GLOBAL ACCOUNTING AND CONTROL: A

MANAGERIAL EMPHASIS

❂ Sidney J. Gray, University of New South

Wales
❂ Stephen B. Salter, University of Cincinnati
❂ Lee H. Radebaugh, Brigham Young
University

❂ Slides Prepared by: Jennifer Anne Salter

Gray, Salter & Radebaugh
Chapter 2
CHAPTER TWO

FOREIGN CURRENCIES AND EXCHANGE RISK

MANAGEMENT

Gray, Salter & Radebaugh

Chapter 2
INTRODUCTION
❂ This chapter explains:
• terminology of foreign exchange;
• major foreign exchange products;
• major types of foreign exchange risks;
• alternative approaches to foreign exchange
risk management.

Gray, Salter & Radebaugh

Chapter 2
FOREIGN EXCHANGE RISKS AND
SOLUTIONS - Import for Cash Problem
❂ Let’s explain with an example.

❂ Your firm, Alamo Computers of San Antonio,

Texas, USA, wishes to buy some computer
motherboards.
❂ Here are three suppliers with prices in
their local currency.
Gray, Salter & Radebaugh
Chapter 2
FX RISKS & SOLUTIONS CONT’D
- An Import for Cash Problem

Firm Location Currency Amt

Suntech California, US$ $107
USA
Changi Singapore Sin. $ $170
Boards
McBoards Edinburgh, British £ £64
UK

Gray, Salter & Radebaugh

Chapter 2
FX RISKS & SOLUTIONS CONT’D
- An Import for Cash Problem

❂ What do we do now?
• Calculate the price in a common currency (US$
would be logical since you are US based).
❂ How do we do that?
• Get the price in local currency (LCP) for each
location from the table.
• Divide the LCP by the LC/US$ exchange rate to
get the US$ Price. See Table 2.1/2.2 or
http://www.bmo.com/economic/.
Gray, Salter & Radebaugh
Chapter 2
Lets look at 2.1 First
❂ it’s a word file

Gray, Salter & Radebaugh

Chapter 2
FX RISKS & SOLUTIONS CONT’D
- An Import for Cash Problem

Company Country Local # of US$

Currency Foreign Price
Price Currency
Units per
US$
Suntech USA $105 1 $105
Changi Singapore Sin$170 1.6783 $101.29
Boards
McBoards U.K. £64 0.6054 $105.71

Gray, Salter & Radebaugh

Chapter 2
 Lets change the number to
Today's rates from BMO
Compa Cou Local Number of Units US $
ny ntry Currency Per $Foreign Price
price (A) Currency (B)
A/B
Suntec USA $105 1.0000 $105.00
h
Changi Sing SGD 170.00 $0.55 $92.65
Boards apo
re
Mcboar Briti £64.00 $1.41 $90.39
ds sh
Pou
nds Gray, Salter & Radebaugh
Chapter 2
FOREIGN EXCHANGE RISKS AND
SOLUTIONS - Import for Credit
❂ What if you want to buy on credit?
❂ Is Singapore still the cheapest supplier?
❂ Will the exchange rate stay the same?
❂ Can you protect yourself from fluctuations
in the exchange rate?

Gray, Salter & Radebaugh

Chapter 2
FOREIGN EXCHANGE RISKS AND
SOLUTIONS - Import for Credit Problem
GBP/ ❂ McBoards offers 6
DATE US$
Jan-99 $0.61 mos. interest free
Feb-99 $0.61 credit.
Mar-99 $0.62 ❂ For the others you
Apr-99 $0.62 must borrow at 1% per
May-99 $0.62 month.
Jun-99 $0.63
Jul-99 $0.63
❂ However, the British
Aug-99 $0.62 Pound is a floating
Sep-99 $0.62 currency.
Gray, Salter & Radebaugh
Chapter 2
The British Pound Floats
1.7

1.65
US$/GBP

1.6 Number of $ per GBP

1.55

1.5
J an- Feb- Mar- Apr- May- J un- J ul- A Sep-
99 99 99 99 99 99 99 ug- 99
99
Gray, Salter & Radebaugh
Mont h
Chapter 2
FOREIGN EXCHANGE RISKS AND
SOLUTIONS - Import for Credit Problem
❂ You can neutralize the
risk of the British £
changing in value by
using a derivative.
❂ FX Derivatives can
include forward
contracts, futures,
swaps and options.

