The Foreign Exchange Market

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

T he foreign exchange market is a market for converting the currency of one country into that of another country The exchange rate is the rate at which one currency is converted into another

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 (the adverse consequences of unpredictable changes in exchange rates)

Classroom Performance System The rate at which one currency is converted into another is the Exchange rate Cross rate Conversion rate Foreign exchange market Classroom Performance System Answer: a

Currency Conversion International businesses use foreign exchange markets 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 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) Internet Extra: To see real time currency conversions, go to XE.com { Click on Quick Currency converter, and enter the currencies you want to convert.

Insuring Against Foreign Exchange Risk The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possible adverse consequences of unpredictable changes in exchange rates) Spot Exchange Rates The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day

Forward Exchange Rates A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future A forward exchange rate occurs when two parties agree to exchange currency and execute the deal at some specific date in the future Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

Currency Swaps 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, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk Management Focus: South African Airlines’ Disastrous Currency Hedge Summary This feature examines how the failure to fully insure against foreign exchange rate risk can have severe negative consequences for a firm. In 2002, South African Airlines entered into forward contracts to protect itself against a drop in the South African rand relative to the dollar. The rand had been weak against the dollar for several years and South African Airlines felt this trend was likely to continue. The company ran into trouble when the rand appreciated by almost 30 percent relative to the dollar in 2002 and early Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. What type of exposure was South African Airlines facing in 2002? Why do you think the company failed to adequately protect itself? 2. How should South African Airlines have hedged its foreign exchange exposure? What can other companies learn from the experiences of South African Airlines?

Classroom Performance System The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the Currency swap rate Forward rate Specific rate Spot rate Classroom Performance System Answer: d

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

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), and the gap would close The US dollar is often used as a vehicle currency to facilitate the exchange of other currencies Internet Extra: Companies can anticipate how currencies might move by following various economic and political indicators. To explore the effect of these indicators on exchange rates, go to { Examine the effect of factors such as interest rates and geo-political tensions on exchange rates. What happens to a currency’s value of exchange rates or exports rise, or there is a threat of terrorism? What factors should companies track to better predict what might happen to a currency’s value?

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

Prices and Exchange Rates The Law of One Price 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 PPP 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

Money Supply and Price Inflation A positive relationship between the inflation rate and the level of money supply exists When the growth in the money supply is greater than the growth in output, inflation will occur PPP suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run

Empirical Tests of PPP Theory Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes

Interest Rates and Exchange Rates Interest rates also affect exchange rates. The 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 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.

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

Investor Psychology and Bandwagon Effects Exchange rates can also be affected by investor psychology. The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join the bandwagon and move exchange rates based on group expectations Governmental intervention can prevent the bandwagon from starting, but is not always effective Country Focus: Why Did the Korean Won Collapse? Summary This feature describes South Korea’s 1997 financial crisis. In the space of a few months Korea saw its economy and currency move from prosperity to critical lows. Much of the blame for Korea’s financial collapse can be placed with the country’s chaebol (large industrial conglomerates) that had built up massive debts as they invested in new factories. Speculators, concerned about the chaebol’s ability to repay their debts, began to withdraw money from the Korean Stock and Bond markets fueling a depreciation in the Korean Won. Despite government efforts to halt the fall in the currency, the won fell some 67% relative to the dollar. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Discuss investor psychology and bandwagon effects and their role in accelerating Korea’s difficulties. 2. As a CEO of an American company, what or how does Korea’s situation affect your operations? 3. In your opinion, did the Korean government take the right steps to ease the crisis? Explain your response.

Summary Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates

Classroom Performance System All of the following impact future exchange rate movements except A country’s price inflation A country’s interest rate A country’s arbitrage opportunities Market psychology Classroom Performance System Answer: c

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 rates 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

The Efficient Market School An efficient market is one in which prices reflect all available information Most empirical tests seem to confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services

The Inefficient Market School An inefficient market is one in which prices do not reflect all available information So, in 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 services

Approaches to Forecasting Fundamental Analysis Forecasters that use fundamental analysis to predict exchange rates draw upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information

Technical Analysis Forecasters that use technical analysis typically chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves

CURRENCY CONVERTIBILITY Convertibility and Government Policy 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 currency A 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 way A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

Free convertibility is the norm in the world today, although many countries impose some restrictions on the amount of money that can be converted The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency). When a country’s currency is nonconvertible, firms may turn to countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade

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 Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

