HTM

Foreign exchange market

Market for converting the currency of one country into the currency of another country.

Exchange rate

The rate at which one currency is converted into another.

Main functions of the forex market

Enables currency conversion and provides insurance against foreign exchange risk.

Currency conversion

Used to convert export receipts, foreign investment income, licensing income, payments to foreign firms, and short-term money market investments.

Currency speculation

Short-term movement of funds from one currency to another to profit from exchange rate changes.

Carry trade

Borrowing in a currency with low interest rates and investing in a currency with high interest rates.

Foreign exchange risk

The risk of negative consequences from unpredictable exchange rate changes.

Hedging

Protection against foreign exchange risk.

Spot rate

Exchange rate for an immediate currency transaction.

Forward rate

Exchange rate agreed today for a future currency transaction, often 30, 90, or 180 days ahead.

Forward contract

Agreement that locks in a future exchange rate to reduce the risk of an unprofitable currency movement.

Currency swap

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

Purpose of currency swaps

Used to move temporarily from one currency to another without taking on exchange rate risk.

Nature of the forex market

A global network of banks, brokers, and dealers connected electronically and open somewhere in the world at all times.

Arbitrage

Buying a currency low in one market and selling it high in another market without risk.

Vehicle currency

A currency commonly used as an intermediary in international transactions, especially the U.S. dollar.

Main factors affecting exchange rates

Price inflation, interest rates, and market psychology.

Law of One Price

In competitive markets without trade barriers or transportation costs, identical goods should sell for the same price when measured in the same currency.

Purchasing Power Parity

Theory that a basket of goods should cost roughly the same in each country when prices are converted into one currency.

PPP prediction

If a country has relatively high inflation, its currency should depreciate.

Money supply and inflation

Inflation occurs when money supply grows faster than the output of goods and services.

PPP weakness

PPP is more accurate in the long run than the short run because transport costs, trade barriers, government intervention, and investor psychology matter.

Fisher effect

A country's nominal interest rate equals the real interest rate plus expected inflation.

Fisher effect formula

i = r + π, where i is nominal interest rate, r is real interest rate, and π is expected inflation.

International Fisher Effect

Spot exchange rates should change in the opposite direction of differences in nominal interest rates between countries.

Bandwagon effect

When trader expectations become self-fulfilling and many traders move exchange rates in the same direction.

Efficient market school

View that prices reflect all available information and forward exchange rates are the best predictors of future spot rates.

Inefficient market school

View that prices do not reflect all available information, so firms should invest in forecasting services.

Fundamental analysis

Forecasting method using economic factors such as interest rates, monetary policy, inflation, and balance of payments.

Technical analysis

Forecasting method using past price and volume data to predict future exchange rate trends.

Freely convertible currency

Currency that residents and nonresidents can convert into foreign currency without limits.

Externally convertible currency

Currency where only nonresidents can convert domestic currency into foreign currency.

Nonconvertible currency

Currency that residents and nonresidents are prohibited from converting into foreign currency.

Capital flight

When people rush to convert domestic currency into foreign currency because they fear losing value.

Countertrade

Barter-like trade where goods and services are exchanged for other goods and services.

Transaction exposure

Effect of exchange rate changes on income from individual short-term transactions.

Translation exposure

Effect of exchange rate changes on a company's reported financial statements.

Economic exposure

Effect of exchange rate changes on a firm's future international earning power.

Lead strategy

Collect foreign currency receivables early if the currency is expected to depreciate and pay foreign currency payables early if the currency is expected to appreciate.

Lag strategy

Delay collecting foreign currency receivables if the currency is expected to appreciate and delay payables if the currency is expected to depreciate.

Reducing economic exposure

Distribute productive assets across countries to reduce long-term exchange rate risk.

Managing foreign exchange risk

Use central control, separate exposure types, forecast exchange rates, maintain reporting systems, and produce monthly exposure reports.

International monetary system

The institutional arrangement that governs exchange rates.

Floating exchange rate

A system where the foreign exchange market determines a currency's value.

Pegged exchange rate

A system where a currency's value is fixed to a reference currency.

Managed float

A system where market forces determine currency value, but the central bank intervenes if the currency moves too sharply.

Dirty float

Another name for a managed float exchange rate system.

Fixed exchange rate system

A system where countries fix their currencies against each other at agreed values.

Dollarization

When a country abandons its own currency and adopts another currency, usually the U.S. dollar.

Gold standard

A system where countries peg their currencies to gold and guarantee convertibility.

