INTERNATIONAL BUSINESS

Professor H. Michael Boyd, Ph.D.

Chapter 9 Foreign Exchange Market

Foreign Exchange Market



Essential for managers to understand the:



working of the foreign exchange market impact of currency exchange rates on their firms
sales  profits  strategy


Foreign Exchange Market



Foreign Exchange Market  Market for converting the currency of one country into the currency of another Exchange Rate  Rate at which one currency is converted into another Foreign Exchange Risk  Risk that arises from changes in exchange rates

Functions of the Foreign Exchange Market

  

Convert currency of one country into another currency Provide some insurance against foreign exchange risk 65% of all foreign exchange transactions are forward instruments 35% of all foreign exchange transactions are spot exchanges

Currency Conversion


Firms receiving payment in foreign currencies need to convert into their home currency  payments for exports  income from foreign investments or licensing fees Firms paying foreign firms in foreign currencies for goods or services they have purchased Firms invest spare cash in short-term money market accounts Firms making a foreign direct investment Profiting from short-term exchange rate changes (Speculation)

Insuring Against Foreign Exchange Risk



Attempt to reduce the risk of adverse consequences on the firm due to unpredicted changes in future exchange rates

Hedging when a firm insures itself against foreign exchange risk

Spot Exchange Rate

Exchange rate of one currency into another currency on a particular day


Spot exchange rates are reported on a real-time basis

 

on a minute-by-minute basis determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies

Quoted as the
 

amount of foreign currency one U.S. dollar will buy value of U.S. dollar for a one unit of foreign currency

Forward Exchange
Two parties agree to exchange currency and execute the deal at some specific date in the future


Used by firms to insure or hedge against foreign exchange risk that can make a transaction unprofitable Exchange rates governing such future transactions are referred to forward exchange rates Forward exchange rates can be quoted for 30 days, 60 days, 90 days, 180 days or longer into the future

Forward Exchange Rates

Selling at a Premium Expectation that the dollar will appreciate against the yen over the next 30 days
 

Spot Rate: 30 days Forward:

$1 = Y120 $1 = Y130

Forward Exchange Rates

Selling at a Discount Expectation that the dollar will depreciate against the yen over the next 30 days
 

Spot Rate: 30 days Forward:

$1 = Y120 $1 = Y110

Reducing Risk
Forward Exchange When two parties agree to exchange currency and execute the deal at some specific future date


Insures against foreign exchange risk for a limited period

Textbook Example


See pages 327-328

  

US firm imports laptops (at the price of Y200,000) from a Japanese supplier and must pay the supplier in 30 days after arrival in Yen Current dollar/yen spot exchange rate is $1 = Y120 Importers cost is $1,667 (200,000/120) Importer can sell the laptop at $2,000 at a gross profit of $333 (2,000-1,667) Importer does not have the funds to pay the supplier until laptops are sold To hedge against the risk of exchange rate movements between the $ and Yen, the importer can engage in a forward exchange Assume the dollar is selling at a 30-day discount at $1 = Y110 Importer is guaranteed to not pay more than $1,818 (200,000/110) Importer guaranteed $182 gross profit and insures against a loss If the dollar is selling at a 30-day premium at $1 =Y130 Importer guaranteed to not pay more than $1,538 (200,000/130) Importer guaranteed $462 gross profit and insures against a loss

 

  

  

Reducing Risk
Currency Swap Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

Insures against foreign exchange risk for a limited period Swaps are transacted between:  international firms and their banks  between banks  between governments

Textbook Example


See page 327

Today 90 Days

Apple needs to pay $1 M account payable to Japanese supplier Apple collects Y120 M account receivable from Japanese customer $1 = Y120 $1 = Y110

Spot Rate Today 90 Day Forward Rate

Swap  Apple sells $1 M to its bank in return for Y120 M and can pay its accounts payable today


At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting Y120 M into US dollars Thus, in 90 days, Apple will receive $1.09 M (Y120/110 = 1.09) Since the Yen is selling at 90-day premium, Apple receives more dollars than it started with.but the opposite could also occur.but Apple knows today!

Foreign Exchange Market

Global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems


Highly integrated and interdependent High-speed computer linkages create a single market Volume growing at a rapid pace Never sleeps: 24 hours - 7days

Foreign Exchange Market



Londons dominant trading center due to:  History: capital of first major industrialized nation  Geography: between Tokyo, Singapore, New York US Dollar plays a central role  Serves as a vehicle currency  Involved in 89% of currency trades in world

Arbitrage
Purchase of currency in one market for immediate resale in another market to profit from a price discrepancy


Due to the high-speed computer linkages between the trading centers, there rarely is a significant difference in exchange rates quoted in the trading centers Few arbitrage opportunities arise and often they are small and disappear in minutes

Economic Theories of Exchange Rate Determination



At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another But it does not tell us what underlying factors and/or conditions determine the demand and supply of a currency If we understand how exchange rates are determined, we may be able to forecast exchange rate movements The forces that determine exchange rates are complex and no theoretical consensus exists

Economic Theories of Exchange Rate Determination



Most economic theories of exchange rate movements seem to agree that three factors impact the future exchange rate movements in a countrys currency:


the countrys price inflation the countrys interest rate market psychology

Economic Theories of Exchange Rate Determination



Prices and Exchange Rates  Law of One Price  Purchasing Power Parity (PPP) Interest Rates and Exchange Rates Investor Psychology and Bandwagon Effects

