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Global Business Today 7eby Charles W.L.HillGlobal Business Today 7eChapter 9The Foreign Exchange MarketChapter 9The Foreign Exchange Introduction Question:What is the foreign exchange market?Answer:The foreign exchange market is a market for converting the currency of one country into that of another country Question:What is the exchange rate?Answer:The exchange rate is the rate at which one currency is converted into anotherIntroduction Question:What The Functions of the FX Market Question:What is the purpose of the foreign exchange market?Answer:The foreign exchange market1.enables the conversion of the currency of one country into the currency of another2.provides some insurance against foreign exchange risk-the adverse consequences of unpredictable changes in exchange rates The Functions of the FX MarkeCurrency ConversionInternational firms use foreign exchange marketsto convert export receipts,income received from foreign investments,or income received from licensing agreementsto pay a foreign company for products or services to invest spare cash for short terms in money marketsfor currency speculation-the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange ratesCurrency ConversionInternationInsuring Against FX RiskThe foreign exchange market can be used to provide insurance to protect against foreign exchange risk-the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firma firm that protects itself against foreign exchange risk is hedgingThe market performs this function using1.spot exchange rates2.forward exchange rates3.currency swaps Insuring Against FX RiskThe foInsuring Against FX Risk1.Spot Exchange Rate-the rate at which a foreign exchange dealer converts one currency into another currency on a particular daydetermined by the interaction between supply and demand,and so change continuallyInsuring Against FX Risk1.SpoInsuring Against FX Risk2.Forward Exchange Rates-the exchange rate governing a forward exchangeA forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the futureforward rates are typically quoted for 30,90,or 180 days into the futureInsuring Against FX Risk2.ForInsuring Against FX Risk3.Currency Swap-the simultaneous purchase and sale of a given amount of foreign exchange for two different value datesswaps are used when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk Insuring Against FX Risk3.CurThe Nature of the FX MarketThe foreign exchange market is a global network of banks,brokers,and foreign exchange dealers connected by electronic communications systemsThe market is always open somewhere in the worldif exchange rates quoted in different markets were not essentially the same,there would be an opportunity for arbitrage-the process of buying a currency low and selling it highMost transactions involve U.S.dollars on one sidethe U.S.dollar is a vehicle currencyThe Nature of the FX MarketTheTheories of Exchange Rate Determination Question:What factors are important to future exchange rates?Answer:Three factors that have an important impact on future exchange rate movements are1.a countrys price inflation 2.a countrys interest rate3.market psychologyTheories of Exchange Rate DetePrices and Exchange Rates Question:How are prices related to exchange rate movements?Answer:To understand how prices and exchange rates are linked,we need to understand the law of one price,and the theory of purchasing power parity Prices and Exchange Rates QPrices and Exchange RatesThe law of one price-in competitive markets free of transportation costs and barriers to trade,identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currencyPurchasing power parity theory-given relatively efficient markets(markets in which few impediments to international trade and investment exist)the price of a“basket of goods”should be roughly equivalent in each country Prices and Exchange RatesThe lPrices and Exchange RatesPPP predicts that changes in relative prices will result in changes in exchange rateswhen inflation is relatively high,a currency should depreciateSo,if we can predict inflation rates,we can predict how a currencys value might changethe growth of a countrys money supply determines its likely future inflation rate when the growth in the money supply is greater than the growth in output,inflation will occur Prices and Exchange RatesPPP pPrices and Exchange Rates Question:How well does PPP theory work?Answer:Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run,but is relatively accurate in the long run Prices and Exchange Rates Interest Rates and Exchange Rates Question:How do interest rates affect exchange rates?Answer:The Fisher Effect states that a countrys nominal interest rate(i)is the sum of the required real rate of interest(r)and the expected rate of inflation over the period for which the funds are to be lent(l)in other words,i=r+ISo,if the real interest rate is the same everywhere,any difference in interest rates between countries reflects differing expectations about inflation rates Interest Rates and Exch Interest Rates and Exchange RatesThe International Fisher Effect suggests that for any two countries,the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countriesin other words:(S1-S2)/S2 x 100=i$-i where i$and i are the respective nominal interest rates in two countries(in this case the US and Japan),S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period Interest Rates and Excha Investor Psychology and Bandwagon Effect Question:How are exchange rates influences by investor psychology?Answer:The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies,and traders join the bandwagon and move exchange rates based on group expectationsgovernmental intervention can prevent the bandwagon from starting,but is not always effective Investor PsychologySummaryRelative monetary growth,relative inflation rates,and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates,but poor predictors of short term changes So,international businesses should pay attention to countries differing monetary growth,inflation,and interest rates SummaryRelative monetary growtExchange