Global Business Today 6eGlobal Business Today 6e
by Charles W.L. Hill
McGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 9Chapter 9
The ForeignExchange Market
9-3
Introduction
Question: What is the foreign exchangemarket?
The foreign exchange market is a marketfor converting the currency of onecountry into that of another country
Question: What is the exchange rate?
The exchange rate is the rate at whichone currency is converted into another
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The Functions ofthe Foreign Exchange Market
Question: What is the purpose of theforeign exchange market?
The foreign exchange market
1.enables the conversion of thecurrency of one country into thecurrency of another
2.provides some insurance againstforeign exchange risk (the adverseconsequences of unpredictablechanges in exchange rates)
9-5
Currency Conversion
International firms use foreign exchange markets
to convert export receipts, income receivedfrom foreign investments, or income receivedfrom licensing agreements
to pay a foreign company for products orservices
to invest spare cash for short terms in moneymarkets
for currency speculation (the short-termmovement of funds from one currency toanother in the hopes of profiting from shifts inexchange rates)
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Insuring AgainstForeign Exchange Risk
The foreign exchange market can be used toprovide insurance to protect against foreignexchange risk (the possibility that unpredictedchanges in future exchange rates will haveadverse consequences for the firm)
A firm that protects itself against foreignexchange risk is hedging
The market performs this function using
1.spot exchange rates
2.forward exchange rates
3.currency swaps
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Insuring AgainstForeign Exchange Risk
1. Spot Exchange Rates
The spot exchange rate is the rate atwhich a foreign exchange dealerconverts one currency into anothercurrency on a particular day
Spot rates are determined by theinteraction between supply anddemand, and so change continually
9-8
Insuring AgainstForeign Exchange Risk
2. Forward Exchange Rates
A forward exchange occurs when twoparties agree to exchange currency andexecute the deal at some specific date inthe future
A forward exchange rate is the exchangerate governing such a future transaction
Forward rates are typically quoted for30, 90, or 180 days into the future
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Insuring AgainstForeign Exchange Risk
3. Currency Swaps
A currency swap is the simultaneouspurchase and sale of a given amount offoreign exchange for two different valuedates
Swaps are used when it is desirableto move out of one currency intoanother for a limited period withoutincurring foreign exchange rate risk
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The Nature of theForeign Exchange Market
The foreign exchange market is a globalnetwork of banks, brokers, and foreignexchange dealers connected by electroniccommunications systems
The market is always open somewhere in theworld
If exchange rates quoted in different marketswere not essentially the same, there wouldbe an opportunity for arbitrage (the processof buying a currency low and selling it high)
Most transactions involve U.S. dollars on oneside
The U.S. dollar is a vehicle currency
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Economic Theories ofExchange Rate Determination
Question: What factors are important tofuture exchange rates?
Three factors that have an importantimpact on future exchange ratemovements are
1.a country’s price inflation
2.a country’s interest rate
3.market psychology
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Prices and Exchange Rates
Question: How are prices related toexchange rate movements?
To understand how prices and exchangerates are linked, we need to understandthe law of one price, and the theory ofpurchasing power parity
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Prices and Exchange Rates
The law of one price states that in competitivemarkets free of transportation costs and barriersto trade, identical products sold in differentcountries must sell for the same price whentheir price is expressed in terms of the samecurrency
Purchasing power parity theory argues thatgiven relatively efficient markets (markets inwhich few impediments to international tradeand investment exist) the price of a “basket ofgoods” should be roughly equivalent in eachcountry
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Prices and Exchange Rates
PPP predicts that changes in relative prices willresult in changes in exchange rates
When inflation is relatively high, a currencyshould depreciate
So, if we can predict inflation rates, we canpredict how a currency’s value might change
The growth of a country’s money supplydetermines its likely future inflation rate
When the growth in the money supply isgreater than the growth in output, inflationwill occur
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Prices and Exchange Rates
Question: How well does PPP theorywork?
Empirical testing of the PPP theoryindicates that it is not completelyaccurate in estimating exchange ratechanges in the short run, but is relativelyaccurate in the long run
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Interest Rates and Exchange Rates
Question: How do interest rates affect exchangerates?
