Mechanics of Foreign Exchange - money movement around the world and how different currencies will affect your profit

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1 Dear Business Leader, Welcome to the Business Insight Seminars an exclusive, informational series to help you gain a powerful edge in today s highly competitive business environment. Our first topic in this series highlights Foreign Exchange, an integral part of doing business in today s global economy. Many businesses are exposed to some type of international payment or receivable and the possible exchange risk that relates to the transaction. In the following pages, we have summarized: Foreign Exchange Overview - advantages to using Foreign Exchange and the types of exposures businesses face Mechanics of Foreign Exchange - money movement around the world and how different currencies will affect your profit Smart Strategies - tactics you can use to control costs and protect profit margins when doing business internationally Key Foreign Exchange Terms- definitions for your ongoing reference Chase offers a team of Foreign Exchange professionals dedicated to businesses like yours. We hope that this information will encourage you to speak with them for more information. Together we ll stay one step ahead of the competition. Sincerely, Kevin Watters

2 Foreign Exchange Overview Americans drive cars made in Germany, use DVD players made in Japan and wear clothing from around the world. The Japanese love American rock stars and the Europeans eat McDonalds, but you don t have to be a large company to participate in the Foreign Exchange market. Statistics from the U.S. Department of Commerce show that U.S. businesses exported over $800 billion and imported $1.6 trillion in goods last year. Of these, more than 90% were small businesses, clearly highlighting the connection between you as a business owner and the world economy. With that connection come some challenges for business owners: How are international financial transactions done? How do I navigate the monetary system? How can I maximize profit and control my risk at the same time? The Foreign Exchange market plays an indispensable role in providing a mechanism to make payments across borders, determine currency pricing and manage international business risk. Foreign Exchange is the exchange of one currency for another that helps to facilitate trade and investment. Foreign Exchange instruments can help reduce risks that can affect bank balances, profit margin, competitiveness, company financial statements and more. Using Foreign Exchange strategies helps you: Lock in exchange rates - On the day you make your foreign payment, you know your exact cost in U.S. dollars, and you re protected against losses from fluctuating rates Avoid hidden expenses You can eliminate the hidden costs and market-fluctuation markups that can accompany foreign bills or invoices quoted in U.S. dollars; ask for both the foreign currency and U.S. dollar payment amounts to see your potential savings Make timely and secure payments - Your international payments will be sent to the designated foreign bank within two business days; the U.S. equivalent is deducted from your account on the day the request is made and the currency payment is sent to the designated foreign bank

3 Mechanics of International Payments Ever wonder how money moves around the globe? When an international payment is made, the money remains in the local banking system and an electronic message is sent detailing balance changes via SWIFT (the Society for Worldwide Interbank Financial Telecommunications). SWIFT membership is open only to banks and financial institutions and provides a secure network for currency exchange. These types of networks are important for security, as the Foreign Exchange market is the largest unregulated market in the world. Most trades typically take two days to settle, mainly due to time zone differences. Standard currency quotes are given in pairs and given in the International term, defined as how many foreign currencies it takes to buy one U.S. dollar. For example, Canadian dollars might equal one U.S. dollar. An alternative lesser-used method is the American term, which expresses the dollar amount that can be exchanged for one unit of foreign currency ($.8390 = one Canadian dollar.) By market convention, the Australian dollar, British pound, Euro and New Zealand dollar are quoted in the American term. Local Currency Quotes When you do business abroad in US dollars, you shift the responsibility for currency conversion to your vendor (when you import) or your customer (when you export). There are several disadvantages to this: When You Import: Paying inflated prices the local bank may charge excess premiums to convert U.S. dollars into the local currency and the vendor will receive less local currency at conversion Loss of control of exchange rate risk if the U.S. dollar falls in value against the foreign currency, your dollar payments will increase Risk of payment delays U.S. dollar wires sent internationally can take up to 3-5 business days to be received by the vendor; payments sent in the local currency can be delivered same day in some cases When You Export: Lost sales opportunities your customer may choose a competitor s substitute product because it s priced in the local currency Risk of payment delays if the dollar strengthens significantly against your customer s home currency, your customer may be more inclined to wait for the exchange rate to improve in their favor before sending a U.S. dollar payment

