1. Foreign Exchange and International Financial Markets
Chapter 8
Foreign Exchange and International Financial Markets

2. The Four Risks of International Business

3. Introduction
International financial markets consist of the foreign exchange, derivative, debt and equity markets
Important to governments and central banks in financing their fiscal and current account deficits, and to maintain their exchange rates
Important to firms for their currency requirements, assistance in management of currency risk, and the ability to raise capital at a lower cost
Important to investors to diversify their portfolios and to achieve higher rates of returns.
The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.

4. Introduction The value of national currencies is in constant flux
This fluctuation means we have to keep three things in mind:
The issue whether we and our supplier agreed on an exchange rate in advance, or if the exchange rate is to be decided on the date of the actual payment
We should keep in mind whether the purchase agreement quoted the price in our currency or in the supplier’s currency
Fluctuations in the exchange rate could cost us money or earn us money
Currency risk – arises from changes in the price of one currency relative to another

5. Introduction
The foreign exchange market is where the financial instruments are traded and the price is exchange rate
The foreign exchange market is an informal market with no physical location.
All transactions are conducted over phone lines and by computer screens, and the markets are open continuously
Main participants in the foreign exchange market:
Banks
Brokers
Multinational firms
Central banks

6. Foreign Exchange Market - Functions
Conversion: To facilitate sale or purchase, or invest directly abroad
Hedging: Insure against potential losses from adverse exchange-rate changes
Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit
Speculation: Sequential purchase and sale (or vice versa) of a currency for profit

9. I. Conversion of currencies
Companies use the foreign exchange market to convert one currency into another.
Pay for imports
Foreign direct investment
Repatriation of profits
Tourists

10. Currency Values Change in U.S. dollar against Polish zloty
February 1: PLZ 5/$
March 1: PLZ 4/$
%change = [(4-5)/5] x 100 = -20%
U.S. dollar fell 20%
Change in Polish zloty against U.S. dollar
Make zloty base currency (1÷ PLZ/$)
February 1: $.20/PLZ
March 1: $.25/PLZ
%change = [( )/.20] x 100 = 25%
Polish zloty rose 25%

11. Cross Rate Exchange rate calculated using two other exchange rates
Use direct or indirect exchange rates against a third currency

12. Cross Rate Example Direct quote method Indirect quote method
Quote on euro = € /$
Quote on yen = ¥ /$
€ /$ ÷ ¥ /$ = € /¥
Costs euros to buy 1 yen
Indirect quote method
Quote on euro = $ /€
Quote on yen = $ /¥
$ /€ ÷ $ /¥ = € /¥
Final step: 1 ÷ € /¥ = € /¥
Costs euros to buy 1 yen

13. II. Hedging- Insuring Against Foreign Exchange Risk
To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges
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 rate governing such future transactions
Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future
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

14. Example of hedging using Forward Exchange
US company imports laptop computers from Japan payable in 30 days when shipment arrives
¥200,000 per laptop
Spot rate $1 = ¥120
At this rate, each laptop costs $1,667 (200,000/120)
If sell at $2,000 each , make a profit of $333
But no money to pay exporter until all units have been sold
2 choices – i. sell the laptops, wait 30 days and pay exporter, or
ii. engage in a forward exchange.

15. Example of hedging using Forward Exchange
If over the next 30 days, $ depreciates against ¥,
$1=¥95, What happen to the importer’s position?
If $ appreciates against ¥, $1=¥130, what happen to the importer’s position?
Forward exchange rate for 30 days is $1 = ¥110. What happen when importer enters 30 forward contract
How forward exchange market is used to insure one’s position?

16. Example If done nothing
If $1=¥95, then, importer has to pay import 200,000/95 = $2,105 (loss of $105 per unit)
If $1=¥130, then importer has to pay import 200,000/130 = $1,538 (profit of $462 per unit)
Question is whether to take the risk of changes in exchange rate?
If enter forward contract, 30 day forward at $1=¥110
200,000/110 = $1,818 (Guaranteed profit of $182 regardless of fluctuation in exchange rate)

17. Insuring Against Foreign Exchange Risk
A currency swap is a transaction in which the same currency is bought and sold simultaneously, but delivery is made at two different points in time.
Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

18. III. Currency Arbitrage
The instantaneous purchase and sale of a currency in different markets for profits. (example: euro in Tokyo is lower than euro in New York)
High tech communication and trading systems allow the entire arbitrage transaction to occur within seconds
But if the difference between the value of the euro in Tokyo and the value in New York is not greater than the cost of conducting the transaction, the trade is not worth making.

19. IV. Currency Speculation
The purchase or sale of a currency with the expectation that its value will change and generate a profit.
The shift in value might be expected to occur suddenly or over a longer period.
The foreign exchange trader may bet that a currency’s price will go up or down in the future

20. 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—it is not located in any one place
The most important trading centers are London, New York, Tokyo, and Singapore
The markets is always open somewhere in the world—it never sleeps

21. The Nature Of The Foreign Exchange Market
High-speed computer linkages between trading centers around the globe have effectively created a single market—there is no significant difference between exchange rates quotes 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), and the gap would close
Most transactions involve dollars on one side—it is a vehicle currency along with the euro, the Japanese yen, and the British pound

22. Convertible and Nonconvertible Currencies
Convertible currency- can be readily exchanged for other currencies.
Hard currencies- most convertible currencies- universally accepted, e.g. U.S. dollar, Japanese yen, Canadian dollar, British pound, and the European euro.
Most transactions use these currencies and nations prefer to hold them as reserves because of their strength and stability.
Nonconvertible- not acceptable for international transactions
Bartering - in some developing economies, currency convertibility is so strict that firms sometimes receive payments in the form of products rather than cash.

