1. International Business An Asian PerspectiveBy
Charles W.L. Hill
Chow-Hou Wee
Krishna Udayasankar
Welcome to International Business, An Asian Perspective, by Charles W.L. Hill, Chow-Hou Wee and Krishna Udayasankar

2. The Foreign Exchange Market
Chapter 9
The Foreign Exchange Market
Chapter 9: The Foreign Exchange Market
McGraw-Hill/Irwin
Copyright © 2011 by the McGraw-Hill Companies, Inc. All rights reserved.

3. Why Is The Foreign Exchange Market Important?
is used to convert 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
The exchange rate is the rate at which one currency is converted into another
Events in the foreign exchange market affect firm sales, profits, and strategy
You’re probably familiar with some of the major currencies in the world like the U.S. dollar, the European euro, the British pound, and the Japanese yen. But do know how much each foreign currency is worth in terms of your own currency?
In this chapter, we’ll try to answer that question, and we’ll explain how the foreign exchange market works, explore the forces that determine exchange rates, and talk about predicting exchange rates. We’ll also discuss the implications for international business of changing exchange rates and the foreign exchange market.
Let’s go over couple of basic definitions first. The foreign exchange market is simply a market for converting the currency of one country into that of another country, and an exchange rate is the rate at which one currency is converted into another.
What’s the purpose of the foreign exchange market?
The foreign exchange market serves two main functions.
First, it’s used to convert the currency of one country into the currency of another. if you’ve ever converted your currency into another currency, you’ve participated in the foreign exchange market
Second, it’s used to provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.
Let’s talk more about each of these beginning with currency conversion.

4. When Do Firms Use The Foreign Exchange Market?
International companies use the foreign exchange market when
the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies
they must pay a foreign company for its products or services in its country’s currency
they have spare cash that they wish to invest for short terms in money markets
they are involved in currency speculation - the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
There are four ways International companies use the foreign exchange market to convert currencies.
First, they use it to convert the foreign exchange payments they receive for exports, or the income they receive from foreign investments or from licensing agreements with foreign firms in foreign currencies.
Second, they use the market when they need foreign exchange to pay a foreign company for products or services.
Third, it might be used for short term money market investments. If a company has a sum of money that it wants to invest for a few months, it might find that interest rates are higher in foreign locations than at home.
Fourth, firms that engage in currency speculation where they move funds from one currency to another in the hopes of making a profit use the foreign exchange markets.

5. How Can Firms Hedge Against Foreign Exchange Risk?
The foreign exchange market provides 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 insures itself against foreign exchange risk is hedging
To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges - two parties agree to exchange currency and execute the deal at some specific date in the future
As we said before, the second main way companies are active in the foreign exchange market to insure against foreign exchange risk which occurs when unpredicted changes in future exchange rates have adverse consequences for the firm. You may have heard the term hedging use to describe this process.
Let’s talk about how this works.
A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future using a forward exchange rate.
Sometimes, companies can be caught off guard when they don’t hedge their currencies. Hedging against adverse exchange rate movements is an important part of an international firm’s financial strategy. You can learn how Volkswagen approaches hedging in the Management Focus in your text.

6. What Is The Difference Between Spot Rates And Forward 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 change continually depending on the supply and demand for that currency and other currencies
A forward exchange rate is the rate used for hedging in the forward market
rates for currency exchange are typically quoted for 30, 90, or 180 days into the future
What’s the difference between a spot rate and a forward rate?
Well, as we just said, a forward exchange rate is used when you know you’ll be needing foreign currency in the future.
So, if you know you’re going to need 200,000 yen in 30 days to pay for some components your company imports, rather than taking the chance that the rate might change over the 30 days, you might enter into a forward agreement to buy the yen now and lock–in the rate, and pay for them in 30 days when your need them.
Forward rates are quoted 30, 90, and 180 days into the future.
In contrast, a spot exchange rate is the rate at which a foreign exchange dealer coverts one currency into another currency on a particular day. So, when you’re on a trip to Germany and you change dollars for euros, you’ll get the spot rate for the day.
Spot rates can be quoted either in terms of how much foreign currency the dollar will buy, so using the chart in your text, you would know that one dollar would buy about €.79 in February of 2009, or spot rates can be quoted in terms of how many dollars you get for one unit of foreign currency, so one euro would buy about $1.26.
Keep in mind that spot rates are continually changing based on supply and demand for that currency.

7. What Is A Currency Swap?
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
Swaps are transacted
between international businesses and their banks
between banks
between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk
A forward exchange can also take the form of what’s known as a currency swap, which is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
Usually, swaps take place between international companies and their banks, between banks, and between governments when they want to move out of one currency into another for a limited period without incurring foreign exchange risk.

