 Hello and welcome to this session. This is Professor Farhad and this session would look at introduction to foreign currency transaction. We would look at brief historical overview as well as basic terms you need to be familiar with. This topic is covered in international accounting for course as well as international finance CPA exam the far section as well as the ACCA exam. As always I would like to remind you to connect with me on LinkedIn. YouTube is where you would need to subscribe. I have 1500 plus accounting, auditing and tax lecture. If you like my lectures please like them it helped me tremendously. Share them put them in playlist let the world know about them. If you like them it means other people might like them as well so share the wealth. This is my Instagram account please follow me on Instagram as I'm trying to grow my following. This is my Facebook and this is my website. On my website if you'd like to support the channel you do have the option to donate. I always have offers on my website right now. Becker CPA review is offering a discount on their CPA course. Please check it out if you are interested. By looking at brief overview of a historical background about international trade and foreign exchange international trade right now represent the significant portion of the world economy. So most countries most companies they sell in outside their territory and most countries they buy supplies from outside their national territory. Therefore we have to have a foreign exchange rate because when you trade when you buy or when you sell in other country you have to use their currency. Therefore you have to have a foreign exchange rate and that's the price to which you pay for a particular foreign currency. For example one US dollar today one USD one US dollar would buy you for example dollar 30 of Canadian dollar. This is the exchange rate. Now you have to understand that the mechanism for the exchange rate has evolved over the years. After World War II from 1945 to 1973 the exchange rate was fixed. So countries fixed the power value of their currency in terms of US dollar within one or plus or minus one percent. What does that mean? It means your foreign currency can is equivalent to a certain dollar amount and that dollar amount is fixed it did not change versus today we're going to see the the prices of currencies fluctuate up and down. Now also the US dollar value was fixed in terms of gold. So the ounce of gold equal to $35 for $35 you can buy an ounce of gold. So that was the rate for the US dollar and other currencies were fixed against that rate. Now what happened is US gold reserve declined substantially from 24 billion in 1949 to 10 billion in 1971 as foreign currencies exchanged their US dollar into gold because you could exchange $35 and get one ounce of gold and what was happening foreign countries they were exchanging US dollar into gold and the gold reserve the US gold reserve went down. So what happened we changed the system in 1973 the gold standard system was abolished and the currency began to float. Float means they can trade they can trade it means the price of the currency could go up the price of the currency could go down depending on interest rate supply and demand macroeconomic macroeconomic factors the level of inflation on that particular country. So we abolished this this this fixed system to a to a float system currency arrangement right now we have three system we have an independent float packed system and European monetary system let's talk about those three currency arrangement where's independent float independent float is the is when the value of the currency is allowed to fluctuate up and down according to market forces so the market determined the price of your currency with little of no intervention from the central bank sometimes the central bank might intervene but it's it's not the main determinant of your prices. Who would use a float currency the US Australia Canada Japan Mexico Sweden most advanced economies use a float float system basically they would like their currency float and let the market forces determine the price of that currency another system is called the packed system packed to another currency here the value of the currency is packed it means it's fixed in terms of a particular foreign currency and the central bank intervene as is necessary to maintain the fixed value think of it as the previous system where your currency is fixed in terms of US dollar for example several countries such as Hong Kong Panama Jordan Saudi Arabia and among among other pegged their currency to the US dollar for example they might say you know 50 units of our currency equal to one USD and what happen is if the prices go up or if the prices go down the central bank will either buy buy buy more of their local currency or sell more of their local currency to bring it back to 50 unit per dollar okay some systems like the EU basically you can see it's an European monetary system you have to understand in 1998 the country the countries comprising the EU adopted a common currency called the euro and established European central bank up until 2002 local currencies such as the German Frank and the German mark and the French Frank continue to exist but they were fixed in in terms of the euro so basically now they're gone basically the German mark and the in the French Frank basically they're all they're all are translated or they're all converted into euros okay January 1st 2002 I still remember that day local currencies disappeared and the euro became effective in 12 European countries okay in 1913 in 2013 17 countries were members of the EU zone the EU zone okay so the value of the EU fluctuate