Final term Topic 2

Foreign Exchange
 Economic Policies
Monetary Policy: It is a financial tool that is used by the central banks in
regulating the flow of money and the interest rates in an economy. The
instruments are interest rate and money supply
• Expansionary monetary policy meaning lowering the interest rate and
increasing the money supply- contractionary just vice versa
• Contractionary monetary policy meaning increasing the interest rate and
decreasing the money supply
• Central bank of the country and focus is stabilizing the economy – also
impacts on the exchange rate
• Monetary policy targets inflation in an economy, therefore has an impact
on the borrowing in an economy
 Economic Policies
Fiscal Policy: It is a financial tool that is used by the central government in
managing tax revenues and policies related to expenditure for the benefit of
the economy
• Expansionary fiscal policy meaning lowering the tax and increasing the
government expenditure
• Contractionary fiscal policy meaning increasing the tax rate and decreasing
the government expenditure
• Ministry of Finance of an economy and focus is growth the economy

• Fiscal policy has an impact on the budget deficit (trade surplus , trade
deficit, budget surplus, budget deficit)
 Why do we have capital markets? What is their function?

A capital market brings together those who want to invest money and those
who want to borrow money. Those who want to invest money include
corporations with surplus cash, individuals, and nonbank financial institutions
(e.g., pension funds, insurance companies). Those who want to borrow
money include individuals, companies, and governments. Between these two
groups are the market makers. Market makers are the financial service
companies that connect investors and borrowers,
Why do we need a global capital market? Why are domestic
capital markets not sufficient?

A global capital market benefits both borrowers and investors. It benefits

borrowers by increasing the supply of funds available for borrowing and by
lowering the cost of capital.

It benefits investors by providing a wider range of investment opportunities,

thereby allowing them to build portfolios of international investments that
diversify their risks.
The Borrower’s Perspective: Lower
Cost of Capital
In a purely domestic capital market,
the pool of investors is limited to
residents of the country. The Investor’s Perspective: Portfolio
for greater liquidity and a lower cost Diversification
of capital, By using the global capital market,
investors have a much wider range of
investment opportunities than in a
purely domestic capital market. The
most significant consequence of this
choice is that investors can diversify
their portfolios internationally
 Currency Convertibility
Currency conversion: Currency conversion is the process that facilitates
transactions where the issuer and acquirer use different currencies by
exchanging one type of currency for another.
Freely Convertible: A currency is said to be freely convertible within countries
if the Government allows both residents and non-residents to purchase
unlimited amounts of foreign currency with it.

Extremely Convertible: A currency is said to be externally convertible when

only non-residence can convert into a foreign currency without any
limitations
Non Convertible: A currency is nonconvertible where neither residence
non-non-residents are allowed to convert it into a foreign currency
 Capital Flight
Capital Flight: Governments Typical impose convertibility restrictions on the
currency because of the fear that free convertibility we lead to a run on their
foreign exchange reserves. This occurs when residents and non-residence rush to
convert their holdings of domestic currency into a foreign currency and this
phenomenon is Generally referred to as capital flight.

Capital flight is most likely to occur when the value of domestic currency is
depreciating rapidly because of hyperinflation
 Countertrade
Countertrade:
companies can deal with non-convertibility problems by engaging in
countertrade. countertrade refers to a range of barter, like agreements, with
important goods and services can be traded for other goods and services

countertrade can make sense when are countries currency is nonconvertible

 Fixed vs. floating
A fixed exchange rate denotes a nominal exchange rate that is set firmly by
the monetary authority with respect to a foreign currency or a basket of
foreign currencies.

By contrast, a floating exchange rate is determined in foreign exchange

markets depending on demand and supply, and it generally fluctuates
constantly.
 Fisher Effect
Fisher Effect: Fisher's equation reflects that the real interest rate (r )can be
taken by subtracting the expected inflation rate ( I) from the nominal interest
rate ( I). i= r+I

Nominal interest rates reflect the financial return an individual gets when they deposit
money. For example, a nominal interest rate of 10% per year means that an individual will
receive an additional 10% of their deposited money in the bank.

if the nominal interest rate on a savings account is 10% and the expected rate of inflation is
7%, then the money in the savings account is really growing at 3%. The smaller the real
interest rate, the longer it will take for savings deposits to grow substantially when
observed from a purchasing power perspective.
 Exchange rate and risks
Exchange rate: The exchange rate of a currency is how much of one currency
can be bought for each unit of another currency. Occurs when a company buys products
• Appreciating /depreciating situation from a supplier in another country, and
price is provided in the supplier’s currency.
If the supplier’s currency appreciates vs.
Transactions the buyer’s currency, the buyer will have to
Transaction
risks pay more in its base currency to meet the
contracted price. Essentially, the time delay
between transaction and settlement is the
source of Transaction risk can be mitigated
Exchange rate Translational
Types
risks of risk Translation
risks
using forward contracts and options.

