Foreign Exchange Markets | USA | Accounting

Each country uses its own currency as the unit of value for the purchase and sale of goods and services. The currency used in the United States is the U.S. dollar, the currency used in Mexico is the Mexican peso, and so on. If a U.S. citizen travels to Mexico and wishes to purchase local goods, Mexican merchants require payment to be made in Mexican pesos.

To make a purchase, a U.S. citizen has to purchase pesos using U.S. dollars. The foreign exchange rate is the price at which the foreign currency can be acquired. A variety of factors determines the exchange rate between two currencies; unfortunately for those engaged in international business, the exchange rate can fluctuate over time.

Exchange Rate Mechanisms:

Exchange rates have not always fluctuated. During the period 1945-1973, countries fixed the par value of their currency in terms of the U.S. Dollar, and the value of the U.S. dollar was fixed in terms of gold. Countries agreed to maintain the value of their currency within 1 percent of the par value.

If the exchange rate for a particular currency began to move outside this 1 percent range, the country’s central bank was required to intervene by buying or selling its currency in the foreign exchange market. Because of the law of supply and demand, a central banks purchase of currency would cause the price of the currency to stop falling, and its sale of currency would cause the price to stop rising.

The integrity of the system hinged on the U.S. dollar maintaining its value in gold and the ability of foreign countries to convert their U.S. dollar holdings into gold at the fixed rate of $35 per ounce. As the United States began to incur balance of payment deficits in the 1960s, a glut of U.S. dollars arose worldwide, and foreign countries began converting their U.S. dollars into gold.

This resulted in a decline in the U.S. government’s gold reserve from a high of $24.6 billion in 1949 to a low of $10.2 billion in 1971. In that year, the United States sus­pended the convertibility of the U.S. dollar into gold, signaling the beginning of the end for the fixed exchange rate system. In March 1973, most currencies were allowed to float in value.

Today, several different currency arrangements exist.

Some of the more important ones and the countries affected follow:

1. Independent Float:

The value of the currency is allowed to fluctuate freely according to market forces with little or no intervention from the central bank (Canada, Japan, Sweden, Switzerland, and United States).

2. Pegged to Another Currency:

The value of the currency is fixed (pegged) in terms of a par­ticular foreign currency and the central bank intervenes as necessary to maintain the fixed value. For example, 25 countries peg their currency to the U.S. dollar (including the Bahamas and Syria).

3. European Monetary System (Euro):

In 1998, the countries comprising the European Monetary System adopted a common currency called the euro and established a European Central Bank. Until 2002, local currencies such as the German mark and French franc continued to exist but were fixed in value in terms of the euro. On January 1, 2002, local currencies disappeared, and the euro became the currency in 12 European countries. The-value of the euro floats against other currencies such as the U.S. dollar.

Foreign Exchange Rates:

Exchange rates between the U.S. dollar and most foreign currencies are published on a daily basis in The Wall Street Journal and major U.S. newspapers. To better illustrate exchange rates and the foreign currency market, next we examine the exchange rates published in the Wall Street Journal for Tuesday, January 23, 2007, as shown in Exhibit 9.1.

These are known as direct quotes. The direct quote for the Swedish krona on January 23 was $0.1434; in other words, 1.0 krona could be purchased with $0.1434. The second column, per US$, indicates the number of foreign currency units that could be purchased with one U.S. dollar. These are called indirect quotes, which are simply the inverse of direct quotes. If one krona can be purchased with $0.1434, then 6.9735 kroner can be purchased with $1.00. (The arithmetic does not always work out perfectly because the direct quotes published in The Wall Street Journal are carried out to only four decimal points. To avoid confusion, direct quotes are used exclusively.

The third column indicates the year-to-date change in the value of each foreign currency. In the three weeks following January 1, 2007, the Brazilian real declined in value relative to the U.S. dollar by 0.2 percent, whereas during the same time period, the Mexican peso increased in value by 1.3 percent. Several currencies, such as the Bahraini dollar and the Saudi Arabian riyal, did not change in value because they were pegged to the U.S. dollar.

Spot and Forward Rates:

Foreign currency trades can be executed on a spot or forward basis. The spot rate is the price at which a foreign currency can be purchased or sold today. In contrast, the forward rate is the price today at which foreign currency can be purchased or sold sometime in the future. Because many international business transactions take some time to be completed, the ability to lock in a price today at which foreign currency can be purchased or sold at some future date has definite advantages.