Rate Forecasting Question:Should companies invest in exchange rate forecasting services to help with decision-making?Answer:The efficient market school-forward exchange rates are the best predictors of future spot exchange ratesinvesting in forecasting services is a waste of moneyThe inefficient market school-companies should invest in forecasting services forward rates are not the best predictor of future spot ratesExchange Rate Forecasting The Efficient Market SchoolAn efficient market-one in which prices reflect all available informationif the foreign exchange market is efficient,forward exchange rates should be unbiased predictors of future spot rates Most empirical tests confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services,but some recent studies have challenged the theory The Efficient Market SchoolAn The Inefficient Market SchoolAn inefficient market-one in which prices do not reflect all available informationin an inefficient market,forward exchange rates are not the best predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting servicesHowever,the track record of forecasting services is questionable The Inefficient Market SchoolAApproaches to Forecasting Question:How should exchange rate forecasts be prepared?Answer:There are two approaches to exchange rate forecasting1.fundamental analysis2.technical analysisApproaches to Forecasting Approaches to Forecasting1.Fundamental Analysis-draws upon economic factors like interest rates,monetary policy,inflation rates,or balance of payments information to predict exchange rates2.Technical Analysis-focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves Approaches to Forecasting1.FuCurrency Convertibility Question:Are all currencies freely convertible?Answer:A currency is freely convertible when both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currencyA currency is externally convertible when only non-residents can convert their holdings of domestic currency into a foreign currencyA currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currencyCurrency Convertibility QuCurrency Convertibility Question:Why do countries limit currency convertibility?Answer:The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight-when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currencyIn the case of a nonconvertible currency,firms may turn to countertrade(barter like agreements by which goods and services can be traded for other goods and services)to facilitate international tradeCurrency Convertibility QuImplications for Managers Question:What does the foreign exchange market mean for international firms?Answer:Firms must understand the influence of exchange rates on the profitability of trade and investment deals This exchange rate risk can be divided into 1.Transaction exposure2.Translation exposure3.Economic exposureImplications for Managers Transaction ExposureTransaction exposure-the extent to which the income from individual transactions is affected by fluctuations in foreign exchange valuescan lead to a real monetary loss Transaction ExposureTransactioTranslation ExposureTranslation exposure-the impact of currency exchange rate changes on the reported financial statements of a company deals with the present measurement of past eventsGains and losses from translation exposure are reflected only on paperTranslation ExposureTranslatioEconomic ExposureEconomic exposure-the extent to which a firms future international earning power is affected by changes in exchange ratesconcerned with the long-term effect of changes in exchange rates on future prices,sales,and costsEconomic ExposureEconomic expoReducing FX Exposure Question:How can firms minimize translation and transaction exposure?Answer:Firms can buy forward use swapslead and lag payables and receivables-paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements Reducing FX Exposure QuestiReducing FX Exposure A lead strategy-attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciateA lag strategy-delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciatelead and lag strategies can be difficult to implementReducing FX Exposure A lead stReducing FX Exposure Question:How can a firm reduce economic exposure?Answer:To reduce economic exposure firms need to distribute productive assets to various locations so the firms long-term financial well-being is not severely affected by changes in exchange ratesThis requires that the firms assets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produceReducing FX Exposure Questi Other Steps for Managing FX Risk Question:Are there other strategies to manage foreign exchange risk?Answer:To further manage foreign exchange risk,firms should 1.establish central control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies Other Steps for Managing Other Steps for Managing FX Risk2.distinguish between transaction and translation exposure on the one hand,and economic exposure on the other hand3.attempt to forecast future exchange rates4.establish good reporting systems so the central finance function can regularly monitor the firms exposure position5.produce monthly foreign exchange exposure reports Other Steps for Managing Classroom Performance SystemThe rate at which one currency is converted into another is thea)Exchange rateb)Cross ratec)Conversion rated)Foreign exchange market Classroom Performance System Classroom Performance SystemThe rate at which a foreign exchange dealer converts one currency into another currency on a particular day is thea)Currency swap rateb)Forward ratec)Specific rated)Spot rate Classroom Performance System Classroom Performance SystemAll of the following impact future exchange rate movements excepta)A countrys price inflationb)A countrys interest ratec)A countrys arbitrage opportunitiesd)Market psychology Classroom Performance System Classroom Performance SystemThe extent to which income from individual transactions is affected by fluctuations in foreign exchange values is a)Translation exposureb)Accounting exposurec)Transaction exposured)Economic exposure Classroom Performance System
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