ACCA F9 Financial Management - 2010 - Study text

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Chapter 19: Foreign exchange risk

The FX markets: spot rates

 Bid and offer rates

 Spot rates

 Quoting exchange rates

2 The FX markets: spot rates

2.1 Bid and offer prices

In an examination, you might be given one figure for the current exchange rate between

two currencies. In practice, banks quote two rates: a bid rate and an offer rate.

 The bid rate is the rate at which the bank will buy the base currency.

 The offer rate is the rate at which the bank will sell the base currency.

In the foreign exchange markets, most exchange rates are quoted to four decimal

places.

It is easy to get confused about which exchange rate should be applied to a

particular transaction. The basic rule to remember is that the bank will use the

rate that is more favourable to itself and less favourable to the customer.

Example

A UK company needs $20,000 to pay a US supplier. The bank’s current rates for

sterling/US dollar (US$/£1) are 1.8850 – 1.8860.

The company needs to buy US dollars in exchange for British pounds, in order to

pay the US supplier. The bank is selling dollars and receiving British pounds in

exchange. It will apply a rate of 1.8850 to the currency transaction with the

company, because 1.8850 will give it more British pounds than the rate of 1.8855.

The cost of buying the dollars is therefore £10,610.08 (= $20,000/1.8850).

Example

The same UK company receives US$25,000 from a customer, and it wants to convert

these dollar receipts into British pounds. The exchange rate is 1.8850 – 1.8860.

The bank will buy dollars and sell the pounds at 1.8860, and so the company will

receive £13,255.57 (= $25,000/1.8860) in exchange for the dollars.

Taking this transaction and the previous example together, the UK company’s cash

flows in British pounds from the two transactions would be as follows:

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 £

Buy$20,000at1.8850:pay (10,610.08)

Sell$25,000at1.8860:receive 13,255.57

Netreceipts 2,645.49

It would be more sensible for the company to pay $20,000 to the US supplier out of

the $25,000 it receives from its customer. That would leave it needing to sell just

US$5,000 at 1.8860. The receipts in British pounds would then be £2,651.11 (=

$5,000/1.8860) which is more than from buying $20,000 and selling $25,000 in

separate transactions. The difference is small, but for a company engaged

extensively in foreign trade, the total amounts involved can become very large over

time.

Exercise 1

(a) A French company has received Aus$7,000 from a customer in Australia. The

current exchange rate for the euro and the Australian dollar (Aus$/€1) is

1.5230 – 1.5240.

How much will the company receive in euros for selling the Australian

dollars?

(b) An Australian company needs to buy €12,000 to pay a Spanish supplier. The

exchange rate is the same as above. How much will it cost the company to

obtain the euros that it needs?

2.2 Spot rates

In the FX markets, banks trade currencies both spot and forward. A spot transaction

is a transaction for the sale of one currency in exchange for another, for ‘immediate’

settlement. ‘Immediate’ settlement in practice usually means after two working

days, so that if a company makes a spot transaction with a bank on a Monday, the

actual exchange of currencies will happen on Wednesday, two working days later.

For the purpose of the examination, however, you can treat spot transactions as

transactions for immediate settlement.

For examination purposes, the spot exchange rate is the current exchange rate for a

transaction ‘now’ to buy one currency in exchange for another.

2.3 Quoting exchange rates

Normal practice in the foreign exchange markets is to quote exchange rates with the

base currency first and the variable currency second. This means, for example, that

if the sterling/US dollar rate is 1.8800, we mean that the exchange rate is £1 =

US$1.8800. Similarly, if the euro/US dollar rate is 1.5700, we mean €1 = US$1.5700.

An examination question may use a different way of quoting exchange rates. For

example, a question might state that the dollar/sterling rate is 1.8800, when it means

£1 = US$1.8800. Or it might state that the dollar/euro rate is 1.5700 when it means

€1 = US$1.5700.

Chapter 19: Foreign exchange risk

It may therefore be important to read an examination question carefully, and make

sure that you understand the meaning of a quoted exchange rate, and identify the

base currency and the variable currency in the rate.

