FOREIGN EXCHANGE INSTRUMENTS

tools of international exchange

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Foreign Exchange

Also referred to as FOREX or FX A mechanism by which currency of one country gets converted into the currency of another country. Foreign currency or claims relating to foreign currency Can be in form of cash, funds available on debit and credit cards, travelers cheques, bank deposits or other short-term claims. To an Indian, a 10 currency note or a 10 travelers cheque or a demand draft drawn on London Bank would be forex

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Foreign Exchange Market

A market where money denominated in one currency is traded with money denominated in another currency.
FOREX MARKET

OVER -THE -COUNTER (OTC) MARKET

EXCHANGE TRADED MARKET

Venue of Maximum FOREX activity Composed of commercial banks, investment banks & financial institutions

Composed of securities exchanges Venue of specific FOREX instruments like exchange-traded options & futures

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Rate of Exchange
The number of units of one currency that buys one unit of another currency. Can be expressed in two ways
DIRECT QUOTATION One unit of foreign currency expressed in terms of domestic currency. Method also known as American terms E.g. In New Delhi : $1 / Rs 45 INDIRECT QUOTATION

One unit of domestic currency expressed in terms of foreign currency. Method also known as European terms E.g. In New Delhi : Rs 1 / $ 0.0222

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Other Terms
BID (Buyers rate): price at which trader is willing to buy foreign currency ASK (Sellers rate): price at which trader is willing to sell foreign currency SPREAD : difference between bid and ask price > the profit margin for the trader = (Ask price Bid price) / Ask price X 100 E.g.: Suppose, in India, a customer exchanges US dollar for the rupee at Rupee-US Dollar rate of Rs. 40.00-40.30/US $ Bid rate = Rs. 40.00 (bank will buy US $ at 40.00 for transaction) Ask rate = Rs. 40.30 (bank will sell US $ at 40.3. to Indian) Hence, Spread = (40.30 40.00) / 40.30 X 100 = 0.744% or bank makes a profit of Rs. 0.30 per US dollar

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Foreign Exchange Instruments

FOREIGN EXCHANGE INSTRUMENTS

TRADITIONAL FOREX INSTRUMENTS FX SWAP SPOT FORWARD

DERIVATIVE INSTRUMENTS CURRENCY SWAPS OPTIONS FUTURES

EQUITY & DEBT INSTRUMENTS

ADR GDR FOREIGN BONDS EURO BONDS

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1. Spot Market
Spot transactions : Exchange of currency the second day after the date on which two foreign-exchange traders agree to do the transaction Spot rate : Rate at which transaction is settled Value date/ Settlement date : Day on which delivery of currency takes place i.e. on the second day of the agreement Example : On Thursday, an Indian and an American agree to execute the deal in spot market. When will the deal be effected ? Now, the exchange of currencies will take place on Saturday. If the particular market is closed on Saturday and Sunday , delivery of currency shall take place on Monday.

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Currency Arbitrage in Spot Market

Arbitrageurs buy a particular currency at cheaper rate in one market and sell it at a higher rate in another. Suppose, bid rate in : New York : US $ 1.9810 10 London : US $ 1.9700 10 The arbitrageurs will buy pound in London and will sell the pound in New York. Then, assuming no transaction costs, they make a profit of : $ 1.9810 - $ 1.9700 = $ 0.0110 per pound sterling

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2. Forward Market
Contracts are made to buy and sell currencies for future delivery, say after a fortnight, one month, two months and so on. Rate of exchange for the transaction is agreed upon on the very day the deal is finalized. Forward Rate : rate quoted for transaction that call for delivery after two business days Example : The one month forward contracts were contracted respectively on the 28th & 29th January 2013. What would be the settlement date ? For both, it will be 28th February as 2013 was not a leap year. So this is the value date in both the transactions.

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Relation to Spot Rates

Forward exchange rate is generally expressed in relation to spot rate ruling at the time when forward rate is quoted. Forward quotations can be made as :
At a premium on the spot rate or at a discount from it, referred to as forward differential or at par with the spot rate. If forward rate > spot rate : forward premium If forward rate < spot rate : forward discount

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3. FOREX Swap

FX Swap is a simultaneous spot and forward transaction A simultaneous sale and purchase of a certain amount of foreign currency for two different dates It is accounted as a single transaction. FIRST LEG : SPOT TRANSACTION (Trader buys or sells on the spot market) SECOND LEG : FORWARD TRANSACTION - reverse (Trader buys or sells on the forward market) Also known as spot-forward swap

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FOREX Swap: Example

Parties - Punjab National Bank (PNB) & State Bank of India (SBI) Currency - Euro FOR PNB : It is long on current holdings of Euro and considers itself short one-month forward because of net forward sales. FOR SBI : It is short on current holdings of Euro but long one-month forward. Solution: First Peg : Spot Transaction PNB will sell Euro Spot to SBI & SBI will buy Euro Spot from PNB Second Peg : Forward Transaction PNB will buy Euro forward from SBI & SBI will sell Euro forward to PNB

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4. Currency Swap
A combination of a spot foreign exchange transaction and an offsetting forward foreign transaction undertaken with the same counterparty An exchange of debt or assets denominated in one currency for debt or assets denominated in another currency They are OTC instruments Involve exchange of principal and interest payments for an agreed period of time and to exchange rate at maturity A currency swap between the World Bank and IBM in August 1981 was the first of its kind with Salomon Brothers acting as intermediary between the two.

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4. Currency Swap: Example

A borrower wishes to obtain Swiss francs (SFr) to finance business expansion in Switzerland but may not be able to do so. At the same time, this borrower has access to dollar capital market and may be able to borrow it on relatively attractive terms. If a counterparty exists who has, a net asset position in SFr and a desire for low-cost dollar funds, the opportunity for currency swap exists.

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5. Options

A right but not the obligation to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate. Parties : option buyer and option seller/writer The rate at which one currency can be purchased or sold is one of the terms of the option and is known as exercise/strike price. The fee or cost of the option is called premium. Can be purchased OTC from a commercial or investment bank or it can be purchased on a stock exchange where options are traded

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Options: Types
CALL OPTION An option to purchase the underlying currency It gives the right but not the obligation to purchase an option PUT OPTION An option to sell the underlying currency It gives the right but not the obligation to sell an option

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Option : Example
A person decides to acquire options to buy SFr at a price of US $ 0.70 along with a premium for US $ 0.02. On the maturity date, if: a) Spot rate of SFr (0.65) < Agreed rate (0.70) The buyer will let the option expire as he can purchase it in the spot market at a cheaper rate. b) Spot rate of SFr (0.75) > Agreed rate (0.70) The buyer will exercise the option as his cost of buying the Swiss francs under the options contract will be 0.72 (0.70+0.02), whereas, he can sell this currency in spot market at a higher rate (0.75).

