Chapter 3

Buy, Sell, Risk! Users of Foreign Exchange Markets

In This Chapter

Identifying the participants in foreign exchange markets

Understanding the risk of multinational companies

Understanding the risk of speculators

Diverse groups are involved in foreign exchange markets. This chapter identifies these groups, explains the nature of their involvement, and illustrates the risk associated with their involvement. Numerical examples guide you through the concepts and illustrate the risk taken by various participants in foreign exchange markets.

Identifying Major Actors in Foreign Exchange Markets

Multinational firms, speculators, and central banks are the important participants in foreign exchange markets. Multinational companies operate in different countries and, therefore, deal with a variety of currencies in their daily business. Speculators invest in assets denominated in different currencies and, therefore, buy or sell currencies. Central banks may be engaged in foreign exchange markets to increase or decrease the value of their currency with respect to other currencies.

Multinational firms

The term multinational firm refers to a wide range of domestic firms that are engaged in business with foreign countries in different ways. One point to remember is that, independent of the type of foreign involvement, all multinational businesses deal with exchange rates. You see in this section that multinational companies have to buy or sell foreign currency as part of their daily business. Therefore, these companies face foreign exchange risk every day. A short definition of foreign exchange risk is the possibility of losing money when you buy or sell currency because of unexpected changes in exchange rates. When you learn about the general characteristics of participants in foreign exchange markets in the next section, you can work on numerical examples regarding foreign exchange risk.

Some multinational companies are export or import firms. These companies are engaged in selling domestic goods abroad or buying foreign goods. Therefore, an American company that exports to Germany is a multinational company. So is an American firm that imports from Germany. Exchange rates affect both types of firms. For example, if the American firm bills the German importer in euros, the former receives its payments in euros. But an American firm can’t use euros in its daily business, so it sells euros as soon as it receives them. Conversely, the American firm may bill the German importer in dollars. Then it becomes the German importer’s responsibility to buy dollars and pay the American exporter.

Other domestic firms may be involved in the production of goods in foreign countries in a variety of ways.

Licensing means that a firm provides its technology to another firm abroad in exchange for a fee. Depending on the currency in which the fee is denominated, one of the firms faces the foreign exchange risk.

The September 17, 2012 issue of Pharmaceutical Business Review reported that the Canadian vaccine developer Medicago entered a licensing agreement with the American firm Philip Morris Products (PMP) to allow PMP to use Medicago's proprietary vaccine-manufacturing technologies for developing and manufacturing pandemic and seasonal influenza vaccines in China. Medicago received fees totaling $7.5 million, as well as royalty payments on future sales of pandemic and seasonal influenza vaccines produced by PMP in China.

In this example, you know the amount of the licensing fee, but you don’t know the denomination PMP plans to use. If PMP pays the licensing fee from its dollar accounts in the United States, it doesn’t face an exchange rate risk. But Medicago, a Canadian firm, is going to receive periodic U.S. dollar–denominated payments. If Medicago wants to convert these fees into Canadian dollars, it exposes itself to changes in exchange rates. Alternatively, if PMP pays the licensing fee out of its revenues in China by exchanging yuan into dollars (unless the Chinese government has restrictions on payments denominated in yuan), PMP and Medicago are both exposed to exchange rate risk.

Franchising implies that a domestic firm allows its production, sales, marketing, and management strategies to be used in a foreign market in exchange for a periodic payment. You see such chains as Starbucks, McDonald’s, and Pizza Hut around the world; to open these businesses in other countries, foreign firms need to have franchising agreements with these American ­companies.

The September 7, 2012 issue of Business Day reports that international franchises are opening new locations in Africa, where the demand for their products is strong, unlike in stagnant developed markets. Hilton Hotels, Kentucky Fried Chicken, and fashion retailer Mango are just a few companies that are expanding their franchising in Africa. The franchising industry employs an estimated 500,000 people in Africa, and nearly 700 brands operate franchises there.

If American firms are franchised in Africa, the American firms collect franchising fees from African owners of these franchises. If American firms want to receive their franchising payments in dollars, the African owners face the exchange rate risk. Because their revenues are in local currencies, they need to convert some of their revenues into dollars to pay the franchising fee.

Domestic firms engage in joint ventures with foreign firms. A joint venture is a business arrangement between two businesses to produce a particular good, where these firms share expenditures, revenues, and assets. For example, an American firm may enter a joint venture to test the waters before entering a foreign country on its own. Or an American company may want to use the existing distribution network of a foreign firm to sell its product abroad.

