 Hello and welcome to this session in which we will discuss foreign currency exchange rate We will discuss why it exists the reason type of currency exchanges. We'll talk about the bid ask spread The spot rate versus the forward rate and here we'll talk a little bit about the forward contract Then we will discuss briefly foreign currency options. What are they starting with why it exists? Why do we have foreign currency exchange markets simply put because we have international trade? Businesses in the US sell their product in Europe sell their product in China sold their product in the Middle East and as a result Partners usually wants to be paid or pay using a local currency So if you sold your product to a European they want to pay in euros because that's their local currency And if they sell you something they want to be paid in euros because that's their local currency So partners will want to be paid in their local currency So one part you will always have to buy or sell the foreign currency So if you receive it you want to sell it because you want to convert it And if you want to pay in a foreign currency you have to buy it as a result of the international trade There's a need for a market where you can buy and sell foreign currency now from 1945 Which is after World War two till 1973 the exchange rate was fixed So you would know exactly how much each a French Frank or Deutsche German Deutsche mark will be converted in the USD Those are gone now. They are replaced with the euros So you will know exactly the fixed rate and also even the US dollar because everything was fixed in terms of US dollar You could also find the exchange rate of the US dollars in terms of gold So all the currencies were fixed post 1973 most currencies float in value And what does float mean? We're gonna see in a moment. It means it changes based on market supply and demand Before we proceed any further. I have a public announcement about my company farhatlectures.com Farhat Accounting Lectures is a supplemental educational tool That's gonna help you with your CPA exam preparation as well as your accounting courses My CPA material is aligned with your CPA review course such as Becker, Roger, Wiley, Gleam, Miles My accounting courses are aligned with your accounting courses broken down by chapter and topics. My resources consist of Lectures multiple choice questions through false questions as well as exercises. Go ahead start your free trial today No obligation. No credit card required So we have Two main types of currency exchanges. We have independent float or simply put float Where market forces market forces means what means economic conditions supply and demand Determine the exchange rate determine what the exchange between two countries is for example For example to buy a euro. You need one point US dollar Well, this rate could change tomorrow to 1.05 or it could also go up to 1.07 So what does it depend on depending on market conditions supply and demand the government usually has little or no Intervention the government don't intervene sometime they do but often they don't Countries that have this independent float rate US Canada UK, Japan, Australia, Brazil, Switzerland, the Eurozone And we also have another type of exchange rate Which is called fixed or pegged to another country pegged to another currency not country to another currency Usually they pack it to the US dollar so if the US dollar goes up in value their currency goes up If it goes down it goes their currency go down and some countries to name few Saudi Arabia Bahrain, Hong Kong and Panama Those are the currency are pegged you might be asking why so why a country like Saudi Arabia With pegged their currency to the US dollar simply put they have most of the revenue in USD Why because most of the revenue is generated from oil and oil is priced in USD So it's easy for them to plan to create governmental budget to plea to create budget for the whole country expenditure roads network so on and so forth in USD since their revenue is US dollar although they have their own currency But the value of their currency is fixed in terms of the US dollar the other countries basically each country has their own reasons We're not that's is beyond the scope, but of the course But the point is to know there are certain currencies that are pegged or fixed to the US dollar Let's talk about the bid ask spread So when you look up a currency you could look it up the currency in more than one way for example here I said if I want to buy a euro how much would it cost me in US dollar? Well, it's gonna cost me in US dollar one dollar and six pennies to buy a euro So if I'm a US citizen, I'll say okay How much it's gonna cost me to buy a euro I would say one dollar and six cent another way to see this is indirectly is to say, okay How much will I need? In euros to buy a US dollar well I need 94 euros to buy a US dollar and how do I go from here to here is One divided by this rate. So if I take one divided by 1.06 will give me 94 pennies Now this is most likely rounding but you would need 94 euros to buy a dollar or Or You can exchange another way to say it if you want to travel to Europe You have to you pay 1.06 to buy one euro now when you are dealing with foreign currency Foreign currencies you have to be aware of something called the bid and the ask price What is the bid and what's the ask