Chapter 2 Power Point Slides

GLOBAL ACCOUNTING AND CONTROL: A MANAGERIAL EMPHASIS Sidney J. Gray, University of New South Wales ❂ Stephen B. Salter, University of Cincinnati ❂ Lee H. Radebaugh, Brigham Young University ❂

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Slides Prepared by: Jennifer Anne Salter Gray, Salter & Radebaugh Chapter 2

CHAPTER TWO

FOREIGN CURRENCIES AND EXCHANGE RISK MANAGEMENT

Gray, Salter & Radebaugh Chapter 2

INTRODUCTION ❂

This chapter explains: • • • •

terminology of foreign exchange; major foreign exchange products; major types of foreign exchange risks; alternative approaches to foreign exchange risk management.

Gray, Salter & Radebaugh Chapter 2

FOREIGN EXCHANGE RISKS AND SOLUTIONS - Import for Cash Problem ❂

Let’s explain with an example.

Your firm, Alamo Computers of San Antonio, Texas, USA, wishes to buy some computer motherboards. ❂ Here are three suppliers with prices in their local currency. ❂

Gray, Salter & Radebaugh Chapter 2

FX RISKS & SOLUTIONS CONT’D - An Import for Cash Problem Firm Suntech Changi Boards McBoards

Location California, USA Singapore

Currency Amt US$ $107 Sin. $

$170

Edinburgh, UK

British £

£64

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FX RISKS & SOLUTIONS CONT’D - An Import for Cash Problem ❂

What do we do now? • Calculate the price in a common currency (US$ would be logical since you are US based).

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How do we do that? • Get the price in local currency (LCP) for each location from the table. • Divide the LCP by the LC/US$ exchange rate to get the US$ Price. See Table 2.1/2.2 or http://www.bmo.com/economic/. Gray, Salter & Radebaugh Chapter 2

Lets look at 2.1 First ❂

it’s a word file

Gray, Salter & Radebaugh Chapter 2

FX RISKS & SOLUTIONS CONT’D - An Import for Cash Problem Company

Country

Local Currency Price

Suntech USA $105 Changi Singapore Sin$170 Boards McBoards U.K. £64

# of US$ Foreign Price Currency Units per US$ 1 $105 1.6783 $101.29 0.6054

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$105.71

Lets change the number to Today's rates from BMO Compa Cou ny ntry

Local Currency price (A)

Number of Units Per $Foreign Currency (B)

Suntec USA $105 1.0000 h Changi Sing SGD 170.00 $0.55 Boards apo re Mcboar Briti £64.00 $1.41 ds sh Pou Gray, Salter & Radebaugh nds Chapter 2

US $ Price A/B $105.00 $92.65

$90.39

FOREIGN EXCHANGE RISKS AND SOLUTIONS - Import for Credit What if you want to buy on credit? ❂ Is Singapore still the cheapest supplier? ❂ Will the exchange rate stay the same? ❂ Can you protect yourself from fluctuations in the exchange rate? ❂

Gray, Salter & Radebaugh Chapter 2

FOREIGN EXCHANGE RISKS AND SOLUTIONS - Import for Credit Problem DATE

Jan-99 Feb-99 Mar-99 Apr-99 May-99 Jun-99 Jul-99 Aug-99 Sep-99

GBP/ US$

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$0.61 $0.61 $0.62 ❂ $0.62 $0.62 $0.63 ❂ $0.63 $0.62 $0.62

McBoards offers 6 mos. interest free credit. For the others you must borrow at 1% per month. However, the British Pound is a floating currency.

