The Foreign Exchange Market Chapter 9 The Foreign Exchange Market

Contents 1 Introduction The Functions of the Foreign Exchange Market 2 Economic Theories of Exchange Rate Determination 3 Implications for Managers 4

Introduction Question: What is the foreign exchange market? Question: What is the exchange rate?

Implications for Managers Firms must understand the influence of exchange rates on the profitability of trade and investment deals This exchange rate risk can be divided into Transaction exposure Translation exposure Economic exposure

Kurs Bank Mandiri

The world's least valuable currencies Ja 10 Japanese yen

09 Kenyan shilling

08 Pakistani rupee

07 hungarian-forint

06 Chilean Peso

The Functions of the Foreign Exchange Market Question: What is the purpose of the foreign exchange market? The foreign exchange market enables the conversion of the currency of one country into the currency of another provides some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)

Insuring Against Foreign Exchange Risk The 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 firm) A firm that protects itself against foreign exchange risk is hedging

Spot exchange rates Hedging Forward exchange rates Currency swaps

Economic Theories of Exchange Rate Determination Question: What factors are important to future exchange rates? Three factors that have an important impact on future exchange rate movements are a country’s price inflation a country’s interest rate market psychology

Mengapa Rupiah Anjlok?

Case Study: Tebang Pilih Investasi Pasar Berkembang

Prices and Exchange Rates Question: How are prices related to exchange rate movements? 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 The law of one price states that 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 currency Purchasing power parity theory argues that 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

Case Study Big Mac price and the exchange rate: An application of purchasing power parity. Sumber: The Economist

Interest Rates and Exchange Rates Question: How do interest rates affect exchange rates? The Fisher Effect states that a country’s 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 + I So, 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 Exchange Rates The 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 countries In 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

05 korean-won

04 Tanzanian Shilling

03 Colombian Peso

RUPIAH

01 Vietnamese Dong

Summary Relative 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

Implications for Managers Question: What does the foreign exchange market mean for international firms?

Should The UK Be A Member Of The Euro?

Is Europe an Optimal Currency Zone? Price Transparency Promotes Trade Currency Stability and Transparency Promotes Competition

UK Entry the Euro Lost Trade Lower Foreign Investment Weaker Financial Market Reduced Competitiveness Convergence Euro Policy and Politics

Cu Next Week

Exchange Rate Risk Transaction exposure Translation exposure 1 Transaction exposure 2 Translation exposure 3 Economic exposure

Exchange Rate Risk

Insuring Against Foreign Exchange Risk

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