter) lack negotiability.The importer essentially has three alternatives:
    • Leave The Exposure Open (do nothing) – he will gain if the $ weakens (pick them up more cheaply), but lose if the $ strengthens.
    • Arrange a Forward Contract – he will gain if the $ strengthens (pick them up at the fixed forward rate), but lose if the $ weakens (lose the opportunity to pick them up at the relatively cheap spot rate, as he must deal at the agreed fixed rate).
    • Arrange An Option – he is protected if the $ strengthens but he also retains the opportunity to benefit from a weaker $.

    Suppose that the company buys a Call Option for $10k., expiring in 3 months time (European), at a strike price of RWF579/$ for a premium of RWF10 per $.  Therefore, a premium of RWF100,000 must be paid up-front.

    • If in 3 months time the spot rate has appreciated to, say 595/$, the company will exercise its option at the more favourable rate of RWF584 and pay RWF5,840,000 ($10k x 584). The cost of $10k at the spot rate of 595/$ would have been RWF5,950,000.  Thus, the company saves RWF110,000 over the cost of spot $’s or a net saving of RWF10,000 if the premium is taken into account.

     

    • If in 3 months time the spot rate has weakened to, say RWF568/$, the company will allow the option to lapse and buy the $10k at the more favourable spot rate of RWF568, paying RWF5,680,000. The cost of forward cover would have been RWF5,840,000, so the company saves RWF160,000 or a net RWF60,000, if the premium is taken into account.

    An option can never perform quite as well as forward cover if the spot moves against the company, or an open exposure if the spot moves in its favour (because a premium must be paid for the option).  However, in a world of volatile and unpredictable exchange rates an option can significantly outperform an unfavourable forward contract or an open position.  At the same time, it can capture a high percentage of the gains provided by a favourable covered or open exposure, especially if there is a major move in the spot rate.

    It is possible that the rates would be adjusted so that both parties shared equally in the saving or the stronger party (in this case SM Inc.) receives more of the saving.

    • A bank may take a position between the two parties and make a profit by taking a turn out of the funds paid on to one or both parties. Alternatively, the bank may act purely as a broker and charge a fee or commission to one or both parties.
    • Currency Swaps offer several advantages:
      • Companies have a greater access to funds as they can borrow in any currency and swap it into the currency they need.
      • They are off-balance sheet instruments.
      • They can enable a company to source cheap funding in one currency by borrowing another currency and swapping it into the currency needed.
      • They can be tailored in terms of start date, maturity, principal, interest rates, currencies etc.

    Foreign Currency Invoicing

    One way of avoiding exchange risk is for an exporter to invoice the customer in his domestic currency, or for an importer to be invoiced in his domestic currency.  However, only one party can deal in his domestic currency, the other must accept the exchange risk.

    It is more usual for the exporter to invoice in his own currency and the importer to be invoiced in a foreign currency.

    Consideration must be given to the bargaining position of the exporter/importer; the company’s policy on price revisions etc.

    Netting

    A Rwandan company with receipts and payments in the same foreign currency should plan to net them off against each other, where possible.  Thus, it does not matter whether the currency strengthens or weakens against the RWF as there is no purchase or sale of the currency.

    There is very little cost with this approach but it is only practicable to the extent that receipts and payments can be matched.  Any mismatch could be covered by some other method e.g. forward contract.

    Matching

    Matching is an asset and liability management technique in which a company matches, say, its dollar outflows with its dollar inflows, such that they correspond in size and the period in which they occur.  This particular strategy is valuable if the firm wishes to minimize the impact of unanticipated exchange rate changes on its net cash flows.  If the matching is complete in terms of currency, size and timing, then changes in values of outflows will be offset by equivalent changes in values of inflows.

    An example is where the purchase of a U.S. subsidiary or property by a Rwandan company would be financed by a U.S. $ loan, rather than a RWF loan.

    Leading & Lagging

    This involves altering the normal receipts/payments schedule by accelerating or delaying foreign currency payments, in anticipation of exchange rate fluctuations.

    Lead Payment – where the foreign currency is strengthening it may be worthwhile making an early payment of an outstanding liability, rather than taking an extended credit period and running the risk of having to pay more in RWF’s.  However, account must be taken of any additional financing costs, due to the early payment.

    Lagged Payment – if it is felt that the foreign currency is weakening it may be worthwhile delaying payment for as long as possible to obtain the benefit of a more favourable exchange rate.

    Purchasing Power Parity Theory (PPP)

    This theory is based on the idea that in terms of an international price a product should cost the same wherever it is produced.  Using this basic idea, expected exchange rate changes and forecast inflation differentials can be linked.  If the expected rate of inflation in country A is greater than that in country B then the rate of exchange of the currency of country A will fall against the currency of country B.