Most of the quotes published in The Wall Street Journal are spot rates. In addition, it publishes forward rates quoted by New York banks for several major currencies (British pound, Canadian dollar, Japanese yen, and Swiss franc) on a daily basis. This is only a partial listing of possible forward contracts. A firm and its bank can tailor forward contracts in other currencies and for other time periods to meet the firm s needs. Entering into a forward contract has no up-front cost.

The forward rate can exceed the spot rate on a given date, in which case the foreign cur­rency is said to be selling at a premium in the forward market, or the forward rate can be less than the spot rate, in which case it is selling at a discount. Currencies sell at a premium or a discount because of differences in interest rates between two countries.

When the interest rate in the foreign country exceeds the interest rate domestically, the foreign currency sells at a dis­count in the forward market. Conversely, if the foreign interest rate is less than the domestic rate, the foreign currency sells at a premium. Forward rates are said to be unbiased predictors of the future spot rate.

The spot rate for British pounds on January 23, 2007, indicates that 1 pound could have been purchased on that date for $1.9818. On the same day, the one-month forward rate was $1.9816. By entering into a forward contract on January 23, it was possible to guarantee that pounds could be purchased on February 23 at a price of $1.9816, regardless of what the spot rate turned out to be on February 23.

Entering into the forward contract to purchase pounds would have been beneficial if the spot rate on February 23 was more than $1.9816. On the other hand, such a forward contract would have been detrimental if the spot rate was less than $1.9816. In either case, the forward contract must be honored and pounds must be purchased on February 23 at $1.9816.

As it turned out, the spot rate for pounds on February 23, 2007, was $1.9635, so entering into a one-month forward contract on February 23, 2007, to purchase pounds at $1.9816 would have resulted in a loss.

Option Contracts:

To provide companies more flexibility than exists with a forward contract, a market for foreign currency options has developed. A foreign currency option gives the holder of the option the right but not the obligation to trade foreign currency in the future. A put option is for the sale of foreign currency by the holder of the option; a call is for the purchase of foreign currency by the holder of the option.

The strike price is the exchange rate at which the option will be executed if the option holder decides to exercise the option. The strike price is similar to a for­ward rate. There are generally several strike prices to choose from at any particular time. For­eign currency options can be purchased on the Philadelphia Stock Exchange, the Chicago Mercantile Exchange, or directly from a bank in the so-called over-the-counter market.

Unlike a forward contract, for which banks earn their profit through the spread between buying and selling rates, options must actually be purchased by paying an option premium, which is a function of two components intrinsic value and time value. An option’s intrinsic value is equal to the gain that could be realized by exercising the option immediately. For example, if a spot rate for a foreign currency is $1.00, a call option (to purchase foreign cur­rency) with a strike price of $0.97 has an intrinsic value of $0.03, whereas a put option (to sell foreign currency) with a strike price of $0.97 has an intrinsic value of zero.

An option with a positive intrinsic value is said to be “in the money.” The time value of an option relates to the fact that the spot rate can change over time and cause the option to become in the money. Even though a 90-day call option with a strike price of $1.00 has zero intrinsic value when the spot rate is $1.00, it will still have a positive time value because there is a chance that the spot rate could increase over the next 90 days and bring the option into the money.

The value of a foreign currency option can be determined by applying an adaptation of the Black-Scholes option pricing formula. In very general terms, the value of an option is a function of the difference between the current spot rate and strike price, the difference between domestic and foreign interest rates, the length of time to expiration, and the potential volatility of changes in the spot rate. The premium originally paid for a foreign currency option and its subsequent fair value up to the date of expiration derived from applying the pricing formula.

On December 20, 2006, the United Currency Options Market of the Philadelphia Stock Exchange indicated that a January 2007 call option in euros with a strike price of $1.32 could have been purchased by paying a premium of $0.0125 per euro. Thus, the right to purchase a standard contract of 62,500 euros in January 2007 at a price of $1.32 per euro could have been acquired by paying $781.25 ($0.0125 × 62,500 euros).

If the spot rate for euros in January 2007 turned out to be more than $1.32, the option would be exercised and euros pur­chased at the strike price of $1.32. If, on the other hand, the January spot rate is less than $1.32, the option would not be exercised; instead, euros would be purchased at the lower spot rate. The call option contract establishes the maximum amount that would have to be paid for euros but does not lock in a disadvantageous price should the spot rate fall below the option strike price.