The Global Monetary System Source: © ICP-Tech/incamerastock/Alamy Stock Photo Chapter 10: The Foreign Exchange Market

Learning Objectives LO 10-1 Describe the functions of the foreign exchange market. LO 10-2 Understand what is meant by spot exchange rates. LO 10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk. LO 10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits. LO 10-5 Identify the merits of different approaches toward exchange rate forecasting. LO 10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and explain the implications for management practice.

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

The Functions of the Foreign Exchange Market 1 of 6 Enables the conversion of the currency of one country into the currency of another Provides some insurance against foreign exchange risk: the adverse consequences of unpredictable changes in exchange rates LO 10-1 Describe the functions of the foreign exchange market.

The Functions of the Foreign Exchange Market 2 of 6 Currency Conversion To convert export receipts, income received from foreign investments, or income received from licensing agreements To pay a foreign company for products or services To invest spare cash 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 Carry trade borrows one currency where interest rates are low and invests these in another currency where interest rates are high Carry trade, which involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high, has become a more common form of speculation. Internet Extra: To see real time currency conversions, go to XE.com {http://www.xe.com}. Click on Quick Currency converter, and enter the currencies you want to convert.

The Functions of the Foreign Exchange Market 3 of 6 Insuring Against Foreign Exchange Risk The foreign exchange market can provide insurance against foreign exchange risk: the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm A firm that protects itself against foreign exchange risk is hedging The market performs this function using Spot exchange rates Forward exchange rates Currency swaps LO 10-2 Understand what is meant by spot exchange rates.

The Functions of the Foreign Exchange Market 4 of 6 Insuring Against Foreign Exchange Risk continued Spot Exchange Rates Rate at which a foreign exchange dealer converts one currency into another currency on a particular day Determined by the interaction between supply and demand Changes continually

The Functions of the Foreign Exchange Market 5 of 6 Insuring Against Foreign Exchange Risk continued 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 some 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 LO 10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

The Functions of the Foreign Exchange Market 6 of 6 Insuring Against Foreign Exchange Risk continued Currency Swaps Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Swaps are used when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk Swaps can take many forms – some quite complicated – depending on the relationships between spot and forward exchange rates and interest rates in both countries. Book example – agreement with bank to buy Yen today on spot market and simultaneously agrees to sell the Yen back in the future on the forward market. Gardner: Another common option – borrow $ today in U.S. and exchange those $ for Yen that were borrowed in Japan by Japanese company with agreement to swap funds and repay both in future

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 communications systems The market is always open somewhere in the world If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage: the process of buying a currency low and selling it high Most transactions involve U.S. dollars on one side The U.S. dollar is a vehicle currency

Economic Theories of Exchange Rate Determination 1 of 9 Three factors have an important impact on future exchange rate movements A country’s price inflation A country’s interest rate Market psychology Gardner – all of these are related to the supply and demand for the currency on the foreign exchange market. LO 10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

Economic Theories of Exchange Rate Determination 2 of 9 Prices and Exchange Rates The law of one price In competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when price is expressed in terms of the same currency Purchasing power parity (PPP) Given relatively efficient markets (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

Economic Theories of Exchange Rate Determination 3 of 9 Prices and Exchange Rates continued Purchasing Power Parity continued PPP predicts that changes in relative prices will result in changes in exchange rates When inflation is relatively high, a currency should depreciate Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar  Summary  This feature describes the process of quantitative easing and its implications for the economy. The injection of money into the market by the Federal Reserve in the fall of 2010 was designed to help stimulate the struggling U.S. economy. The move was criticized though by those who felt the move would actually generate inflation and a falling dollar. Time proved the critics wrong as the value of the currency remained virtually unchanged for several months. Discussion of the feature can begin with the following questions.  Suggested Discussion Questions  1. What does the 2010 purchase by the Federal Reserve of $600 billion in U.S. government bonds tell you about U.S. fiscal policy? What was the Federal Reserve trying to accomplish?  Discussion Points: The decision by the Federal Reserve to purchase $600 billion in U.S. government bonds suggests that the United States was trying to expand the money supply. A larger money supply implies lower interest rates. Lower interest rates decrease the cost of borrowing and should therefore increase investment in the economy. Most students will recognize that the goal of the Federal Reserve was to stimulate the U.S. economy  2. Why did the Federal Reserve receive so much criticism for its policy of quantitative easing? Do you agree with the critics? Was the policy simply mercantilism in disguise?  Discussion Points: Critics claim that the decision by the Federal Reserve to increase the money supply via quantitative easing was actually a form of protectionism, and in particular, simply a mercantilist policy. According to critics, the Federal Reserve’s policy would prompt a decline in the value of the U.S. dollar making it easier for U.S. companies to export, and harder for foreign companies to export their products to the United States. Most students will probably agree that the fears of the critics proved to be unfounded as the value of the dollar against a basket of major currencies remained virtually unchanged.  Lecture Note: To extend this discussion, consider {http://www.businessweek.com/magazine/content/10_49/b4206055411492.htm}.

