978-0077861667 Chapter 9 Lecture Note Part 2

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1.1.1.1 Net exposure

The dollar value of foreign currency assets is at risk from falling exchange rates and the dollar

value of foreign currency liabilities is at risk from rising foreign currency values. Net exposure

is the value of exposed assets minus the value of exposed liabilities. If this calculation is positive

the firm has a net exposure to falling exchange rates, if negative the firm’s dollar value will be

reduced by rising foreign currency values.

Net exposure can be hedged on or off the balance sheet. For example if a U.S. firm has a net

liability exposure to the pound in Britain, the firm can either acquire pound assets (an on balance

sheet hedge) or buy the pound forward (an off balance sheet hedge) to offset the liability.

Teaching Tip: Larger firms centralize their exchange risk management and net their exposures

across subsidiaries. Because currency values are related, additional netting across currencies can

be done and not all exposures have to be individually hedged. Newer risk assessment methods

such as Value at Risk (VAR) can be used to improve hedging efficiency by accounting for the

correlation among currencies.

Teaching Tip: Diversification and operating in multiple markets can limit a company’s exposure

to changing market conditions, including exchange rates. For instance, in the fourth quarter of

2007, Toyota Motor Corp had a net profit increase of 7.5%, largely due to strong sales in China,

Russia and other emerging markets even though U.S. profits were down and the yen value of

U.S. profits was also reduced due to the dollar’s weakness.1 The text provides other example of

foreign currency effects on earnings.

The text provides examples of simple currency trades and of banks exploiting covered interest

arbitrage opportunities although this term is not used. For instance, a U.S. bank may wish to

convert dollars to euros and make a loan in euros in France if the French loan rate is above the

U.S. dollar loan rate. This will leave the bank exposed to a depreciating euro. The bank could

cover the future receipt of euros by selling the euro forward. This will be profitable to the bank

as long as the percentage difference in the forward and spot rates for the euro is less than the

difference in U.S. and French loan rates.

Numerical example of currency arbitrage:

A currency quote in the U.S. for the £ is £1 = $1.8302 – $1.8409. The first number is the dealer’s

bid price, the latter is the dealer’s ask. A similar quote for the dollar in London may be $1 =

£0.5252 – £0.5288. A currency trader could take advantage of these quotes by selling dollars and

buying the pound at the U.S. quote at the ask price of $1.8409 / £. This will yield 1/$1.8409 =

£0.5432 per dollar exchanged. The trader can simultaneously buy dollars (sell pounds) at the

London ask of £0.5288. This will give £0.5432 / £0.5288 = $1.0272. The trader can accomplish

these trades risklessly in a matter of moments. This works because the dollar is valued more

highly at the U.S. quote where the trader sold dollars and bought pounds.

1 “Toyota’s Emerging-Market Push Pays Off: Net Profit Rises 7.5% as China, Russia Offset

North America Decline,” by John Murphy, February 6, 2008, The Wall Street Journal Online,

Page A12.

Numerical example of covered interest arbitrage:

A bank has borrowed $1 million at 4% for one year (bullet borrowing). It can convert the dollars

to euros at a spot exchange rate of $1.20 per euro. Annual interest rates on euro denominated

deposits are 5% and the one year forward rate to sell euros against the dollar is $1.19

The transactions of the arbitrage are

1. Borrow $1 million at 4% for one year. In one year the bank will owe $1 mill * 1.04 =

$1,040,000

2. Convert the $1 million to euro today at the spot of $1.20 / euro:

$1,000,000 * € / $1.20 = €833,333

3. Invest the euros in the deposits paying 5%. In one year the deposits will yield:

€833,333 * 1.05 = €875,000

4. Sell the euros forward to ensure the dollar value in one year:

€875,000 * $1.19 / € = $1,041,250

5. Repay the amount owed of $1,040,000, and clear the difference, $1,250, risklessly

without using any of the bank’s money.

This works because the euro drops in value by less than the difference in interest rates (see the

interest rate parity discussion). The one year term helps keep the math simple.

