Foreign Exchange Market

Chapter 09 - The Foreign Exchange Market

The Foreign Exchange Market

Learning objectives

Be conversant with the functions of the foreign exchange market. Understand what is meant by spot exchange rates. Appreciate the role that foreign exchange rates play in insuring against foreign exchange risk. Understand the different theories explaining how currency exchange rates are determined and their relative merits. Be familiar with the merits of different approaches towards exchange rate forecasting.

Understand the differences between transaction, translation, and economic exposure, and what managers do to manage each type of exposure.The foreign exchange market is the market where currencies are bought and sold and currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.

Exchange rates determine the value of one currency in terms of another. While dealing in multiple currencies is a requirement of doing business internationally, it also creates risks and significantly impacts the attractiveness of different investments over time.

The foreign exchange market is used for:

1. Currency conversion, 2. Currency hedging,

3. Currency arbitrage, 4.Currency speculation.

Firms can use the foreign exchange market to minimize the risk of adverse exchange rate movement. Such arrangements can prevent them from benefiting from favorable movements.

OUTLINE OF CHAPTER 9: THE FOREIGN EXCHANGE MARKET

Opening Case: Hyundai and Kia Face a Strong WonIntroduction

The Functions of the Foreign Exchange Market

Currency Conversion

Insuring Against Foreign Exchange Risk

Management Focus: Volkswagens Hedging Strategy

The Nature of the Foreign Exchange Market

Economic Theories of Exchange Rate Determination

Prices and Exchange Rates

The Law of One Price

Interest Rates and Exchange Rates

Investor Psychology and Bandwagon Effects

Summary

Country Focus: Anatomy of a Currency Crisis

Exchange Rate Forecasting

The Efficient Market School

The Inefficient Market School

Approaches to Forecasting

Currency Convertibility

Implications for Managers

Transaction Exposure

Translation Exposure

Economic Exposure

Reducing Translation and Transaction Exposure

Reducing Economic Exposure

Other Steps for Managing Foreign Exchange Risk

Management Focus: Dealing with the Rising Euro

Chapter Summary

Critical Thinking and Discussions Questions

Closing Case: The Curse of the Strong Dollar at STMicro

CLASSROOM DISCUSSION POINTGive students a copy of a recent currency exchange report from the Wall Street Journal, The New York Times or The Financial Times. Then, show students how to read the chart and understand the difference between direct quotes and indirect quotes.

Next, give students some money (slips of paper designated with certain currency values) and ask them to convert their money into a foreign currency at the bank and purchase several things like a hamburger and drink.

Finally, create a shortage of a popular currency to give students an feel for how supply and demand can affect a currencys value.

OPENING CASE: Hyundai and Kia Face a Strong WonThe opening case describes the international strategy of two South Korean auto companies, Hyundai and Kia. Both companies have approached the U.S. and European Union markets with high quality, well-designed, attractively-priced vehicles. While this strategy has been successful for the companies, it also means they are vulnerable to changes in the value of the Korean won relative to the U.S. dollar and European euro. Discussion of the case can revolve around the following questions:1. How does a strong Korean won affect Hyundai and Kia? Why are the two companies more vulnerable to currency movements than other automakers?

2. How can Hyundai and Kia protect themselves from adverse currency movements. In your opinion, are the two companies taking the right steps to hedge their exposure?

3. Both Hyundai and Kia have recently opened new facilities in the U.S. What is the motivation for this strategy?

Another Perspective: To explore Hyundai and Kias strategies in greater depth, go to the companies web sites at {http://www.hyundai.com} and {http://www.kia.com}.LECTURE OUTLINE

This lecture outline follows the Power Point Presentation (PPT) provided along with this instructors manual. The PPT slides include additional notes that can be viewed by clicking on view, then on notes. The following provides a brief overview of each Power Point slide along with teaching tips, and additional perspectives.

Slide 9-3 Introduction This chapter:

explains how the foreign exchange market works

examines the forces that determine exchange rates and discusses the degree to which it is possible to predict exchange rate movements

maps the implications for international business of exchange rate movements and the foreign exchange market The foreign exchange market is a market for converting the currency of one country into that of another country. The exchange rate is the rate at which one currency is converted into another.