Economic Theories of Exchange Rate Determination 4 of 9 Prices and Exchange Rates continued Money Supply and Price Inflation If we can predict inflation rates, we can predict how a currency’s value might change The growth of a country’s money supply determines its likely future inflation rate When the growth in the money supply is greater than the growth in output, inflation will occur Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar  Summary  This feature describes the process of quantitative easing and its implications for the economy. The injection of money into the market by the Federal Reserve in the fall of 2010 was designed to help stimulate the struggling U.S. economy. The move was criticized though by those who felt the move would actually generate inflation and a falling dollar. Time proved the critics wrong as the value of the currency remained virtually unchanged for several months. Discussion of the feature can begin with the following questions.  Suggested Discussion Questions  1. What does the 2010 purchase by the Federal Reserve of $600 billion in U.S. government bonds tell you about U.S. fiscal policy? What was the Federal Reserve trying to accomplish?  Discussion Points: The decision by the Federal Reserve to purchase $600 billion in U.S. government bonds suggests that the United States was trying to expand the money supply. A larger money supply implies lower interest rates. Lower interest rates decrease the cost of borrowing and should therefore increase investment in the economy. Most students will recognize that the goal of the Federal Reserve was to stimulate the U.S. economy  2. Why did the Federal Reserve receive so much criticism for its policy of quantitative easing? Do you agree with the critics? Was the policy simply mercantilism in disguise?  Discussion Points: Critics claim that the decision by the Federal Reserve to increase the money supply via quantitative easing was actually a form of protectionism, and in particular, simply a mercantilist policy. According to critics, the Federal Reserve’s policy would prompt a decline in the value of the U.S. dollar making it easier for U.S. companies to export, and harder for foreign companies to export their products to the United States. Most students will probably agree that the fears of the critics proved to be unfounded as the value of the dollar against a basket of major currencies remained virtually unchanged.  Lecture Note: To extend this discussion, consider {http://www.businessweek.com/magazine/content/10_49/b4206055411492.htm}.

Economic Theories of Exchange Rate Determination 5 of 9 Prices and Exchange Rates continued Empirical Tests of PPP Theory Indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run (see next slide The purchasing power parity puzzle Assumes away transportation costs and barriers to trade PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations.

Economic Theories of Exchange Rate Determination PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations.

Economic Theories of Exchange Rate Determination 6 of 9 Interest Rates and Exchange Rates The Fisher Effect states that a country’s nominal interest rate (i) is the sum of the required real rate of interest (r ) and the expected rate of inflation over the period for which the funds are to be lent (I), so i = r + I So, if the real interest rate is the same everywhere, any difference in interest rates between countries reflects differing expectations about inflation rates, so the textbook suggests that a high interest rate will cause a currency’s value to FALL in the future. Gardner – above not true if high nominal rate is thought to reflect a high real rate of interest

Economic Theories of Exchange Rate Determination 8 of 9 Investor Psychology and the Bandwagon Effects Bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations Governmental intervention can prevent the bandwagon from starting, but is not always effective (Gardner) – exchange rates also affected by perceived strength and stability of the economy.

Economic Theories of Exchange Rate Determination 9 of 9 Summary of Exchange Rate Theories Relative monetary growth, relative inflation rates, and nominal interest rate differentials (and economic strength) are all moderately good predictors of long-run changes in exchange rates, but poor predictors of short term changes So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates

Exchange Rate Forecasting 1 of 3 The Efficient Market School 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 LO 10-5 Identify the merits of different approaches toward exchange rate forecasting.

Exchange Rate Forecasting 2 of 3 The Inefficient Market School 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 LO 10-5 Identify the merits of different approaches toward exchange rate forecasting.

Exchange Rate Forecasting 3 of 3 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 skeptical of technical analysis

Currency Convertibility 1 of 2 Various types of currencies Freely convertible: both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency Externally convertible: only non-residents can convert their holdings of domestic currency into a foreign currency Nonconvertible: both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

Currency Convertibility 2 of 2 The main reason is 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 How important is countertrade? Twenty years ago, a large number of nonconvertible currencies existed in the world, and countertrade was quite significant. However, in recent years, many governments have made their currencies freely convertible, and the percentage of world trade that involves countertrade is probably significantly below 5 percent.

Focus on Managerial Implications 1 of 4 Foreign Exchange Rate Risk Firms must understand the influence of exchange rates on the profitability of trade and investment deals Transaction exposure The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values Translation exposure The impact of currency exchange rate changes on the reported financial statements of a company Economic exposure The extent to which a firm’s future international earning power is affected by changes in exchange rates LO 10-6 Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure. Translation exposure: Deals with the present measurement of past events Gains and losses from translation exposure are reflected only on paper

Focus on Managerial Implications 2 of 4 Reducing Translation and Transaction Exposure Buy forward Use swaps Lead Strategy Collect foreign currency receivables early when a foreign currency is expected to depreciate Paying foreign currency payables before they are due when a currency is expected to appreciate Lag Strategy Delay collection of foreign currency receivables if that currency is expected to appreciate Delay payables if the currency is expected to depreciate Lead and lag strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important customers who are in a position to dictate payment terms

Focus on Managerial Implications 3 of 4 Reducing Economic Exposure Firms need to distribute productive assets to various locations to avoid long-term financial problems associated with changes in exchange rates

Focus on Managerial Implications 4 of 4 Other Steps for Managing Risk Establish central control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand Attempt to forecast future exchange rates Establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position Produce monthly foreign exchange exposure reports

Summary In this chapter we have Described the functions of the foreign exchange market. Understood what is meant by spot exchange rates. Recognized the role that forward exchange rates play in insuring against foreign exchange risk. Understood the different theories explaining how currency exchange rates are determined and their relative merits. Identified the merits of different approaches toward exchange rate forecasting. Compared and contrasted the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.