8. What Is 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 most important trading centers are London, New York, Tokyo, and Singapore
the market is always open somewhere in the world—it never sleeps
Where is the foreign exchange market located?
It’s actually not located in any single place, rather it’s a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems.
The most important centers are London, New York, Tokyo, and Singapore.
Remember, that the foreign exchange market never sleeps! Currencies are always being traded somewhere in the world.

9. Do Exchange Rates Differ Between Markets?
High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers
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 dollars on one side—it is a vehicle currency along with the euro, the Japanese yen, and the British pound
In addition, thanks to high-speed computer links between trading centers around the world, there is now a single market for currencies!
If there were significant differences between markets, dealers could take advantage of arbitrage opportunities where they buy the currency at a low price in one market, and sell if for a high price in another market. Of course, as other dealers jumped on the opportunity, the gap between the markets would quickly close.
Another feature of the foreign exchange market is the dollar is used as a vehicle currency to facilitate the exchange of other currencies. In other words, if you have won, but you need yen, you might first convert your won into dollars and then the dollars into yen.

10. How Are Exchange Rates Determined?
Exchange rates are determined by the demand and supply for different currencies
Three factors impact future exchange rate movements
A country’s price inflation
A country’s interest rate
Market psychology
How are exchange rates determined?
The answer is easy---supply and demand! The bigger question then becomes what affects the supply and demand for a currency?
We say that there are three main factors that influence future exchange rates, a country’s price inflation, a country’s interest rate, and market psychology. Let’s look more closely at how each of these factors works.

11. How Do Prices Influence 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 (PPP) 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
predicts that changes in relative prices will result in a change in exchange rates
How do prices affect exchange rates?
To understand how prices affect exchange rates we need to explore a concept called the law of one price which 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.
In other words, if you can buy a pair of jeans in New York for $75, then you should be able to buy the same type of jeans in London for the same price after you’ve converted your dollars to pounds.
Then, the theory of purchasing power parity, or PPP, argues that given relatively efficient markets, or markets where there are few impediments to international trade and investment, the price of a basket of goods should be roughly equivalent in each country.
So, using a simplistic example, if our basket of goods is a Big Mac, we should be able to buy a Big Mac in New York, and then take the same amount of money, convert it to yen, and buy a Big Mac in Japan, or convert the money to pounds, and buy a Big Mac in London, and so on. If you can’t, then you know that one of the currencies is undervalued or overvalued! Your text has a chart showing the cost of Big Macs around the world. Check it out when you get a chance, and see how much you’d pay in different parts of the world!

12. How Do Prices Influence Exchange Rates?
A positive relationship exists between the inflation rate and the level of money supply
When the growth in the money supply is greater than the growth in output, inflation will occur
PPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run
a country with high inflation should see its currency depreciate relative to others
Empirical testing of PPP theory suggests that it is most accurate in the long run, and for countries with high inflation and underdeveloped capital markets
So, the theory essentially tells us that changes in relative prices will result in changes in exchange rates. We also know that there is a positive relationship between a country’s money supply and its inflation rate. So, if the money supply is growing, we’ll see inflation going up.
In other words, if a government suddenly decided to give everyone $10,000, an increase in the money supply, many people would use the money to buy more clothes, furniture, and other “stuff.” The increased demand would encourage stores, and other providers of goods to raise prices, which of course, is inflation. The increased supply of currency in the economy, would then cause the value of the currency to drop.
So, does PPP work well to predict exchange rates? Sometimes! Empirical studies show that PPP isn’t completely accurate at estimating exchange rates, especially in the short-run.
There are several reasons why the theory isn’t accurate in the short run including the fact that it assumes away transportation costs and trade barriers, it doesn’t consider the power of MNEs to influence prices, control distribution channels, and differentiate their products, and the theory doesn’t consider government intervention in the foreign exchange market.

13. How Do Interest Rates Influence Exchange Rates?
The International Fisher Effect states 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 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
How do interest rates influence exchange rate?
Irvin Fisher explored this relationship and developed the concept known as the International Fisher Effect which 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 two countries.
In other words, in countries where inflation is expected to be high, interest rates will be high as well, in order to encourage investors to keep their money in the market. Otherwise, investors would simply shift their money elsewhere.
If there are no restrictions on capital flows, real interest rates must be the same everywhere, or an arbitrage situation would exist. In other words, if the real interest in France was 10 percent, but in the U.S., the real interest rate was just 6 percent, investors would borrow “cheap” dollars to invest in France. This would bring the value of the dollar up, and consequently push the real interest rate in the U.S. up. The opposite would occur in France.
So, the international Fisher Effect states 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.

