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.