23. Economic Theories Of Exchange Rate Determination
At the most basic level, exchange rates are determined by the demand and supply for different currencies.
The greater the supply of a currency, the lower its price
The lower the supply of a currency, the higher its price
The greater the demand for a currency, the higher its price
The lower the demand for a currency, the lower its price

24. Foreign Exchange Rate Determination
Three other factors have an important impact on future exchange rate movements:
i. a country’s price inflation
ii. a country’s interest rate
iii. market psychology

25. Exchange rate and inflation
Inflation is an increase in the price of good and services, so that money buys less than in preceding years
Countries such as Argentina, Brazil, and Zimbabwe have had prolonged periods of hyperinflation – persistent annual double digit and indeed triple digit rates of consumer price increase
In a high inflation environment, the purchasing power of a currency is constantly falling
Fundamentally, inflation occurs when:
Demand grows more rapidly than supply
The central bank increases the nation’s money supply faster than output. – When disproportionate large amount of money is introduced into an economy, the result is too much money chasing a relatively fixed supply of goods and services, which causes prices to go up.

26. Prices And Exchange Rates – What is a Currency worth?
At what rate should one currency be exchanged for another?
Purchasing power parity (PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries
In essence, PPP claims that a change in relative inflation between two countries must cause a change in exchange rates in order to keep prices of goods in two countries fairly similar.

27. Purchasing Power Parity
For example: Japanese inflation were 2% and U.S. inflation were 3.5%, the dollar would be expected to fall by the difference in inflation rates

28. Prices And Exchange Rates
The version of PPP that estimates the exchange rate between 2 currencies using just one good or service as a measure of the proper exchange for all goods and services is called law of one price
According to 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
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 = .78Eur
A jacket selling for $50 in New York should retail for Eur in Paris (50x.78)

31. The Law of One Price Example: The Big Mac Index
Average price of Big Mac in U.S. $2.49 on 5 July 08
Average Big Mac in Canada C$=3.33 on 5 July 08
Therefore, PPP exchange rate = C$3.33/$2.49 = C$1.34/$
The actual exchange rate on 5 July 08 was C$1.57/$.
This means that each $ was actually worth 1.57 Canadian dollars, when Big Mac index indicates should have been worth 1.34 Canadian dollars.
Therefore, Canadian dollar was undervalued by 15 percent.

32. Prices And Exchange Rates
A positive relationship between the inflation rate and the level of money supply exists
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

33. Prices And Exchange Rates
Example: PPP theory argues that the exchange rate will change if relative price change.
Assume no price inflation in USA, while 10% inflation a year in Japan
At beginning of the year, a basket of goods cost $200 in the US and ¥20,000 in Japan, so exchange rate according to PPP is $1= ¥100.
At the end of the year, the exchange rate should E$/ ¥ = $200/ ¥22,000,
Thus $1= ¥110 (or ¥1=$0.0091)
Because of 10 percent price inflation, the Japanese yen has depreciated by 10 percent against the dollar.

34. Interest Rates And Exchange Rates
Economy theory states that interest rates reflect expectations about likely future inflation rates.
Where inflation is expected to be high, interest rates also will be high because investors want compensation for the decline in the value of their money
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 inflation over the period for which the funds are to be lent (I)
i = r + I

35. Interest rates and exchange rates
Since PPP theory shows that there is a link between inflation and exchange rates, and since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and 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

36. Investor Psychology And Bandwagon Effects
Investor psychology, or unpredictable behavior of investors also affects exchange rates
The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join the bandwagon and move exchange rates based on group expectations
Governmental intervention can prevent the bandwagon from starting, but is not always effective
Government restrictions can include:
A restriction on residents’ ability to convert the domestic currency into a foreign currency
Restricting domestic businesses’ ability to take foreign currency out of the country
Governments will limit or restrict convertibility for a number of reasons that include:
Preserving foreign exchange reserves
A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight

37. Summary
Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates
So, international businesses should pay attention to countries’ differing monetary growth, inflation, and interest rates
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.

38. Exchange Rate Forecasting
Should companies use exchange rate forecasting services to aid decision-making?
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
The inefficient market school argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

39. The Efficient Market School
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

40. The Inefficient Market School
An inefficient market is one in which prices do not reflect all available information
So, 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

41. Approaches To Forecasting
There are two schools of thought on forecasting:
Fundamental analysis draw 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

42. Currency Convertibility
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

43. Currency Convertibility
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) to facilitate international trade

44. Implications For Managers
Firms need to understand the influence of exchange rates on the profitability of trade and investment deals
There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure

45. Transaction Exposure
Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
It includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending o funds in foreign currencies

46. Translation Exposure
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company
It is concerned with the present measurement of past events
Gains or losses are “paper losses” –they’re unrealized

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

48. Reducing Translation And Transaction Exposure
To minimize transaction and translation exposure, firms can:
buy forward
use swaps
leading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)

49. 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

50. Reducing 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
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
Management Focus: Dealing with the Rising Euro
Summary
This feature describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper. 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? If the U.S. dollar had appreciated against the euro and the Canadian dollar, instead of depreciating, which company would have done better? Why?
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. If the dollar had appreciated relative to the euro and the Canadian dollar, SMS Elotherm would have probably been better off as compared to Keiper. SMS Elotherm would have been earning profits in strong dollars while its costs were in weak euros.

51. Other Steps For Managing Foreign Exchange Risk
In general, firms 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