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More Winter ahead…. Foreign Currency. What is it? Why does it change? Risk for international managers How to manage risk. Linkage Between Currencies. World Market for Euros. World Market for Dollars. Price = $ / €. Price = € / $. S. S. € .77 / $. $1.30 / €. D. D.

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Foreign currency l.jpg
Foreign Currency

  • What is it?

  • Why does it change?

  • Risk for international managers

  • How to manage risk


Linkage between currencies l.jpg
Linkage Between Currencies

World Market

for Euros

World Market

for Dollars

Price = $ / €

Price = € / $

S

S

€.77 / $

$1.30 / €

D

D

Same “market”…different perspective.


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Trade, FDI, and the Economy

Computers

  • Increase demand for Japanese computers – trade deficit

  • Increase demand for computer inputs (components, labor, etc.) – inflationary

  • Increase demand for Yen – appreciates

  • Stronger Yen increases U.S. prices – decreases demand for Japanese computers

Cash $$


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German Market for BMWs

S

Price in Euros

€ 100,000

D


Global market for bmws americans want to import bmws l.jpg
Global Market for BMWs:Americans want to import BMWs

S

Pricein Euros

€ 110,000

€ 100,000

D’

D


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World Market for Euros

S

Price in Dollars

$0.77 / €

D


World market for d marks americans need to convert dollars to euros l.jpg
World Market for D-Marks:Americans need to convert Dollars to Euros

Price = $ / €

S

$0.74 / €

$0.77 / €

D’

D


Linkage between currencies9 l.jpg
Linkage Between Currencies

World Market

for Euros

World Market

for Dollars

Price =

$ / €

Price =

€/ $

S

S

$0.77/ €

€ 1.30/$

D

D


Linkage between currencies10 l.jpg
Linkage Between Currencies

World Market

for Euros

World Market

for Dollars

Price =

$ / €

Price =

€/ $

S’

S

S

$0.74/ €

$0.77/ €

€ 1.30/$

€ 1.35/$

D’

D

D


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Other Forces Causing Change

  • Foreign Direct Investment

  • Foreign Portfolio Investment

    • MNCs

    • Government Debt Instruments

  • Currency Arbitrage and Speculation

  • Governmental Intervention

    • Official and Unofficial “pegs”

    • International Agreements (e.g., G-7, the Euro)

    • Posturing (e.g., “talking” the dollar down)


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Index of Swiss Franc vs. Dollar1990 = 100

2000

1980

1990



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The Big Mac Index

www.economist.com


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Short-term F/X Management

  • Currency Hedges

    • Forward Contracts

    • Options

    • Negotiation of Ratcheted Pricing Schedule

  • Adjustment of Prices and Target Profits

    • Lower foreign prices to keep market share when home currency appreciates … lowers profit margin

    • Raise foreign prices to keep profit margins when home currency depreciates … less price competitive


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Today: US Dealer to Import BMWs

  • Sales Contract:

    • Quantity: 100 BMW 750s

    • Price: € 100,000 each

    • Payment: Due in 3 months

  • Value of Sales Contract =

    • € 10.0 million

    • Spot Rate = $1.30 / €

    • $13.0 million


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In Three Months: Payment is DueUncovered Transaction

  • Euro appreciates

    • New spot rate = $1.35 / €

    • € 10.0 million

  • Adjusted Value of Sales Contract

    • “Risk penalty” = $0.05 per € traded

    • $13.5 million

  • US Dealer’s Loss = $500,000


Today us dealer to import bmws hedged transaction l.jpg
Today: US Dealer to Import BMWsHedged Transaction

  • Sales Contract:

    • Quantity: 100 BMW 535s

    • Price: € 100,000 each

    • Payment: Due in 3 months

  • Value of Sales Contract =

    • € 10 million

    • at 90-day Forward Rate = $1.305 / €

    • “Insurance premium” = $0.005 per € traded

    • $13.05 million


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In Three Months: Payment is DueHedgedTransaction

  • Euro appreciates

    • New spot rate = $ 1.35 / €(Doesn’t matter!!!)

    • € 10 million

  • Adjusted Value of Sales Contract

    • Locked-in Forward Rate = $ 1.305 / €

    • $13.05 million

  • Cost of Hedge (insurance premium) = $50,000


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In Three Months: Payment is DueHedged Transaction

  • Euro Depreciates

    • New spot rate = $ 1.25 / €

    • € 10 million

  • Adjusted Value of Sales Contract

    • Locked-in Forward Rate = $ 1.305 / € (Spot better!!)

    • $12.5 million

  • Currency Windfall - Cost of Hedge = $450,000


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Medium-Term F/X Management

  • Balance sheet hedge

    • Match foreign assets with same level of foreign liabilities in same currency

  • Cash flow hedge

    • Match foreign A/P with A/R in same currency


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Long-Term F/X Management

  • Shift sourcing and procurement

  • Shift production

  • Cut costs / improve productivity


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