Slide 9-4 The Functions of the Foreign Exchange Market

The foreign exchange market is used: to convert the currency of one country into the currency of another

to provide some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates

Slide 9-5 Currency Conversion

Companies use the foreign exchange market:

to convert payments it receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms

when they must pay a foreign company for its products or services in its countrys currency

when they have spare cash that they wish to invest 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

Another Perspective: XE.com {http://www.xe.com/} provides a real time currency cross-rate chart, and an option to do currency conversions.

Slides 9-6-9-10 Insuring Against Foreign Exchange Risk

A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk.

The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

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 occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. 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, and between governments when it is desirable to move out o one currency into another for a limited period without incurring foreign exchange rate risk.

Slides 9-11-9-12 The Nature of the Foreign Exchange Market

The foreign exchange market is not a place, but a network of banks, brokers, and dealers that exchange currencies 24 hours/day.

Slide 9-14 Economic Theories of Exchange Rate DeterminationThree factors have an important impact on future exchange rate movements in a countrys currency: the countrys price inflation its interest rate market psychology

Another Perspective: To find out more about how various factors affect, or are affected by, exchange rates, go to {http://www.fxcmtr.com/education/what-moves-rates.html?engine=exchangerate+rostext2+text&CMP=SFS-701300000003SF7AAM&keyword=01t031} and click on what moves rates.

Slide 9-15-9-16 Prices and Exchange RatesThe law of one price suggests that in competitive markets free of transportation costs and trade barriers, identical products in different countries must sell for the same price when their price is expressed in terms of the same currency.

A less extreme version of the PPP theory states that given relatively efficient markets that is, 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. Slide 9-17 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. Slide 9-18 Investor Psychology and Bandwagon Effects

Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and move exchange rates based on group expectations.

Slide 9-19 Summary

International businesses should pay attention to countries differing monetary growth, inflation, and interest rates.

Slide 9-21 Exchange Rate Forecasting

The efficient market school, argues that forward exchange rate do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money, while the inefficient market school, argues that companies can improve the foreign exchange markets estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services.Slide 9-22 The Efficient Market School

An efficient market is one in which prices reflect all available information. Slide 9-23 The Inefficient Market School

In an inefficient market, prices do not reflect all available information.

Slide 9-24 Approaches to Forecasting

There are two approaches to forecasting exchange rates:

fundamental analysis - draws upon economic theories to predict future exchange rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments information

technical analysis - chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves

Slides 9-25-9-26 Currency Convertibility

A currency is said to be 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 said to be 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.

Free convertibility is the norm in the world today, although many countries impose restrictions on the amount of money that can be converted. The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight.

Countertrade refers to a range of barter like agreements by which goods and services can be traded for other goods and services. It can be used in international trade when a countrys currency is nonconvertible.

Another Perspective: The American Countertrade Association maintains a web site with information for those interested in countertrade. The site is worth a visit. It is available at {http://schema-root.org/commerce/associations/american_countertrade_association/}.

Slide 9-28 Implications for Managers

There are three types of foreign exchange risk:

1. Transaction exposure

2. Translation exposure

3. Economic exposure

Slide 9-29 Transaction Exposure

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.

Slide 9-30 Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company.

Slide 9-31 Economic Exposure

Economic exposure is the extent to which a firms future international earning power is affected by changes in exchange rates. Slides 9-33-9-34 Reducing Translation and Transaction Exposure

Firms can minimize their foreign exchange exposure by:

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

Slide 9-35 Reducing Economic Exposure

Firms can reduce economic exposure by ensuring 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 they produced.Slide 9-36 Other Steps for Managing Foreign Exchange RiskTo manage foreign exchange risk: (a) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies; (b) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand; (c) the need to forecast future exchange rates cannot be overstated; (d) firms need to establish good reporting systems so the central finance function can regularly monitor the firms exposure position; (e) the firm should produce monthly foreign exchange exposure reports.

CRITICAL THINKING AND DISCUSSION QUESTIONS

QUESTION 1: The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%. The US interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

ANSWER 1: Drawing on what we know about the Fisher effect, the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

QUESTION 2: Two countries, Great Britain and the US, produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is 3.70 per pound.

