Principles of Finance

# 20.3Exchange Rates and Risk

Principles of Finance20.3 Exchange Rates and Risk

### Learning Outcomes

By the end of this section, you will be able to:

• Describe exchange rate risk.
• Identify transaction, translation, and economic risks.
• Describe a natural hedge.
• Explain the use of forward contracts as a hedge.
• List the characteristics of an option contract.
• Describe the payoff to the holder and writer of a call option.
• Describe the payoff to the holder and writer of a put option.

The managers of companies that operate in the global marketplace face additional complications when managing the riskiness of their cash flows compared to domestic companies. Managers must be aware of differing business climates and customs and operate under multiple legal systems. Often, business must be conducted in multiple languages. Geopolitical events can impact business relationships. In addition, the company may receive cash flows and make payments in multiple currencies.

### Exchange Rates

The costs to companies are impacted when the prices of the raw materials they use change. Very little coffee is grown in the United States. This means that all of those coffee beans that Starbucks uses in its espresso machines in Seattle, New York, Miami, and Houston were bought from suppliers outside of the United States. Brazil is the largest coffee-producing country, exporting about one-third of the world’s coffee.6 When a company purchases raw materials from a supplier in another country, the company needs not just money but the money that is used in that country to make the purchase. Thus, the company is concerned about the exchange rate, or the price of the foreign currency.

Figure 20.2 Brazilian Reals to One US Dollar7

The currency used in Brazil is called the Brazilian real. Figure 20.2 shows how many Brazilian reals could be purchased for $1.00 from 2010 through the first quarter of 2021. In March 2021, 5.4377 Brazilian reals could be purchased for$1.00. This will often be written in the form of

BRL is an abbreviation for Brazilian real, and USD is an abbreviation for the US dollar. This price is known as a currency exchange rate, or the rate at which you can exchange one currency for another currency.

If you know the price of $1.00 is 5.4377 Brazilian reals, you can easily find the price of Brazilian reals in US dollars. Simply divide both sides of the equation by 5.4377, or the price of the US dollar: If you have US dollars and want to purchase Brazilian reals, it will cost you$0.1839 for each Brazilian real you want to buy.

The foreign exchange rate changes in response to demand for and supply of the currency. In early 2020, the exchange rate was . In other words, $1 purchased fewer reals in early 2020 than in it did a year later. Because you receive more reals for each dollar in 2021 than you would have a year earlier, the dollar is said to have appreciated relative to the Brazilian real. Likewise, because it takes more Brazilian reals to purchase$1.00, the real is said to have depreciated relative to the US dollar.

### Exchange Rate Risks

Starbucks, like other firms that are engaged in international business, faces currency exchange rate risk. Changes in exchange rates can impact a business in several ways. These risks are often classified as transaction, translation, or economic risk.

#### Transaction Risk

Transaction risk is the risk that the value of a business’s expected receipts or expenses will change as a result of a change in currency exchange rates. If Starbucks agrees to pay a Brazilian coffee grower seven million Brazilian reals for an order of one million pounds of coffee beans, Starbucks will need to purchase Brazilian reals to pay the bill. How much it will cost Starbucks to purchase these Brazilian reals depends on the exchange rate at the time Starbucks makes the purchase.

In March 2021, with an exchange rate of , it would have cost Starbucks to purchase the reals needed to receive the one million pounds of coffee beans. If, however, Starbucks agreed in March to purchase the coffee beans several months later, in July, Starbucks would not have known then what the exchange rate would be when it came time to complete the transaction. Although Starbucks would have locked in a price of BRL 7,000,000 for one million pounds of coffee beans, it would not have known what the coffee beans would cost the company in terms of US dollars.

