Financial markets LO10

Chapter Ten: Foreign Exchange Basics

Introduction to Global Business

  • Global business encompasses goods, services, stocks, bonds, etc.

  • Understanding exchange rates is crucial for cross-border transactions.

  • Exchange rate: Measures the price of one currency in terms of another.

Key Topics in Foreign Exchange

  • How foreign exchange rates are determined.

  • Factors causing fluctuations over short and long periods.

  • Connection between foreign exchange rates and exchange markets.

Foreign Exchange Basics

Currency Use in Transactions

  • Travelers must pay in the local currency of the country visited.

  • Example: Members of the European Monetary Union use euros.

  • Dollar-euro exchange rate: Price of one euro in dollars.

The Nominal Exchange Rate

Definition and Fluctuation

  • Nominal exchange rate: The price of a currency to purchase another.

  • Changes daily: For instance, the dollar-euro exchange rate can fluctuate.

Example of Exchange Rates

  • Price of British pound reflects dollar value similar to euros.

  • The same applies to Japanese yen; quoted as the yen amount per dollar.

The Real Exchange Rate

Understanding the Real Exchange Rate

  • Real exchange rate compares purchasing power between different currencies.

  • It examines costs of a basket of goods from one country to another.

    • Example: Price of espresso in the U.S. vs. Italy.

Implications of Real Exchange Rate

  • One cup of Starbucks espresso buys 1.1 cups of Italian espresso.

  • Value ratios indicate how competitive exports are based on exchange rates.

Tools of the Trade

Foreign Exchange Rates Tracking

  • The Wall Street Journal provides a daily exchange rate column.

  • Spot rates for immediate exchanges; forward rates for future currency transactions.

Foreign Exchange Markets

Currency Transaction Dynamics

  • The U.S. dollar is involved in 85% of currency transactions.

  • Currency pair transactions often require intermediate exchanges through the U.S. dollar.

  • The UK leads in foreign exchange trading.

Exchange Rates in the Long Run

Determining Exchange Rates

  • Long-run exchange rates influenced by various economic factors.

The Law of One Price

  • Identical products should sell for the same price everywhere due to arbitrage.

  • Example transaction: Cheaper TV in Canada leads to purchase for resale in the U.S. until price equalizes.

  • Considerations: transportation costs, tariffs, product specifications, regional tastes.

Your Financial World: Investing Abroad

  • Diversification benefits from holding foreign stocks reduce risk without sacrificing returns.

  • Investors should consider exchange rate risks.

Purchasing Power Parity (PPP)

Application of the Law of One Price

  • Extends from individual goods to a basket of goods.

  • Theory states that currency will buy the same basket globally.

Relationship Between Currencies and Goods

  • Implications for pricing in different countries and currency adjustments.

  • Inflation rates affect currency values relative to purchasing power.

Exchange Rates in the Short Run

Short-run Dynamics

  • Changes in nominal exchange rates equate to changes in real exchange rates.

  • Demand for and supply of dollars dictate short-run fluctuations.

Demand and Supply of Dollars

  • Demand: Foreigners buy American goods/services, influencing dollar demand.

  • Supply: U.S. preferences for foreign goods affect dollar supply.

Government Policy and Foreign Exchange Intervention

Government Actions

  • Policymakers can adjust currency values through market interventions.

  • Countries either rarely intervene or frequently manage their exchange rates.

The U.S.-China Currency Relationship

  • The Chinese Yuan has been viewed as undervalued relative to the dollar.

  • International pressure for appreciation vs. Chinese exporters' preference for a weaker Yuan.