Another way of presenting bid and offer prices

In your examination you might find that bid and offer prices for exchange rates are

presented as an amount above or below a central exchange rate.

For example, the exchange rate for British pounds against the US dollar might be

shown as:

£1 = US 1.9750 ± 0.0010

This would mean that the exchange rate is 1.9740 – 1.9760.

The bank will deal at the rate that is more favourable to itself.

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Forward FX contracts and forward rates

 Forward contracts

 Forward rates

 Quoting forward exchange rates: premiums and discounts

 Cross rates

3 Forward FX contracts and forward rates

3.1 Forward contracts

Banks trade foreign currencies both spot and forward.

 Spot transactions are for immediate settlement.

 A forward FX contract is a contract entered into ‘now’ for settlement at an

agreed future date (or at any time between two agreed future dates).

A bank will arrange a forward contract for settlement at any future date, but

commonly-quoted forward rates are for settlement in one month, three months, six

months and possibly one year.

For example, an Italian company can arrange a forward contract ‘now’ to sell a

quantity of US dollars in exchange for euros in three months’ time, at a rate of

exchange that is agreed ‘now’.

Example

A UK company has purchased goods from a supplier in the USA and must pay

$150,000 to the supplier in two months time.

The company can wait for two months, and then buy the $150,000 from a bank at

the spot rate, whatever the spot rate happens to be at that time.

Alternatively, the company can arrange a forward contract now with a bank to buy

the $150,000 in two months’ time. The exchange rate is fixed by the forward contract

and this is the rate at which the company will buy the dollars in two months,

regardless of what the spot rate happens to be at that time.

3.2 Forward rates

Banks are able to quote forward exchange rates for currencies because of the money

markets (short-term borrowing and lending markets). Forward exchange rates are

different from spot rates, and they differ from spot rates because of the interest rate

differences between the two currencies.

Chapter 19: Foreign exchange risk

A forward rate can be higher or lower than the spot rate, depending on whether

the interest rate on the variable currency is higher or lower than the interest rate on

the base currency.

Example

The current spot rate for the British pound and the US dollar (US$/£1) is 1.8000. The

interest rate on the British pound is 6% per year and the interest rate on the US

dollar is 4% per year. The one year forward rate is the forward rate that a bank will

quote now for trading dollars in exchange for pounds in one year’s time. This

forward rate is:

One year forward rate = Spot rate ×

interest rate on the variable currency

(

)

1+ interest rate on the base currency

()

In this example, the one year forward rate will be

1.8000×

1.04

1.06

⎡

⎣

⎢

⎤

⎦

⎥

=1.7660

Forward rates do not predict future spot rates

A one-year forward rate of £1 = $1.7660 does not mean that the spot rate of

exchange will be $1.7660 in one year’s time. Forward rates do not attempt to predict

what future spot rates will be. A forward rate represents the comparative

investment value of the two currencies between ‘now’ and the settlement date for

the forward contract.

3.3 Quoting forward exchange rates: premiums and discounts

Forward rates are derived from current spot rates and interest rate differences

between currencies. Spot rates change continually, whereas interest rate changes are

less frequent. It is therefore common practice in the FX markets to quote forward

rates as a premium or a discount to the spot rate.

 When the interest rate on the variable currency is lower than the interest rate on

the fixed currency, the forward rate will be lower than the spot rate. The variable

currency will be worth more forward than spot, and the forward rate is at a

premium to the spot rate

 When the interest rate on the variable currency is higher than the interest rate on

the fixed currency, the forward rate will be higher than the spot rate. The

variable currency will be worth less forward than spot, and the forward rate is at

discount to the spot rate.

If you are given spot rates and the premium or discount for the forward rate, you

should apply the following rule:

 Subtract a premium from the spot rate to derive the forward rate

 Add a discount to the spot rate to derive the forward rate.

A premium might be indicated by the letters ‘pm’ and a discount by ‘dis’.

