Chapter 10: The Foreign Exchange Market (In Class)

Apple lost $5 billion in revenue from

a strong US dollar
(gets 66% of revenue from outside the US)

Foreign Exchange Market

global decentralized or over-the-counter market for the trading of currencies. This market determines the foreign exchange rate.

Foreign Exchange Risk

Adverse consequences of unpredictable changes in exchange rates

Currency Conversion is used to

convert export receipts, incomes from foreign, pay MultiNats

Currency Speculation

Short term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates

Carry Trade

Borrows one currency where interest rates are low and invest in another currency where interest is high

The foreign exchange market can provide

insurance against foreign exchange risk

Protecting your firm from foreign exchange risk is called


Hedging is performed by using

spot exchange rates
forward exchange rates
currency swaps

Spot exchange rates

Rate of converting one currency into another currency on a particular day

Spot exchange rates are determined by

supply and demand, so it changes constantly

Forward Exchange rates

When two parties agree to exchange currency and make a deal at a specific date in the future

Forward Exchange rates are determined by

30,90,180 days in the future. (These are what they used back in the day)
Can sometimes work against a company

Currency Swaps

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

When are swaps used?

When its desired to move out of one currency into another for a limited time without occurring foreign exchange rate risk


The process of buying a currency low and selling it high

Most transactions involve

US dollars on one side

The US dollar is a

vehicle currency

China wants to become a

vehicle currency

Three factors that impact future exchange rate movements

Interest rates
Market Psychology

Law of one price

Identical products sold in different countries must sell for the same price

Purchasing Power Parity

A monetary measurement of development that takes into account what money buys in different countries
Basket of goods comapred

Efficient markets

Markets where few impediments exist

Fisher Effect

Nominal interest rate (i) is the sum of the required real rate of interest (r)over the expected rate of inflation (l)
i = r + l

International Fisher Effect

differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.

Bandwagon effect

expectations on the part of traders turn into self-fulfilling prophecies and traders join.
Moves exchange rates based on group exceptions

Efficient Market

Prices reflect all available information
Forward exchange rates are the best predictors of future
Investing in forecasting is a waste of time

Inefficient Market

Forward exchange rates are NOT the best predictors of future
Investing in forecasting is a great use of time

Freely convertible

Both residents and nonresidents can purchase unlimited amounts of foreign currency with their domestic currency

Externally convertible

Only non-residents can convert their holdings of domestic currency into a foreign currency


Both residents and non residents are prohibited from converting into a foreign currency

Transaction exposure

The extent to which the income from individual transactions is affected by fluctuations in foreign exchange rates

Translation exposure

Impact of currency exchange rate changes on the reported financial statements of a company

Economic Exposure

The extent to which a firm'f future international earning power is affect by changes in exchange rates