Topic 9: Foreign Exchange Market

What is the purpose of the FOREX

convert the currency into another, provides some insurance against foreign exchange risk

What are the top 3 largest trade centres from largest to smallerst

new york, london, singapore

What do you want your currency if you are an exporter

weak

What do you want your currency if you are an importer

strong

What is the most important currency on the FOREX

USD

What are the two most frequently traded pairs (biggest to smallest)

USD/EUR and USD/JPY

What is a spot exchange rate

the rate at which a foreign exchange dealer converts one currency into another currency on a particular day

What is a forward exchange

Two parties agree to exchange currency and execute the deal at some specific date in the future

what is the purpose of a forward exchange

insure or hedge against a possible adverse foreign exchange rate movement

What is a currency swap

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

What are swaps used for

to move out of one currency into another for a limited period without incurring foreign exchange rate risk and each party pays interest on the other’s loan principal amounts throughout the length of the agreement

Who does currency swaps

international business and banks, between bank, between governments

What is currency hedging

attempts to reduce the effects of adverse currency fluctuations on investment performance

Why do firms use currency heding

reduce export to risk from transfer of funds, protect themselves in credit transaction with time lag between invoicing and receipts

How is hedging against exchange rates usually done

forward contracts, options contractions, currency swaps

What are options contracts

the right, but not obligation, to buy currency at a specified rate at a future date

What is currency arbitrage

Simultaneous purchase and sale of a currency in different markets

Who engage in currency arbitrage

FX players, large investors, banks

What is currency speculation

The short-term movement of funds from one currency to another in the hope of profiting from shifts in exchange rates

Why do some currecnies are not freely convertable

government attemps to save foreing currency reserves for interest payments on foreign debt, payments for imports, protect against speculators, prevent capital flight

What are the methods of restricing currency

import licenses, capital controls, restrictions on the repatriations of profits

How are exchange rates determined

supply and demand of the currency

What are the three factors that impact future exchange rate moveemnts

price inflation, interest rate, market psychology

What shows price inflation

PPP

What happens when central banks increase interest rates

foreign lenders earn a higher return which increases foreign capital

What is the international Fisher effect

explains how a change in the interest rate can predict a change in the spot exchange rate

Explain the international fisher effect

 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

What is the problem with PPP and the fisher effect

poor predictors of short term changes in echange rates

What is more important in the short term for exchange rates

confidence and release of information

What are the psychological and behavioural factos

few players know everything, players watch each other, uncertianty and panic spread quickly, financial crises

What is an inefficient market school for exchange rate forecasting

information assymetry

What are the approaches to forcasting future movements

fundamental analysis and technical analysus

What is a fundamental analysis

predictions using econometric models based on economic theory

What is a technical analysis

interpretation of past trends assuming they predict future movements

What are the implications for managers

need to consider transaction exposure, translation exposure, economic exposure

what is a transaction exposure

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

What is translation exposure

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

What is economic exposure

the extent to which a firm’s future international earning power is affected by changes in exchange rates

How to minimise transaction and translation exposure

buy forward to lock in a future exchange rate, use swaps, lead and lag payables and receivables

What is lead strategy

attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate

What is lag strategy

delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate

How to minimise economic exposure

distributive productive assets to various locations, assets are not concentrated in countries where rises in currency values increases in the foreign prices of the goods the firm produces

What are other steps for managing foreign exchange risk

control of exposure, distinguish between the different types of exposure, forecast future exchange rate movements, good reporting system, monthly foreign exchange exposure reports

What is the exporter currency

risk for exporter

What is the importer’s currency

risk for the exporter + third country’s currency

What is the third country’s currency

risk for both exporter and importer

What is the approach if exposure to currency risk is high

risk retention, hedge against currency risk

If there us the same amount of exports and imports in the same foreign currency plus no seasonality

potentila loss is a potential gain, exposure is nil