the bid price is the price at which the market maker? Let's call it the bank the the party that's Transacting with you that's exchanging the money is willing to buy the currency remember be bid be buy, okay Now the ask price they have two prices They have an ask price and a bid price the ask price is the price as which the market maker is willing to Sell the same currency the difference between the bid and the ask price is known as the spread It could be very small. It could be very large But that usually represent not usually it's represent the profit for the market maker for whoever is Doing the exchange. So let's assume a dealer is quoting to buy a euro the bid is 1.06 and 1.08 for the ask so to buy one euro 1.806 is the bid 1 8 oh 1.08 is the ask let's assume someone from Europe traveling to the US and needs to sell 10,000 euros they want to take 10,000 euros They want to sell it they want to exchange it into US dollar to go and spend the money in New York and travel in the US and see the country. Okay, so what's gonna happen is this since They want to buy USD they're gonna we're gonna quote them the bid price the bid price is the price at which the Market maker is willing to buy a currency. So I will buy your euro I will buy your euro at 1.06 so the bid 1.06 and the dealer will pay them the dealer will pay them 10,600 and the dealer now have ten thousand dollar and their treasury ten thousand. I'm sorry ten thousand euros They gave them ten thousand six hundred dollar. They have ten thousand euros Let's assume you're next in line at that dealer and you are traveling to Europe and you want to buy Ten thousand euros and the deal dealer would say sure I will sell you the ten thousand euros the the ask price is one point oh eight and say, okay How much is that they will take ten thousand times one point oh eight and they would say pay me ten thousand eight hundred So obviously you see that the dealer the difference is two hundred dollar the difference in is a profit for the dealer now Usually the spread in the US euro. It's not that high. It's really it's like third or fourth decimal But I'm just trying to make the point here So you can see the profit of the dealer the spread now the spread also could change Depending on the liquidity of the currency and changes in currency values as well as conditions in the market But usually it's not that high unless you are dealing with a third-world country where it's not very liquid Just I'm just making the point. So don't take those spread as real. They make that much for that So this is what we mean by bid and ask spread. Let's talk about the spot rate versus the forward rate What is the spot rate? The spot rate is the rate you can exchange the currency for now There's a bid and there's ask price I just showed you for example If you're traveling at the airport and you want to buy and sell a currency The rate that you can exchange that currency with right at that moment is called the spot rate Now we have the spot rate and we have the forward rate and the forward rate. There is a bed and there's an ask What is a forward rate? Well forward is the future That's a negotiated simply agreed between a firm with its bank to exchange Foreign currency for example for you for US dollar on a specified future date at a predetermined exchange rate So you would say look I'm gonna need 300,000 euros or 300,000 whatever currency I need I need it in three months from now So you can negotiate with the bank and they would say okay We will sell you this currency at 1.05 or 1.08. This is the forward rate They negotiated the forward rate with you. They simply agreed on it. There is no upfront cut Usually there is no upfront cost for For that type of arrangement the difference between the forward rate and the spot rate It's it's called forward points. It could be higher than the spot rate or lower than the spot rate When the forward rate is higher than the spot rate that means higher it means more expensive We say there is a positive forward point and we say there's a premium in the forward market on this currency It means we expect the currency to go up When the forward rate is less than the spot rate We have a negative forward points and we say the currency is selling at a discount Now why is there a difference in the forward and the spot rate? Usually it's the result of the difference and interest rate between the two countries So the interest rate in the two countries differ usually when the interest rate in the foreign country is greater than the domestic rate The foreign currency Usually will trade the forward rate is at a discount and the opposite is true when the when the foreign interest rate is less Then the domestic currency the foreign currency sells at a premium It means they have a lower inflation Generally speaking if it's lower generally speaking, but that's usually the explanation for it So let's talk a little bit about the forward rate the forward rate just like the spot rate subject to changes So for example, if on june 15th The u.s. Dollar per mexican peso spot rate is 11 pennies So you need 11 pennies to buy 11 pennies to buy one pesos and the forward rate Contract to be settled on august 15th Okay, august 15th is point one zero five notice it is It is less it's a point point one zero five zero, which is point one one zero. It's less It's discounted and the discount amount