1. CHAPTER 10 The Foreign Exchange Market

2. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-2 2 Learning Objectives Japan Airline’s experience in foreign exchange markets Thai Bhat crises How is exchange rate determined? Price level, PPP Interest rate

3. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-3 3 Learning Objectives How is exchange rate determined? Investors Psychology Balance of Payment Deficits What are the implications of currency convertibility for the business firms?

4. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-4 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-4

5. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-5 5 Chapter Focus Explain how the foreign exchange (FX) market works. Examine the forces that determine the exchange rates and whether it is possible to determine future rates movement. Map the implications for businesses.

6. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-6 6 Functions of the Foreign Exchange Market Currency Conversion Companies receiving payment in foreign currencies need to convert to their home currency. Companies paying foreign businesses for goods or services. Companies invest spare cash for short terms in money market accounts. Speculation: taking advantage changing exchange rates. Insuring Against FX Risk Spot exchange rate: rate of currency exchange on a particular day. Forward exchange rate: two parties agree to exchange currencies on a specific future date. Currency swap:simultaneous purchase and sale of a given amount of FX for two different value dates.

7. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-7 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-7 FX Transactions * Most forward exchanges are currency swaps.

8. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-8 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-8 Foreign Exchange Trade Growth $ billions

9. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-9 9 The Foreign Exchange Market It is a 24/7 market. The markets are integrated. Connected by high-speed computers, it creates one virtual market. London’s dominance is explained by: History (capital of the first major industrialized nation). Geography (between Tokyo/Singapore and New York).

10. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-10 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-10 Economic Factors 1.Balance of Payments 2.Interest Rates 3.Inflation 4.Monetary and Fiscal Policy 5.International Competitiveness 6.Monetary Reserves 7.Government Controls and Incentives 8.Importance of Currency in World Political Factors 9.Political Party and Leader Philosophies 10.Proximity of Elections or Change in leadership Expectation Factors 11. Expectations 12.Forward Exchange Market Prices Factors Influencing Currency Value

11. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-11 11 Economic Theories of Exchange Rate Determination Base level: rates are determined by the demand/supply of one currency relative to the demand/supply of another. Price and Exchange Rates: Law of One Price Purchasing Power Parity (PPP) Interest Rates and Exchange Rates. Investor Psychology and Bandwagon Effects.

12. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-12 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-12 Price and Exchange Rates Law of One Price: In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. Example: US/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York should retail for FFr 250 in Paris (50x5). Purchasing Power Parity By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient. In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country.

13. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-13 13 Money Supply and Inflation PPP theory predicts that changes in relative prices will result in a change in exchange rates. A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate. Inflation occurs when the money supply increases faster than output increases. Purchasing Power Parity Puzzle.

14. The Big Mac Index Purchasing Power Parity: April 2001 United States $2.54 2.54 - - - - - - - - - Argentina Peso 2.50 2.50 0.98 1.00 -2 Brazil Real 3.60 1.64 1.42 2.19 -35 Canada C $ 3.33 2.14 1.31 1.56 - 16 Euro 2.57 2.27 0.99 0.88 - 11 France FFr 18.5 2.49 7.28 7.44 - 2 Hong Kong HK $10.70 1.37 4.21 7.80 - 46 Japan ¥ 294 2.38 116 124 - 6 Russia Roule 35.00 1.21 13.8 28.9 - 52 Switzerland SwFr 6.30 3.65 2.48 1.73 44 Price in Local Currency Implied PPP of the Dollar Actual Exchange Rate 17/04/01 Local Currency % Over(+) or Under(-) Valuation Against Dollar © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Price in Dollars Big Mac Prices Table 9.3

15. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-15 15 Interest Rates and Exchange Rates Theory says that interest rates reflect expectations about future exchange rates. Fisher Effect (I = r+l). International Fisher Effect: 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 countries.

16. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-16 16 Investor Psychology and Bandwagon Effects Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates. Explanation may be investor psychology and the bandwagon effect. Studies suggest they play a major role in short term movements. Hard to predict.

17. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-17 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-17 Efficient market: where prices reflect all available public information. Early studies seem to confirm the efficient market theory, but recent studies have challenged it. Inefficient market: where prices do not reflect all available information. Use fundamental (economic theory) or technical (price/volume data) analysis to predict the exchange rates. Analysis suggest that professional forecasters are no better than forward exchange rates in predicting future spot rates. Exchange Rate Forecasting

18. McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-18 McGraw-Hill/Irwin © 2003 The McGraw-Hill Companies, Inc., All Rights Reserved. 9-18 Freely convertible. Externally convertible. Not convertible. Preserve foreign exchange reserves. Service international debt. Purchase imports. Government afraid of capital flight. Political decision. Many countries have some kind of restrictions. Countertrade. Barter-like agreements where goods/services are traded for goods/services. Helps firms avoid convertibility issue. Currency Convertibility