Don’t tell me where your priorities are. Show me where you spend your money and I’ll tell you what they are.
James W. Frick
International Financial Management
(Part B)
by
Charles Lamson
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Foreign Exchange Rates
Suppose you are planning to spend some time in London. To put your plan into operation you will need British currency, that is British pounds (￡), so you can pay for your expenses during your stay. How many British pounds you can obtain for $1,000 will depend on the exchange rate at that time. The relationship between the values of two currencies is known as the exchange rate. The exchange rate between U.S. dollars and British pounds is stated as dollars per pound or pounds per dollar. For example, the quotation of $1.37 per pound is the same as ￡.73 per dollar (1/$1.37). At this exchange rate you can purchase 730 British pounds with $1,000. Each day, current exchange rates can be found on the Internet by doing a quick web search. There is no guarantee that any currency will stay strong relative to other currencies and the dollar is no exception. Financial managers should always pay close attention to exchange rates and any changes that might be forecasted to occur. The relative change in the purchasing power between countries affects imports and exports, interest rates, another economic variables. The major reasons for exchange rate movements are discussed in the following sections. Factors Influencing Exchange Rates The present international monetary system consists of a mixture of freely floating exchange rates and fixed rates. The currencies of the major trading partners of the United States are traded in free markets. In such a market the exchange rate between two currencies is determined by the supply of, and the demand for, those currencies. This activity, however, is subject to intervention by many countries' central banks. Factors that tend to increase the supply or decrease the demand schedule for a given currency will bring down the value of that currency in foreign exchange markets. Similarly the factors that tend to decrease the supply or increase the demand for a currency will raise the value of that currency. Since fluctuations in currency values results in foreign exchange risk, the financial executive must understand the factors causing these changes in currency values. Although the current value of a currency is determined by the aggressive aggregate supply and demand for that currency, this alone does not help financial managers understand or predict the changes in exchange rates. Fundamental factors, such as inflation, interest rates, balance of payments, and government policies, are quite important in explaining both the short-term and long-term fluctuations of a currency value.  Inflation A parity between the purchasing powers of two currencies establishes the rate of exchange between the two currencies. Suppose it takes $1 to buy one dozen apples in New York and 1.25 Euros to buy the same apples in Frankfurt, Germany. Then the rate of exchange between the U.S. dollar and the euro is E1.25/$1.00 or $0.80/euro. If prices of Apple's double in New York while the prices in Frankfurt remain the same, the purchasing power of a dollar in New York should drop 50 percent. Consequently, you will be able to exchange $1 for only E.625 in foreign currency markets (or receive $1.60 per euro). Currency exchange rates tend to vary inversely with their respective purchasing powers to provide the same or similar purchasing power in each country. This is called the purchasing power parity theory. When the inflation rate differential between two countries changes, the exchange rate also adjusts to correspond to the relative purchasing powers of the countries. Interest Rates Another economic variable that has a significant influence on exchange rates is interest rates. Capital flows in the direction of higher yield for a given level of risk. This flow of short-term capital between money markets occurs because investors seek equilibrium through arbitrage buying and selling. If investors can earn 6 percent interest per year in Country X and 10 percent per year in Country Y, they will prefer to invest in Country Y, provided the inflation rate and risk are the same in both countries. Thus interest rates and exchange rates adjust until the foreign exchange market and the money market reach equilibrium. This interplay between interest-rate differentials and exchange rates is called the interest rate parity theory. Balance of Payments The term balance of payments refers to a system of government accounts that catalogues the flow of economic transactions between the residents of one country and the residents of other countries. (The balance of payment statement for the United States is prepared by the U.S. Department of Commerce quarterly and annually.) It resembles the cash flow statement presented in Part 6 of this analysis and tracks the country's exports and imports as well as the flow of capital and gifts. When a country sells (exports) more goods and services to foreign countries than it purchases (imports), it will have a surplus in its balance of trade.  Government Policies A national government may, through its central bank, intervene in the foreign exchange market, buying and selling currencies as it sees fit to support the value of its currency relative to others. Sometimes a given country may deliberately pursue a policy of maintaining an undervalued currency in order to promote cheap exports. In some countries the currency values are set by government decree. Even in some free market countries, the central banks fix the exchange rate, subject to periodic review and adjustment. Some nations affect the foreign exchange rate indirectly by restricting the flow of funds into and out of the country. Monetary and fiscal policies also affect the currency value in foreign exchange markets. For example, expansionary monetary policy and excessive government spending are primary causes of inflation, and the continual use of such policies eventually reduces the value of the country's currency. Other Factors A pronounced and extended stock market rally in a country attracts investment capital from other countries, thus creating a huge demand by foreigners for that country's currency. This increased demand is expected to increase the value of that currency. Similarly a significant drop in demand for a country's principal exports worldwide is expected to result in a corresponding decline in the value of its currency. Political turmoil in a country often drive capital out of the country into stable countries. A mass exodus of capital, due to the fear of political risk, undermines the value of a country's currency in the foreign exchange market. Also, widespread labor strikes that may appear to weaken the nation's economy will depress its currency value. Although a wide variety of factors that can influence exchange rates have been discussed, a few words of caution are in order. All of these variables will not necessarily influence all currencies to the same degree. Some factors may have an overriding influence on one currency's value, while their influence on another currency may be negligible at that time. Spot Rates and Forward Rates When you look into a major financial publication, you will discover that two exchange rates exist simultaneously for most major currencies---the spot rate and the forward rate. The spot rate for a currency is the exchange rate at which the currency is traded for immediate delivery. For example, you walk into a local commercial bank and ask for Swiss francs. The banker will indicate the rate at which the frank is selling, say SF 1.35/$. If you like the rate, you buy 1,354.60 francs with $1,000 and walk out the door. This is a spot market transaction at the retail level. The trading of currencies for future delivery is called a forward market transaction. Suppose IBM Corporation expects to receive SF 135,340 from a Swiss customer in 30 days. It is not certain, however, what these franks will be worth in dollars in 30 days. To eliminate this uncertainty, IBM calls a bank and offers to sell SF 130,340 for U.S. dollars in 30 days. In their negotiation the two parties may agree on an exchange rate of SF 1.3534/$. This is the same as $0.7389/SF. The 1.3534 quote is in Swiss francs per dollar. The reciprocal or .7389 is in dollars per Swiss franc.  Since the exchange rate is established for future delivery, it is a forward rate. After 30 days IBM delivers SF 130,340 to the bank and receives $100,000. The forward exchange rate of a currency is slightly different from the spot rate prevailing at that time. Since the forward rate deals with a future time, the expectations regarding the future value of that currency are reflected in the forward rate. Forward rates may be greater than the current spot rate (premium) or less than the current spot rate (discount). The discount or premium is usually expressed as an annualized percentage deviation from the spot rate. The percentage discount or premium is computed with the following formula: Formula 1   The spot forward transactions are said to occur in the over-the-counter market. Foreign currency dealers (usual a large commercial banks) and their customers (importers, exporters, investors, multinational firms, and so on) negotiate the exchange rate, the length of the forward contract, and the commission in a mutually agreeable fashion. Although the length of a typical forward contract may generally vary between 1 months and 6 months, contracts for longer maturities are not uncommon. The dealers, however, may require higher returns for longer contracts.  *MAIN SOURCE: BLOCK & HIRT, 2005, FOUNDATIONS OF FINANCIAL MANAGEMENT, 11TH ED., PP. 607-612* end |
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