14. How Does Investor Psychology Influence Exchange Rates?
The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations
government intervention can prevent the bandwagon from starting, but is not always effective
Can we use PPP, or the International Fisher Effect to predict exchange rates? Not really! Neither is particularly accurate, especially in the short run/ One reason for this may be investor psychology.
How does investor psychology influence exchange rates? Well, the bandwagon effect occurs when expectations by traders turn into self-fulfilling prophecies, and traders join the bandwagon and exchange rates move on group expectations.
We saw this happen in 1992 when George Soros, a well known international financier, made a huge bet against the British pound. He borrowed billions of pounds, and sold them for German marks. This helped push down the value of the pound on foreign exchange markets, and many other investors jumped on the bandwagon and sold pounds as well. You can learn about another situation where bandwagon effects were important in the Country Focus on the 1997 fall of the Korean Won.
Sometimes, intervention by the government can stop a bandwagon from starting, but not always.

15. Should Companies Use Exchange Rate Forecasting Services?
There are two schools of thought
The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money
An efficient market is one in which prices reflect all available information
if the foreign exchange market is efficient, then 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
Is it worthwhile to use a forecasting service to help predict exchange rate movements?
Maybe. There are two schools of thought on this issue: the efficient market school and the inefficient market school.
Let’s look more closely at each school of thought.
According to the efficient market school, forward exchange rates are the best predictors of future exchange rates.
So investing in a forecasting service would be a waste of money, because efficient markets already reflect all available information.
Most studies show that this theory is correct.

16. Should Companies Use Exchange Rate Forecasting Services?
The inefficient market school argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services
An inefficient market is one in which prices do not reflect all available information
in an inefficient market, forward exchange rates will not be the best possible 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 not good
However, the inefficient market school argues that a forecasting service can be valuable.
This perspective suggests that because the foreign exchange market isn’t efficient, prices don’t reflect all available information, and the services could be better at predicting rates.
Unfortunately though, the track record of forecasting companies isn’t good.

17. How Are Exchange Rates Predicted?
There are two schools of thought on 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 charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves
Suppose you decide to go ahead with a forecasting service. How do they go about predicting exchange rate movements?
There are two main methods.
Fundamental analysis uses economic factors like interest rates, monetary policy, and balance of payment information to predict exchange rates.
Technical analysis, typically charts trends and believes that past trends and waves are reasonable predictors of future trends and waves.

18. Are All Currencies Freely Convertible?
A currency is freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency
A currency is externally convertible when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way
A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
Up until now, we’ve assumed that a currency can always be converted to another currency. But, sometimes currencies can’t be changed easily.
A currency is freely convertible when a government of a country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with it.
A currency is externally convertible when only nonresidents can convert it to a foreign currency without limitations.
Finally, a currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.

19. Are All Currencies Freely Convertible?
Most countries today practice free convertibility, although many countries impose some restrictions on the amount of money that can be converted
Countries limit convertibility 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
When a country’s currency is nonconvertible, firms may turn to countertrade - barter like agreements by which goods and services can be traded for other goods and services
What system do most countries follow?
Free convertibility is the norm in the world today, but many countries have some restrictions on the amount of money that can be converted. There are various reasons to limit convertibility including the preservation of foreign exchange reserves, and preventing the capital flight that occurs when residents and nonresidents rush to convert their holdings of a domestic currency into a foreign currency because the domestic currency is rapidly losing value perhaps because of hyperinflation or other economic concerns.
In situations where a currency is nonconvertible, firms might choose to use countertrade to facilitate international transactions.
Countertrade refers to a variety of barter-like agreements by which goods and services are traded for other goods and services. These types of arrangements were more common twenty years ago when more countries maintained nonconvertible currencies.

20. What Do Exchange Rates Mean For Managers?
Managers need to consider three types of foreign exchange risk
Transaction exposure - the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies
Translation exposure - the impact of currency exchange rate changes on the reported financial statements of a company
concerned with the present measurement of past events
gains or losses are “paper losses” –they are unrealized
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
What does all of this mean for managers?
Well, it’s essential that managers understand the influence of exchange rates on the profitability of trade and investment deals because an adverse shift in the value of a currency can make a deal that had appeared to be profitable, a bad choice.
Companies need to protect themselves against three types of foreign exchange risk, transaction exposure, translation exposure, and economic exposure. Let’s talk about each one.
Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
So for example, if a company agrees to purchase components priced in the foreign currency with the payment due in 180 days, and then within the 180 days, the domestic currency depreciates, the price of the foreign components will rise because it will take more units of the domestic currency to buy the agreed upon amount of foreign currency.
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company.
Many American companies with operations in Europe were able to benefit from translation exposure between 2002 and 2004, when the rising euro increased dollar profits.
The third type of foreign exchange exposure, economic exposure, is the extent to which a firm’s future international earning power is affected by changes in exchange rates.
This is different from transaction exposure because it’s concerned with the long-term effect of changes in exchanges rates on future prices, sales, and costs.
Many American firms were affected by this type of exposure in the 1990s when the rise in the dollar made it difficult to be globally competitive, and as you’ll see in the Closing Case, Hyundai and Kia have both been affected by exchange rate fluctuations, and are changing their strategies to ensure their future competitiveness.