against US dollar and fluctuate against other currencies as well so now the EU basically its own the it's it's it has its own currency basically a single currency we have to understand that foreign exchange rate fluctuate on a regular basis it means it goes up and it goes down the difference between buying and selling a foreign currency is called a spread now what do we mean by spread spread is is how banks and foreign exchange brokers like those people that's you see them at airports earn a profit on a foreign exchange now what is this spread so it's spread basically they will have something called bid ask or sometimes they call it bid offer okay and there's it's something to that effect for example let's assume I want to travel let me show you maybe some currency okay let's assume I want to travel to Canada I go to the bank and I noticed let's see the Canadian dollar here they would say the Canadian dollar you pay 0.7869 I'm gonna explain this in a moment well before we go to the bid ask let's talk about the direct quote okay so we'll we'll come back to the spread in a moment so what is the direct quote the direct quote is the US dollar per one unit of foreign currency for example here one US dollar will buy you dollar 27 I'm using the Canadian dollar as well this is the direct quote the inverse of the direct quote is the indirect quote were how much you will need okay how much you will need to buy a Canadian dollar you would need 78 pennies to buy a Canadian dollar so the price could be direct let me show you an indirect so so if you have a direct price one dollar equal to dollar 27 if you take one divided by 1.27 you will find out how much you will need in your currency to buy a foreign currency so you will need 78 pennies 78.78.6975 pennies to buy one Canadian dollar okay now if you go to the bank and you will tell them well you're traveling to Canada and you say I would like to buy I would like to buy 100 dollar or 1000 dollar worth of they convert 1000 dollar US dollar into Canadian money okay well what you're doing now is you are buying so if you are buying they might say the price the bid is 0.7 0.78 0.78 I'll just make it 0.78 so what does that mean that means if you want to convert 1000 dollar you have to pay you will convert them for every Canadian dollar you'll pay 0.78 so let's see how much is that so 1000 dollar divided 0.78 you'll be able to get $1,282 Canadian so you can get 1,282 I believe let me just double check 82 Canadian that's the bid let's assume you want outside the bank and you get a call from your company and say you know what we really need you this weekend you can't sorry you can't go to Canada you just you have to cancel that trip you know we need you for something one of the clients called and you'd say okay you'll buy you will walk inside the bank and you would say okay here's 1,882 Canadian I want to I want one I want my 1000 dollar back they would say oh no problem our offer is 0.75 you would say I just I just converted I just converted 1000 USD into 1,282 now let's now convert the Canadian back to the back to US dollar and they would say the offer or the ask is 0.75 well let's do that so we're going to take the money the Canadian money that you have multiplied by 0.75 and we're going to give you back 961 dollars and 50 cent now we're going to give you back 961.50 USD I was just here 10 minutes ago well it doesn't matter this is how they make profit this is what the spread is when you buy and when you sell there's a difference between the prices they don't buy and sell at the same price they want to make the profit and the profit is the spread so the spread here is 3 pennies the spread here is 3 pennies just left the bank and you get a phone call you came back you wanted to get your US dollar back they will not give it back to you at 0.78 they would only convert it at 0.75 so if you want to buy US dollar they would say well we're going to sell it at 0.75 okay so that's that's what the bid offer or the spread is the difference between the bid and the ask or the bid and the offer remember B4 buy when you want to buy okay so this is how they make their profit again foreign currency can be can have a direct quote for example how much you can get one US dollar per deferring currency or the inverse how much how much if you want to buy one foreign currency how much you will have to pay for example again Canadian dollar you'll have to pay 78 pennies to buy to buy it okay we also need to be familiar with two terms one is called the spot rate and one is called the forward rate what's the spot rate the spot rate is the price at which a foreign currency can be purchased or sold today for example these are spot rates spot rate okay today for example this is how much you can get for the Canadian dollar okay for everyone the US dollar you get $1.27 the forward rate the price today at which a foreign currency can be purchased or sold sometime in the future huh well today is what today is august the 19th 2019 okay august the 19th 2019 now you can buy a forward exchange rate for september 20th 2019 so a month from now i need to go to canada well guess what the price today is i can convert one us dollar into 127 canadian well i'm not going to canada now i'm going a month from now well a month from now i can buy a contract to be able to convert one us dollar into dollar 25 or one us dollar one us dollar into dollar 30 depending on what the forward rate is if the forward rate is less than the spot rate we call it a discount it means the foreign currency is selling at a discount if it's above it means it's selling at a premium now we don't have to worry about why it's a discount or a premium to just know it exists now