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AOF Business in a Global Economy

Lesson 7Foreign Exchange and

International Financial Markets

Teacher Resources

Resource Description

Teacher Resource 7.1 Guide: Travel Choice Simulation

Teacher Resource 7.2 Answer Key: The Foreign Exchange Market Anticipation Guide

Teacher Resource 7.3 Presentation and Notes: Currency Exchange Fluctuations (includes separate PowerPoint presentation)

Teacher Resource 7.4 Guide: Predicting Currency Exchange Fluctuations

Teacher Resource 7.5 Quiz: Foreign Exchange

Teacher Resource 7.6 Answer Key: Foreign Exchange Quiz

Teacher Resource 7.7 Key Vocabulary: Foreign Exchange and International Financial Markets

Teacher Resource 7.8 Bibliography: Foreign Exchange and International Financial Markets

Copyright © 20092016 NAF. All rights reserved.

AOF Business in a Global EconomyLesson 7 Foreign Exchange and International Financial Markets

Teacher Resource 7.1

Guide: Travel Choice SimulationRead the following to your students. Ask each group to calculate the exchange rate between the US dollar (USD) and the New Zealand dollar (NZD) once the group members have decided when they will be exchanging money.

Congratulations! You have won $1,000 USD to pay for a week-long trip to New Zealand this summer. You must use the prize money to purchase a travel package that includes your hotel room, meals, and entertainment. You can use the money left over after your purchase for spending money. You have two choices about when to buy your travel package.

Choice 1: Exchange your $1,000 USD today and take advantage of a prepurchase discount of 10% on all travel packages being offered by Air New Zealand.

Choice 2: Put the $1,000 USD in a 9-month certificate of deposit and earn interest on your money. Exchange your money and buy your package just before you leave.

The Outcomes….Choice 1:If you exchange today:

Today’s exchange rate is 1 USD to 1.723 NZD. This means that if you exchange your money today, you will have $1,723 NZD to spend on your trip. Plus, you get a 10% discount on your purchase. Good choice, traveler!

Choice 2: If you wait:

Since you won your award, demand for the New Zealand dollar has skyrocketed and its value has doubled. Now the exchange rate between the US dollar and the New Zealand dollar is 1 USD to 0.537 NZD. You did earn $14 USD interest on your money but you still have only $541 NZD to spend on your trip. You’d better find a roommate for the trip so you can also afford to eat!




Answer Key: The Foreign Exchange Market Anticipation Guide

The foreign exchange market never closes.

My guess: I agree I disagree

My reason:

I learned:The FX market is the only market that is open 24 hours per day. Because FX trading does not have a central location, trades occur all over the globe; the difference in time zones allows trading to occur all day and night.

Travelers who need foreign money make up the majority of currency exchanges.


My reason:

I learned: Travelers make up a small percentage of currency exchanges. Banks—directly and through brokers—make up the largest amount of trades on the market.

Banks lose money because of currency exchanges.


My reason:

I learned: Banks exchange currency on the FX market in the hopes of earning short-term profits from fluctuations in exchange rates.

The emotions of FX traders actually impact exchange rates.


My reason:

I learned:Market psychology can cause exchange rate fluctuations. This means that the general feeling of those who work in the market—the fear and excitement about a particular currency—can impact prices.




Presentation Notes: Currency Exchange FluctuationsBefore you show this presentation, use the text accompanying each slide to develop presentation notes. Writing the notes yourself enables you to approach the subject matter in a way that is comfortable to you and engaging for your students. Make this presentation as interactive as possible by stopping frequently to ask questions and encourage class discussion.

The foreign exchange (FX) market is where traders, banks, corporations, and governments exchange currency, that is, buy or sell one country’s currency for another. This international trade in currency goes on around the world, 24 hours a day. The three main centers for FX trading are located in the United States, Japan, and the United Kingdom.

But how do those who trade in the FX market know how many dollars there are in a euro? Or yen in a rupee? Let’s look at the factors that determine currency exchange rates and cause them to fluctuate.

Presentation notes



Currency, just like any other product for sale, follows the laws of supply and demand. Its price is its exchange rate. If demand is greater than supply for a certain currency, that currency’s price will rise. On the other hand, if there’s too much of a particular currency available compared with the demand for it, that currency’s price will fall.

