© McGraw Hill Companies, Inc.,2000 The Foreign Exchange Market Chapter 9

© McGraw Hill Companies, Inc.,

Why Convert Currency?  Payments may be made in a foreign currency.  Purchases may have to be paid in the supplier’s currency.  Company may want to invest in a country.  Currency Speculation © McGraw Hill Companies, Inc.,

Foreign Exchange (Fx)  A commodity that consists of currencies issued by countries other than one’s own. © McGraw Hill Companies, Inc.,

Foreign Exchange Exposure Economic The objective is to anticipate and influence the effect of unexpected changes in exchange rates on a firm's future cash flows Arises when payments must be made or received in a foreign currency Transaction Arises from consolidating assets and liabilities measured in foreign currencies with those in the reporting currency Translation © McGraw Hill Companies, Inc.,

© McGraw Hill Companies, Inc.,2000 Exchange Market/Exchange Rate  The Foreign Exchange Market: a market for converting the currency of one country into the currency of another country.  An Exchange Rate: is the rate at which one currency is converted into another. 9-5

Functions of the Foreign Exchange Market  Two functions:  Converting currencies  Reducing risk © McGraw Hill Companies, Inc.,

Currency Risk  In every international transaction there is a currency risk that runs from the date of contract to date of payment.  Currency exchange rates are continuously changing. © McGraw Hill Companies, Inc.,

Reducing Risk  Spot Exchange Rates: when two parties agree to exchange currency and execute the deal immediately.  Forward Exchange Rates: when two parties agree to exchange currency and execute the deal at some specific future date.  Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. © McGraw Hill Companies, Inc.,

Foreign Exchange Transactions April 1995 (Percent) © McGraw Hill Companies, Inc., Figure 9.1 in text

© McGraw Hill Companies, Inc.,2000 The Hierarchy of International Financial Centers Note: Size of dots (squares) indicates cities’ relative importance São Paulo Rio de Janiero Mexico City San Francisco New York Toronto Bombay Melbourne Sydney Tokyo Hong Kong Singapore London Paris Zurich Frankfurt Amsterdam Vienna Madrid Hamburg Dusseldorf Rome Basel Brussels Chicago 9-10

Share of Global Foreign Exchange Trading Accounted for by London, New York, and Tokyo © McGraw Hill Companies, Inc.,

© McGraw Hill Companies, Inc.,2000 Fx Market Turnover in Major Centers 9-12 Figure 9.2

© McGraw Hill Companies, Inc.,2000 Trading Hours of the World’s Major Financial Centers New York San Francisco London Bahrain Tokyo Hong Kong Singapore

Economic Theories  At lowest level = supply/demand.  Law of One Price and Purchasing Power Parity.  Interest rates.  Investor psychology. © McGraw Hill Companies, Inc.,

© McGraw Hill Companies, Inc.,2000 Law of One Price  In competitive markets free of transportation costs and barriers to trade (tariffs), 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/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York should retail for for FFr 250 in Paris (50x5) 9-15

© McGraw Hill Companies, Inc.,2000 Purchasing Power Parity  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.  In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country 9-16

The Big Mac Index Purchasing Power Parity: 1995 United States $ 2.32 (average) Switzerland SwFr Argentina Peso France FFr Japan ¥ Brazil Real Canada C $ Hong Kong HK $ Russia Ruble 8,100 3, , Price in Local Currency Implied PPP of the Dollar Actual Exchange Rate Local Currency % Over(+) or Under(-) Valuation Against Dollar † † As of 4/15/95 © McGraw Hill Companies, Inc.,

Japanese Big Mac Valuation (Yens Over (+) or UNDER (-) Valuation Against the Dollar) © McGraw Hill Companies, Inc.,

East Asian Big Mac Valuation © McGraw Hill Companies, Inc.,

Inflation and the Money Supply Turkey Ecuador Poland Colombia China Portugal Great Britain United States Japan Growth in money supply, % Consumer prices, (%) © McGraw Hill Companies, Inc.,

Exchange Rate Forecasting  Efficient market: where prices reflect all available public information.  Forward exchange rates reflect market participant’s collective predictions of likely spot exchange rates at specified future dates.  Inefficient market: where prices do not reflect all available information. Forward exchange rates are not the best predicators of future spot exchange rates.  Use fundamental or technical analysis to predict the exchange rates. © McGraw Hill Companies, Inc.,

Factors Influencing Currency Value Economic Factors 1.Balance of Payment 2.Interest Rates 3.Inflation 4.Monetary and Fiscal Policy 5.International Competitiveness 6.Monetary Reserves 7.Government Controls and Incentives 8.Importance of Currency in World Political Factors 9.Political Party and Leader Philosophies 10.Proximity of Elections or Change in Leadership Expectation Factors 11.Expectations 12.Forward Exchange Market Prices © McGraw Hill Companies, Inc.,

Currency Convertibility  Freely convertible.  Externally convertible.  Not convertible.  Preserve foreign exchange reserves. Service international debt. Purchase imports.  Political decision.  Many countries have some kind of restrictions.  Countertrade. © McGraw Hill Companies, Inc.,