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Chapter 10

The Foreign

Exchange Market

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10-2

Why Is The Foreign

Exchange Market Important? The foreign exchange market

1. is used to convert the currency of one countryinto the currency of another

2. provides some insurance against foreignexchange risk- the adverse consequences ofunpredictable changes in exchange rates

The exchange rate is the rate at which

one currency is converted into another events in the foreign exchange market affect

firm sales, profits, and strategy

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10-3

When Do Firms Use The

Foreign Exchange Market? 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 foreignfirms are in foreign currencies they must pay a foreign company for its products or

services in its countrys currency they have spare cash that they wish to invest for short

terms in money markets they are involved incurrency speculation - the short-

term movement of funds from one currency to anotherin the hopes of profiting from shifts in exchange rates

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10-4

How Can Firms Hedge Against

Foreign Exchange Risk?The foreign exchange market provides

insurance to protect against foreignexchange risk

the possibility that unpredicted changes infuture exchange rates will have adverseconsequences for the firm

A firm that insures itself against foreignexchange risk is hedging

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10-5

What Is The Difference Between

Spot Rates And Forward Rates?The spot exchange rate is the rate at which a

foreign exchange dealer converts one currencyinto another currency on a particular day

spot rates change continually depending on thesupply and demand for that currency and othercurrencies

Spot exchange rates can be quoted as the

amount of foreign currency one U.S. dollar canbuy, or as the value of a dollar for one unit offoreign currency

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10-6

What Is The Difference Between

Spot Rates And Forward Rates?Value of the U.S. Dollar Against Other Currencies 2/12/11

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What Is The Difference Between

Spot Rates And Forward Rates?To insure or hedge against a possible

adverse foreign exchange rate movement,firms engage in forward exchanges

two parties agree to exchange currency andexecute the deal at some specific date in thefuture

A forward exchange rate is the rate usedfor these transactionsrates for currency exchange are typically

quoted for 30, 90, or 180 days into the future

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What Is A Currency Swap?

A currency swap is the simultaneous purchaseand sale of a given amount of foreign exchangefor two different value dates

Swaps are transactedbetween international businesses and their banks

between banks

between governments when it is desirable to moveout of one currency into another for a limited periodwithout incurring foreign exchange rate risk

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Do Exchange Rates Differ

Between Markets?High-speed computer linkages between

trading centers mean there is nosignificant difference between exchange

rates in the differing trading centersIf exchange rates quoted in different

markets were not essentially the same,there would be an opportunity forarbitrage

the process of buying a currency lowand selling it high

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Do Exchange Rates Differ

Between Markets?Most transactions involve dollars on one

sideit is a vehicle currency

85% of all foreign exchange transactions

involve the U.S. dollar

other vehicle currencies are the euro, theJapanese yen, and the British pound

Chinas renminbi is still only used for about0.3% of foreign exchange transactions

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How Are Exchange Rates

Determined? Exchange rates are determined by the

demand and supply for differentcurrencies

Three factors impact future exchangerate movements

1. A countrys price inflation

2. A countrys interest rate

3. Market psychology

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How Do Prices

Influence Exchange Rates?The law of one price states that in

competitive markets free of transportationcosts and barriers to trade, identical

products sold in different countries mustsell for the same price when their price isexpressed in terms of the same currency

otherwise there is an opportunity for arbitrageuntil prices equalize between the two markets

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How Do Prices

Influence Exchange Rates?Purchasing power parity theory (PPP)

argues that given relatively efficientmarkets (a market with no impediments to

the free flow of goods and services) theprice of a basket of goods should be

roughly equivalent in each country

predicts that changes in relative prices willresult in a change in exchange rates

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How Do Prices

Influence Exchange Rates?A positive relationship exists between the

inflation rate and the level of money supply

when the growth in the money supply is greater than

the growth in output, inflation will occurPPP theory suggests that changes in relative

prices between countries will lead to exchangerate changes, at least in the short run

a country with high inflation should see its currencydepreciate relative to others

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How Do Interest Rates

Influence Exchange Rates?The International Fisher Effect states that for any

two countries the spot exchange rate shouldchange in an equal amount but in the oppositedirection to the difference in nominal interest

rates between two countries In other words:

[(S1 - S2) / S2 ] x 100 = i $ - i

where i$ and i are the respective nominalinterest rates in two countries (in this case theU.S. and Japan), S1 is the spot exchange rate atthe beginning of the period and S2 is the spotexchange rate at the end of the period

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How Does Investor Psychology

Influence Exchange Rates?The bandwagon effectoccurs when

expectations on the part of traders turn into self-fulfilling prophecies - traders can join thebandwagon and move exchange rates based ongroup expectationsinvestor psychology and bandwagon effects

greatly influence short term exchange ratemovements

government intervention can prevent thebandwagon from starting, but is not alwayseffective

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Should Companies Use Exchange

Rate Forecasting Services? There are two schools of thought

1. The efficient market school - forward exchangerates do the best possible job of forecasting

future spot exchange rates, and, therefore,investing in forecasting services would be awaste of money

2. The inefficient market school - companies can

improve the foreign exchange marketsestimate of future exchange rates by investingin forecasting services

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Should Companies Use Exchange

Rate Forecasting Services?

1. An efficient market is one in which pricesreflect all available information

if the foreign exchange market is efficient,

then forward exchange rates should beunbiased predictors of future spot rates

Most empirical tests confirm the efficient

market hypothesis suggesting thatcompanies should not waste their moneyon forecasting services

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Should Companies Use Exchange

Rate Forecasting Services?2. An inefficient market is one in which

prices do not reflect all availableinformation

in an inefficient market, forward exchangerates will not be the best possible predictorsof future spot exchange rates and it may beworthwhile for international businesses to

invest in forecasting services However, the track record of forecasting

services is not good

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How Are Exchange

Rates Predicted? Two schools of thought on forecasting:

1. Fundamental analysis draws upon economicfactors like interest rates, monetary policy,

inflation rates, or balance of paymentsinformation to predict exchange rates

2. Technical analysis charts trends with theassumption that past trends and waves arereasonable predictors of future trends andwaves

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10-24

Are All Currencies

Freely Convertible?Most countries today practice free convertibilitybut many countries impose restrictions on the

amount of money that can be convertedCountries limit convertibility to preserve foreign

exchange reserves and prevent capital flightwhen residents and nonresidents rush to

convert their holdings of domestic currencyinto a foreign currency

most likely to occur in times of hyperinflationor economic crisis

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10-25

Are All Currencies

Freely Convertible?When a currency is nonconvertible, firms may

turn to countertradebarter-like agreements where goods and

services are traded for other goods and

serviceswas more common in the past when more

currencies were nonconvertible, but todayinvolves less than 10% of world trade

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10-26

What Do Exchange Rates

Mean For Managers? Managers need to consider three types

of foreign exchange risk

1. Transaction exposure - the extent to

which the income from individualtransactions is affected by fluctuations inforeign exchange values includes obligations for the purchase or sale

of goods and services at previously agreedprices and the borrowing or lending of fundsin foreign currencies

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10-27

What Do Exchange Rates

Mean For Managers?2. Translation exposure - the impact of

currency exchange rate changes on thereported financial statements of a

company concerned with the present measurement of

past events

gains or losses are paper losses they are unrealized

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10-28

What Do Exchange Rates

Mean For Managers?3. Economic exposure - the extent to which

a firms future international earning

power is affected by changes in

exchange rates concerned with the long-term effect of

changes in exchange rates on future prices,

sales, and costs

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10-29

How Can Managers

Minimize Exchange Rate Risk? To minimize transaction and translation

exposure, managers should

1. Buy forward

2. Use swaps

3. Lead and lag payables and receivables

lead and lag strategies can be difficult toimplement

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10-30

How Can Managers

Minimize Exchange Rate Risk? Lead strategy - attempt to collect foreign

currency receivables early when a foreigncurrency is expected to depreciate and pay

foreign currency payables before they are duewhen a currency is expected to appreciate

Lag strategy - delay collection of foreigncurrency receivables if that currency is

expected to appreciate and delay payables ifthe currency is expected to depreciate

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10-31

How Can Managers

Minimize Exchange Rate Risk? To reduce economic exposure, managers

should

1. Distribute productive assets to various

locations so the firms long-term financial well-being is not severely affected by changes inexchange rates

2. Ensure assets are not too concentrated incountries where likely rises in currency valueswill lead to increases in the foreign prices of thegoods and services the firm produces

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