chap 009 inter biz

7/28/2019 Chap 009 INTER BIZ

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International Business 7e

by Charles W.L. Hill

McGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.


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Chapter 9

The Foreign Exchange Market


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9-3

Introduction

A firms sales, profits, and strategy are affected by events

in the foreign exchange market

The foreign exchange market is a market for convertingthe currency of one country into that of another country

The exchange rate is the rate at which one currency isconverted into another


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9-4

The Functions Of TheForeign Exchange Market

The foreign exchange market:

is used to convert the currency of one country into thecurrency of another

provide some insurance against foreign exchange risk

(the adverse consequences of unpredictable changes inexchange rates)


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9-5

Currency Conversion

International companies use the foreign exchange market when:

the payments they receive for exports, the income they receive fromforeign investments, or the income they receive from licensingagreements with foreign firms are in foreign currencies

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

they have spare cash that they wish to invest for short terms inmoney markets

they are involved incurrency speculation (the short-term movementof funds from one currency to another in the hopes of profiting fromshifts in exchange rates)


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Insuring Against Foreign Exchange Risk

The foreign exchange market can be used to provideinsurance to protect against foreign exchange risk(thepossibility that unpredicted changes in future exchangerates will have adverse consequences for the firm)

A firm that insures itself against foreign exchange risk ishedging


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The spot exchange rate is the rate at which a foreignexchange dealer converts one currency into anothercurrency on a particular day

Spot rates change continually depending on the supplyand demand for that currency and other currencies


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Classroom Performance System

The ________ is the rate at which one currency isconverted into another.

a) Exchange rateb) Cross rate

c) Conversion rate

d) Foreign exchange market


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To insure or hedge against a possible adverse foreignexchange rate movement, firms engage in forwardexchanges

Aforward exchange occurs when two parties agree toexchange currency and execute the deal at some specificdate in the future

A forward exchange rate is the rate governing suchfuture transactions

Rates for currency exchange are typically quoted for 30,90, or 180 days into the future


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A currency swap is the simultaneous purchase and saleof a given amount of foreign exchange for two differentvalue dates

Swaps are transacted between international businessesand their banks, between banks, and betweengovernments when it is desirable to move out of onecurrency into another for a limited period without incurringforeign exchange rate risk

Th N t Of Th


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The Nature Of TheForeign Exchange Market

The foreign exchange market is a global network ofbanks, brokers, and foreign exchange dealers connectedby electronic communications systemsit is not located in

any one placeThe most important trading centers are London, NewYork, Tokyo, and Singapore

The markets is always open somewhere in the worldit

never sleeps

Th N t Of Th


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The Nature Of TheForeign Exchange Market

High-speed computer linkages between trading centersaround the globe have effectively created a single marketthere is no significant difference between exchange rates

quotes in the differing trading centersIf exchange rates quoted in different markets were notessentially the same, there would be an opportunity forarbitrage (the process of buying a currency low and sellingit high), and the gap would close

Most transactions involve dollars on one sideit is avehicle currency along with the euro, the Japanese yen,and the British pound


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The _______ is the rate at which a foreign exchange dealerconverts one currency into another currency on a particularday.

a) Currency swap rate

b) Forward rate

c) Specific rate

d) Spot rate

E i Th i Of


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9-14

Economic Theories OfExchange Rate Determination

Exchange rates are determined by the demand andsupply for different currencies.

Three factors impact future exchange rate movements:a countrys price inflation

a countrys interest rate

market psychology


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Prices And Exchange Rates

The law of one price states that in competitive marketsfree of transportation costs and barriers to trade, identicalproducts sold in different countries must sell for the sameprice when their price is expressed in terms of the same

currencyPurchasing power parity (PPP) theory argues that givenrelatively efficient markets (markets in which fewimpediments to international trade and investment exist)the price of a basket of goods should be roughly

equivalent in each countryPPP theory predicts that changes in relative prices willresult in a change in exchange rates


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Prices And Exchange Rates

A positive relationship between the inflation rate and thelevel of money supply exists

When the growth in the money supply is greater than thegrowth in output, inflation will occur

PPP theory suggests that changes in relative pricesbetween countries will lead to exchange rate changes, atleast in the short run

A country with high inflation should see its currencydepreciate relative to others

Empirical testing of PPP theory suggests that it is mostaccurate in the long run, and for countries with highinflation and underdeveloped capital markets


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Interest Rates And Exchange Rates

There is a link between interest rates and exchange rates

The International Fisher Effect states that for any twocountries the spot exchange rate should change in anequal amount but in the opposite direction to the differencein nominal interest rates between two countries

In other words:

(S1 - S2) / S2 x 100 = i $ - i

where i $ and i are the respective nominal interestrates in two countries (in this case the US and Japan), S1is the spot exchange rate at the beginning of the period andS2 is the spot exchange rate at the end of the period

I t P h l


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Investor PsychologyAnd Bandwagon Effects

Investor psychology also affects exchange rates

The bandwagon effectoccurs when expectations on thepart of traders can turn into self-fulfilling prophecies, andtraders can join the bandwagon and move exchange ratesbased on group expectations

Governmental intervention can prevent the bandwagonfrom starting, but is not always effective


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Summary

Relative monetary growth, relative inflation rates, andnominal interest rate differentials are all moderately goodpredictors of long-run changes in exchange rates

So, international businesses should pay attention tocountries differing monetary growth, inflation, and interest

rates


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Which of the following does notimpact future exchangerate movements?

a) A countrys price inflationb) A countrys interest rate

c) A countrys arbitrage opportunities

d) Market psychology


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Exchange Rate Forecasting

Should companies use exchange rate forecasting servicesto aid decision-making?

