GLOSSARY Absolute form of purchasing power parity Also called the law of one price, this theory suggests that prices of two products of different countries should be equal when measured by a common currency. Accounting exposure The change in the value of a firm s foreign-currency-denominated to a change in exchange rates. Appreciation See Revaluation. accounts due Asian dollar market Market in Asia in which banks collect deposits and make loans denominated in U.S. dollars. Ask price Price at which a trader of foreign exchange (typically a bank) is willing to sell a particular currency. Bank of International Settlements (BIS) Institution which facilitates cooperation among countries involved in international transactions and provides assistance to countries experiencing international payment problems. Bid price Price that a trader of foreign exchange (typically a bank) is willing to pay for a particular currency. Bid/ask spread Difference between the price at which a bank is willing to buy a currency and the price at which it will sell that currency. Blocked currency A currency that is not freely convertible to other currencies due to exchange controls. Bretton woods agreement An agreement, implemented in 1946, whereby each member government pledged to maintain a fixed, or pegged, exchange rate for its currencies vis-à-vis the dollar or gold. These fixed exchange rates were supposed to reduce the riskiness of international transactions, thus promoting growth in world trade. Capital account Net results of public and private international investment and lending activities. Capital asset pricing model (CAPM) A model for pricing risk. The CAPM assumes that investors must be compensated for the time value of money plus systematic risk, as measured by an asset s beta. Capital flight The transfer of capital abroad in response to fears of political risk. Clean float See Free float. Correspondent bank A bank located in any other city, state, or country that provides a service for another bank. Countertrade A sophisticated form of barter in which the exporting firm is required to take the counter value of its sale in local goods or services instead of cash. Country risk General level of political and economic uncertainty in a country affecting the value of loans or investments in that country. Covered-interest arbitrage Movement of short-term funds between two currencies to take advantage of interest differentials with exchange risk eliminated by means of forward contracts. Cross-rate The exchange rate between two currencies, neither or which is the US dollar, calculated by using the dollar rates for both currencies. 339
Cross hedging Hedging an open position in one currency with a hedge on another currency that is highly correlated with the first currency. This occurs when for some reason the common hedging techniques cannot be applied to the first currency. A cross-hedge is not a perfect hedge, but can substantially reduce the exposure. Currency arbitrage Taking advantage of divergences in exchange rates in different money markets by buying a currency in one market and selling it in another. Currency call option A financial contract that gives the buyer the right, but not the obligation, to buy a specified number of units of foreign currency from the option seller at a fixed dollar price, up to the option s expiration date. Currency cocktail bond Bond denominated in a mixture of currencies. Currency diversification Process of using more than one currency as an investing or financing strategy. Exposure to a diversified currency portfolio typically results in less exchange rate risk than if all of the exposure was in a single foreign currency. Currency futures contract Contract for future delivery of a specific quantity of a given currency, with the exchange rate fixed at the time the contract is entered. Futures contracts are similar to forward contracts except that they are traded on organized futures exchanges and the gains and losses on the contracts are settled each day. Currency of denomination Currency in which a transaction is stated. Currency of determination Currency whose value determines a given price. Currency put option A financial contract that gives the buyer the right, but not the obligation, to sell a specified number of foreign currency units to the option seller at a fixed rupee price, up to the option s expiration date. Currency swap A simultaneous borrowing and lending operation whereby two parties exchange specific amounts of two currencies at the outset at the spot rate. They also exchange interest rate payments in two currencies. The parties undertake to reverse the exchange after a fixed term at a fixed exchange rate. Current account Net flow of goods, services, and unilateral transactions (gifts) between countries. Dependent variable Term used in regression analysis to represent the variable that is dependent on one or more other variables. Depreciation See Devaluation. Depreciation tax shield The value of the tax write-off on depreciation of plant and equipment. Devaluation A decrease in the spot value of a currency. Direct quotations Exchange rate quotations representing the value measured by number of dollars per unit. Dirty float See Managed float. Doctrine of sovereign immunity Doctrine that says a nation may not be tried in the courts of another country without its consent. Domestic International Sales Corporation (DISC) A domestic US corporation that receives a tax incentive for export activities. 340
