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Market
Functions of Forex Market
Transfer of funds from one nation & currency to
another.
Why exchange?
# Import & Export of goods
# Import & Export of services
# Tourism
# Investment
Eg. A US commercial bank has oversupply of
pounds, then sell excess pounds, then finally a
nation pays for its tourist exp. imports, investments
etc.
Participants in Forex Market:
Level 1:
Tourists, importers, exporters, investors-
immediate users & suppliers of foreign
currencies.
Level 2:
R=2, i.e. R= 2 $/ £ or
R= $/ £ = 2
i.e. 2 dollars are required to buy one pound.
The Foreign Exchange Rates
X axis- Quantity of
pounds
Y axis- exchange
rate i.e. R
R= $/£
Analysis:
Lower exchange rate:
a) fewer dollars will be required to purchase
one pound.
b) It will be cheaper for US to import funds from
UK.
c) Better for us to invest in UK.
US US Dollar $ 43.30
Euro € 44.87
Short sell
Bid and Ask Rates
A bank is ready to buy and sell a currency at
different prices.
Buy price- Bid rate
Sell price- Ask rate
Spread- Difference between Bid and Ask rate is
called Bid- ask Spread.
It is more in retail market and less in interbank
market as there is more volume, greater liquidity
and lower counterparty risk in interbank
transactions.
Causes of spread are:
Transaction cost
Return on capital employed
= 5.5971 * 0.7555
= (sFr / $)bid * ($/ Can$)bid
= 4.2286
Cross Rates
Eg. We need to calculate the Switzerland
franc / Canadian Dollar (sFr/ Can$) rate from
given sFr / $ and $/ Can$ quotes.
sFr / $ : 5.5971 / 5.5978
$/ Can$ : 0.7555 / 0.7562
Synthetic (sFr/ Can$)ask rate
= 5.5978 * 0.7562
= (sFr / $)ask * ($/ Can$)ask
= 4.2330
Appreciation & Depreciation
Q1. During 2002, the yen went from
$0.0074074 to $0.0084746.
investment
Eg. In Germany, the annualised interest rate
is 11% whereas in London it is 15%.
Suppose, a company has excess funds for 3
months. In which country one should invest?
Covered Interest Arbitrage
Spot purchase of foreign currency to make
the investment and offsetting the
simultaneous the simultaneous forward sale
to cover the foreign risk.
Net return= Positive interest differential (-)
6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution to Illustration1
The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate 6
= 42.8020 – 42.0010 * 100 * 12 = 3.8141 %
42.0010 6
Solution to Illustration1
Negative interest rate differential> forward
premia, therefore, there is a possibility of
arbitrage inflow in India.
Suppose, investment = $1000 by taking a
loan @ 8% in US. Invest in India at spot rate
of Rs 42.0010 @ 12 % for six months and
cover the principal + interest in the six month
forward rate.
Principal= $ 1000 = Rs 42001
Solution to Illustration1
Intereston investment for six months
= Rs 42,001 * 12/ 100* 6/12
= Rs 2520.06
Amount at the end of six months = Interest +
Principal
= Rs 42001+ 2520.06
= Rs 44,521.06
Solution to Illustration1
Converting the above in dollars at the
forward rate = $ 44,521.06 / 42.8020
= $ 1,040.16
The arbitrageur will have to pay at the end of
six months = $1,000+ ($1000* 8/100 *6 /12)
Hence, the arbitrageur gains ($1040.16 -
$1040) = $ 0.16 on borrowing $1000 for six
months.
Illustration 2
Spot rate: Rs 44.0030 = $ 1
6 month forward rate: Rs 45.0010 = $ 1
6 month rupee: 12 %
6 month dollar: 8%
Calculate the arbitrage possibilities.
Solution to Illustration 2
The rule is that if the interest rate differential is
greater than the premium or discount, place the
money in the currency that has a higher rate if
interest or vice –versa.
Given the above data:
Negative interest rate differential= (12-8)= 4%
Forward premia (annualised) =
Forward rate-Spot rate * 100 * 12
Spot rate 6
= 45.0010 – 44.0030 * 100 * 12 = 4.5361%
42.0030 6
Solution to Illustration 2
Negative interest rate differential< forward
premia, therefore, there is a possibility of
arbitrage inflow in US.
Suppose, investment = Rs 10,000 by taking a
loan @ 12% in India.
Invest in US at spot rate of Rs 44.0030 @ 8
% for six months (US $ 227.257) and cover
the principal + interest in the six month
forward rate.
Solution to Illustration 2
Amount at the end of six months = Interest +
Principal
= $227.257* 8/ 100* 6/12
= $ 236.3473
Sell US $ at 6 month forward to receive
236.3473* 45.0010= Rs 10635.865
Return the rupee debt borrowed at 12%. The
amount to be refunded is Rs 10,600
Profit= Rs 10635.865 - 10600= 35.865
Illustration 3
Spotrate FFr 6.00 =$1
6 month forward rate FFr 6.0020 = $1
6 month US $ = 5%
6 month FFr = 8%
Illustration 4
An American firm purchases $4,000 worth of
perfume (FF 20,000) from a French firm. The
American distributor must make the payment
in 90 days in French francs. Given that:
Spot rate $ 0.2000 = 1 FF
Where,
Pa – General price level in Nation A
Pb- General price level in nation B
Rab – Exchange rate between currencies of
Nation A & B
Absolute Purchasing Power
Parity
Itdoes not consider:
a) Transportation cost, tariffs, quotas. Product
differentiation.
b) Existence of non- traded goods and services
eg Cement, bricks, doctors etc.
Relative Purchasing Power
Parity
The change in the exchange rate over a
period of time should be proportional to the
relative change in the price levels in the 2
nations over the same time period.
