1. International
Business
Fourth Edition

2. The Foreign Exchange Market
CHAPTER 9
The Foreign Exchange Market

4. Chapter Focus Explain how the foreign exchange (FX) market works.
Examine the forces that determine the exchange rates and whether it is possible to determine future rates movement.
Map the implications for businesses.

5. Definitions Foreign Exchange Market: Exchange Rate:
A market for converting the currency of one country into the currency of another.
Exchange Rate:
The rate at which one currency is converted into another.
Foreign Exchange Risk:
The risk that arises from changes in exchange rates.

6. Functions of the Foreign Exchange Market
Currency Conversion
Companies receiving payment in foreign currencies need to convert to their home currency.
Companies paying foreign businesses for goods or services.
Companies invest spare cash for short terms in money market accounts.
Speculation: taking advantage changing exchange rates.
Insuring Against FX Risk
Spot exchange rate: rate of currency exchange on a particular day.
Forward exchange rate: two parties agree to exchange currencies on a specific future date.
Currency swap:simultaneous purchase and sale of a given amount of FX for two different value dates.

7. FX Transactions
* Most forward exchanges
are currency swaps.

8. Foreign Exchange Trade Growth
$ billions

9. The Foreign Exchange Market
It is a 24/7 market.
The markets are integrated. Connected by high-speed computers, it creates one virtual market.
London’s dominance is explained by:
History (capital of the first major industrialized nation).
Geography (between Tokyo/Singapore and New York).

10. Geographical Distribution of Global Foreign Exchange Activity (percentage share of total average daily turnover)
Figure 9.1

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

12. Currency Use on One Side of a FX Transaction
Currency April ‘ April ‘ April ‘ April ‘01
Percentage share of average daily turnover
Table 9.2

13. Factors Influencing Currency Value
Economic Factors
1. Balance of Payments
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

14. Economic Theories of Exchange Rate Determination
Base level: rates are determined by the demand/supply of one currency relative to the demand/supply of another.
Price and Exchange Rates:
Law of One Price
Purchasing Power Parity (PPP)
Interest Rates and Exchange Rates.
Investor Psychology and Bandwagon Effects.

15. Price and Exchange Rates
Law of One Price:
In competitive markets free of transportation costs and trade barriers, 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 FFr 250 in Paris (50x5).
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.

16. Money Supply and Inflation
PPP theory predicts that changes in relative prices will result in a change in exchange rates.
A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate.
Inflation occurs when the money supply increases faster than output increases.
Purchasing Power Parity Puzzle.

17. The Big Mac Index Purchasing Power Parity: April 2001
Local Currency
% Over(+)
or Under(-)
Valuation
Against Dollar
Big Mac Prices
Actual
Exchange
Rate
17/04/01
Table 9.3
Price in
Local
Currency
Implied
PPP of the
Dollar
Price in
Dollars
United States $
Argentina Peso
Brazil Real
Canada C $
Euro
France FFr
Hong Kong HK $
Japan ¥
Russia Roule
Switzerland SwFr
Source: The Economist 4/9/94, pg 8.
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

18. Macroeconomic Data for Bolivia, April 1984 -October 1985
May ,512
June ,342
July ,570
August ,038
September ,685
October 1, ,205
November 1, ,469
September 3, ,515
1985
January 4, ,016
February 6, ,101
March 9, , ,137
April , , ,428
May 21, , ,375
June 27, , ,756
July 47, , ,476
August 74, , ,182,300
September 103, , ,087,440
October 132, , ,120,210
Money Supply
(billions of pesos)
Price Level
Relative to 1982
(average=1)
Exchange Rate
(pesos/dollar)
Table 9.4

19. Interest Rates and Exchange Rates
Theory says that interest rates reflect expectations about future exchange rates.
Fisher Effect (I = r+l).
International Fisher Effect:
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.

20. Investor Psychology and Bandwagon Effects
Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates.
Explanation may be investor psychology and the bandwagon effect.
Studies suggest they play a major role in short term movements.
Hard to predict.

21. Exchange Rate Forecasting
Efficient market: where prices reflect all available public information.
Early studies seem to confirm the efficient market theory, but recent studies have challenged it.
Inefficient market: where prices do not reflect all available information.
Use fundamental (economic theory) or technical (price/volume data) analysis to predict the exchange rates.
Analysis suggest that professional forecasters are no better than forward exchange rates in predicting future spot rates.

22. Currency Convertibility
Freely convertible.
Externally convertible.
Not convertible.
Preserve foreign exchange reserves.
Service international debt.
Purchase imports.
Government afraid of capital flight.
Political decision.
Many countries have some kind of restrictions.
Countertrade.
Barter-like agreements where goods/services are traded for goods/services.
Helps firms avoid convertibility issue.