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6. Futures
An agreement between two parties to buy or sell a particular currency at a particular price on a particular date, as specified in the contract to all participants in that currency futures exchange. Its market is an organized market like an exchange and not OTC. Currencies in which futures contracts are traded : Euro, Japanese Yen, Pound sterling, Canadian dollars, Swiss francs, Mexican pesos, Australian dollars Futures deals are struck sitting face-to-face under a trading roof known as pits.

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Futures Contd..
Deal is not settled on maturity instead rates are matched daily with the movements in spot market and gains and losses are credited and debited to the traders account everyday respectively. This is known as marking to market. Parties : Traders, Exchanges, Clearing houses It came into being in 1972 when Chicago Mercantile Exchange set up its international monetary market division for currency futures. Costs in futures deal : brokerage commission, floor trading and clearing fees

CURRENCY & INTEREST RATE SWAPS

tools of international exchange

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Definitions

In a swap, two counterparties agree to a contractual arrangement wherein they agree to exchange cash flows at periodic intervals. There are two types of interest rate swaps:

Single currency interest rate swap

Plain vanilla fixed-for-floating swaps are often just called interest rate swaps. This is often called a currency swap; fixed for fixed rate debt service in two (or more) currencies.

Cross-Currency interest rate swap

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The Generic Swap Structure

Counter parties agree to make payments to one another on the basis of some quantities of underlying assets. Payments are known as service payments The underlying assets that may not be exchanged are known as notional Notional principals may be the same or they may be different. The service payments of the first counterparty are made at a fixed price for the use of the second counterpartys notional assets The service payments of the second counterparty are made at a floating, or market determined price for the use of the first counterpartys notional assets.

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The Swap Bank A swap bank is a generic term to describe a financial institution that facilitates swaps between counterparties. The swap bank can serve as either a broker or a dealer.

As a broker, the swap bank matches counterparties but does not assume any of the risks of the swap. As a dealer, the swap bank stands ready to accept either side of a currency swap, and then later lay off their risk, or match it with a counterparty.

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Swap Market Quotations

Swap banks will tailor the terms of interest rate and currency swaps to customers needs They also make a market in plain vanilla swaps and provide quotes for these. Since the swap banks are dealers for these swaps, there is a bid-ask spread.

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Interest Rate Swap Quotations

The convention is to quote against U.S. dollar LIBOR. Euro- Sterling Swiss franc U.S. $
Bid Ask Bid Ask Bid Ask Bid Ask

1 year
2 year

2.34
2.62

2.37
2.65

5.21
5.14

5.22
5.18

0.92
1.23

0.98
1.31

3.54
3.90

3.57
3.94

3 year
4 year 5 year 6 year 7 year 8 year 9 year 10 year

2.86
3.06 3.23 3.38 3.52 3.63 3.74 3.82

2.89
3.09 3.26 3.41 3.55 3.66 3.77 3.85

5.13 3.85 5.17means 1.50 1.58 bank 4.11 will 4.13 3.82 the swap pay at 3.82% 5.12fixed-rate 5.17 euro 1.73 payments 1.81 4.25 4.28 against receiving dollar LIBOR 5.11 5.16 1.93 2.01 4.37or it4.39 will receive at 5.11 5.16fixed-rate 2.10 euro 2.18 payments 4.46 4.50 3.85% against paying2.33 dollar LIBOR 5.10 5.15 2.25 4.55 4.58
5.10 5.09 5.08 5.15 5.14 5.13 2.37 4.48 2.56 2.45 2.56 2.64 4.62 4.70 4.75 4.66 4.72 4.79

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Swap Quotations
3.823.85 means the swap bank will pay fixed-rate euro payments at 3.82% against receiving dollar LIBOR or it will receive fixed-rate euro payments at 3.85% against paying dollar LIBOR

Firm B

3.85% $LIBOR

Swap Bank

3.82% $LIBOR

Firm A

While most swaps are quoted against flat dollar LIBOR, off-market swaps are available where one party pays LIBOR plus or minus some number.

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Interest Rate Swaps

An agreement between two parties to exchange a series of interest payments tied to different indexes usually a fixed rate and floating rate without exchanging the underlying principal amount For instance, in a fixed-for-floating interest rate swap, one party pays a fixed interest rate on a predetermined notional principal amount in exchange for receiving a floating rate, say the six-month London Interbank Offer Rate (LIBOR) on the same amount.

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Example

Assume that Firm A has fixed-rate assets and floating-rate liabilities and wants to convert the floating-rate liabilities into a fixed-rate liability in order to reduce its interest rate risk. Firm B has floating-rate assets and fixed-rate liabilities and wants to convert the fixed-rate assets into floating-rate assets. Firm A could enter into an interest rate swap contract with Firm B where, for example, Firm A pays to the Firm B a fixed rate of 9.2% in return for receiving the six-month LIBOR from Firm B.

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Mechanics of Swaps
Pay 9.2% fixed

Firm A

Receive LIBOR

Firm B

Floating Rate Liability

Fixed-rate Liability

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Example of an Interest Rate Swap

Consider firms A and B; each firm wants to borrow A $40 million for 3 years. B Fixed
5%

Floating
LIBOR

5.50% LIBOR +.20%

Firm A wants finance an interest-rate-sensitive asset and therefore wants to borrow at a floating rate. A has good credit and can borrow at LIBOR Firm B wants finance an interest-rate-insensitive asset and therefore wants to borrow at a fixed rate. B has less-than-perfect credit and can borrow at 5.5% The swap bank quotes 5.15.2 against dollar LIBOR for a 3-year swap.

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Example of an Interest Rate Swap

Firm 5.10% Swap A LIBOR Bank
If Firm A borrows from their bank at 5.0% fixed and takes up the swap bank on their offer of 5.15.2 they can convert their fixed rate 5% debt into a floating rate debt at LIBOR 0.10%

Bank X

As all-in-cost: = 5.0% + LIBOR 5.10% = LIBOR 0.10%

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Example of an Interest Rate Swap

Swap Bank Firm B LIBOR
5.20%

If Firm B borrows floating from their bank at LIBOR + 0.20% and takes up the swap bank on their offer of 5.15.2 they can convert their floating rate debt into a fixed rate debt at 5.40%

Bs all-in-cost: = LIBOR + LIBOR + 0.20% + 5.20% = 5.40%

Bank Y

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Example of an Interest Rate Swap

Firm 5.10% Swap A LIBOR Bank Firm B LIBOR
5.20%

The Swap Bank makes 10 basis points on the deal: The Swap Banks all-in-cost: = LIBOR + LIBOR 5.20% + 5.10% = 0.10%

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Example of an Interest Rate Swap

Firm 5.10% Swap A LIBOR Bank Firm B LIBOR
5.20%

The notional size is $40 million. The tenor is for 3 years. A earns $40,000 per year on the swap.

