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Exchange Uncertainties One of the added uncertainties of conducting international trade is the fluctuation in exchange rates among currencies. The relative value between the buyer's currency and the seller's currency may change between the time the deal is made and the time payment is received. A devaluation or rise in one currency against another causes either a windfall or a loss to one party or the other involved in the transaction. For example, if an importer in the United States has agreed to pay 200,000 French francs (F) for a shipment and the franc is valued at US$0.19 (its approximate value in late1994), the buyer would expect to pay US$38,000. If the franc later rose in value to 19.5 cents-an increase of just over 2.5%, a not unlikely occurrence in the volatile short-term foreign exchange market-payment at the new rate would require US$39,000, for an added cost of US$1,000 to the importer. On the other hand, if the foreign currency fell in value to 18.5 cents, the importer would have to pay only US$37,000, saving US$1,000. Most traders prefer to avoid such risk rather than speculate on fluctuations in foreign exchange markets. One of the simplest ways for a trader to avoid this type of risk is to quote prices and establish payment in the currency of one's own country; this places the burden and risk on the other party. This is practical when one's own currency is freely convertible and stable. Typically, the currency of a major trading country is used. Therefore, US dollars, German marks, English pounds, Japanese yen, French francs, and Swiss francs are often quoted. If the exporter/seller asks to receive payment in a foreign currency, the importer should consult an international banker before negotiating the purchase contract. Banks can offer advice on foreign exchange trends and risks. Many international banks can also help the importer hedge against such a risk. Terms and Concepts International trade and other transactions involving cross-border flows of funds require the participants to enter the world of foreign exchange. Foreign exchange is defined as claims payable in a foreign country in a foreign currency. (Foreign exchange is often referred to as forex or simply abbreviated as FX.) As a rule, businesses and individuals operate using their own national currencies-money recognized and legally acceptable for transactions (legal tender) within the particular currency zone (the territorial area in which a given currency is recognized, usually coinciding with national boundaries). For example, a seller/exporter in Japan usually wants to be paid in his or her own currency-the yen (¥)-rather than in that of the importer, who, if he is from the US, may want to use U.S. dollars (US$). However, the seller may on occasion prefer to be paid in Deutsche Marks (DM) in order to pay off obligations due to a German firm in that currency. And the French business traveler going to Montreal to negotiate a deal needs to pay expenses in Canadian dollars (Can$) rather than in French francs (F). A British investor may need to convert English pounds sterling (£) into Dutch guilders (G) to put funds into a venture in that country. All of these scenarios require the participants to convert a home currency into one or more foreign currencies or vice versa. Currencies A currency which can be readily exchanged for another is known as a convertible currency. If it can be fully, readily, and legally converted under virtually all circumstances, a currency is referred to as being unrestricted. Many countries maintain restricted convertibility on their currencies, often allowing full convertibility only for nonresidents while limiting the ability of residents to exchange domestic for foreign currencies. Other countries have inconvertible currencies, which cannot legally be taken out of the country or exchanged for foreign currencies at all. Yet other countries distinguish between foreign exchange involving current transactions (for goods and services) and those involving capital investments, with freedom of convertibility being restricted to some degree for one category or the other. This situation often results in what is known as a two-tier market, in which access to restricted currency is rationed and those who need it must obtain special authorization to acquire it. Such exchange controls ration the availability of foreign currency, which can block imports into the country. These limitations often result in a thriving illicit black market trade in currencies and commodities. Hard currencies are those of large, strong economies which have few if any restrictions on the use and exchange of their currencies, while soft currencies are those for which there is little or no demand due to restrictions on free exchange (this is usually also a function of a limited or weak economy). International financial operations are usually transacted using key currencies, that is those which are relatively strong, broadly convertible, and generally accepted. Such currencies, sometimes referred to as reserve currencies, and most international business is transacted using-or at least with reference to-these currencies. Rates of Exchange The exchange rate is simply the amount of a nation's currency that can be bought at a given time for a specified amount of the currency of another country. For example, as of September 30, 1994, $/¥=98.48, meaning that one US dollar was equal to 98.48 Japanese yen. The exchange rate is given either as a direct quote-expressed as the number of units of a foreign currency per US$ (1.547DM/$), or as an indirect quote, expressed as the number of US$ per unit of foreign currency (.646$/DM), which is the reciprocal of the first quote. Because the US$ is the most commonly traded currency, international foreign exchange transactions are usually quoted directly using the US$ as the reference point. Thus an inquiry from a Swiss bank to a German bank about their rates would be quoted not in SwF/DM but in DM/US$, even though both parties understand that the Swiss bank is interested in the rate of the DM against the SwF, not the US$. This necessitates the use of cross-rates, in which currencies are not compared directly with each other but in terms of a reference currency which serves as a common denominator. For example, in order to find the rate for the SwF/DM, you must first have quotes on both currencies in US$ (1.2845SwF/US$ and 1.547DM/US$), then use them to calculate the rate for SwF/DM with reference to the common dollar rates of each (1.2845/1.547=.83SwF/DM). Forex traders quote bid and ask price ranges, with the first figure always that at which they stand ready to buy currencies and the second (always higher) figure that at which they are willing to sell. This difference is conceptually similar to buying wholesale and selling retail, and constitutes the spread, or base profit margin for the institution. Professional traders deal not in full quotes but in a shorthand, referred to as pips or ticks. These are the last decimal places in a quote, usually 1/100th, or .01, of a percent (professionals are assumed to know the base rates and deal only in the marginal fluctuations). The necessary series of conversions allows for the possibility of arbitrage, which involves taking advantage of temporal and spatial anomalies in pricing in the international currency markets. If, as in the example above, the German bank's price on SwF is less than the Swiss bank can get for them in Hong Kong, it will buy SwF from the German bank and immediately sell them to the Hong Kong bank to make a profit on the price differential. However, because virtually all international currency transactions are quoted against the US$ and because instant communications and 24-hour trading compensate for distance and time differences, the opportunities for such arbitrage are few. Professional traders now generally use the term to refer to trading for the institution's own account rather than for that of a client. The actual amount received in a conversion, or the effective exchange rate, usually differs from the stated rate because it takes into account all taxes, commissions, and other costs that the public must pay to complete the transaction and actually receive the foreign funds. Setting Exchange Rates The relative value of one currency against another depends on a variety of economic and political factors, but ultimately it boils down to supply and demand. The main economic factor is the equilibrium rate, or purchasing power parity, at which goods would cost the same in each country. This ignores many important factors, such as quality, exportability, and long-term capital flow issues, but serves as a useful approximation of the relative strength of currencies against each other. If the same amount of currency in country A buys the same goods as an equivalent amount of currency in country B, the currencies are at parity. If the same amount of currency buys more goods in country A than in country B, then the currency of country A is undervalued and/or that of country B is overvalued. A nation's account balance (the sum of the value of goods and services it has exported during a given period netted against the value of those imported during the same period plus any transfer payments remitted abroad) can be used as a barometer of a country's economic strength. If the economy is consistently in a surplus position, that is it has received more than it has paid out, its currency can be expected to strengthen, or appreciate (rise in value) over time. Conversely, in a deficit position-one in which it spends more than it takes in-its currency will be expected to weaken, or depreciate (lose value) with respect to that of partners maintaining a surplus. Most countries keep foreign currency reserves to pay for current needs and serve as a cushion for fluctuations in the international income and outgo of funds. Nations generally try to manage their currencies to maintain stable exchange rates against those of their trading partners. This can be done in a number of ways. The authorities may attempt to maintain a fixed exchange rate in which the value of their currency is linked to a commodity, such as gold, or to another strong currency, such as the US$. When a currency is linked directly to that of a stronger country (usually its main trading partner), it is said to be pegged to that of the stronger country whose lead it follows. The nations of the world have generally been unable to maintain such fixed rates in the volatile and increasingly integrated global economy of the 20th century, leading to the use of floating rates. Since the 1970s, most national currencies have floated, allowing their value to be determined through fluctuations against a variety of other currencies. Floats can be clean, that is, determined solely by market forces without official interference (a situation that never really occurs in the real world), or dirty-managed to a greater or lesser extent by government authorities. Although some governments arbitrarily set exchange rates and policies to enforce them, such management usually involves intervention, or attempts to influence markets. This is accomplished primarily through open market operations in which the government buys or sells large quantities of its own or another country's currency or securities in an attempt to influence