Foreign Currency Management

Exchange RateThis is the rate at which the currency of one country would change hands with currency of another country.

E.g. $1 = SLR 130

Types of Exchange Rate

1. Floating RateThis rate depends on a levels of the international trade of a country and it does not interfere with the government of that country.

2. Fixed RateThis is the rate that the government of the country would set its own currency rate and it is not depending on the market rate.

3. Dirty FloatThis is the rate that mixed between floating rate and fixed rate system. This is where the government would allow exchange rate to float between a particular two limits. If it goes outside either of the limit, then the government would take further action.

Forex Dealings

1. Bid PriceThe price at which the currency is bought by the dealer.

2. Offer PriceThe price at which the currency is sold by the dealer.

When regarding the forex dealings,

Offer Price > Bid Price

Example 01:

David is a UK businessman. He needs $ 400,000 to buy US equipment.Identify the amount of £ required to buy the Dollars? ($/£ 1.75 - 1.77)

Answer:

The amount of £ required = $ 400,000 $/£ 1.75

= £ 228571.43

Example 02:

James is a US businessman. He has just received a payment of £ 150,000 from his main customer in UK.Identify the amount of $ received by James when £ 150,000 are given? (£/$ 0.61 – 0.63)

Answer:

The amount of $ received = £ 150,000 £/$ 0.63

= $ 238095.24

Spot Rate and Forward Rate

Spot Rate

This is the rate which is applicable for the immediate delivery of currency as at now.

Forward Rate

This is a rate that set for the future transaction for a fixed amount of currency. The transaction would take place on the future date at this agreed rate by disregarding the market rate.

Discounts & PremiumsDiscountsIf the forward rate which is quoted cheaper, then it is set to be quoted at a discount.E.g. $/£ current spot is 1.8500-1.8800 and the one month forward rate at 0.0008-0.0012 at a discount.Answer: 1.8500-1.8800 + 0.0008-0.0012 = 1.8508-1.8812

When quoted at a discount, their should be more Dollars being received at a given Pound. So the discount factor have to be added to the spot rate.

Premiums

If the forward rate which is quoted more expensively, then it is set to be quoted at a premium.E.g. $/£ current spot is 1.9000-1.9300 and the one month forward rate at 0.0010-0.0007 at a premium.Answer: 1.9000-1.9300 - 0.0010-0.0007= 1.8990-1.9293

When quoted at a premium, their should be less Dollars being received at a given Pound because of the expensiveness of Dollars. So the premium factor have to be deducted from the spot rate.

Foreign Exchange Rate Risks

1. Transaction Risk

This is the risk that adverse exchange rate movement occurring in the cause of normal international trading transaction. This arises when the prices of imports or exports are fixed in foreign currency terms and there is a movement in the exchange rate between the date when the price is agreed and when the cash is paid or received.

2. Translation Risk

This is the risk that the organization will made exchange losses when the accounting results of its foreign branches or subsidiaries translated into the local currency.

3. Economic Risk

This is the risk that suppose to a effect of exchange rate movements on the international competitiveness of the company.

4. Direct & Indirect Currency Quotes

Direct Quote:This means the exchange rate is mentioned in terms of the amount of domestic currency which needs to be given in returns for one unit of foreign currency.

E.g. SLR 130 for $1

Indirect Quote:This means the amount of foreign currency units that needs to be given to obtain one unit of domestic currency.

E.g. $ 1/130 for SLR 1

Example 01

ABC Ltd is a US company, buying goods from Sri Lanka which cost SLR 200,000. These goods are resold in the US for $2000 at the time of the import purchased. The current spot rate is $1 = SLR 126-130.

Calculate the expected profit of the resale in terms of US Dollars using both direct & indirect quote methods.

Answer:

1.) Under Direct Quote Method $/SLR = 1/126 - 1/130

= 0.00794 – 0.00769 Sales = $2000(-)Purchase Cost=SLR200,000*$/SLR0.00794 =($1588) Expected Profit = $412

2.) Under Indirect Quote Method Sales = $2000(-)Purchase Cost=SLR200,000/SLR126/$ =($1587) Expected Profit = $413

Managing the Exchange Rate Risk1. Invoicing in domestic currency

Since the exporter does not have to do any currency transaction in this method, the risk of currency conversion is transferred to the importer or vice versa.

2. Money Market HedgingBecause of the close relationship between forward exchange rate and the interest rate in two currencies, it is possible to calculate a forward rate by using the spot exchange rate and money market lending or borrowing which is called as a money market hedge.

3. Entering into Forward Exchange Rate ContractsA person can enter into an agreement with a bank to purchase the foreign currency on the fixed date at a fixed rate.

4. Matching receipts & paymentsUnder this method a company can set off its payments against its receipts in that particular currency.

5. OptionsThese are similar to forward trade agreements, but the consumer can choose between the bank’s rate and the market rate.

Example 01A Sri Lankan company has to settle $800,000 after three months time. The current spot rate is $1 = SLR 126-130. The foreign currency depositing interest rate is 12%per annum and the borrowing rate in Sri Lanka is 8% per annum. The agreed exchange rate with the bank is $1 = SLR128.The company has identified to overcome the exchange rate under Money Market Hedging & Forward Exchange Rate Contract methods.Identify the cheapest method to overcome the exchange rate risk.

Answer:1.) Using Money Market Hedging Method

FV = PV* (1+r)n r = 0.12*3/12 PV = $800,000* (1+ 0.03)-1 r = 0.03 PV = $776,699 n = 1

Purchase Cost(SLR) = $776,699*SLR130/$1 = SLR 100,970,870

Interest Cost(SLR) = SLR 100,970,870*0.08*3/12 = SLR 2,019,417

Total Cost(SLR) = SLR(100,970,870+2,019,417) = SLR 102,990,287

2.) Using Forward Exchange Rate Contract Method

Total Cost (SLR) = $ 800,000*SLR128/$1 = $102,400,000

The best method is forward Exchange Rate Contract Method, because it gives the lowest total cost when compare to Money Market Hedging Method.

Reasons for Short Term Changes of Exchange Rate

1. Investment FlowsIf a country does more investment to outside countries, then there would be a higher demand for foreign currency. Therefore the domestic will depreciated or vice versa.

2. Trade FlowsIn a given time if a country has more imports and less exports, the domestic currency will depreciated, because of the higher demand for the foreign currency or vice versa.

3. Economic Prospectus

If a country has good economic policies and is showing shines of economic growth, it could receive more investment and therefore the domestic currency would appreciated.

Reasons for Long Term Changes of Exchange Rate

1. Purchasing Power Parity TheoryThis theory describes how the differences in inflation rate among two countries would lead to changes in the exchange rates.

Future Rate(A/B)=Spot Rate(A/B) * (1+ Inflation Rate of A) (1 +Inflation Rate

of B)2. Interest Rate Parity Theory

This theory links the future currency rates with differences in interest rate among two countries.

Future Rate(A/B)=Spot Rate(A/B) * (1+ Interest Rate of A) (1 +Interest Rate

of B)

3. Monetarist Theory

This theory identifies the relationship between exchange rate and the government money supply to an economy of one country.

E.g. When the government released more money to their economy, individual would have more money. So they would purchased more, the demand will increased & through that result in higher prices & high inflation.

This would lead to a high level of depreciation to the currency.

4. Keynesian ApproachThis theory says that an exchange rate may not change in a balance and sometimes currency may continuously appreciate or depreciate without reverse.

E.g. There is a high taste & demand for imported product in one country while their exports are losing its export position in other countries.

Therefore, without any appreciation of currency will continuously depreciate over a long time period in that country.