The company can determine how many Korean won it would take to purchase $100,000 today. If the current exchange rate is , then it will need KWN 110,000,000 to pay the bill. The current exchange rate is known as the spot rate. The company, however, does not need the US dollars for another six months. The company can purchase a call option, which is a contract that will allow it to purchase the needed US dollars in six months at a price stated in the contract. This allows the company to guarantee a price for dollars in six months, but it does not obligate the company to purchase the dollars at that price if it can find a better price when it needs the dollars in six months. The price that is in the contract is called the strike price (exercise price). Suppose the company purchases a call contract for US dollars with a strike price of KWN 1,200/USD. While this contract would be for a set size, or a certain number of US dollars, we will talk about this transaction as if it were per one US dollar to highlight how options contracts work. The company must pay a price, known as the premium, to purchase this call option contract. For our example, let’s assume the premium for the call option contract is KWN 50. In other words, the company has paid KWN 50 for the right to buy US dollars in six months for a price of KWN 1,200/USD. In six months, the company makes a choice to either (1) pay the strike price of KWN 1,200/USD or (2) let the option expire. If the company chooses to pay the strike price and purchase the US dollars, it is exercising the option. How does the company choose which to do? It simply compares the strike price of KWN 1,200/USD to the market, or spot, exchange rate at the time the option is expiring. If, six months from now, the spot exchange rate is , it will be cheaper for the company to buy the US dollars it needs at the spot price than it would be to buy the dollars with the option. In fact, if the spot rate is anything below , the company will not choose to exercise the option. If, however, the spot exchange rate in six months is , the company will exercise the option and purchase each US dollar for only KWN 1,200. The profitability, or the payoff, to the owner of a call option is represented by the chart in Figure 20.4 below. Possible spot prices are measured from left to right, and the financial gain or loss to the company of the option contract is measured vertically. If the spot price is anything less than KWN 1,200/USD, the option expires without being exercised. The company paid KWN 50 for something that ended up being worthless. Figure 20.4 The Payoff to the Holder of a Call Option If, in six months, the spot exchange rate is , then the company will choose to exercise the option. The company will be saving KWN 25 for each dollar purchased, but the company originally paid 50 KWN for the contract. So, the company will be 25 KWN worse off than if it had never purchased the call option. If the spot exchange rate is , the company will be in exactly the same position having purchased and exercised the call option as it would have been if it had not purchased the option. At any spot price higher than KWN 1,250/USD, the firm will be in a better financial position, or will have a positive payoff, because it purchased the call option. The more the Korean won depreciates over the next six months, the higher the payoff to the firm of owning the call contract. Purchasing the call contract is a way that the company can protect itself from the currency exposure it faces. For any transaction, there must be two parties—a buyer and a seller. For the company to have purchased the call option, another party must have sold the call option. The seller of a call option is called the option writer. Let’s consider the potential benefits and risks to the writer of the call option. When the company purchases the call option, it pays the premium to the writer. The writer of the option does not have a choice regarding whether the option will be exercised. The purchaser of the option has the right to make the choice; in essence, the writer of the option sold the right to make that decision to the purchasers of the call option. Figure 20.5 shows the payoff to the writer of the call option. Recall that the buyer of the call option will let the option expire if the spot rate is less than when the call option matures in six months. If this occurs, the writer of the option collected the KWN 50 option premium when the contract was sold and then never hears from the purchaser again. This is what the writer of the option is hoping for; the writer of the call option profits when the options contract is not exercised Figure 20.5 The Payoff to the Writer of a Call Option If the spot rate is above , then the holder of the option will choose to exercise the right to purchase the won at the option strike price. Then the writer of the option will be obligated to sell the Korean won at a price of KWN 1,200/USD. If the spot rate is , the option writer will be obligated to sell the dollars for KWN 50 less than what they are worth; because the option writer was initially paid a KWN 50 premium for taking on that obligation, the option writer will just break even. For any exchange rate higher than , the writer of the call option will have a loss. The option contract is a zero-sum game. Any payoff the owner of the option receives is exactly equal to the loss the writer of the option has. Any loss the owner of the option has is exactly equal to the payoff the writer of the option receives. #### Put Options While the call option you just considered gives the owner the right to buy an underlying asset, the put option gives the owner to right to sell an underlying asset. Take, for example, an Indian company that has a contract to provide graphic artwork for a US company. The US company will pay the Indian company 200,000 US dollars in three months. While the Indian company receives US dollars, it must pay its workers in Indian rupees. Because the company does not know what the spot exchange rate will be in three months, it faces transaction risk and may be interested in hedging this exposure using a put option. The company knows that the current spot rate is , meaning that the company would be able to use$200,000 to purchase if it possessed the \$200,000 today. If the Indian rupee appreciates relative to the US dollar over the next three months, however, the company will receive fewer rupees when it makes the exchange; perhaps the company will not be able to purchase enough rupees to cover the wages of its employees.

Assume the company can purchase a put option that gives it the right to sell US dollars in three months at a strike price of INR 75/USD; the premium for this put option is INR 5. By purchasing this put option, the company is spending INR 5 to guarantee that it can sell its US dollars for rupees in three months at a price of INR 75/USD.

