1. Global Business Today 9e
by Charles W.L. Hill
and Tomas Hult

2. The Foreign Exchange Market
Chapter 10
The Foreign
Exchange Market

3. Learning Objectives The learning objectives for this chapter are to:
Describe the functions of the foreign exchange market.
Understand what is meant by spot exchange rates.
Recognize the role that forward exchange rates play in insuring against foreign exchange risk.
Understand the different theories explaining how currency exchange rates are determined and their relative merits.
Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

4. Introduction Question: What is the foreign exchange market?
Answer: The foreign exchange market is a market for converting the currency of one country into that of another country
Question: What is an exchange rate?
Answer: An exchange rate is the rate at which one currency is converted into another

5. Functions of the FX Market
Question: What is the function of the foreign exchange market?
Answer:
The foreign exchange market:
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

6. Currency Conversion International firms use foreign exchange markets:
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, 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 {
Click on Quick Currency converter, and enter the currencies you want to convert.

7. Insuring Against FX 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

8. Insuring Against FX Risk (continued from Slide 10-7)
1. Spot exchange rate: the 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

9. Insuring Against FX Risk (continued from Slide 10-8)
2. 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 rates are typically quoted for 30, 90, or 180 days into the future
Management Focus: Volkswagen’s Hedging Strategy
Summary
This feature examines the effects of Volkswagen’s decision to not properly hedge its foreign exchange exposure in Volkswagen saw a 95 percent drop in its fourth quarter profits after an unexpected surge in the value of the euro left the company with losses of $1.5 billion. Traditionally, Volkswagen, which produced its vehicles in Germany and exported them to the United States, hedged some 70 percent of its foreign exchange exposure. However, in 2003, the company made the unfortunate decision to hedge just 30 percent of its exposure. Discussion of the feature can begin with the following questions:
Suggested Discussion Questions
1. Explain how Volkswagen’s failure to fully protect itself against foreign exchange fluctuations had a negative effect on the company. What can Volkswagen and other companies learn from this experience?
Discussion Points: Traditionally, Volkswagen hedged 70 percent of its foreign exchange exposure, but in 2003, the company was caught off guard by a sudden rise in the value of the euro against the dollar. Experts had failed to predict the rise in the euro, and Volkswagen, like other companies that failed to hedge their foreign exchange exposure, was hard hit. Volkswagen lost some €1.2 billion as a result of its decision to hedge just 30 percent of its foreign exchange exposure. Most students will recognize that the experiences of Volkswagen underscores the volatility of the foreign exchange market and the need for companies to take steps to protect themselves even if there are no anticipated changes in currency values.
2. Volkswagen saw its fourth quarter 2003 profits tumble 95 percent after losing €1.2 billion in currency losses after the euro rose relative to the U.S. dollar. Why was Volkswagen so vulnerable to the change in the value of the euro relative to the U.S. dollar?
Discussion Points: Volkswagen was especially vulnerable to the rise of the euro against the U.S. dollar in 2003 because the company manufactured its cars in Germany and then exported them to the United States. When Volkswagen failed to adequately hedge its exposure to foreign exchange rate changes, and the euro-dollar relationship shifted, the company lost out. Most students will probably recognize that had Volkswagen produced some of its cars in the United States, the effects of the currency shift would have been much smaller.
Teaching Tip: To learn more about Volkswagen, go to {
Lecture Note: To extend this case, consider discussing Volkswagen’s recent decision to focus on growing in China and Eastern Europe. Consider { { and {
 Lecture Note: To expand the discussion to include Volkswagen’s other foreign investments, consider { and {

10. Insuring Against FX Risk (continued from Slide 10-9)
3. Currency swap - the 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

11. The Nature of the FX 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
Internet Extra: Companies can anticipate how currencies might move by following various economic and political indicators. To explore the effect of these indicators on exchange rates, go to { Click on Market News and look at what variables might have influenced exchange rates.
Examine the effect of factors such as interest rates and geo-political tensions on exchange rates. What happens to a currency’s value of exchange rates or exports rise, or there is a threat of terrorism?
What factors should companies track to better predict what might happen to a currency’s value?

