Global Business Management (MGT380) Lecture #13: Foreign Exchange Market

Learning Objectives  Be familiar with the form and function of the foreign exchange market  Understand the difference between spot and forward exchange rates  Understand how currencies exchange rate are determined

Recap of the last lecture  Benefits of the euro  savings from having to handle one currency, rather than many, Travelers. $40 billion/year  it is easier to compare prices across Europe, so firms are forced to be more competitive  Cost of production reduce  gives a strong boost to the development of highly liquid pan-European capital market like NASDAC  increases the range of investment options open both to individuals and institutions  Benefits of the euro  loss of control over national monetary policy  EU is not an optimal currency area (they have different wage rate, tax rate, business cycle, effects of shocks)  Shifting the economic affects to other countries  Political influence; Fortress Europe

 The North American Free Trade Area includes the United States, Canada, and Mexico  abolished tariffs on 99% of the goods traded between members  removed barriers on the cross-border flow of services  protects intellectual property rights  removes most restrictions on FDI between members  allows each country to apply its own environmental standards  establishes two commissions to impose fines and remove trade privileges when environmental standards or legislation involving health and safety, minimum wages, or child labor are ignored  Benefits of all countries

 The Andean Pact -formed in 1969 using the EU model between Bolivia, Chile, Ecuador, Colombia, Peru  MERCOSUR-originated in 1988 as a free trade pact between Brazil and Argentina; was expanded in 1990 to include Paraguay and Uruguay and in 2005 with the addition of Venezuela  Talks began in April 1998 to establish a Free Trade of The Americas (FTAA) by 2005, Brazil and US have their concerns  The Association of Southeast Asian Nations (ASEAN, 1967)-currently includes Brunei, Indonesia, Malaysia, the Philippines, Singapore, Thailand, Vietnam, Myanmar, Laos, and Cambodia  An ASEAN Free Trade Area (AFTA) between the six original members of ASEAN came into effect in 2003, ASEAN and AFTA are moving towards establishing a free trade zone  The East African Community (EAC) was re-launched in 200

Why Is The Foreign Exchange Market Important?  You’re probably familiar with some of the major currencies in the world like the U.S. dollar, the European euro, the British pound, and the Japanese yen. But do know how much each foreign currency is worth in terms of your own currency?  Let’s go over couple of basic definitions first. The foreign exchange market is simply a market for converting the currency of one country into that of another country, and an exchange rate is the rate at which one currency is converted into another.  What’s the purpose of the foreign exchange market

Why Is The Foreign Exchange Market Important?  The foreign exchange market 1. is used to convert the currency of one country into the currency of another 2. provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates  The exchange rate is the rate at which one currency is converted into another  Events in the foreign exchange market affect firm sales, profits, and strategy

When Do Firms Use The Foreign Exchange Market?  International companies use the foreign exchange market when  the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies  they must pay a foreign company for its products or services in its country’s currency  they have spare cash that they wish to invest for short terms in money markets. E.g. if interest rates are higher in foreign locations than at home.  they are involved in currency speculation - the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

Example:  For instance, a company has $1 million to invest in three months. It suspects that the US dollar is overvalued against Pakistani rupee. It expects the value of the dollar to depreciate against that of Pakistani Rupee. Imagine the current exchange rate is $1=Rs 100. The company exchanges its $1 million into Pakistani rupee, receiving Rs 100 million. Over the next three months the value of dollar depreciates until $ 1= Rs 95, now the company exchanges its Rs 100 million back to dollar and gets $ 1.05 million. The company has made $50,000 profit on currency speculation in three months.

How Can Firms Hedge Against Foreign Exchange Risk?  The foreign exchange market provides 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 insures itself against foreign exchange risk is hedging  To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges - two parties agree to exchange currency and execute the deal at some specific date in the future using a forward exchange rate.

