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Chapter 09 - The Foreign Exchange Market

The Foreign Exchange Market

Learning objectives

Be conversant with the

functions of the foreign
exchange market.

Understand what is meant by

spot exchange rates.

Appreciate 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

Be familiar with the merits of

different approaches towards
exchange rate forecasting.

Understand the differences

between transaction,
translation, and economic
exposure, and what managers
do to manage each type of

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
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.



Opening Case: Hyundai and Kia Face a Strong Won
The Functions of the Foreign Exchange Market
Currency Conversion
Insuring Against Foreign Exchange Risk
Management Focus: Volkswagens 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
Country Focus: Anatomy of a Currency Crisis
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: The Curse of the Strong Dollar at STMicro

Give students a copy of a recent currency exchange report from the Wall Street Journal,
The New York Times 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 an feel for how supply
and demand can affect a currencys value.
OPENING CASE: Hyundai and Kia Face a Strong Won
The opening case describes the international strategy of two South Korean auto
companies, Hyundai and Kia. Both companies have approached the U.S. and European
Union markets with high quality, well-designed, attractively-priced vehicles. While this
strategy has been successful for the companies, it also means they are vulnerable to
changes in the value of the Korean won relative to the U.S. dollar and European euro.
Discussion of the case can revolve around the following questions:
1. How does a strong Korean won affect Hyundai and Kia? Why are the two companies
more vulnerable to currency movements than other automakers?
2. How can Hyundai and Kia protect themselves from adverse currency movements. In
your opinion, are the two companies taking the right steps to hedge their exposure?
3. Both Hyundai and Kia have recently opened new facilities in the U.S.
motivation for this strategy?

What is the

Another Perspective: To explore Hyundai and Kias strategies in greater depth, go to the
companies web sites at {} and {}.
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructors 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 9-3 Introduction

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 9-4 The Functions of 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
Slide 9-5 Currency Conversion
Companies use the foreign exchange market:
to convert payments it receives for its exports, the income it receives from foreign
investments, or the income it receives from licensing agreements with foreign
when they must pay a foreign company for its products or services in its countrys
when they have spare cash that they wish to invest for short terms in money
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: {} provides a real time currency cross-rate
chart, and an option to do currency conversions.

Slides 9-6-9-10 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.
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. A forward exchange rate
occurs when two parties agree to exchange currency and execute the deal at some
specific date in the future.
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 o one currency into another for a
limited period without incurring foreign exchange rate risk.

Slides 9-11-9-12 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.
Slide 9-14 Economic Theories of Exchange Rate Determination
Three factors have an important impact on future exchange rate movements in a countrys
the countrys 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 {
and click on what moves rates.

Slide 9-15-9-16 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 9-17 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 9-18 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.
Slide 9-19 Summary
International businesses should pay attention to countries differing monetary growth,
inflation, and interest rates.
Slide 9-21 Exchange Rate Forecasting
The efficient market school, argues that forward exchange rate 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 markets estimate of future exchange rates (as contained in the forward rate) by
investing in forecasting services.

Slide 9-22 The Efficient Market School

An efficient market is one in which prices reflect all available information.
Slide 9-23 The Inefficient Market School
In an inefficient market, prices do not reflect all available information.
Slide 9-24 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 9-25-9-26 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
countrys currency is nonconvertible.
Another Perspective: The American Countertrade Association maintains a web site with
information for those interested in countertrade. The site is worth a visit. It is available at

Slide 9-28 Implications for Managers

There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
Slide 9-29 Transaction Exposure
Transaction exposure is the extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values.

Slide 9-30 Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported
financial statements of a company.
Slide 9-31 Economic Exposure
Economic exposure is the extent to which a firms future international earning power is
affected by changes in exchange rates.