Price and Exchange Rates

Law of One Price


In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example:  US/Euro exchange rate: $1 = Euro 5  A jacket selling for $50 in New York  Should retail for Euro 250 in Paris (50x5)

Price and Exchange Rates

Purchasing Power Parity (PPP)


By comparing the prices of identical products in different currencies, it should be possible to determine the real or PPP exchange rate


if markets were efficient (no impediments to trade)

In relatively efficient markets, then a basket of goods should be roughly equivalent in each country PPP theory predicts that changes in relative prices will result in a change in exchange rates

Money Supply and Price Inflation



PPP theory predicts that changes in relative prices will result in a change in exchange rates  A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate  Inflation occurs when the money supply increases faster than output increases An increase in a countrys money supply, which increases the amount of currency available, changes the relative demand and supply conditions in the foreign exchange market

Money Supply and Price Inflation

Empirical Test of PPP Theory


Research has yielded mixed results Relatively accurate for long-term predictions Not a strong short-term predictor (5 years or less)

Interest Rates and Exchange Rates



Economic theory says that interest rates reflect expectations about likely future inflation rates In countries where inflation is expected to be high, interest rates will also be high because investors want compensation for the decline in the value of their money

Fisher Effect (i = r+I)

Nominal Interest Rate = real interest rate + expected inflation rate

Interest Rates and Exchange Rates

International Fisher Effect For any two nations, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two nations


Since PPP theory links inflation and exchange rates, and interest rates reflect expectations about inflation, there must be a link between interest rates and exchange rates Not a good predictor of short-run changes in spot exchange rates

Investor Psychology and Bandwagon Effects



Research suggests that neither PPP theory nor the International Fisher Effect are good at explaining short- term movements in exchange rates Increasing evidence supports the role of investor psychology and the bandwagon effect  Studies suggest they play a major role in determining short-run exchange rate movements  But these factors are hard to predict!

Economic Theories of Exchange Rate Determination

In Summary


Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates But they are poor predictors of short-run changes in exchange rates

Exchange Rate Forecasting

Two Schools of Thought


Efficient Market School Inefficient Market School

Efficient Market School



Forward exchange rates represent market participants collective predictions of likely spot exchange rates at specified future dates Forward exchange rates/prices reflect all available public information and should be unbiased predictors  Predictions will not be accurate in every situation  Inaccuracies will be randomly and consistently above and below future spot rates Early studies seem to confirm the efficient market theory, but recent studies challenge it

Inefficient Market School



Foreign exchange rates do not reflect all available information Fundamental Analysis uses economic theory to construct sophisticated modes for predicting exchange rate movements Technical Analysis uses price/volume data of past trends which are expected are expected to continue in the future Analysis suggest that professional forecasters are no better than forward exchange rates in predicting future spot rates.but is gaining favor

Managing Foreign Exchange Risk

Risk that future changes in a countrys exchange rate will hurt the firm


Transaction Exposure Translation Exposure Economic Exposure

Transaction Exposure
extent to which fluctuations in foreign exchange values affect the income from individual transactions


Includes obligations for the:  purchase or sale of goods and services at previously agreed prices  borrowing or lending of funds in foreign currencies

Translation Exposure
impact of currency exchange rates on the reported financial statements of a firm


Concerned with the present measurement of past events Resulting accounting gains or losses are said to be unrealizedthey are paper gains or losses Can impact the level of financial leverage (debt ratio) of the firm and/or the financial profits of foreign subsidiaries

Economic Exposure
extent to which a firms future international earning power is affected by changes in exchange rates


Concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs Can impact the price competitiveness of a firm

Tactics and Strategies for Reducing Foreign Exchange Risk

Reducing Transaction and Translation Exposure


Primarily protects short-term cash flows by:



Buying Forward Currency Swaps Lead Strategy Lag Strategy

Lead Strategy


collecting foreign currency receivables from customers early when anticipating foreign currency devaluation paying foreign currency payables to suppliers early when anticipating foreign currency appreciation

Lag Strategy


delay collection of foreign currency receivables when anticipating foreign currency appreciation delay paying of foreign currency payables when anticipating foreign currency depreciation

Tactics and Strategies for Reducing Foreign Exchange Risk

Reducing Economic Exposure Distribute the firms productive assets to various locations in the world across major currencies so the firm is not severely affected by exchange rate changes

Developing Policies for Managing Foreign Exchange Exposure

No universal rule as to how, but common themes are:
 

 

centralize the control of foreign exchange exposure distinguish between transaction, translation and economic exposure forecast future exchange rate movements establish good reporting systems to monitor firms exposure to exchange rate changes produce monthly foreign exchange exposure reports

Currency Convertibility


Governments limit convertibility to:  preserve foreign exchange reserves  service international debt  purchase imports  avoid capital flight


rush on converting local currency to foreign currency

Many countries have some kind of restrictions

Currency Convertibility


Freely Convertible


Government allows both residents and non-residents to purchase unlimited amounts of foreign currency with domestic currency

Externally Convertible


Government allows only non-residents to convert domestic currency into foreign currency

Nonconvertible


Neither residents or nonresidents are allowed to convert into a foreign currency

Countertrade


Used by firms to deal with non-convertibility Barter-like agreements where goods/services are traded for goods/services Playing a decreasing role in world trade  below 10% of total world trade