Foreign Exchange Market

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The Foreign Exchange Market

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Full file at http://testbanksinstant.eu/ Solution-Manual-for-International-Business,-9E--revised-edition-

Learning objectives

· Describe the functions of the foreign exchange market.

· Understand what is meant by spot exchange rates.

· Recognize the role that foreign exchange rates play in insuring against foreign exchange risk.

· Understand the different theories explaining how currency exchange rates are determined and their relative merits.

· Identify the merits of different approaches towards exchange rate forecasting.

· Compare and contrast the differences between transaction, translation, and economic exposure, and what managers do to manage each type of exposure.

The foreign exchange market is the market where currencies are bought and sold and currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.

Exchange rates determine the value of one currency in terms of another. While dealing in multiple currencies is a requirement of doing business internationally, it also creates risks and significantly impacts the attractiveness of different investments over time.

The foreign exchange market is used for:

1. Currency conversion, 2. Currency hedging,

3. Currency arbitrage, 4.Currency speculation.

Firms can use the foreign exchange market to minimize the risk of adverse exchange rate movement. Such arrangements can prevent them from benefiting from favorable movements.

The opening case explores how the rise of the Swissy during a period of global financial strife. The closing case explores the effects of changing exchange rates on Caterpillar Tractor’s strategy and profits.

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OUTLINE OF CHAPTER 10: THE FOREIGN EXCHANGE MARKET

Opening Case: The rise of the Swissy

Introduction

The Functions of the Foreign Exchange Market

Currency Conversion

Insuring Against Foreign Exchange Risk

Management Focus: Volkswagen’s Hedging Strategy

The Nature of the Foreign Exchange Market

Economic Theories of Exchange Rate Determination

Prices and Exchange Rates

The Law of One Price

Interest Rates and Exchange Rates

Investor Psychology and Bandwagon Effects

Summary

Country Focus: China - the currency manipulator?

Exchange Rate Forecasting

The Efficient Market School

The Inefficient Market School

Approaches to Forecasting

Currency Convertibility

Implications for Managers

Transaction Exposure

Translation Exposure

Economic Exposure

Reducing Translation and Transaction Exposure

Reducing Economic Exposure

Other Steps for Managing Foreign Exchange Risk

Management Focus: Dealing with the Rising Euro

Chapter Summary

Critical Thinking and Discussions Questions

Closing Case: Caterpillar Tractor

CLASSROOM DISCUSSION POINT

Give students a copy of a recent currency exchange report from the Wall Street Journal, or The Financial Times. Then, show students how to read the chart and understand the difference between direct quotes and indirect quotes.

Next, give students some “money” (slips of paper designated with certain currency values) and ask them to convert their money into a foreign currency at the “bank” and purchase several things like a hamburger and drink.

Finally, create a shortage of a popular currency to give students a feel for how supply and demand can affect a currency’s value.

OPENING CASE: The rise of the Swissy

The opening case explores the implications of the Swissy’s rise. For many years it has been a safe haven currency. It is one that investors flock to when the global or regional financial outlook turns gloomy. The franc strengthened by 30% against the euro during the three years to September 2011 as investors searched for safe places to deposit their cash as the global financial crisis morphed into an economic crisis, then euro area sovereign debt crisis, which threatened the very existence of the euro zone. Discussion of the case can revolve around the following questions:

1. What is the impact if the Swissy being overvalued?

2. What are the potentialbenefits of having such a strong currency?

3. Explain why exchange rates have been so volatile in recent years.

Another Perspective: For a fresh look at the Swissy read http://ftalphaville.ft.com/blog/2012/06/18/1048981/the-swiss-franc-proving-a-fundamental-trilemma/

LECTURE OUTLINE

This lecture outline follows the Power Point Presentation (PPT) provided along with this instructor’s manual. The PPT slides include additional notes that can be viewed by clicking on “view”, then on “notes”. The following provides a brief overview of each Power Point slide along with teaching tips, and additional perspectives.

Slide 10-3 Why is the Foreign Exchange Market Important?

This chapter:

· explains how the foreign exchange market works

· examines the forces that determine exchange rates and discusses the degree to which it is possible to predict exchange rate movements

· maps the implications for international business of exchange rate movements and the foreign exchange market

The foreign exchange market is a market for converting the currency of one country into that of another country. The exchange rate is the rate at which one currency is converted into another.

