Chapter 9: The Foreign Exchange Market PDF

CHAPTER 9: The Foreign Exchange Market Money Supply and Price Inflation Inflation is a monetary phenomenon. It occurs when the quantity of money in  Foreign Curr...

CHAPTER 9: The Foreign Exchange Market Money Supply and Price Inflation Inflation is a monetary phenomenon. It occurs when the quantity of money in  Foreign Currency Market: A market for converting the currency of one circulation rises faster than the stock of goods and services. That is when the country into that of another country. money supply increases faster than output increases.  Exchange Rate: The rate at which one currency is converted into another. A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow Functions of the Foreign Exchange Market: from the government and for individuals and companies to borrow from banks. I. Currency Conversion: The resulting increase in credit causes increases in demand for goods and =Each country has currency in which the prices are quoated services. Unless the output of goods and services is growing at a rate similar to  United States: US Dollar ($) that of the money supply, the result will be inflation - this relationship has been  Great Britain: Pound (£) observed time after time in country after country.  France, Germany, and other members of the Eurozone: Euro (€) So now we have a connection between the growth in a country’s money supply,  Japan: Yen (¥) price inflation, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is International businesses have four main uses of the foreign exchange fueled. market: 1. The payment a company receives for its exports. Empirical Test of PPP Theory: The income it receives from foreign investments or the income it receives from While PPP theory seems to yield relatively accurate predictions in the long run, it licensing agreements with foreign firms maybe in forieng currencies. does not appear to be a strong predictor of short-run movements in exchange 2. International Businesses use foreign exchange markets when they must pay a rates covering time spans of five years or less. In addition, the theory seems to foreign company for products or services in its country currency. best predict exchange rate changes for countries with high ratios of inflation and 3. International Businesses use foreign exchange markets when they have underdeveloped capital markets. The theory is less useful for predicting short- spare cash that they wish to invest for short terms in money markets. term exchange rate movements between the currencies of advanced 4. Currency speculation is another use of foreign exchange markets. industrialized nations that have relatively small differentials in inflation rates. Currency Speculation: This involves the short-term movement of funds from one Purchasing Power Parity Puzzle - the failure to find a strong link between currency to another in hopes of profiting from shift in exchange rates. relative inflation rates and exchange rate movements. II. Insuring Against Foreign Exchange Risk Interest Rates and Exchange Rates:  Foreign Currency Risk: The possibility that unpredictable changes in Economic theory tells us that interest rates reflect expectations about likely future future exchange rates will have adverse consequences for the firm. inflation rates. In countries where inflation is expected to be high, interest rates  Hedging: An advanced risk management strategy that involves buying or also will be high because investors want compensation for the decline in the selling an investment to potentially help reduce the risk of loss of an value of their money. existing position. Fischer effect - states that a country’s nominal interest rate is the sum of the TYPES OF EXCHANGE RATES: required real rate of interest and the expected rate of inflation over the period of 1. Spot Exchange Rates: is the rate at which a foreign exchange dealer converts which the funds are to be lent. one currency into another currency on a particular day. Where in: i = nominal interest rate 2. Forward Exchange Rates: occurs when two parties agree to exchange r = real interest rate currency and execute the deal at some specific date in the future. I(big I) = expected rate of inflation over the period =Forward exchange rates - exchange rates governing such future transactions. Ex: Example: If the real rate of interest in a country is 5% and annual inflation is expected to be $1 = ¥120 - spot exchange rate 10%, the nominal rate will be 15%. $1 = ¥110 - forward exchange rate Ans: Let us assume the 30-day forward exchange rate for converting dollars into yen $$i = r + I$$ is $1 = ¥110. The importer enters into a 30-day forward exchange transaction $$15\% = 5\% + 10\%$$ with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each computer (¥2,000,000 ÷ ¥110). This International Fischer Effect (IFE) = states that for any two countries, the spot guarantees her a profit of $182 per computer. exchange rate should change in an equal amount but in the opposite direction to ($2,000/computer sold - $1,818/computer bought = $182/computer gain) the difference in nominal interest rates between the two countries. 3. Currency Swaps: is the simultaneous purchase and sale of a given amount of Investor Psychology and Bandwagon Effects: foreign exchange for two different value dates. According to a number of studies, investor psychology and bandwagon effect play a major role in determining short-run exchange rate movements. However, THE NATURE OF THE FOREIGN MARKET: this effect can be hard to predict. Investor psychology can be influenced by The foreign exchange market is not located in any one place. It is a global political factors and by micro-economic events, such as the investment decisions network of banks, brokers, and foreign exchange dealers connected by of individual firms, many of which are only loosely linked to macroeconomic electronic communications systems. When companies wish to convert currencies, fundamentals, such as relative inflation rates. Also, bandwagon effects can be they typically go through their own banks rather than entering the market directly. both triggered and exacerbated by the idiosyncratic behavior of politicians. 