The September 24, 2012 issue of the Washington Post reported that breakfast giant Kellogg formed a joint venture to expand the distribution of its cereals and snacks in China in 2013. Kellogg plans to tap the infrastructure and local expertise of Wilmar International, a Singapore-based agribusiness.

In this case, Kellogg is likely to pay Wilmar for the privilege of using the latter’s infrastructure and expertise. Suppose Kellogg provides these payments in U.S. dollars. This form of payment shifts the exchange rate risk to Wilmar, which has to convert these U.S. dollars into a combination of Singapore dollars and Chinese yuan to pay for the expenses of including Kellogg in its network in Singapore and China.

Domestic firms may buy existing firms abroad, which involves the acquisition of existing foreign firms. An acquisition allows an American firm to enter a foreign market with an existing production facility and a distribution network.

The September 26, 2012 issue of Businessweek reported that Canada’s Onex Corporation was in talks to buy KraussMaffei AG, a German maker of machinery for processing plastics and rubber. Onex reportedly planned to pay €568 million for KraussMaffei, the company’s first European-based acquisition.

In this news article, the payment for the German company is discussed in euros. The Canadian buyer, Onex Corporation, faces exchange rate risk here, especially if acquisition payments are to be made in installments.

Domestic firms establish new subsidiaries in other countries. The term foreign direct investment (FDI) refers to establishing a new production facility, distribution network, management, and so forth in a foreign country.

On September 18, 2012, cnbc.com reported on the global appeal of Mexico for FDI. The country attracted more than $19 billion FDI in 2011, and half of this investment went toward manufacturing. Major automakers, such as General Motors, Nissan, Audi, Honda, and Mazda, recently announced plans to open plants in Mexico during the next few years. Many other companies, including aluminum producer Alcoa, General Electric, Honeywell, Hawker Beechcraft, and Swedish appliance maker Electrolux, already have production facilities in Mexico.

These American, Japanese, and European firms are engaged in FDI, which indicates substantial new investment in a foreign country. Therefore, parent companies have to transfer funds denominated in foreign currency to the FDI-receiving country. Also, depending on the FDI-receiving country’s restrictions, parent companies may receive income/profits from their foreign operations denominated in foreign currency. All these activities imply exchange rate risk.

Speculators

The generic term speculator includes a wide variety of market participants. Foreign exchange traders and brokers make up a relatively small segment among speculators; commercial banks, hedge funds, and other financial companies represent the most important group among speculators. Regardless of type, speculators in foreign exchange markets want to profit from buying currency low and selling it high. In other words, all speculators try to make a profit from fluctuations in exchange rates.

The interbank market, which consists of large commercial banks and financial firms, is a major player in foreign exchange markets. Its activity helps determine the bid (buy) and ask (sell) price of currencies. This market has no trading floor, but banks can trade with each other directly or via electronic brokerage systems that connect market participants.

Multinational companies also engage in speculation because they make or receive payments denominated in various currencies to and from firms around the world. These currencies fluctuate on a daily basis. Therefore, multinational companies are also involved in speculation to hedge against their exchange rate risk.

Central banks

Central banks have a unique place in foreign exchange markets. First, unlike the other groups involved in foreign exchange markets, the central banks’ involvement in foreign exchange markets doesn’t have a profit motive.

Second, central banks’ decisions regarding monetary policy are extremely influential on exchange rate determination. Chapters 5–7 discuss exchange rate determination and how central banks indirectly affect exchange rates through their monetary policy decisions. In every country, central banks are responsible for conducting monetary policy, among their other roles. The main goals of monetary policy are to promote price stability and economic growth. Basically, a central bank addresses the domestic economy’s problems by changing the quantity of money and interest rates, which leads to changes in the exchange rate as well.

Third, central banks can directly affect exchange rates through interventions into foreign exchange markets. A central bank can use its domestic currency and foreign currency reserves to buy or sell foreign currencies directly in the foreign exchange market. Alternatively, central banks may be involved in foreign exchange markets for reasons that aren’t related to their own countries but are related to the common concerns at the international level. For example, several central banks may come together in a joint action in foreign exchange markets to provide liquidity and credit across the world. Chapter 14 shows how central banks directly intervene in foreign exchange markets.