Gray, Salter & Radebaugh Chapter 2

The British Pound Floats 1.7

US$/GBP

1.65

1.6

Number of $ per GBP

1.55

1.5 J an- Feb- Mar- Apr- May- J un- J ul- A Sep99 99 99 99 99 99 99 ug- 99 99

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FOREIGN EXCHANGE RISKS AND SOLUTIONS - Import for Credit Problem ❂

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You can neutralize the risk of the British £ changing in value by using a derivative. FX Derivatives can include forward contracts, futures, swaps and options. Gray, Salter & Radebaugh Chapter 2

Derivatives - Forward Contracts A Forward Contract is a contract between a foreign currency trader and a client for the future sale or purchase of foreign currency at a forward rate. ❂ The Forward Rate is a contractual rate between the FX trader/client for the amount of currency A needed to acquire one unit of currency B at a fixed future & Radebaugh date. (Tbl 2.1)Gray, SalterChapter 2 ❂

Derivatives - Forward Contracts Extract from Table 2.1 British Pound Per Dollar ❂ Spot ❂ One Month Forward ❂ Three Months Forward ❂ Six Months Forward ❂

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.6054 .6054 .6051 .6053

Derivatives - Forward Contracts Table 2.3 shows the impact of applying the information on forward and interest rates to the purchase of boards. ❂ The Singapore $ rate assumes that you have to pay cash spot for the purchase from Singapore. ❂

Gray, Salter & Radebaugh Chapter 2

Derivatives - Forward Contracts Co.

LCP LC (A) Units Per $ (B) Suntech $105 1.00 Changi 170 1.68 Boards McBoards 64 0.61

US $ Cost of Interest for Price 100 units 6 months A/B

Total Cost

105.00 $10,500 101.29 $10,129

$630 $607.7

$11,130 $10,736

105.73 $10,573

$0

$10,573

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Derivatives - Forward Contracts ❂

From the pervious table we can conclude: • McBoard’s initial US$ price is higher than other suppliers; • A deferred payment option with a forward contract makes the British product a great deal more attractive. Lets redo this for today’s rate in $/FC

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Now let’s talk about other methods of containing FX risks. Gray, Salter & Radebaugh Chapter 2

At Today's Rates Co.

LCP (A)

LC Units US $ Price Cost of Interest for Total Cost Per $ (B) A*B 100 units 6 months

Suntech

$105

1

105

$10,500

$630

$11,130

Changi Boards

SGD 170

0.545

92.65

$10,129

$607.70

$10,736

£64

1.4018

89.7152

$10,573

$0

$10,573

McBoards

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Derivatives - Futures, Swaps and Options A Future is a highly standardized foreign exchange contract written against the exchange clearing house for a fixed number of foreign currency units and for delivery on a fixed day. ❂ A Swap is a simultaneous spot and forward transaction. ❂

Gray, Salter & Radebaugh Chapter 2

Derivatives - Futures, Swaps and Options Continued An Option is the right to trade foreign currency at a given exchange rate on or before a given date in the future. ❂ There are two types of options: ❂

• American Options - exercised during a stipulated period. • European Options - exercised at a specified end date. Gray, Salter & Radebaugh Chapter 2

Derivatives - Futures, Swaps and Options Continued ❂

Options have the following terms: • An up front fee for the right to buy or sell a fixed amount of foreign currency. • This is given in US cents per foreign currency unit. • This is in addition to the actual cost of the foreign currency. • Tables 2.4-2.6 in your text contain an example Gray, Salter & Radebaugh Chapter 2

Lets look at some options ❂

http://www.cme.com/market/quote.html

Gray, Salter & Radebaugh Chapter 2

Major World Currency Markets ❂

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Markets cover almost 24 hours, starting with Auckland which is 14-16 hours ahead of Ohio, ie., if it’s 4pm in Cincinnati, it’s 11am the next day in Auckland. Tokyo: Cincinnati + 13 hours. About 15% of total volume Hong Kong & Singapore: Cincinnati + 11 and 12 hours respectively. Together roughly equal to Tokyo in volume. Gray, Salter & Radebaugh Chapter 2

• Continued: European Markets: London is the largest market. Cincinnati + 5 hours. About 25% of total world market volume ❂ Other markets include Frankfurt and Zurich ❂ North American Markets: New York is the second largest market. Other markets include Chicago, San Francisco and Toronto. ❂

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Continued: ❂

NOTE: Over 90% of all transactions include the US$ as one part, e.g., DM/$, etc.