Bank X

B earns $40,000 per year on the swap. Swap Bank earns $40,000 per year.

Bank Y

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Using a Swap to Transform a Liability

Firm A has transformed a fixed rate liability into a floater.

A is borrowing at LIBOR .10% A savings of 10 bp

Firm B has transformed a floating rate liability into a fixed rate liability.

B is borrowing at 5.40% A savings of 10 bp

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Comparative advantage and structure of a swap

The firms borrow in their relatively advantaged market and swap.

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Implementation of Interest Rate Swaps

Unilever borrows at 7% p.a., and then enters into interest rate swap with Citibank. Unilever agrees to pay Citibank a floating rate LIBOR and to receive 7% p.a. interest. Xerox borrows at LIBOR+3/4%, and then swaps the payments with Citibank. Xerox agrees to pay Citibank 7.875% p.a. interest and to receive LIBOR+3/4%. Net borrowing cost are:

LIBOR for Unilever (saving of % p.a.) 7.875% p.a. for Xerox (saving of 1/8% p.a.)
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Currency Swaps

In a cross-currency swap, two parties exchange principal amounts at the beginning of a swap contract at the initial exchange rate, usually the spot exchange rate During the intermediate time, parties exchange interest payments with each counterparty paying interest in the currency that it received at the beginning of the swap contract At the maturity of the swap contract, initial exchange of principals is reversed usually again at the initial spot rate of exchange Principal amounts may be exchangedcrosscurrency swaps If principal amount is not exchanged currency interest swaps

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Basic Structure of a Currency Swap

Firm B pays 500 million

Firm A pays $5 million

Pay 5% fixed in yen Firm A

Pay Dollar LIBOR Firm B pays $5 million

Firm B

Firm A pays 500 million

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Risks of Interest Rate and Currency Swaps

Interest Rate Risk

Interest rates might move against the swap bank after it has only gotten half of a swap on the books, or if it has an unhedged position.

Basis Risk
If the floating rates of the two counterparties are not pegged to the same index.

Exchange rate Risk

In the example of a currency swap given earlier, the swap bank would be worse off if the pound appreciated.

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Risk contd..

Credit Risk
This is the major concern for a swap dealer: the risk that a counter party will default on its end of the swap.

Mismatch Risk
It is difficult to find a counterparty that wants to borrow the exact amount of money for the exact amount of time.

Sovereign Risk
The risk that a country will impose exchange rate restrictions that will interfere with performance on the swap.

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Sample Interest Rate Swap Problem

A is a credit-worthy firm

A can borrow at 8% fixed A can borrow at flat LIBOR A prefers to borrow floating

B is a less-credit-worthy firm

B can borrow at 9% fixed B can borrow at LIBOR + % B prefers to borrow fixed

Fixed Floating A 8% LIBOR B 9% LIBOR +

Both firms want a 10-year maturity Devise a swap that is mutually beneficial for A and B.

Follow the convention of pricing against flat LIBOR.

Step 2: We are to quote the swap against flat LIBOR Step 4: check our work Step 3: The QSD = so we have 50 bp to As all-in-cost: distribute among 3 LIBOR 0.2 players. Lets try 20 for LIBOR LIBOR Bs all-in-cost: (Step 2) A and B, (Step 2) 8.8% (this leaves 10 bp Swap Bank Profit: for the swap bank) 8.2% 8.3% 10 basis points (Step 3)

Swap Bank

(Step 1)

8%

(Step 1)

LIBOR +
Step 1: A is better at borrowing fixed; B is better at borrowing floating so have them borrow externally according to their comparative advantage
Fixed A 8% B 9%
QSD = 1%

Outside Lender

Floating LIBOR LIBOR +

% = %

Outside Lender

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Sample Currency Swap Problem

A is an Italian firm

A can borrow in euro at 5% fixed A prefers to borrow in dollars but faces $8% cost B has already borrowed in dollars at $8% 5 years ago they issued a 15-year bond B now prefers to borrow in euro but faces 6% cost

B is an American firm

Both firms want a 10-year maturity Devise a feasible swap that eliminates exchange rate risk for A and B

Step 2: We are to eliminate exchange rate risk for A and B Step 4: check our work Step 3: The QSD = so As all-in-cost: we have 50 bp to distribute $7.8% among 3 players. Lets try Bs all-in-cost: $8% 5% 20 for A and B, 5.8% (Step 2) (Step 2) Swap Bank Profit: 10 basis points at (this leaves 10 bp $7.8% 5.8% current exchange rate for the swap bank) (Step 3)

Swap Bank

(Step 1)

5%
Step 1: A is better at borrowing ;
B is better at borrowing $

(Step 1)

$8%

Outside LenderX

so have them borrow externally according to their comparative advantage

Outside Lender

EURO CURRENCY MARKET &ITS INSRUMENTS

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WHAT IS EURO CURRENCY?

Euro Currency

Any currency banked outside its country of origin.

Example- US dollar banked in England

Euro bank

Banks that accepts deposits and make loans in foreign countries

Example - Euro Currency Bank at Frankfurt franc

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EURO CURRENCY DEPOSIT

A deposit in the relevant currency with a bank outside the home country of that currency. A US dollar deposit with a bank in London is a Euro Dollar deposit, a Sterling deposit with a bank in Luxembourg is a Euro Sterling deposit. A Eurodollar Loan is a dollar loan made by a bank outside the US to a customer or another bank. Note- .(Location of the bank matters, neither the ownership of the bank nor the ownership of the deposit)

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EURO CURRENCY MARKETS

The international currency markets, also known as offshore markets where currencies are borrowed and lent. Dollar deposits outside USA or sterling deposits outside UK are called offshore funds and have a market, so long as they are convertible and readily usable in international transactions. Convertible currency is defined as one, which is widely, accepted international payments and whose country does not have Current account controls under Article VIII of the I.M.F. Agreements.

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Euro Currency Market.

Thus Euro-currency market is a market principally located in Europe for lending and borrowing the Worlds most important convertible currencies, namely Dollar, Sterling, French franc, yen, etc. The European Currency Market is an external banking system that runs parallel to the domestic banking system of the country that issued the currency In US, the banks are subject to the Federal reserve Regulation specifying reserve requirements on bank time deposits. The reduced cost structure has led to the growth of the euro-currency and euro dollar market. The Eurocurrency market operates at the interbank/ and or wholesale level.