The text also includes the International Fisher Effect (IFE) which relates interest rates to

changes in expected exchange rates as follows:

[(1+rhome) / (1+rforeign)]T = eT / e0

Where r is the interest rate and e is the exchange rate in terms of dollars per 1 unit of foreign

currency. The IFE is simply uncovered interest arbitrage and is a risky arbitrage since eT is not

known apriori. When the forward rate is substituted for eT, this relationship is the same as

interest rate parity or covered interest arbitrage.

a. Role of Financial Institutions in Foreign Exchange Transactions

The foreign exchange market is largely an interbank OTC market that operates 24 hours a day.

Banks are some of the world’s largest and most active currency traders. Text Table 9-4 presents

U.S. bank positions in foreign currency in 2007. The majority of interbank exchange trading is

now done electronically with Thomson-Reuters and electronic brokerage systems (EBS)

dominating activity. The electronic trading platforms have been integrated with corporate

customers, allowing the corporate customer to process exchange orders with a bank in a highly

automated format.

Even though trading volumes are quite large, banks’ net exposures in most currencies are

modest. Net exposure = (FX assets – FX liabilities) + (FX bought – FX sold) where FX =

foreign exchange. Positive exposure implies that a FI is net long in a currency; negative

exposure is net short in a currency.

U.S. non-bank FIs also have currency exposures, but they are typically much smaller than for

banks. For many institutions, currency volatility is too great to justify significant exposures due

to concerns about prudent person regulations and lack of experience in foreign markets.

The advent of the euro and the ongoing consolidation of major banks reduced the volume of

foreign exchange trading because there were fewer currencies to trade and fewer players to trade

them. With the ongoing globalization however, the currency markets have continued to grow

(although the importance of given players or even locations may change). From 2000 to 2013

trading volume in foreign exchange markets grew by 345%. Growth in currency trading resulted

from growth in global trade, greater volatility of currencies resulting in more speculating and

hedging and larger interest rate differentials. London remains the global capital of international

finance and currency trading.

FIs participate in foreign currency market for four reasons:

1. To facilitate international trade for their corporate customers

2. To allow corporations to take positions in currencies.

3. To hedge open (unhedged) positions created by the first and second activities.

4. To speculate on currency movements.

About 200 U.S. FIs are actively involved in currency trading although about 25 banks are the

market makers for the five major currencies. About 45% of open positions are arranged through

foreign exchange brokers.

2. Interaction of Interest Rates, Inflation, and Exchange Rates

For an excellent article on global linkages and an explanation of terms often quoted in the media

see the article: “International Credit Market Connections, Steven Strongin, Federal Reserve

Bank of Chicago, Economic Perspectives, July/August 1990, pp.2-10.

a. Purchasing Power Parity

The concept underlying purchasing power parity (PPP) is the law of one price, or the idea that

similar traded goods and services that provide similar benefits should have the same price in

different countries. Arbitrage opportunities then ensure the ‘law’ will hold. If relative

purchasing power parity (PPP) holds then differences in inflation rates between two countries

are perfectly adjusted for by changes in exchange rates to maintain constant purchasing power.

In other words, the nominal exchange rate adjusts to maintain a constant real exchange rate as

relative inflation rates change. The concept underlying PPP is the idea that similar traded goods

and services that provide similar benefits should have the same price in different countries. For

example, if the nominal $/¥ exchange rate is $0.009091/¥ and the U.S. has 3% inflation and

Japan has 1%; the nominal exchange rate would adjust to ¥1 = $0.009091  1.03/1.01 =

$0.009271.2 With the new stronger yen one could purchase exactly the same amount of U.S.

goods and services as before, i.e. the real exchange rate; $0.009271  1.01/1.03 = $0.009091 is

unchanged. Thus if S0 is the original spot rate and S1 is the new spot rate then

Relationship 1: S1 / S0 = (1 + IPUS) / (1+ IPF)

where IP is the expected level of inflation in the home (US) and foreign (F) country respectively.

Using the approximation version as in the text gives:

2The text uses the approximation version. In this case the exchange rate change would be 2%,

the difference in inflation rates.

Relationship 1: (S1 – S0) / S0 = IPUS – IPF. Approximate version

Teaching Tip: The exchange rates must be in the form of U.S. dollars per unit of foreign currency

in these equations.

