Foreign Exchange and Exchange Rates

Global Business Environment: Foreign Exchange

Nominal Values of Currencies

  • Nominal values of currencies, in and of themselves, mean nothing.
  • They are simply a way for a country to measure value.
  • The exchange rate (e.g., one million to a US dollar versus one to a US dollar) does not reflect the strength of a country's economy or its currency.

Learning Objectives

  • Describe the functions of the foreign exchange market.
  • Explain exchange rate risk and hedging strategies.
  • Understand the determinants of exchange rate changes.
  • Identify the merits of different approaches to exchange rate forecasting.

The Nature of the Foreign Exchange Market

  • The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communication systems.
  • The market operates continuously across the globe.
  • Arbitrage opportunities arise if exchange rates differ across markets; arbitrage is the process of buying a currency low and selling it high.
  • Most transactions involve U.S. dollars on one side.

The Functions of the Foreign Exchange Market

Currency Conversion

  • Enables conversion of one currency into another for:
    • Export receipts
    • Income from foreign investments
    • Income from licensing agreements
    • Payment to foreign companies for products or services

Currency Speculation

  • Short-term movement of funds from one currency to another to profit from exchange rate shifts.

Insuring Against Foreign Exchange Risk

  • The foreign exchange market provides insurance against foreign exchange risk.
  • Hedging is when a firm protects itself against foreign exchange risk.
  • The market uses:
    • Spot exchange rates
    • Forward exchange rates
    • Currency swaps

Spot Exchange Rates

  • The rate at which a foreign exchange dealer converts one currency into another on a particular day.
  • Determined by supply and demand.
  • Changes continually

Forward Exchange Rates

  • The exchange rate governing a forward exchange.
  • A forward exchange occurs when two parties agree to exchange currency and execute the deal at a specific date in the future.
  • Forward exchange rates are typically quoted for 30, 90, or 180 days into the future.
  • Can sometimes work against a company.

Currency Swaps

  • Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
  • Used to move out of one currency into another for a limited period without incurring foreign exchange rate risk.

Economic Theories of Exchange Rate Determination

  • Three factors impacting future exchange rate movements:
    • A country’s price inflation
    • A country’s interest rate
    • Market psychology

Prices and Exchange Rates

The Law of One Price

  • In competitive, barrier-free markets, identical products sold in different countries must sell for the same price when expressed in the same currency.

Purchasing Power Parity (PPP)

  • Given efficient markets, the price of a “basket of goods” should be roughly equivalent in each country.
    *PPP predicts that changes in relative prices will result in changes in exchange rates.
    *When inflation is relatively high, a currency should depreciate.

Interest Rates and Exchange Rates

Fisher Effect

  • A country’s nominal interest rate (i) is the sum of the required real rate of interest (r) and the expected rate of inflation (I) over the period for which the funds are to be lent.
  • Formula: i = r + I
  • If the real interest rate is the same everywhere, any difference in interest rates between countries reflects differing expectations about inflation rates.

International Fisher Effect

  • 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 the two countries.

Empirical Tests of PPP Theory

  • PPP is not completely accurate in estimating exchange rate changes in the short run but is relatively accurate in the long run.

The ‘Big Mac’ Index

  • Compares the prices of a Big Mac in different countries.
  • In theory, the prices when divided by exchange rates should be equal (PPP).
  • Often used to show which currencies are strong (overvalued) or weak (undervalued).
  • Historically a good predictor of currency movement.
  • Calculation:
    1. Divide the price of a Big Mac in one country (in its local currency) by the price of a Big Mac in another country (in its local currency).
    2. Compare this value with the current exchange rate.
    3. A lower value indicates the first currency has been undervalued; a higher value indicates the first currency is overvalued.

Investor Psychology and Bandwagon Effects

  • The bandwagon effect occurs when traders' expectations turn into self-fulfilling prophecies.
  • Traders join the bandwagon and move exchange rates based on group expectations.

Summary of Exchange Rate Theories

  • Relative inflation rates and nominal interest rate differentials are moderately good predictors of long-run changes in exchange rates but poor predictors of short-term changes.
  • International businesses should pay attention to countries’ differing inflation and interest rates.

Exchange Rate Forecasting

The Efficient Market School

  • An efficient market is one in which prices reflect all available information.
  • Forward exchange rates are the best predictors of future spot exchange rates.
  • Investing in forecasting services is a waste of money.

The Inefficient Market School

  • An inefficient market is one in which prices do not reflect all available information.
  • Forward exchange rates are not the best predictors of future spot exchange rates.
  • Companies should invest in forecasting services.

Approaches to Forecasting

Fundamental Analysis

  • Draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates.

Technical Analysis

  • Uses price and volume data to determine past trends that are expected to continue.
  • Many economists are skeptical of technical analysis.

Currency Convertibility

  • Not all currencies are freely convertible.
  • Governments limit convertibility to preserve foreign exchange reserves and prevent capital flight—when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency.
  • In the case of a nonconvertible currency, firms may turn to countertrade—barter-like agreements by which goods and services can be traded for other goods and services—to facilitate international trade.

Focus on Managerial Implications

  • Firms must understand the influence of exchange rates on the profitability of trade and investment deals.

Summary

  • Know the functions of the foreign exchange market.
  • Understand how to hedge using forward exchange rates to insure against foreign exchange risk.
  • Be able to explain how currency exchange rates are determined.
  • Know the merits of different approaches toward exchange rate forecasting.