(a) According to PPP theory, what should the $/ spot exchange rate be?

(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to 4.65 in Britain. What should be the one year forward $/ exchange rate?

(c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10%, what would you expect current interest rate to be in Britain?

ANSWER 2:

(a) According to PPP, the $/ rate should be 2.80/3.70, or .76$/.

(b) According to PPP, the $/ one year forward exchange rate should be 3.10/4.65, or .67$/.

(c) Since the dollar is appreciating relative to the pound, and given the relationship of

the international Fisher effect, the British must have higher interest rates than the US. Using the formula (S1 - S2)/S2 x 100 = i - i$ we can solve the equation for i, with S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.

QUESTION 3: Reread the Management Focus feature on Volkswagen in this chapter, then answer the following questions:

a) Why do you think management at Volkswagen decided to hedge only 30 percent of their foreign currency exposure in 2003? What would have happened if they had hedged 70 percent of their exposure?

b) Why do you think the value of the U.S. dollar declined against that of the Euro in 2003?

c) Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its exposure to future declines in the value of the U.S. dollar against the euro?

ANSWER 3:

a) When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in 2003, the company essentially gambled that the euro would decline in value relative to the dollar. The company hoped that by saving the cost of the commission involved in selling a currency forward, it would increase its profit margin. This strategy of course, backfired.

b) The appreciation of the euro relative to the U.S. dollar took many people by surprise. Its rise has been attributed to record U.S. foreign trade deficits and pessimism about the future value of the dollar.c) In addition to using forward contracts, Volkswagen could use currency swaps, and lead and lag payables and receivables. QUESTION 4: You manufacture wine goblets. In mid-June you receive an order for 10,000 goblets from Japan. Payment of 400,000 is due in mid-December. You expect the yen to rise from its present rate of $1=130 to $1=100 by December. You can borrow yen at 6% per annum. What should you do?

ANSWER 4: The simplest solution would be to just wait until December, take the 400,000 and convert it at the spot rate at that time, which you assume will be $1=100. In this case you would have $4,000 in mid-December. If the current 180-day forward rate is lower than 100/$, then a forward contract might be preferable since it both locks in the rate at a better level and reduces risk. If the rate is above 100/$, then whether you choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion. There is a third possibility also. You could borrow money from a bank that you will pay back with the 400,000 you will receive (400,000/1.03 = 388,350 borrowed), convert this today to US$ (388,350/130 = $2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution, you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to be an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this method would also reduce any exchange rate risk. What you should do depends upon the interest rates available, the forward rates available, how large a risk you are willing to take, and how certain you feel that the spot rate in December will be 100 = $1.

QUESTION 5: You are the CFO of a US firm whose wholly owned subsidiary in Mexico manufactures component parts for your US assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

ANSWER 5: Your financing and operating capital are in dollars, yet many of your costs (labor) must be in peso. Your hard assets are all in peso, and their value will decline. On the other hand, if the peso depreciates, then your dollars will go further. So perhaps doing nothing is the best approach. If you are pretty sure that the peso will depreciate, then you may want to avoid any major peso-denominated costs that you can until after devaluation. That may mean holding back on shipments if possible, and you may want any dollar-denominated purchases made before the devaluation. You may want to move any peso-denominated major accounts into dollars before the devaluation.

CLOSING CASE: The Curse of the Strong Dollar at STMicro

Summary

The closing case explores the effect of a strong dollar on STMicro, a European manufacturer of semiconductors. The majority of STMicros operations are located in Western Europe. Accordingly, when the dollar was strong relative to the euro, STMicro made a healthy profit, but saw its profit tumble when the value of the euro rose. Discussion of the case can revolve around the following questions.QUESTION 1: In retrospect, could the fall in the value of the dollar against the Euro have been predicted in 2003?

ANSWER 1: Since its introduction, the euro has been volatile relative to the U.S. dollar. Most analysts were surprised in 2003 by the rapid rise in value of the euro relative to the dollar. However, given that a key reason for the rise in value of the euro was the record U.S. foreign trade deficit which created an outward flow of dollars, and a lower value for the dollar, some might argue that the trend should have been expected.QUESTION 2: What was the fundamental reason for the decline in the value of the dollar against the euro in 2003-2006? To what extent is the decline in the value of the dollar consistent with the theories of exchange rate determination discussed in this chapter?