Teaching Tip: There are significant costs to applying the arbitrage strategy that underlies the idea

of PPP. Differential tariffs and other regulations, transportation and insurance costs, fixing prices

for given contract periods, etc. all imply that PPP is unlikely to hold exactly, even for traded

goods and services, particularly in the short run. The empirical evidence generally indicates that

PPP holds only over longer time periods such as 5-7 years, except in countries experiencing

hyperinflation where parity tends to hold year to year. (See Foundations of Multinational

Financial Management, 3rd edition, 1999: Allen Shapiro, Wiley Publishing)

The Fisher effect states that iUS = IPUS + RIRUS where iUS is the nominal U.S. interest rate, IPUS is

equal to the expected level of U.S. inflation and RIRUS is the real U.S. interest rate. This

relationship should hold in each country, and if the RIR is the same in two countries then the

nominal interest rates in the two countries should differ only by the differences in inflation. That

is:

Relationship 2: iUS – iF = IPUS – IPF for any foreign country F.

b. Interest Rate Parity

If we assume that the forward rate is an estimator of the expected future spot rate, S1, then

putting Relationship 1 and Relationship 2 together yields the Interest Rate Parity Theorem

(IRPT) for any time t:

Relationship 3: IRPT: (1 + iUS) / (1 + iF) = Forwardt / St

The text version is: (iUS – iF) / (1 + iF) = (Forwardt – St )/ St

Notice this is very similar to the IFE.

Teaching Tip: There are various ways to explain the logic underlying this equation. The text

demonstrates that parity holds when the discounted value of the difference in interest rates equals

the percentage change in the exchange rate. If parity holds no covered interest arbitrage is

possible. Hence, the steps of a covered interest arbitrage strategy can be used to explain the

parity condition. For instance, suppose a bank sees that U.S. interest rates are lower than Swiss

rates. The entrepreneurial bank could borrow U.S. $, convert the $ to Swiss francs (Sfr) at the

spot rate and invest the money in the Sfr denominated investment. The catch is the bank will

owe dollars and will earn Sfrs. Thus to cover the interest arbitrage the bank sells the Swiss francs

forward at the forward rate. Parity holds if this strategy does not make money. Outlining the

transactions yields the following:

Borrow U.S. dollars with a single payment loan. At year end the bank will owe (per $

borrowed): $1  (1 + iUS)

Convert the dollar to Sfr and invest it in the Switzerland. In a year this will yield

1/St  (1 + iSfr)

Cover the future receipt of Swiss francs by selling them forward:

1 / St  (1 + iSfr)  Forwardt

If this amount equals $1 (1 + iUS) then no arbitrage is possible and parity holds. Thus:

$1 (1 + iUS) = 1 / St  (1 + iSfr)  Forwardt

This is the IRPT shown above.

Teaching Tip: Banks set forward rates in relationship to differences in interest rates so that they

are not the source of a profitable arbitrage. Suppose U.S. interest rates are 9%, British interest

rates are 11% and the current spot rate is £1 = $1.60. Unless the forward rate offsets the

difference in interest rates, investors will wish to borrow at the U.S. $ rate and invest at the U.K

£ rate. Suppose the bank sets the forward rate at £1 = $1.55. This is a 3.125% drop in value of

the pound. The drop is greater than the interest rate differential. U.S. investors would borrow at

11% in the U.K., owing £1.11 pounds at year end. They would then sell the pound spot and

invest in the U.S. This would yield $1.60  1.09 = $1.744. The £1.11 pounds owed would be

bought forward at $1.55 a pound for a dollar cost of $1.7205. The net gain is $1.744 – $1.7205 =

$0.0235 per pound borrowed. A typical wholesale transaction is for the equivalent of $3 million

or more and on that scale, this is economically significant. The bank winds up buying pounds in

the spot and selling them forward. However, the actions of traders would depress the spot price

of the pound and increase the forward price. In both cases, the bank takes losses on its exchange

trades.

Appendix 9A: Balance of Payments Accounts (available on Connect or from your

McGraw-Hill representative)

The balance of payments measures flows into and out of a country. If a given account is in

surplus that means on net, money flowed into the country as a result of activities in that account.

If an account is in deficit, on net money flowed out of the country. Money in has to equal money

out and the balance of payments must balance.

Teaching Tip: Academicians and the media often speak of a country having a balance of

payments deficit. What they mean is a deficit in one or more (but not all) of the balance of

payments accounts, usually the current account.

