1. Global Business Today 6e
by Charles W.L. Hill
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.

2. The Foreign Exchange Market
Chapter 9
The Foreign Exchange Market

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

4. The Functions of the Foreign Exchange Market
Question: What is the purpose of the foreign exchange market?
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)

5. 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)
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.

6. Insuring Against Foreign Exchange Risk
The foreign exchange market can be used to provide insurance to protect 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

7. Insuring Against Foreign Exchange Risk
1. Spot Exchange Rates
The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day
Spot rates are determined by the interaction between supply and demand, and so change continually

8. Insuring Against Foreign Exchange Risk
2. Forward Exchange Rates
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 is the exchange rate governing such a future transaction
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 challenge of whether, given the dollar’s value, to sell its popular Scirocco in the United States. Go to {

9. Insuring Against Foreign Exchange Risk
3. Currency Swaps
A currency swap is 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

10. 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
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 What Moves 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?

11. Economic Theories of Exchange Rate Determination
Question: What factors are important to future exchange rates?
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

12. Prices and Exchange Rates
Question: How are prices related to exchange rate movements?
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

13. Prices and Exchange Rates
The law of one price states that 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 theory argues that 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

14. Prices and Exchange Rates
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

15. Prices and Exchange Rates
Question: How well does PPP theory work?
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

16. Interest Rates and Exchange Rates
Question: How do interest rates affect 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 (l )
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

17. Interest Rates and Exchange Rates
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 US 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

18. Investor Psychology and Bandwagon Effects
Question: How are exchange rates influences by investor psychology?
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
Country Focus: Anatomy of a Currency Crisis
Summary
This feature describes South Korea’s 1997 financial crisis. In the space of a few months Korea saw its economy and currency move from prosperity to critical lows. Much of the blame for Korea’s financial collapse can be placed with the country’s chaebol (large industrial conglomerates) that had built up massive debts as they invested in new factories. Speculators, concerned about the chaebol’s ability to repay their debts, began to withdraw money from the Korean Stock and Bond markets fueling a depreciation in the Korean Won. Despite government efforts to halt the fall in the currency, the won fell some 67% relative to the dollar. Discussion of the feature can begin with the following questions.
Suggested Discussion Questions
1. Discuss investor psychology and bandwagon effects and their role in accelerating Korea’s difficulties.
Discussion Points: Studies show that the role of psychological factors is an important element in the strategies of currency traders. Moreover, expectations about the future of exchange rates tend to become self-fulfilling prophecies. When traders start to anticipate similar movements, the bandwagon effect of many traders all coming to the same conclusion actually has the effect of making speculation reality. Students will probably suggest that this appears to have contributed to South Korea’s situation where currency values fell very rapidly after foreign investors became alarmed when issues arose regarding the ability of South Korean companies to service their debt.
2. As a CEO of an American company, how does Korea’s situation affect your operations?
Discussion Points: The situation in South Korea increased the risk for any company doing business with the nation. However, students should recognize that the effect on an American company depends on the company situation itself. For some companies, exports to South Korea may dry up if the South Korean buyer no longer exists or has significantly lower demand. However, for other companies exporting to South Korea, or actually operating in the country, the situation may actually increase opportunities as business that was formerly conducted by South Korean companies becomes available.
3. In your opinion, did the Korean government take the right steps to ease the crisis? Explain your response.
Discussion Points: Some students will probably claim that the Korean government made its first mistake in the early 1990s when it encouraged the country’s chaebol to increase capacity in expectation of greater exports. The chaebol borrowed heavily, and when demand did not materialize, were stuck with excess capacity, falling prices, and debt. Some students will probably argue that the South Korean government did not act quickly enough to half the drop in the won, and then began to make desperation moves without really anticipating the reaction of investors.

