 Hello and welcome to this session in which we will discuss foreign currency exchange risk now Why do we have foreign currency exchange risk because companies or entities or individuals? They sell and they buy goods and services and currencies other than their home currency. What does that mean? Let's take a look for example a US companies US companies will sell to European customers when you sell to European customer You might have an account receivable in a foreign currency because you sell them the goods They're gonna pay you in euros. Well, you have an account receivable that account receivable is dominated in foreign currency Also, the same US company might buy supplies from Europe Well, they have an account spayable and that account spayable Is dominated in a foreign currency? So when I abbreviate AR in this session, it means accounts receivable AP and account spayable and FC and foreign currency Well, this the US companies now they might have receivable They might have payable and the foreign currency could go up the foreign the foreign currency could go down in value It might fluctuate and this is what will create the risk So the foreign currency fluctuates there's a volatility in the value Which give rise to either gains and or losses from the AP and the AR So what do we have to do companies will have to find a way to reduce or minimize or even eliminate that risk First we're gonna see what factors influence the exchange risk Before we proceed any further. 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No credit card required Here are the factors that influence the exchange risk for the CPA exam They break them into two categories trade factors and financial factors and we're gonna look at each one separately Trade factors could include inflation income government policies Financial factors would include interest rate ease of capital flow Let's take a look at each one of them separately real briefly just to understand that we can answer a multiple choice Questions about these easy questions The first one is a trade factor relative rate inflation or simply inflation What happened is this in an inflation the value of the currency goes down? Well, if the value of the currency is reduced Well, think about it. You might think well, guess what more people would buy it. That's not the case If the value of the of your currency is being reduced because of inflation What's gonna happen the people hold in that currency They are going to try to convert it into another currency. They're gonna run away from it So simply put think of the Turkish lira in Turkey when the Turkish lira goes down in value What do holders of the Turkish lira do they exchange it? They exchange their local currency for example to us dollar Why because they want to maintain their currency simply put if they have a million Turkish lira And today let's assume the rate is a dollar They can get a million us dollar The fear is if they still have that one million Turkish lira And the rate of the dollar becomes Dollar 50 then they're not gonna get they are not going to get the million dollar They are going to lose value therefore what they do they exchange it because if it becomes dollar 50 Their value of their currency is only 666,000 so if they have a million of Turkish lira and inflation is going up They will exchange quickly because if they keep that one million of Turkish lira and the us dollar increases The value of their money goes down. That's why you switch Relative income factor. Well, if an income rises in a certain country, that's gonna create a demand for foreign currency Why because the people living in that country generally speaking they have a purchasing power their income rises Therefore the foreign currency should rise. Why because you are creating a demand buying more goods and services Government policies and intervention government plays a huge role in foreign currencies. For example We could have a monetary policy. What is a monetary policy? It's when the federal reserve Bank of that country either dump more money into the market or take out more money When they dump more money when they print more money It's called expansionary policy Lead to the depreciation in the currency generally speaking now in the real world that Sometimes the opposite could happen. But if you supply more money The the the the currency should go down in value. Why because supply and demand you you bring more Money into the market more us dollar. For example, when the federal reserve prints more money The expectation is the us dollar will weakened and the opposite is true If the federal reserve is being restrictive, it means taking money away from the market How would they do that they will buy back the dollar through bonds then it would lead to appreciation of the us dollar The fiscal policy could lead to appreciation or depreciation depending on how it's being done Generally speaking when the when the government spends more money, they have expansionary They could have an appreciation generally speaking or if they are going through a restrictive They could have a depreciation but it all depends on the situation Also, the government could set a fixed exchange rate where they control the exchange rate If they're helping subsidizing a certain product, they could influence the exchange rate If they are encouraging export or they are encouraging import because certain countries they do try to encourage export Well, what they do if they want to encourage export They would weakened their currency if they want to encourage import They will strengthen their currency The government could also place trade barrier, which is basically not allowing foreign product to come in or make it Costly to bring in foreign foreign product, which would reduce the demand for the foreign currency So the government could intervene and make those changes or influence the exchange rate We have financial factors Generally speaking interest rate is the higher one If you increase your interest rate if the federal government increases their interest rate Generally speaking, they should bring more money to earn a higher return Generally speaking and the opposite is true When you want to attract less money, you would lower the interest rate and you would attract less money Also ease of capital flow how easy to bring money in and out Generally speaking The currency should rise if it if there's an ease of movement in and out without any restriction Why because the currency would be considered less risky Which which should be considered a safe haven. That's why it's less risky. It should appreciate because less risk is better That's the general concept Now let's start with a simple example to illustrate the concept how exchange risk is being utilized So let's assume we have adam international in a us-based company And adam buys raw material from canada. So they buy from a canadian supplier. The current exposure is one million canadian dollar So right now adam company will have an ap of a million dollar and that ap is the Denominated in canadian dollar And it's due in 60 days from now today. The spot rate is 1.35. So simply put if adam today decided to pay this bill So we'll take a million divided by 1.35 And adam will have to pay 700 And 40 740 dollars. This is how we compute this one million divided by 1.35 to satisfy this obligation But this obligation is not due today adam will have 90 days to pay So here's what could happen adam could fear and adam that could happen that the canadian dollar might strengthen And expect it to be one dollar to 120 canadian in the next 60 days. What can adam do? Well, let's assume adam fear are realized if adam fear Are realized what's going to happen is this? Adam if they want to buy the