Question

International Finance
Cash flows in various parts of a multinational corporate system will be denominated in different currencies. Hence, exchange rates must be included in all financial analyses.
Foreign exchange rate quotations can be found in The Wall Street Journal and in other leading print publications and on websites. Exchange rates are given in two different ways: (1) Direct Quotation – the home currency price of one unit of the foreign currency and (2) Indirect Quotation – the foreign currency price of one unit of the home currency. If the foreign exchange markets are in equilibrium, which is usually the case for the major traded currencies, the two quotations must be reciprocals of each other.
Example, Canadian Dollar and US Dollar:
Canadian Dollar 1/0.9814 = 1.0190
1/1.0190 = 0.9814
Suppose, though, that a German executive is flying to Tokyo on business. The exchange rate in which he or she is interested is not euros or yen per dollar – rather, the issue is how many yen can be purchased with a euro. This is called a cross rate – exchange rate between any two currencies.
Example, spot rate for Euro is €0.7511/$l
spot rate for Yen is ¥96.02/$1
For the German national, the cross rates are found as follows:
Euro / $ Yen / $
Euro / Yen exchange rate = or Yen / Euro exchange rate =
Yen / $ Euro / $
Problem:

Monblanc Trading Company imports French cheeses for distribution in the United States. On July 1, the company purchased cheese costing 100,000 Euro. Payment is due in Euro on October 1. The spot rate on July 1 was $1.20 per Euro, and on October 1, it was $1.25 per Euro.
Determine the following:
1. The company’s liabilities in US Dollars prior to payment
2. The amount of payment in US Dollars on October 1
3. The exchange gain or loss
Briefly discuss implications.

Answer 1

FOREIGN EXCHANGE RATES

Foreign exchange rates or cross currency rates can be defined as the value of one currency which can be exchanged in terms of another. For example. if $1 = INR. 75, this means for $1 a person caqn exchagne Indian 75 Indian INR. Form indian point of view, for one will needf INR75 to purchase one Doller. Conversly, it can also be expressed as 1INR = $0.134.

Now let ius solve points mentioned in question.

1. LIABILITY CALCULATIONThis part requires us to calculate liability of importing entity on 1July when they imported goods where exchange rate was Euro 1 = $1.20. According to this rate, for purchasing 1 unit of Euro, peerson will need to spend $1.20 and therefore liability for importing goods worth Euro 1,00,000, person will need to book a liability of 1,00,000 x 1.20 = $1,20,000 (value of goods in euro x price per euro)

2.PAYNMENT AMOUNT CALCULATIONhis part requires us to calculate paynent of importing entity on 1Sept. when importer paid for goods prucored. Exchange rate on Oct 01 was Euro 1 = $1.25. According to this rate, for purchasing 1 unit of Euro, peerson will need to spend $1.25 and therefore for making payment for importing goods worth Euro 1,00,000, person will need to pay as 1,00,000 x 1.25 = $1,25,000 (value of goods in euro x price per euro).

3. EXCHANGE GAIN OF LOSS CALCULATIUON As visible under above two parts, person had paid $1,25,000 on Oct,01 instead of $1,20,000 liability booked on the date of purchase. This led to an exchange loss of $5,000 as the value of $ has depreciated by 0.05 per unit i.e. a person can purchase 1.25 more of doller for one euro instead of 1.20 now i.e. 0.05 more. From the opposite side, to purchase one euro, now person needs to pay 1.25 instead of 1.20 which means 0.05 more.

IMPLICATION OF FOREIGN EXCHANGEForeign exchange rates are used on carrying out international trade and payments. There are two methods of quoting foreign exchange rates -

1 Direct method - (morepopular) where home country price is calculated in terms of one unit of foireign currency.

2. indirect method - Foreign currency price is quoted for one unit of home country courrency.

Implication on importer

Exchange rates are not constant and vary from time to time due to variuos factors affecting the international market. Like most recent virus pendamic has adversly affected all counteries. This has led to depreciation of majorly all affected country but effect of this or any other factor is not same on all countries over the world and therefore some currencies will depreciate more as compared to another. The volatility of exchnage rates gives rise to uncertainity which in turn may affect business. Like in this question importing person will have to bear an extra cost of $5,000 just because of adverse change in doller i.e. dollers have depreciated from euro from July to Oct1. Hadd there been reverse change i.e. appreciation of $ against euro, person would have availed foreign exchange gain. For example if exchange rate on Oct01 would became One Euro = $1.10, then importer would have paid only 1,10,000.

Implication on economy

Overall entire economy is affected either directly or indirectly by change in currency exchange rates as appreciation of home currency will lead to building a stornger economy and depreciation will lead to increasing cost of imported goods and services and hence affecting economy adversly.

This changing foregin exchange gives rise to three business as follows: -

1. Hedging: - If importer on July 1 had entered into a contract to purchaser 1,00,000 euro on Oct01 for $1.20 per euro, his cost would have been fixed at 1.204/Euro. This contracts are known as hedging contracts.

2. Speculation: - There are established markets where currencies are traded. Over such place, different person having bullish and bearsih views about any currency may enter into contract with the motive of earning profits in future.

3. Arbitrage: - This is a form of trading with 0 investment and sure profit. A currency on one exchnage rate may not be trading with same exchange rate in another market. This gives rise to an arbitrage opportunity where one can buy a currency at lower cost in one market and sell it in another where same currency is overpriced.