ANSWER 2: Investor psychology probably played a role in the decline of the dollar versus the euro in 2003-2006. Foreigners were pessimistic after the U.S. government announced that a weak dollar was acceptable since it helped firms trying to export. In addition, the U.S. governments record budget deficit contributed to the demise of the dollar relative to the euro. Many foreigners believed the U.S. would have to finance its spending through an expansion in the money supply, which would lead to inflation, and cause a drop in the value of the dollar. QUESTION 3: Why do you think that STMicro did very little currency hedging?

ANSWER 3: Hindsight is 20/20. During the early years of the euro, STMicro enjoyed high profits thanks to the weak euro and strong dollar. When the market began to shift, STMicro was unprepared. When the dollar fell, STMicro saw a negative impact on its profits. In the good years, the company was able to save the costs of currency hedging, however these costs savings were wiped out by the losses associated with the weak dollar.QUESTION 4: What strategy is STMicro now adopting to deal with possible future fluctuations in exchange rates? Is this a smart strategy?

ANSWER 4: To deal with possible future fluctuations in exchange rates, STMicro is actively cutting costs by closing some European operations and cutting jobs. In addition, the company is shifting some production to Asia with the idea of being able to switch production between Asia and Europe as the situation warrants. It is not clear whether the company intends to do any currency hedging, but it could complement STMicros other strategies. Another Perspective: Students can further explore STMicros current situation by going to its web site at {http://www.st.com/stonline/}.INTEGRATING iGLOBESThere are several iGLOBE video clips that can be integrated with the material presented in this chapter. In particular, you might consider the following:

Title: Federal Reserve Moves to Stabilize Market

Federal Reserve Spends BillionsRun Time: 10:21Abstract: This video explores the efforts by the Federal Reserve and other central banks to stabilize financial markets.

Key Concepts: international monetary system, investor psychology and the bandwagon effect, globalization

Notes: Global markets, concerned about the availability of credit, received some reassurance recently when the Federal Reserve, along with the European Central Bank, and other central banks, announced that they would pump billions of dollars into the global financial system. The hope is that the additional liquidity will ensure that prices in the market reflect underlying risks. As a result of the Federal Reserves actions, the federal funds rate, which had been 6 percent, dropped back to the targeted 5.25 percent. Liquidity in the market had been disrupted by a very abrupt re-pricing of risk in the economy.

Glenn Hubbard, dean of the Columbia Business School, believes that the move was important for restoring market confidence and ensuring that there were no developments in the market that could lead to a financial crisis. Laurence Meyer, former governor of the Federal Reserve Board, noted that the problems that were addressed began in the United States, and in particular with sub-prime loans. However, because financial markets today are global in nature, the problems quickly spread to other countries in Europe. Glenn Hubbard also stresses the need to fully understand the global nature of financial markets, and the interconnectedness of the global economy.

Hubbard points out that while the current problem began in the United States and spread to other countries, the contributions to global liquidity and investments in the United States came from foreign markets. He notes that today, risks are spread and diversified around the world. Hubbard expects further intervention in the market. Hubbard believes the current situation is actually a correction in the market that will more accurately price risk. He notes that the correction took place very quickly as people became worried about credit spreads.

Discussion Questions:

1. Why did the Federal Reserve recently pump money into financial markets? What problems was it trying to address? Did it succeed?

2. Consider the recent move by the Federal Reserve to inject additional liquidity into financial markets. The Federal Reserves efforts were just part of a worldwide effort to reassure investors of the availability of credit. Why was it important for the Federal Reserve to work in tandem with other central banks? Could the Federal Reserve have corrected the problem by working alone?

2. Reflect on the global nature of world financial markets. What are the implications of this interconnectedness? As an investor, how does this affect you?