Watching Out for Risk

This section looks at the most important motivation for understanding how exchange rates are determined. When you’re involved in foreign exchange markets in any capacity, you face foreign exchange risk. The following examples show the nature of foreign exchange risk, assuming that you’re a multinational firm or a speculator.

Note that this section doesn’t mention central banks. The reason is that, unlike multinational firms and speculators, central banks don’t have a profit motive. Central banks’ concerns center on the economic performance of the country. Chapter 14 provides examples for central banks’ intervention into foreign exchange markets.

In addition, this section demonstrates only the nature of foreign exchange risk, not how to hedge against it. Chapter 11 examines foreign exchange derivatives that you can use to hedge against exchange rate risk.

FX risk of an exporting firm

Exporting firms may have accounts receivable in foreign currency. The foreign exchange risk of these firms is the possibility of depreciation in foreign currency. In this case, when the exporting firm exchanges foreign currency for the domestic currency, it receives a smaller amount of domestic currency for the same amount of foreign currency.

Suppose you export backpacks to Germany, and your accounts receivable are denominated in euros, totaling €100,000. As an American firm, you don’t use euros in your daily operations. Therefore, as soon as you receive the euros from the German importer — say, a week from now — you plan to convert them into dollars. Suppose that the current dollar–euro rate is $1.28, and you observe the dollar appreciating every day until it reaches an exchange rate of $1.25 a week from now, when you convert the euros to dollars.

Note that the exchange rate used here is the dollar–euro rate. A decline in this exchange rate from $1.28 to $1.25 per euro indicates an appreciation of the dollar because fewer dollars are necessary to buy one euro. If the dollar appreciates against the euro, the euro must depreciate against the dollar. As Chapter 2 explains, you can invert this exchange rate and easily see that the euro depreciates. The euro–dollar exchange rate increases from €0.78 (1 ÷ 1.28) to €0.80 (1 ÷ 1.25) per dollar. Clearly, you need more euros to buy one dollar, which means depreciation of the euro.

If the exchange rate of $1.28 had remained constant, the American firm would have received $128,000 (€100,000 × $1.28). However, because the euro depreciated (or the dollar appreciated), the American firm receives only $125,000 (€100,000 × $1.25).

You may argue that most international trade is denominated in dollars. If this case is true, then somebody else is facing foreign exchange risk — namely, the German importer. Suppose that the German importer of backpacks is supposed to pay you $128,000 for the latest shipment. By using the same exchange rates discussed, a week earlier, the company needed €100,000 ($128,000 ÷ 1.28). But when the euro depreciates (or the dollar appreciates) to $1.25 per euro, the company must spend €102,400 ($128,000 ÷ 1.25) to pay for your backpacks.

FX risk of an importing firm

Importing firms may have accounts payable in foreign currency. The exchange rate risk these firms face is the risk of appreciation in foreign currency. Remember, appreciation of a foreign currency means that a dollar buys fewer units of foreign currency. In this case, the amount of a domestic firm’s payments in foreign currency gets larger.

Suppose your firm imports cheese from France, and your accounts payable are denominated in euros, totaling €100,000. Again, the current dollar–euro rate as $1.28, but suppose that each day the dollar depreciates. Assume an exchange rate of $1.31 a week from now, when you make your payment.

Note that an increase in the dollar–euro rate indicates depreciation of the dollar. When the exchange rate increases from $1.28 to $1.31 per euro, clearly you need more dollars to buy one euro. If the dollar depreciates against the euro, the euro must appreciate against the dollar. Again, you can invert this exchange rate and easily see that the euro appreciates. The euro–dollar exchange rate decreases from €0.78 (1÷ 1.28) to €0.76 (1 ÷ 1.31) per dollar. Clearly, you need fewer euros to buy one dollar, which means an appreciation of the euro.

If the initial exchange rate had remained the same, you would have paid $128,000 (€100,000 × $1.28) for the imported French cheese. However, because the euro appreciated, now you have to pay $131,000 (€100,000 × $1.31) for your imports.

Again, if your accounts payable are denominated in dollars, then the French exporter faces the foreign exchange risk. Suppose you have to pay $128,000 to the French firm for the latest shipment of cheese. By using the same exchange rates, a week earlier, the French firm would have received €100,000 ($128,000 ÷ 1.28) as payment. But when the dollar depreciates to $1.31, it receives €97,710 ($128,000 ÷ 1.31).

FX risk in a domestic company–foreign subsidiary setting

If a domestic firm is involved in foreign operations in any way, such as a joint venture or FDI, funds flow between the domestic and foreign firms. These funds may involve the domestic firm’s provision of money to a foreign partner or subsidiary, or the domestic firm may receive income or profits from its foreign subsidiaries.

