Chapter 10 - The Foreign Exchange Market

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

1. Central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

2. Firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure

3. The need to forecast future exchange rate movements cannot be overstated

4. 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

5. The firm should produce monthly foreign exchange exposure reports