09. Foreign Exchange Markets

the foreign exchange (FOREX) market is a global network of…

banks, brokers, and foreign exchange dealers connected by electronic communications systems

the FOREX market is used to…

covert the currency of one country into the currency of another

the spot exchange rate is the rate at which a…

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

the spot exchange rate changes continually depending on…

the supply and demand for that currency and other currencies

a forward exchange rate is the rate at which…

two parties agree to exchange currencies on a specific future date at a price fixed today

currency swap (FX) is the…

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates without incurring foreign exchange risk

currency hedging attempts to…

reduce the effects of adverse currency fluctuations on investment performance

forward contracts

buying currency at a specified rate at a future date

options contracts

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

currency arbitrage is…

simultaneous purchase and sale of a currency in different markets

currency speculation is…

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

carry trade borrows…

one currency where interest rates are low and invests these in another currency where interest rates are high

hedge funds

manipulate exchange rates due to high volume of forex trading

methods of restricting currencies

import licenses, capital controls, limitations for residents travelling abroad, multiple exchange rates

3 factors that impact future exchange rate movements

a country’s price inflation, a country’s interest rate and market psychology

competitive markets

identical products sell in different markets for the same price when price expressed in same currency

purchasing power parity (PPP) argues that…

given relatively efficient markets, the price of a basket of goods should be roughly equivalent in each country

the international Fisher effect (IFE) explains how…

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

the bandwagon effect occurs when…

expectations on the part of traders turn into self-fulfilling prophecies - traders can move exchange rates based on group expectations

efficient market

prices reflect all available info on public domain

inefficient market

prices do not reflect all available info on public domain

fundamental analysis

predictions using econometric models based on economic theory

technical analysis

extrapolation/interpretation of past trends assuming they predict future movements

transaction exposure

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

translation exposure

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

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 future exchange rates, use swaps, lead and lag payables and receivables

lead strategy

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

lag strategy

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

how to minimise economic exposure

distribute productive assets to various locations and ensure assets are not too concentrated in countries

other steps for managing foreign exchange risk

central control of exposure, distinguish between exposures, forecast future exchange rate movements, establish good reporting systems