These rules are summarised in the following table:

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The interest rate on the

variable currency is:

Higher

Lower

The forward rate is quoted

forward at a:

Discount to the spot rate

(dis)

Premium to the spot

rate (pm)

Rule for obtaining the forward

rate:

Add the discount to the

spot rate

Subtract the premium

from the spot rate

Example

A UK company expects to receive US$75,000 in six months from a US customer and it

wishes to hedge the exposure to currency risk by arranging a forward contract. The

following rates are available (US$/£1):

GBP/USD

Spot 1.7530

– 1.7540

Six months forward 240

– 231 pm

The dollar is quoted forward at a premium. The premium is shown in ‘points’ of

price, so that 240 – 231 means 0.0240 – 0.0231.

The bank will apply the rate that is more favourable to itself. (If you need to work

out which rate is more favourable, use the spot rates to do this). The company will

be selling US dollars in exchange for pounds, and the higher rate will be used (the

offer rate).

Spot rate 1.7540

Forward points (deduct premium) (0.0231)

Forward rate 1.7309

The company can use a forward contract to fix its future income from the US dollars

at £43,330.06 (75,000/1.7309).

Exercise 2

A US company needs to pay a Mexican supplier in three months. It will have to pay

the supplier 10 million Mexican pesos. The company wants to arrange a forward

contract to hedge its risk exposure. A bank quotes the following rates (pesos/$1):

USD/MXP

Spot 11.2470

– 11.2485

Three months forward 340

– 360 dis

Using a forward contract, what will it cost the US company in dollars to pay the

Mexican supplier in three months’ time?

Chapter 19: Foreign exchange risk

Another way of presenting bid and offer prices

In your examination, just as spot rates might be shown as an amount above or

below a central exchange rate, forward rates might be quoted in the same way.

For example, the three months forward rate for British pounds against the US dollar

might be shown as:

£1 = US 1.9830 ± 0.0015

This would mean that the exchange rate is 1.9815 – 1.9845.

The bank will deal at the rate that is more favourable to itself.

3.4 Cross rates

The exchange rate for two currencies might be derived as a cross rate. This means

that they are not traded directly on the FX markets, but both currencies are traded

through the US dollar. For example, if the exchange rate for the US dollar against

the Hong Kong dollar (USD/HKD) is 8.1000 and the rate for the US dollar against

the Canadian dollar (USD/CAD) is 1.2475, the cross rate for the Hong Kong dollar

against the Canadian dollar (CAD/HKD) is 8.1000/1.2475, which is C$1 =

HK$6.4930.

Exercise 3

The three-month forward rate for the US dollar against the Swiss franc is 1.2166

(US$1 = SwFr1.2166). The three-month forward rate for the US dollar against the

British pound is £1 = US$1.8610.

What is the three-month forward rate for the Swiss franc against the British pound

(quoting the pound as the base currency)?

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Forecasting future spot exchange rates

 Reasons for forecasting future spot rates

 Forecasting exchange rates with purchasing power parity theory

 Forecasting exchange rates with interest rate parity theory

4 Forecasting future spot exchange rates

4.1 Reasons for forecasting future spot rates

A company might wish to forecast what spot exchange rates in the future. The most

usual reasons for needing this information are:

 to assess foreign investments and a foreign investment strategy, or

 to carry out a capital investment appraisal of a proposed foreign investment.

For example a UK company is might plan to invest in another country, say

Argentina. The investment will be in the Argentinian currency, pesos, but the UK

company will have to invest British pounds to make the investment, because it

needs to buy the pesos. The company will then expect to earn profits in pesos over a

number of years and convert these back into British pounds. The value of the

returns in sterling (British pounds) will depend partly on the size of cash profits in

pesos and partly on the exchange rate between sterling and pesos.

The company will therefore want to consider what will happen to the exchange rate

over the term of the investment project. If the peso is expected to fall in value

against sterling, the value of the future profits to the UK company will be reduced.

Note: the aim is to forecast future spot rates

It is important to understand that the requirement is to forecast future spot rates of

exchange, not to calculate a forward rate for a forward exchange contract.

 A forward rate is an exchange rate that can be obtained now in a forward

exchange contract, for settlement at a future date (usually within 12 months). It

is not an estimate of what the future spot rate will be at settlement date.

 An estimate of a future spot rate is simply a forecast of what the exchange rate

might be at a future date, sometimes several years ahead.