Slide 10-4 When Do Firms Use the Foreign Exchange Market?

The foreign exchange market is used:

· to convert the currency of one country into the currency of another

· to provide some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates

Companies use the foreign exchange market:

· to convert payments they receive for exports, the income they receive from foreign investments, or from licensing agreements with foreign firms

· when they must pay a foreign company for products or services in a foreign currency

· when they have spare cash that they wish to invest for short terms in money markets

· for currency speculation - the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

Another Perspective: XE.com {http://www.xe.com/} provides a real time currency cross-rate chart, and an option to do currency conversions.

Slides 10-5 Insuring Against Foreign Exchange Risk

A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk.

Slide 10-6-10-8 Spot Rates and Forward Rates

The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.

Slide 10-9 Currency Swap

A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk.

Slide 10-10 The Nature of the Foreign Exchange Market

The foreign exchange market is not a place, but a network of banks, brokers, and dealers that exchange currencies 24 hours/day.

Slides 10-11-10-12 Exchange Rates between Markets

Opportunities for arbitrage exist when exchange rates are not the same between markets.

About 85 percent of al foreign exchange transactions involve the U.S. dollar. It is a vehicle currency.

Slide 10-13 Economic Theories of Exchange Rate Determination
Three factors have an important impact on future exchange rate movements in a country’s currency:

· the country’s price inflation

· its interest rate

· market psychology

Another Perspective: To find out more about how various factors affect, or are affected by, exchange rates, go to {http://www.fxcm.com/docs_pdfs/dailyfx-article/The_5_Things_that_Move_the_Currency_Markets.pdf}.

Slides 10-14-10-17 Prices and Exchange Rates

The law of one price suggests that in competitive markets free of transportation costs and trade barriers, identical products in different countries must sell for the same price when their price is expressed in terms of the same currency.

A less extreme version of the PPP theory states that given relatively efficient markets – that is, markets in which few impediments to international trade and investment exist – the price of a “basket of goods” should be roughly equivalent in each country.

Slide 10-18 Interest Rates and Exchange Rates

The International Fisher Effect states that 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 two countries.

Slide 10-19 Investor Psychology and Bandwagon Effects

Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and move exchange rates based on group expectations.

Slides 10-20-10-22 Exchange Rate Forecasting

The efficient market school, argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money, while the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services.

An efficient market is one in which prices reflect all available information.

In an inefficient market, prices do not reflect all available information.

Slide 10-23 Approaches to Forecasting

There are two approaches to forecasting exchange rates:

· fundamental analysis - draws upon economic theories to predict future exchange rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments information

· technical analysis - chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves

Slides 10-24-10-26 Currency Convertibility

A currency is said to be freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency.

A currency is said to be externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way.

A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency.

Free convertibility is the norm in the world today, although many countries impose restrictions on the amount of money that can be converted. The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight.

Countertrade refers to a range of barter like agreements by which goods and services can be traded for other goods and services. It can be used in international trade when a country’s currency is nonconvertible.

Another Perspective: The American Countertrade Association {http://www.globaloffset.org} maintains a web site with information for those interested in countertrade. Also, students can learn more about countertrade at {http://www.barternews.com/countertrade.htm}.

Slide 10-27-10-29 Implications for Managers

There are three types of foreign exchange risk:

1. Transaction exposure

2. Translation exposure

3. Economic exposure

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company.

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates.

Slides 10-31-10-32 Reducing Translation and Transaction Exposure

Firms can minimize their foreign exchange exposure by:

· buying forward

· using swaps

· leading and lagging payables and receivables - paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements

Firms can reduce economic exposure by ensuring assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produced.

Slide 10-33 Other Steps for Managing Foreign Exchange Risk

To manage foreign exchange risk:

(a) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

(b) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

(d) firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position

(e) the firm should produce monthly foreign exchange exposure reports.

CRITICAL THINKING AND DISCUSSION QUESTIONS

QUESTION 1: The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%. The US interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

ANSWER 1: Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

QUESTION 2: Two countries, Great Britain and the US, produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound.

(a) According to PPP theory, what should the $/£ spot exchange rate be?

(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate?

(c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10%, what would you expect current interest rate to be in Britain?

ANSWER 2:

(a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£.

(b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65, or .67$/£.

the international Fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.