The Current Account

The current account measures net flows in goods, services, net investment income and

unilateral grants, foreign aid, etc. The U.S. has a merchandise trade deficit but has a surplus in

services. Net investment income is also typically near zero and the overall current account is in

deficit, reaching all time highs before the U.S. slowdown in 2007. A current account deficit

means the U.S. imports more goods and services (and pays out more income on their

investments) than the U.S. exports (receive on their foreign investments). In short, U.S. agents

buy more from the rest of the world than they sell to the rest of the world. In 2007 the current

account deficit was about $793 billion. For 2012 the deficit was $440.4 billion.

Teaching Tip: Is a current account deficit bad? Presumably, if this account were in surplus the

U.S. would be producing more goods and services and have higher incomes and more jobs since

we would make more goods here instead of importing them. The problem with this argument is

that it assumes that globalization is a zero sum game. However, corporations can operate more

cost effectively, and provide cheaper goods and services, by reallocation labor and capital to

exploit different and evolving comparative advantages in different countries. Even with a

burgeoning current account deficit, the U.S. has generated higher economic growth than other

countries that have had (at times) large current account surpluses, including Japan and Germany.

High U.S. demand for foreign goods and services has fueled global growth, particularly in

emerging countries. The large deficit reflects Americans’ desire to consume more than they

produce. The deficit may represent a problem to the extent that it represents excessive

consumption today relative to consumption tomorrow (i.e., too low investment today). The large

deficit must be financed with the capital account (see below). Recently, much of the financing

has come from foreign central banks attempting to keep their currencies low rather than from

foreign private sources who believe the U.S. has good investment opportunities.

As of the summer of 2005, the Bank of China began to allow the yuan to revalue slightly against

the dollar and announced they would permit limited flexibility. Flexibility was increased in May

2007. Also in 2005 the Bank of Korea announced a move to diversify out of dollars and the

dollar plunged on the announcement. The BOK quickly stated they had no plans to dump

dollars. The size of the deficit and the resulting need for foreign money certainly make the U.S.

more dependent on global investors’ willingness to invest in America to sustain American’s

spending habits. (See Foundations of Multinational Financial Management, 3rd edition, 1999:

Allen Shapiro, Wiley Publishing)

Capital Accounts

The capital account measures the flow of capital investment into and out of a country. A capital

account surplus represents net borrowing from overseas (money in). A capital account deficit

indicates that a country’s net foreign capital investment is positive. Since the current account

measures current spending, a current account deficit, spending more than you have, must be

financed by a capital account surplus. A capital account surplus arises from net borrowing from

overseas agents and/or selling U.S. real assets to foreigners. For 2012 the U.S. capital account

surplus was $440.4 billion, matching the current account deficit.

Teaching Tip: It is very important to understand that the sustainability of the U.S. current account

deficit depends on foreigners’ willingness to invest in the U.S. A large current account deficit

does not put pressure on the dollar to fall if the excess funds placed in the global currency

markets due to excess importing are simply reinvested in the U.S. via capital account

transactions. The ‘sustainability’ of the U.S. desire to purchase more than we produce (the root

cause of the current account deficit) lies with foreigners’ willingness to reinvest the money in the

U.S., and perhaps more subtly, what we do with the money that is reinvested here. The long term

decline in the dollar suggests a reduced willingness of foreigners to finance the U.S. current

account and budget deficits.3

Instructor’s Manual Appendix: Factors Affecting Exchange Rates (Not in

3 To the extent that the budget deficit represents excess demand for funds, the budget deficit

contributes to the size of the current account deficit.

Text or Appendix)

The U.S. demand for foreign goods and services and financial assets determines the supply of

dollars U.S. agents are willing to provide for foreign exchange. Foreign demand for U.S. goods

and services and financial assets determines the demand for dollars. The interaction of supply

and demand then sets the exchange rate between the foreign currency and the dollar.

What factors determine the supply and demand of the dollar provided for foreign exchange?

Relative inflation rates: The country with the higher inflation rate will tend to see its currency

devalue relative to other countries with lower inflation rates.

Relative real interest rates: Countries with higher real rates will attract more capital and have

higher currency values.

Relative economic growth rates: Countries with higher real growth rates will tend to attract

more capital.