In terms of the outgoing funds to the subsidiary, the domestic firm may have to provide these funds in foreign currency. In this case, the domestic firm faces the exchange rate risk, which lies in the appreciation of the foreign currency. Suppose an American firm has a subsidiary in Indonesia and plans to wire Rp100,000,000 to the subsidiary for the expansion of the production facility (Rp stands for the Indonesian rupiah). If the current rupiah–dollar exchange rate is Rp9,575 and remains the same for another week until the American firm sends the money, it costs the American firm $10,444 (Rp100,000,000 ÷ 9,575). But if the rupiah appreciates in a week from Rp9,575 to Rp9,250 per dollar, the American firm has to pay $10,811 (Rp100,000,000 ÷ 9,250) for the same amount of rupiah.

Now if the American firm expects some of the profits from its Indonesian operation, the exchange rate risk lies in the depreciation of the rupiah. Suppose the amount of funds coming from the subsidiary in a week is Rp150,000,000. By using the same current exchange rate of Rp9,575, and assuming that the exchange rate doesn’t change in a week, the American firm receives $15,666 (Rp150,000,000 ÷ 9,575). However, if the rupiah depreciates to Rp9,950, the firm receives $10,050 (Rp100,000,000 ÷ 9,950).

Speculation: Taking a Risk to Gain Profit

This section provides insight into speculation with exchange rates. Speculation involves profiting from the change in the price of an asset. No matter what kind of asset you consider, the desired change in price is an increase when you sell it. In other words, all speculation involves buying low and selling high.

Currencies can also be bought and sold for a profit. Types of speculation with exchange rates differ, but they all have one thing in common: an expectation regarding the change in the exchange rate in the near future. Other than this expectation, your aim is always to buy low and sell high, as in the case of all speculation. Of course, you can buy and sell currency in spot markets or derivative markets. In spot markets, assets are traded for immediate delivery. In other words, if you can buy or sell euros now, it means you’re trading in a spot foreign exchange market. In derivative markets, although the agreement is done today, the actual transaction (the buying or selling of foreign currency) takes place at a future date (for example, two months from now). Chapter 11 examines various types of derivatives markets and their use in both speculation and hedging. For simplicity, this chapter deals only with spot foreign exchange markets.

The following numerical examples involve a little more than just buying or selling foreign currencies. As before, the change in the exchange rate remains important because you’re buying or selling currencies. But when you speculate with foreign currencies, you may want to earn interest on foreign currency while you’re holding it. For simplicity, the following examples assume that you want to buy a foreign currency and put it in an interest-earning account. Now this doubles the sources of your profits: You can make money from the changes in the exchange rate and the interest earned on the foreign currency.

The following section includes two numerical examples about speculating with exchange rates. In the first example, the speculator makes a profit. In the second example, the speculator experiences a loss.

When speculation goes right

Suppose USA Bank expects the Swiss franc (SFR) to appreciate from $1.069 to $1.112 a year from now. USA Bank borrows $10,000,000 at an interest rate of 1.5 percent for a year, converts it into Swiss francs at the current rate, and deposits the funds into a Swiss bank account at Helvetica Bank for a year at an annual interest rate of 1.75 percent. A year from now, USA Bank withdraws the Swiss francs, converts them into dollars in the future spot market, and hopes to make a profit.

Now you see the translation of each step into equations. At the end of the calculations, you see how much money the USA Bank makes in this transaction. Here are the steps in calculating the bank’s profits:

1. USA Bank converts $10,000,000 into Swiss francs at the exchange rate of $1.069 and receives SFR9,354,537 ($10,000,000 ÷ 1.069).

2. USA Bank deposits SFR9,354,537 into a savings account with Helvetica Bank for a year at an annual interest rate of 1.75 percent. Therefore, you need to calculate how much money USA Bank receives from the Swiss bank a year from now.

At this point, you need a formula that relates an amount of money that you currently hold to its future value, assuming that this money will earn interest for a year. The formula that relates the future value (FV) to the present value (PV) is:

The previous formula indicates that the future value is greater than the present value by the interest factor (1 + R). Suppose that you currently have $100, which is the present value (PV). In a year, you want today’s $100 to become $110, which is the future value (FV). Plug these numbers into the equation:

$110 ÷ $100 = 1 + R = 1.1

Note that dollars cancel in the equation. Future value is 10 percent greater than present value, indicating an interest rate (R) of 10 percent.