Gray, Salter & Radebaugh

Chapter 2
Derivatives - Forward Contracts
❂ A Forward Contract is a contract between a
foreign currency trader and a client for the
future sale or purchase of foreign currency
at a forward rate.
❂ The Forward Rate is a contractual rate
between the FX trader/client for the
amount of currency A needed to acquire
one unit of currency B at a fixed future
date. (Tbl 2.1)Gray, SalterChapter
& Radebaugh
2
Derivatives - Forward Contracts
Extract from Table 2.1
❂ British Pound Per Dollar
❂ Spot .6054
❂ One Month Forward .6054
❂ Three Months Forward .6051
❂ Six Months Forward .6053

Gray, Salter & Radebaugh

Chapter 2
Derivatives - Forward Contracts
❂ Table 2.3 shows the impact of applying the
information on forward and interest rates
to the purchase of boards.
❂ The Singapore $ rate assumes that you
have to pay cash spot for the purchase
from Singapore.

Gray, Salter & Radebaugh

Chapter 2
 Derivatives - Forward Contracts
Co. LCP LC US $ Cost of Interest for Total
(A) Units Price 100 units 6 months Cost
Per $ A/B
(B)
Suntech $105 1.00 105.00 $10,500 $630 $11,130
Changi 170 1.68 101.29 $10,129 $607.7 $10,736
Boards
McBoards 64 0.61 105.73 $10,573 $0 $10,573

Gray, Salter & Radebaugh

Chapter 2
Derivatives - Forward Contracts
❂ From the pervious table we can conclude:
• McBoard’s initial US$ price is higher than other
suppliers;
• A deferred payment option with a forward
contract makes the British product a great deal
more attractive. Lets redo this for today’s rate
in $/FC
❂ Now let’s talk about other methods of
containing FX risks.
Gray, Salter & Radebaugh
Chapter 2
 At Today's Rates
Co. LCP (A) LC Units US $ Price Cost of Interest for Total Cost
Per $ (B) A*B 100 units 6 months

Suntech $105 1 105 $10,500 $630 $11,130

Changi SGD 170 0.545 92.65 $10,129 $607.70 $10,736

Boards

McBoards £64 1.4018 89.7152 $10,573 $0 $10,573

Gray, Salter & Radebaugh

Chapter 2
Derivatives - Futures, Swaps and
Options
❂ A Future is a highly standardized foreign
exchange contract written against the
exchange clearing house for a fixed
number of foreign currency units and for
delivery on a fixed day.
❂ A Swap is a simultaneous spot and forward
transaction.

Gray, Salter & Radebaugh

Chapter 2
Derivatives - Futures, Swaps and
Options Continued
❂ An Option is the right to trade foreign
currency at a given exchange rate on or
before a given date in the future.
❂ There are two types of options:
• American Options - exercised during a
stipulated period.
• European Options - exercised at a specified
end date.
Gray, Salter & Radebaugh
Chapter 2
Derivatives - Futures, Swaps and
Options Continued
❂ Options have the following terms:
• An up front fee for the right to buy or sell a fixed
amount of foreign currency.
• This is given in US cents per foreign currency
unit.
• This is in addition to the actual cost of the
foreign currency.
• Tables 2.4-2.6 in your text contain an example
Gray, Salter & Radebaugh
Chapter 2
Lets look at some options
❂ http://www.cme.com/market/quote.html

Gray, Salter & Radebaugh

Chapter 2
Major World Currency Markets

❂ Markets cover almost 24 hours, starting with

Auckland which is 14-16 hours ahead of Ohio, ie., if
it’s 4pm in Cincinnati, it’s 11am the next day in
Auckland.
❂ Tokyo: Cincinnati + 13 hours. About 15% of total
volume
❂ Hong Kong & Singapore: Cincinnati + 11 and 12
hours respectively. Together roughly equal to
Tokyo in volume.
Gray, Salter & Radebaugh
Chapter 2
• Continued:

❂ European Markets: London is the largest

market. Cincinnati + 5 hours. About 25% of
total world market volume
❂ Other markets include Frankfurt and Zurich
❂ North American Markets: New York is the
second largest market. Other markets
include Chicago, San Francisco and
Toronto.
Gray, Salter & Radebaugh
Chapter 2
Continued:

❂ NOTE: Over 90% of all transactions include

the US$ as one part, e.g., DM/$, etc.

