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Principles of Finance

3.5 Foreign Exchange Rates

Principles of Finance3.5 Foreign Exchange Rates

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Table of contents
  1. Preface
  2. 1 Introduction to Finance
    1. Why It Matters
    2. 1.1 What Is Finance?
    3. 1.2 The Role of Finance in an Organization
    4. 1.3 Importance of Data and Technology
    5. 1.4 Careers in Finance
    6. 1.5 Markets and Participants
    7. 1.6 Microeconomic and Macroeconomic Matters
    8. 1.7 Financial Instruments
    9. 1.8 Concepts of Time and Value
    10. Summary
    11. Key Terms
    12. Multiple Choice
    13. Review Questions
    14. Video Activity
  3. 2 Corporate Structure and Governance
    1. Why It Matters
    2. 2.1 Business Structures
    3. 2.2 Relationship between Shareholders and Company Management
    4. 2.3 Role of the Board of Directors
    5. 2.4 Agency Issues: Shareholders and Corporate Boards
    6. 2.5 Interacting with Investors, Intermediaries, and Other Market Participants
    7. 2.6 Companies in Domestic and Global Markets
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Video Activity
  4. 3 Economic Foundations: Money and Rates
    1. Why It Matters
    2. 3.1 Microeconomics
    3. 3.2 Macroeconomics
    4. 3.3 Business Cycles and Economic Activity
    5. 3.4 Interest Rates
    6. 3.5 Foreign Exchange Rates
    7. 3.6 Sources and Characteristics of Economic Data
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  5. 4 Accrual Accounting Process
    1. Why It Matters
    2. 4.1 Cash versus Accrual Accounting
    3. 4.2 Economic Basis for Accrual Accounting
    4. 4.3 How Does a Company Recognize a Sale and an Expense?
    5. 4.4 When Should a Company Capitalize or Expense an Item?
    6. 4.5 What Is “Profit” versus “Loss” for the Company?
    7. Summary
    8. Key Terms
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  6. 5 Financial Statements
    1. Why It Matters
    2. 5.1 The Income Statement
    3. 5.2 The Balance Sheet
    4. 5.3 The Relationship between the Balance Sheet and the Income Statement
    5. 5.4 The Statement of Owner’s Equity
    6. 5.5 The Statement of Cash Flows
    7. 5.6 Operating Cash Flow and Free Cash Flow to the Firm (FCFF)
    8. 5.7 Common-Size Statements
    9. 5.8 Reporting Financial Activity
    10. Summary
    11. Key Terms
    12. CFA Institute
    13. Multiple Choice
    14. Review Questions
    15. Problems
    16. Video Activity
  7. 6 Measures of Financial Health
    1. Why It Matters
    2. 6.1 Ratios: Condensing Information into Smaller Pieces
    3. 6.2 Operating Efficiency Ratios
    4. 6.3 Liquidity Ratios
    5. 6.4 Solvency Ratios
    6. 6.5 Market Value Ratios
    7. 6.6 Profitability Ratios and the DuPont Method
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  8. 7 Time Value of Money I: Single Payment Value
    1. Why It Matters
    2. 7.1 Now versus Later Concepts
    3. 7.2 Time Value of Money (TVM) Basics
    4. 7.3 Methods for Solving Time Value of Money Problems
    5. 7.4 Applications of TVM in Finance
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  9. 8 Time Value of Money II: Equal Multiple Payments
    1. Why It Matters
    2. 8.1 Perpetuities
    3. 8.2 Annuities
    4. 8.3 Loan Amortization
    5. 8.4 Stated versus Effective Rates
    6. 8.5 Equal Payments with a Financial Calculator and Excel
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Problems
    12. Video Activity
  10. 9 Time Value of Money III: Unequal Multiple Payment Values
    1. Why It Matters
    2. 9.1 Timing of Cash Flows
    3. 9.2 Unequal Payments Using a Financial Calculator or Microsoft Excel
    4. Summary
    5. Key Terms
    6. CFA Institute
    7. Multiple Choice
    8. Review Questions
    9. Problems
    10. Video Activity
  11. 10 Bonds and Bond Valuation
    1. Why It Matters
    2. 10.1 Characteristics of Bonds
    3. 10.2 Bond Valuation
    4. 10.3 Using the Yield Curve
    5. 10.4 Risks of Interest Rates and Default
    6. 10.5 Using Spreadsheets to Solve Bond Problems