Demand for a country’s goods and services and financial assets. The higher the demand, the

greater a country’s currency is likely to be, ceteris paribus. For example, specialized

products or brand names such as Marlboro or Levi jeans may create steady (inelastic)

demand for a country’s products.

Government restrictions on foreign exchange, trade and investment can depress a currency’s

value.

Consumer preferences for domestic versus foreign goods.

Special considerations for the dollar:

The extent to which the currency is used in international transactions affects a currency’s

value. Many of the world’s commodities are priced in dollars, this adds to the demand

for the dollar.

The dollar still has the top spot in the global debt market, remaining ahead of the euro

and the dollar still dominates in usage in currency trading, involved in about 86% of all

trades.

Many exports that are NOT destined for the U.S. are still dollar denominated.

The so called “reserve currency status” of the dollar is being eroded by recent U.S.

economic problems, but it will probably take 30 to 40 years before major shifts out of the

dollar are actually achieved. For more information see, “Dollar’s Dive Deepens as Oil

Soars: Power of Greenback Faces Severe Test, But No Rivals Loom, by Craig Karmin

and Joanna Slater, The Wall Street Journal Online, February 29, 2008, Page A1.

Risk is also a major determinant of a currency’s value; hence, other factors that can affect a

currency’s value include:

The economy’s history. The shorter the history and the more volatile the economy, the lower

the currency value, ceteris paribus.

The reputation of the central bank. Strong, independent central banks with a history of

keeping inflation low add to a currency’s value.

Large foreign currency reserves help maintain a currency’s value.

Large current account deficits can foreshadow currency problems since these imply a large

amount of foreign capital is needed to finance current spending levels.

Modest to low foreign currency debt to GDP ratios help maintain a currency’s value. The

recent crisis in Asia was largely just another leverage crisis.

Appropriate fiscal policy spending in line with the country’s ability to pay for the spending

without incurring large amounts of foreign borrowing.

The presence or absence of institutions to manage conflict and the degree of social

fractionalizations strongly affect whether an economic shock to a country results in a major

crisis or not. See “Globalisation, Social Conflict and Economic Growth,” D. Rodrik, The

World Economy: 1998

Murder will out so they say, and so will corruption. History teaches that at some point corrupt

systems always fail eventually.

The above is adapted from various sources, but see for instance Foundations of Multinational

Financial Management, 3rd edition, 1999: Allen Shapiro, Wiley Publishing

VI. Web Links

http://www.federalreserve.gov/ Website of the Board of Governors of the Federal Reserve

http://www.wsj.com/ Website of the Wall Street Journal Interactive edition. The web

version of the well known financial newspaper can be

personalized to meet your own needs. Instructors can also

receive via e-mail current events cases keyed to financial

market news complete with discussion questions

http://www.ft.com/ Financial Times, won two Espy awards for best new site and

best non U.S. news site. Coverage of global events and

markets

http://www.ustreas.gov/ Website of the U.S. Treasury

http://www.bea.gov/ U.S. Department of Commerce, Bureau of Economic

Analysis: Balance of payment data is available here

http://www.dailyfx.com/ Website containing fundamental and technical

forecasts of values of major currencies, tutorials and

links to more information

1.1.1.1.1.1 VII. Student Learning Activities

1. Obtain a forecast of Brazilian inflation and a forecast of U.S. inflation. Forecast what the

spot rate of foreign exchange should be in one year using the purchasing power parity

relationship. Find the one year forward rate. Is your estimate in line with the actual one year

forward rate? Why or why not? One place to find Brazilian inflation data is the website of

the Brazilian central bank http://www.bcb.gov.br/?english.

2. Compare one year U.S. and Japanese government bond rates. What do these imply about the

likely direction of change in the yen to dollar exchange rate?

3. What does it mean when we say the U.S. dollar is the world’s reserve currency? What was

the reserve currency before the U.S. dollar? What caused the change? Is it likely that the

dollar will retain its reserve currency status over the next several decades? Explain.

4. Suppose that your firm is considering committing to a major sale of goods in Great Britain.

The sale is denominated in pounds and the pound price will be set now, but your firm won’t

receive payment for 6 months. What are the risks to your firm? If the sale is for £1 million

calculate the dollar proceeds for the firm if the sale is hedged with a 6 month forward

contract. Forward quotes can be obtained from many sources, one of which is the Wall Street

Journal at www.wsj.com.