Foreign Exchange and Hedging Strategies The Foreign Exchange Market · Where pairs of currencies can be bought and sold in exchange for one another i.e. • £ UK Pounds (Sterling) • $ US Dollars • € Euros • ¥ Japanese Yen · Over the counter (OTC) market: • Banks • Brokers FX Rates · FX rates are stated as the number of foreign currency units per unit of the domestic currency: . i.e. if the US Dollar Sterling ($tif) rate is 1.6000 then $1.6 (foreign) is equivalent to £1 (domestic) . To convert a domestic currency amount to the foreign currency - multiply by the FX rate i.e. £10,000 => 10,000 x 1.6 = $16,000 · To convert a foreign currency amount to the domestic currency - divide by the FX rate i.e. $16,000 => 16,000 = 1.6 = £10,000 FX Rate Structure Bid - the dealing rate when Offer - the dealing rate when selling the domestic currency buying the domestic currency and buying the foreign currency and selling the foreign currency $/£ - US Dollars (foreign) per UK Pound (domestic) $/£ Spot - the rate for dealing today and settling today Forward - the rate for dealing today but settling in the future Spot 1.5995 1.6005 1-month forward 195 pm 190 pm 3-month forward 75 ds 85 ds Bid Offer The difference between the bid and offer rates is known as the spread Rates are typically quoted to 4 decimal places (each 10,000th is called a pip) pm - the premium of the spot rate over the forward rate (in pips) ds - the discount of the spot rate to the forward rate (in pips)
To calculate forward rates: · deduct premiums (pm) from the spot rate · add discounts (ds) to the spot rate $/£ Bid Spot 1.5995 1 month forward 1.5995 - 0.0195 = 1.5800 195 pm 3 month forward 1.5995 + 0.0075 = 1.6070 75 ds Bid Spot 1.5995 1.6005 1 month forward 1.5800 1.5815 3 month forward 1.6070 Offer 1.6005 1.6005 - 0.0190 = 1.5815 190 pm 85 ds 1.6005 + 0.0085 = 1.6090 Offer 1.6090 If a UK company wants to buy $100,000 for settlement today: · Deal at the spot bid rate (1.5995) · f's payable today => 100,000 + 1.5995 = £62,520 (to nearest £) If a UK company wants to sell $100,000 for settlement in one month: · Deal at the 1 month forward offer rate (1.5815) · f's receivable in one month => 100,000 + 1.5815 = £63,231 (to nearest £) FX Rate Movements · In the long term, FX rates are: · Determined by relative levels of national economic growth which will ultimately impact on: · Inflation rates; and · Interest rates . In the short term, FX rates are: · Volatile; and · Unpredictable
The $/£ exchange rate over the past year: BUK Pound Sterling / US Dollar FX Spot Rate (GBP -- FX) > F1.36 F1.34 £ weaker / $ stronger E1.32 $1.30 $1.28 -> >