AFIN1002 Week 12: International Finance Notes

Foreign Exchange Market

Introduction

• Firms use the foreign exchange market for cross-currency transactions.
  • An Australian firm importing goods from Italy might buy euros to pay for the purchase.
  • An Australian firm exporting to Italy might receive euros and sell them for Australian dollars.

Functions of the Foreign Exchange Market

• The main functions of foreign exchange markets are:
  • To facilitate cross-currency payments arising from imports, exports, investment, and financing flows.
  • To reveal the value of currencies.
  • To allow participants to manage their exchange rate risks.

Institutional Aspects of the Foreign Exchange Market

• Foreign exchange transactions are conducted via electronic communication networks.
• Foreign exchange dealers in Australia must be licensed by the Australian Securities and Investment Commission (ASIC).
  • The largest dealers in Australia include the Big 4 banks, Macquarie Bank, and international banks.
• The Australian dollar (AUD) is the sixth most traded currency.
• The five most traded currencies are the US dollar (USD), European euro (EUR), Japanese yen (JPY), Great British pound (GBP), and Chinese yuan (CNY).

Foreign Exchange Rates

• Exchange rate: Price of one currency in terms of another.
• Base currency: The currency being priced.
• Terms currency: The currency in whose terms the price is expressed.
• Example:
  • Exchange rate of 0.6672 USD per AUD.
  • 1 AUD is priced in terms of USD.
  • Buying 1 AUD costs 0.6672 USD.
  • Selling 1 AUD yields 0.6672 USD.
  • Base currency = AUD.
  • Terms currency = USD.
  • Can be written as 0.6672 USD / AUD, meaning 1 AUD = 0.6672 USD.
• Reciprocal:
  • $\frac{1}{0.6672} = 1.4988$
  • 1 USD is priced in terms of AUD.
  • 1.4988 AUD per USD or 1 USD = 1.4988 AUD.
  • Base currency = USD.
  • Terms currency = AUD.

Spot and Forward Exchange Rates

• Spot exchange rates: Prices for immediate delivery of a currency.
• Forward market: Market for buying and selling currency for future delivery.
  • Forward exchange rate can be locked in today for future delivery if you know that you are going to pay or receive foreign currency at some future date

Exchange Rate Fluctuations

• Most exchange rates are floating; they change depending on supply and demand in the market.
• Supply and demand are driven by:
  • Firms trading goods.
  • Firms raising finance in foreign currencies.
  • Investors trading securities.
  • The actions of central banks in each country.

Exchange Rate Risk

Exchange Rate Fluctuations: The Importer-Exporter Dilemma

• Fluctuating exchange rates can create the importer-exporter dilemma.
• Example:
  • A U.S. firm imports parts from Australia.
    • If the Australian supplier sets the price in AUD, the U.S. firm risks the AUD rising, making the parts more expensive in USD.
    • If the Australian supplier sets the price in USD, the supplier risks the USD falling, receiving fewer AUD for the parts.

The Effect of Exchange Rate Risk

• Example:
  • A U.S. firm imports parts from an Australian firm.
  • Agreed price: AUD 1,000,000, payable upon delivery in one year.
  • Today’s spot exchange rate: 0.6672 USD per AUD.
  • If the exchange rate remains constant, the U.S. firm pays $0.6672 \times \text{AUD } 1,000,000 = \text{USD } 667,200$.
  • A fall in the price of 1 AUD means the AUD has weakened or depreciated against the USD, making the USD stronger in comparison
  • A rise in the price of 1 AUD means the AUD has strengthened or appreciated against the USD, making the USD weaker in comparison

Hedging with Forward Contracts

• The U.S. firm can eliminate exchange rate risk using a currency forward contract.
  • Currency forward contract: Sets an exchange rate and an amount to exchange in advance of a future delivery date.
  • Forward exchange rate: The rate set in a currency forward contract.
• Example:
  • Banks offer a one-year forward contract with a rate of 0.6717 USD per AUD.
  • The U.S. firm enters a forward contract to purchase AUD 1,000,000 in one year at 0.6717 USD per AUD.
  • The U.S. firm pays $0.6717 \times \text{AUD } 1,000,000 = \text{USD } 671,700$ in one year.
  • This locks in the one-year forward exchange rate, eliminating exchange rate risk.
• The risk initially transfers to the bank, which may offset it by entering into another forward contract.