is point zero zero five and the two month forward Due to higher interest rate in mexico rather than the u.s. So that could be the explanation Let's assume That a month later the spot rate decreases to point zero eight now. You only need eight pennies to buy the mexican pesos Well, guess what most likely the forward rate would be would be would be still less than point eight Assuming, you know, there's no major changes at interest rate. So this is how the forward rate. This is how the forward rate Works and we'll talk about this later on when we looked at the forward contract Basically, you want to lock in your price. That's why you engage in forward contract because you have to Pay your suppliers in mexico. You want to lock in that rate. You will agree between The firm and the bank to make sure you're going to have those mexican pesos at a certain price Foreign currency options. They are more flexible than forward contract the foreign currency options They give you the right not the obligation. Remember the forward contract is a contract You are kind of obligated to buy or sell those currencies The foreign currency options as the word suggests options. They have they are right and not obligation and we have two type of options You can buy a call option Which is the right to buy or purchase a foreign currency at a strike price strike price is what strike price or Sometimes it's called the exercise price. It's the price that you can buy that foreign currency on so this is like for example You know 1.56 1.56 or whatever that price is there's a strike price Put option is the opposite of a call option the right to sell put means put it away and someone will take care of it They have to buy it from you right to sell A foreign currency at a strike price for a period of time Just basically the difference is this if you have a payment in a foreign currency If you have a payment in a foreign currency what you need to do if you have a payment What you do is you buy a call option This way you can buy the currency and make the payment and know exactly what you are paying The put option is used is when you have a Receivable and a foreign currency when you have a receivable you buy the put option to make sure you can sell those receivable At a certain price in concept It's similar to the forward rate the same concept for the forward rate the forward rate you enter into a contract If you have a payment to lock in the rate and if you have a receivable to lock in the rate in which you can sell it You buy the option unlike a forward contract the forward contract is basically an agreement There is nothing you have to pay for the option. You have to pay a price There's a premium to pay So if you want to lock in you have the right to buy the currency and there's and the option currency is Organized there's a there's the Philadelphia exchange where you can buy and sell those options and you have to pay a premium for that Now the value of any option Has two components. It has an intrinsic value and a time value So the option is what option gives you the option gives you the option to buy something at a locked price How does the option work? Think about I want to go to Europe tomorrow or in a month from now And right now I can exchange. I have to pay One dollar and six pennies Uh to buy one euro Okay, and I think by the time I By the time I'm traveling I might have to pay dollar 20 Okay, a month from now. I think that's what's gonna happen. So what would I do? I buy I might pay for example $300 I pay a premium and I lock in my price at 110 Here comes two three months later when I want to travel Well, if the price is indeed 120, well, great. I locked in my price at 110 Let's assume the price actually I was wrong now It's like I need one dollar and three pennies to buy a euro then forget it. I lost the 300 dollars Now I'm going to go to the market because I have the option. I don't have to use the option It's an option. I can keep it. I can pull it whenever I want to but eventually it expires We'll talk about this but this is what the options are for it gives you The option the peace of mind that you have an option to exercise And buy the currency at a certain price. So the option has two parts an intrinsic value and a time value What is the intrinsic value the intrinsic value equal? Equal to the gain that could be realized by exercise and the option immediately usually not usually Not usually most of the time when you immediately buy the option. It has no intrinsic value Okay, for example of the spot rate of the euro Is dollar 21 a call option to purchase the euros at 118 has an intrinsic value True you might you might be saying, okay Why don't I buy the option at 118 at sell it at 121 and make immediately Three pennies and profit usually when that's the case you might have to pay a premium Three pennies sometimes the premium is more but at least the premium that they will charge you is three pennies So when you pay the premium three twenties Sorry three pennies if they make you pay a premium of 320 Well, now it's constantly 121 in the euro you can sell it at 121 you make no profit no loss Now you make a profit if the prices start to go higher than one 121 on the other hand when the spot rate for the euro is 115 It means you can buy it or sell it right now at 115 A put option which is to sell the euros with the strike price of 112 has an