Gold par value

The amount of a currency needed to buy one ounce of gold.

Balance-of-trade equilibrium

When money earned from exports equals money paid for imports.

Strength of the gold standard

It helped countries achieve balance-of-trade equilibrium.

Why the gold standard ended

Countries devalued currencies after World War I, confidence fell, gold reserves came under pressure, and convertibility was suspended.

Bretton Woods Agreement

1944 agreement creating a new monetary system where the U.S. dollar was convertible to gold and other currencies were fixed to the dollar.

Bretton Woods goal

To create a stable postwar economic order that supported growth and trade.

IMF

International Monetary Fund, created to maintain order in the international monetary system.

World Bank

Institution created to promote general economic development.

IMF discipline role

Fixed exchange rates discouraged competitive devaluations and helped control inflation.

IMF flexibility role

The IMF could lend foreign currencies to countries with short-term balance-of-payments deficits.

Fundamental disequilibrium

A serious balance-of-payments problem that could justify a currency devaluation above 10 percent with IMF approval.

IBRD

International Bank for Reconstruction and Development, part of the World Bank that lends money raised through bond sales.

IDA

International Development Association, part of the World Bank that gives very low-interest loans to the poorest countries.

Collapse of Bretton Woods

Caused partly by U.S. expansionary monetary policy, inflation, Vietnam War spending, and welfare spending.

1971 dollar convertibility change

The U.S. dollar was no longer convertible into gold.

1973 Bretton Woods collapse

The fixed exchange rate system collapsed.

Jamaica Agreement

1976 agreement that formalized the floating exchange rate system.

Jamaica Agreement rules

Floating rates became acceptable, gold was abandoned as a reserve asset, and IMF quotas were adjusted.

Exchange rates since 1973

Exchange rates became more volatile and less predictable.

Case for floating rates

Floating rates give countries monetary policy autonomy, smoother trade balance adjustment, and crisis recovery support.

Monetary policy autonomy

Government freedom to control money supply without maintaining exchange rate parity.

Floating rates and crisis recovery

A falling currency can make exports cheaper and help recovery after investors pull money out.

Case for fixed rates

Fixed rates impose monetary discipline, reduce destabilizing speculation, and lower business uncertainty.

Criticism of floating rates

A depreciating currency may cause inflation instead of improving exports and imports.

Currency board

A system where a country commits to converting domestic currency into another currency at a fixed rate.

Currency board reserves

A currency board must hold foreign reserves equal to at least 100 percent of domestic currency issued.

Currency board limitation

The government loses the ability to set its own interest rates.

Currency crisis

A speculative attack that sharply lowers a currency's value or forces authorities to use reserves and raise interest rates.

Banking crisis

A loss of confidence in banks that leads to a run on the banking system.

Foreign debt crisis

When a country cannot service its foreign debt obligations.

Common causes of financial crises

High inflation, current account deficits, excessive borrowing, high government deficits, and asset price inflation.

Modern IMF role

Lends money to countries in financial crises in exchange for macroeconomic policy reforms.

IMF loan conditions

Usually include tight macroeconomic and tight monetary policies.

Inappropriate policies criticism

Criticism that the IMF uses a one-size-fits-all approach that may not fit each country.

Moral hazard criticism

People or governments may behave recklessly if they expect to be rescued.

Lack of accountability criticism

Criticism that the IMF has too much power without enough accountability.

Business response to exchange volatility

Firms can use forward markets, swaps, and strategic flexibility.

Strategic flexibility

Ability to reduce long-term exchange rate risk by dispersing production and outsourcing across locations.

Corporate-government relations goal

Firms should encourage governments to support trade, investment, and a stable monetary system.

Strategy

Actions managers take to attain the goals of the firm.

Profitability

The rate of return a firm makes on invested capital.

Profit growth

The percentage increase in net profits over time.

Value creation

Activities that increase the value of goods or services to consumers.

Value creation formula

Value creation is measured as V minus C, where V is the price customers will pay and C is production cost.

Differentiation strategy

Strategy focused on increasing perceived value through design, style, functionality, or features.

Low-cost strategy

Strategy focused on lowering costs below competitors.

Focus strategy

A narrow strategy aimed at a specific market segment.

Strategic positioning

Choosing a viable position on the efficiency frontier and aligning operations and structure to support it.

Bretton Woods Agreement date

1944; created a new international monetary system after World War II.

Bretton Woods system setup

U.S. dollar was convertible to gold, and other currencies were fixed to the dollar.