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Important Features of Eurocurrency Market

1.

It is an international market and it is under no national control.

The dollar deposits in London are outside US control because they are in London It is outside the British control because they are in dollars.

2.

It is a short-term money market.

The deposits in this market range in maturity from one day to several months and interest in paid on all of them

3.

It is a wholesale market.

The size of the individual transaction is usually above $ 1 million

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Important Features of Eurocurrency Market

4.

It is a highly competitive and sensible market.

High competitive: This market is characterized as highly competitive because the market is growing and accepted internationally. Sensible: The Eurodollar market is said to be sensible because it responds faster to the changes in demand and supply of the funds and also reacts to changes in the interest rates.

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Benefits of the Euro ()

The most important implications of having a common currency, the Euro, are: Exchange rate certainty while travelling across Europe No exchange risk and, therefore, no cost of hedging against it No transaction costs Increased transparency and fewer transactions for importers and exporters Increased liquidity in the United Euro financial market

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Factors Contributed to the growth of Euro Currency

1.

Relaxation of exchange control and resumption of currency convertibility.

The general relaxation of exchange control , the stability of the exchange market and the redemption of the currency convertibility in western Europe in 1958 provided an added impetus to the growth of the euro market.

2.

The political factors

The cold war between the United states and the communist countries also contributed to the euro currency market.

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Factors Contributed to the growth of Euro Currency

3.

Balance of payment deficit of the US

It means that the outflow of dollars from US increased to other nations.

It was in 1950 that US started facing the problem of deficit, but it was in 1958 that the problem reached to the saturation point. The outflow of USD contributed as a factor for expanding Eurocurrency market.

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Factors Contributed to the growth of Euro Currency

4.

The regulation of Q

Regulation Q was a United States government regulation which fixed the maximum interest payable by the banks in US and restricted the payment of interest on deposits less than 30 days. Unlike US, Eurodollar market paid interest on the deposits of less than 30 days.

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Factors Contributed to the growth of Euro Currency

5.

Innovative banking
The advent of the Innovative banking, spearheaded by the US banks in europe and the willingness of the banks in the market to operate on a narrow basis also encouraged the growth of euro market.

6.

Supply of petrodollars
The flow of petro dollar facilitated by the increase in the OPECS oil revenue following by the oil price hike since 1973 has been a significant source of growth of Euro currency.

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European Central Bank

It was set up in 1998 It is based in Frankfurt (Germany) Its job is to manage the EURO It is responsible for framing and implementing EUs economic and monetary policy The 16 members who have adopted euro as their currency make up the Euro area and their central banks together with ECB, make up what is called Eurosystem.

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Members of Eurocurrency Market

Only 16 out of 27 members states use euro as their currency. These are:Austria (2000) Belgium (2000) Cyprus (2008) Finland (2000) France (2000) Germany (2000) Greece (2006) Ireland (2000)

Italy (2000) Luxembourg (2000) Malta (2008) Netherlands (2000) Portugal (2000) Slovakia Slovenia (2007) Spain (2000)

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Origins of Eurocurrency Markets

Markets originated in mid--1950s when banks in Europe and Canada decided to use their funds in $ to finance trade and investment projects. Eurobanks could circumvent domestic policies and regulations, which made the business more attractive. Both supply and demand factors helped the growth of the Eurocurrency Markets. Supply Factors

U.S. dollars were held by Europeans for transactions in commodities and metals, for hedging purposes and as a store of a value. Russians and Eastern Europeans were reluctant to keep their $ in U.S. Relaxation of exchange controls in Europe in 1958.

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Contd.

Demand Factors

After the use of the was banned for financing foreign trade, British merchant Banks offered overseas loans in $. Eurobanks were able to offer higher rates on $ deposits than the rates that domestic U.S. banks could offer.

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Eurocurrency Loans

The most important characteristics of the Eurocurrency Market is that loans are made on a floating rate basis. Interest rates on loans to governments and their agencies, corporations, and nonprime banks are set at a fixed margin above LIBOR for the given period and the currency chosen.

At the end of each period, the interest for the next period is calculated at the same fixed margin over the new LIBOR

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Multicurrency Clauses

Borrowing can be done in many different currencies. This clause allows the borrower the right to switch from one currency to another on any rollover date Rates are fixed, at companys discretion, at 3-months, 6 months or 12-months interval. At each rollover date, the firm can choose from any freely available Eurocurrency except Eurosterling.

Relationship b/w Domestic and Eurocurrency markets

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Interest rates differ in both the markets due to the following reasons:Additional Costs like legal formalities of foreign country Risk associated with moving currency. The effectiveness of the monetary authorities controls. In general, Eurocurrency spreads are narrower than in domestic money markets.

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Contd.
Lending rates can be lower for the following reasons: The lack of reserve requirements increases a banks earning assets rate. Regulatory expenses are lower or nonexistent Eurobanks are not forced to lend money to certain borrowers at concessionary rates. Most borrowers are well known, reducing the cost of information gathering and credit analysis. Eurocurrency lending is characterized by high volumes, and thus transaction costs are reduced.

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Contd.
Eurocurrency deposit rates are higher because of the following reasons: They must be higher to attract domestic deposits. Eurobanks can afford to pay higher rates based on their lower regulatory costs. A larger percentage of deposits can be lent out. Eurobanks are not subject to interest rate ceilings that prevail in many countries.

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Features of Euro-Currency Market

1. 2.

3.

4.
5. 6.

7.

Types of transactions Control of the country of issue of the currency Huge amounts of transactions Highly competitive Market Floating rates of interest based on LIBOR Dominance of Dollar denominated transactions Four different segments

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Contd.
1. Types of Transactions

Japanese Exporter, earning USD, keeps these USD in London Bank (say AMEX)as Deposit. AMEX bank may use such deposits for lending to a French Importer.
Indian exporter, earning Japanese Yen, keeps these Yen in Korea as Deposit . Nigerian Importer avails loan in INR from Russia to import machinery from India.

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Contd.
2. Control of the country of issue of the currency

No Direct Control of the country which issued the currency: Utility of the currency that is being bought and sold is entirely outside the control of the country of its issue. But Indirect control is possible: As the settlement always takes place in the country in which the currency is issued, indirect control is possible.

Because of this Euro-Currencies are also referred to as Offshore Currencies.

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Contd. 3. Huge amount of Transactions

Generally they are in only millions of USD.

This has lead to Syndication of loans, where large numbers of banks participate in the lending operations. It also consists of pool of large number of short term deposits, which provides the biggest single source of funds for commercial banks .

