The Foreign Exchange Market -Chapter 10

Maria G. Perez, Trevor Mcdonald, Mike Spalding, Lydia Gellis, Ricardo Cantu, Kevin Calderon, Andrew Mitchell

• Foreign Exchange Market: is a market for converting the currency of one country into that of another country.

• Exchange Rate: is simply the rate at which one currency is converted into another. • Ex: an exchange rate of 1 euro= $1.30

specifies that 1 euro buys 1.30 U.S dollars

Foreign Exchange Market

Two main functions:

1) Convert the currency of one country into the currency of another.

2) Provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.

• Without the foreign exchange market, international trade & international investment on the scale that we see today would be impossible; companies would have to resort to barter.

• The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other.

Risks

• International trade and investment have risks.

• Some of these risks exist because future exchange rates cannot be perfectly predicted.

• The rate at which one currency is converted into another can change over time.

Currency Conversion

• Each country has a currency in which the prices of goods and services are quoted.

• U.S: Dollar

• Great Britain: Pound

• France, Germany, & the other 15 members of the euro zone: Euro

• Japan: Yen

Foreign Exchange Market participation

Italian WineMust use

National

Currency

Currency Speculation

is another use of foreign exchange markets. It involves short-term movement of funds from one currency to another in the hopes of profiting from shift in exchange rates.

• Very risky business: the company cannot know what will happen to exchange rates.

Carry Trade

• A kind of speculation that has become more common in recent years.

Spot Exchange Rate

• The rate at which a foreign exchange dealer converts one currency into another on a particular day.

• They are reported on a real-time basis on many financial websites, they change continually.

Forward Exchange Rates

• Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.

• They are the exchange rate governing forward exchange transaction.

Currency Swaps• A currency swap is the simultaneous

purchase & sale of a given amount of foreign exchange for two different value dates. • Swaps are transacted between international

businesses & their banks, between banks, &between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk.

• A common kind of swap is spot against forward.

The Foreign Exchange Market is?

A) A market where all money is stored and invested.

B) A kind of speculation that has become more common in recent years.

C) A market for converting the currency of one country into that of another country.

D) The simultaneous purchase & sale of a given amount of foreign exchange for two different value dates.

Volkswagen’s Hedging Strategy

Volkswagen reported a 95% drop in Q4 profits in 2003

Two factors were focused on as the main causes

The sharp rise in the value of the euro against the dollar

Volkswagen’s decision to hedge 30% of its foreign currency exposure instead of 70%; like in the past

Exchange Rate: euro vs. dollar

€1=$1 in late 2002

Quickly rose to €1=$1.25 by the end of 2003

Exchange rate affecting Volkswagen

Volkswagen made cars in Germany, exported them to The United States, sold them in dollars, then brought the money back to Germany and exchanged them for euros

When the euro got stronger against the dollar it reduced the amount of euros VW got back for their cars sold in the U.S.

At a 1:1 ratio in 2002 VW made roughly €1,000 for every Jetta sold in U.S.

At 1:1.25 ratio in 2003, VW lost roughly €2,000

Hedging against changing exchange

ratesCompanies can lower risk of doing business in foreign currency by buying a forward contract that allows them to exchange two currencies in the future (in 180 days for example) at the current exchange rate

Upside:In the example of VW, the weaker the euro was in 2002 would have helped them make more money in 2003

Downside:If the euro gets weaker against the dollar and VW has a contract in place, they miss out on more profits by having to exchange at the contract rate

The Nature of the Foreign Exchange Market

Foreign Exchange Market: A network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

• Rapid growth of the foreign exchange market• March 1986: $200 billion exchanged per day

• April 1995: $1,200 billion per day

• April 2007: $3.21 trillion per day

• April 2010: $4 trillion per day

• Activity centers• London (37% of trading activity)

• New York (18% of trading activity)

• Zurich, Tokyo, Singapore (5% respectively)

The Nature of the Foreign Exchange Market

Most transactions are done with the dollar on one side of the equation, even if that is not the end goal of the person making the transaction

Example: a broker wanting to trade Bazillion real for Korean won will trade real for dollars, then dollars for won

Economic Theories of Exchange Rate Determination

The Law of One PriceIn 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 the same currency

According to this theory differences in price will work themselves out based on the law of supply and demand

Higher demand will increase the price in one market and reduced demand in the other market will lower the price till they reach equilibrium

This theory keeps brokers from buying goods in one country and then selling those goods in another where the exchange rates gives them a profitable advantage

Economic Theories of Exchange Rate Determination (cont.)