The exchange rate of a country’s currency can either be floating or fixed. The value of a currency with a floating rate (e.g., the United States) is determined by the market. On the other hand, if a currency is fixed (e.g., China, until 2005), its value is pegged to another currency, group of currencies, or other measure of value, like gold. The central banks of countries with fixed exchange rates must buy and sell their own currency to maintain the fixed exchange rate.

Some governments choose fixed exchange rates to help control inflation or stabilize their currencies. But fixed exchange rates may fail to reflect the true value of a currency since they do not adjust according to market forces. If a fixed exchange rate is too different from what is consistent with market supply and demand for the currency, the result can be a financial crisis that forces a change in the fixed exchange rate. Therefore, most countries choose to let the exchange rate of their currency vary according to supply and demand in the market; that is, they have a floating exchange rate.

Presentation notes



There are a few currencies that traders in the currency market tend to prefer over others. But why? What exactly are they looking for? Let’s compare two countries. One has a stable government and political environment. Its economy is steadily growing, and it exports a variety of products to other foreign markets. The second country is in turmoil, perhaps undergoing a civil war, with an economy that has little to offer in the way of trade. In these cases, the first country’s currency would generally be more highly valued. People, companies, and other countries will want to do business with that country and therefore will desire its currency.

Political events can greatly affect a currency’s exchange rate. For instance, when a new government comes into power, it brings up a variety of questions. Will the new government maintain the current economic policies? Will its economic policies be better or worse? Will there be internal or regional political upheaval and fighting, or is the political landscape calm and stable? Traders consider how national and international politics affect what a currency is worth and how the currency may fluctuate in the future. These potential fluctuations are what shape a trader’s excitement or fear about a currency.

Presentation notes



The economic policies of a country (which are decided by governments) and the trends of its economy affect the value of its currency in the foreign exchange market. Central banks such as the US Federal Reserve have substantial control over interest rates, which determine the cost of borrowing money in that currency.

Whether a country’s gross domestic product (GDP) is increasing or decreasing also impacts the value of its currency. Recall that GDP is a commonly used indicator of a country's economic health. It's the monetary value of all goods and services produced within a country during a specific time period, usually a year. Countries with growing industries see a rise in employment rates and prosperity for the nation. When a country’s prosperity rises, its currency tends to appreciate, or rise, in value.

Economic conditions also influence exchange rates in other ways. One major factor influencing the value of a currency is inflation. When a country has high inflation (a general increase in the price of goods within a country), people from other countries may desire its currency less. When there’s inflation, what you can buy with a unit of a currency—its purchasing power—goes down. For example, a pack of gum that may have once cost $1 now costs $2 because of inflation. Thus, inflation in a country will cause the value of its currency to depreciate, or lessen, in relation to other countries’ money.

Presentation notes



Like any other human endeavor, the FX market is influenced by the perceptions and emotions of the people involved. This is called market psychology. Investing in currency, as with other investments, involves taking risks. Currencies in developing countries with expanding economies are risky investments. They offer FX traders new opportunities, but these currencies often come from less economically and politically stable countries.

Rumors and expectations play a large role in the valuation of currencies. If many traders believe a positive event is going to happen in a country, that belief may be enough to raise the price of that currency. Traders also place a lot of importance on specific economic statistics, although which statistics they consider to be important may change over time. They may focus on a country’s inflation rate, trade balance, or employment figures in an attempt to predict the price of its currency in the future.

In a market this big and volatile, the traders do all they can to predict what other traders will do and how currency exchange rates will fluctuate. They may analyze a country’s economy and political environment to see if they believe a currency is overvalued or undervalued.

When traders think the current price of a currency is too low and expect it to rise, they will buy a large amount of the currency. If their expectation turns out to be right, they’ll be able to sell that currency later at a profit when the price goes up. If their expectation turns out to be wrong and the price falls, they will suffer a loss. If, on the other hand, they believe a currency is overvalued and expect its exchange rate to fall, they’ll sell it now and buy it back later when the price drops.

Presentation notes



Because exchange rates affect the economy of a country in so many ways, governments look for ways to keep their currencies stable, in an attempt to keep them from getting too strong or too weak.