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Contd. 4. Highly competitive market

There are no entry barriers. There is free access to the new institutions in the market.
The lending rates are low and deposit rate are high, thus allowing a wafer thin margin for operations. Consumers, i.e. investors and borrowers derive advantage out of this situation.

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Contd.
5. Floating rates of interest based on LIBOR

The rate of interest in the market is linked to the Base Rate usually LIBOR, i.e. London Inter-Bank Offered Rate . The rate of interest on advances and deposits is reviewed periodically and amended according to changed circumstances, if any in LIBOR

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Contd. 6. Dominance of Dollar in the market

Dollar is a leading currency traded in the market (about 90% to 95% market share). However other currencies are now emerging thus reducing the role of dollar somewhat (about 80% market share)

Euro Japanese Yen Pound Sterling

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Contd. 7. Eurocurrency market Segments

There are four predominant market segments as follows:

1. Euro-credit markets: where international group of banks engage in lending for medium and long term 2. Euro-bond market: where banks raise funds on behalf of international borrowers by issuing bonds 3. Euro-currency (deposit) market: where banks accept deposits, mostly for short term 4. Euro-notes market: where Corporates raise funds

EUROCURRENCY MARKET INSTRUMENTS

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Segment 1: Euro-Credit Markets

1.

2.

3.

4.

1.

2.

Tenure: Medium and Long Term Loans [up to 10--15 years 10% of loans, 58 years 85% of loans, 1 5 years 5% of loans] provided by group of banks. Amount: It is a wholesale sector of the international capital market. Security: Loans are provided without any primary or collateral security. Credit rating is the essence of lending Type of loan: a) Revolving [like cash credit] b)Term Credit Interest Rate: Generally 1% above the reference rate, rolled over every six moths Currency: Generally USD, but can be any other currency, as required by the borrower and ability of the lender.

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Segment 1: Euro-Credit Markets

Syndication of Loan:

Managing banks, as desired by the borrower Lead bank, generally who takes the largest share of lending Agent bank, as required to take interest of the banks in syndication and comply with the procedure Common assessment of the borrower and his country Common documentation In very few cases co-financing with IMF or IBRD is possible

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Segment 2: Euro-Bonds

Euro-Bonds are unsecured securities They are therefore issued by borrowers of high financial standing When they are issued by government corporation or local bodies, they are guaranteed by the government of the country concerned Euro-Bond is outside the regulation of a single country. The investors are spread worldwide However foreign bonds are issued in only one country and are subject to the regulation of the country of issue.

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Segment 2: Euro-Bonds

Selling of EB is through syndicates of the banks Lead manager advises about size, terms and timing of the issue Entire issue is underwritten Lead managers fees, underwriting commission and selling commission is somewhere between 2% and 2.5% of the value of the issue

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Segment 2: Euro-Bonds

Lead manager allocates the bonds to all members of the selling group at face value less their commission Thereafter every member is on his own They can sell to investors at whatever price they can obtain Thus no two investors in the Euro-Bond market need pay the same price for the newly issued bonds

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Segment 2: Euro-Bonds

Features of Euro-Bonds:

Most Euro-Bonds are bearer securities Most bonds are denominated in USD 10,000 Average maturity of the Euro-Bond is 5 to 6 years In some cases maturity extends to 15 years Straight or Fixed Rate Bonds Convertible Bonds Currency Option Bonds Floating Rate Notes

Types of Euro-Bonds:

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Types of Euro-Bonds
1. Straight or Fixed Rate Bonds

These are fixed interest bearing securities Interest is normally payable yearly Year is considered of 360 days Maturities range from 3 years to 25 years Right of redemption before maturity may be there or may not be there If the right of redemption is there then redemption is done by offering an premium

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Types of Euro-Bonds
2. Convertible Bonds

These are fixed interest bearing securities Investor has an option to convert bonds into equity shares of the borrowing company The conversion is done at the stipulated price and during the stipulated period Conversion price is normally kept higher than the market price

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Convertible Bonds Contd.

The rate of interest is lower than the rate of interest on comparable straight bond. Sometimes the bonds are issued in a currency other than the currency of the share. This provides an opportunity to diversify the currency risk as these bonds are issued with fixed exchange rate of conversion. Bonds with warrants: warrant is part of the bond but is detachable and traded separately, when the conversion takes place. The investor can keep the bond and trade the warrant for shares.

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Types of Euro-Bonds
3. Currency Option Bonds

They are similar to straight bonds Generally issued in one currency and option to take interest and principal in another currency. Exchange Rate is either fixed (generally not) or is spot rate prevailing in the market three business days before the due date of payment of interest and principal

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Types of Euro-Bonds
4. Floating Rate Notes

FRN is similar to straight bonds with respect to maturity and denomination Rate of interest however varies and is based on LIBOR + 1/8%, %,1.5%........ Rate of interest is adjusted every six months Minimum interest rate clause may be included drop lock clause may also be included, which means if minimum interest rate happens to be paid then it is locked for the remaining period of the bond. Generally it is found that banks issue and invest in FRNs

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Segment 3: Euro-Currency Deposits

1.

Euro-bonds represent the funds amassed by the bank on behalf of international borrower; Euro-currency deposits represent the funds accepted by the bank themselves.

2.

The Euro-currency market consists of all deposits of currencies placed with the banks outside their home currency. The deposits are accepted in Eurocurrencies, as well as currency cocktails (SDR, ECU etc.)

3.

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Segment 3: Euro-Currency Deposits

4. The deposits are placed at call (overnight, two days or seven days notice) for USD, Sterling pounds, Canadian dollars and Japanese Yen; and of two days in any other currencies 5. Time deposits are accepted for periods of 1,3,6 and 12 months for all currencies 6. USD and Sterling pound can be placed for a period of five years 7. Minimum size of deposit is USD50,000 or its equivalent

Segment 3: Euro-Currency Deposits: Certificate of Deposit

1. 2.

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3. 4. 5. 6. 7.

8.

It is negotiable instrument They are bearer instrument and can be traded in the secondary market Period: 1 year (1 month through 12 months) Minimum amount: USD50,000 Currencies: USD, Sterling Pound, Yen Interest Rate: 1/8 % below LIBOR Tranche CD: carries different rates of interest for each tranche Discount CD: they are issued at discount

1-90

Segment 4: Euro-Notes Market

1.

2.

3.

4.

This market constitutes the instruments of borrowing issued by the corporate in the Eurocurrency market The instruments issue may be underwritten or may not be underwritten The borrowers directly approach the lenders without the intermediation of the banks or financial institution. Instruments are of the following categories:

Commercial Paper Note issuance Facilities Medium Term Notes

1-91

Commercial Paper

An unsecured, short-term loan issued by a bank or corporation in the international money market, denominated in a currency that differs from the corporation's domestic currency. It is a promissory note with maturity less than a year, generally the period varies between 90 days to 180 days.