Purchasing Power ParityGiven a relatively efficient market (market with few impediments to trade) and a basket of predetermined goods in two currencies, one can determine the exchange rate with the following formula

Purchasing Power Parity (cont.)

So; given a basket of goods in dollars, and the same basket of goods in yen, the exchange rate can be easily found using the formula

$200

¥20,000

Exchange rate (S)=$200/¥20,000$1=¥100

Money Supply & Price Inflation

A country with a high rate of inflation should expect its’ currency to depreciate against the currency of another country where the inflation rate is lower

A country with a high growth rate of money supply should expect high inflation

Thus, a country with a high growth rate of money supply should expect a weaker exchange rate

Inflation

Occurs when the amount of currency in circulation grows at a rate greater than the output of goods and services, causing businesses to increase the prices due to the increase in demand

Government Role in Controlling the Money Supply

Governments often increase the money supply to pay for large public expenditures (building roads, etc.), instead of increasing taxes to pay for them

This may be more popular in the short-term to avoid paying higher taxes, it can lead to long-term inflation

Quantitative Easing in the U.S.

Fall 2010: the Federal Reserve decided to pump $600 billion into the economy by purchasing government bonds

Critics argued that this action would lead to a weaker dollar and higher inflation levels

The FED was very afraid of deflation at the time and the extra money would help to kick-start the economy by increasing demand and putting people back to work

When looking at QE from the beginning of 2010 to the beginning of 2011, the exchange rate remained relatively unchanged when compared to other major currencies in the foreign market

Empirical Tests of PPP Theory

Purchasing Power Parity Theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates.

While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.

The theory seems to best predict exchange rate changes for countries with:

High rates of inflation

Underdeveloped capital markets

Empirical Tests of PPP Theory

PPP theory is less useful for predicting:Short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates.

Purchasing Power Parity Puzzle: The failure to find a strong link between relative inflation rates and exchange rate movements.

Several factors may explain the failure of PPP theory to predict exchange rates more accurately:

Assumes away transportation costs and barriers to trade

Governments routinely intervene in international trade (tariff and nontariff barriers)

Many national markets are dominated by a handful of multinational enterprises that have sufficient market power. (Example on next slide)

Empirical Tests of PPP Theory

Example: This dominance situation presents itself in a number of industries:

Detergent: Unilever and Procter & Gamble

Heavy earthmoving equipment: Caterpillar and Komatsu

Semiconductor equipment: Applied Materials

In such cases, dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions (Price discrimination).

Interest & Exchange Rates

Economic theory tells us that interest rates reflect expectations about likely future inflation rates.

In countries where inflation is expected to be high, interest rates also will be high.

This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect.

Fisher effect: states that a country’s “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.

More formally i = r + I

Interest & Exchange Rates

For example:If the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent (i = 5 + 10).

As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates.

Application in a world of many countries and unrestricted capital flows:

When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real interest rates did emerge between countries, arbitrage would soon equalize them.

For example, if the real interest rate in Japan was 10% and only 6% in the U.S., it would pay investors to borrow money in the U.S. and invest it in Japan.

Interest & Exchange Rates

The International Fisher effect: 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 countries.

For example: the change in the spot exchange rate between the U.S. and Japan, can be modeled as follows:

[(S1 – S2) / S2] X 100 = i$ – IY

Where i$ and iY are the respective nominal interest rates in the U.S. and Japan, S1 is the spot exchange rate at the beginning of the period, and S2 is the spot exchange rate at the end of the period.

Interest & Exchange Rates

Do interest rate differentials help predict future currency movements?

