W5

The Risk of International Trade and Foreign Exchange market

David G. Lynn

Financial Risk It is common practice to summarize the financial risks of foreign trade or investment under three headings. Economics

Risk Transaction Risk Translation Risk

Financial Risk  Economics

Risk occurs when there is a risk that actual and forecast cash flows will differ as a consequence of exchange rate movements

Financial Risk Translation Risk Transaction risk is a simple concept, it describes a risk that arises because most goods and services are sold on credit.

Financial Risk 

Example Deere Co. is a well known US-based agricultural and industrial equipment manufacturer, suppose they receive a contract from a German wholesaler for 200 tractors, at price of Eupos 46,000 each. The exchange rate on the date of issue of the invoice is 1 Eur = 0.92 USD. The invoice is paid three months later, when the exchange rate is 1 Eur = 0.90 USD at he exchange rate prevailing at the invoice date, the dollar value of the invoice is 46,000*200*0.92=US 8,464,000 at the exchange rate prevailing at the date of payment, the dollar value of the sum received is 46,000*200*0.9=US 8,280,000 so the second figure is US 184,000 lower than the first.

Financial Risk Translation Risk

The exchange rate risk associated with companies that deal in foreign currencies or list foreign assets on their balance sheets. The greater the proportion of asset, liability and equity classes denominated in a foreign currency, the greater the translation risk.

Financial Risk

This poses a serious threat for companies conducting business in foreign markets. Exchange rates usually change between quarterly financial statements, causing significant variances between the reported figures. Companies attempt to minimize these transaction risks by purchasing currency swaps or hedging through futures contracts.

Political Risk Political Risk is the probability that political forces will negatively affect international cooperation profit or impede the attainment of other critical business objectives.  Macro Political Risk  Micro political Risk (Reading Chapter 13: Political Risk and Negotiation Strategies p357-p359)

Managing Political Risk  Forecasting

Political Risk  Examining the political system  Evaluating products and operations  Quantifying Risk Vulnerability (Reading Chapter 13: Political Risk and Negotiation Strategies p360--p362)

Foreign Exchange Foreign Exchange Market is the world largest financial market. It is the market where one country’s currency is traded for another’s. Most of the trading takes place in a few currencies: the U.S dollar, British pound, Japanese yen, Swiss Franc etc.

Foreign Exchange

The foreign exchange market is an overcounter market. There is no single location where traders get together. Instead, traders are located in the major commercial and investment banks around the world. They communicate using computer terminals. One element in the communication is the Society for World Interbank Financial Telecommunications (SWIFT)

Foreign Exchange  Exchange –

rate

The price of one currency in terms of another.  NZD

/ USD  USD / JPY – –

The first currency is called Base currency The 2nd currency is called quote or counter currency

Foreign Exchange 

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USD/RMB: Refer to the number Deutschemarks equal to 1US dollar. (Called “Indirect” or “European”quotation against dollar) The indirect quotation is the most case in the world DEM/USD: refer to the number of US dollars equal to 1Deutschemarks. Called “Direct quotation against dollar” The code on the left is the base currency, always be 1. On the right is Variable Currency/counter currency/ quoted currency.

Foreign Exchange Key explanation Bank prepared to buy the base currency against the variable currency is called “bid’ for base currency. Bank prepared to sell the base currency against the variable currency is called “offer” of base currency

Foreign Exchange A rate between any two currencies, neither of which is the dollar, called cross-rate. Example: NZD/AUD. A useful website: http://www.hifx.co.uk/currency/converter.asp The difference between the two prices is called spread.

FX:

ISO/SWIFT codes for selected currencies AUD NZD CAD IDR(Currency of Indonesia) JPY PHP GBP(British Pound) THB (Thailand Baht) CHF(Swiss franc) CNY USD INR EUR SGD(Singapore dollar) HKD KRW(currency of south korea) ISO: International Organization for Standardization SWIFT: society for worldwide interbank financial telecommunications

NZD/USD Exchange Rate on 02/08/06

NZD/USD Exchange Rate since August 2005

NZD/USD Exchange Rate since 1988

Foreign Exchange Three types of trades take place in the foreign exchange market:  Spot-exchange rate.  Forward-exchange rate  Swap

Foreign Exchange 

A spot transaction is an outright purchase or sale of one currency for another currency, for delivery two working days after the dealing date (the day on which the contract is made)

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A forward outright is an outright purchase or sale of one currency in exchange for another currency for settlement on a fixed date in the future other than the spot value date.

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Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together

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Foreign Exchange Although forward outright are an important instrument, bank do not in practice deal between themselves in forward outright, but rather in forward swaps

Foreign Exchange Forward outright rate may be seen both as the marker’s assessment of where the spot rate will be in the future, and as a reflection of current interest rates in the two currencies concerned. Forward outright = spot * 〔 1+(variable currency interest rate/year)*days 〕 1+(base currency interest rate/years)*days

Foreign Exchange Example  USD/DEM  Spot rate:1.6876  DEM interest rate 3% for 31 days  USD interest rate 5% for 31 days  Forward outright = 1.6876*(1+(0.03/365)*31) (1+(0.05/365)*31) =1.6847

Foreign Exchange Although forward outright are an important instrument, bank do not in practice deal between themselves in forward outright, but rather in forward swaps. Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together.

Foreign Exchange Example:  1) Spot USD/DEM 1.6874/1.6879  2) Forward outright: 1.7019/1.7029  3) Forward swap:0.0148/0.0150 (1)-(2)

Foreign Exchange Forward swap spot* 〔 (variable currency interest rate/year)*days-(base currency interest rate/years)*days 〕 1+(base currency interest rate/years)*days

Foreign Exchange Example:  31

days DEM interest rate 3%  31 day USD interest rate 5%  Spot USD/DEM: 1.6876 Forward swap: 1.6876*((0.03/365)*31)-(0.05/365)*31) 1+(0.05/365)*31 =-0.187