Chapter 10 The Foreign Exchange Market

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• A quote in American terms (US$/Fx) is always the reciprocal of a quote in European terms (Fx/US$).

$1.00/¥.009430 ¥106.04/$1.00

• Base currency: the quoted, underlying, or fixed currency

�Traders always quote:Base currency (the denominator) first, followed by the Terms currency (the numerator).

An example:Dollar-yen quote: dollar = base, yen = terms

Sep. 10, 2011 April 9, 2013¥76.78/$1.00 ¥99.13/$1.00

The dollar (base) strengthened; the yen (terms) weakened

American & European Terms

Direct and Indirect Quotes

"European Terms" - Foreign Currency Price per U.S. Dollar

European Terms were adopted in 1978

Used for MOST countries

Indirect Quote in the U.S = European Terms

Example – Euro 0.76/ 1 USD

"American Terms" - U.S. Dollar per Foreign Currency Price

Used for U.K. Pound Sterling

Direct Quote in U.S. = American Terms

Example - USD 1.30/ 1 Euro

The U.K. pound sterling for centuries was divided into 20 shillings, each of which had 12 pence. This non-decimal method was difficult to convert. The U.K. converted to decimals in 1971, but "American Terms" are still used.

Exchange ProblemForm Informal Groups

1. You have 2 buckets – 3 gallon bucket and 5 gallon bucketYou have infinite amounts of waterWhat will you do to measure exactly 4 gallons?

Solution

1. Fill the 5 gallon and empty into the 3 gallon (this leaves 2 gallons in the 5 gallon bucket)

2. Spill out the 3 gallon and fill the 3 gallon with the 2 gallons (from the 5 gallon bucket)

3. Fill the 5 gallon bucket and then fill the 3 gallon bucket (with an additional 1 gallon) from the 5 gallon bucket

4. The 5 gallon bucket now has 4 gallons in it

Exchange Rate Arbitrage – 3 Currencies

A. USD B. Vietnam Dong C. Argentine Peso(A to B)

1000 USD -> Vietnam Dong = 16,625,000 (@16.625)(B to C)

16,625,000 Vietnam Dong -> Argentine Peso = 3,027.5006125 (@0.0001821)(C to A)

3,027.5006125 Argentine Peso = 1000.0002USD (@0.3303)(A to C)

1000 USD -> Argentine Peso = 3,027.4999 (@3.0275)

(A to B)*(B to C) should = (A to C)(16.625)(0.0001821) = 0.0030274 – Yes = 0.0030275

Trade A for B, B for C and C for A is known as a currency cycle.

Most of the time all the exchange rates are synchronized Occasionally - out of sync (arbitrageurs can make a profit)

Want to be a Billionaire?

It depends on where …In Zimbabwe (2008-2009)

$100 billion will buy 3 eggs (2008)

Hyperinflation made Money meaningless(2008)

Zimbabwe

$100 trillion – largest bank note ever made (2008 in Zimbabwe)

“Inflation will increase when money supply growth exceeds the expansion of real economic activity …”Source: 2011 Annual Report, Federal Reserve Bank of Dallas

Current Situation – 2013 forecast …

Is the Global Economy on the Verge of Another Meltdown?

Global Economist speaks: FILM (10)

(PPP) – Purchasing Power Parity theory

� Theory states: In ideally efficient markets, identical goods should have only one price� More useful in comparing differences in living

standards

� PPP takes into account the relative cost of living

and the inflation rates of different countries (Not just GDP)

PPP – revisited (9/2008)

PPP – revisited (9/2008)

International Comparison Program, 2005 Round (PPP)

�Determine price levels within nations

�Direct price comparisonsof about 1,000 goods and services

�Number of participating countries has increasedfrom 118 in the previous round (1993) to 146 now

GDP versus PPP

Source: http://www.gapminder.org/world/

Look at the relationship between:- GDP (US$) vs.- GDP (PPP$)

Chart Explanation* 3 different slopes

Nominal Interest Rate – Intl Fisher Effect

Nominal Interest Rate

� Interest rate + Inflation (expected annual rate)

International Fisher Effect

�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, if the nominal interest rate in one country is higher than another we expect the currency to depreciate

� In the long term – tends to be accurate

� In the short term – not accurate

Investment Returns?

European Euros/ Dollar

Month Year Rate

March 2004 0.815March 2005 0.758March 2006 0.814March 2007 0.755March 2008 0.644

Trends:

Nearly 21% depreciation (weakening) of US $, with a trend toward a weaker Dollar.

If we invested in bonds in Euros, factoring in interest rates AND currency fluctuation trends . . .

Approaches To Forecasting

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

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

The International Monetary System

Chapter 11

The Bretton Woods System

The Bretton Woods agreement (1944) established two multinational institutions:

�the International Monetary Fund (IMF) to maintain order in the international monetary system

�the World Bank to promote general economic development

A STRONG Dollar – (10/1/2016)

Dollar Strength – Film (11 min)

Please answer these questions while watching the film:

Consider a STRONG dollar

1. How does a strong dollar impact business?

2. How does the strong dollar affect consumers? In your opinion, is the strong dollar a good or bad thing?

FILM

Go to: http://instruction2.mtsac.edu/rjagodka

Click “International Business Resources” -> “Country Data” (first link on page)

ConsultaPedia.com – (1) Click on your assigned country

(2) Click on tabs for details about your country

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