The evidence is mixed

PPP theory, in the long run, there seems to be a relationship however, considerable short-run deviation occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot exchange rates.

Investor Psychology & Bandwagon Effects

Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates.

A famous example:In 1992, George Soros made a huge bet against the British pound.

He immediately sold those pounds for German deutsche marks (before the advent of the euro).

Known as short-selling (can earn enormous profits if he can subsequently buy back the pounds he sold at a much better exchange rate).

Investor Psychology & Bandwagon Effects

Example (cont.)By selling pounds and buying deutsche marks, Soros helped to start pushing down the value of the pound.

When Soros started shorting the pound, many foreign exchange traders, knowing Soros’s reputation, jumped on the bandwagon and did likewise.

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.

Investor Psychology & Bandwagon Effects

Investor psychology & bandwagon effects play an important role in determining short-run exchange rate movements.

However, these effects can be hard to predict.

Investor psychology can be influenced by:Political factors

Macroeconomic fundamentals (such as relative inflation rates)

Summary of Exchange Rate Theories

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates; they are poor predictors of short-run changes.

However, poor predictors of short-run changes can be influenced by psychological factors, investor expectations, and bandwagon effects on short-term currency movements.

The long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports are all influenced by long-term movements in exchange rates, international businesses would be advised to pay attention to:

Countries’ differing monetary growth

Inflation

Interest rates

Exchange Rate Forecasting

A company’s need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision making.

Two schools of thought address this issue:The Efficient Market School: argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, therefore, investing in forecasting services would be a waste of money.

The Inefficient Market School: argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services. This school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

The Efficient Market School

Many economists believe the foreign exchange market is efficient at setting forward rates.

Efficient Market: a market in which prices reflect all available public information.

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates

This does not mean the predictions will be accurate; it means inaccuracies will not be consistently above or below future spot rates. They will be random.

The Inefficient Market School

Inefficient Market: on in which prices do not reflect all available information.

Forward exchange rates will not be the best possible predictors of future spot exchange rates.

If true, it may be worthwhile for international businesses to invest in forecasting services.

Professional exchange rate forecasts might provide better predictions of future spot rates, however, professional forecasting services are not that good.

Example: forecasting services did not predict the rise of the dollar that occurred during late 2008 during the financial crisis. Many thought it would decline.

Approaches to Forecasting

Fundamental analysis: draws on economic theory to construct sophisticated econometric models fore predicting exchange rate movements.

Variables included in fundamental analysis include: relative money supply growth rates, inflation rates, balance-of-payments, and interest rates.

Example: running a deficit on a balance-of-payments current account (imports exceed exports) creates pressure that may result in the depreciation of the country's currency on the foreign exchange market.

Technical analysis: uses price and volume data to determine past trends, which are expected to continue into the future.

Based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves.

Currency Convertibility

Freely Convertible - Japanese yen (¥)

Externally Convertible Currency- Capital Flight - Fear restrictions, due to depreciation of a country’s currency - limit investing abroad - Rise on Import Prices - Depleting Foreign Exchange Reserves – N/A pay debts

Nonconvertible Currency - Soviet Union - Russia

QUESTION?

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

Externally Convertible Currency

Goal: Keep domestic currency in home country, i.e. avoiding losing value of their currency.

Currency Convertibility Cont.

Nonconvertible Currency

- Countertrade (Bartering) - “eye for an eye”

- Romanian Government – General Electric

- Venezuela Government – Caterpillar

- Indonesia Government (goods) – Libya ( oil)

Nonconvertible currency >10% ALL Govts.

Another Perspective

Billion’s of dollars are leaving Pakistan through Unofficial Channels

State Bank of Pakistan failed to control this

Politicians, Officials and Money Chargers involed

Money being transferred to Dubai and some other countries because the people of Pakistan are afraid to invest in their own country.

Managerial Implications

Transaction ExposureTransaction Exposure – Individual transactions affect foreign exchange values

- Project in 2004 cost $1 billion - ($1 = € 1.10) (€ 1.2/1.1 = $1.09 billion)

- Same project completed in 2008 – Now

($1 = € 0.80) (€1.2/.80 = $1.5 billion)

An Increase ^ of $ 0.41 Billion

Question?