Economic risks
Economic
 Exchange rate and risks
Translation risk: the risk that a Economic Risk: is the risk that a
company’s equities, assets, liabilities or company’s market value is impacted by
income will change in value as a result unavoidable exposure to exchange rate
of exchange rate changes. fluctuations. Such a type of risk is
This risk occurs because subsidiaries of usually created by macroeconomic
a parent company in another country conditions such as geopolitical
denominate their currency in the instability and/or government
countries where they are located. The
regulations.
parent company faces potential losses
when it must translate the subsidiaries’
financial statements into its own
country’s currency.
 Foreign exchange risks resolutions
Establish a forward contract with a bank or foreign exchange service
provider.
As the most direct and common method for managing foreign exchange risk,
this option ensures that a U.S. exporter will receive a predetermined payment
in U.S. dollars even if the rate fluctuates.
Forwardcontract
Forward contract A Forward Contract is an arrangement that allows you to transfer money at some
time (up to 12 months) in the future at an exchange rate that you agree to now,

A legal agreement to buy or sell a particular commodity asset, or security at a

future
Future predetermined price at a specified time in the future.

options Grants its owner the right to buy or sell a certain amount of a stock or asset at a
Option certain price on or before a specific date.

This is an agreement in which two parties agree to exchange (or swap) cash flows
swap
SWAP or other financial instruments over multiple periods.
 Lead and Lag Strategy
Lead Strategy: Lead strategy involves attempting to collect foreign currency
receivables payments from customers early If a foreign currency is expected
to depreciate and paying the foreign currency payables to suppliers before
they are due in currency is expected to appreciate

A lag strategy involves delaying collection of foreign currency receivables if

that currency is expected to appreciate and delaying payables if, the currency
is expected to depreciate
 Lead and Lag Strategy
leading and lagging involved at accelerating payments from weak currency to
strong currency countries, and dealing inflows from strong currency to weak
currency countries

leading and lagging strategies can be difficult to implement, however, the

firms be in a position to say some control over payment terms they do not
always have the same kind of bargaining power when particularly dealing
with an important customers who is in a position to dictate payment terms

Many governments limit leading and lagging. For example, some countries set
180 days as a limit for receiving payments for exports and making payments
for imports.
 Related Theories
Purchasing power parity: The theory aims to determine the adjustments
needed to be made in the exchange rates of two currencies to make them at
par with the purchasing power of each other. In other words, the expenditure
on a similar commodity must be same in both currencies when accounted for
exchange rate. The purchasing power of each currency is determined in the
process.

The law of one price: The theory states that states that the price of an
identical asset or commodity will have the same price globally, regardless of
location, when certain factors are considered. The law of one price is an
economic concept
 Math 1
Let's consider an example using hypothetical prices of Big Mac burgers in
two countries, Country A and Country B:

Price of a Big Mac in Country A: $5

Price of a Big Mac in Country B: €4

Assuming the current exchange rate is $1 = €0.70, calculate the implied

exchange rate based on the price of Big Macs in each country (using Big Mac
Index) and suggest which currency will depreciate.
 Math 2
You just came back from Canada, where the Canadian dollar was worth
£0.43. You still have C$200 from your trip and could exchange them for
pounds at the airport, but the airport foreign exchange desk will only buy
them for £0.40.

in your transit the airport foreign exchange desk will sell you pesos for
£0.055 per peso with pounds.

You met a tourist at the transit who is from Mexico and is on his way to
Canada. He is willing to buy your pounds for 1500 New pesos. Should you
accept the offer or cash the Canadian dollars in at the airport? Explain.
 Math 3
A U.S. company that imports laptop computers from Japan knows that in 30
days it must pay yen to a Japanese supplier when a shipment arrives. The
company will pay the Japanese supplier ¥200,000 for each laptop computer,
and the current dollar/yen spot exchange rate is $1 = ¥120. The importer
knows she can sell the computers the day they arrive for $2,000 each.

If over the next 30 days the dollar unexpectedly depreciates against the yen,
say, to $1 = ¥95, how much will be the loss for the U.S. company? Should
the go for the transaction?
 Math 4
In the previous example, if the 30-day forward exchange rate is ¥110/$, how
much profit the supplier would make? What about $1 = ¥130?