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  12. 11 Stocks and Stock Valuation
    1. Why It Matters
    2. 11.1 Multiple Approaches to Stock Valuation
    3. 11.2 Dividend Discount Models (DDMs)
    4. 11.3 Discounted Cash Flow (DCF) Model
    5. 11.4 Preferred Stock
    6. 11.5 Efficient Markets
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  13. 12 Historical Performance of US Markets
    1. Why It Matters
    2. 12.1 Overview of US Financial Markets
    3. 12.2 Historical Picture of Inflation
    4. 12.3 Historical Picture of Returns to Bonds
    5. 12.4 Historical Picture of Returns to Stocks
    6. Summary
    7. Key Terms
    8. Multiple Choice
    9. Review Questions
    10. Video Activity
  14. 13 Statistical Analysis in Finance
    1. Why It Matters
    2. 13.1 Measures of Center
    3. 13.2 Measures of Spread
    4. 13.3 Measures of Position
    5. 13.4 Statistical Distributions
    6. 13.5 Probability Distributions
    7. 13.6 Data Visualization and Graphical Displays
    8. 13.7 The R Statistical Analysis Tool
    9. Summary
    10. Key Terms
    11. CFA Institute
    12. Multiple Choice
    13. Review Questions
    14. Problems
    15. Video Activity
  15. 14 Regression Analysis in Finance
    1. Why It Matters
    2. 14.1 Correlation Analysis
    3. 14.2 Linear Regression Analysis
    4. 14.3 Best-Fit Linear Model
    5. 14.4 Regression Applications in Finance
    6. 14.5 Predictions and Prediction Intervals
    7. 14.6 Use of R Statistical Analysis Tool for Regression Analysis
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  16. 15 How to Think about Investing
    1. Why It Matters
    2. 15.1 Risk and Return to an Individual Asset
    3. 15.2 Risk and Return to Multiple Assets
    4. 15.3 The Capital Asset Pricing Model (CAPM)
    5. 15.4 Applications in Performance Measurement
    6. 15.5 Using Excel to Make Investment Decisions
    7. Summary
    8. Key Terms
    9. CFA Institute
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  17. 16 How Companies Think about Investing
    1. Why It Matters
    2. 16.1 Payback Period Method
    3. 16.2 Net Present Value (NPV) Method
    4. 16.3 Internal Rate of Return (IRR) Method
    5. 16.4 Alternative Methods
    6. 16.5 Choosing between Projects
    7. 16.6 Using Excel to Make Company Investment Decisions
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  18. 17 How Firms Raise Capital
    1. Why It Matters
    2. 17.1 The Concept of Capital Structure
    3. 17.2 The Costs of Debt and Equity Capital
    4. 17.3 Calculating the Weighted Average Cost of Capital
    5. 17.4 Capital Structure Choices
    6. 17.5 Optimal Capital Structure
    7. 17.6 Alternative Sources of Funds
    8. Summary
    9. Key Terms
    10. CFA Institute
    11. Multiple Choice
    12. Review Questions
    13. Problems
    14. Video Activity
  19. 18 Financial Forecasting
    1. Why It Matters
    2. 18.1 The Importance of Forecasting
    3. 18.2 Forecasting Sales
    4. 18.3 Pro Forma Financials
    5. 18.4 Generating the Complete Forecast
    6. 18.5 Forecasting Cash Flow and Assessing the Value of Growth
    7. 18.6 Using Excel to Create the Long-Term Forecast
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Problems
    13. Video Activity
  20. 19 The Importance of Trade Credit and Working Capital in Planning
    1. Why It Matters
    2. 19.1 What Is Working Capital?
    3. 19.2 What Is Trade Credit?
    4. 19.3 Cash Management
    5. 19.4 Receivables Management
    6. 19.5 Inventory Management
    7. 19.6 Using Excel to Create the Short-Term Plan
    8. Summary
    9. Key Terms
    10. Multiple Choice
    11. Review Questions
    12. Video Activity
  21. 20 Risk Management and the Financial Manager
    1. Why It Matters
    2. 20.1 The Importance of Risk Management
    3. 20.2 Commodity Price Risk
    4. 20.3 Exchange Rates and Risk
    5. 20.4 Interest Rate Risk
    6. Summary
    7. Key Terms
    8. CFA Institute
    9. Multiple Choice
    10. Review Questions
    11. Problems
    12. Video Activity
  22. Index

