3.5 Foreign Exchange Rates

Foreign exchange rates are crucial in international finance, affecting global trade and investments. Spot rates represent current currency values, while appreciation and depreciation impact purchasing power. Understanding these concepts is vital for businesses operating in multiple countries.

Exchange rates significantly influence international transactions, affecting the costs of imports and exports. Companies must manage foreign exchange exposure through various hedging strategies to mitigate risks associated with currency fluctuations. These strategies help protect against transaction, translation, and economic exposures.

Foreign Exchange Rates

Spot exchange rates and currency fluctuations

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• Spot exchange rate represents the current price of one currency in terms of another currency used for immediate delivery of the currency
  • Example: If the spot exchange rate for USD/EUR is 0.85, it means 1 USD can be exchanged for 0.85 EUR
• Currency appreciation occurs when a currency increases in value relative to another currency leading to increased purchasing power for the appreciating currency
  • Example: If the U.S. dollar appreciates against the euro, one dollar can buy more euros than before (USD/EUR moves from 0.85 to 0.90)
• Currency depreciation occurs when a currency decreases in value relative to another currency leading to decreased purchasing power for the depreciating currency
  • Example: If the U.S. dollar depreciates against the euro, one dollar can buy fewer euros than before (USD/EUR moves from 0.85 to 0.80)
• Exchange rate regime refers to the system a country uses to determine its currency's value relative to other currencies

Exchange rates in international transactions

• Importing goods and services becomes cheaper when a domestic currency appreciates and more expensive when a domestic currency depreciates
  • Example: A U.S. company importing goods from Europe will find it cheaper when the USD appreciates against the EUR
• Exporting goods and services becomes more challenging when a domestic currency appreciates as goods and services become more expensive for foreign buyers and easier when a domestic currency depreciates as goods and services become cheaper for foreign buyers
  • Example: A U.S. company exporting goods to Europe will find it more difficult when the USD appreciates against the EUR
• Exchange rate fluctuations can impact the profitability of foreign subsidiaries of multinational corporations
  • Translation exposure is the risk of changes in the reported financial statements due to exchange rate movements
  • Economic exposure is the risk of changes in the present value of future cash flows due to exchange rate movements
• Purchasing power parity theory suggests that exchange rates should adjust to equalize the purchasing power of different currencies

Foreign exchange exposure management

• Transaction exposure is the risk of changes in the value of outstanding foreign currency-denominated contracts due to exchange rate fluctuations
  • Hedging strategies for transaction exposure include:
    1. Forward contracts: Agreeing to buy or sell a specific amount of foreign currency at a predetermined exchange rate on a future date
    2. Futures contracts: Standardized contracts traded on an exchange to buy or sell a specific amount of foreign currency at a predetermined exchange rate on a future date
    3. Options: Contracts giving the holder the right, but not the obligation, to buy (call option) or sell (put option) a specific amount of foreign currency at a predetermined exchange rate on or before a future date
    4. Currency swaps: Agreements to exchange principal and interest payments in different currencies over a specified period
• Translation exposure is the risk of changes in the reported financial statements of foreign subsidiaries due to exchange rate movements
  • Hedging strategies for translation exposure include:
    1. Matching foreign currency assets and liabilities to minimize the net exposure
    2. Using derivatives such as forward contracts or currency swaps to hedge the net exposure
    3. Adjusting the capital structure by borrowing in the same currency as the foreign subsidiary's assets
• Economic exposure is the risk of changes in the present value of future cash flows due to exchange rate movements
  • Hedging strategies for economic exposure include:
    1. Diversifying operations across multiple currencies to reduce the impact of exchange rate fluctuations on overall cash flows
    2. Using operational hedges such as shifting production or sourcing to countries with more favorable exchange rates
    3. Implementing strategic pricing policies to adjust prices in response to exchange rate movements

Foreign Exchange Market and Economic Factors

• The foreign exchange market is where currencies are traded and exchange rates are determined
• Interest rate parity theory suggests that interest rate differentials between countries should be offset by expected changes in exchange rates
• Balance of payments, which records a country's international transactions, can influence exchange rates and currency values