Chapter 9: The Foreign Exchange Market Notes

Learning Objectives

  • Functions of the Foreign Exchange Market: Understand the essential roles played by the foreign exchange market in global trade and finance.
  • Nature of the Foreign Exchange Market: Gain insight into how the market operates and its significance for various participants.
  • Currency Exchange Rate Theories: Explore different theories that explain how exchange rates are determined, including their merits and limitations.
  • Exchange Rate Forecasting: Learn various approaches to predicting exchange rate movements and discuss issues related to currency convertibility.
  • Exposure Types: Identify and differentiate between translation, transaction, and economic exposure in international finance. Discuss strategies for managing these exposures.

Introduction

  • British Pound Crisis (September 23, 2022): Review the factors leading to the decline of the British Pound following a "mini budget" and the actions taken by the Bank of England (BoE) in response.

Foreign Exchange Market

  • Definition: A marketplace for converting currencies of different countries.
  • Exchange Rate: The price for which one currency can be exchanged for another.
  • Foreign Exchange Risk: The financial risk due to fluctuating currency exchange rates.

Currency Conversion in Business

  • Tourist Participation: Tourists constitute minor participants in foreign exchange.
  • International Business Uses:
    1. Receiving payments from exports and licensing agreements.
    2. Paying for products/services using foreign currency.
    3. Investing in foreign currency for short-term gains.
    4. Engaging in currency speculation, including common practices like carry trades.

The Canadian Dollar and Global Dynamics

  • Petrocurrency: The Canadian dollar is linked to the export of raw materials, notably oil and natural gas.
  • Market Influences: Speculation on the Canadian dollar and its effects on export pricing are discussed, with parallel examples from countries like Germany.

Insuring Against Foreign Exchange Risk

  • Spot Exchange Rates: The current rate for currency exchange.
  • Forward Exchange Rates: Agreements to exchange currencies at a predetermined future date.
  • Currency Swaps: Purchasing and selling a specified amount of currency simultaneously for different date valuations.

Structure of the Foreign Exchange Market

  • Key Trading Centers:
    • London: 38% of global activity.
    • New York: 18% of global activity.
    • Other significant markets include Zurich, Tokyo, and Singapore.
  • Chinese Yuan: Accounts for 2.88% of global currency reserves as of 2022.

Key Exchange Rate Theories

  • Law of One Price: Suggests that identical goods should have the same price in different countries when expressed in a common currency.
  • Purchasing Power Parity (PPP): Addresses how exchange rates are adjusted based on inflation rates over time.

Interest Rates and Exchange Rates

  • Fisher Effect: Describes the relationship between nominal interest rates (i), real interest rates (r), and expected inflation (I) with the formula:
    i = r + I
    For instance, with $r = 5 ext{%}$ and $I = 10 ext{%}$, then $i = 15 ext{%}$.

Investor Psychology

  • Market Influences: The role of psychological factors and investor behaviors, notably the bandwagon effect, impacts short-term currency fluctuations and trends.

Exchange Rate Forecasting Approaches

  • Fundamental Analysis: Utilizes economic models and statistical methods for predicting currency movements.
  • Technical Analysis: Examines past market data to identify trends and predict future movements.

Currency Convertibility Types

  • Freely Convertible: Both residents and non-residents can exchange currency without limits.
  • Externally Convertible: Only non-residents have unlimited conversion rights.
  • Nonconvertible: Neither residents nor non-residents can engage in currency exchanges.

Countertrade

  • Defines barter-like agreements for trading goods and services without currency, providing examples from China and India.

Managing Foreign Exchange Risk

  1. Transaction Exposure: Risk from currency conversion in transactions.
  2. Translation Exposure: Risk in financial statements from currency fluctuations impacting reported earnings.
  3. Economic Exposure: Long-term risk affecting cash flows from unexpected changes in exchange rates.
  4. Risk Management Strategies: Various measures to manage each exposure type effectively.

Closing Case: Algerian Dinar

  • Discusses the implications of the IMF’s classification of the Algerian dinar and the existence of a parallel market influencing its value.