If, in three months, when the company receives payment in US dollars, the spot exchange rate is higher than , the company will simply exchange the US dollars for rupees at that exchange rate, allowing the put option to expire without exercising it. The payoff to the company for the option is INR -5, the premium that was paid for the option that was never used (see Figure 20.6).

Figure 20.6 The Payoff to the Holder of a Put Option

If, however, in three months, the spot exchange rate is anything less than , then the company will choose to exercise the option. If the spot rate is between and , the payoff for the option is negative. For example, if the spot exchange rate is , the company will exercise the option and receive three more Indian rupees per dollar than it would in the spot market. However, the company had to spend INR 5 for the option, so the payoff is INR -2. At a spot exchange rate of , the company has a zero payoff; the benefit of exercising the option, INR 5, is exactly equal to the price of purchasing the option, the premium of INR 5.

If, in three months, the spot exchange rate is anything below , the payoff of the put option is positive. At the theoretical extreme, if the USD became worthless and would purchase no rupees in the spot market when the company received the dollars, the company could exercise its option and receive INR 75/USD, and its payoff would be INR 70.

Now that we have considered the payoff to a purchaser of a put contract, let’s consider the opposite side of the contract: the seller, or writer, of the put option. The writer of a put option is selling the right to sell dollars to the purchaser of the put option. The writer of the put option collects a premium for this. The writer of the put has no choice as to whether the put option will be exercised; the writer only has an obligation to honor the contract if the owner of the put option chooses to exercise it.

The owner of the option will choose to let the option expire if the spot exchange rate is anything above . If that is the case, the writer of the put option collects the INR 5 premium for writing the put, as shown by the horizontal line in Figure 20.7. This is what the writer of the put is hoping will occur.

Figure 20.7 The Payoff to the Writer of a Put Option

The owner of the option will choose to exercise the option if the exchange rate is less than . If the spot exchange rate is between and , the writer of the put option has a positive payoff. Although the writer must now purchase US dollars for a price higher than what the dollars are worth, the INR 5 premium that the writer received when entering into the position is more than enough to offset that loss.

If the spot exchange rate drops below , however, the writer of the put option is losing more than INR 5 when the option is exercised, leaving the writer with a negative payoff. In the extreme, the writer of the put will have to purchase worthless US dollars for INR 75/USD, resulting in a loss of INR 70.

Notice that the payoff to the writer of the put is the negative of the payoff to the holder of the put at every spot price. The highest payoff occurs to the writer of the put when the option is never exercised. In that instance, the payoff to the writer is the premium that the holder of the put paid when purchasing the option (see Figure 20.7).

Table 20.2 provides a summary of the positions that the parties who enter into options contract are in. Remember that the buyer of an option is always the one purchasing the right to do something. The seller or writer of an option is selling the right to make a decision; the seller has the obligation to fulfill the contract should the buyer of the option choose to exercise the option. The most the seller of an option can ever profit is by the premium that was paid for the option; this occurs when the option is not exercised.

Benefits Harm
Party to an Option Contract Right of the Party Obligation of the Party When Maximum Profit When Maximum Loss
Buyer of a call To buy   Price of underlying rises Unlimited Price of underlying falls Premium paid
Seller of a call   To sell Price of underlying falls Premium received Price of underlying rises Unlimited
Buyer of a put To sell   Price of underlying falls Strike price minus premium Price of underlying rises Premium paid
Table 20.2 Summary of Option Contracts

### Footnotes

• 6Global Agricultural Information Network. Brazil: Coffee Annual 2019. GAIN Report No. BR19006. Washington, DC: USDA Foreign Agricultural Service, May 2019. https://apps.fas.usda.gov/newgainapi/api/report/downloadreportbyfilename?filename=Coffee%20Annual_Sao%20Paulo%20ATO_Brazil_5-16-2019.pdf
• 7Data from Board of Governors of the Federal Reserve System (US). “Brazil / US Foreign Exchange Rate (DEXBZUS).” FRED. Federal Reserve Bank of St. Louis, accessed August 6, 2021. https://fred.stlouisfed.org/series/DEXBZUS
• 8Data from Board of Governors of the Federal Reserve System (US). “Japan / US Foreign Exchange Rate (DEXJPUS).” FRED. Federal Reserve Bank of St. Louis, accessed August 6, 2021. https://fred.stlouisfed.org/series/DEXJPUS
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