Exchange Rates

The Case of the Drifting Exchange Rate: TEACHING NOTES Case Description A recent expatriate now living in Mexico finds himself treasurer of a foreign homeowners association (HOA). The budget of the HOA, for which the treasurer has some oversight responsibility, details anticipated expenditures of approximately 5,250,000 pesos. Since most homeowners are also expatriates the peso denominated budget is converted to U.S. dollars and homeowners are billed accordingly. By implication the treasurer must consider the impact of fluctuating exchange rates on owners and management. Strategies for mitigating possible implications of exchange rate fluctuations are weighed as well. Intended Audience This case can be used in personal finance, principles of finance, or undergraduate international finance courses. Other course usage is possible depending on the coverage of topics found therein. Purpose The purpose of this case is to provide students an opportunity to consider exchange rate fluctuations and their impact on different stakeholders. Additionally students have reason to devise estimation procedures for future exchange rates and reflect on how they affect business entities. The case also provides a vehicle for considering currency hedging techniques in a unique and interesting setting. Learning Objectives This case should allow students to thoughtfully consider how changing foreign currency exchange rates affect disparate parties involved in a set of financial transactions. Users are required to seek out quoted exchange rate futures as well as formulating projected rates. Students must also contemplate other approaches to minimize or eliminate the complexities caused by exchange rate fluctuations. Teaching Strategies Prior to assigning this case students should be familiar with foreign currency exchange rates, currency futures and forward contracts, and formulation approaches for estimating future

exchange rates. Suggested Questions: Note these questions can be provided with the case if more structure is desired for the students. Also the professor may use the information provided in Appendix A at the end of the case or instruct the students to locate current information on the web to determine an appropriate answer. 1. Assuming Mr. Bozarth would prefer to use external sources for an exchange rate, how would you suggest a rate for converting next year’s budget from pesos to U.S. dollars be determined? 2. What alternate methods might Mr. Bozarth propose to the Board for dealing with foreign currency fluctuations? 3. How might Mr. Bozarth go about formulating an estimate of the exchange rate for the upcoming year rather than relying on external quotes? 4. What are the implications for the owners and the HOA manager of using the actual foreign exchange rate as compared to the 10.5 pesos per U.S. dollar rate used in prior years’ budgeting process? How might this influence the owners’ and manager’s preferences regarding the choice of exchange rate for next year’s budget? Suggested solutions: 1. Assuming Mr. Bozarth would prefer to use external sources for an exchange rate, how would you suggest a rate for converting next year’s budget from pesos to U.S. dollars be determined? Randy could utilize one of several websites that provide futures prices for foreign currencies. One such website that shows futures prices for 15 months out is: http://futures.tradingcharts.com/marketquotes/MQ.html The futures prices provided could be used as an estimate for converting the pesos denominated budget into U.S. dollars to derive the quarterly HOA fees. 2. What alternate methods might Mr. Bozarth propose to the Board for dealing with foreign currency fluctuations? Randy could propose denominating the HOA fees in pesos rather than in U.S. dollars. Since owners are not all from the U.S. some owners are required to convert from Canadian dollars or

Euros to U.S. dollars to pay their fees anyway. Denominating in pesos would simply require all owners to go through a currency exchange process each quarter. This approach would eliminate the variation in the number of pesos available to the management of the HOA. Perhaps a more attractive approach (at least for U.S. owners) would be for the HOA to utilize forward contracts scheduled for Jan. 1, April 1, July 1, and October 1. In this way an exact number of pesos would be provided to management eliminating exchange rate risk for both owners and management. 3. How might Mr. Bozarth go about formulating an estimate of the exchange rate for the upcoming year rather than relying on external quotes? Randy could utilize the following formula to set the price for a futures contract for a given currency pair: F = S {(1 + (RQ x T)) ÷ (1 + (RB x T))} Where: F = the price for the currency futures contract S = the spot rate for the currency pair RQ = the interest rate of the quote currency (decimal) RB = the interest rate of the base currency (decimal) T = the tenor or time to maturity (in days) Note: The best way to handle the T is just divide the annual interest rates by the fraction of the year you need to estimate. So if you are estimating 6 months out then take the annual rates and divide by 2. See the example below. (From http://www.fxpedia.com/Currency_Futures Similar formulations can be found in any number of finance text books.) A projection of the money market rate (risk free) in Mexico was found to be 4.50% for the year 20X1. This could be determined using online research. One site that provides the desired information is: http://www.ustreas.gov/offices/domestic-finance/debt-management/interestrate/yield.shtml The money market rate in the US for the year 20X1 is estimated at about 0.25%. Again there are various web sites that can be used the estimate this. One such site is:

http://www.money-rates.com/mmarket.htm The current exchange rate was found to be 13.0302 pesos/US$ on the following web site: http://moneycentral.msn.com/investor/market/exchangerates.aspx So to estimate today’s future exchange rate (say six months out, 180 days) use the formula from above. The 180 days are the same for each rate. A six month rate is needed. Therefore the annual rates given will be cut in half: US rate = .0025/2 = .00125 The Mexican rate = .045/2 = .0225. F180 = 13.03 {(1+.0225)/(1+.00125)} = 13.03(1.0212) = 13.306 pesos/US$. This makes sense because as the exchange rate gets larger it takes more pesos in the future to buy a dollar. One way to think of this is by looking at the interest rates. A higher interest rate (i.e. the peso vs. the US$) implies a higher expected inflation in Mexico. (Recall that interest rates are made up of a real rate plus expected inflation.) This will cause the peso to lose value faster than the US$. If that occurs, then it will take more pesos to buy a dollar in the future, as the answer above indicates. How close does this come to the current futures prices? If one looks at the chart given at the web site under (1) above and in Appendix 1 they will see that the futures price for March 20X1 (about 6 months out) is given as 0.075125. This rate is given in terms of US$/peso. Prices are quoted this way by convention. Invert the rate to get the peso/US$ future price which is 13.311 peso/US$. This is essentially the same as the 13.306 calculated above. Other factors in addition to the interest rates may enter into the futures price which is ultimately set by traders in the forex market. Also one can argue about the interest rate projections for each country. Nevertheless, the price of 13.31 Peso/US$ would provide a reasonable estimate of the exchange rate in six months. This rate will probably be off somewhat but will likely be decidedly better than using prior periods’ exchange rate of 10.5. One possible way to proceed is to collect the money in advance based upon the futures price. Then when the money is actually spent the condo owners could be debited or credited by

whatever amount is actually needed to convert dollars to pesos. If the futures price turns out to be exactly correct (which it seldom will) then no debiting or crediting will be needed. Or one could bill the owners based upon the futures price without subsequent adjustment. Sometimes they will win sometimes they will lose but usually by a relatively small amount. The futures price is thought to be an unbiased estimator of future spot prices. If this is true, the amount they win and lose should even out over time. 4. What are the implications for the owners and the HOA manager of using the actual foreign exchange rate as compared to the 10.5 pesos per U.S. dollar rate used in prior years’ budgeting process? How might this influence the owners’ and manager’s preferences regarding the choice of exchange rate for next year’s budget? The homeowners would likely expect that the recent favorable movement in exchange rates would either reduce their cost in terms of dollars or provide a significant reserve for future periods. However, this is not the case since the rate used in the determination of HOA fees is based on a pre-determined rate rather than the actual exchange rate. And, since the budget is denominated in U.S. dollars there is little incentive for management to retain those funds as a reserve. Given the movement in exchange rates, by using the 10.5 rate management now has considerably more pesos available than anticipated in the original budget. This makes management’s job somewhat easier in that they have more funds available to meet their obligations. The cushion created by a more favorable exchange rate (i.e. the 10.5 vs. the 13.31) is probably what management does not want to give up. Undoubtedly this is a significant factor relating to their arguments to keep the 10.5 rate used last year. Owners would likely prefer utilization of a more recent rate such as the spot rate of 13.03 pesos to the U.S. dollar. This of course reduces fees for U.S. owners at least in their base currency.

One must remember when establishing a policy that the exchange rate can move in either direction. If the peso becomes more valuable in comparison to the U.S. dollar the number of dollars required to fulfill the budgetary requirements will be greater. Whatever policy is agreed upon it needs to be fair and easy to administer. The parties involved (management and owners) should avoid creating a policy that will financially cripple the organization or the homeowners if there are significant swings in exchange rates. Epilogue After much discussion and political wrangling the following compromise solution was agreed upon. The budget was denominated in pesos since this is the functional currency (the currency in which virtually all transactions are denominated). Each quarter management determines the appropriate billing amount for homeowners in pesos for HOA fees, utilities, and other services received. The treasurer, Randy Bozarth, provides to the HOA manager an average exchange rate for the previous quarter which is used to convert the peso billing into U.S. dollars. A statement is then sent to homeowners which details all of their charges for the quarter denominated in both pesos and U.S. dollars. Homeowners can select the currency to use in paying their HOA fees. If they are Mexican nationals or are in Mexico and want to pay in pesos they may. However, many are not in Mexico and pay in U.S. dollars. Unfortunately the homeowners’ ability to select either currency for paying their fees gives them the opportunity to “game” the system by choosing the currency that benefits them based current exchange rates. However that does not appear to be a significant issue as yet. This is not a perfect solution since HOA fees are billed in advance using last quarter’s exchange rate and gaming is possible. However, utilities and other services are being billed based on the average rate actually encountered for the services received. In spite of the shortcomings the approach adopted is far superior to using the arbitrary 10.5 rate.