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The Foreign Exchange Market
market for converting currency of one country into that of another country
exchange rate
the rate at which one currency is converted into another
future exchange rates cannot be accurately predicted
The Functions of the Foreign Exchange Market
convert the currency of one country into the currency of another
provide some insurance against foreign exchange risk
currency fluctuations can make profitable deals unprofitable, and vice versa
Currency Conversion
in general, within the borders of a particular country, one must use the national currency
Businesses use the foreign exchange market to
to convert the payments received for its exports, the income received from foreign investments, or the income received from licensing agreements with foreign firms
to make payment to a foreign company for its products or services in its country’s currency
to invest cash for short terms in foreign money markets
for 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
borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high
An American company today invests some of its spare cash in a British money market account that will earn 8% for two months. Which of the following, if it happens during the next two months, would imply that the company will earn less than 8% on its investment?
the dollar appreciates against the British Pound
Insuring Against Foreign Exchange Risk
the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm
hedging is that a firm insures itself against foreign exchange rate risk
spot exchange rates
foreign exchange rates
currency swaps
Spot Exchange Rates
reported on a real-time basis
the amount of foreign currency one U.S. dollar will buy or the value of a dollar for one unit of foreign currency
Foreign Exchange Rates
forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future
usually quoted for 30 days, 90 days, and 180 days into the future
to insure or hedge against the risk, the U.S. importer might want to exchange in a forward exchange
forward discount = forward price < spot price
forward premium = forward price > spot price
Currency Swaps
the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
common type - spot against forward (e.g. Apple)
The Nature of Foreign Exchange Market
global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems
rapidly growing
most important trading centers are London (largest), New York, Zurich, Tokyo, and Singapore
open 24 hours a day
most transactions involve the dollar
high-speed computer linkages among trading centers around the globe have effectively created a single market
Major players in the foreign exchange market
international banks
corporate treasurers
pension funds
hedge funds
insurance companies
central banks
treasury departments
What are exchange rates determined by?
the demand and supply of the currency
can forecast exchange rate movements, if understanding the factors
no simple explanation
inflation, interest rate, and market psychology
The Law of One Price
identical products sold in different countries must sell for the same price when the price is expressed in terms of the same currency
arbitrage would continue until prices were equalized
Purchasing Power Parity (PPP)
comparison of prices identical products determine the real or exchange rate
the price of a “basket of goods” should be roughly equivalent in each country
e.g. Big Mac Index
Suppose the price of a Big Mac in New York is $3 and the price of a Big Mac in Paris is equivalent to $3.75 at the prevailing euro/dollar exchange rate. Using the concept of purchasing power parity, the euro is?
overvalued by 25% against the dollar
Money Supply and Price Inflation
the growth rate of a country’s money supply determines its likely future inflation
an increase in money supply makes it easier to borrow, which increases demand for goods and services
a country with high inflation rate will see depreciation in its currency exchange
government policy determines growth rate
Empirical Tests of PPP Theory
exchange rates are determined by relative prices and changes in relative prices will result in a change in exchange rates
not a strong predictor of short-run movements in exchange rates covering time spans of five years or less
best predicts exchange rate changes for countries with high rates of inflation and underdeveloped capital markets
Reflect expectations about likely future inflation rates
the fisher effect
i = r + l
if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates
Investor Psychology and Bandwagon Effects
neither PPP theory nor the international Fisher effect is particularly good or explaining short-term movements in exchange rates
investor psychology
bandwagon effect
Summary of Exchange Rate Theories
relative monetary growth, relative inflation rates, and nominal interest rate differentials all moderately good predictors of long-run changes in exchange rates
but they are poor predictors of short-run changes
The Efficient Market School
prices reflect all available public information
forward exchange rates should be unbiased predictors of future spot rates
The Inefficient Market School
prices do not reflect all available information
forward exchange rates will not be the best possible predictors of future spot exchange rates
Approaches to Forecasting
Fundamental Analysis
Technical Analysis
Fundamental Analysis
draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements
includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance - of - payments positions
Technical Analysis
uses price and volume data to determine past trends, which are expected to continue into the future
there are analyzable market trends and waves that can be used to predict future trends and waves
Currencies can be
freely convertible
externally convertible
nonconvertible
Governments can limit convertibility to preserve their foreign market reserves
capital flight
countertrade
Foreign Exchange Rate Risk
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
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
Reducing Translation and Transaction Exposure
forward exchange rate contracts
buying swaps
lead strategy
lab strategy
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
Lab 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
Reducing Economic Exposure
distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates
Other Steps for Managing Foreign Exchange Risk
Central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies
Firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure
The need to forecast future exchange rate movements cannot be overstated
Firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions
The firm should produce monthly foreign exchange exposure reports
Note 
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