12. Exchange Rate Theories
Question: What factors are important to future exchange rates?
Answer:
Three factors that have an important impact on future exchange rate movements are:
A country’s price inflation
A country’s interest rate
Market psychology

13. Prices and Exchange Rates
Question: How are prices related to exchange rate movements? Answer: To understand how prices and exchange rates are linked, we need to understand the law of one price, and the theory of purchasing power parity

14. Prices and Exchange Rates (continued from Slide 10-13)
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 their 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

15. Prices and Exchange Rates (continued from Slide 10-14)
PPP predicts that changes in relative prices will result in changes in exchange rates
When inflation is relatively high, a currency should depreciate
So, 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 {

16. Prices and Exchange Rates (continued from Slide 10-15)
Question: How well does PPP theory work?
Answer:
Empirical testing of the 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

17. Interest Rates & Exchange Rates
Question: How do interest rates affect exchange rates?
Answer:
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)
In other words, 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

18. Interest Rates & Exchange Rates (continued from Slide 10-17)
The International Fisher Effect suggests 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 the two countries
In other words:
(S1 - S2) / S2 x 100 = i $ - i ¥
where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the U.S. and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period

19. Investor Psychology
Question: How are exchange rates influenced by investor psychology?
Answer:
The 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

20. Exchange Rate 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 poor predictors of short term changes
So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates

21. Exchange Rate Forecasting
Question: Should companies invest in exchange rate forecasting services to help with decision-making?
Answer:
The efficient market school: forward exchange rates are the best predictors of future spot exchange rates
Investing in forecasting services is a waste of money
The inefficient market school: companies should invest in forecasting services
Forward rates are not the best predictor of future spot rates

22. The Efficient Market School
An efficient market: one in which prices reflect all available information
If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates
Most empirical tests confirm the efficient market hypothesis
Companies should not waste their money on forecasting services
Some recent studies have challenged the theory

23. The Inefficient Market School
An inefficient market: one in which prices do not reflect all available information
In an inefficient market, forward exchange rates are not the best predictors of future spot exchange rates
It may be worthwhile for international businesses to invest in forecasting services
However, the track record of forecasting services is questionable

24. Approaches to Forecasting
Question: How should exchange rate forecasts be prepared?
Answer:
There are two approaches to exchange rate forecasting
Fundamental analysis
Technical analysis

25. Approaches to Forecasting (continued from Slide 10-24)
Fundamental analysis: draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates
Technical analysis: focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves

26. Currency Convertibility
Currencies are:
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

27. Currency Convertibility (continued from Slide 10-26)
Question: Why do countries limit currency convertibility?
Answer:
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

28. Implications for Managers
Question: What does the foreign exchange market mean for international firms?
Answer:
Firms must understand the influence of exchange rates on the profitability of trade and investment deals
This exchange rate risk can be divided into
Transaction exposure
Translation exposure
Economic exposure

29. Transaction Exposure
Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
Can lead to a real monetary loss

30. Translation Exposure
Translation exposure: the impact of currency exchange rate changes on the reported financial statements of a company
Deals with the present measurement of past events
Gains and losses from translation exposure are reflected only on paper

31. Economic Exposure
Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates
Concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

32. Question: How can firms minimize translation and transaction exposure?
Reducing FX Exposure
Question: How can firms minimize translation and transaction exposure?
Answer:
Firms can:
Buy forward
Use swaps
Lead and lag payables and receivables: paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements

33. Reducing FX Exposure (continued from Slide 10-32)
Lead strategy
Collecting 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
Delaying collection of foreign currency receivables if that currency is expected to appreciate
Delaying payables if the currency is expected to depreciate
Lead and lag strategies can be difficult to implement.

34. Reducing FX Exposure (continued from Slide 10-33)
Question: How can a firm reduce economic exposure?
Answer:
Firms need to distribute productive assets to various locations to avoid long-term financial problems associated with changes in exchange rates

35. Other Steps for Managing Risk
Question: Are there other strategies to manage foreign exchange risk?
Answer:
To further manage foreign exchange risk, firms should
Establish central control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

36. Other Steps for Managing Risk (continued from Slide 10-35)
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

37. 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.
Compared and contrasted the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.