10. Foreign Exchange Market

foreign exchange market

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

exchange rate

The rate at which one currency 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

A kind of speculation that involves borrowing in one currency where interest rates are low and then using the proceeds to invest 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 a forward exchange transaction.

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

A market where prices reflect all available information

Fisher effect

Nominal interest rates (i) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of time for which the funds are to be lent (l). That is, i = r + I.

international Fisher effect (IFE)

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.

bandwagon effect

Movement of traders like a herd, all in the same direction and at the same time, in response to each other’s perceived actions.

inefficient market

One in which 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

Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency.

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

Converting domestic currency into a foreign currency.

countertrade

The trade of goods and services for other goods and services.

transaction exposure

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

translation exposure

The extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in foreign exchange values.

economic exposure

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

lead strategy

Collecting foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.

lag strategy

Delaying the collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if that currency is expected to depreciate.

currency swap

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.