Confusion can arise because although a forward rate is not a prediction of what the

future spot exchange rate will be, one technique for estimating future spot rates is

similar to the method by which forward rates are actually derived.

There are two related methods of estimating future spot exchange rates:

 purchasing power parity theory

 interest rate parity theory.

Chapter 19: Foreign exchange risk

These theories were mentioned earlier, in the context of factors that cause changes in

exchange rates.

Remember, however, that spot exchange rates move up and down continually, and

any forecast of what the spot rate will be can only be an

approximate estimate of

what the average exchange rate for a future period will be.

4.2 Forecasting exchange rates with purchasing power parity theory

Purchasing power parity (PPP) theory states that the spot rates between two

currencies will change over time in relation to the rate of inflation in the countries

from which the currencies originate.

Estimated spot rate in Year n = Current spot rate ×

1+ i

VBLE

(

)

1+ i

BASE

()

where:

VBLE

is the forecast annual rate of inflation for the variable currency

BASE

is the forecast annual rate of inflation for the base currency

n is the (end of the) year for which a forecast of the spot rate is being made.

Example

The current exchange rate for the British pound and the US dollar is £1 = $2. It is

expected that the rate of inflation in the UK will be 3% per year for the next few

years, and in the US the rate of inflation will be 2% per year.

Purchasing power parity theory would predict that the following movements in the

exchange rate:

EndofYear Adjustmentfactor

Predicted

exchangerate

02.0000

1 2.00×(1.02/1.03)

 1.9806

2 2.00×(1.02/1.03)

 1.9614

3 2.00×(1.02/1.03)

 1.9423

Example

The current exchange rate for euro/British pound (£/€1) is 0.8150. A UK company

wishes to evaluate a proposed capital investment in Germany. The investment will

be for five years, and a large proportion of the project cash flows will be in euros.

The company needs to forecast what the euro/British pound spot rate will be each

year for the full project period. It has been estimated that inflation in the UK will be

3% each year UK for years 1 to 4 and 5% in year 5. It has also been estimated that

inflation in the euro zone will be 1.5% each year for three years, and 2% in each of

years 4 and 5.

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The spot exchange rates at the end of each year can be estimated using PPP theory,

as follows. (The variable currency in this example is the British pound, since €1 =

£0.8150).

Year Forecastrate

0 Actualrate 0.8150

1 0.8150×(1.03)/(1.015) 0.8270

2 0.8150×(1.03)2/(1.015)2 0.8393

3 0.8150×(1.03)3/(1.015)3 0.8517

4 0.8150×(1.03)4/[(1.015)3)(1.02)] 0.8600

5 0.8150×[(1.03)4(1.05)]/[(1.015)3(1.02)2] 0.8853

The value of the euro is forecast to increase against the British pound, because the

rate of inflation in the eurozone is expected to be lower than the rate of inflation in

the UK.

4.3 Forecasting exchange rates with interest rate parity theory

Interest rate parity theory states that changes in an exchange rate are caused by

differences in interest rates between two currencies. If this is true, it should be

possible to predict future spot exchange rates from differences in expected future

interest rates between the currencies.

Estimated spot rate in Year n = Current spot rate ×

1+ r

VBLE

(

)

1+ r

BASE

()

where:

VBLE

is the forecast annual rate of interest for the variable currency

BASE

is the forecast annual rate of interest for the base currency

n is the (end of the) year for which a forecast of the spot rate is being made.

This formula is similar to the PPP theory formula, except that the forecast annual

interest rate is used instead of the annual forecast rate of inflation.

Example

The current exchange rate for the South African rand against the US dollar is 7.4000

rand = $1. The forecast annual interest rate for the rand is 6% for the next 5 years

and the forecast interest rate for the US dollar is 2% in years 1 and 2 and 4% in years

3 – 5.

The US dollar is the base currency because the exchange rate is expressed in rands

to $1.

Applying interest rate parity theory, we can predict the exchange rate at the end of

year 5 as follows:

$1 = 7.4000 ×

(1.06)

(1.02)

(1.04)

= 8.4618 rand to $1

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

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