Why should you forecast contractual agreements?

A. Because it is cool

B. Appreciation and Depreciation Reasoning

C. Product Life Cycle Theory

D. Porters 5 Forces

Translation Exposure

Translation Exposure – Individual short term transactions

EX: A US subsidiary in Mexico, and the Peso Depreciates = reduced $ value of firms equity

= Increased debt ratio & cost of borrowing & limit to capital market

Question?

The US has multiple firms/acquisitions/mergers located in Mexico. 5 of the largest Coca-Cola factories burn down, and in response the value of the Peso depreciates rapidly. What effects/outcomes should the US expect?

Decrease on ALL of their investments within Mexico

Economic Exposure

Economic Exposure – Earning power affected by exchange rates

EX: ^ value of US $ in 1990s hurt the price competitiveness of US producers in world markets

EX: Reverse Phenomena value of US $ declined & increased price competitiveness for US manufactures in world markets

Question?

In world markets, the fall in the value of the dollar benefits whom , in terms of price competitiveness?

A. My Mommy

B. USA

C. Producers

D. Manufactures

Reducing Translation and Transaction Exposure

• Protect short-term cash flows = forward exchange rate contracts and buying swaps

Lead Strategy – Collect money for projects initially (if currency is predicted to depreciate)

Lag Strategy – The opposite (currency is expected to appreciate)

Question?

The USA wants to build the first highly efficient refinement factory in Cameroon, refining oil/gas, but their currency is expected to appreciate after the project is completed. What strategy should the USA implement?

Lag Strategy

Reducing Economic Exposure

Strategically disperse Country’s assets

EX: Rising yen = Toyota has production facilities across globe = affirms price of Toyota’s are still suitable for local markets

EX: Caterpillar = Global Production Facilities=

Acts as a hedge against possibility that a strong dollar will price their goods out of foreign markets

Video on Hedging

http://www.investopedia.com/video/play/hedging/

Dispersing productive assets to various locations, to avoid adverse exchange rates

Being an asset heavy company is Not profitable, i.e. all assets depreciate at a constant rate,

The minute you drive your new car off the lot

Other Steps For Managing Foreign Exchange Risk

Central Control of Exposure

Flexible Sourcing – Black & Decker = economies of scale (narrow product differentation)

WATCH Future movements in foreign exchange rates

Good Reporting System of Currency Fluctuations – balance reports

Question?

Economies of Scale

A. Average cost As scale of production

B. Average cost As scale of production

C. Are Monopolies

Economies of Scope

A. Diverting risk by creating hedge funds

B. Lowering the average cost for producing 2+ goods and services

C. Decreasing the average cost on one product line

Chapter Review

• Foreign Exchange Market – a market for converting the currency of one country into that of another country.

• Exchange Rate – the rate at which one country is converted into another.

• Foreign Exchange Risk – the risk that changes in exchange rates will hurt the profitability of a business deal.

• Currency Speculation – involves short term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.

• Carry Trade – involves borrowing in one currency where interest rates are low and then using the proceeds to incest in another currency where interest rates are high

• Spot Exchange Rate – the exchange rate at which a foreign exchange dealer will convert one currency into another that particular day.

• Forward Exchange – when two parties agree to exchange currency and execute a deal at some specific date in the future.

• Forward Exchange Rate – the exchange rate governing forward exchange transactions.

• Currency Swap – simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

• Arbitrage – the purchase of securities in one market for immediate resale in another to profit from a price discrepancy.

• 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 the same currency.

• Efficient Market –few impediments to international trade and investment exist.

• Fisher Effect –Interest Rate (i) = Real Rate of Interest (r) + Lent Funds (l)

• International Fisher Effect – the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries.

• 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.

• Inefficient Market –prices do not reflect all available information

• Freely Convertible Currency – a country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency

• Externally Convertible Currency – 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.

• Nonconvertible Currency – a currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.