A strong currency is one that has increased in value compared with other currencies and is expected to continue to increase. A country with a booming economy and trade surplus will generally have a strong currency. A weak currency is one that has decreased in value and is expected to continue to decrease compared with other currencies. A country with a poorly performing economy or large budget deficits will generally tend to have a weak currency.

Governments usually have a view about what the exchange rate of their country’s currency ought to be, even if their economic policy also calls for a floating exchange rate. Governments often work to keep their currencies from getting too strong or too weak relative to this preferred level. Keeping a currency stable keeps prices, tourism, and business contracts stable as well. It also helps keep the market psychology toward the currency favorable.

Presentation notes



The global FX market is a vast and turbulent place. Governments, corporations, banks, and individuals must look at an array of issues, political events, and economic statistics to try and figure out where a currency’s value is likely to go. Will it rise? Will it fall? What does the future hold?

Though FX is not an exact science, FX traders do their best to understand the economic, political, and psychological factors that influence the value of each currency today and are likely to influence it in the future. One thing is certain: this market provides an exciting and challenging world for those who choose to take part in it.

Presentation notes




Guide: Predicting Currency Exchange FluctuationsReview how the value of the currency will probably change and the reasons why with your students.

1. A country is undergoing an election. It seems likely that the political challenger will win, but many people believe that the current president will not give up power without a fight. It may not be a smooth transition.

The value of this currency will probably fall.

Reason why: political instability

2. Though this country has long had a stable economy, it’s going through some turbulent times. Much of its heavy industry, including auto manufacturing, is suffering. Because of this, the country’s trade deficit is growing.

The value of this currency will probably fall.

Reasons why: a country with trade deficits often has a weak currency, foreign entities may invest less in this country, unemployment rates will rise, GDP may decline, market psychology may cause fear in the market

3. A developing country is beginning to enter the fast-growing electronics industry, making items such as DVD players and TVs as well as components for computers.

The value of this currency will probably rise.

Reasons why: the country is moving toward or has a trade surplus, foreign investment will likely increase, GDP will rise, employment will expand and the unemployment rate will fall

4. The numbers haven’t been published yet, but rumor has it that this country’s unemployment numbers will be down and its GDP will be up.


Reasons why: market psychology will interest investors in the currency, higher GDP and employment numbers sometimes correlate with a stronger currency

5. This country has just signed a free-trade agreement with several of its neighbors. The agreement effectively ends tariffs on trade between the nations.


Reasons why: trade will significantly increase, increasing GDP and employment rates; new investments in the economy will occur




Quiz: Foreign ExchangeStudent Name:_______________________________________________________ Date:___________

1. You are traveling to Argentina to give a presentation at the flamenco convention. The exchange rate between the US dollar and the Argentine peso (ARS) is 1 USD = 3.7 ARS. Your boss has asked you to spend no more than $1,250 USD on the trip. How many Argentine pesos do you have to spend?

2. Explain how the law of supply and demand affects the value of currency.

3. Name one benefit of having a floating exchange rate.

4. Name one economic condition that causes currency fluctuation. Explain why it causes fluctuation.

5. Explain two to three risks of doing a spot exchange.




Answer Key: Foreign Exchange Quiz1. You are traveling to Argentina to give a presentation at the flamenco convention. The exchange

rate between the US dollar and the Argentine peso (ARS) is 1 USD = 3.7 ARS. Your boss has asked you to spend no more than $1,250 USD on the trip. How many Argentine pesos do you have to spend?

4,625 ARS

2. Explain how the law of supply and demand affects the value of currency.

When the supply of a currency increases, assuming demand for the currency is unchanged, that currency will depreciate against other currencies (its exchange rate will fall). When the supply of a currency decreases, assuming demand for the currency is unchanged, that currency will appreciate against other currencies (its exchange rate will rise).

3. Name one benefit of having a floating exchange rate.

Either of these answers is acceptable: the rate automatically adjusts to the balance of trade and market forces; countries’ central banks (such as the US Federal Reserve) do not need to continually buy and sell in the FX market as they would need to do if they had to ensure that a fixed exchange rate stayed fixed.