the relationship between the two by altering supply and demand factors. Because foreign exchange markets are so large and active, it has become virtually impossible for any government or international agency to effectively exercise control over exchange rates. In practice, floating exchange systems rely on a variety of mechanisms to set actual prices. The main ones involve trade-weighted rates which hinge on the degree of importance of a given country's trade with the nation. A variation of this is to use a basket of currencies in which the exchange rate is figured in proportion to the value of the various currencies among the designated countries. This has been implemented by such schemes as the snake, a system in which northern European countries agreed to keep their currencies within a certain proportional relationship to each other (because adjustments occurred serially rather than simultaneously, the effect of such changes as they worked through the system was thought to resemble the undulations of a snake). The crawling peg-in which a country with a subsidiary currency commits to adjust by incremental stages to maintain its agreed upon level with respect to the stronger currency that it tracks-represents a further variation on this theme. Often the pegged currency will have a daily or weekly limit on how much it can rise or fall to adapt to the target currency. The fixed band within which a currency is allowed to fluctuate is called the grid. On occasion a currency cannot move either rapidly or far enough by using such mechanisms to reach an equilibrium point. The authorities must then realign, or change the official value of, the currency. Such realignments may require officials to devalue-officially reduce its value relative to that of the currency of another country-or revalue-officially raise its value relative to that of another country. In devaluation, the country's currency buys less, hurting imports (but also perhaps boosting sales of its now-cheaper exports). Upward revaluation allows the country to buy more abroad with its more valuable currency, but usually cuts into overseas sales of its now more expensive exports. The Mechanics of Foreign Exchange Operations Most foreign exchange trading stems from the need to acquire foreign currency for a specific transaction. If the conversion is for use in a current transaction, it occurs in the spot market at the current price, or spot rate, for immediate delivery (actually within two business days). If the foreign exchange is required for a future transaction, it occurs in the forward market for future delivery. The basic difference between the prices in the spot and forward markets is due to the relative levels of interest rates in the two countries. If a currency is actually held by the party, it can earn interest between now and when it is needed at prevailing money market rates. Or, conversely, it must be borrowed at a cost commensurate with the value of the interest earnings foregone by the lender. So the forward price will include the amount of interest which could be earned during the period, usually making forward rates higher than spot rates due to this premium. Hedging Risks The ability to buy forward foreign exchange allows businesses to hedge their risks by counterbalancing a current transaction through a similar future transaction to offset the effects of price changes during the interim. In currency trading this is often accomplished through a swap-the spot purchase (or sale) of foreign exchange and a simultaneous forward sale (or purchase) of the same currency. A spot purchase coupled with a future sale is known as an outward swap, while a spot sale linked to a forward purchase is an inward swap. A forward purchase or sale not covered by an offsetting spot transaction is known as an outright transaction. Actual holdings of a currency are known as long positions, while those with uncovered future positions, that is with net indebtedness, are said to be short of exchange. It is possible to buy forward (or futures) contracts for set amounts of major currency deliverable at a specified future date. These can vary from short-term spot/next swaps (in which the spot side is the current price and the offsetting closeout position is the price on the next business day) and tom/next swaps (in which the current price is that for the next business day and the offsetting position is valued at the price for the next business day after that) to positions as far out as one year. Options While futures-contracts to buy or sell a specified quantity of foreign currency at a stated date in the future, the basis of forward transactions-are useful for hedging risks, options are largely speculative instruments. Options contracts allow foreign exchange traders the right to buy (call) or sell (put) specified quantities of currencies at a point in the future. If an option is in the money-that is the actual price is above the exercise price and therefore the option is profitable-it can be exercised. If it is out of the money (the exercise price being below the actual price and therefore unprofitable to exercise), it can be allowed to expire. Options traders seldom if ever take delivery of the actual currencies but simply close out the profitable contracts for the amount of the profit. Contracts known as American options can be exercised at any time during the life of the contract, while European options can only be exercised on the expiration date. Markets Despite the growth of trade and an increasingly interdependent global economy, most foreign exchange trading involves financial institutions trading for their own accounts rather than straight business transactions on behalf of clients. Such