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Selling at a Premium or Discount -

❂ Appli es ❂

to For war ds /Future s

PREM IUM - IF th e q uota ti on o f th e c urr enc y in the denomi na tor , e. g., £ i n a $/ £ i s gr ea ter f or del ive ry i n th e f utu re (fo rw ar d) tha n f or del ive ry n ow (s pot), th at c urr enc y i s a t A

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Premium or Discount ❂ PREMIU

M . IF THE SPOT FOR £ IS $1.5 PER £ AND THE FORWARD QUOTE IS $ 1.60 PER £. ❂ Note : In the example $ AT A DISCOUNT.

Gray, Salter & Radebaugh Chapter 2

OPTIONS: COMPUTING THE COST AND BENEFIT OF AN OPTION

This exercise first calculates the cost of an option and then its potential benefit. ❂ The example is for 30-day option to buy Japanese Yen using US Dollars. ❂ 30 days will take us to July. ❂

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Computing Option Cost ❂ The

rate we want to buy the Yen at is $.00775 per ¥. ❂ The premium charged to execute such a contract is 1.64 hundredths of a cent per ¥ covered (dollars .000164 per ¥). Gray, Salter & Radebaugh Chapter 2

Computing AN Option ❂

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Contracts come in blocks of ¥6,250,000. The cost of a contract is as follows: Premium at .000164$/¥ *6,250,000 $1,025

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Brokerage Cost (admin. fee) 25

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Total Cost per Contract $1,050 Gray, Salter & Radebaugh Chapter 2

$

A TYPICAL OPTION SCENARIO

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Covering ¥ one hundred million (100mm).

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How many contracts do we need? 100 mm ÷ 6.25mm = 16

Cost of cover: 16 x $1,050 = $16,800 Gray, Salter & Radebaugh Chapter 2

Option Scenario : Costs ❂

Potential benefit: If the value of the ¥ exceeds $0.00775 per ¥ plus the transaction cost, we can exercise the option and sell the ¥ for a profit.

Gray, Salter & Radebaugh Chapter 2

Option Scenario : Costs Buy 100mm ¥ at $.00775/¥ $775,000 Option Cost 16 contracts

$16,800

Additional admin. fees on exercising

$400

Total

$792,200 Gray, Salter & Radebaugh Chapter 2

Option Scenario : Benefits ❂

If we sell the ¥ at .0080 $/¥, we have a profit of $7,800.

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At .0090 $/¥, the profit is $107,800.

Gray, Salter & Radebaugh Chapter 2

FOREIGN EXCHANGE RISK &THE MULTINATIONAL ENTERPRISE ❂

The Multinational Enterprise is often referred to as an MNE.

Gray, Salter & Radebaugh Chapter 2

Classifying Risk and Exposure ❂

There are 3 types of foreign exchange exposure: • Transaction • Translation • Economic

Gray, Salter & Radebaugh Chapter 2

Classifying Risk and Exposure Transaction Exposure ❂

Transaction Exposure arises because we do not have a method of accounting for multiple currencies

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Examples of Transaction Exposure include purchasing or selling on credit, goods or services where the price is stated in a foreign currency. Gray, Salter & Radebaugh Chapter 2

Classifying Risk and Exposure Transaction Exposure ❂

How do we handle inherent risks? • Prepare a separate budget for international cash flows. • This will allow you to assess if the volume of unhedged cash flows is significant.

Gray, Salter & Radebaugh Chapter 2

Classifying Risk and Exposure Translation Exposure Translation Exposure is when assets and liabilities on a balance sheet in one currency, have to be re-expressed in another currency . ❂ Accounting for this has caused discord between financial regulators and the business community. ❂

Gray, Salter & Radebaugh Chapter 2

Classifying Risk and Exposure Economic Exposure ❂

Economic Exposure involves uncontracted and unplanned changes in future cash flows which are the result of changes in exchange rates.

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Classifying Risk and Exposure Economic Exposure Cont’d Any decisions based on economic exposure are primarily long term. ❂ These decisions include choosing market and production facility locations. ❂

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