International Business Fourth Edition

The Foreign Exchange Market CHAPTER 9 The Foreign Exchange Market

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.

Definitions Foreign Exchange Market: Exchange Rate: A market for converting the currency of one country into the currency of another. Exchange Rate: The rate at which one currency is converted into another. Foreign Exchange Risk: The risk that arises from changes in exchange rates.

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.

FX Transactions * Most forward exchanges are currency swaps.

Foreign Exchange Trade Growth $ billions

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).

Geographical Distribution of Global Foreign Exchange Activity (percentage share of total average daily turnover) Figure 9.1

The Hierarchy of International Financial Centers São Paulo Rio de Janiero Mexico City San Francisco New York Toronto Bombay Melbourne Sydney Tokyo Hong Kong Singapore Paris Zurich Frankfurt Amsterdam Vienna Madrid Hamburg Dusseldorf Rome Brussels Chicago London Basel Note: Size of dots (squares) indicates cities’ relative importance

Currency Use on One Side of a FX Transaction Currency April ‘92 April ‘95 April ‘98 April ‘01 Percentage share of average daily turnover Table 9.2

Factors Influencing Currency Value 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

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.

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.

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.

The Big Mac Index Purchasing Power Parity: April 2001 Local Currency % Over(+) or Under(-) Valuation Against Dollar Big Mac Prices Actual Exchange Rate 17/04/01 Table 9.3 Price in Local Currency Implied PPP of the Dollar Price in Dollars 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 Source: The Economist 4/9/94, pg 8. © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Macroeconomic Data for Bolivia, April 1984 -October 1985 May 330 31.1 3,512 June 440 32.3 3,342 July 599 34.0 3,570 August 718 39.1 7,038 September 889 53.7 13,685 October 1,194 85.5 15,205 November 1,495 112.4 18,469 September 3,296 180.9 24,515 1985 January 4,630 305.3 73,016 February 6,455 863.3 141,101 March 9,089 1,078.6 128,137 April 12,885 1,205.7 167,428 May 21,309 1,635.7 272,375 June 27,778 2,919.1 481,756 July 47,341 4,854.6 885,476 August 74,306 8,081.0 1,182,300 September 103,272 12,647.6 1,087,440 October 132,550 12,411.8 1,120,210 Money Supply (billions of pesos) Price Level Relative to 1982 (average=1) Exchange Rate (pesos/dollar) Table 9.4

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.

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.

Exchange Rate Forecasting 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.

Currency Convertibility 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.