ACCA F9 Financial Management - 2010 - Study text

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Chapter 18: Business valuations

Some of these concepts might seem familiar to you, and you might agree that

investors are likely to behave in illogical ways.

However, there are limitations to the value of behavioural finance.

 Behavioural finance can explain why investors might act irrationally and why

share prices move higher or lower than should be expected on rational economic

grounds. However, concepts of behavioural finance cannot be used to predict

what share prices will be, or how they will move. It does not therefore provide a

reliable basis for making investment decisions.

 It might also be argued that irrational behaviour affects share prices in the short

term, but essentially investors are likely to act in a way they consider rational, in

order to maximise their investment returns. In spite of the effects of psychology

and irrational behaviour on share prices, the logical methods of share price

valuation are probably the most reliable methods of valuation we can use.

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Paper F9

Financial management

CHAPTER

Foreign exchange risk

Contents

1 Thenatureofforeignexchangerisk

2 TheFXmarkets:spotrates

3 ForwardFXcontractsandforwardrates

4 Forecastingfuturespotexchangerates

5Hedgingexposuretoforeignexchangerisk

6 Moneymarkethedging

7 Foreigncurrencyderivatives

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The nature of foreign exchange risk

 The need for foreign exchange

 Exchange rates and volatility

 Types of foreign currency risk

 Government measures to stabilise exchange rates

 Causes of exchange rate fluctuations

 Introduction to purchasing power parity theory

 International Fisher effect: the Fisher formula

 Introduction to interest rate parity theory

1 The nature of foreign exchange risk

1.1 The need for foreign exchange

Many companies make foreign exchange transactions with their banks. The need for

foreign exchange arises from international trade and international investment.

 A company buying goods from another country might be required to pay in a

foreign currency, such as the domestic currency of the supplier. It must therefore

obtain the foreign currency to make the payment.

 A company selling goods abroad might price the goods in the buyer’s domestic

currency, or in another currency such as US dollars. When the customer pays in

the foreign currency, the company might sell the currency received in exchange

for its own domestic currency

 A company investing abroad might need to obtain foreign currency to acquire or

to make the investment.

Many foreign currencies can be bought and sold freely in the foreign exchange

markets (FX markets), which are operated world-wide by banks.

1.2 Exchange rates and volatility

When currencies can be bought and sold in the FX markets, banks quote exchange

rates at which they will deal. Exchange rates are quoted as a number of units of one

currency (the variable currency) in exchange for one unit of the other currency (the

base currency). For example, the sterling/US dollar exchange rate (GBP/USD)

might be 1.9850, meaning that each £1 can be exchanged for US$1.9850 in the

market.

Experience has shown that exchange rates can be very volatile. Volatility means that

exchange rates can move up or down by large amounts, within a fairly short period

of time.

Chapter 19: Foreign exchange risk

 A notable example in recent years has been the euro/US dollar exchange rate.

Since the euro was created in 1999, when its value was about EUR 1 = $1.20, the

exchange rate has ranged between about EUR 1 = $0.80 to about EUR 1 = $1.60.

 The exchange rate between the British pound and the US dollar has also been

volatile, ranging in fairly recent times between about US$1 to £1 to over US$2 to

£1.

Exchange rate volatility creates foreign exchange risk (also called currency risk

and FX risk) for anyone involved in buying, selling, borrowing or investing foreign

currency.

1.3 Types of foreign currency risk

Foreign currency risk can be classified into three types:

 Translation risk

 Transaction risk

 Economic risk

Translation risk

Translation risk arises in international companies with foreign subsidiaries. Income

statements and statements of financial position (balance sheets) will be denominated

in the local currency of the subsidiary and, on consolidation, will be translated into

the currency of the holding company. On translation of financial statements from

one currency to another, losses or gains arise due to exchange rate movements.

Translation risk is therefore the risk of losses (or gains) arising on the translation of

the financial statements of a foreign subsidiary into the currency of the parent

company, for the purpose of preparing consolidated accounts.

Transaction risk

Transaction risk is the foreign exchange risk that arises in transactions between two

parties:

 where the normal transaction currency of each party is different, and

 when the transaction involves a future receipt/payment between the two

parties.

Transaction risk is the risk that, for any future transaction in a foreign currency, the

amount received or paid in domestic currency might be different from the amount

originally expected because of movements in the exchange rate between the date of

the initial transaction and the date of settlement (payment/receipt).

For example, transaction risk will arise when a UK company buys goods from a

Chinese supplier when the price is in US dollars, and payment is required three

months after the date of the purchase.

