2 The Foreign Exchange Market Chapter 10The Foreign Exchange Market
3 Why Is The Foreign Exchange Market Important? is used to convert the currency of one country into the currency of anotherprovides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange ratesThe exchange rate is the rate at which one currency is converted into anotherevents in the foreign exchange market affect firm sales, profits, and strategyLO1: Describe the functions of the foreign exchange market.The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.The Opening Case: Billabong illustrates how one company has faced the challenges of adverse exchange rate movements.
4 When Do Firms Use The Foreign Exchange Market? International companies use the foreign exchange market whenthe 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 currenciesthey must pay a foreign company for its products or services in its country’s currencythey have spare cash that they wish to invest for short terms in money marketsthey 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
5 How Can Firms Hedge Against Foreign Exchange Risk? The foreign exchange market provides insurance to protect against foreign exchange riskthe possibility that unpredicted changes in future exchange rates will have adverse consequences for the firmA firm that insures itself against foreign exchange risk is hedging
6 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 dayspot rates change continually depending on the supply and demand for that currency and other currenciesSpot exchange rates can be quoted as the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar for one unit of foreign currencyLO2: Understand what is meant by spot exchange rates.
7 What Is The Difference Between Spot Rates And Forward Rates? Value of the U.S. Dollar Against Other Currencies 2/12/11
8 What Is The Difference Between Spot Rates And Forward Rates? To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchangestwo parties agree to exchange currency and execute the deal at some specific date in the futureA forward exchange rate is the rate used for these transactionsrates for currency exchange are typically quoted for 30, 90, or 180 days into the futureLO3: Recognize the role that forward exchange rates play in insuring against foreign exchange risk.Management Focus: Volkswagen’s Hedging Strategy examines Volkswagen’s hedging strategy and why Volkswagen lost over €1 billion in 2003.
9 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 datesSwaps are transactedbetween international businesses and their banksbetween banksbetween governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk
10 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 systemsthe average total value of global foreign exchange trading in March, 1986 was just $200 billion, in April, 2010 it hit $4 trillion per daythe most important trading centers are London, New York, Zurich, Tokyo, and Singaporethe market is always open somewhere in the world—it never sleeps
11 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 centersIf exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitragethe process of buying a currency low and selling it high
12 Do Exchange Rates Differ Between Markets? Most transactions involve dollars on one side—it is a vehicle currency85% of all foreign exchange transactions involve the U.S. dollarother vehicle currencies are the euro, the Japanese yen, and the British poundChina’s renminbi is still only used for about 0.3% of foreign exchange transactions
13 How Are Exchange Rates Determined? Exchange rates are determined by the demand and supply for different currenciesThree factors impact future exchange rate movementsA country’s price inflationA country’s interest rateMarket psychologyLO4: Understand the different theories explaining how currency exchange rates are determined and their relative merits.
14 How Do Prices Influence 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 currencyotherwise there is an opportunity for arbitrage until prices equalize between the two marketsIn 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 currencyExample: U.S./Euro exchange rate: $1 = € .78A jacket selling for $50 in New York should retail for € in Paris (50x.78)
15 How Do Prices Influence Exchange Rates? Purchasing power parity theory (PPP) argues that given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a “basket of goods” should be roughly equivalent in each countrypredicts that changes in relative prices will result in a change in exchange rates
16 How Do Prices Influence Exchange Rates? A positive relationship exists between the inflation rate and the level of money supplywhen the growth in the money supply is greater than the growth in output, inflation will occurPPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short runa country with high inflation should see its currency depreciate relative to othersCountry Focus: Quantitative Easing, Inflation and the U.S. Dollar explores the notion of quantitative easing. The technique was used by the U.S. government to expand the money supply in Critics worried that the policy would lead to a decline in the value of the dollar.
17 How Do Prices Influence Exchange Rates? Question: How well does PPP work?Empirical testing of PPP theory suggests thatit is most accurate in the long run, and for countries with high inflation and underdeveloped capital marketsit is less useful for predicting short term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates
18 How Do Interest Rates Influence Exchange Rates? The International Fisher Effect states 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 two countriesIn 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 U.S. 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
19 How Does Investor Psychology Influence Exchange Rates? The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectationsinvestor psychology and bandwagon effects greatly influence short term exchange rate movementsgovernment intervention can prevent the bandwagon from starting, but is not always effectiveGovernment restrictions can include:A restriction on residents’ ability to convert the domestic currency into a foreign currencyRestricting domestic businesses’ ability to take foreign currency out of the countryGovernments will limit or restrict convertibility for a number of reasons that include:Preserving foreign exchange reservesA fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight
20 Should Companies Use Exchange Rate Forecasting Services? There are two schools of thoughtThe efficient market school - forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of moneyThe inefficient market school - companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting servicesLO5: Identify the merits of different approaches towards exchange rate forecasting.
21 Should Companies Use Exchange Rate Forecasting Services? An efficient market is one in which prices reflect all available informationif the foreign exchange market is efficient, then forward exchange rates should be unbiased predictors of future spot ratesMost empirical tests confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services
22 Should Companies Use Exchange Rate Forecasting Services? An inefficient market is one in which prices do not reflect all available informationin an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting servicesHowever, the track record of forecasting services is not good
23 How Are Exchange Rates Predicted? Two schools of thought on forecasting:Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange ratesTechnical analysis charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves
24 Are All Currencies Freely Convertible? A currency is freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currencyA currency is 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 wayA currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
25 Are All Currencies Freely Convertible? Most countries today practice free convertibilitybut many countries impose restrictions on the amount of money that can be convertedCountries limit convertibility to preserve foreign exchange reserves and prevent capital flightwhen residents and nonresidents rush to convert their holdings of domestic currency into a foreign currencymost likely to occur in times of hyperinflation or economic crisis
26 Are All Currencies Freely Convertible? When a currency is nonconvertible, firms may turn to countertradebarter-like agreements where goods and services are traded for other goods and serviceswas more common in the past when more currencies were nonconvertible, but today involves less than 10% of world trade
27 What Do Exchange Rates Mean For Managers? Managers need to consider three types of foreign exchange riskTransaction exposure - the extent to which the income from individual transactions is affected by fluctuations in foreign exchange valuesincludes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currenciesLO6: Compare and contrast the differences between translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.
28 What Do Exchange Rates Mean For Managers? Translation exposure - the impact of currency exchange rate changes on the reported financial statements of a companyconcerned with the present measurement of past eventsgains or losses are “paper losses”they are unrealized
29 What Do Exchange Rates Mean For Managers? Economic exposure - the extent to which a firm’s future international earning power is affected by changes in exchange ratesconcerned with the long-term effect of changes in exchange rates on future prices, sales, and costs
30 How Can Managers Minimize Exchange Rate Risk? To minimize transaction and translation exposure, managers shouldBuy forwardUse swapsLead and lag payables and receivableslead and lag strategies can be difficult to implement
31 How Can Managers Minimize Exchange Rate Risk? Lead strategy - attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciateLag strategy - delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate
32 How Can Managers Minimize Exchange Rate Risk? To reduce economic exposure, managers shouldDistribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange ratesEnsure assets are not too concentrated in countries where likely rises in currency values will lead to increases in the foreign prices of the goods and services the firm producesManagement Focus: Dealing with the Rising Euro describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper.
33 How Can Managers Minimize Exchange Rate Risk? In general, managers shouldHave central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategiesDistinguish between transaction and translation exposure on the one hand, and economic exposure on the other handAttempt to forecast future exchange ratesEstablish good reporting systems so the central finance function can regularly monitor the firm’s exposure positionProduce monthly foreign exchange exposure reports