Now you can manipulate the basic formula, depending upon what is unknown in a situation. In the USA Bank example, you know the present value (PV) and the interest rate (R). Therefore, the unknown variable is the future value (FV). The next formula shows that the future value (FV) equals the present value (PV) multiplied by the interest factor (1 + R):

Now you can plug in the known variables in the previous equation. You know that USA Bank has SFR9,354,537 and that the annual interest rate is 1.75 percent. Therefore, the future value is:

FV = SFR9,354,537 × (1+0.0175) = SFR9,518,241

So USA Bank will receive SFR9,518,241 a year from now.

3. Suppose USA Bank is correct in its expectation, and the Swiss franc does appreciate to $1.112 a year from now. Therefore, USA Bank withdraws SFR9,518,241 from Helvetica Bank, converts it into dollars, and receives $10,584,284 (SFR9,518,241 × $1.112).

4. But wait! USA Bank still needs to pay off its loan a year from now at the interest rate of 1.5 percent. Here you can also use the future value formula, where the present value is the amount of the loan, $10,000,000, and the interest rate is 1.5 percent:

5. Therefore, after paying off the loan, USA Bank has a profit of $434,284 ($10,584,284 - $10,150,000). To calculate USA Bank’s rate of return on this speculation, calculate the percent change between the amount of money the bank received and paid:

This result suggests that USA Bank received an annual rate of return (or profit) of 4.28 percent from this speculation. But be careful when you call it a profit. In this example, you’re not provided with alternative investment opportunities for USA Bank in the U.S. or elsewhere. As long as the rate of return USA Bank would have received in the U.S. or anywhere in the world is below 4.28 percent (holding the risk constant), this example shows speculation that went right.

The previous speculation example involves a period of one year. But USA Bank may want to consider a shorter time period. What if USA Bank deposited the money with Helvetica Bank for only 60 days and the expected exchange rate of $1.112 refers to the exchange rate expected 60 days from now? In this case, the previous formula for the future value calculation needs to be adjusted. In fact, you want to apply the adjustment to the interest rate because the interest rate is an annual rate, but USA Bank wants to keep its Swiss Francs at Helvetica Bank for only 60 days.

The next future value formula applies the ratio of 60 days to 360 days (60 ÷ 360 = 0.17) to the annual interest rate, essentially lowering the annual interest rate. Also note that using the 360-day year is common practice in international finance.

Given the data:

This time, USA Bank receives SFR9,381,821 at the end of 60 days. Assume that USA Bank is correct in its expectation, and the Swiss franc appreciates to $1.112 in 60 days. Then USA Bank makes SFR9,381,821 at Helvetica Bank, converts it into dollars, and receives $10,432,585 (SFR9,381,821 × 1.112). USA Bank pays off its 60-day loan at the annual interest rate of 1.5 percent:

Therefore, USA Bank’s profit from this speculation is $407,585 ($10,432,585 – $10,025,000). In fact USA Bank’s rate of return on this speculation is

or 4.07 percent.

When speculation goes wrong

Now you see how USA Bank can lose money in speculation. As in the previous example, USA Bank expects an appreciation of the Swiss franc (SFR) from $1.069 to $1.112 in 60 days. USA Bank borrows $10,000,000 at an interest rate of 1.5 percent for 60 days, converts it into Swiss francs at the current rate, and deposits the funds into an account at Helvetica Bank for 60 days at an interest rate of 1.75 percent. At the end of the 60-day period, USA Bank converts its Swiss francs into dollars.

Therefore, most of your calculations associated with the previous example are also correct here, meaning that USA Bank converts $10,000,000 into Swiss francs and receives SFR9,354,537. Then it deposits the money with Helvetica Bank for 60 days at an interest rate of 1.75 percent. At the end of the 60-day period, USA Bank receives SFR9,381,821.

But suppose that USA Bank is wrong this time in terms of its expectations regarding the future spot rate. As USA Bank withdraws SFR9,381,821 from Helvetica Bank, it observes that the Swiss franc has depreciated from $1.069 to $1.059 instead of appreciating to $1.112. In this case, USA Bank receives $9,935,348 (SFR9,381,821 × 1.059), which is less than the payment due on the loan ($10,025,000). In this case, USA Bank suffers a loss of $89,652 ($9,935,348 – $10,025,000).