4. Discuss the implications of global financial markets, and the potential for a worldwide economic crisis.

INTEGRATING VIDEOS

There are also several longer video clips that can be integrated with the material presented in this chapter. In particular, you might consider the following:

Title 11: Chinese Currency Change

Summary

After more than a decade, the Chinese yuan is finally being decoupled from the U.S. dollar. The yuan will now float against a basket of foreign currencies. China has been under increasing pressure from the U.S. to make such a move. In fact, U.S. Treasury Secretary John Snow has complained that continuing to peg the yuan to the dollar was tantamount to subsidizing companies, and threatened retaliatory trade sanctions if China failed to take corrective actions. Analysts, however, note that China is only revaluing the yuan by two percent, so the net effect is negligible given that estimates have the yuan as being undervalued by as much as 40 percent. China is reluctant to make a significant change to the yuan because its economic policy centers on growing exports, and the undervalued yuan amounts to a 33 percent subsidy to exporters. Eliminating the subsidy results in a loss of competitiveness for Chinese exporters, and an increase in competitiveness for American exporters.

The question now is whether China will take steps to further revalue its currency. Analysts seem to believe that political pressure and internal pressures will force China to continue to continue to revalue its currency, a move that could have repercussions in other parts of Asia. There is also some concern that inflationary pressures will rise in the U.S. if China makes any significant moves to revalue its currency.

Discussion Questions:

1. China, which has been under strong political pressure for some time to revalue its currency, has finally agreed to do just that, only in a very small way. Is this move by China a win for the U.S. or a win for China? What are the political implications of this action?

2. Until now, Chinas currency valuation has represented a significant subsidy to Chinese exporters, a situation that is seen in a negative light by American exporters. However, as a beneficiary of cheap goods made in China, how do you feel about the U.S. efforts to force China to raise its currency?

3. After more than a decade, the value of the yuan has risen relative to the dollar. While the revaluation amounts to just a two percent difference at the moment, there is speculation that the Chinese will continue to allow the yuan to rise. What effect will this initial movement have on Chinese workers and consumers? What are the effects if the yuan continues is ascent?

4. Chinas revaluation of the yuan was echoed in other parts of Asia. For example, in India, the rupee appreciated, as did the Japanese yen. Consider the implications of further currency revaluations for the Asian region.

globalEDGE Exercise Questions

Use the globalEDGE site {http://globalEDGE.msu.edu/} to complete the following exercises:Exercise 1

One component of learning about another country or region is to understand the relationship of its currency with others on the world currency market. As such, you are assigned the duty of ensuring the availability of 100,000 yen for a payment scheduled for next month. Considering that your company possesses only US dollars, identify the spot and forward exchange rates. What are the factors that influence your decision to use the spot or forward exchange rate? Which one would you choose? How many dollars must you spend to acquire the amount of yen required?

Exercise 2

Sometimes, analysts use the price of specific products across locations to compare currency valuation and purchasing power. In fact, the Big Mac Index compares the purchasing-power parity of many countries based on the price of a Big Mac. Locate the latest edition of this index that is accessible. Identify the five countries (and the currencies) with the lowest purchasing-power parity according to this classification. Which currencies, if any, are overvalued?

Answers to the Exercises

Exercise 1

The currency exchange rates can be accessed through a variety of sources. A list of these sources is available {http://globaledge.msu.edu/ResourceDesk/} and can be accessed by searching the term exchange rates. The first resource listed under this search is the FX Street website, located under the globalEDGE category Money: Finance. This site offers daily updated information about foreign exchange markets as forex news, market reports, forecasts, and real-time exchange rates and charts. A currency converter and historical tables are also available. By using the search function for such key terms as spot rate and forward rate, reports for each definition are provided. Additionally, forward and spot rates are readily available on the website. Be sure to check the Resource Desk only checkbox of the search function on the globalEDGE website.

Search Phrase: Exchange Rates

Resource Name: FX Street

Website: {http://www.fxstreet.com}globalEDGE Category: Money: Finance

Exercise 2

The Big Mac Index can be accessed by searching the term Big Mac Index at {http://globaledge.msu.edu/ResourceDesk/}. The resource is located under the globalEDGE category Money: Finance. Be sure to check the Resource Desk only checkbox of the search function on the globalEDGE website.

Search Phrase: Big Mac Index

Resource Name: Economist: The Big Mac IndexWebsite: {http://www.economist.com/markets/bigmac/}

globalEDGE Category: Money: Finance

9

PAGE 9-7