1、Global Business Today 7eby Charles W.L.HillChapter 9The Foreign Exchange MarketIntroduction Question:What is the foreign exchange market?Answer:The foreign exchange market is a market for converting the currency of one country into that of another country Question:What is the exchange rate?Answer:Th
2、e exchange rate is the rate at which one currency is converted into another The Functions of the FX Market Question:What is the purpose of the foreign exchange market?Answer:The foreign exchange market enables the conversion of the currency of one country into the currency of another1.provides some
3、insurance against foreign exchange risk-the adverse consequences of unpredictable changes in exchange rates Currency ConversionInternational firms use foreign exchange marketsto convert export receipts,income received from foreign investments,or income received from licensing agreementsto pay a fore
4、ign company for products or services to invest spare cash for short terms in money marketsfor currency speculation-the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange ratesInsuring Against FX Risk The foreign exchange market can be used to
5、provide 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 protects itself against foreign exchange risk is hedging The market performs this function using spot exchange rates fo
6、rward exchange rates currency swaps Insuring Against FX Risk1.Spot Exchange Rate-the rate at which a foreign exchange dealer converts one currency into another currency on a particular daydetermined by the interaction between supply and demand,and so change continuallyInsuring Against FX Risk2.Forwa
7、rd Exchange Rates-the exchange rate governing a forward exchangeA forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the futureforward rates are typically quoted for 30,90,or 180 days into the futureInsuring Against FX Risk3.Currency Swa
8、p-the simultaneous purchase and sale of a given amount of foreign exchange for two different value datesswaps are used 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 FX MarketThe foreign exchange marke
9、t is a global network of banks,brokers,and foreign exchange dealers connected by electronic communications systemsThe market is always open somewhere in the worldif exchange rates quoted in different markets were not essentially the same,there would be an opportunity for arbitrage-the process of buy
10、ing a currency low and selling it highMost transactions involve U.S.dollars on one sidethe U.S.dollar is a vehicle currencyTheories of Exchange Rate Determination Question:What factors are important to future exchange rates?Answer:Three factors that have an important impact on future exchange rate m
11、ovements area countrys price inflation a countrys interest rate1.market psychologyPrices and Exchange Rates Question:How are prices related to exchange rate movements?Answer:To understand how prices and exchange rates are linked,we need to understand the law of one price,and the theory of purchasing
12、 power parity Prices and Exchange RatesThe law of one price-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 currencyPurchasing power parity theory-
13、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 Prices and Exchange RatesPPP predicts that changes in relative prices will result in changes in exchange rateswh
14、en inflation is relatively high,a currency should depreciateSo,if we can predict inflation rates,we can predict how a currencys value might changethe growth of a countrys money supply determines its likely future inflation rate when the growth in the money supply is greater than the growth in output
15、,inflation will occur Prices and Exchange Rates Question:How well does PPP theory work?Answer:Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run,but is relatively accurate in the long run Interest Rates and Exchange R
16、ates Question:How do interest rates affect exchange rates?Answer:The Fisher Effect states that a countrys 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(l)in other words,i=r+ISo,if the r
17、eal interest rate is the same everywhere,any difference in interest rates between countries reflects differing expectations about inflation rates Interest Rates and Exchange RatesThe International Fisher Effect suggests that for any two countries,the spot exchange rate should change in an equal amou
18、nt but in the opposite direction to the difference in nominal interest rates between the 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 US and Japan),S1 is the spot exchange rate at the beginning of the peri
19、od and S2 is the spot exchange rate at the end of the period Investor Psychology and Bandwagon Effect Question:How are exchange rates influences by investor psychology?Answer:The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies,and traders join th
20、e bandwagon and move exchange rates based on group expectationsgovernmental intervention can prevent the bandwagon from starting,but is not always effectiveSummaryRelative monetary growth,relative inflation rates,and nominal interest rate differentials are all moderately good predictors of long-run
21、changes in exchange rates,but poor predictors of short term changes So,international businesses should pay attention to countries differing monetary growth,inflation,and interest rates Exchange Rate Forecasting Question:Should companies invest in exchange rate forecasting services to help with decis
