Chapter 10: The Foreign Exchange Market

• Describe the functions of the foreign exchange market. 
• Understand what is meant by spot exchange rates. 
• Recognize 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. 
• Identify the merits of different approaches toward exchange rate forecasting. 
• Compare and contrast the differences among 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, and

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. 

The opening case illustrates how a decline in the value of the Japanese yen against the U.S. dollar led to a sharp rise in sales in the United States.  The closing case explores the effects of exchange rate fluctuations on the profit margins of Brazilian aircraft manufacturer Embraer.

 

LECTURE OUTLINE

 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. 

Slide 10-2 Why Is the Foreign Exchange Market Important?

This chapter:

• explains how the foreign exchange market worksexamines 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 10-4 When Do Firms Use 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 

Companies use the foreign exchange market:

• to convert payments they receive for exports, the income they receive from foreign investments, or from licensing agreements with foreign firms
• when they must pay a foreign company for products or services in a foreign 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.  

 

Slide 10-5 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.

 

Slides 10-6 and 10-7 Spot Rates and Forward Rates 

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.

 

Slide 10-8 Currency Swap

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 of one currency into another for a limited period without incurring foreign exchange rate risk.

 

Slide 10-9 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. 

 

Slides 10-10 and 10-11 Exchange Rates between Markets

Opportunities for arbitrage exist when exchange rates are not the same between markets.  

About 85 percent of al foreign exchange transactions involve the U.S. dollar.  It is a vehicle currency.

 

Slide 10-12 Economic Theories of Exchange Rate Determination
Three factors have an important impact on future exchange rate movements in a country’s currency:

• the country’s price inflation
• its interest rate
• market psychology

 

Slides 10-13 through 10-17 Prices and Exchange Rates

The 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 10-18 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 10-19 Investor Psychology and Bandwagon Effects

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

 

Slides 10-20 through 10-22 Exchange Rate Forecasting

The efficient market school, argues that forward exchange rates 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 market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services. 

An efficient market is one in which prices reflect all available information.  

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

 

Slide 10-23 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 10-24 through 10-26 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 country’s currency is nonconvertible.  

 Another Perspective: The American Countertrade Association {http://www.globaloffset.org} maintains a web site with information for those interested in countertrade.  Also, students can learn more about countertrade at {http://www.barternews.com/countertrade.htm}.

 

Slide 10-27 Think Like a Manager: Foreign Exchange Risk

 

Slides 10-28 through 10-30 Implications for Managers

There are three types of foreign exchange risk:

1. Transaction exposure

2. Translation exposure

3. Economic exposure 

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

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

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates.  

 

Slides 10-31 and 10-32 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.

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 10-33 and 10-34 Other Steps for Managing Foreign Exchange Risk

To manage foreign exchange risk:

(1) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

(2) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

(3) the need to forecast future exchange rates cannot be overstated

(4) firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position

(5) the firm should produce monthly foreign exchange exposure reports. 

 

Chapter 11: The International Monetary System                           

• Describe the historical development of the modern global monetary system. 
• Explain the role played by the World Bank and the IMF in the international monetary system. 
• Compare and contrast the differences between a fixed and a floating exchange rate system. 
• Identify exchange rate regimes used in the world today and why countries adopt different exchange rate regimes. 
• Understand the debate surrounding the role of the IMF in the management of financial crises. 
• Explain the implications of the global monetary system for currency management and business strategy.

This chapter discusses the evolution of the international monetary system and the implications of this system for international business, focusing on the institutional context within which exchange rates move. 

 The history of monetary systems includes a period with the gold standard, a fixed exchange rates system, and the current managed float system. Since WWII, the IMF and the World Bank have played an important role in the world economy. 

The role of the IMF is to maintain order in the international monetary system to avoid a repetition of the competitive devaluations of the 1930s, and to control price inflation by imposing monetary discipline on countries. 

IMF-mandated macro-economic policies are under serious debate, with critics charging that at times the IMF imposes inappropriate conditions on developing nations. 

The opening case explores the recent political and economic crisis in Ukraine and the attempts by the IMF to restore stability to the country’s currency value and to promote economic growth. The closing case explores the recent debt crisis in Iceland and the country’s economic recovery thanks to a floating currency exchange rate and loans from the IMF.

  LECTURE OUTLINE 

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. 

Slides 11-3 through 11-5 What Is the International Monetary System?

The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates.  Governments adopt various types of exchange rate systems including the pegged rate, the dirty float, and the fixed rate.

 

Slides 11-6 and 11-7 The Gold Standard

The system of exchange rates known as the gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value. 

Pegging currencies to gold and guaranteeing convertibility is central to the gold standard.

In the 1880s, most of the world’s trading nations followed this exchange rate system.

 

Slides 11-8 and 11-9 Strength of the Gold Standard

The gold standard provides a powerful mechanism to pull trade imbalances between countries back into balance-of-trade equilibrium. 

Another Perspective: The Advantages Of  The Gold Standard was the topic of a 1961 paper by former Federal Reserve Board Chairman, Alan Greenspan.  The paper is available at {http://www.usagold.com/gildedopinion/Greenspan.html}. 

The gold standard worked fairly well from the 1870s until the start of World War I in 1914, but by 1939 the gold standard had collapsed.

 

Slides 11-10 and 11-11 The Bretton Woods System

The Bretton Woods system established a fixed exchange rate system where all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold.  Devaluations could not to be used for competitive purposes and a country could not devalue its currency by more than 10% without IMF approval. 