Generally issue is not underwritten

Amount: USD 100,000 or equivalent Issued on Discount to Yield basis, but interest rate works out lesser than that is paid on bank borrowing and higher than that is paid by the bank on deposits

For example, if a U.S. corporation issues a short-term bond denominated in Canadian dollars to finance its inventory through the international money market, it has issued euro commercial paper.

1-92

Note Issuance Facilities (NIF)

1.

2.

3.

4.

A medium-term legally-binding commitment under which a borrower can issue a short-term paper in its own name, underwritten by banks which are committed either to purchase any note the borrower is unable to sell, or to provide credit. Borrowers place short term notes of 3 months to 6 months maturity directly with the investors and the notes are rolled over on maturity The banks underwrite at the time of issue as well as when the notes are rolled over With slight variation they are also known as: Revolving underwriting facility (RUF) Standby Note Issuance Facility (SNIF) Note Purchase Facility (NPF)

1-93

Euro Medium-Term Notes

1.

MTN represents Long Term, Non Underwritten and fixed interest rate source of raising finance. It can be comparable with Euro-bonds with a difference that Eurobonds issue is underwritten, where as MTN issue is not underwritten. Their maturity is somewhere between short term CPs(less than one year) and long term Euro bonds(more than five years) They are privately placed and have great flexibility

2.

3.

4.

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Euro-Issues

Access to Euro Equity Market is through the following two ways:

Foreign Currency Convertible Bonds Depository Receipts *** (FCCB has already been explained)

Depository Receipts:

American Depository Receipts Global Depository Receipts

1-95

American Depository Receipts

A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction.

1-96

ADR contd.

It is an excellent way to buy shares in a foreign company while realizing any dividends and capital gains in U.S. dollars. However, ADRs do not eliminate the currency and economic risks for the underlying shares in another country. For example, dividend payments in Euros would be converted to U.S. dollars, net of conversion expenses and foreign taxes and in accordance with the deposit agreement. ADRs are listed on either the NYSE, AMEX or Nasdaq.

1-97

Global Depository Receipts

A Global Depository Receipt or global depositary receipt (GDR) is a certificate issued by a depository bank, which purchases shares of foreign companies and deposits it on the account. GDRs represent ownership of an underlying number of shares Global depository receipts facilitate trade of shares, and are commonly used to invest in companies from developing or emerging markets

1-98

Global Depository Receipts contd

Shares of the issuing company are issued in the name of an international bank, located in foreign country and is called as Depository The physical possession of the shares issued is with the Custodian, in the issuing country Based on the shares issued to depository, depository issues GDR in USD GDR is a negotiable instrument GDR is a bearer instrument and traded in international market, either through stock exchange mechanism or on Over The Counter basis

Exchange risk is borne by the investor

1-99

Global Depository Receipts contd

Prices of global depositary receipt are often close to values of related shares, but they are traded and settled independently of the underlying share. Several international banks issue GDRs, such as JPMorgan Chase, Citigroup, Deutsche Bank, Bank of New York. A GDR is very similar to an American Depositary Receipt (ADR).

1-100

International Bond

An international bond is a type of long-term debt security. An international bond essentially works like a loan, with the investor being the lender and the issuing entity being the borrower. International bonds can provide bondholders with the ability to earn fixed interest payments for a set period of time. The investor then earns interest payments at periodic intervals until the bond reaches its maturity date. Once the bond matures, the initial principal is paid back to the investor in full.

1-101

Contd.
A Eurobond is a type of international bond that is issued using currency that differs from the domestic market countrys currency. Eurobonds are named according to the currency in which they are denominated in. For example, a Euroyen bond is denominated in Japanese yen.

1-102

Issues in Foreign Domestic Market

When bonds (or equities) are issued in only one foreign domestic capital market, they are known as:

Yankee Bonds, if issued in US domestic market Bulldog bonds, if issued in UK domestic market Samurai Bonds, if issued in Japanese domestic market

Measuring and Managing Foreign Exchange RISK & Exposure

What is it and How it Affects the Multinational Firm?

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Definitions

Exposure refers to the degree to which a company is affected by exchange rate changes.

Exchange rate risk is defined as the variability of a firms value due to uncertain changes in the rate of exchange.

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What is Foreign Exchange Exposure?

Simply put, foreign exchange exposure is the risk associated with activities that involve a global firm in currencies other than its home currency. Essentially, it is the risk that a foreign currency may move in a direction which is financially detrimental to the global firm. Given our observed potential for adverse exchange rate movements, firms must:

Assess and Manage their foreign exchange exposures.

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Foreign Exchange Exposure

Foreign exchange exposure is a measure of the potential for a firms profitability, net cash flow, and market value to change because of a change in exchange rates

These three components (profits, cash flow and market value) are the key financial elements of how we view the relative success or failure of a firm While finance theories tell us that cash flows matter and accounting does not, we know that currencyrelated gains and losses can have destructive impacts on reported earnings which are fundamental to the markets opinion of that company

Does Foreign Exchange Exposure Matter? What do Global Firms Say

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Nike: Our international operations and sources of supply are subject to the usual risks of doing business abroad, such as possible revaluation of currencies (2005). Starbucks: In fiscal 2004, international company revenue [in US dollars] increased 32%, [in part] because of the weakening U.S. dollar against both the Canadian dollar and the British pound. (2005). McDonalds: In 2000, the weak euro, British pound and Australian dollar had a negative impact upon reported [US dollar] results. (2000).

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Global Companies and FX Exposure

What are the specific risks to a global firm from foreign exchange exposure?

Cash inflows and outflows, as measured in home currency equivalents, associated with foreign operations can be adversely affected.

Revenues (profits) and Costs

Settlement value of foreign currency denominated contracts, in home currency equivalents, can be adversely affected.

For Example: Loans in foreign currencies.

The global competitive position of the firm can be affected by adverse changes in exchange rates.

Influence on required return.

End Result: The value (market price) of the firm can be adversely affected.

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Types of Foreign Exchange Exposure

There are three distinct types of foreign exchange exposures that global firms may face as a result of their international activities. These foreign exchange exposures are:

Transaction exposure (sometimes called contractual exposure)

Any MNC engaged in current transactions involving foreign currencies.

Operating exposure)

exposure(sometimes

called

economic

Results for future and unknown transactions in foreign currencies resulting from a MNC long term involvement in a particular market.

Translation exposure (sometimes called accounting exposure).

Important for MNCs with a physical presence in a foreign country.