Dynamic hedging Strategy of hedging in those periods when existing currency positions are expected to be adversely affected, and remaining unhedged in other periods when currency positions are expected to be favorably affected. Economic exposure The extent to which the value of the firm will change due to an exchange rate change. Efficient market A market in which new information is readily incorporated into the prices of traded securities. Equilibrium exchange rate Exchange rate at which demand for a currency is equal to the supply of the currency for sale. Exercise price (strike price) Price (exchange rate) at which the owner of a currency call option is allowed to buy a specified currency; or the price (exchange rate) at which the owner of a currency put option is allowed to sell a specified currency. Eurobond A bond sold outside the country in whose currency it is denominated. Eurocommercial paper (Euro-CP) Euronotes that are not underwritten. Eurocurrency A currency deposited in a bank outside the country of its origin. Euronote A short-term note issued outside the country of the currency it is denominated in. European Community A group of European nations whose purpose is to reduce trade barriers among member states. European Currency Unit (ECU) A composite currency, consisting of fixed amounts of European currencies. European Monetary System (EMS) Monetary system formed by the major European countries under which the members agree to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. These central exchange rates are denominated in currency units per ECU. Exchange-rate mechanism (ERM) A process whereby each member of the European Monetary System determines a mutually agreed upon central exchange rate for its currency; each rate is denominated in currency units per ECU. Exchange risk The variability of a firm s value that is due to uncertain exchange rate changes. Export-Import Bank (EximBank) U.S. government agency dedicated to facilitating U.S. exports, primarily through subsidized export financing. Exposure netting Offsetting exposures in one currency with exposures in the same or another currency, where exchange rates are expected to move in such a way that losses (gains) on the first exposed position should be offset by gains (losses) on the second currency exposure. Fiat money Nonconvertible paper money. Fisher effect States that the nominal interest differential between two countries should equal the inflation differential between those countries. Fixed exchange rate An exchange rate whose value is fixed by the governments involved. Floating exchange rate An exchange rate whose value is determined in the foreign exchange market. 341
Foreign exchange market Market composed primarily of banks, serving firms and consumers who wish to buy or sell various currencies. Foreign market beta A measure of foreign market risk that is derived from the capital asset pricing model. Forward differential Annualized percentage difference between spot and forward rates. Forward rate The rate quoted today for delivery at a fixed future date of a specified amount of one currency against dollar payment. Free float An exchange rate system characterized by the absence of government intervention. Also known as a clean float. Functional currency As defined in FASB No. 52, an affiliate s functional currency is the currency of the primary economic environment in which the affiliate generates and expends cash. Gold standard A system of setting currency values whereby the participating countries commit to fix the prices of their domestic currencies in terms of a specified amount of gold. Hedge To enter into a forward contract in order to protect the home currency value of foreign-currencydenominated assets or liabilities. Import-substitution development strategy A development strategy followed by many Latin American countries and other LDCs that emphasized import substitution-accomplished through protectionism-as the route to economic growth. Independent variable Term used in regression analysis to represent the variable that is expected to influence another (so called dependent ) variable. Indirect quotations Exchange rate quotations representing the value measured by number of units per dollar. Interbank market Market that facilitates the exchange of currencies between banks. Intercompany loan Loan made by one unit of a corporation to another unit of the same corporation. International Bank for Reconstruction and Development (IBRD) Also known as the World Bank, the IBRD is owned by its member nations and makes loans at nearly conventional terms to countries for projects of high economic priority. International Fisher effect States that the interest differential between two countries should be an unbiased predictor of the future change in the spot rate. International fund A mutual fund that can invest only outside the United States. International Monetary Fund (IMF) International organization created at Bretton Woods, N.H., in 1944 to promote exchange rate stability, including the provision of temporary assistance to member nations trying to defend their currencies against transitory phenomena. International monetary system The set of policies, institutions, practices, regulations, and mechanisms that determine the rate at which one currency is exchange for another. J-curve theory Theory that says a country s trade deficit will initially worsen after its currency depreciates because higher prices on foreign imports will more than offset the reduced volume of imports in the short run. 342
Law of one price The theory that exchange-adjusted prices identical tradeable goods and financial assets must be within transaction costs of equality worldwide. Leading and lagging A letter addressed to the seller, written and signed by a bank acting on behalf of the buyer, in which the bank promises to honor drafts drawn to on itself if the seller conforms to the specific conditions contained in the letter. Loan syndication Group of banks sharing a loan. Locational arbitrage Action to capitalize on a discrepancy in quoted exchange rates between banks. Louvre Accord An agreement, named for the Paris landmark where it was negotiated, that called for the G-7 nations to support the falling dollar by pegging exchange rates within a narrow, undisclosed range, while they also moved to bring their economic policies into line. Managed float Also known as a dirty float, this is a system of floating exchange rates with central bank intervention to reduce currency fluctuations. Monetary union Agreement among several economic units to establish one central bank with the sole power to issue a single currency. Money market hedge The use of borrowing and lending transactions in foreign currencies to lock in the home currency value of a foreign currency transaction. Multicurrency clause This clause gives a Eurocurrency borrower the right to switch from one currency to another when the loan is rolled over. Multilateral netting system Complex interchange for netting between a parent and several subsidiaries. Netting See Exposure netting or Payments netting. Net transaction exposure Consideration