21. How Can Managers Minimize Exchange Rate Risk?
To minimize transaction and translation exposure, managers should
Buy forward
Use swaps
Lead and lag payables and receivables
lead strategy - attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay 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 and delay payables if the currency is expected to depreciate
Lead and lag strategies can be difficult to implement
How can firms minimize their translation and transaction exposure?
There are several ways. We’ve already talked about using forward contracts and swaps.
Firms can also use a strategy of leading and lagging payables and receivables where they pay suppliers or collect payments early or late depending on anticipated exchanged rate movements.
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’re due when a currency is expected to appreciate.
A lag strategy involves delaying collection of foreign currency receivables if a currency is expected to appreciate, and delaying payables if a currency is expected to depreciate.
While this type of strategy can be effective, it’s difficult to implement because the firm has to be in a position of power over payment terms

22. How Can Managers Minimize Exchange Rate Risk?
To reduce economic exposure, managers should
Distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates
Ensure assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services the firm produces
Reducing economic exposure is a little more difficult.
It goes beyond simple financial transactions, and requires the firm to distribute productive assets to various locations so that the firm’s financial well-being isn’t severely affected by changing exchange rates.
Reducing economic exposure also requires firms to be sure that assets aren’t concentrated in countries where likely rises in currency values will mean significant increases in the prices of the goods and services produced.
The Management Focus in your text describes how two German firms are trying to reduce their economic exposure. You might also recall from the Opening Case how Hyundai and Kia had to deal with fluctuations in the Won

23. How Can Managers Minimize Exchange Rate Risk?
In general, managers should
Have central control of exposure 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
What else can firms do to minimize foreign exchange risk?
Firms can implement a system of centralized control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. For example, some companies set up in-house foreign exchange centers to execute most foreign exchange deals.
Firms can also distinguish between transaction, translation, and economic exposure. Many firms focus on transaction and translation exposure, but fail to consider economic exposure.
Third, firms need to try to forecast future exchange rates, however, remember that it’s difficult to do.
Fourth, firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position.
Finally, firms need to produce monthly foreign exchange exposure reports that can be used as the basis for hedging strategies.

24. Review Question The ________ is the rate at which one currency
is converted into another.
a) Exchange rate
b) Cross rate
c) Conversion rate
d) Foreign exchange market
Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready?
The ________ is the rate at which one currency is converted into another.
a) Exchange rate
b) Cross rate
c) Conversion rate
d) Foreign exchange market
The answer is a.

25. Review Question The _______ is the rate at which a foreign
exchange dealer converts one currency into
another currency on a particular day.
a) Currency swap rate
b) Forward rate
c) Specific rate
d) Spot rate
The _______ is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
a) Currency swap rate
b) Forward rate
c) Specific rate
d) Spot rate
The answer is d.

26. Review Question Which of the following does not impact future
exchange rate movements?
a) A country’s price inflation
b) A country’s interest rate
c) A country’s arbitrage opportunities
d) Market psychology
Which of the following does not impact future exchange rate movements?
a) A country’s price inflation
b) A country’s interest rate
c) A country’s arbitrage opportunities
d) Market psychology
The answer is c.

27. Review Question When a government of a country allows both
residents and non-residents to purchase unlimited
amounts of foreign currency with the domestic
currency, the currency is
a) Nonconvertible
b) Freely convertible
c) Externally convertible
d) Internally convertible
When a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency, the currency is
a) Nonconvertible
b) Freely convertible
c) Externally convertible
d) Internally convertible
The answer is b.

28. Review Question The extent to which a firm’s future
international earning power is affected by
changes in exchange rates is called
a) Accounting exposure
b) Translation exposure
c) Transaction exposure
d) Economic exposure
The extent to which a firm’s future international earning power is affected by changes in exchange rates is called
a) Accounting exposure
b) Translation exposure
c) Transaction exposure
d) Economic exposure
The answer is d.

29. Review Question Firms that want to minimize transaction and
translation exposure can do all of the
following except
a) buy forward
b) have central control of exposure
c) use swaps
d) lead and lag payables and receivables
Firms that want to minimize transaction and translation exposure can do all of the following except
a) buy forward
b) have central control of exposure
c) use swaps
d) lead and lag payables and receivables
The answer is b.