1-110

EXPOSURE OF FOREIGN EXCHANGE RISK

Three types of Exposure:

Exchange Rate Shock

1. Translation or Accounting Exposure in FE rate in Accounting statements 3. Operating Exposure in FE rate in future cash flows

2. Transaction Exposure in FE rate in outstanding obligations

1-111

Exhibit: Corporate Foreign Exchange Exposure

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Transaction Exposure

Transaction Exposure: Results from a firm taking on fixed cash flow foreign currency denominated contractual agreements.

Examples of translation exposure:

An Account Receivable denominate in currency. A maturing financial asset (e.g., denominated in a foreign currency. An Account Payable denominate in currency. A maturing financial liability (e.g., denominated in a foreign currency.

a foreign a bond)

a foreign a loan)

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Operating Exposure

Operating Exposure: Results from the physical entry (and on-going presence) of a global firm into a foreign market.

This is a long term foreign exchange exposure resulting from a previous FDI location decision.

Over time, the firm will acquire foreign currency denominated assets and liabilities in the foreign country. The firm will also have operating income and operating costs in the foreign country. Operating exposure impacts the firm through contracts and

transactions which have yet to occur, but will, in the future, because of the firms location.

These are really future transaction exposures which are unknown today. Operating exposure can have profound impacts on a global

firms competitive position and on the market value of that firm.

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The Two Channels of Operating Exposure

Foreign currency denominated asset & liability exposure

Impact on the home currency value of foreign assets and liabilities

Exchange Rate Fluctuations

MNCs Competitive Position and Value

Impact on home Operating exposure currency amount of (Revenues and Costs) future operating cash flows

1-115

Translation Exposure

Translation Exposure: Results from the need of a global firm to consolidated its financial statements to include results from foreign operations.

Consolidation involves translating subsidiary financial statements from local currencies (in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent). Consolidation can result in either translation gains or translation losses.

These are essentially the accounting systems attempt to measure foreign exchange ex post exposure.

1-116

Assessing Foreign Exchange Exposure

All global firms are faced with the need to analyze their foreign exchange exposures.

In some cases, the analysis of foreign exchange exposure is fairly straight forward and known. For example: Transaction exposure. There is a fixed (and thus known) contractual obligation (in some foreign currency) . While in other cases, the analysis of the foreign exchange exposure is complex and less certain. For example: Economic exposure There is great uncertainty as to what the firms exposures will look like over the long term.

Specifically when they will take place and what the amounts will be.

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Using a Hedge to Deal with Exposures

In using a hedge, a firm establishes a situation opposite to its initial foreign exchange exposure.

A firm with a long position: i.e., it expects to receive foreign currency in the future, will: Offset that position with a short position (i.e., a payment in the future) in the same currency. A firm with a short position: i.e., it expects to pay foreign currency in the future, will: Offset that position with a long position in the same currency. In essence, the firm is covering (offsetting) the original foreign exchange position.

Since the firm has two opposite foreign exchange positions, they will cancel each other out.

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To Hedge or Not to Hedge?

What are some of the factors that would influence a global firms decision to hedge its exposures?

Perhaps the firms assessment of the future strength or weakness of the foreign currency it is exposed in.

This involves forecasting and how comfortable the firm is with the results of the forecast. For example; If the firm has a long position in what they think will be a strong currency they may decide not to hedge, or do a partial hedge. Under these assumptions, a firm might accept an open position.

On the other hand, firms may decide not have any currency exposures and simply focus on their core business.

Does Starbucks want to sell coffee overseas or speculate on currency moves? Obviously, this is different from a company managing a hedge fund, or a currency trading floor?

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Hedging Strategies

It appears that most MNC firms (except for those involved in currency-trading) would prefer to hedge their foreign exchange exposures. But, how can firms hedge?

(1) Financial Contracts Forward contracts (also futures contracts) Options contracts (puts and calls) Borrowing or investing in local markets. (2) Operational Techniques Geographic diversification (spreading the risk)

Managing TRANSACTION Exposure

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Transaction Exposure

Transaction exposure exists when the future cash transactions of a firm are affected by exchange rate fluctuations. When transaction exposure exists, the firm faces three major tasks:
Identify its degree of transaction exposure, Decide whether to hedge its exposure, and Choose among the available hedging

techniques if it decides on hedging.

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Measurement of Transaction Exposure

Transaction exposure measures gains or losses that arise from the settlement of existing financial obligations, namely

Purchasing or selling on credit goods or services when prices are stated in foreign currencies Borrowing or lending funds when repayment is to be made in a foreign currency Being a party to an unperformed forward contract and Otherwise acquiring assets or incurring liabilities denominated in foreign currencies

1-123

Identifying Net Transaction Exposure

Centralized Approach - A centralized group consolidates subsidiary reports to identify, for the MNC as a whole, the expected net positions in each foreign currency for the upcoming period(s). Note that sometimes, a firm may be able to reduce its transaction exposure by pricing some of its exports in the same currency as that needed to pay for its imports.

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Techniques to Eliminate Transaction Exposure

Hedging techniques include:

Futures hedge, Forward hedge, Money market hedge, and Currency option hedge.

MNCs will normally compare the cash flows that could be expected from each hedging technique before determining which technique to apply.

1-125

Techniques to Eliminate Transaction Exposure

A futures hedge involves the use of currency futures. To hedge future payables, the firm may purchase a currency futures contract for the currency that it will be needing. To hedge future receivables, the firm may sell a currency futures contract for the currency that it will be receiving.

1-126

Techniques to Eliminate Transaction Exposure

A forward hedge differs from a futures hedge in that forward contracts are used instead of futures contract to lock in the future exchange rate at which the firm will buy or sell a currency.

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Techniques to Eliminate Transaction Exposure

An exposure to exchange rate movements need not necessarily be hedged, despite the ease of futures and forward hedging. Based on the firms degree of risk aversion, the hedge-versus-no-hedge decision can be made by comparing the known result of hedging to the possible results of remaining unhedged.

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Techniques to Eliminate Transaction Exposure

Real cost of hedging payables (RCHp) =

+ nominal cost of payables with hedging nominal cost of payables without hedging

Real cost of hedging receivables (RCHr) =

+ nominal home currency revenues received without hedging nominal home currency revenues received with hedging
Hence, If the real cost of hedging is negative, then hedging is more favorable than not hedging.

1-129

Techniques to Eliminate Transaction Exposure

A money market hedge involves taking one or more money market position to cover a transaction exposure. Often, two positions are required.

Payables: Borrow in the home currency, and invest in the foreign currency. Receivables: borrow in the foreign currency, and invest in the home currency.

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Techniques to Eliminate Transaction Exposure

Note that taking just one money market position may be sufficient.

