Introduction to Foreign Exchange Rates

Thomas J. O'Brien

• Publisher: Business Expert Press
• Year: 2013
• Print ISBN: 9781606497364
• eBook ISBN: 9781606497371
• Topic: Business
• Subtopic: Finance
• Index: Business

As managers expand their international business operations, they are confronted by the puzzling and vexing world of foreign exchange (FX) rates. This text is designed as a resource that can help managers quickly understand and navigate the FX market. The text may be used as an introductory module in a course in international finance, whether the course is oriented to international markets, international investments, or international corporate finance. The primary intended audience is an applied MBA course aimed at executives, managers, and would-be managers. After an introduction to foreign exchange (FX) rates, the text covers the important topic FX rate valuation. It is important for managers to understand when an FX rate is incorrectly valued, as this situation may have a bearing on strategic decisions to operate or invest overseas. The text also covers the mechanics of forward FX contracts, and their use in managing the risk of future foreign currency cash flows. In the case study included in the text, the case company is faced with FX exposure in the revenues of a proposed new foreign customer. The decision-maker applies the text material to evaluate whether the FX rate is over-, under-, or correctly valued. The final decision is whether to expand sales to the foreign market and whether to hedge the FX risk.

CHAPTER 1

Foreign Exchange Rates

Global growth is essential to many large companies. Managers need to understand the impact of foreign exchange (FX) rates on corporate results and strategic decisions. This chapter introduces some basic “mechanics” of FX rates. The subsequent chapters cover what economic factors drive FX rates.

Foreign Exchange Rates

An FX rate is, simply, the price of one currency in terms of another. An FX rate between U.S. dollars and British pounds can be expressed as either (a) U.S. dollars per British pound or (b) British pounds per U.S. dollar. We use the notation 2 $/£ to mean 2 U.S. dollars ($2) per British pound, or that $2 will buy 1 British pound. Equivalently, we can use the reciprocal, and say that the FX rate is 0.50 £/$, which means 0.50 British pounds (£0.50) per U.S. dollar, or that £0.50 will buy 1 U.S. dollar.

In general, an FX rate expresses the price of the “denominator currency” in terms of the “numerator currency.” The numerator currency is called the pricing currency, or the terms currency. The denominator currency is sometimes called the base currency. Always remember that when we use the expression “FX price of such-and-such currency,” we are thinking in terms of that currency as the “denominator currency,” and we are expressing its price in terms of the “numerator currency.” For 2 $/£, we are expressing the FX price of the British pound in terms of the U.S. dollar as the pricing currency. For 0.50 £/$, we are expressing the FX price of the U.S. dollar in terms of the British pound as the pricing currency.

In financial markets, FX rate quotes usually involve the U.S. dollar as one of the two currencies. The usual convention is to quote the FX rate with the U.S. dollar as the base currency. For example, an FX quote of 1.20 in the case of the Swiss franc (the “Swissie”) implies 1.20 Swiss francs per U.S. dollar, or 1.20 Sf/$, and an FX quote of 108 for the Japanese yen means 108 yen per U.S. dollar, or 108 ¥/$. The common FX market convention to quote the FX price of the U.S. dollar is called European terms, although the pricing currency involved is not necessarily a European currency. The convention to quote most FX rates in European terms emerged after World War II, when the U.S. dollar replaced the British pound as the principal international currency. Basically, the FX rates expressed the price of 1 U.S. dollar in terms of the currency of each country, many of which were European.

Although most FX rates are conventionally quoted in European terms, a few important currencies are typically quoted with the U.S. dollar as the pricing currency. This style is referred to as American terms. An FX quote of 1.50 in the case of the British pound means 1.50 U.S. dollars per British pound, or 1.50 $/£, which is the FX price of a British pound (in U.S. dollars). Other significant currencies usually quoted in American terms include the Australian dollar (A$) and the New Zealand dollar (NZ$). Before World War II, the tradition was to quote FX rates as the FX price of one British pound in terms of the other currency, because the British pound was the main international currency. Even after the U.S. dollar replaced the British pound as the main international currency, the traditional quotation style was retained for the British pound and currencies of some countries of the former British Empire.

When the euro (€) emerged in the 1990s as the common currency of many European countries, the American terms convention was adopted for the important FX rate between euros and U.S. dollars. For example, a quote of 1.35 for the euro means 1.35 U.S. dollars per euro, or 1.35 $/€, which is the FX price of one euro in terms of U.S. dollars. The euro is the currency of 17 of the 27 countries of the European Union. The 17 countries using the euro are known collectively as the Eurozone: Austria, Belgium, Cyprus, Estonia, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia, and Spain. Of the 10 EU member countries outside the Eurozone, seven are obligated to join once they fulfill the strict entrance requirements: Bulgaria, the Czech Republic, Hungary, Latvia, Lithuania, Poland, and Romania. Three EU member countries are not obligated to join the Eurozone and have their own currencies: Sweden, Denmark, and the United Kingdom. Switzerland is not in the EU.

The FX rates seen streaming on Bloomberg TV and CNBC follow the market's quotation conventions, as does this text. So you should try to get used to them. For major currencies, it will help to remember that the euro, the British pound, the Australian dollar, and the New Zealand dollar are typically quoted in American terms, while all the rest are usually in European terms.

An FX rate for immediate delivery is called a spot FX rate. The notation for a spot FX rate in this text is the capital letter X. To keep things straight, generally we'll follow X with a two-currency superscript. Thus, X^Sf/$ represents a spot FX rate expressed in Swiss francs per U...

Table of contents

• Cover
• Half Title
• Title Page
• Copyrights
• Dedication Page
• Abstract
• Contents
• Chapter 1 Foreign Exchange Rates
• Chapter 2 Foreign Exchange Rate Volatility
• Chapter 3 Purchasing Power Parity
• Chapter 4 Extensions of Purchasing Power Parity
• Chapter 5 Interest Rates and Foreign Exchange
• Chapter 6 Topics in Uncovered Interest Rate Parity
• Chapter 7 Forward FX Contracts
• Chapter 8 Foreign Exchange Transaction Exposure
• Case Houston Marine Electronics
• Notes
• References
• Index
• Ad Page
• Back Cover