intrinsic value of zero Hold on a second. Why? Because You can sell it right now at 115 you have the right to sell it at 112. Why would I sell that 112? So this option this put option is worthless When would this option be worth something when the euro fold falls to 1.11 1.10 1.05 Below 112 if I have a put option my fear is My currency it's gonna it's gonna drop you want it to drop when it drops At 1.05 and you can sell it at 1.12 Then you are in the money in the money So remember the put has a different purpose than the call and don't worry about this just basic have a basic understanding But the point is you need to know that there's an intrinsic value the intrinsic value is if you exercise it How much do you get that's the intrinsic value an option with an intrinsic an option with a positive intrinsic value is said to be in the money That's the term Okay, for example this This option here is in the money assuming, you know, there is no premium because you can buy it at 118 Sell it at 121 assuming there is no premium of three pennies. We said it's in the money. Okay Now out of the money Let's assume you have to pay a premium of five pennies And you can sell it at one you can buy it at 118 Well 118 118 plus five pennies. It means it cost me 123 It cost me 123. I can sell it at 121. We say the option right now is out of the money. Why because If I exercise it cost me more And let's assume back to three pennies premium If I have if I paid Three pennies in premium and the exercise price is 118 and the spot rate is 121 My premium plus my cost is 121. So it cost me 121. I can sell it for 121 I have no intrinsic value because if I exercise it my profit is zero So the option could be in the money in the money means it has a positive intrinsic value out of the money When if you exercise it you lose and if you exercise it have no gain and no loss It has zero intrinsic value. So that's one part of the value of the option called the intrinsic value The other part of the option is called the time value the value of time within the option Well, the spot rate remember can change over time and cause the option intrinsic value to increase or decrease So as time goes by remember the stock price could go up from here for example, this This this 121 could go up to 125 if the spot rate is 125 immediately This will have more value because your intrinsic value went up because the spot rate changes over time There's a time value a call option to purchase the euro with a strike price of 1.12 has a zero intrinsic value when the spot is 1.12 because if you go ahead and exercise Well, it's the same thing as the spot rate It has a positive time value because there's a chance that the spot rate could increase over the next 90 days Let's assume we're going to say right now the intrinsic value is zero But I still have 90 days For that option. Well 90 days what I'm hoping is if I have the call option I'm hoping that this goes up to 120 or 113 anything above 112 the value The possibility of that happening called time value because I have time I have value in the option However as time passes as time goes by so if I go from 90 to 89 days to 80 days To 70 days as time goes by I have less and less time for the for the currency to change The value of the time decreases as well So as time passes the time value of an option decreases because there is less time remaining for the option to increase an intrinsic value I have less time for that to happen now one in one day, you know The the currency could shoot up or shoot down. That's a different story. But as time goes by you have less time Think about you are trying to sell a gallon of milk and that gallon of milk has a 30 day expiration Okay, what's going to happen as you get closer to the 30 days That gallon of milk it's going to have less and less value because at some point you cannot sell it because it's going to expire Same thing with the time value actually the time value at the expiration date It's equal to zero because that's it the time passed There's no way you you don't have time anymore So the the value of the option has two values Intrinsic value intrinsic value It's numerical and time value is I have time and I'm hoping tomorrow the euro will go up I'm hoping in a week from now the euro will go up because I still have a month I'm hoping two weeks from now but I but as I approach the end of the period My my time value goes down my time value goes down think about playing a soccer game If if a team is losing one to zero in a soccer game, you know, I'm sure you're watching the world cup now As the time ticks down to that 90 minutes You have less and less time to recover Okay, for example at minute 60, they still have 30 minutes to go. So they still have value They still have time 30 minutes to equalize the game But if you're playing at minute 90, you're just going to have maybe three or four minutes in in overtime And that's it. So the time value of the game is gone Okay, this is what we mean by value of option What should you do now go to far hat lectures and look at mcqs through false Exercises that's going to help you understand this concept better This is an advanced accounting course Again, the topics we're going to be using everything that we learned here to apply it in different settings So make sure you are familiar with With the basics. Good luck study hard. And of course, stay safe