one million canadian one million divided by 1.2 adam will have to pay 883,333 Why because adam will have to take the million dollar canadian divided by 1.2 because i can only now buy 1.2 with my dollar not dollar 35 So the canadian dollar strengthened. It means the u.s. Dollar weakened So what happened i can lose adam can lose 92,593 because right now if adam can buy the currency now But adam may not be able to buy the currency now And if he waits and indeed the currents the the canadian currency strengthened How does it strengthen the u.s. Dollar was able to buy you dollar 35? The expectation is the u.s. Dollar would only buy you dollar 20 Now also the opposite could happen rather than strengthening The u.s. Currency could weaken further, but that's not my risk if it weakened Adam will be happy if it weakened further for example if the u.s. Dollar start to buy you dollar 50 canadian Adam is happy because adam will have an account spable to pay So what i want you to do is copy this data down because we're going to be using this example as i am illustrating various scenarios So we have a u.s. Company adam company. They have an account spable for a million dollar for a canadian supplier Now what are my risk exposure? Let's look real quick if you are an exporter if you are an exporter It means you are selling when you are selling you have an account receivable account receivable is an asset well When you have an account receivable account receivable Denominated in a foreign currency you have an asset well think about it Do you want your asset to weaken or strengthen you want your asset to strengthen? There's therefore if you have an account receivable your risk is the foreign currency weakening Simply put you want the foreign currency to strengthen. Why? Because you are expecting to receive money in that foreign currency It's the opposite of the previous example in the previous example Adam was an importer adam was buying from canada Well, if you have if you're an imp if you're a net importer you have an account spable You have an exposure to an account spable your risk now is the foreign currency Is strengthening your risk is the canadian dollar strengthened? That's your risk well of the canadian dollar weakened. That's good if you're an importer So this is a summary now. Let's look at various exposures big little bit more into the risks So we're we're thinking about a u.s company versus europe So the home currency is the u.s dollar and and think of it the foreign currency is european Now if the domestic currency appreciates, so if the u.s dollar goes up It's gonna benefit any u.s Company buying stuff from europe so it will benefit my ip If the u.s currency goes up it will benefit my account spable Why because i can buy more of the foreign currency with the same token It becomes more expensive for european to buy u.s goods So if you're an exporter it's gonna hurt you why because it's gonna be more expensive for them to buy Your goods with the same token if the domestic currency appreciate I just told you it's gonna harm my account receivable Why because less people will buy my goods because my goods are more expensive now with the same token Cheaper for u.s consumers and companies to buy foreign goods so and when the when the Domestic currency appreciate it will be cheaper for u.s companies and consumers for that matter to go to europe Go on vacation to europe. Why because you can buy more more euros now Those two statements are saying the same thing one from A liability perspective one from an asset perspective now if the domestic currency depreciates it if the u.s dollar weakened As an exporter it benefits my account receivable. I'm gonna be happy if i'm an exporter net exporter It's gonna be less expensive for european to buy us goods. That's good Bring them on If it's if it's less expensive they're gonna buy i'm an exporter i'm gonna be happy You're gonna see more europeans tourists in new york city Why because now the european they feel rich Why because their euros buy more us dollars and i still remember In the in the uh during 2008 through 2010 The us dollar weakened and if you go to new york city you would see a lot of europeans Why because the u.s currency was depreciated after the financial crisis The federal reserve print a lot of money remember what i told you earlier that if you put more money into the market that the currency will Will depreciate well if the currency depreciate it's gonna benefit the europeans because they can buy more us dollars So they are happy The flip side of this if the domestic currency depreciate It's gonna harm my account's payable. So if i have an account's payable and a foreign currency Well and my currency depreciate now i need more of my currency to satisfy the obligation. So i'm not gonna like this So it's and it's gonna become more expensive for us consumer to buy foreign goods Why because it's more expensive i have to use more us dollar To buy the goods why because my currency depreciate therefore i buy less from europe And then the european will buy more from me because it becomes less expensive for the european So i just want to show it to you from both ends make sure you understand it because you could see multiple multiple mcqs about this topic What is the exposure who would benefit and who would be harmed so make sure you're aware Comfortable and understanding what i have on this slide. This is a good summary Let's see if we can apply what we just learned If the u.s company has a net cash outflow because sometimes they give you this information in this language net cash outflow It means what it means they have to pay if they have a net cash outflow. It means they have an accounts Payable that's their exposure overall an account's payable and a foreign currency Which of the following is correct simply put if they do have an account's payable and a foreign currency What would they like let's start with the Appreciation or depreciation of the foreign currency would be irrelevant. That's not true Depreciation or appreciation will be relevant if you have an exposure to a foreign currency So this is an easy elimination The u.s company would suffer a loss from a decrease in the value of the foreign currency Well, if the foreign currency goes down, are they going to be happy or not happy? Well, guess what if the foreign currency goes down, they will not suffer a loss They would suffer they will enjoy again Why because they have to pay that in a foreign currency. Therefore the u.s company would benefit Would benefit would benefit from a decrease in the value of the foreign currency not suffer Why because they have to exchange their money into that foreign currency? That's out The u.s company would benefit from an increase in the value of the foreign currency. No the u.s company would suffer From an increase if it becomes more expensive They're gonna have to use more u.s dollar. Well by the process of elimination. We have a is the answer The u.s company would benefit from a drop in the value of the foreign currency Yes, they want the foreign currency to weakened. Why? Because they have to buy their currency one of their currency is weakened They will need to they will need to put out less money In the next session, we would look at how to mitigate the foreign currency risk If you have a net cash outflow the net cash inflow an ap exposure an ar exposure What instrument do we need? What should you do now go to far hat lectures and look at additional mcq's multiple choice through false That's going to help you understand this topic because in the next session We would look at your exposure and how to mitigate how to reduce the risk of that exposure. Good luck Study hard. This concept is important on the cpa exam