of inflows and outflows in a given currency to determine the exposure after offsetting inflows against outflows. Nominal exchange rate Actual spot rate. Official reserves Holdings of gold and foreign currencies by official monetary institutions. Operating exposure Degree to which an exchange rate change, in combination with price changes, will alter a company s future operating cash flows. Optimum currency area The largest economic unit that should have the same currency. This is the area that trades off the benefits of a single currency (reduced risk and lower transactions costs) against its costs (loss of pricing flexibility). Outright rate Actual forward rate expressed in dollars per currency unit, or vice versa. Outsourcing The practice of purchasing a significant percentage of intermediate components from outside suppliers. Overhedging Hedging an amount in a currency larger than the actual transaction amount. Parallel loan Simultaneous borrowing and lending operation usually involving four related parties in two different countries. Payments netting Reducing fund transfers between affiliates to only a netted amount. Netting can be done on a bilateral basis (between pairs of affiliates) or on a multilateral basis (taking all affiliates together). 343
Pegged exchange rate Exchange rate whose value is pegged to another currency s value or to a unit of account. Plaza Agreement A program launched in September 1985 by the G-5 nations that was designed to force down the dollar against other major currencies and, thereby, improve American competitiveness. Political risk Uncertain government action that affects the value of a firm. Pooling Transfer of excess affiliate cash into a central account (pool), usually located in a low-tax nation, where all corporate funds are managed by corporate staff. Prepayment Method which exporter uses to receive payment before shipping goods. Price-specie-flow mechanism An automatic balance-of-payments adjustment mechanism under the classical gold standard whereby disturbances in the price level in one country would be wholly or partly offset by the flow of gold coins (also called specie). Purchasing power parity The notion that the ratio between domestic and foreign price levels should equal the equilibrium exchange rate between domestic and foreign currencies. Real cost of hedging The additional cost of hedging when compared to not hedging (a negative real cost would imply that hedging was more favorable than not hedging). Real exchange rate The spot rate adjusted for relative price level changes since a base period. Regression analysis Statistical technique used to measure the relationship between variables and the sensitivity of a variable to one or more other variables. Regression coefficient Term measured by regression analysis to estimate the sensitivity of the dependent variable to a particular independent variable. Relative form of purchasing power parity Theory stating that the rate of change in the prices of products should be somewhat similar when measured in a common currency, as long as transportation costs and trade barriers are unchanged. Reporting currency The currency in which the parent firm prepares its own financial statements; that is U.S. dollars for a U.S. company. Revaluation An increase in the spot value of a currency. Society for Worldwide Interbank Financial Telecommunications (SWIFT) A dedicated computer network to support funds transfer messages internationally between over 900 member banks worldwide. Sovereign risk The risk that the country or origin of the currency a bank is buying or selling will impose foreign exchange regulations that will reduce or negate the value of the contract; also refers to the risk of government default on a loan made to it or guaranteed by it. Smithsonian Agreement Conference between nations in 1971 that resulted in a devaluation of the dollar against major currencies and a widening of boundaries (2 percent in either direction) around the newly established exchange rates. Snake Arrangement established in 1972, whereby European currencies were tied to each other within specified limits. Special Drawing Rights (SDR) A new form of international reserve assets, created by the IMF in 1967, whose value is based on a portfolio of widely used currencies. 344
Spot market Market in which exchange transactions occur for immediate exchange. Spot rate The price at which foreign exchange can be bought or sold with payment set for the same day. Sterilized intervention Foreign exchange market intervention in which the monetary authorities have insulated their domestic money supplies from the foreign exchange transactions with offsetting sales or purchases or domestic assets. Straddle Combination of a put option and a call option. Subsidiary A foreign-based affiliate that is a separately incorporated entity under the host country s law. Swap rate The difference between spot and forward rate expressed in points. Systematic risk That element of an asset s risk that cannot be eliminated no matter how diversified an investor s portfolio. Target-zone arrangement A monetary system under which countries pledge to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Tax haven A nation with a moderate level of taxation and/or liberal tax incentives for undertaking specific activities such as exporting. Terms of trade The weighted average of a nation s export prices relative to its import prices. Time series analysis Analysis of relationships between two or more variables over periods of time. Transaction exposure The extent to which a given exchange rate change will change the value of foreign-currency-denominated transactions already entered into. Translation exposure See Accounting exposure. Triangular arbitrage Action to capitalize on a discrepancy where the quoted cross exchange rate is not equal to the rate that should exist at equilibrium. Two-tier foreign exchange market This arrangement involves an official market (at the official rate) for certain transactions and a free market for remaining transactions. Unsterilized intervention Foreign exchange market intervention in which the monetary authorities have not insulated their domestic money supplies from the foreign exchange transactions. World Bank See International Bank for Reconstruction and Development. 345