F/X Exposure

1
More Winter ahead
2
Trade, FDI, and the Economy
Cash
T-bills, assets

• U.S. trade deficit offset by capital surplus
• U.S. attracts FDI reduces U.S. imports

3
Foreign Currency

• What is it?
• Why does it change?
• Risk for international managers
• How to manage risk

4
Linkage Between Currencies
World Market for Euros
World Market for Dollars
Price /
Price /
S
S
.77 /
1.30 /
D
D
Same marketdifferent perspective.
5
Trade, FDI, and the Economy
Computers
Cash

• 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

6
German Market for BMWs
S
Price in Euros
100,000
D
7
Global Market for BMWsAmericans want to import
BMWs
S
Price in Euros
110,000
100,000
D
D
8
World Market for Euros
S
Price in Dollars
0.77 /
D
9
World Market for D-MarksAmericans need to
convert Dollars to Euros
Price /
S
0.74 /
0.77 /
D
D
10
Linkage Between Currencies
World Market for Euros
World Market for Dollars
Price /
Price /
S
S
0.77/
1.30/
D
D
11
Linkage Between Currencies
World Market for Euros
World Market for Dollars
Price /
Price /
S
S
S
0.74/
1.30/
0.77/
1.35/
D
D
D
12
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)

13
Index of Swiss Franc vs. Dollar1990 100
2000
1990
1980
14
Depreciating Peso
15
The Big Mac Index
www.economist.com
16
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

17
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

18
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 Dealers Loss 500,000

19
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

20
In Three Months Payment is Due Hedged
Transaction

• Euro appreciates
• New spot rate 1.35 / (Doesnt matter!!!)
• 10 million
• Adjusted Value of Sales Contract
• Locked-in Forward Rate 1.305 /
• 13.05 million
• Cost of Hedge (insurance premium) 50,000

21
In Three Months Payment is Due Hedged
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

22
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

23
Long-Term F/X Management

• Shift sourcing and procurement
• Shift production
• Cut costs / improve productivity