What Is The Difference Between Spot Rates And Forward Rates?  The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day  spot rates change continually depending on the supply and demand for that currency and other currencies  A forward exchange rate is the rate used for hedging in the forward market  rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

 So, if you know you’re going to need 200,000 yen in 30 days to pay for some components your company imports, rather than taking the chance that the rate might change over the 30 days, you might enter into a forward agreement to buy the yen now and lock–in the rate, and pay for them in 30 days when your need them. Forward rates are quoted 30, 90, and 180 days into the future.  In contrast, a spot exchange rate is the rate at which a foreign exchange dealer coverts one currency into another currency on a particular day. So, when you’re on a trip to Germany and you change dollars for euros, you’ll get the spot rate for the day.  Spot rates can be quoted either in terms of how much foreign currency the dollar will buy, so using the chart in your text, you would know that one dollar would buy about €.79 in February of 2009, or spot rates can be quoted in terms of how many dollars you get for one unit of foreign currency, so one euro would buy about $1.26.  Keep in mind that spot rates are continually changing based on supply and demand for that currency.

 In forward exchange rate, you sell a currency at a  Discount: Dollar is selling at a discount on the 30 day forward market (it is worth more on the spot market than 30-day forward market). On 15/05/2015, you have $1 and you can buy Rs. 102 from it, but on 15/06/2015 you can buy Rs. 98 from it.  Premium: Dollar is selling at a premium on the 30-day forward market. On 15/05/2015, you have $1 and you can buy Rs. 102 from it, but on 15/06/2015 you can buy Rs. 105 from it.

What Is A Currency Swap?  A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates  Swaps are transacted  between international businesses and their banks  between banks  between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

 A currency swap is an exchange of a liability in one currency for a liability in another currency.  Nature: US corporation with operations in France can obtain comparatively better terms by borrowing dollars, but prefers a loan in euros. French corporation with operations in the US can obtain comparatively better terms by borrowing euros, but prefers a loan in dollars. The two companies could go to a swap bank who could arrange for a loan swap.

Example:  An American multinational company (Company A) may wish to expand its operations into Brazil. Simultaneously, a Brazilian company (Company B) is seeking entrance into the U.S. market. Financial problems that Company A will typically face stem from Brazilian banks' unwillingness to extend loans to international corporations. Therefore, in order to take out a loan in Brazil, Company A might be subject to a high interest rate of 10%. Likewise, Company B will not be able to attain a loan with a favourable interest rate in the U.S. market. The Brazilian Company may only be able to obtain credit at 9%.  Company A could hypothetically take out a loan from an American bank at 4% and Company B can borrow from its local institutions at 5%.  The loans are then swapped.

9-17 What Is 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  the most important trading centers are London, New York, Tokyo, and Singapore  the market is always open somewhere in the world—it never sleeps. Currencies are always being traded somewhere in the world.

9-18 Do Exchange Rates Differ Between Markets?  High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers  If 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 high  Most transactions involve dollars on one side—it is a vehicle currency along with the euro, the Japanese yen, and the British pound. 87% of all transactions in $.

Example:  For example, the if the dollar/Pakistani Rs exchange rate quoted in London at 3pm in $1=Rs. 95, the dollar rate in NY at 9pm should be identical, if it is $1=Rs. 100, a dealer could make a profit through arbitrage. If such prices differ then dealer could purchase Rs. 10,000,000 for $100,000 in NY and immediately sell them in London for $105,000 and make a quick profit of $10,000. Imagine all the dealers want to avail this investment opportunity and buy Rs from NY which results in appreciation of Rs in against dollar in NY, while increase in supply of Rs. in London would result in their depreciation there. The discrepancy between London and NY would disappear very quickly. It can take only few minutes.

Summary of the lecture  The foreign exchange market 1. is used to convert the currency of one country into the currency of another 2. provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates  The exchange rate is the rate at which one currency is converted into another  International companies use the foreign exchange market when  the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies  they must pay a foreign company for its products or services in its country’s currency  they have spare cash that they wish to invest for short terms in money markets. E.g. if interest rates are higher in foreign locations than at home.  they are involved in currency speculation - the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

 The foreign exchange market provides 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 insures itself against foreign exchange risk is hedging  To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges - two parties agree to exchange currency and execute the deal at some specific date in the future using a forward exchange rate.  The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day  spot rates change continually depending on the supply and demand for that currency and other currencies  A forward exchange rate is the rate used for hedging in the forward market  rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

 A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates  Swaps are transacted  between international businesses and their banks  between banks  between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk  The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems  If 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 high; Vehicle-currency.