Cash-and-Carry and the Pricing of Forwards

• Cash-and-Carry Strategy: Locks in the future cost of an asset by buying the asset for cash today and “carrying” it until a future date, which can also eliminate exchange rate risk.
• Creating Cash Flows:
  • Goal: Pay AUD and receive USD in one year.
  • Three simultaneous transactions:
    1. Borrow AUD today for one year at the AUD interest rate $r_{AUD}$.
    2. Exchange AUD for USD today at the spot exchange rate.
    3. Deposit the USD today for one year at the USD interest rate $r_{USD}$.
• Diagram:
  • t = 0: Borrow AUD (1 / (1 + $r_{AUD}$)), Exchange AUD for USD (× Spot rate)
  • t = 1: Lend USD (× (1 + $r_{USD}$)), Exchange AUD for USD in one year at forward rate (× Forward rate)
• The forward contract and the cash-and-carry strategy accomplish the same conversion, so they must do so at the same rate.
• Formula for the forward exchange rate:
  • $Forward\ Rate = Spot\ Rate \times \frac{1 + r<em>{USD}}{1 + r</em>{AUD}}$

Covered Interest Parity

• The formula $Forward\ Rate = Spot\ Rate \times \frac{1 + r<em>{USD}}{1 + r</em>{AUD}}$ is the covered interest parity equation.
• States that the difference between the forward and spot exchange rates is related to the interest rate differential between the currencies.
• Example:
  • Spot exchange rate: 0.6672 USD per AUD.
  • U.S. interest rate: 5.2%.
  • Australian interest rate: 4.5%.
  1. Borrow $\frac{1}{1.045} = 0.9569$ AUD today to pay 1 AUD in one year.
  2. Exchange 0.9569 AUD for $0.9569 \times 0.6672 = 0.6385$ USD.
  3. Deposit 0.6385 USD today to receive $0.6385 \times 1.052 = 0.6717$ USD in one year.
• Which is equal to the one-year USD per AUD forward exchange rate calculated as follows:
  • $Forward\ Rate = 0.6672 \times \frac{1.052}{1.045} = 0.6717 \text{ USD per AUD}$
• Generalized Formula:
  • $Forward\ Rate = Spot\ Rate \times \frac{1 + r<em>{Terms} T}{1 + r</em>{Base} T}$
  • $r_{Terms}$ = interest rate for the terms currency.
  • $r_{Base}$ = interest rate for the base currency.
  • T = number of years

Hedging with Option Contracts

• Hedging with forward contracts locks in a future exchange rate, whether advantageous or not.
• Hedging with currency options insures against the exchange rate moving beyond a certain level.
  • Can pay the spot exchange rate or the rate in the option contract (i.e., exercise price), whichever is better.
• Example: U.S. firm paying AUD 1,000,000 in one year to purchase parts from an Australian firm.
  • The U.S. firm can buy a call option on the AUD, giving it the right to buy AUD 1,000,000 at a maximum price.
  • One-year European call option on the AUD with an exercise price of 0.6717 USD per AUD and costs USD 0.02.
• If the spot exchange rate in one year is less than the 0.6717 USD per AUD exercise price of the option:
  • The firm will not exercise the option and will buy AUD at the spot exchange rate.
• If the spot exchange rate in one year is greater than the 0.6717 USD per AUD exercise price of the option:
  • The firm will exercise the option and will buy AUD at the exercise price of 0.6717 USD per AUD.
• Adding in the initial cost of the option gives the total USD cost per AUD paid by the firm.

International Financing Decisions

Foreign Currency Borrowings

• Many Australian firms issue debt in international debt markets.
  • The most common types of debt issued are private placements and public bonds.
• Why do Australian firms issue debt in international debt markets?
  • To match their foreign currency liabilities and assets.
  • Access a broader range of investors and hence better pricing.
  • Ability to handle larger bond issues.
  • Diversification.
• Issuing debt offshore in foreign currencies creates exchange rate risk for the borrower.
  • An Australian firm borrowing USD needs to sell AUD in exchange for USD to pay USD interest and principal payments.
  • A weakening of the AUD against the USD hurts this firm as it will need to sell more AUD for the required USD payments.

Formula Summary

• Forward exchange rate: $Forward\ Rate = Spot\ Rate \times \frac{1 + r<em>{Terms} T}{1 + r</em>{Base} T}$
  • $r_{Terms}$ = the interest rate for the terms currency
  • $r_{Base}$ = the interest rate for the base currency
  • T = number of years