- •Chapter 3: The international financial marketplace key chapter concepts
- •Glossary of new terms
- •Financial challenge
- •Introduction
- •The global economy and multinational enterprises
- •Table 3—1
- •Table 3—1
- •Foreign currency markets and exchange rates
- •Direct and Indirect Quotes
- •Table 3 — 2 Spot Foreign Exchange Rates
- •Spot Rates
- •Forward Rates
- •Table 3 — 3. Forward Foreign Exchange Rates
- •Foreign Currency Futures
- •Table 3-4. Futures Contract Quotations
- •Foreign Currency Options
- •The Eurocurrency Market
- •Factors that affect exchange rates
- •Covered Interest Arbitrage and Interest Rate Parity
- •Purchasing Power Parity
- •Expectations Theory and Forward Exchange Rates
- •The International Fisher Effect
- •An Integrative Look at International Parity Relationships
- •Figure 3—1. International Parity Conditions: An Integrative Look
- •Forecasting future exchange rates
- •Using Forward Rates
- •Using Interest Rates
- •Foreign exchange risk
- •Transaction Exposure
- •Table 3-5. Example of Transaction Exchange Rate Risk
- •Economic Exposure
- •Translation Exposure
- •Table 3 – 6. Effect of a Decrease in the Exchange Rate on American Products' Balance Sheet
- •International finance and the practice of financial management
- •Ethical issues: payment of bribes abroad
- •Summary
- •Questions and topics for discussion
- •Self test problems
- •Problems
- •Solutions to self test problems
Spot Rates
Exchange rates between U.S. dollars and the currencies of most countries are reported daily in the Wall Street Journal. Table 3-2 lists the (direct quote) exchange rates between U.S. dollars and various currencies as of March 3, 1986, and December 1, 19931. These quotes are for trades made among banks in amounts of $1 million or more. Smaller, retail transactions, usually result in fewer units of a foreign currency per dollar. The quotes in table 3-2 are known as spot rates. Spot rates represent the rate of exchange for currencies being bought and sold for immediate delivery2.
Banks profit from their foreign currency transactions by buying currencies at one rate (bid) and selling them at another, higher rate (ask or offer). For example, a bank may quote the Deutsche Mark at $0.5795 bid, and $0.5807 offer. This quote is often written simply as 0.5795-07. The spread between bid and offer for widely traded currencies is likely to be in the range of 0.1 to 0.5%
Forward Rates
In addition to spot transactions, currencies can also be bought and sold today for delivery at some future tune, usually - 50, 90, or 180 days from today. In these cases, Forward rates are used, rather than spot rates. Forward exchange rates between U.S. dollars and the currencies of several of the major industrial countries also are reported daily in the Wall Street Journal. Table 3-3 lists some forward exchange rates as of December 1, 19Q3.
A comparison of the spot and forward rates in Tables 3-2 and 3-3 shows that the 30, 90 and 180-day forward rates for the British pound, Canadian dollar,
Table 3 — 3. Forward Foreign Exchange Rates
Source: Wall Street Journal (December 2, 1993)
|
EXCHANGE RATE (U.S. DOLLARS) DECEMBER 1, 1993 |
||
Currency |
30-Day Forward |
90 Day Forward |
180-Day Forward |
Pound |
$1.4751 |
$1.4707 |
$1.4650 |
Canadian dollar |
0.7492 |
0.7488 |
0.7473 |
French franc |
0.16778 |
0.16696 |
0.16602 |
Yen |
0.009201 |
0.009212 |
0.009263 |
Swiss franc |
0.6650 |
0.6641 |
0.6637 |
Mark |
0.5791 |
0.5767 |
0.5740 |
French franc, Swiss franc and the German mark are below their respective spot rates, indicating a market expectation that these currencies will lose value relative to the dollar over this time horizon. In contrast, the forward rates for the Japanese yen are above the spot rate ($0.009191/yen), indicating an expectation of increasing value of the yen relative to the dollar.
The premium or discount between the spot rate, S0, and a forward rate, F, for a currency (relative to the dollar, for example) can be expressed on an annualized percentage basis (using direct quotes) as follows:
(3.1)
where n is the number of months in the forward contract. A positive value calculated using Equation 3.1 indicates that a currency is trading at a forward premium relative to the dollar, whereas a negative value indicates a forward discount.
Using the exchange rates from tables 3-2 and 3-3 the following annualized discount for the 180-day forward quote on the Deutsch mark (DM) can be calculated:
Similarly, the annualized premium for the 180-day forward quote on the Japanese yen can be calculated as:
Thus we can say that the DM is trading at a forward discount relative to the dollar (i.e., the dollar is expected to strengthen relative to the DM), and the yen is trading at a forward premium relative to the dollar (i.e., the dollar is expected to weaken relative to the yen).
As shown later in the chapter, firms engaged in international transactions can use the forward foreign exchange market to hedge against the risk of adverse fluctuations in exchange rates.