A firm that has excess cash need not borrow in the home currency when hedging payables. Similarly, a firm that is in need of cash need not invest in the home currency money market when hedging receivables.

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Techniques to Eliminate Transaction Exposure

The known results of money market hedging can be compared with the known results of forward or futures hedging to determine which the type of hedging that is preferable.

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Techniques to Eliminate Transaction Exposure

A currency option hedge involves the use of currency call or put options to hedge transaction exposure. Since options need not be exercised, firms will be insulated from adverse exchange rate movements, and may still benefit from favorable movements. However, the firm must assess whether the premium paid is worthwhile.

1-133

Techniques to Eliminate Transaction Exposure

Hedging Payables Futures hedge Forward hedge Money market hedge Purchase currency futures contract(s). Negotiate forward contract to buy foreign currency. Borrow local currency. Convert to and then invest in foreign currency. Hedging Receivables Sell currency futures contract(s). Negotiate forward contract to sell foreign currency. Borrow foreign currency. Convert to and then invest in local currency.

Currency option

Purchase currency call option(s).

Purchase currency put option(s).

Managing OPERATING Exposure

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Operating Exposure

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Exchange rate risk as applied to the firms competitive position. Any anticipated changes in the exchange rates would have been already discounted and reflected in the firms value. Economic exposure can be defined as the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.

Operating Exposure

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Analyze change in PV of firm resulting from changes in future operating cash flows & competitive position caused by any unexpected change in exchange rates.

Operating cash flows arise from inter-company and intra-company receivables & payables, rent & lease payments, royalty & licensing fees. Financing cash flows are payments for use of inter- and intra- company loans & stockholder equity.

1-137

Operating Exposure
US$ Reporting
US$/ Lucent US
Will altered profits of German subsidiary, in euro, translate into more/ less US $?

Euro

Lucent Europe

How sales, costs, & profits of German subsidiary change w/ $/EUR?

Lucent Suppliers
Will costs change w/ $/EUR?

Lucent Customers
Will prices & sales volume change w/ $/EUR?

1-138

Managing Operating Exposure

Can diversify firms operating & financing base.

Diversifying operations:

diversifying firm sales. diversifying location production facilities. diversifying raw material sources. If firm diversified, management can profit from change in worldwide competitive conditions.

Diversifying financing: raising funds in more capital markets & currencies.

If financially diversified, management can take advantage of deviations from Fisher open.

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How to manage operation exposure?

Can partially manage exposure by operating/ financing policies offsetting anticipated currency exposures. Common policies:

Matching currency cash flows. Risk-sharing agreements. Back-to-back (parallel) loans. Currency swaps.

Managing TRANSLATION Exposure

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Translation Exposure

Translation exposure, also called accounting exposure, arises because the financial statements of foreign subsidiaries must be restated in the parents reporting currency for the firm to prepare its consolidated financial statements Translation exposure is the potential for an increase or decrease in the parents net worth and reported income caused by a change in exchange rates since the last transaction Translation methods differ by country along two dimensions One is a difference in the way a foreign subsidiary is characterized depending on its independence The other is the definition of which currency is most important for the subsidiary

1-142

Subsidiary Characterization

Most countries specify the translation method to be used by a foreign subsidiary based upon its operations A foreign subsidiary can be classified as

Integrated Foreign Entity one which operates as an extension of the parent company, with cash flows and line items that are highly integrated with the parent Self-sustaining Foreign Entity one which operates in the local economy independent of its parent

The foreign subsidiary should be valued in terms of the currency that is the basis of its economic viability

1-143

Functional Currency

A foreign affiliates functional currency is the currency of the primary economic environment in which the subsidiary operates The geographic location of a subsidiary and its functional currency can be different

Example: US subsidiary located in Singapore may find that its functional currency could be

US dollars (integrated subsidiary) Singapore dollars (self-sustaining subsidiary) British pounds (self-sustaining subsidiary)

1-144

Translation Methods

There are two basic methods for the translation of foreign subsidiary financial statements The current rate method The temporal method Regardless of which is used, either method must designate The exchange rate at which individual balance sheet and income statement items are remeasured Where any imbalances are to be recorded This can affect either the balance sheet or the income statement

1-145

Current Rate Method

Under this method all financial statement items are translated at the current exchange rate Assets & liabilities are translated at the rate of exchange in effect on the balance sheet date Income statement items all items are translated at either the actual exchange rate on the dates the various revenues, expenses, gains and losses were incurred or at a weighted average exchange rate for the period Distributions dividends paid are translated at the rate in effect on the date of payment Equity items common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year

1-146

Current Rate Method

Any gain or loss from re-measurement is closed to an equity reserve account entitled the cumulative translation adjustment, rather than through the companys consolidated income statement These cumulative gains and losses from remeasurement are only recognized in current income under the current rate method when the foreign subsidiary giving rise to that gain or loss is liquidated

1-147

Temporal Method

Under this method, specific assets and liabilities are translated at exchange rates consistent with the timing of the items creation The temporal method assumes that a number of line items such as inventories and net plant and equipment are restated to reflect market value If these items were not restated and carried at historical costs, then the temporal method becomes the monetary/non-monetary method

1-148

Temporal Method

Line items included in this method are

Monetary assets (primarily cash, accounts receivable, and long-term receivables) and all monetary liabilities are translated at current exchange rates Non-monetary assets (primarily inventory and plant and equipment) are translated at historical exchange rates Income statement items are translated at the average exchange rate for the period except for depreciation and cost of goods sold which are associated with non-monetary items, these items are translated at their historical rate

1-149

Temporal Method

Line items included in this method are

Distributions dividends paid are translated at the exchange rate in effect the date of payment Equity items common stock and paid-in capital are translated at historical rates; year end retained earnings consist of year-beginning plus or minus any income or loss on the year plus or minus any imbalance from translation

Under the temporal method, any gains or losses from re-measurement are carried directly to current consolidated income and not to equity reserves

1-150

Managing Translation Exposure

Balance Sheet Hedge this requires an equal amount of exposed foreign currency assets and liabilities on a firms consolidated balance sheet

A change in exchange rates will change the value of exposed assets but offset that with an opposite change in liabilities This is termed monetary balance The cost of this method depends on relative borrowing costs in the varying currencies

1-151

Managing Translation Exposure

When is a balance sheet hedge justified?

The foreign subsidiary is about to be liquidated so that the value of its CTA would be realized The firm has debt covenants or bank agreements that state the firms debt/equity ratios will be maintained within specific limits Management is evaluated on the basis of certain income statement and balance sheet measures that are affected by translation losses or gains The foreign subsidiary is operating in a hyperinflationary environment

1-152

THANK YOU