Foreign Exchange Market
a market for converting the currency of one country into the currency of another
Exchange Rate
the rate at which one current is converted into another
Foreign Exchange Risk
the risk that changes in exchange rates will hurt the profitability of a business deal
Main Function of the Foreign Exchange Market (currency conversion)
-companies receiving payment in foreign currencies need to convert to home currency
-companies paying the foreign businesses for goods or services
-companies invest spare cash for short terms in money market accounts
-currency speculation
Spot Exchange rate
the exchange rate at which a foreign exchange dealer will convert one currency into another currency on a particular day
Forward exchange rate
when two parties agree to exchange currency and execute the deal at some specific date in the future
Currency Swap
simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
Floating exchange rate
a system under which the exchange rate for converting one currency into another is continuously adjusted depending on the laws of supply and demand
Pegged exchange rate
Currency value is fixed relative to a reference currency
Dirty float system
a system under which a country's currency is nominally allowed to float freely against other currencies but in which the government will intervene buying and selling currency if it believes that the currency has deviated too far from its fair value
Fixed exchange rate
a system user which the exchange rate for converting one currency into another is fixed
Law of one price
in 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 the same currency
Purchasing Power Parity (PPP)
-If the law of one price holds for all goods and services, the PPP exchange rate can be found by comparing the prices of identical products in different countries
-Changes in relative prices will change exchange rates
-inflation occurs when the money supp
Interest Rates
reflect expectations about the future of ___ ____, high ___ ____ reflect high inflation expectation
Fisher Effect
i=r+I
i="Nominal" interest rate in a country
r="real" interest rate
I= inflation over the period the funds are to be lent
International Fisher Effect
(S1-S2)/S2*100=i$-iY
for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries
S1=spot rate at time
S2=spot rate at time 1
i$,iY=nomina
Bandwagon Effect
When traders move like a herd, all in the same direction and at the same time in response to each others' perceived actions
Factors affecting currency valuations (Economic)
Inflation
interest rates
monetary and fiscal policy
government controls and incentives
monetary reserves
international competitiveness
balance of payments
importance of currency in the world
Factors affecting currency valuations (political)
political party and leaders philosophies
proximity of elections or change in leadership
Factors affecting currency valuations (expectation)
expectations
forward exchange market prices
The efficient market school
prices reflect all available public information
The inefficient market school
prices do not reflect all available public information
Fundamental analysis
draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements
Technical analysis
uses prices and volume data to determine past trends, which are expected to continue into the future
freely convertible
a country's currency is freely convertible when the government of that country allows both residents and non residents to purchase unlimited amounts of a foreign currency with it
Externally convertible
nonresidents can convert their holdings of domestic currency into foreign currency but the ability of residents to convert the currency is limited in some way
Non-convertible
a currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency
transaction exposure
extent which income from individual transactions is affected by fluctuations in foreign exchange values
translation exposure
the extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuates in foreign exchange values
economic exposure
the extent to which a firm's future international earning power is affected by changes in exchange rates
Ways to reduce foreign exchange risk
-central control of exposure is needed to protect resource efficiently and ensure that each subunit adopts te correct mix of tactics and strategies
-distinguish between transaction and translation exposure and economic exposure
-need to forecast future ex
History of the global monetary system
-Gold & Siver (until 1870)
-Gold standard (1870s to 1939)
-Bretton Woods system of fives exchange rates (1944-1973) dollar backed by gold, established IMF and World Bank, created fixed exchange rate
-Floating exchange rates (1973-present) US dollar not ba