Gray, Salter & Radebaugh

Chapter 2
- Selling at a Premium or
Discount

❂ Appli es to For war ds /Future s

❂ PREM IUM - IF th e q uota ti on o f th e c urr enc y
in the denomi na tor , e. g., £ i n a $/ £ i s
gr ea ter f or del ive ry i n th e f utu re
(fo rw ar d) tha n f or del ive ry n ow (s pot),
th at c urr enc y i s a t A

Gray, Salter & Radebaugh

Chapter 2
Premium or Discount

❂ PREMIU M . IF THE SPOT FOR £ IS $1.5

PER £ AND THE FORWARD QUOTE IS $
1.60 PER £.
❂ Note : In the example $ AT A DISCOUNT.

Gray, Salter & Radebaugh

Chapter 2
OPTIONS: COMPUTING THE COST
AND BENEFIT OF AN OPTION

❂ This exercise first calculates the

cost of an option and then its
potential benefit.
❂ The example is for 30-day option
to buy Japanese Yen using US
Dollars.
❂ 30 days will take us to July.

Gray, Salter & Radebaugh

Chapter 2
Computing Option Cost

❂ The rate we want to buy the

Yen at is $.00775 per ¥.
❂ The premium charged to
execute such a contract is 1.64
hundredths of a cent per ¥
covered (dollars .000164 per
¥).
Gray, Salter & Radebaugh
Chapter 2
Computing AN Option

❂ Contracts come in blocks of ¥6,250,000.

The cost of a contract is as follows:
❂ Premium at .000164$/¥ *6,250,000
$1,025
❂ Brokerage Cost (admin. fee) $
25
❂ Total Cost per Contract

$1,050
Gray, Salter & Radebaugh
Chapter 2
A TYPICAL OPTION SCENARIO

❂ Covering ¥ one hundred million

(100mm).
❂ How many contracts do we
need?
100 mm ÷ 6.25mm = 16
Cost of cover: 16 x $1,050 =
$16,800 Gray, Salter & Radebaugh
Chapter 2
Option Scenario : Costs

❂ Potential benefit: If the value

of the ¥ exceeds $0.00775 per
¥ plus the transaction cost, we
can exercise the option and
sell the ¥ for a profit.

Gray, Salter & Radebaugh

Chapter 2
Option Scenario : Costs

Buy 100mm ¥ at $.00775/¥

$775,000
Option Cost 16 contracts
$16,800
Additional admin. fees
on exercising $400
Total $792,200
Gray, Salter & Radebaugh
Chapter 2
Option Scenario : Benefits

❂ If we sell the ¥ at .0080 $/¥, we

have a profit of $7,800.

❂ At .0090 $/¥, the profit is

$107,800.

Gray, Salter & Radebaugh

Chapter 2
FOREIGN EXCHANGE RISK &THE
MULTINATIONAL ENTERPRISE
❂ The Multinational Enterprise is often
referred to as an MNE.

Gray, Salter & Radebaugh

Chapter 2
Classifying Risk and Exposure
❂ There are 3 types of foreign exchange
exposure:
• Transaction
• Translation
• Economic

Gray, Salter & Radebaugh

Chapter 2
Classifying Risk and Exposure -
Transaction Exposure
❂ Transaction Exposure arises because we
do not have a method of accounting for
multiple currencies

❂ Examples of Transaction Exposure include

purchasing or selling on credit, goods or
services where the price is stated in a
foreign currency.
Gray, Salter & Radebaugh
Chapter 2
Classifying Risk and Exposure -
Transaction Exposure
❂ How do we handle inherent risks?
• Prepare a separate budget for international
cash flows.
• This will allow you to assess if the volume of
unhedged cash flows is significant.

Gray, Salter & Radebaugh

Chapter 2
Classifying Risk and Exposure -
Translation Exposure
❂ Translation Exposure is when assets and
liabilities on a balance sheet in one
currency, have to be re-expressed in
another currency .
❂ Accounting for this has caused discord
between financial regulators and the
business community.

Gray, Salter & Radebaugh

Chapter 2
Classifying Risk and Exposure -
Economic Exposure
❂ Economic Exposure involves uncontracted
and unplanned changes in future cash
flows which are the result of changes in
exchange rates.

Gray, Salter & Radebaugh

Chapter 2
Classifying Risk and Exposure -
Economic Exposure Cont’d
❂ Any decisions based on economic
exposure are primarily long term.
❂ These decisions include choosing market
and production facility locations.

Gray, Salter & Radebaugh

Chapter 2