4 Let s examine how you can gain clear advantages by using Foreign Exchange to protect your profit margins and market share: Weak USD Strong USD Exporters that receive FX Foreign currency receivables convert to more dollars: more dollars * * Risk Management Advantage: hedge Hedge strategy may may increase profit profit margin * Competitive Advantage: Hedge hedge strategy may may allow allow U.S. US company Company to to undercut competitors who price in U.S. USD dollars and gain and gain market market share share Foreign currency receivables convert to fewer dollars: less dollars * Risk Management Advantage: hedge to control profit control margins profit margins * Competitive Advantage: Hedge to hold prices constant and and maintain market share share Importers who pay in FX Foreign currency payables convert to Foreign more dollars: currency payables convert to more dollars * Risk Management Advantage: hedge to * Risk Management Advantage: hedge to lock cost of goods purchased and to lock protect COGS profit and to margins protect profit margins * Competitive Advantage: Transparent * Competitive Advantage: transparent vendor pricing and avoid paying vendor pricing and avoidance of paying excessive excessive risk premium risk premium Foreign currency payables require less fewer dollars: dollars * Risk Management Advantage: Hedge hedge strategy strategy may may decrease COBS cost and of goods increase purchased and profit increase margin profit margin * Competitive Advantage: Opportunity opportunity to undercut competitor s prices and to gain market share market share Smart Strategies Because it s your livelihood, you know your business is an asset worth protecting. That s why you develop strategies to minimize risk along the way. Your participation in the Foreign Exchange market should have safeguards in place like any other part of your business does. First, let s examine a few of the common risks your business may be subject to: Transactional (or cash flow) risk applies to the profitability of operations o Revenues are worth less than budgeted/expected in U.S. dollar terms o Costs are higher than budgeted/expected in U.S. dollar terms Example: A company sells its products in foreign countries and prices in foreign currency terms Economic (or competitive) risk applies to lost business or decreased margins due to U.S. dollar pricing abroad. Example: A U.S. based exporter has large customers in Austria and prices in dollar terms. A stronger dollar/weaker Euro effectively raises the price to the Austrian customers in Euro terms. Therefore, the customers takes their business to a competitor that will price in Euro terms. Translational risk applies to the U.S. dollar value of assets held abroad Example: A company has a subsidiary in Canada that has various assets. The U.S. dollar book value of these foreign assets varies each reporting period according to the U.S. dollar/canadian dollar (CAD) exchange rate.

5 Understanding what types of Foreign Exchange instruments are available to help mitigate those risks will help you when dealing with international trade. The Federal Reserve Bank of New York ( helps us explain these instruments. Spot Contract is a straightforward exchange of one currency for another. The spot rate is the current market price. These transactions don t require immediate settlement or payment on the spot. The settlement date is the second business day after the date the transaction was agreed upon. The benefit to using this type of transaction is that business owners know the exact amount and payments are timely. Forward Contract is a sale of one currency for another but it is settled on any pre-agreed date three or more business days after the deal date. The forward rate for any two currencies is a function of their spot rate and the interest rate differential between them. However, the exchange rate is fixed at the outset and no money necessarily changes hands until the transaction takes place. These transactions can be used to cover a known future expenditure so that the cost of goods can be locked in and the business is protected from a possible negative exchange rate. This instrument is very flexible and can be customized to meet the specific customer needs. Forward Window Contract allows you to exercise a forward contract on demand, in whole or part, at any time during a pre-established time period. The exchange rate and the start and end dates of the contract are fixed at the outset of the transaction. This allows you even more flexibility, especially when the date and size of the transaction isn t known.

6 Currency Call Option was developed to address a lack of flexibility in forward transactions. For a price, you can buy the right (but not the obligation) to buy a currency at a fixed price on or before an agreed upon future date. The agreed upon price is called the strike price. In exchange for the right, you generally pay a nonrefundable premium to the bank two days after the transaction date. The option premium is determined by the spot rate, forward rate (or interest rate differential), tenor, strike price and implied volatility. Generally, an option: Is exercised at maturity if it s in the money (strike is better than spot) Expires without value if it s out of the money (spot is better than strike) When using an option, you: Know the maximum future cost of imported goods (the dollar amount at strike plus the premium paid up front) because the option ensures that you won t pay anything worse than the strike price Protect your operating margin from Foreign Exchange risk Currency Put Option is similar to a call option except you can buy the right (but not the obligation) to sell a currency at a fixed price on or before an agreed upon future date at the strike price. In exchange for this right, you pay a nonrefundable premium to the bank. You are guaranteed a minimum dollar income on the currency sale and protection of dollar margin on the sold goods. There is also upside benefit if the specified currency appreciates during the life of the option. Operate locally. Think globally. The Foreign Exchange market is fast-paced, volatile and enormous. According to the Federal Reserve Bank of New York, an estimated $1.2 trillion in different currencies is traded daily in the Foreign Exchange market around the world. An average of $461 billion is traded every day in the United States. As your business expands, you might be faced with the challenges of operating in different markets and across time zones. Or maybe you are looking for better ways to centralize your operations to increase efficiency. Chase has the experience and expertise to simplify the options and help you make the right financial choices. Whether you re buying, selling or investing at home or abroad we can help you minimize your foreign currency exposure risk and achieve stability and control while maximizing profits. Talk with your Chase Relationship Manager today.

