Lecture 10: Foreign Exchange & IB Payment Systems Flashcards
What is the foreign exchange market and the exchange rate?
Foreign exchange market:
A market for converting the currency of one country into that of another country.
The exchange rate (XR): The ratio of one unit of currency of Country A to a unit of the currency of Country B at the time of the buy or sell transaction
What are the functions of the foreign exchange market?
Currency conversion (primary function)
- global market open 24/7 - different time zones
- tourists, international businesses paying for goods, international businesses investing, financial institutions managing exposures
Speculation on currency movements
- short-term movement of funds from one currency to another in hope of profiting from shifts in XR
- results in “hot money” flows and “runs” on currencies
- central banks intervene to “knock the tops and bottoms” off volatile currency swings
Hedging
* insuring against the possible losses from unpredictable XR swings - the opposite of speculation
Arbitrage
* the purchase of securities in one market for immediate resale in another market to profit from a price discrepancy
What is hedging?
Insuring against the possible losses from unpredictable XR swings - the opposite of speculation. There is
- spot exchange rates
- the XR at the time of the exchange (settlement in 2 days)
- continually fluctuating
- forward exchange rates:
- two parties agree today to exchange currencies at a particular rate, on a specified future date
- forex swaps (using forward exchange):
- an agreement between two parties to the simultaneous purchase and sale of the same amount of a given currency for two different settlement dates e.g. a spot purchase offset by a forward sale (a spot-forward swap)
What is arbitrage?
The purchase of securities in one market for immediate resale in another market to profit from a price discrepancy
Arbitrage, by its nature, cannot exist for long. If everyone knows that there are price discrepancies, then they will all seek to profit from them - then demand and supply forces will naturally reduce the discrepancies.
The force behind the ‘law of one price’
- in the absence of transport costs and trade barriers prices for the same products should be equivalent over time
What are 3 XR risk exposures?
Transaction risk:
* the extent to which income from individual transactions is affected by fluctuations in foreign exchange values - consequence of unexpected changes in pre-existing cash flows in the near future
Translation risk (Accounting); * the extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in foreign exchange values - translation is not a physical conversation but a change in monetary expression
Economic risk (Operations): * the extent to which a firm's future international earning power is affected by changes in XR - consequence of unexpected changes in expected future cash flows
What is transaction risks management? (It’s used to manage XR risk exposures)
Hedging with financial instruments - forward market and swaps
Leading (pay/collect early) and lagging (pay/collect late) strategies in relation to accounts payable and accounts receivable
Accelerate payments from weak currency to strong currency; delay collections from strong currency to weak currency
‘Leading’ is a strategy to collect or send payment earlier (foreign currency receivables should be collected earlier if that currency is expected to depreciate, while payment of foreign currency payables should be sent earlier if that currency is expected to appreciate)
‘Lagging’ is a strategy to collect or send payment later (collection of foreign currency receivables should be delayed if that currency is expected to appreciate, while payment of foreign currency payables should be delayed if that currency is expected to depreciate)
Currency diversification – a portfolio of currencies
Having receipts, payments, assets and liabilities denominated in many different currencies
E.g., BHP Billiton
What are some common payment methods buy importers/exporters?
Open account: seller (exporter) ships goods to a buyer (importer) before receiving payment
Prepayment: buyer (importer) pay for goods in advance before they are shipping by seller (exporter)
Letter of credit (L/C): a contract between an importer and a bank that indicates that the bank will give credit to the importer and pay the exporter (pay the bill of exchange) against stipulated documents
What is countertrade?
The trade of G/S - barter is one form (other methods include buyback, counterpurchase and offset)
Used when country’s inflation is out of control or currency is not convertible
What is spot rate?
The price of foreign exchange at the present moment is referred to as the spot price
What is the cross rate?
The exchange rate between two currencies calculated from the rate of each currency compared to the $US
What is forward rate?
The value of the exchange rate agreed in 30, 90 or 180 days from the present is called the forward exchange rate