 For the UK buyer, there is a risk that the US dollar will increase in value against

the British pound in the three months before settlement is required. If the dollar

strengthens in value, the cost in pounds of obtaining the dollars to pay the

supplier will be higher than originally expected.

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 For the Chinese supplier, there is a risk that the US dollar will fall in value

against the Chinese renminbi in the three months before settlement. If the dollar

falls in value, the dollar receipts will learn less in renminbi that originally

expected when the sale was made.

Volatile exchange rates increase transaction risk. Transaction risk can disrupt

international trade, and make businesses more reluctant to trade internationally,

because losses arising from adverse movements in an exchange rate reduce the

profit on sales transactions, or increase costs of purchases. The transaction loss

might even offset the amount of normal trading profit.

Example

A German company sells goods to a US buyer for US$280,000 when the exchange

rate is €1 = $1.4000. The US buyer is allowed three months’ credit, and when the

German company eventually receives the US dollars three months later, and

exchanges them for euros, the exchange rate has moved to €1 = $1.6000.

The original expectation would have been that the sale proceeds in euros would be

€200,000 ($280,000/1.4000). However, during the time that it was exposed to the

currency risk, the exchange rate has moved in an adverse direction, and the actual

receipts are only €175,000 ($280,000/1.6000). The ‘FX loss’ has been €25,000.

This example illustrates several points about transaction risk.

 Currency risk arises from exposure to the consequences of a rise or fall in an

exchange rate. Here, the German company was exposed to the risk of a fall in the

value of the US dollar.

 Transaction risk arises only when the settlement of the transaction (and

receipt/payment) will occur at a future date.

 An exposure lasts for a period of time. Here, the exposure lasts from when the

goods were sold on credit until the time that the customer eventually pays.

 Currency risk is a two-way risk, and exposure to risk can lead to either losses or

gain from movements in an exchange rate. In this example, the exchange rate

could have moved the other way. For example, if the exchange rate after three

months had been €1= $1.25, the German company would have received

€224,000, which is €24,000 more than it would have expected at the time of the

sale. There would have been an ‘FX gain’ of €24,000.

 Trading profits for companies engaged in foreign trade can be significantly

affected by currency movements. When exchange rates are volatile and

unpredictable, the gain or loss on currency exchange could possibly be even

bigger than the expected gross profit from the transaction.

Economic risk

Economic risk refers to the long-term movement in exchange rates caused by

changes in the competitiveness of a country.

Chapter 19: Foreign exchange risk

For example, over the long term the euro might increase in value against the US

dollar. If this happens, goods produced and paid for in US dollars will become

cheaper relative to goods produced and paid for in euros. US companies will

therefore become more competitive in terms of price, relative to companies in the

eurozone, because of the exchange rate movement.

Economic risk, in the context of foreign exchange, is therefore the risk that a

company might choose to locate its operations in a country whose currency gains in

value over time against the currencies of its competitors in world markets. The

consequence of an increase in the value of the domestic currency is a loss of

competitiveness.

Summary: currency risks

Translation risk does not affect the cash flows of a group of companies. It is a risk

of non-cash (‘paper’) losses or gains in preparing consolidated financial statements.

Transaction risk does affect cash flows, because movements in exchange rates affect

the amount of cash received in domestic currency, or the amount paid in domestic

currency, for at least one of the two parties to the transaction.

Economic risk is a strategic risk, affecting the competitiveness of a business entity

over the longer term

1.4 Government measures to stabilise exchange rates

A government might try to stabilise the exchange rate for its currency. In the past,

some governments were able to manage the exchange rate by dealing on the foreign

exchange markets, using their official reserves of foreign exchange to either buy or

sell domestic currency. By creating demand or supply for its currency in the

markets, the government would try to move the exchange rate up or down against

major currencies such as the dollar. However, the foreign exchange markets are now

so large, due to the enormous scale of international trade and investment, that very

few countries are in a position to manage the exchange rate effectively in this way.

(Countries such as China might be an exception.)

The most effective way for a government to manage its exchange rate today, if it

wished to do so, would be to increase or reduce domestic interest rates on its

currency. Raising or reducing interest rates should affect the demand for the

currency from investors. For example, raising the interest rate should attract more

investment into the currency, and by increasing demand for the currency, the

foreign exchange value of the currency should increase.

1.5 Causes of exchange rate fluctuations

There are several approaches to explaining the causes of exchange rate fluctuations

 supply and demand

 purchasing power parity theory

 interest rate parity theory.

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Supply and demand

Exchange rates are determined by supply and demand in the foreign exchange

markets.

For example, the value of the British pound against other currencies is determined

by supply and demand for the pound.