Rab1 = Pa1/ Pa0 * Rab0
Pb1/ Pb0
If the absolute PPP were to hold true, the
relative PPP would also hold. However, the
vice- versa will not hold true.
Problems in Relative PPP
Ratio of prices of non- traded goods to the
prices of traded goods & services is
consistently higher in developed nations than
in developing nations.
Various factors other than relative price levels
can influence exchange rates in the short run.
International Fisher Effect (IFE)
IFE uses interest rates rather than inflation
rates
The relationship between the percentage
change in the spot exchange rate over time
and the differential between comparable
interest rates in different national capital
markets is known as “international Fisher
Effect”.
International Fisher Effect (IFE)
The IFE suggests that given two countries,
the currency in the country with the higher
interest rate will depreciate by the amount of
interest rate differential. That is, within a
country, the nominal interest rate tends to
approximately equal the real interest rate plus
the expected inflation rate.
Nominal= Real + Expected inflation rate
International Fisher Effect (IFE)
The proportion that the nominal interest rate
varies directly with the expected inflation rate,
known as Fisher effect.
Inc. in interest rate- Inc. in exchange rate
Transaction exposure
Economic exposure
1. Translation exposure
All financial statements of a foreign
subsidiary have to be translated into the
home currency for the purpose of finalising
the accounts for any given period.
Translation exposure is the degree to which a
firm’s foreign currency denominated financial
statements are affected by the exchange rate
changes.
1. Translation exposure
The changes in the asset valuation due to
fluctuations in the exchange rate will affect
the group’s assets, capital structure ratios,
profitability ratios, solvency ratios etc.
1. Translation exposure
The following procedure has been followed:
Assets & Liabilities are to be translated at the
current rate, i.e. the rate prevailing at the time of
preparation of consolidated statements.
All revenues & expenses are to be translated at the
actual exchange rates prevailing on the date of
transactions.
Translation adjustments (gains or losses) are not be
charged to the net income of the reporting company.
(They are accumulated & reported in a separate
account).
Measurement of Translation
exposure
Translationexposure = (Exposed assets –
Exposed liabilities) * (Change in exchange in
exchange rates)
Example
Current exchange rate: $ 1 = Rs 47.10
Assets Liabilities
Rs. 15,300,000 Rs 15,300,000
$ 3,24,841 $ 3,24,841
Example
In the next period, exchange rate fluctuates
to $ 1 = Rs. 47.50
Assets Liabilities
Rs. 15,300,000 Rs 15,300,000
$ 3,22,105 $ 3,22,105
Decrease in the Book Value of the assets is $
2736.
Transaction exposure
This exposure refers to the extent to which
the future value of firm’s domestic cash flow
is affected by exchange rate fluctuations. It
arises from thepossibility of incurring
exchange rate gains or losses on transaction
already entered into and denominated in a
foreign currency.
More the transactions, more the risk.
Transaction exposure
All transactions gains and losses should be
accounted for and included in the equity’s net
income for the reporting period.
Option contract
c) Input mix
d) Plant location
e) Raising productivity
Market selection
Market strategy considerations for an
exporter are the markets in which to sell, i.e.
market selection. It is also necessary to
consider the issue of market segmentation
with individual countries.
A firm that sells differentiated products to
more affluent customers may not be harmed
as much by a foreign currency devaluation as
will a mass marketer.
Product strategy
Companies can also respond to exchange
rate changes by altering their product
strategy, which deals in such areas as new
product introduction.
Product line decisions
Product innovations
Promotional strategy
A firm exporting its products after a domestic
devaluation may well find that the return per
home currency expenditure on advertising or
selling is increased because of the product’s
improved price positioning.
Pricing Strategy- Market Share
vs Profit Margin
To begin the analysis, a firm selling overseas
should follow the standard economic
proposition of setting the price that
maximizes dollar profits (by equating
marginal revenues and marginal costs). In
making this decision, however, profits should
be translated using the forward exchange
rate that reflects the true expected dollar
value of the receipts upon collection.
Input Mix
Outright additions to facilities overseas
accomplish a manufacturing shift. A more
flexible solution is to purchase more
components overseas. This practice is called
as outsourcing.
Shifting production among
plants
MNCs with world wide production systems
can allocate production among their several
plants in line with the changing home
currency cost of production, increasing
production in a nation whose currency has
devalued and decreasing production in a
country where their has been a revaluation.
Assumption- Company has a portfolio of
plants worldwide.
Plant location
Raising Productivity
Raising productivity through closing
inefficient plants, automating heavily and
negotiating wage benefit cutbacks and work
rule concessions is another alternative to
manage economic exposure.
Corporate philosophy for
Exposure Management
High risk
Low risk
Multinational Cash
Management
Multinational Cash
Management
Objectives of cash management
How to manage & control the cash resources
of the company as quickly and efficiently as
possible.
Achieve the optimum utilization and
conservation of the funds.
Objective of an efficient
system:
Minimise the currency exposure risk.
Minimise the country and political risk.
Pay $ 30,000
Pay $ 40,000
Pay $ 10,000
Multinational Netting System
In this system, each affiliate nets all its inter
affiliate receipts against all its disbursements.
It then transfers or receives the balance,
depending upon whether it is the net receiver
or a payer.
To be really effective, it needs centralised
and effective communication system and
discipline.
Multinational Netting System
X
$ 20 m $ 20 m
Y Z
$ 20 m
Country Risk Analysis
Political Risk Indicators
It is very difficult to measure political risk
associated with a particular country or a
borrower. Assessing political risk is a
continuous problem.
Stability of the local political environment
Consensus regarding priorities
Attitude of the host government
War
Mechanisms for expressions of discontent
Economic Risk Indicators
Inflation
rate
Current and potential state of the country’s
economy
Resource base