19. 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

20. Exchange Rate Forecasting
Question: Should companies invest in exchange rate forecasting services to help with decision-making?
The efficient market school argues that forward exchange rates are the best predictors of future spot exchange rates
Therefore, investing in forecasting services would be a waste of money
The inefficient market school argues that companies should invest in forecasting services
This school of thought does not believe that forward rates are the best predictor of future spot rates

21. The Efficient Market School
An efficient market is 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 suggesting that companies should not waste their money on forecasting services, but some recent studies have challenged the theory

22. The Inefficient Market School
An inefficient market is 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 and it may be worthwhile for international businesses to invest in forecasting services
However, the track record of forecasting services is questionable

23. Approaches to Forecasting
Question: How should exchange rate forecasts be prepared?
There are two approaches to exchange rate forecasting
fundamental analysis
technical analysis

24. Approaches to Forecasting
1. Fundamental Analysis
Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates
2. Technical Analysis
Technical analysis focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves

25. Currency Convertibility
Question: Are all currencies freely convertible?
A currency is freely convertible when both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency
A currency is externally convertible when only non-residents can convert their holdings of domestic currency into a foreign currency
A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

26. Currency Convertibility
Question: Why do countries limit currency convertibility?
The main reason to limit convertibility 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

27. Implications for Managers
Question: What does the foreign exchange market mean for international firms?
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

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

29. Translation Exposure
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company
it deals with the present measurement of past events
Gains and losses from translation exposure are reflected only on paper
Management Focus: Dealing with the Rising Euro
Summary
This feature describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper. Both companies supplied DaimlerChrysler with parts, however, SMS Elotherm, which manufactured its parts in Germany was hit hard by the dollar’s slide relative to the euro in the early 2000s. Keiper, which had opened a plant in Canada, was able to avoid the negative effects of the currency swing to a large extent. Discussion of the feature can revolve around the following questions:
Suggested Discussion Questions
1. Could SMS Elotherm have taken steps to avoid the position it now found itself in? What were those steps? Why do you think the company did not take these steps?
Discussion Points: SMS Elotherm signed a deal in late 2004, to sell parts to DaimlerChrsyler. The company anticipated making about €30,000 profit on each part. However, within days, the anticipated profit was just €22,000. SMS Elotherm, which had priced its parts in dollars, but had its costs in euros, faced transaction exposure. The company could have done several things to limit its exposure to exchange rates. One of the easiest strategies would have involved entering forward contracts to buy euros with the dollars it would receive from DaimlerChrysler. The company could have followed a similar strategy with options to buy euros. A more involved strategy would have been to diversify its manufacturing so costs were spread across more than one currency. Finally, the company might have negotiated a deal with DaimlerChrysler to price some of its sales in dollars and others in euros.
2. Why was Keiper weathering the rise in the euro better than SMS Elotherm?
Discussion Points: Keiper was able to limit its exposure to the sudden shift in exchange rates because it had opened a plant in Canada where its parts were being made. While the company still encountered exchange rate exposure, because its costs were in Canadian dollars and its profits were in U.S. dollars, its exposure was not as great.
3. In retrospect, what might Keiper have done differently to improve the value of its “real hedge” against a rise in the value of the euro?
Discussion Points: Keiper’s decision to produce its parts in Canada proved to be a good one. However, Keiper, like SMS Elotherm, could have further limited its exposure to exchange rate changes by using forward contracts and options to hedge its profits in U.S. and Canadian dollars.
Video Note: The iGlobe Dollar’s Falling Value Ripples through U.S. Economy examines how various U.S. companies are dealing with the falling dollar. The iGlobe provides an opportunity to extend the discussion of this feature, and also the Implications for Managers section.

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

31. Reducing Translation and Transaction Exposure
Question: How can firms minimize translation and transaction exposure?
Firms can
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 movements)

32. Reducing Translation and Transaction Exposure
A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate
A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate
Lead and lag strategies can be difficult to implement

33. Reducing Economic Exposure
Question: How can a firm reduce economic exposure?
To reduce economic exposure firms need to distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates
This requires that the firm’s assets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce

34. Other Steps for Managing Foreign Exchange Risk
Question: Are there other strategies to manage foreign exchange risk?
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

35. Other Steps for Managing Foreign Exchange Risk
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