 The demand for pounds comes from buyers of British exports, who are required

to pay in pounds. Pounds are also bought by British exporters who receive

payments in foreign currencies and want to exchange their currency receipts into

pounds.

 Demand for pounds is also created by flows of investment capital and savings.

Foreign investors wishing to purchase investments in the UK must buy pounds

to pay for their investments. UK investors selling their foreign investments

might exchange their sale receipts (in a foreign currency) into pounds.

The supply of pounds comes from individuals and organisations who want to sell

pounds in exchange for a foreign currency.

 UK buyers of foreign goods who must pay in a foreign currency will sell pounds

and buy the currency they need to make the payment.

 Foreign investors who sell their UK investments and receive payment in sterling

will want to sell the pounds in exchange for another currency. UK investors

buying investments abroad must buy currency (and sell pounds) to pay for the

investments.

A balance of trade deficit might affect the exchange rate. This is the difference

between the value of a country’s exports of goods and services and the cost of its

imports. As a general rule if a country has a large balance of trade deficit, its

currency is likely to depreciate in value because supply of its currency from

international trading operations (e.g. from importers who need to pay in foreign

currency) exceeds the demand (e.g. from foreign buyers of exported goods).

Supply and demand for currencies explain the continual fluctuations in currency

values.

However, there are other theories that explain the underlying reasons for exchange

rate movements, especially over the longer term, and an advantage of these other

theories – purchasing power parity theory and interest rate parity theory – is that

they can be used to make estimates of what exchange rates will be in the future.

1.6 Introduction to purchasing power parity theory

Purchasing power parity theory (PPP theory) attempts to explain changes in an

exchange rate by the relative rate of price inflation in each country. The theory is

based on the assumption that the exchange rate will adjust to enable the same

amount of goods to be purchased in any country with a given amount of money.

Chapter 19: Foreign exchange risk

For example suppose that at the beginning of a year, a basket of goods would cost

£100 in the UK and the same basket of goods would cost $200 in the USA. During

the year, price inflation is 5% in the UK and 2% in the USA.

At the end of the year the basket of goods would cost £105 in the UK and $204 in the

USA, but the same amount of goods could be purchased with equivalent amounts of

each currency. This means that the exchange rate must be £105 = $204, or £1 =

$1.9429.

PPP theory therefore predicts that if inflation is higher in one country than in

another, its exchange rate value will fall so as to restore purchasing power parity.

In reality, an exchange rate does not change in the way predicted by PPP theory

because other factors apart from price inflation affect the rate, especially in the short

term. It might be argued, however, that PPP theory provides a useful guide to the

likely direction and extent of exchange rate movements over a longer period of time.

1.7 International Fisher effect: the Fisher formula

The economist Irving Fisher gave his name to the so-called Fisher effect and

international Fisher effect.

The Fisher effect is simply that the real rate of return on an investment is the

nominal rate of return adjusted for the rate of inflation:

(1 + nr) = (1 + rr) (1 + i)

Where

nr = nominal rate of interest

rr =real rate of interest

i = rate of inflation

So if the nominal rate of inflation is 4% per year and the rate of inflation is 2.5%, the

real rate of return is:

(1.04/1.025) – 1 = 0.0146 = 1.46%.

Fisher argued that investors in all countries expect the same real rate of return, after

allowing for inflation, and the difference in interest rates between two countries

could be explained by differences in the rates of inflation in those countries. This is

the so-called international Fisher effect.

From this argument, it is possible to derive interest rate parity theory.

1.8 Introduction to interest rate parity theory

Interest rate parity theory is based on the assumption that exchange rates will adjust

to eliminate differences in interest rates between countries. For example, suppose

that the current exchange rate between the British pound and the US dollar is £1 =

$2, and interest rates are 3% in the USA and 5% in the UK. An investor with £100 in

the UK could invest the money for one year to obtain principal plus interest of £105

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after one year. An investor with $200 in the US could also invest money for one year

to receive interest and principal of $206 at the end of that time.

According to interest rate parity theory, the exchange rate after one year will be £105

= $206, or £1 = 1.9619.

The theory predicts that the currency of a country with a higher interest rate will

depreciate in value over time against the currency of a country with a lower interest

rate.

Like PPP theory, interest rate parity theory cannot explain all exchange rate

movements, especially in the short term, but it might provide a useful guide to

changes in the exchange rate over a longer period.

Purchasing power parity theory and interest rate parity theory are important for

your examination, and can be used to forecast future exchange rates. Forecasting

exchange rates is explained in more detail in a later section.

ACCA F9 Financial Management - 2010 - Study text - Emile Woolf Publishing

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