• Capital Flight – residents convert domestic currency into a foreign currency.

• Countertrade – the trade of goods and services for other goods and services.

INDIAN RUPEE

Indian Rupee

The Indian rupee has slipped to 20th in 2013 from 15th in 2010 in the global foreign exchange market turnover

The Indian rupee slide to a record low, dropping from 56.51 rupees per dollar to 58.41

The Rupee falls when money is coming into the country rather than what is leaving

Indian Rupee

A falling rupee is a concern because it is a signal of weakness to the external world; a weaker currency makes it more expensive to buy imported goods like oil, which in turn aggravates the problem of inflation

A softening rupee increases the implicit cost of India’s high foreign debt

Indian Rupee

One fundamental factor involves the country’s trade deficit, which is becoming a more serious problem, judging by the government’s mounting concern about gold imports.

Finance Minister P. Chidambaram pleased the Indians to stop buying gold. Gold and oil constitute around 45% of imports, and with oil price remaining steady, evidently gold imports have upset the status quo

Indian Rupee

Rupee depreciation does have its advantages since it makes Indian goods cheaper overseas and therefore more attractive customers, which benefits exporters. In fact, some importers of Indian goods are asking exporters to lower their prices on account of this price advantage

U.S. stocks hit record high

Reporting by: Jamie Chisholm in London, Patrick McGee in Hong Kong and Vivianne Rodrigues in New York

Debt Ceiling

Oct 17th a deal was reached Debt ceiling is to last till February 7th

Meetings in December and January to resolve

Good News and Bad News

The shut down and last minute dealThe damage it has done

The dollar value

Under pressure

International marketsStocks rising

InvestorsAmericas credit damaged

Dagong creditagency

Question?

What are the main factors that effect exchange rates in both the long run and short run?

Short run exchange rates

Monetary growth

Inflation rates

Nominal interest rates

Psychological factorsDagong credit

Dollar value

Australia's Currency

Conversion Deal

Australia's Currency Conversion Deal

Australian Prime Minister Julia Gillard traveled to Beijing to secure a currency conversion deal with her nation’s most important trading partner, China.

Currently Chinese and Australian companies must use the U.S. dollar as an intermediary for trade.

The deal’s important ramifications:It provides a step towards full convertibility of the Yuan on international markets.It will dent the primacy of the U.S. dollar as the world reserve’s currency of choice.The Australian dollar would become directly convertible to the Chinese Yuan, overcoming the need to first convert to U.S. dollars. This removes expensive exchange rate issues.

Australia’s relations with China & the U.S.Gillard must perform the difficult task of assuring China that their relationship with the U.S. will post no threat to China, or Beijing.

Australia has recently started growing defense agreements with the U.S. which permits American naval and aircraft access to Australia.

The visit was deliberately scheduled shortly after the recent leadership change in China.

This reflects the importance of the rapidly growing relationship with China.

Greater Economic interaction with Asia

The currency conversion deal is primarily aimed as furthering the Australian government’s ambition for greater engagement with Asia.

“Australia in the Asia Century”, a major policy essay released before the proposed deal was released, acknowledged that Australia’s economic prosperity was tied to Asia.

The key of their prosperity would be to take advantage of the rise of a massive Asian middle class.

Australian economic dependence on ChinaAustralian dependence on China to become an economic power has been clear for many years.

In 2011-12, China was Australia’s largest two-way trading partner for goods and services, with trade topping $128 Billion.China accounts for 14.7% of total trade goods and services and takes 25% of Australian exports.

Possible Outcomes

The Chinese economy is expected to grow 8% this year. This deal would boost the struggling Gillard government in an election year, & thus make it possible for Australia to improve their economic relations with other Asian countries.

The Australian dollar will remain high due to Chinese demand & the perception that Australia is a safe currency haven.

The Australian dollar to U.S. dollar exchanges are now estimated to be the fifth highest traded currencies in the world.

True or False?

• The newly proposed currency conversion deal between Australia and China will have no affect on the U.S. dollar being the world reserve’s currency of choice.

• Australia’s main economic trading partner is South Korea, while China is a close second.