IB 150 Lecture Notes - Lecture 14: Credit Suisse, Forward Contract, Australian Dollar

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IB 150 – Lecture 14
Foreign Exchange Rate and Market
Companies Use Foreign Exchange Market
When the payments they receive for exports, the income they receive from foreign
investments, or the income they receive from licensing agreements with foreign firms are in
foreign currencies
When they must pay a foreign company for its products or services in its country’s currency
When they have spare cash that they wish to invest for short terms in foreign money markets
When they are involved in currency speculation - the short-term movement of funds from
one currency to another in the hopes of profiting from shifts in exchange rates
Basic Terms and Definitions
Foreign exchange
Currencies and other financial instruments of payment denominated in foreign currencies
Exchange rate
The number of units of one currency needed to acquire one unit of another currency: a
Spot exchange rate
The exchange rate for immediate delivery of the currency (in 2 business days)
Forward exchange rate
The rate for currency delivered in the future
Forward exchanges occur when two parties agree to exchange currency and execute the
deal at some specific date in the future
Exchange rates governing such future transactions are referred to as forward
exchange rates
For most major currencies, forward exchange rates are quoted for 30 days, 90
days, and 180 days into the future
When a firm enters into a forward exchange contract, it is taking out insurance against the
possibility that future exchange rate movement will make a transaction unprofitable by the
time when that transaction will be executed
Forward premium: when the forward rate is greater than the spot rate
Forward discount: when the forward rate is less than the spot rate
Swap transaction: an exchange of currencies in the spot market with te agreement to
reverse the transaction in the future
Currency Swap
The simultaneous purchase and sale of a given amount of foreign exchange for two different
value dates
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Swaps are transacted between international businesses and their banks, between banks, and
between governments when it is desirable to move out of one currency into another for a
limited period without incurring foreign exchange risk
Direct quote (US dollar equivalent)
Units of domestic currency needed to buy 1 unit of foreign currency, e.g., $1.50/pound
“in US Dollar” by WSJ
Indirect quote (currency per US dollar)
Units of foreign currency needed to buy 1 unit of domestic currency, e.g. L. 66/$1.00
“Per US Dollar” by WSJ
Cross rate
Exchange rate computed from two other exchange rates, e.g.
SwF0.8921/US$1.00 HK$7.7571/US$1.00
0.8921/7.7571 = SwF0.115/HK$1.00
Good for exchange rates that are unknown and not correlated often
Currency Convertibility
Freely convertible: when the country’s government allows both residents and non-residents
to purchase unlimited amounts of foreign currency with its own country’s currency – more
Externally convertible: when only nonresidents may convert a country’s currency into a
foreign currency without any limitations
Nonconvertible: when neither residents nor nonresidents are allowed to convert a country’s
currency into foreign currency (about 10%) – just the government benefits from it
Baterlike agreements by which goods and services can be traded for other goods and services
Used to get around the non-convertibility of currencies
Direct exchange of goods or services between 2 parties without a cash transaction
Firm agrees to purchase a certain amount of materials back from the importer to whom a
sale is made using cash
Similar to counterpurchase but exporter can fulfil the obligation with any firm in the
importing country
Switch trading
Involves a 3rd party. When enters into offset agreement, a firm gets credits, Then sells the
credit to 3rd party, who sells them to another firm that can make use of them
Compensation trade or buybacks
When a firm builds a plant or facility in a country and that firm takes a percentage of the
output of the plant as payment
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