7 Frequently Asked Questions Why deal in foreign currency? Dealing in foreign currency can save you time and money, reduce risk, and help you gain a competitive advantage. Save Money - Eliminate the hidden costs and market-fluctuation markups that can accompany foreign bills or invoices quoted in U.S. dollars. We encourage you to ask for both the foreign currency and U.S. dollar payment amounts to see your potential savings. Save time - Your international payments will be sent to the designated foreign bank within two business days via SWIFT. The U.S. equivalent is held the day of the transfer and deducted from your account on the day the payment is sent to the designated foreign bank. Gain competitive advantage. You may be able to negotiate a better price with your overseas business partner when they avoid assuming the risks of currency rate fluctuations. Reduce Risk - On the day you order your foreign payment, we lock in the exchange rate. This means you know your exact cost in U.S. dollars, and you re protected against losses from fluctuating rates. What is the foreign exchange market? It is not a single location. It is a worldwide system made up of banks, companies and individuals trading in major financial centers like London, New York, Tokyo, and Hong Kong. How are foreign exchange rates determined? Most foreign exchange rates are determined by supply and demand in the same way as the price for any other commodity. What factors influence foreign exchange rates? Many factors influence rates but the most common are: Trade and investment flows Interest rate differentials Economic data Market Psychology How important is the foreign exchange rate? Foreign exchange rates flucuate constantly and can move dramatically. This means the cost for a transaction today could be different tomorrow or next week, depending on the value of the foreign currency to the U.S. dollar.

8 Who can I contact for more information? Call your Relationship Manager, or a member of the Chase Business Banking Foreign Exchange team at

9 Glossary of Terms American style option: Allows the investor to exercise the option at any time prior to the expiration date. American term: An alternative lesser-used currency quote method, which expresses the dollar amount that can be exchanged for one unit of foreign currency. Appreciation: A rise in the value of one currency in relation to another. Asset currency: Currency in which the asset is held. At the money (ATM): A currency option whose strike price is equal to or near the current Foreign Exchange market price of the underlying financial instrument. Base currency: Foreign exchange is quoted as the number of units of one currency needed to buy or sell one unit of another currency. The currency whose value is set at 1.00 is the base currency. For example, in a British pound quote of , the pound is the base currency ( USD per GBP). In a CHF quote of , the dollar is the base currency ( CHF per USD). Call option: An option contract that gives the holder the right, but not the obligation to buy the call currency at a specified price for a certain, fixed period of time. Central Bank: The only institution that has the right to issue banknotes and that has authority over monetary and credit policies for a particular currency zone. The central bank also supplies the economy with money and credit, regulates domestic and foreign payment transactions, and maintains internal and external monetary stability. Currency option: The right to buy or sell one currency against another currency at a specified price for a certain fixed period of time. Currency pair: Currencies only have a value relative to each other. Therefore, all foreign exchange investments are listed in pairs. Discount: The amount by which the forward rate is reduced relative to the spot rate, i.e. the forward rate is lower than the spot rate. European style option: Allows the investor to exercise the option at expiration date only.

10 Exchange rate: Price of a foreign currency expressed in domestic currency. For example, $/CHF = 1.5 means that one US dollar costs 1.5 Swiss francs. Exercise price: The price at which the option buyer can purchase (call option) or sell (put option) the underlying currency. Also called the strike price. Expiration date: The last day that an option can be exercised. Forward rate: Contracted rate for a forward trade, which equals the spot rate plus or minus forward points. Forward trades: The exchange of a specified amount of one currency for another at a contracted rate, with a settlement date greater than two days. FX swap: Spot foreign exchange transaction simultaneously reversed by a forward contract. The difference in rates reflects interest rate differentials between the two currencies. Hedge: The forward sale or purchase of a foreign currency to reduce the exchange risk exposure connected with the assets or liabilities denominated in a foreign currency. Implied volatility: The volatility implied by the market price of the option based on an option-pricing model. Interbank market: The wholesale marketplace for currency exchange for professional dealers with reciprocal market-making agreements. Interbank rate of exchange: The rate at which banks deal with one another in the market. It is usually a tighter market with narrower spreads than the market offered on commercial transactions. International term: Standard currency quote describing how many foreign currencies it takes to buy one US dollar. Maturity date: The settlement date or delivery date agreed upon for a forward contract. Option: The contractually agreed upon right to buy (call) or sell (put) a specific amount of currency at a predetermined price on a future, or "forward," date at a specified exchange rate. A premium is paid up front for an option. In-the-money call option - the market price is greater than the strike price In-the-money put option - the market price is less than the strike price Out-of-the-money call option the market price is less than the strike price Out-of-the-money put option - the market price is greater than the strike price

11 Premium: Forward points corresponding to interest rate differentials that are added to the spot rate; price of an option that the option buyer pays to the option writer. Put option: An option contract that gives the holder the right, but not the obligation to sell the put currency at a specified price for a certain, fixed period of time. Reporting currency: The currency in which a parent firm prepares its financial statements. Spot trades: The exchange of a specified amount of one currency for another at a contracted rate with a settlement date of 2 business days following trade date. Spot rate: Contracted rate of a spot trade. Strike price: Rate at which the option holder has the right to purchase (call currency) or sell (put currency) upon exercise of the option contract. Tenor: The term or life of a contract. Value date is the date on which currency is exchanged, delivered, or on which a contract settles (also called settlement date) Volatility: The standard deviation of the change in value of a financial instrument with a specific time horizon.