FX Concepts

1. FX Concepts

2. Foreign Exchange (FX) Conversion of one currency into another eg EUR into USD

3. What is FX/FOREX? Conversion of one currency into another eg EUR into USD BUT this definition is in a mathematic formula context! A$ A$ worth in terms of a basket of currencies A$ worth in terms of GBP BUT Why convert? A currency, say AUD, is measured in another currency or basket of currencies to understand what is its worth (value) according to factors of supply and demand for that currency (AUD)

4. What determines a currency’s FX rate? A currency, say AUD, is measured in another currency or basket of currencies to understand what is its worth (value) according to factors of supply and demand for that currency (AUD) Influences of FX Rates: Differences of inflation rates in countries Differences of interest rates in countries Different current-account deficits of countries Different public deficits in countries Different balance of payments between countries Different political stability and economic performance in countries (Source: http://www.investopedia.com/articles/basics/04/050704.asp)

5. FX Markets in Different Cities Across the World Treasury-staff Funds Mgt staff Risk Managers Brokers International Companies FX Trading Corporate Finance-staff Treasury-staff Funds Mgt staff Dealers/Traders Funds Managers What is Forex? (1.53m)

6. Functions of FX Markets • Transaction Purposes • Currency conversion • Currency hedging (conversion value risk reduction) • Currency arbitrage (profit taking without conversion losses) • Currency speculation (speculative profit taking) Currency Buyers Currency Sellers

7. 4 Buyer is worried of worst case What is a FX Hedge? 3 Buyer has to pay in AUD in the future. If there is no FX hedge (insurance), buyer could be: Paying more if JPY/AUD rate decreases (AUD is worth more) Paying less if JPY/AUD rate increases (AUD is worth less) 1 Transact Deal AUD JPY Can result in loss 2 NOW- Contract Agreement Settlement date in the future 5(b) Agree to lock in a fixed FX rate 5 (a) Buyer purchases a hedge contract against an unfavourable JPY/AUD movement on settlement date

8. FX Hedging Process • Examples of the different types of hedging strategies: • Forward exchange contract for currencies • Currency future contracts • Money Market Operations for currencies • Forward Exchange Contract for interest • Money Market Operations for interest • Future contracts for interest • Derivatives eg risk reversal, delta neutral instruments – What are Derivatives? (4.18 m)

9. History of Gold Standard WW1 (1914-18) WW2 (1939-45) 1870s Currencies valued against gold • Governments started printing $ • Inflation & collapse of gold standard when people used gold as a commodity for transactions Gold standard ended at first of WW2 Gold was a powerful tool for achieving balance of trade equilibrium between countries  evolution of international monetary policy development

10. International Monetary Funds (IMF) 188 countries working together to: foster global monetary cooperation, secure financial stability, facilitate international trade, promote high employment and sustainable economic growth, reduce poverty around the world (Source: http://www.imf.org/external/about.htm) Also lend $ to countries (governments) subject to resolve in: Implementing governmental reforms to stabilize monetary policy and Fostering economic growth eg encourage FDI in developing countries

11. Fixed & Floating FX Rate Regimes FIXED FX Rate A currency’s FX is pegged to another • Aims to: • Ensure governments do not expand $upply at inflationary rates • Increases certainty in terms of uncertainty • Negative: • No clear correlation between FX rate and trade balance

12. Fixed & Floating FX Rate Regimes Floating FX Rate A currency’s FX is pegged to another • Aims to: • Give monetary policy autonomy to countries • Automatic trade balance adjustments • Negative: • Trade deficit  depreciation of a currency  currency is worth less • Trade surplus  currency appreciates  worth more Obama: China currency undervalued (13 Apr 2010) – 1.51 m China to re-engage the managed floating exchange rate (19 Jun 2010) - 2.06m

13. Caterpillar Case • The world’s leading manufacturer of: • Construction & mining equipment, • diesel & natural gas engines, • industrial turbines & • diesel-electric locomotives. • Is also a leading financial services provider via Caterpillar Financial Services. International business Manufacturing & Financial Services

14. Caterpillar Case Usually payable in another currency Business Transactions in multiple currencies Contract Transaction GBP 000 000 000…. Contract Transaction USD 000 000 000…. Contract Transaction JPY 000 000 000…. Transaction exposure = payment currency value (+worth changes) when FX rates move

15. Caterpillar Case Usually payable in another currency Business Transactions in multiple currencies Contract Transaction GBP 000 000 000…. Contract Transaction USD 000 000 000…. Contract Transaction JPY 000 000 000…. Translation exposure = General Ledger’s book values of foreign currencies’ payments & receivables converted to the currency used in a firm’s financial statement reporting at corporate and other international branch levels General Ledger

16. Caterpillar Case In the 1980s a stronger dollar hurt Caterpillar’s competitive position, but in 2008, a stronger dollar did not seem to have the same effect How did Caterpillar use strategy as a “real hedge” to reduce its exposure to FX risk? What is the downside of this approach? Explain the difference between transaction exposure and translation exposure using material in the Caterpillar Tractor case to illustrate your answer.