activity serves to add depth and liquidity to the forex market. Because of the high turnover in self-liquidating transactions-many of which are highly leveraged-the nominal dollar value of the volume of such trade far outstrips that of the underlying economic and monetary base that supports it. Major foreign exchange markets are run out of New York, London, Frankfurt, Amsterdam, Singapore, Hong Kong, and Tokyo, but traders can operate anywhere thanks to modern communications links. Trading is most active during the business hours in these respective locations, but can occur anytime. Euromarkets-consisting of informal markets to deal in transactions involving a currency outside of its country of origin-provide offshore international access to funds unencumbered by governmental regulation. London, Frankfurt, Zurich, and Amsterdam are the main centers of this trade. The US$ accounts for about two-thirds of the Euromarket, with the DM, SwF, and ´ collectively making up as much as one-quarter of the remainder. The Asian dollar market, operating primarily out of Singapore, is also growing rapidly. Again the US$ is the primary currency, but use of the ´ is increasing. By some accounts, more US$ are traded in such markets than in the domestic market. For example, the average daily turnover in the Singapore Asian dollar market was nearly US$75 billion in 1990. Within the U.S., futures contracts are handled through the International Monetary Market of the Chicago Mercantile Exchange. Standard foreign exchange options are traded through the Philadelphia Stock Exchange and the Chicago Board Options Exchange. Many large, internationally-oriented banks will write specific nonstandard futures contracts to cover the needs of clients. | ||
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1. Monitor change. The relative value of currencies is continually changing. Familiarity with currency trends can avert potentially costly mistakes. There are several readily available international media sources which provide up to date information on the relative values of several currencies. The Wall Street Journal, The Economist, and the International Herald Tribune are all available in large cities throughout the world and quote currency rates as well as report relevant news from around the world. 2. Understand the implications of dealing in a particular currency. A decision to use one currency over another can have serious implications for your profit margins. Some currencies are readily convertible on the open market, though many have restrictions attached to their exchange. Some countries have wholly inconvertible currencies, which cannot legally be taken out of the country or exchanged for foreign currencies at all. Before finalizing payment terms, make certain that they can be carried out in accordance with the contract. 3. Understand the mechanics of foreign exchange. There are many ways to protect yourself against foreign currency fluctuations. It is essential to become familiar with these methods. If the conversion is for use in a current transaction, it occurs in the spot market at the current price, or spot rate, for immediate delivery (actually within two business days). 4. Hedge your risks. The spot purchase (or sale) of foreign exchange and a simultaneous forward sale (or purchase) of the same currency is called a swap, and allows businesses to hedge their risks by counterbalancing a current transaction through a similar future transaction to offset the effects of price changes during the interim. 5. Options for risk-takers. Options contracts allow foreign exchange traders the right to buy (call) or sell (put) specified quantities of currencies at a point in the future. Options traders seldom if ever take delivery of the actual currencies but simply close out the profitable contracts for the amount of the profit. 6. Seek expert advice. Banks can offer advice on the foreign exchange risks that exist and can help you analyze the best methods and terms of payment regarding your business abroad. 7. Factor your transaction costs. Many methods for dealing with foreign exchange risks have fairly substantial transaction costs associated with them. These costs are generally proportional to the amount of risk and/or complexity associated with the transaction method. 8. Understand exchange controls. Exchange control systems differ from country to country. While some governments do not interfere at all with currency exchange transactions, many others impose restrictions to various degrees. It is important to know and understand the regulations in effect in the country in which you intend to do business prior to finalizing any agreement. You many not get paid otherwise. 9. Be alert to change. especially in countries where the government maintains heavy controls on the exchange system. In some cases, a government may even make changes in exchange regulations retroactive, which can obviously have serious ramifications on an agreed transaction. 10. Look for incentives. Many governments offer attractive financial incentives to lure foreign investment, especially in underdeveloped regions or industries pegged for export growth. Tax exemptions, rent rebates, preferential financing, and production subsidies are some common incentives that can make countries more attractive for investment. Currencies are used as a store of liquid wealth by other countries, which keep their international reserves in these hard currencies. The US$, ¥, £, DM, F, Can$, G (also abbreviated as "f," for Dutch florin), and Swiss franc (SwF) are considered to be key or reserve currencies, and most international business is transacted using-or at least with reference to these currencies. |