Foreign Exchange Market: Managing Risks

spot exchange rate

the rate at which a foreign exchange dealer converts one currency into another currency on a particular day
-determined by the interaction between supply and demand
-changes continually
-the sign you see in the foreign exchange rates office in airports

arbitrage

the process of buying currency low and selling it high
-the snake in the 80s

vehicle currency

acts as an intermediary currency that facilitates trade and investment
-enhances liquidity and reduces transaction costs

1 € = 1.08 USD

Example: 40 € x 1.08 USD = 43.13 USD

1 USD = 0.93 €

Example: 45 USD x 0.93 € = 41.72 €

foreign exchange market

-a market in which currencies of different countries are bought and sold
-enables the conversion of the currency of one country into the currency of another
-provides some insurance against foreign exchange risk--the adverse consequences of unpredictable changes in exchanges

exchange rate

the rate at which one currency is converted into another

international firms use foreign exchange markets

-to convert export receipts
-income received from licensing agreements
-to pay foreign company for products or services
-to invest spare cash for short terms in money markets
-for currency speculation

export receipts

income/money received from foreign investments

currency speculation

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

carry trade

legal gambling

the foreign exchange market can be used to provide insurance to protect against:

foreign exchange risk

foreign exchange risk

-possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm
-the foreign exchange market is the largest market in the world

hedging

a firm that protects itself against foreign exchange risk

the market protects against foreign exchange risk by:

-forward exchange contact (banks help businesses secure prices for their currency/money)
-farmers will arrange to secure prices for their crops (for a fee)

spot market

current market price

Insuring against FX risk:

- spot exchange rate
- forward exchange rate

foreign exchange markets for international firms:

firms must understand the influence of exchange rates on the profitability of trade and investment deals

forward exchange rates

the exchange rate governing a foreign exchange
-forward exchange occurs when 2 parties agree to exchange currency and execute the deal at some specific date in the future
-forward rates are typically quoted for 30, 90, or 180 days into the future

the foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

-the market is always open somewhere in the world
-the exchange rates quoted in diff markets were not the same, there would be an opportunity for arbitrage
-most transactions involve US dollars on one side
-the US dollar is a vehicle currency

this exchange rate risk can be divided into:

-transaction exposure
-translation exposure
-economic exposure

transaction exposure

the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
-can lead to a real monetary loss
-concerns for future transactions
-"money today isnt worth what it used to be"

translation exposure

the impact of currency exchange rates on the reported financial statements of a company
-deals with present measurement of past events
-gains and losses from translation exposure are reflected only on paper

economic exposure

extent to which a firm's future international earning power is affected by changes in exchange rates
-concerned with long-term effect or changes in exchange rates on future prices, sales, and costs
-concerned with geopolitical instability or/and governmental regulations