2 Features of the Foreign Exchange Market: 1. The market never sleeps Bondwagon Effect - when people do something primarily because other people 2. The integration of the various trading centers are doing it. Arbitrage- is the simultaneous purchase and sale of the same or similar assets EXCHANGE RATE FORECASTING: in different markets in order to profit from tiny differences in the assets' listed 2 schools of thought address in the issue of exchange rate forecasting: price. 1. The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and therefore, investing in ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION: forecasting services would be a waste of money. At the most basic level, exchange rates are determined by the demand and 2. The inefficient market school argues that companies can improve the foreign supply of one currency relative to the demand and supply of another. exchange market's estimate of future exchange rates (as contained in the Example: forward rate) by investing in forecasting services. If the demand for dollars outstrips the supply of them and if the supply of Japanese yen is greater than the demand for them, the dollar/yen exchange rate 2 TYPES OF SCHOOL IN EXCHANGE RATE FORECASTING: will change. The dollar will appreciate against the yen (or the yen will depreciate 1. The Efficient market school - is one in which prices reflect all available public against the dollar). information. If the foreign exchange market is efficient, forward exchange rates should be PRICES AND EXCHANGE RATES unbiased predictors of future spot rates. 2. The Inefficient market school - is one in which prices do not reflect all available THE LAW OF ONE PRICE information. The law of one price - states that in competitive markets free of transportation In an inefficient market, forward exchange rates will not be the best possible costs and barriers to trade (such as tariffs), identical products sold in different predictors of future spot exchange rates. countries must sell for the same price when their price is expressed in terms of the same currency. APPROACHES TO FORECASTING: 2 TYPES OF APPROACHES TO FORECASTING: Purchasing Power Parity 1. Fundamental Analysis= draws on economic theory to construct sophisticated Purchasing Power Parity (PPP) - is a money conversion rate used to express the econometric models for predicting exchange rate movements. purchasing power of different currencies in common units. 2. Technical Analysis= uses price and volume data to determine past trends, EX: If you want to buy a tank of gas for $20 and you now pay $50 for the same which are expected to continue into the future. tank of gas, your PPP has decreased. CURRENCY CONVERTIBILITY  Freely Convertible - when the country’s agreement allows both residents and non-residents to purchase unlimited amounts of a foreign currency with it.  Externally Convertible - when only non-residents may convert it into a foreign currency without any limitations.  Nonconvertible - when neither residents nor non-residents are allowed to convert it into a foreign currency.  Capital Flight - occurs when the value of the domestic currency is depreciating, typically because of hyperinflation or when a country’s economic prospects are shaky in other respects.  countertrade - refers to a range of barter-like agreements by which goods and services can be traded for other goods and services.  carry trade - borrowing at a low-interest rate and investing the proceeds in an asset that provides a higher rate of return. 3 TYPES OF FOREIGN EXCHANGE RISK 1. Transaction exposure - is the extent to which fluctuations in foreign exchange values affect the income from individual transactions. 2. Translation exposure - is the impact of currency exchange rate changes on the reported financial statements of a company. 3. Economic Exposure - is the extent to which a firm's future international earning power is affected by changes in exchange rates. REDUCING TRANSLATION AND TRANSACTION EXPOSURE A number of tactics can help firms minimize their transaction and translation exposure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. 2 ways in minimizing foreign exchange exposure: 1. Lead strategy - involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables to suppliers before they are due when a currency is expected to appreciate. 2. 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. REDUCING ECONOMIC EXPOSURE Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm's productive assets to various locations so the firm's long-term financial well-being is not severely affected by adverse changes in exchange rates. OTHER STEPS FOR MANAGING FOREIGN EXCHANGE RISK: 1. Central control exposure is needed to protect resources efficiently and ensure that each subsidiary adopts the correct mix of tactics and strategies. 2. Firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. 3. The need to forecast future exchange rate movements cannot be overstated. 4. Firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm's exposure positions. 5. On the basis of the information it receives from exchange rate forecasts and its own regular reporting systems.