The efficient market school argues that forward exchangerates do the best possible job of forecasting future spotexchange rates, and, therefore, investing in forecastingservices would be a waste of money

The inefficient market school argues that companies canimprove the foreign exchange markets estimate of future

exchange rates by investing in forecasting services


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The Efficient Market School

An efficient market is one in which prices reflect allavailable information

If the foreign exchange market is efficient, then forwardexchange rates should be unbiased predictors of futurespot rates

Most empirical tests confirm the efficient markethypothesis suggesting that companies should not wastetheir money on forecasting services


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The Inefficient Market School

An inefficient market is one in which prices do not reflectall available information

So, in an inefficient market, forward exchange rates willnot be the best possible predictors of future spot exchangerates and it may be worthwhile for international businessesto invest in forecasting services

However, the track record of forecasting services is notgood


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Approaches To Forecasting

There are two schools of thought on forecasting:

Fundamental analysis draw upon economic factors likeinterest rates, monetary policy, inflation rates, or balance ofpayments information to predict exchange rates

Technical analysis charts trends with the assumption thatpast trends and waves are reasonable predictors of futuretrends and waves


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Currency Convertibility

A currency is freely convertible when a government of acountry allows both residents and non-residents topurchase unlimited amounts of foreign currency with thedomestic currency

A currency is externally convertible when non-residentscan convert their holdings of domestic currency into aforeign currency, but when the ability of residents toconvert currency is limited in some way

A currency is nonconvertible when both residents andnon-residents are prohibited from converting their holdingsof domestic currency into a foreign currency


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Currency Convertibility

Most countries today practice free convertibility, althoughmany countries impose some restrictions on the amount ofmoney that can be converted

Countries limit convertibility to preserve foreign exchange

reserves and prevent capital flight (when residents andnonresidents rush to convert their holdings of domesticcurrency into a foreign currency)

When a countrys currency is nonconvertible, firms may

turn to countertrade (barter like agreements by whichgoods and services can be traded for other goods andservices) to facilitate international trade


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When a government of a country allows both residents andnon-residents to purchase unlimited amounts of foreigncurrency with the domestic currency, the currency is

a) Nonconvertible

b) Freely convertible

c) Externally convertible

d) Internally convertible


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Implications For Managers

Firms need to understand the influence of exchangerates 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


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Transaction Exposure

Transaction exposure is the extent to which the incomefrom individual transactions is affected by fluctuations inforeign exchange values

It includes obligations for the purchase or sale of goods

and services at previously agreed prices and the borrowingor lending o funds in foreign currencies


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Translation Exposure

Translation exposure is the impact of currency exchangerate changes on the reported financial statements of acompany

It is concerned with the present measurement of past

events

Gains or losses are paper losses theyre unrealized


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Economic Exposure

Economic exposureis the extent to which a firms futureinternational earning power is affected by changes inexchange rates

Economic exposure is concerned with the long-term

effect of changes in exchange rates on future prices, sales,and costs


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The extent to which a firms 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

Reducing Translation


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Reducing TranslationAnd Transaction Exposure

To minimize transaction and translation exposure, firmscan:

buy forward

use swaps

leading and lagging payables and receivables (payingsuppliers and collecting payment from customers early orlate depending on expected exchange rate movements)

Reducing Translation


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Reducing TranslationAnd Transaction Exposure

A lead strategy involves attempting to collect foreigncurrency receivables early when a foreign currency isexpected to depreciate and paying foreign currencypayables before they are due when a currency is expected

to appreciateA lag strategy involves delaying collection of foreigncurrency receivables if that currency is expected toappreciate and delaying payables if the currency is

expected to depreciateLead and lag strategies can be difficult to implement


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Reducing Economic Exposure

To reduce economic exposure, firms need to:

distribute productive assets to various locations so thefirms long-term financial well-being is not severely affectedby changes in exchange rates

ensure assets are not too concentrated in countrieswhere likely rises in currency values will lead to damagingincreases in the foreign prices of the goods and servicesthe firm produces

Other Steps For Managing


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Other Steps For ManagingForeign Exchange Risk

In general, firms should:

have central control of exposure to protect resourcesefficiently and ensure that each subunit adopts the correctmix of tactics and strategies

distinguish between transaction and translation exposureon the one hand, and economic exposure on the otherhand

attempt to forecast future exchange rates

establish good reporting systems so the central financefunction can regularly monitor the firms exposure position

produce monthly foreign exchange exposure reports

C f S


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Firms that want to minimize transaction and translationexposure 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


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6. Topic 6: Foreign exchange market

- Exchange rate: definition, spot and forward

exchange rates- Factors influencing exchange rates

- Influence of exchange rates on import, export

activities.

- What tools can be taken by Vietnamesecompanies to minimize the effects of exchange rate

fluctuations?- Introduce services offered by banks in HCMCthat help companies to avoid exchange rate

fl t ti ?

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