The Bretton Woods system also provided for two multinational institutions – the International Monetary Fund (IMF) and the World Bank (IBRD). 

Another Perspective: For more information about the Bretton Woods Agreement go to {http://avalon.law.yale.edu/20th_century/decad047.asp} and also at {http://www.econ.iastate.edu/classes/econ355/choi/bre.htm}.

 

Slides 11-12 and 11-13 The IMF and the World Bank

The IMF was charged with executing the main goal of the Bretton Woods agreement - avoiding a repetition of the chaos that occurred between the wars through a combination of discipline and flexibility. 

Another Perspective: The homepage of the IMF is available at {http://www.imf.org}.  Students can click on either “For First Time Visitors” or on “For Students” to get a good overview of the IMF and its activities. 

The World Bank is also known as the International Bank for Reconstruction and Development (IBRD). 

Another Perspective:  For more information on the World Bank, go to {http://www.worldbank.org/index.html}.  Click on “Data” to pull information on World Bank activities, or on “Countries” to explore World Bank activities by country.

 

Slide 11-14 The Collapse of the Fixed Exchange System

The Bretton Woods worked well until the late 1960s, before collapsing.

 

Slide 11-15 The Floating Exchange Rate Regime

The Jamaica Agreement was signed in 1976 following the collapse of Bretton Woods.  The rules that were agreed on then are still in place today. 

Under the Jamaica agreement:

• floating rates were declared acceptable
• gold was abandoned as a reserve asset
• total annual IMF quotas were increased to $41 billion 

 

Slides 11-16 and 11-17 Exchange Rates since 1973

Exchange rates have become more volatile and less predictable than they were between 1945 and 1973.

 

Slide 11-18 Think Like a Manager: Floating Exchange Rates and Foreign Exchange Risk

 

Slides 11-19 and 11-20 Fixed Versus Floating Exchange Rates

The merit of a fixed exchange rate versus a floating exchange rate system continues to be debated. 

The case for floating exchange rates has three main elements:

1. monetary policy autonomy

2. automatic trade balance adjustments

3. help countries recover from financial crises 

Supporters of fixed exchange rates focus on monetary discipline, uncertainty, and the lack of connection between the trade balance and exchange rates.

 

Slide 11-21 Who Is Right?

There is no real agreement as to which system is better. 

 

Slides 11-22- and 11-23 Exchange Rate Regimes in Practice

Currently:

• 21% of IMF members follow a free float policy
• 23% of IMF members follow a managed float system
• 5% of IMF members have no legal tender of their own (excluding EU countries)
• the remaining countries use less flexible systems such as pegged arrangements, or adjustable pegs

 

Slide 11-24 Pegged Exchange Rates

A country following a pegged exchange rate system, pegs the value of its currency to that of another major currency.

 

Slide 11-25 Currency Boards

Countries using a currency board commit to converting their domestic currency on demand into another currency at a fixed exchange rate.

 

Slides 11-26 through 11-28 Crisis Management by the IMF

Today, the IMF focuses on lending money to countries experiencing financial crises. 

A currency crisis occurs when a speculative attack on the exchange value of a currency results in a sharp depreciation in the value of the currency, or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates in order to defend prevailing exchange rates. 

A banking crisis refers to a situation in which a loss of confidence in the banking system leads to a run on the banks, as individuals and companies withdraw their deposits. 

A foreign debt crisis is a situation in which a country cannot service its foreign debt obligations, whether private sector or government debt.

 

Slide 11-29 Mexican Currency Crisis of 1995

The Mexican currency crisis of 1995 was a result of:

• high Mexican debts
• a pegged exchange rate that did not allow for a natural adjustment of prices

 

Slides 11-30 through 11-33 The Asian Crisis

The 1997 Southeast Asian financial crisis was caused by a series of events that took place in the previous decade.

 

Slides 11-34 and 11-35 Evaluating the IMF Policy Prescriptions

Critics of the IMF worry:

• the “one-size-fits-all” approach to macroeconomic policy is inappropriate for many countries
• the IMF is exacerbating moral hazard (when people behave recklessly because they know they will be saved if things go wrong)
• The IMF has become too powerful for an institution without any real mechanism for accountability

 

Slides 11-36 and 11-37 Implications for Managers

The present floating rate system mandates that firms carefully manage their foreign exchange transactions and exposures. 

Managers must recognize that the current international monetary system is a managed float system in which government intervention can help drive the foreign exchange market. 

Managers need strategic flexibility. 

Companies should promote an international monetary system that facilitates international growth and development.

 

Chapter 12: The Global Capital Market

Learning objectives 

• Describe the benefits of the global capital market. 
• Identify why the global capital market has grown so rapidly. 
• Understand the risks associated with the globalization of capital markets. 
• Compare and contrast the benefits and risks associated with the Eurocurrency market, the global bond market, and the global equity markets. 
• Understand how foreign exchange risks affect the cost of capital. 

The chapter explores the nature of the Eurocurrency market, the global bond market, and the international equities market. 

The opening case explores the decision by Chinese company Alibaba to list its share on the New York Stock Exchange. This choice gave the company access to the world’s largest and most liquid pool of investors while allowing it to maintain ownership control. The closing case considers the implications of the decline in cross-border capital flows following the global financial crisis in 2008.  

This chapter discusses the form and function of the global capital market. The market is attractive because its size lowers the cost of capital for borrowers, and allows investors to diversify their portfolios, thereby reducing their risk. 

Advances in information technology, together with the deregulation of financial services and the relaxation of regulations on cross-border capital flows have contributed to the growth of the global capital market.