Translation Exposure Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company Management Focus: Translation Exposure at Baxter International Summary This feature describes impact of changing exchange rates for Baxter International, a U.S. producer of medical products. In 2000, Baxter’s CEO predicted that the company would hit earnings and sales targets for 2000, and grow revenues and earning in However, just three months later the company reported that growth would be slower than previously anticipated due to the continuing weakness of the euro against the U.S. dollar. About 27 percent of the company’s earnings came from European sources and the weak euro meant that its revenues would decline significantly. Suggested Discussion Questions 1. Consider the experience of Baxter International in Explain which type(s) of foreign exchange exposure the company faced. How could the company protect itself from the exposure? 2. Why didn’t Baxter International hedge its exposure to the falling euro? 3. As an investor, how do you feel about Baxter’s response to the declining euro? Did the company make the right decisions? How would you have acted differently?

Economic Exposure Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates Economic exposure is concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs Management Focus: Translation Exposure at Baxter International Summary This feature describes impact of changing exchange rates for Baxter International, a U.S. producer of medical products. In 2000, Baxter’s CEO predicted that the company would hit earnings and sales targets for 2000, and grow revenues and earning in However, just three months later the company reported that growth would be slower than previously anticipated due to the continuing weakness of the euro against the U.S. dollar. About 27 percent of the company’s earnings came from European sources and the weak euro meant that its revenues would decline significantly. Suggested Discussion Questions 1. Consider the experience of Baxter International in Explain which type(s) of foreign exchange exposure the company faced. How could the company protect itself from the exposure? 2. Why didn’t Baxter International hedge its exposure to the falling euro? 3. As an investor, how do you feel about Baxter’s response to the declining euro? Did the company make the right decisions? How would you have acted differently?

Reducing Translation and Transaction Exposure Firms can minimize their foreign exchange exposure by: buying forward and using swaps leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)

A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Lead and lag strategies can be difficult to implement.

Reducing Economic Exposure The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates Reducing economic exposure necessitates that the firm ensure its assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce

Classroom Performance System The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is Translation exposure Accounting exposure Transaction exposure Economic exposure Classroom Performance System Answer: c

Other Steps for Managing Foreign Exchange Risk To manage foreign exchange risk: central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand firms should attempt to forecast future exchange rates firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position firms should produce monthly foreign exchange exposure reports

CRITICAL THINKING AND DISCUSSION QUESTIONS 1. The interest rate on South Korean government securities with one-year maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The US interest rate on government securities with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot exchange rate for Korea won is $1 = W Forecast the spot exchange rate one year from today. Explain the logic of your answer. Answer: From the Fisher effect, we know that the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

CRITICAL THINKING AND DISCUSSION QUESTIONS 2. Two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound. (a) According to PPP theory, what should the $/£ spot exchange rate be? (b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate? (c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10 percent, what would you expect current interest rate to be in Britain? Answer: (a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£. (b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or .67$/£. (c) Since the dollar is appreciating relative to the pound, and given the relationship of the international fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

CRITICAL THINKING AND DISCUSSION QUESTIONS 3. You manufacture wine goblets. In mid June you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid December. You expect the yen to rise from its present rate of $1=¥130 to $1=¥100 by December. You can borrow yen at 6% per annum. What should you do? Answer: The simplest solution would be to just wait until December, take the ¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100. In this case you would have $4,000 in mid-December. If the current 180 day forward rate is lower than 100¥/$, then it would be preferable since it both locks in the rate at a better level and reduces risk. If the rate is above ¥100/$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion. There is a third possibility also. You could borrow money from a bank that you will pay back with the ¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4, ,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be ¥100 = $1.

CRITICAL THINKING AND DISCUSSION QUESTIONS 4. You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take? Answer: This question deals with the risk faced by businesses related to changes in exchange rates. If the peso depreciates as expected peso relative to the dollar, the dollar value of the company’s Mexican subsidiary would decrease substantially. This would then reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet, raising the apparent leverage of the firm, which could increase the firm’s cost of borrowing and limit its access to the capital market. Most students will suggest that the company explore the use of forward contracts and swaps to protect itself from the currency movement for individual transactions. In addition, the company may want to engage in a lead strategy and collect its foreign receivables early.

The Foreign Exchange Market

Similar presentations

Presentation on theme: "The Foreign Exchange Market"— Presentation transcript:

Similar presentations

About project

Feedback

Log in

Auth with social network:

The Foreign Exchange Market

Similar presentations

Presentation on theme: "The Foreign Exchange Market"— Presentation transcript:

Similar presentations

About project

Feedback