Chapter 10 - IB

The Foreign Exchange Market

International Businesses engage in a variety of transactions, such as:

• Conversion of foreign income (from exports, FDI, licensing)

• Payment to foreign suppliers

• Short-term money market investment

• Raising capital on foreign stock market exchange

• Borrowing capital in countries that offer lower interest rates

Foreign Exchange Market:

A market for converting the currency of our country into that of another country; Global network of banks, brokers, and foreign exchange dealers; USD is a vehicle currency

(Spot) exchange rate

The rate at which one currency is converted into another currency

Functions of the foreign exchange market:

• Enable companies based in countries that use different currencies to trade with each other; Hedging of foreign exchange risk;

• Also allows currency speculation and currency arbitrage

Foreign Exchange Market actors:

Businesses, governments, investments funds, banks, and speculators from different countries

Currency Speculation

Movement of funds from one currency to another in the hope of profiting from shift in exchange rates

Carry trade

It involves borrowing in one currency when interest rates are low and using the proceeds to invest in another currency where interest rates are high.

How currency conversation works

• Quoted in currency pair

• E.g. EUR/USD 1.3732

  • Currency to the left of slash is base currency

  • The currency on the right is quote or counter currency

  • 1 euro = 1.3732 USD

Currency Appreciation

An increase in the value of currency in terms of another

Foreign Exchange Risk

Risk introduced into international business transactions by changes in exchange rates.

Usually divided into three main categories

1. Transaction or contractual exposure

2. Translation Exposure

3. Economic or Operating Exposure

Transaction Exposure

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

Arises from:

• Obligations for the purchases or sales of goods and services at previously agreed prices (often in domestic currencies)

• The borrowing or lending of funds in foreign currencies

(Look at slide 11 for example)

Translation Exposure

The impact of currency exchange rate changes on the reported financial statements of a company

• Concerned with the present measurement of past events

• Gains or losses are on "paper.”

• I.e. unrealized gains or losses

Economic exposure

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

• Concerned with long-term effect of changes in exchange rates on future prices, sales, and costs

What are the two types of risk management strategies?

1. Hedging

2. Exploiting differences in interest rates

Hedging

To reduce the long-term volatility of cash flows or earnings

• Using financial instruments such as forwards and swaps

• Using lead and lag strategies

Exploiting differences in interest rates

Used to create competitive advantages

• Raise funds in one country to finance investments in another

Forward Exchange Contract

• Two parties agree to exchange currency and execute the deal at some specific date in the future

• Used to protect the buyer from fluctuations in currency prices

• Can be canceled only with mutual agreement involved

• Used for these future transactions: rates for currency exchanges are typically quoted 30, 90, or 180 days into the future

Currency swap

The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Swaps are transacted between

• International businesses and their banks

• Banks

• Governments

Common type of swap

spot against forward

How are exchange rates determined?

By the demand and supply of different currencies

Three factors seem to impact future exchange rate movements

1. Relative inflation levels

2. Differences in interest rates

3. Investor psychology

Law of one price

In competitive markets free of transportation costs and trade barriers

• Identitical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

• Otherwise, there is an opportunity for arbitrage until prices equalize between the two markets

• E.g. U.s./Euro exchange rate: $1 = € .78

  • A jacket selling for $50 in New York should retail for € 39 in Paris (50x.78)

Purchasing power parity theory (PPP)

Given efficient markets

• The price of a “basket of goods” should be roughly equivalent for each country

  - If a basket of goods costs 100 US Dollars in the US and
  – the same basket of goods costs 6000 Rupees in India then
  – The Dollar/Rupee exchange rate should be $100/Rs 6000 i.e. 1 USD = 60 INR

What does PPP theory predict?

The changes in relative prices → changes in exchange rates

Inflation occurs when

The supply of money grows faster than the output of a country

High inflation indicate

• more supply of money on the foreign exchange market

• currency depreciates relative to others

IB managers attempting to predict future currency movements should

Examine a country’s policy toward monetary growth

Controlled rate of growth in money supply leads to

Low future inflation rate

Economic theory tells us that

Interest rates reflect expectations about future inflation rates

• High inflation correlates with high interest rates.

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 two countries

• The link between interest rates and exchange rates

• A good predictor of long-run exchange rates (but not short-run rates)

Investor psychology can be influenced by

– Political factors
– Microeconomic events (i.e. investment decisions of firms)
– Bandwagon effect: Traders moving as a herd in the same
direction at the same time

Exchange rates are affected by:

• In the long-run by:
– Monetary growth
– Inflation rates
– Interest rate differentials

• In the short-term by:
– Investor expectations
– Psychological factors
– Bandwagon effects

To minimize transaction and translation exposure, managers:

• Buy forwards
• Use swaps
• Lead and lag payables and receivables

To reduce economic exposure, managers:

• Distribute productive assets to various locations
• To reduce impact of adverse changes in exchange rates

• Ensure that assets are not too concentrated in countries
• Where rise in currency values will make goods and services
expensive