you might be saying why wouldn't you why would you buy it at dollar 30 if you can buy today a dollar 27 i don't need it today i need it a month from now and month from now i fear that the price could be dollar 40 therefore i'm happy to buy it at dollar 25 or why don't you buy it at dollar 25 and lock your price well because there is a risk there but on september 20th a month from now the price could be dollar 20 and i could lose so what you have the option of locking your prices into the future okay the forward rate can exceed the spot rate it's called selling at a premium the forward rate can be less than the spot rate that's sold at a discount okay let's assume the spot rate today is dollar 27 and one month forward rate is dollar 25 therefore what i did i purchased i purchased the forward rate at dollar 25 let's assume we'll work two examples assuming you are an exporter assuming you are an importer because those are the two options let's assume i'm a us exporter simply put i sell product and let's assume i sell product to germany and i'm going to be receiving 100 000 euros one month from now so i sold some parts to a german company but they're gonna pay me 30 days from now well guess what 30 days from now i really have no clue what's gonna happen to the euro today the euro is dollar 27 but i don't have the euro i don't have the money in my hand so i cannot convert i'm gonna get the money later a month later so what i would do i would buy a forward contract at dollar 25 why would i do so so when i get my euros i can convert them at dollar 25 okay what could happen between now and the month from now a month from now the spot rate when i received that money could be dollar 29 guess what if it's dollar 29 it's it worked against me because if i did not buy the the contract if i did not buy the contract if i take 100 000 euro times dollar 29 out of cat 129 000 us dollar now i'm only getting 125 because i logged in my rate at 125 well if the rate if the spot rate was dollar 20 then i did good if the spot rate is dollar 20 i can convert at dollar 25 so rather than getting 120 i'm getting 125 so that's why you would buy the forward contract because you don't know what the spot rate a month from now would be it could be dollar 29 it could be dollar 20 you don't want to take the risk you buy the dollar 25 now this is assuming you are an exporter so if you are an exporter if you are selling if you are selling and receive it a foreign currency you want your home currency you want the us dollar to weakened you want the us dollar to weakened okay now let's assume you are an importer importer you are buying and let's assume the opposite you are buying from a german company and you have to pay them 100 000 100 000 euros now today you can buy it at dollar 25 or you can buy a contract to buy it at dollar today you can buy it at dollar 27 that's the spot rate or you can buy a forward contract and buy it at dollar 25 let's assume you did buy the contract so you are only responsible for coming up with 125 000 what could happen in the future the price could be dollar 29 you did good you locked your price you locked your price at dollar 25 and now that the the spot rate is dollar 29 that's good or guess what the spot rate could be dollar 20 and you overpaid 5000 dollar if you waited then you would have had only had to pay 120 but you would have been taking that risk okay so notice the forward rate they can help you to hedge your risk but the thing about the forward rate the forward market is you have to exercise that price you have to buy you have to exchange the foreign currency either exchange it buy it or sell it at that particular foreign foreign currency rate forward rate okay now is there a better option well there is there is option contract which is a little bit different similar but more flexible than the forward contract so options are more flexible than forward contract why because a foreign currency option gives the holder the option the option but not the obligation to trade the foreign currency into the future so what you would do you will you will have the option you will have the option what does that mean it means let's go back if you are us importer let's go back to this example if you are us importer and you have an option to buy it at dollar 25 you have an option now but the price is dollar 20 you would let your option expire and you buy it at dollar 20 so it gives you that option you don't have to buy it at dollar 25 the forward contract you have to buy it at dollar 25 so you you have an option now guess what you have to pay a price for that option there's a price for that option so it's not free there's a price for it we have two types of option we have a put option put option refer to the sale of foreign currency by the holder of the option when do you buy a put options when you are an exporter so if you're an exporter you will buy a put option why because it gives you the right to sell the foreign currency at a particular rate okay or you can buy a call option a call option refer to the purchase of a foreign currency in the future that's if you are an importer importer means you're going to have to pay the german company in euros therefore what you do is you buy a call option to have the option to buy that product to buy the currency at a certain price so if you are an importer you will buy a call option generally speaking there's something called the strike price so you need to know what a put option is call option is what is a strike price the strike price is the exchange rate at which the option will be executed if the holder of the option decide to exercise the option so the strike price could be dollar 25 this is the strike