Foreign Exchange Market

Functions of the Foreign Exchange Market

• Currency Conversion:

  • Converts payments for exports, foreign investments, or licensing agreements.
  • Makes foreign payments in local currency.
  • Invests in short-term foreign money markets.
  • Engages in speculation (e.g., carry trade).

• Insuring Against Foreign Exchange Risk:

  • Spot Exchange Rates: Rates that fluctuate daily based on supply and demand for immediate currency exchange.
  • Forward Exchange Rates: Agreements to exchange currencies at a future date, usually quoted for 30, 90, or 180 days.
  • Currency Swaps: Simultaneous buy/sell of currency with different value dates; common among banks and businesses.

Nature of the Foreign Exchange Market

• Global Network:
  • Composed of banks, brokers, and dealers operating via electronic systems.
  • Major centers are London, New York, Zurich, Tokyo, and Singapore.
  • 24/7 Market: Operates continuously due to high-speed communications.
  • Arbitrage Opportunities: Buying low and selling high across different markets, particularly involving USD.

Economic Theories of Exchange Rate Determination

• Law of One Price: Identical products must have the same price across countries when expressed in common currency.
• Purchasing Power Parity (PPP): Price comparisons of identical goods determine real exchange rates.
• Money Supply and Inflation: Growth in money supply indicative of future inflation; higher inflation leads to currency depreciation.
• Interest Rates: Impacts exchange rates via the Fisher Effect and International Fisher Effect (IFE); reflects inflation expectations.
• Investor Psychology: Short-term rate movements influenced by market sentiment and bandwagon effects.

Exchange Rate Forecasting

• Efficient Market School: Belief that forward exchange rates should accurately predict future spot rates.
• Inefficient Market School: Forward rates may not reflect all information, leading to less accuracy.
• Fundamental Analysis: Uses economic theories to model currency movements based on economic indicators.
• Technical Analysis: Focuses on past price trends to predict future movements.

Currency Convertibility

• Types of Convertibility:
  • Freely Convertible: Unlimited conversions allowed for residents and nonresidents.
  • Externally Convertible: Residents can convert domestic currency without limitations.
  • Nonconvertible: Restrictions on conversions.
• Capital Flight: Happens during rapid depreciation of domestic currency; companies may counter this through countertrade.

Managerial Implications of Foreign Exchange Risk

• Transaction Exposure: Effect of exchange rate fluctuations on individual transactions.
• Translation Exposure: Impact of currency changes on financial statements.
• Economic Exposure: Effect on future international earning power.
• Risk Reduction Strategies:
  • Forward contracts, buying swaps, lead/lag strategies for receivables management.
  • Distributing assets across locations to mitigate risk.
• Monitoring Practices:
  • Need for central control, distinction between exposure types, forecasting, effective reporting systems.