Slides 9-33-9-34 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
Slide 9-35 Reducing Economic Exposure
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 9-36 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; (c) the need to forecast future
exchange rates cannot be overstated; (d) firms need to establish good reporting systems
so the central finance function can regularly monitor the firms exposure position; (e) the
firm should produce monthly foreign exchange exposure reports.
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
(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?
(a) According to PPP, the $/ rate should be 2.80/3.70, or .76$/.
(b) According to PPP, the $/ one year forward exchange rate should be 3.10/4.65, or .
(c) Since the dollar is appreciating relative to the pound, and given the relationship of
the international Fisher effect, the British must have higher interest rates than the US.
Using the formula (S1 - S2)/S2 x 100 = i - i$ 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.
QUESTION 3: Reread the Management Focus feature on Volkswagen in this chapter,
then answer the following questions:
a) Why do you think management at Volkswagen decided to hedge only 30 percent of
their foreign currency exposure in 2003? What would have happened if they had hedged
70 percent of their exposure?
b) Why do you think the value of the U.S. dollar declined against that of the Euro in
c) Apart from hedging through the foreign exchange market, what else can Volkswagen
do to reduce its exposure to future declines in the value of the U.S. dollar against the
a) When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in
2003, the company essentially gambled that the euro would decline in value relative to
the dollar. The company hoped that by saving the cost of the commission involved in
selling a currency forward, it would increase its profit margin. This strategy of course,
b) The appreciation of the euro relative to the U.S. dollar took many people by surprise.
Its rise has been attributed to record U.S. foreign trade deficits and pessimism about the
future value of the dollar.
c) In addition to using forward contracts, Volkswagen could use currency swaps, and lead
and lag payables and receivables.

QUESTION 4: You manufacture wine goblets. In mid-June you receive an order for
10,000 goblets from Japan. Payment of 400,000 is due in mid-December. You expect
the yen to rise from its present rate of $1=130 to $1=100 by December. You can
borrow yen at 6% per annum. What should you do?
ANSWER 4: The simplest solution would be to just wait until December, take the
400,000 and convert it at the spot rate at that time, which you assume will be $1=100.
In this case you would have $4,000 in mid-December. If the current 180-day forward
rate is lower than 100/$, then a forward contract might be preferable since it both locks
in the rate at a better level and reduces risk. If the rate is above 100/$, then whether you
choose to lock in the forward rate or wait and see what the spot does will depend upon
your risk aversion. There is a third possibility also. You could borrow money from a
bank that you will pay back with the 400,000 you will receive (400,000/1.03 = 388,350
borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these
dollars in a US account. For this to be preferable to the simplest solution, you would
have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to
be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest
rates, then this method would also reduce any exchange rate risk. What you should do
depends upon the interest rates available, the forward rates available, how large a risk you
are willing to take, and how certain you feel that the spot rate in December will be 100 =
QUESTION 5: You are the CFO of a US firm whose wholly owned subsidiary in Mexico
manufactures component parts for your US assembly operations. The subsidiary has been
financed by bank borrowings in the United States. One of your analysts told you that the
Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign
exchange markets over the next year. What actions, if any, should you take?
ANSWER 5: Your financing and operating capital are in dollars, yet many of your costs
(labor) must be in peso. Your hard assets are all in peso, and their value will decline. On
the other hand, if the peso depreciates, then your dollars will go further. So perhaps
doing nothing is the best approach. If you are pretty sure that the peso will depreciate,
then you may want to avoid any major peso-denominated costs that you can until after
devaluation. That may mean holding back on shipments if possible, and you may want
any dollar-denominated purchases made before the devaluation. You may want to move
any peso-denominated major accounts into dollars before the devaluation.
CLOSING CASE: The Curse of the Strong Dollar at STMicro

