More Winter ahead…

1. More Winter ahead…

2. Foreign Currency • What is it? • Why does it change? • Risk for international managers • How to manage risk

3. Linkage Between Currencies World Market for Euros World Market for Dollars Price = $ / € Price = € / $ S S €.77 / $ $1.30 / € D D Same “market”…different perspective.

4. Trade, FDI, and the Economy Computers • Increase demand for Japanese computers – trade deficit • Increase demand for computer inputs (components, labor, etc.) – inflationary • Increase demand for Yen – appreciates • Stronger Yen increases U.S. prices – decreases demand for Japanese computers Cash $$

5. German Market for BMWs S Price in Euros € 100,000 D

6. Global Market for BMWs:Americans want to import BMWs S Pricein Euros € 110,000 € 100,000 D’ D

7. World Market for Euros S Price in Dollars $0.77 / € D

8. World Market for D-Marks:Americans need to convert Dollars to Euros Price = $ / € S $0.74 / € $0.77 / € D’ D

9. Linkage Between Currencies World Market for Euros World Market for Dollars Price = $ / € Price = €/ $ S S $0.77/ € € 1.30/$ D D

10. Linkage Between Currencies World Market for Euros World Market for Dollars Price = $ / € Price = €/ $ S’ S S $0.74/ € $0.77/ € € 1.30/$ € 1.35/$ D’ D D

11. Other Forces Causing Change • Foreign Direct Investment • Foreign Portfolio Investment • MNCs • Government Debt Instruments • Currency Arbitrage and Speculation • Governmental Intervention • Official and Unofficial “pegs” • International Agreements (e.g., G-7, the Euro) • Posturing (e.g., “talking” the dollar down)

12. Index of Swiss Franc vs. Dollar1990 = 100 2000 1980 1990

13. Depreciating Peso

14. The Big Mac Index www.economist.com

15. Short-term F/X Management • Currency Hedges • Forward Contracts • Options • Negotiation of Ratcheted Pricing Schedule • Adjustment of Prices and Target Profits • Lower foreign prices to keep market share when home currency appreciates … lowers profit margin • Raise foreign prices to keep profit margins when home currency depreciates … less price competitive

16. Today: US Dealer to Import BMWs • Sales Contract: • Quantity: 100 BMW 750s • Price: € 100,000 each • Payment: Due in 3 months • Value of Sales Contract = • € 10.0 million • Spot Rate = $1.30 / € • $13.0 million

17. In Three Months: Payment is DueUncovered Transaction • Euro appreciates • New spot rate = $1.35 / € • € 10.0 million • Adjusted Value of Sales Contract • “Risk penalty” = $0.05 per € traded • $13.5 million • US Dealer’s Loss = $500,000

18. Today: US Dealer to Import BMWsHedged Transaction • Sales Contract: • Quantity: 100 BMW 535s • Price: € 100,000 each • Payment: Due in 3 months • Value of Sales Contract = • € 10 million • at 90-day Forward Rate = $1.305 / € • “Insurance premium” = $0.005 per € traded • $13.05 million

19. In Three Months: Payment is DueHedgedTransaction • Euro appreciates • New spot rate = $ 1.35 / €(Doesn’t matter!!!) • € 10 million • Adjusted Value of Sales Contract • Locked-in Forward Rate = $ 1.305 / € • $13.05 million • Cost of Hedge (insurance premium) = $50,000

20. In Three Months: Payment is DueHedged Transaction • Euro Depreciates • New spot rate = $ 1.25 / € • € 10 million • Adjusted Value of Sales Contract • Locked-in Forward Rate = $ 1.305 / € (Spot better!!) • $12.5 million • Currency Windfall - Cost of Hedge = $450,000

21. Medium-Term F/X Management • Balance sheet hedge • Match foreign assets with same level of foreign liabilities in same currency • Cash flow hedge • Match foreign A/P with A/R in same currency

22. Long-Term F/X Management • Shift sourcing and procurement • Shift production • Cut costs / improve productivity