The Foreign Exchange Market
THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
Currency Conversion
Insuring Against Foreign Exchange Risk
THE NATURE OF THE FOREIGN EXCHANGE MARKET
ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION
Prices and Exchange Rates
Interest Rates and Exchange Rates
Investor Psychology and Bandwagon Effects
EXCHANGE RATE FORECASTING
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
CURRENCY CONVERTIBILITY
FOCUS ON MANAGERIAL IMPLICATIONS
Transaction Exposure
Translation Exposure
Economic Exposure
Reducing Translation and Transaction Exposure
Reducing Economic Exposure
Learning Objectives
1. Be conversant with the functions of the foreign exchange market.
2. Understand what is meant by spot exchange rates.
3. Appreciate the role that forward exchange rates play in insuring against foreign exchange risk.
4. Understand the different theories explaining how currency exchange rates are determined and their relative merits.
5. Be familiar with the merits of different approaches toward exchange rate forecasting.
6. Understand the differences between translation, transaction and economic exposure, and what managers can do to manage each type of exposure.
Chapter Summary
This chapter focuses on the foreign exchange market. At the outset, the chapter explains how the foreign exchange market works. Included in this discussion is an explanation of the difference between spot exchange rates and forward exchange rates. The nature of the foreign exchange market is discussed, including an examination of the forces that determine exchange rates. In addition, the author provides a discussion of the degree to which it is possible to predict exchange rate movements. Other topics discussed in the chapter include exchange rate forecasting, currency convertibility, and the implications of exchange rate movements on business. Finally, the chapter concludes with a discussion of the implications of exchange rates for businesses. For instance, it is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable.
INTRODUCTION
A) This chapter has three main objectives. The first objective is to explain how the foreign exchange market works. The second objective is to examine the forces that determine exchange rates and to discuss the degree to which it is possible to predict exchange rate movements. The third objective is to map the implications for international business of exchange rate movements and the foreign exchange market.
B) The foreign exchange market is a market for converting the currency of one country into that of another country.
C) The exchange rate is the rate at which one currency is converted into another.
D) Dealing in multiple currencies is a requirement of doing business internationally. Therefore, it is important to understand the risks involved and how varying exchange rates affect the attractiveness of different investments and deals over time. Firms can use the foreign exchange market to hedge the risk of adverse exchange rate changes, but doing so can prevent firms from benefiting from favorable changes.
THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
A) The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates). Currency Conversion
B) International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. Third, international businesses use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. Finally, currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.
Insuring Against Foreign Exchange Risk
C) A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk.
Spot Exchange Rates
D) 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, and are determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies.
Forward Exchange Rates
E) 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.
F) Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future. Currency Swaps
G) 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.
THE NATURE OF THE FOREIGN EXCHANGE MARKET
A) The foreign exchange market is not located in any one place. Rather, it 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, Zurich, Tokyo, and Singapore. Two significant features of the market are (1) it never sleeps, and (2) high-speed computer linkages between trading centers around the globe have effectively created a single market.
B) The exchange rates quoted worldwide are basically the same. If different U.S. dollar/Japanese yen rates were being offered in New York and Tokyo, there would be an opportunity for arbitrage and the gap would close. An illustrative example can be done showing how someone could make money through arbitrage (buying a currency low and selling it high), and how this would affect the supply and demand for the currencies in both markets to close the gap.
C) The U.S. dollar frequently serves as a vehicle currency to facilitate the exchange of two other currencies.
ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION:
A) At the most basic level, exchange rates are determined by the demand and supply for different currencies. Most economic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a country’s currency: the country’s price inflation, the country’s interest rate, and market psychology.
Prices and Exchange Rates
B) To understand how prices are linked to exchange rates, it is important to understand the law of one price.
The Law of One Price
C) The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), 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
D) If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. A less extreme version of the PPP theory states that given relatively efficient markets– that is, 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
E) There is a positive relationship between the inflation rate and the level of money supply. When the growth in a country’s money sup ply is greater than the growth in its output, inflation will occur.
A country with a high inflation rate will see a depreciation in its currency.
F) Simply put, PPP suggests that changes in relative prices between countries will lead to exchange rate changes. The empirical tests suggest that this relationship does not hold in the long run, but not in the short run. While PPP assumes no transportation costs or barriers to trade and investment, it also assumes that governments do not intervene to affect their exchange rates – a topic for the next chapter.
Empirical Tests of PPP Theory
G) Extensive empirical testing of the PPP theory has not shown it to be completely accurate in estimating exchange rate changes.
Interest Rates and Exchange Rates
H) Interest rates also affect exchange rates. The Fisher Effect says 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 (I).
i = r + I
I) 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 countries. Stated more formally:
(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.
J) While interest rate differentials suggest future exchange rates, this appears to hold in the long run but not necessarily in the short run.
Investor Psychology and Bandwagon Effects
K) Investor psychology and bandwagon effects can also influence exchange rate movements. Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and move exchange rates based on group expectations. This is known as the bandwagon effect. While such changes can be important in explaining some short-term exchange rate movements, they are very difficult to predict. At times governmental intervention can prevent the bandwagon from starting, but at other times it is ineffective and only encourages traders.
L) Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. Consequently, international businesses should pay attent ion to countries’ differing monetary growth, inflation, and interest rates.
EXCHANGE RATE FORECASTING
A) A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision-making. Two schools of thought address this issue. One school, the efficient market school, argues that forward exchange rate do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investi ng in forecasting services.
The Efficient Market School
B) Many economists believe the foreign exchange market is efficient at setting forward rates. An efficient market is one in which prices reflect all available information. There have been a large number of empirical tests of the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services), some recent studies have challenged it.
The Inefficient Market School
C) An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates. If this is true, it may be worthwhile for international businesses to invest in forecasting services (and many do).
Approaches to Forecasting
D) Two approaches to forecasting exchange rates are fundamental analysis and technical analysis. Fundamental Analysis.
E) Forecasters that use fundamental analysis draw upon economic theories to predict future exchange rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments information.
Technical Analysis
F) 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
A) Many currencies are not freely convertible into other currencies. A currency is said to be 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.
B) A currency is said to be 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.
C) 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).
D) Countertrade refers to a range of barter like agreements by which goods and services can be traded for other goods and services. It can be used in international trade when a country’s currency is nonconvertible.
IMPLICATIONS FOR MANAGERS
A) First, it is absolutely critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals. Foreign exchange risk can be divided into three main categories: transaction exposure, translation exposure, and economic exposure.
Transaction Exposure
B) Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
Translation Exposure
C) Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Translation exposure is basically concerned with the present measurement of past events.