The Foreign Exchange Market 9 chapter The Foreign Exchange Market McGraw-Hill/Irwin Global Business Today, 5e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Chapter 9: The Foreign Exchange Market INTRODUCTION This chapter: Explains how the foreign exchange market works Examines the forces that determine exchange rates Discusses the degree to which it is possible to predict exchange rate movements Maps the implications for international business of exchange rate movements and the foreign exchange market

Chapter 9: The Foreign Exchange Market THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET The foreign exchange market serves two main functions: to convert the currency of one country into the currency of another to provide some insurance against foreign exchange risk

Chapter 9: The Foreign Exchange Market Currency Conversion Insuring Against Foreign Exchange Risk

THE NATURE OF THE FOREIGN EXCHANGE MARKET The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. Two significant features of the market are: It never sleeps High-speed computer linkages between trading centers around the globe have effectively created a single market

Chapter 9: The Foreign Exchange Market ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION Exchange rates are determined by the demand and supply for different currencies. Three factors impact future exchange rate movements: A country’s price inflation A country’s interest rate Market psychology

Chapter 9: The Foreign Exchange Market Prices and Exchange Rates Interest Rates and Exchange Rates Investor Psychology and Bandwagon Effects Summary

EXCHANGE RATE FORECASTING Is it worthwhile for a company to invest in exchange rate forecasting services to aid decision-making?

Two schools of thought address this issue: the efficient market school argues that forward exchange rate do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

Chapter 9: The Foreign Exchange Market The Efficient Market School The Inefficient Market School Approaches to Forecasting

Chapter 9: The Foreign Exchange Market CURRENCY CONVERTIBILITY A currency is said to be freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency. A currency is said to be externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way. A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency.

Chapter 9: The Foreign Exchange Market IMPLICATIONS FOR MANAGERS It is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Transaction Exposure Translation Exposure Economic Exposure

Chapter 9: The Foreign Exchange Market IMPLICATIONS FOR MANAGERS Reducing Translation and Transaction Exposure Reducing Economic Exposure Other Steps for Managing Foreign Exchange Risk