The Foreign Exchange Market
A firm's sales, profits, and strategy are affected by events in the foreign exchange market
Foreign Exchange Market
is a market for converting the currency of one country into that of another country
Exchange rate
is the rate at which one currency is converted into another
The Functions of the Foreign Exchange Market
is used to convert the currency of one country into the currency of another
provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)
Currency Conversion
International companies use the foreign exchange market 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
Insuring Against Foreign Exchange Risk (1/3)
The foreign exchange market can be used to 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 insures itself against foreig
Insuring Against Foreign Exchange Risk (2/3)
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 depending on the supply and demand for that currency and other currencies.
Insuring Against Foreign Exchange Risk (3/3)
To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges.
A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.
A forward exch
The Nature Of The Foreign Exchange Market (1/2)
The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems�it is not located in any one place.
The most important trading centers are London, New York, Tokyo, and Singapor
The Nature Of The Foreign Exchange Market (2/2)
High-speed computer linkages between trading centers around the globe have effectively created a single market�there is no significant difference between exchange rates quotes in the differing trading centers.
If exchange rates quoted in different markets
The _______ is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
a) Currency swap rate
b) Forward rate
c) Specific rate
** Spot rate
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 (1/2)
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
Prices And Exchange Rates (2/2)
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 theory suggests that changes in relative prices between countries
Investor Psychology And Bandwagon Effects
Investor psychology also affects exchange rates.
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.
Governm
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
Exchange Rate Forecasting
Should companies use exchange rate forecasting services to aid decision-making?
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 ser
The Efficient Market School
An efficient market is one in which prices reflect all available information.
If the foreign exchange market is efficient, then forward exchange rates should be unbiased predictors of future spot rates.
Most empirical tests confirm the efficient market hy
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 b
Approaches To Forecasting
There are two schools of thought on forecasting:
Fundamental analysis draw upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates.
Technical analysis charts trends with the
Currency Convertibility
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
Implications For Managers
Firms need to understand the influence of exchange rates on the profitability of trade and investment deals
There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
Transaction Exposure
Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
It includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowin
Translation Exposure
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company
It is concerned with the present measurement of past events
Gains or losses are "paper losses" -they're unrealized
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
Reducing Translation And Transaction Exposure
To minimize transaction and translation exposure, firms can:
buy forward
use swaps
leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)
Reducing Economic Exposure
To reduce economic exposure, firms need to:
distribute productive assets to various locations so the firm's long-term financial well-being is not severely affected by changes in exchange rates.
ensure assets are not too concentrated in countries where lik
Other Steps For Managing Foreign Exchange Risk
In general, firms should:
have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies.
distinguish between transaction and translation exposure on the one hand, and econom
Firms that want to minimize transaction and translation exposure can do all of the following except
a) buy forward
** have central control of exposure
c) use swaps
d) lead and lag payables and receivables