The closing case explores the effect of a strong dollar on STMicro, a European
manufacturer of semiconductors. The majority of STMicros operations are located in
Western Europe. Accordingly, when the dollar was strong relative to the euro, STMicro
made a healthy profit, but saw its profit tumble when the value of the euro rose.
Discussion of the case can revolve around the following questions.
QUESTION 1: In retrospect, could the fall in the value of the dollar against the Euro
have been predicted in 2003?
ANSWER 1: Since its introduction, the euro has been volatile relative to the U.S. dollar.
Most analysts were surprised in 2003 by the rapid rise in value of the euro relative to the
dollar. However, given that a key reason for the rise in value of the euro was the record
U.S. foreign trade deficit which created an outward flow of dollars, and a lower value for
the dollar, some might argue that the trend should have been expected.
QUESTION 2: What was the fundamental reason for the decline in the value of the dollar
against the euro in 2003-2006? To what extent is the decline in the value of the dollar
consistent with the theories of exchange rate determination discussed in this chapter?
ANSWER 2: Investor psychology probably played a role in the decline of the dollar
versus the euro in 2003-2006. Foreigners were pessimistic after the U.S. government
announced that a weak dollar was acceptable since it helped firms trying to export. In
addition, the U.S. governments record budget deficit contributed to the demise of the
dollar relative to the euro. Many foreigners believed the U.S. would have to finance its
spending through an expansion in the money supply, which would lead to inflation, and
cause a drop in the value of the dollar.
QUESTION 3: Why do you think that STMicro did very little currency hedging?
ANSWER 3: Hindsight is 20/20. During the early years of the euro, STMicro enjoyed
high profits thanks to the weak euro and strong dollar. When the market began to shift,
STMicro was unprepared. When the dollar fell, STMicro saw a negative impact on its
profits. In the good years, the company was able to save the costs of currency hedging,
however these costs savings were wiped out by the losses associated with the weak
QUESTION 4: What strategy is STMicro now adopting to deal with possible future
fluctuations in exchange rates? Is this a smart strategy?

ANSWER 4: To deal with possible future fluctuations in exchange rates, STMicro is

actively cutting costs by closing some European operations and cutting jobs. In addition,
the company is shifting some production to Asia with the idea of being able to switch
production between Asia and Europe as the situation warrants. It is not clear whether the
company intends to do any currency hedging, but it could complement STMicros other
Another Perspective: Students can further explore STMicros current situation by going
to its web site at {}.
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: Federal Reserve Moves to Stabilize Market
Federal Reserve Spends Billions
Run Time: 10:21
Abstract: This video explores the efforts by the Federal Reserve and other central banks
to stabilize financial markets.
Key Concepts: international monetary system, investor psychology and the bandwagon
effect, globalization
Notes: Global markets, concerned about the availability of credit, received some
reassurance recently when the Federal Reserve, along with the European Central Bank,
and other central banks, announced that they would pump billions of dollars into the
global financial system. The hope is that the additional liquidity will ensure that prices in
the market reflect underlying risks. As a result of the Federal Reserves actions, the
federal funds rate, which had been 6 percent, dropped back to the targeted 5.25 percent.
Liquidity in the market had been disrupted by a very abrupt re-pricing of risk in the
Glenn Hubbard, dean of the Columbia Business School, believes that the move was
important for restoring market confidence and ensuring that there were no developments
in the market that could lead to a financial crisis. Laurence Meyer, former governor of
the Federal Reserve Board, noted that the problems that were addressed began in the
United States, and in particular with sub-prime loans. However, because financial
markets today are global in nature, the problems quickly spread to other countries in
Europe. Glenn Hubbard also stresses the need to fully understand the global nature of
financial markets, and the interconnectedness of the global economy.

Hubbard points out that while the current problem began in the United States and spread
to other countries, the contributions to global liquidity and investments in the United
States came from foreign markets. He notes that today, risks are spread and diversified
around the world. Hubbard expects further intervention in the market. Hubbard believes
the current situation is actually a correction in the market that will more accurately price
risk. He notes that the correction took place very quickly as people became worried
about credit spreads.
Discussion Questions:
1. Why did the Federal Reserve recently pump money into financial markets? What
problems was it trying to address? Did it succeed?
2. Consider the recent move by the Federal Reserve to inject additional liquidity into
financial markets. The Federal Reserves efforts were just part of a worldwide effort to
reassure investors of the availability of credit. Why was it important for the Federal
Reserve to work in tandem with other central banks? Could the Federal Reserve have
corrected the problem by working alone?
2. Reflect on the global nature of world financial markets. What are the implications of
this interconnectedness? As an investor, how does this affect you?
4. Discuss the implications of global financial markets, and the potential for a worldwide
economic crisis.
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following:
Title 11: Chinese Currency Change