4. Name one economic condition that causes currency fluctuation. Explain why it causes fluctuation.

Any of these answers are acceptable: Supply or demand for currency could change due to new investments or prosperity; increasing GDP could cause a rise in the value of the country’s currency by encouraging investment; decreasing GDP could cause a fall in currency value; high inflation rates sometimes correspond with a rapid increase in the money supply, often leading to a reduced currency value; higher interest rates may mean less borrowing but tend to lead to a stronger currency as banks and others move their money into the country to earn the higher interest available there; a trade deficit means a country’s imports exceed its exports, which tends to lead to a weaker currency; a trade surplus means a country’s exports exceed its imports, which tends to lead to a stronger currency.

5. Explain one risk of doing a spot exchange.

It is impossible to know what the exchange rate between two currencies will be in the future. If the currency you are trading appreciates in the future, you will lose out on all the potential profit of a forward exchange.




Key Vocabulary: Foreign Exchange and International Financial Markets

Term Definition

appreciation When a currency’s value increases in terms of another currency.

currency Another word for money.

depreciation When a currency’s value decreases in terms of another currency.

fixed exchange rate An exchange rate that the government pegs its currency’s value relative to another currency, a group of currencies, or another measure of value, such as gold. Fixed exchange rates tend to help keep inflation in check but tend to hide a currency’s true market value.

floating exchange rate An exchange rate that is allowed to vary. With a floating exchange rate, the value of the currency is determined by buying and selling the currency in the FX market.

foreign exchange market The largest trading market in the world, where currency trading takes place. It is also called the FX, forex, or currency market.

forward transaction A currency trade in which one party agrees to sell, and the other party agrees to buy, a particular currency at an agreed exchange rate on a specific date in the future.

hedging Techniques aimed at minimizing the business risks arising from FX fluctuations.

inflation A rise in prices due to the decline of a currency’s value. Inflation causes a decline in the value of a currency as measured by purchasing power parity (PPP).

market psychology The emotions and beliefs of traders on the FX market that influence exchange rates.

options Currency trades that give the owner of the option the right, but not the obligation, to buy or sell a particular currency at a prearranged exchange rate on a specified date.

spot transaction A currency trade that happens immediately, at the current exchange



Term Definition

rate.

strong currency A currency with a value (in terms of other currencies) that is high and that tends to rise.

weak currency A currency with a value (in terms of other currencies) that is low and that tends to fall.




Bibliography: Foreign Exchange and International Financial Markets

The following sources were used in the preparation of this lesson and may be useful for your reference or as classroom resources. We check and update the URLs annually to ensure that they continue to be useful.

PrintCzinkota, Michael R., et al. Fundamentals of International Business. Mason, Ohio: South-Western, 2004.

Hill, Charles W. L. Global Business Today. New York: McGraw-Hill, 2006.

Online“Exchange Rate.” Wikipedia, http://en.wikipedia.org/wiki/Exchange_rate (accessed May 12, 2016).

“Foreign Exchange Market.” Wikipedia, http://en.wikipedia.org/wiki/Foreign_exchange_market (accessed May 12, 2016).

“Foreign Exchange Option.” Wikipedia, http://en.wikipedia.org/wiki/Foreign_exchange_option (accessed May 12, 2016).

“History of Foreign Exchange.” Global-View, http://www.global-view.com/forex-education/forex-learning/gftfxhist.html (accessed May 12, 2016).

“The History of Forex Trading.” EarnForex.com, http://www.earnforex.com/articles/the-history-of-forex-trading (accessed May 12, 2016).

“Market Psychology.” Investopedia, http://www.investopedia.com/terms/m/marketpsychology.asp (accessed May 12, 2016).

“Understanding the Effects of Currency Exchange Rates.” Nebraska Council, http://ecedweb.unomaha.edu/NEandWorld/NElesson5.pdf, (accessed May 12, 2016.).


http://ecedweb.unomaha.edu/NEandWorld/NElesson5.pdf

http://www.investopedia.com/terms/m/marketpsychology.asp

http://www.earnforex.com/articles/the-history-of-forex-trading

http://www.earnforex.com/articles/the-history-of-forex-trading

http://www.global-view.com/forex-education/forex-learning/gftfxhist.html

http://en.wikipedia.org/wiki/Foreign_exchange_option

http://en.wikipedia.org/wiki/Foreign_exchange_market

http://en.wikipedia.org/wiki/Exchange_rate

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