Learning Outcomes

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

  • Explain what it means for a currency to appreciate or depreciate.
  • Define spot exchange rate.
  • Explain the risks involved in translation exposure.

Spot Exchange Rate

An exchange rate is simply the price of a currency. If you live in the United States and are going on a trip to Mexico, you will need pesos to pay for your food, hotel, and other items. You will need to purchase pesos. Suppose that you go to your bank to purchase pesos. Suppose the bank tells you that it will cost $0.0625 to purchase one Mexican peso. If you want to take 10,000 Mexican pesos with you on your trip, it will cost you $625 to purchase the desired pesos.

In this example, the price of one peso is six and one-quarter cents. This price will often be written in the form of

MXN1=USD0.0625MXN1=USD0.0625

MXN is an abbreviation for the Mexican peso, 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. Because this is the price you would pay to purchase Mexican pesos right now, it is known as the spot exchange rate.

If you know the price of Mexican pesos in dollars, you can easily find the price of US dollars in Mexican pesos. Simply divide both sides of the equation by 0.0625, or the price of a peso:

MXN1=USD0.0625MXN1=USD0.0625
MXN10.0625=USD0.06250.0625MXN10.0625=USD0.06250.0625
MXN16=USD1MXN16=USD1

If you have Mexican pesos and you want to exchange them for dollars, you will be using the pesos to buy dollars. Each US dollar will cost you MXN 16.

Currency Appreciation

Just as the price of gasoline changes, resulting in it costing more to purchase gasoline on some visits to the gas station than on other visits, the price of a currency also changes. Currency appreciation occurs when it costs more to purchase a currency than it did before.

If the next time you go to the bank to purchase pesos, the bank quotes an exchange rate of MXN1=USD0.0800MXN1=USD0.0800, it means that it now costs $0.0800 (up from $0.0625) to purchase a Mexican peso. Hence, the price of a peso has risen, or the peso has appreciated.

Currency prices are determined in the marketplace through the same types of supply-and-demand forces we discussed earlier in this chapter. What would cause the peso to appreciate? Either an increase in the demand for pesos or a decrease in the supply of pesos.

Currency Depreciation

Just as a currency can appreciate, it can depreciate. If the quote at the bank was MXN1=USD0.0500MXN1=USD0.0500, it would only cost $0.0500 to purchase a Mexican peso. When it costs fewer dollars to purchase a peso, the peso has depreciated. Either a decrease in demand for pesos or an increase in supply of pesos will cause the peso to depreciate.

Because an exchange rate is the price of one currency expressed in terms of another currency, if one of the currencies depreciates, the other currency must, by definition, appreciate. If it costs $0.0500 to purchase a Mexican peso, the price of a US dollar, in terms of a Mexican peso would be calculated as

MXN1=USD0.0500MXN1=USD0.0500
MXN10.0500=USD0.05000.0500MXN10.0500=USD0.05000.0500
MXN20=USD1MXN20=USD1

So, the price of one US dollar would be 20 Mexican pesos.

Exchange Rate Risk

Businesses that engage in international business face currency exchange rate risk. As exchange rates change, a business can be impacted in a number of ways. One of these risks, transaction exposure, 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. A pottery-making business that has sold merchandise to a company in the United States for $20,000, for example, will need to exchange the $20,000 for pesos to be able to pay its workers and other expenses in pesos. How many pesos it will receive for $20,000 will change depending on the exchange rate. If the exchange rate is MXN16=USD1MXN16=USD1, the company will receive 320,000 pesos for the $20,000. If the exchange rate is MXN20=USD1MXN20=USD1, the company will receive 400,000 pesos for the $20,000. Thus, as the peso depreciates (and the US dollar appreciates), the same number of dollars will provide more pesos. Conversely, as the peso appreciates (and the US dollar depreciates), the same number of dollars will provide fewer pesos.

Firms that hold assets in a foreign country also face translation exposure. When a company creates its financial statements, items are reported using one currency. As foreign exchange rates change, the value of how items are reported on these financial statements can change. This type of risk is an accounting risk.

Economic exposure is the risk that a change in exchange rates will impact a business’s number of customers and sales. For example, tourists have the option of spending a week-long vacation at a resort in the United States or in Mexico. As the dollar appreciates, US citizens can exchange their dollars for more pesos, resulting in their purchasing power going further at a Mexican resort. Because an appreciating dollar also means a depreciating peso, it would mean that Mexicans who earn pesos will receive fewer dollars when they exchange their pesos. A Mexican who wants to stay at a $200-per-night hotel in Colorado will need more pesos to pay for the room when the peso depreciates. The depreciating peso will likely mean that more Mexicans will spend their vacation week in Mexico, and fewer will vacation in the United States.

Even businesses that do not view themselves as involved in international business can face economic exposure. The ski lodge in Colorado will find that its customers from Mexico decrease when the dollar appreciates. Likewise, when the dollar appreciates, some of the ski lodge’s US-based customers may choose instead to visit a resort in Mexico, where their purchasing power is strong.

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