The preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international trade—and you would be right. According to the most recent data, forward instruments account for almost two-thirds of all foreign exchange transactions, while spot exchanges account for about one-third.3 However, the vast majority of these forward exchanges are not forward exchanges of the type we have been discussing, but rather a more sophisticated instrument known as currency swaps.
Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk. A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today.
Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 = ¥120 and the 90-day forward exchange rate is $1 = ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/110 = $1.09 million). Because the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.
MANAGEMENT FOCUS Volkswagen’s Hedging Strategy
In January 2004, Volkswagen, Europe’s largest carmaker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen’s operating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention—the sharp rise in the value of the euro against the dollar during 2003 and Volkswagen’s decision to only hedge 30 percent of its foreign currency exposure, as opposed to the 70 percent it had traditionally hedged. In total, currency losses due to the dollar’s rise are estimated to have reduced Volkswagen’s operating profits by some €1.2 billion ($1.5 billion).
The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had recorded a volatile trading history against the U.S. dollar. In early 1999, the exchange rate stood at €1 = $1.17, but by October 2000 it had slumped to €1 = $0.83. Although it recovered, reaching parity of €1 = $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar during 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003, the exchange rate stood at €1 = $1.25.
For Volkswagen, which made cars in Germany and exported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To understand what happened, consider a Volkswagen Jetta built in Germany for export to the United States. The Jetta costs €14,000 to make in Germany and ship to a dealer in the United States, where it sells for $15,000. With the exchange rate standing at around €1 = $1.00, the $15,000 earned from the sale of a Jetta in the U.S. could be converted into €15,000, giving Volkswagen a profit of €1,000 on every Jetta sold. But if the exchange rate changes during the year, ending up at €1 = $1.25 as it did during 2003, each dollar of revenue will now only buy €0.80 (€1/$1.25 = €0.80), and Volkswagen is squeezed. At an exchange rate of €1 = $1.25, the $15,000 Volkswagen gets for the Jetta is now worth only €12,000 when converted back into euros, meaning the company will lose €2,000 on every Jetta sold (when the exchange rate is €1 = $1.25, $15,000/1.25 = €12,000).
Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign exchange market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 = €1 (a forward contract gives the holder the right to exchange one currency for another at some point in the future at a predetermined exchange rate). Called hedging, the financial strategy of buying forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to exchange the dollars it got from selling Jettas in the United States into euros at $1 = €1, irrespective of what the actual exchange rate was at that time. In 2003, such a strategy would have been good for Volkswagen. However, hedging is not without its costs. For one thing, if the euro had declined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive because foreign exchange dealers will charge a high commission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 through forward contracts, rather than the 70 percent it had historically hedged. The decision cost the company more than €1 billion. For 2004, the company reverted back to hedging 70 percent of its foreign currency exposure.
Sources: Mark Landler, “As Exchange Rates Swing, Car Makers Try to Duck,” The New York Times, January 17, 2004, pp. B1, B4; N. Boudette, “Volkswagen Posts 95% Drop in Net,” The Wall Street Journal, February 19, 2004, p. A3; and “Volkswagen’s Financial Mechanic,” Corporate Finance, June 2003, p. 1.
The Nature of the Foreign Exchange Market
The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange market has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment (see Chapter 1). In March 1986, the average total value of global foreign exchange trading was about $200 billion per day. According to the triannual survey by the Bank of International Settlements, by April 1995, it was more than $1,200 billion per day; by April 2007, it had surged to $3.21 trillion per day; and by April 2010, it had hit $4 trillion a day.4 The most important trading centers are London (37 percent of activity), New York (18 percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of activity).5 Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney.
London’s dominance in the foreign exchange market is due to both history and geography. As the capital of the world’s first major industrial trading nation, London had become the world’s largest center for international banking by the end of the nineteenth century, a position it has retained. Today, London’s central position between Tokyo and Singapore to the east and New York to the west has made it the critical link between the East Asian and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York.6
Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these three hours, trading continues in a number of minor centers, particularly San Francisco and Sydney, Australia. The second feature of the market is the integration of the various trading centers. High-speed computer linkages among trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers. For example, if the yen/dollar exchange rate quoted in London at 3 p.m. is ¥120 = $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New York time) will be identical. If the New York yen/dollar exchange rate were ¥125 = $1, a dealer could make a profit through arbitrage, buying a currency low and selling it high. For example, if the prices differed in London and New York as given, a dealer in New York could take $1 million and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for dollars in London, where the transaction would yield $1.041666 million, allowing the trader to book a profit of $41,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the demand for yen in New York would rise, resulting in an appreciation of the yen against the dollar such that the price differential between New York and London would quickly disappear. Because foreign exchange dealers are always watching their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes.
The purchase of securities in one market for immediate resale in another to profit from a price discrepancy.
Another feature of the foreign exchange market is the important role played by the U.S. dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency and buy another. A dealer wishing to sell Korean won for Brazilian real, for example, will usually sell the won for dollars and then use the dollars to buy real. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of real who wants to buy won. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for won or real.
Due to its central role in so many foreign exchange deals, the dollar is a vehicle currency. In 2010, 85 percent of all foreign exchange transactions involved dollars on one side of the transaction. After the dollar, the most important vehicle currencies were the euro (39 percent), the Japanese yen (19 percent), and the British pound (13 percent)—reflecting the historical importance of these trading entities in the world economy. The euro has replaced the German mark as the world’s second most important vehicle currency. The British pound used to be second in importance to the dollar as a vehicle currency, but its importance has diminished in recent years. Despite this, London has retained its leading position in the global foreign exchange market.
• QUICK STUDY
1. What is a spot exchange rate?
2. What is the difference between a spot exchange rate and a forward rate?
3. Why do businesses use forward exchange rates?
4. What is the difference between a forward exchange rate and a currency swap?
5. Due to arbitrage, what will be the difference between exchange rates in different financial centers?