price okay you can buy it or sell it whether you have an option or a call and dollar 25 okay the strike price is similar to the forward rate I just told you there are generally several strike prices to choose from at any particular time there's always different strike prices because you can buy different options most foreign currency options are purchased directly from a bank in the so-called over the counter market but they can also be purchased from the Philadelphia Stock Exchange and the Chicago Mercantile Exchange by the way I pass next to the Philadelphia Stock Exchange on almost daily basis when I go to work so you can buy those options you can buy those options okay now as I said unlike forward contract where bank earns a profit through the spread okay the option must actually be purchased by by paying an option premium so you have to pay a premium you have to pay a price maybe to buy those 100 000 you have to pay a premium of three thousand dollar or two thousand dollar or a thousand dollar or five thousand dollar depending on the option that you are getting okay there's a premium there's a price for that okay so the option premium is it has two functions an intrinsic value function and a time value function so how much do you pay and premium there is is is depending on how long is the contract okay the longer you want the contract to be the longer you not the option counter the longer you want it to be the more you pay because the more you say I want an option to buy within next three years well guess what you're gonna have to pay a lot of premium to have that option but if you want an option for one month it's gonna cost you less this is the time value what is the intrinsic value the intrinsic value equal to the gain that could be realized by exercising the option immediately often time when you buy an option it's it has often time it has no intrinsic value in other words a few exercises today you don't make any profit okay for example of the spot rate of a foreign exchange currency is a dollar a call option with a strike price of 97 has an intrinsic value of three pennies why it's three pennies because you because it has a value and the value is called an intrinsic because immediately you can buy it at 97 and the price is a dollar this usually does not does not happen if it happens most probably you paid maybe three pennies premium per per per per currency okay if you pay three penny premiums a they would let you buy that 97 but you already paid them three pennies so you are it has no intrinsic value generally speaking when you buy the option generally speaking immediately it does not have any intrinsic value when it has intrinsic values when you can convert it and make a profit whereas a put option which is to sell a foreign currency with a strike price of a dollar or less has an intrigue intrinsic value equal to zero so if you have a put option and you went to sell the foreign currency and you can sell it at dollar or less it has no value because you can sell it at a dollar without the option but if it's a call option it has an intrinsic value of three pennies an option with an positive intrinsic value is said to be in the money an option that has no intrinsic value it says to be out of the money obviously the opposite it has no intrinsic value what is the time value as i said the longer you have the more time you have for that option the more value it has because between now and the time you exercise that this option the longer the time the more option because time is valuable so the the time value of an option related to the fact that the spot rate can change over time and cause the option to become in the money so the more time you have the more options you have and options are good the longer your options the more value they have okay as they get closer and closer to the to the end date then the chance of that currency fluctuating much more is less because you have less time okay even though a 90-day call option with a strike of a dollar has zero intrinsic value when the spot rate is dollar it still have a positive time value because you still have 90 days for that currency to change because now it's a dollar but if it goes up to dollar 50 well you can buy it for a dollar okay you can buy it for a dollar it could go up to dollar 50 but you have 90 days or it could go up to dollar 10 or to dollar 05 or something above a dollar you have 90 days for that to change the more time you have the more options you have so the option has two values it has two component an intrinsic value and the intrinsic value is how much profit would you make if you exercise it today immediately and the time value is depending on how long you have how much time you have between now and the time it expires okay so the value of a foreign currency option can be determined by applying something called the black shawl option pricing model which is we don't cover in this course this is covered an international finance course and it's a function of the difference between the spot rate and the strike price the difference between domestic and foreign interest rate the length of time exploration potential volatility macroeconomic factors and other things so the black shawl model was just basically it's a formula that they use to value the option and this is basically what i'm going to cover in this chapter if you have any questions this is basically an introduction to foreign currency transaction in the next session we're going to start to work actual actual journal entries for buying and selling product in in in a foreign currency if you have any questions email me if you happen to visit my website for 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