22、ion-making?Answer:The efficient market school-forward exchange rates are the best predictors of future spot exchange ratesinvesting in forecasting services is a waste of moneyThe inefficient market school-companies should invest in forecasting services forward rates are not the best predictor of fut
23、ure spot ratesThe Efficient Market SchoolAn efficient market-one in which prices reflect all available informationif the foreign exchange market is efficient,forward exchange rates should be unbiased predictors of future spot rates Most empirical tests confirm the efficient market hypothesis suggest
24、ing that companies should not waste their money on forecasting services,but some recent studies have challenged the theory The Inefficient Market SchoolAn inefficient market-one in which prices do not reflect all available informationin an inefficient market,forward exchange rates are not the best p
25、redictors 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 questionable Approaches to Forecasting Question:How should exchange rate forecasts be prepared?Answer:There are two appro
26、aches to exchange rate forecastingfundamental analysis1.technical analysisApproaches to Forecasting1.Fundamental Analysis-draws upon economic factors like interest rates,monetary policy,inflation rates,or balance of payments information to predict exchange rates2.Technical Analysis-focuses on trends
27、 and believes that past trends and waves are reasonable predictors of future trends and waves Currency Convertibility Question:Are all currencies freely convertible?Answer:A currency is freely convertible when both residents and non-residents can purchase unlimited amounts of foreign currency with t
28、he domestic currencyA currency is externally convertible when only non-residents can convert their holdings of domestic currency into a foreign currencyA currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign
29、 currencyCurrency Convertibility Question:Why do countries limit currency convertibility?Answer: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 forei
30、gn currencyIn the case of a nonconvertible currency,firms may turn to countertrade(barter like agreements by which goods and services can be traded for other goods and services)to facilitate international tradeImplications for Managers Question:What does the foreign exchange market mean for internat
31、ional firms?Answer:Firms must understand the influence of exchange rates on the profitability of trade and investment deals This exchange rate risk can be divided into Transaction exposure Translation exposure1.Economic exposureTransaction ExposureTransaction exposure-the extent to which the income
32、from individual transactions is affected by fluctuations in foreign exchange valuescan lead to a real monetary loss Translation ExposureTranslation exposure-the impact of currency exchange rate changes on the reported financial statements of a company deals with the present measurement of past event
33、sGains and losses from translation exposure are reflected only on paperEconomic ExposureEconomic exposure-the extent to which a firms 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
34、 costsReducing FX Exposure Question:How can firms minimize translation and transaction exposure?Answer:Firms can buy forward use swapslead and lag payables and receivables-paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements Reducing FX E
35、xposure A lead strategy-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 appreciateA lag strategy-delaying collection of foreign currency receivables if t
36、hat currency is expected to appreciate and delaying payables if the currency is expected to depreciatelead and lag strategies can be difficult to implementReducing FX Exposure Question:How can a firm reduce economic exposure?Answer:To reduce economic exposure firms need to distribute productive asse
37、ts to various locations so the firms long-term financial well-being is not severely affected by changes in exchange ratesThis requires that the firms assets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goo
38、ds and services they produce Other Steps for Managing FX Risk Question:Are there other strategies to manage foreign exchange risk?Answer:To further manage foreign exchange risk,firms should 1.establish central control to protect resources efficiently and ensure that each subunit adopts the correct m
39、ix of tactics and strategies Other Steps for Managing FX Riskdistinguish 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
40、 the firms exposure positionproduce monthly foreign exchange exposure reports Classroom Performance SystemThe rate at which one currency is converted into another is the Exchange rate Cross rate Conversion rate Foreign exchange market Classroom Performance SystemThe rate at which a foreign exchange
41、dealer converts one currency into another currency on a particular day is the Currency swap rate Forward rate Specific rate Spot rate Classroom Performance SystemAll of the following impact future exchange rate movements except A countrys price inflation A countrys interest rate A countrys arbitrage opportunitiesa)Market psychology Classroom Performance SystemThe extent to which income from individual transactions is affected by fluctuations in foreign exchange values is Translation exposure Accounting exposure Transaction exposure Economic exposure