After more than a decade, the Chinese yuan is finally being decoupled from the U.S.
dollar. The yuan will now float against a basket of foreign currencies. China has been
under increasing pressure from the U.S. to make such a move. In fact, U.S. Treasury
Secretary John Snow has complained that continuing to peg the yuan to the dollar was
tantamount to subsidizing companies, and threatened retaliatory trade sanctions if China
failed to take corrective actions. Analysts, however, note that China is only revaluing the
yuan by two percent, so the net effect is negligible given that estimates have the yuan as
being undervalued by as much as 40 percent. China is reluctant to make a significant
change to the yuan because its economic policy centers on growing exports, and the
undervalued yuan amounts to a 33 percent subsidy to exporters. Eliminating the
subsidy results in a loss of competitiveness for Chinese exporters, and an increase in
competitiveness for American exporters.
The question now is whether China will take steps to further revalue its currency.
Analysts seem to believe that political pressure and internal pressures will force China to
continue to continue to revalue its currency, a move that could have repercussions in
other parts of Asia. There is also some concern that inflationary pressures will rise in the
U.S. if China makes any significant moves to revalue its currency.
Discussion Questions:
1. China, which has been under strong political pressure for some time to revalue its
currency, has finally agreed to do just that, only in a very small way. Is this move by
China a win for the U.S. or a win for China? What are the political implications of this
2. Until now, Chinas currency valuation has represented a significant subsidy to Chinese
exporters, a situation that is seen in a negative light by American exporters. However, as
a beneficiary of cheap goods made in China, how do you feel about the U.S. efforts to
force China to raise its currency?
3. After more than a decade, the value of the yuan has risen relative to the dollar. While
the revaluation amounts to just a two percent difference at the moment, there is
speculation that the Chinese will continue to allow the yuan to rise. What effect will this
initial movement have on Chinese workers and consumers? What are the effects if the
yuan continues is ascent?
4. Chinas revaluation of the yuan was echoed in other parts of Asia. For example, in
India, the rupee appreciated, as did the Japanese yen. Consider the implications of
further currency revaluations for the Asian region.

globalEDGE Exercise Questions

Use the globalEDGE site {} to complete the following
Exercise 1
One component of learning about another country or region is to understand the
relationship of its currency with others on the world currency market. As such, you are
assigned the duty of ensuring the availability of 100,000 yen for a payment scheduled for
next month. Considering that your company possesses only US dollars, identify the spot
and forward exchange rates. What are the factors that influence your decision to use the
spot or forward exchange rate? Which one would you choose? How many dollars must
you spend to acquire the amount of yen required?
Exercise 2
Sometimes, analysts use the price of specific products across locations to compare
currency valuation and purchasing power. In fact, the Big Mac Index compares the
purchasing-power parity of many countries based on the price of a Big Mac. Locate the
latest edition of this index that is accessible. Identify the five countries (and the
currencies) with the lowest purchasing-power parity according to this classification.
Which currencies, if any, are overvalued?
Answers to the Exercises
Exercise 1
The currency exchange rates can be accessed through a variety of sources. A list of these
sources is available {} and can be accessed by
searching the term exchange rates. The first resource listed under this search is the FX
Street website, located under the globalEDGE category Money: Finance. This site
offers daily updated information about foreign exchange markets as forex news, market
reports, forecasts, and real-time exchange rates and charts. A currency converter and
historical tables are also available. By using the search function for such key terms as
spot rate and forward rate, reports for each definition are provided. Additionally,
forward and spot rates are readily available on the website. Be sure to check the
Resource Desk only checkbox of the search function on the globalEDGE website.
Search Phrase: Exchange Rates
Resource Name: FX Street
Website: {}
globalEDGE Category: Money: Finance

Exercise 2
The Big Mac Index can be accessed by searching the term Big Mac Index at
{}. The resource is located under the
globalEDGE category Money: Finance. Be sure to check the Resource Desk only
checkbox of the search function on the globalEDGE website.
Search Phrase: Big Mac Index
Resource Name: Economist: The Big Mac Index
Website: {}
globalEDGE Category: Money: Finance