The Fisher Effect states that a country’snominal interest rate (i) is the sum of therequired real rate of interest (r ) and theexpected rate of inflation over the period forwhich the funds are to be lent (l )
In other words, i = r + I
So, if the real interest rate is the sameeverywhere, any difference in interest ratesbetween countries reflects differingexpectations about inflation rates
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Investor Psychology andBandwagon Effects
Question: How are exchange ratesinfluences by investor psychology?
The bandwagon effect occurs whenexpectations on the part of traders turninto self-fulfilling prophecies, and tradersjoin the bandwagon and move exchangerates based on group expectations
Governmental intervention can preventthe bandwagon from starting, but is notalways effective
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Summary
Relative monetary growth, relativeinflation rates, and nominal interest ratedifferentials are all moderately goodpredictors of long-run changes inexchange rates, but poor predictors ofshort term changes
So, international businesses should payattention to countries’ differing monetarygrowth, inflation, and interest rates
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Exchange Rate Forecasting
Question: Should companies invest inexchange rate forecasting services to help withdecision-making?
The efficient market school argues that forwardexchange rates are the best predictors of futurespot exchange rates
Therefore, investing in forecasting serviceswould be a waste of money
The inefficient market school argues thatcompanies should invest in forecasting services
This school of thought does not believe thatforward rates are the best predictor of futurespot rates
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The Efficient Market School
An efficient market is one in which pricesreflect all available information
If the foreign exchange market isefficient, forward exchange rates shouldbe unbiased predictors of future spotrates
Most empirical tests confirm the efficientmarket hypothesis suggesting thatcompanies should not waste their moneyon forecasting services, but some recentstudies have challenged the theory
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The Inefficient Market School
An inefficient market is one in whichprices do not reflect all availableinformation
In an inefficient market, forwardexchange rates are not the bestpredictors of future spot exchange ratesand it may be worthwhile for internationalbusinesses to invest in forecastingservices
However, the track record of forecastingservices is questionable
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Approaches to Forecasting
1. Fundamental Analysis
Fundamental analysis draws uponeconomic factors like interest rates,monetary policy, inflation rates, orbalance of payments information topredict exchange rates
2. Technical Analysis
Technical analysis focuses on trendsand believes that past trends andwaves are reasonable predictors offuture trends and waves
9-23
Currency Convertibility
Question: Are all currencies freely convertible?
A currency is freely convertible when bothresidents and non-residents can purchaseunlimited amounts of foreign currency with thedomestic currency
A currency is externally convertible when onlynon-residents can convert their holdings ofdomestic currency into a foreign currency
A currency is nonconvertible when bothresidents and non-residents are prohibited fromconverting their holdings of domestic currencyinto a foreign currency
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Currency Convertibility
Question: Why do countries limit currencyconvertibility?
The main reason to limit convertibility is topreserve foreign exchange reserves andprevent capital flight (when residents andnonresidents rush to convert their holdings ofdomestic currency into a foreign currency).
In the case of a nonconvertible currency, firmsmay turn to countertrade (barter likeagreements by which goods and services canbe traded for other goods and services) tofacilitate international trade
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Implications for Managers
Question: What does the foreignexchange market mean for internationalfirms?
Firms must understand the influence ofexchange rates on the profitability oftrade and investment deals
This exchange rate risk can be dividedinto
1.Transaction exposure
2.Translation exposure
3.Economic exposure
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Transaction Exposure
Transaction exposure is the extent towhich the income from individualtransactions is affected by fluctuations inforeign exchange values
It can lead to a real monetary loss
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Translation Exposure
Translation exposure is the impact ofcurrency exchange rate changes on thereported financial statements of acompany
it deals with the present measurement ofpast events
Gains and losses from translationexposure are reflected only on paper
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Economic Exposure
Economic exposure is the extent towhich a firm’s future international earningpower is affected by changes inexchange rates
It is concerned with the long-term effectof changes in exchange rates on futureprices, sales, and costs
9-29
Reducing Translationand Transaction Exposure
Question: How can firms minimizetranslation and transaction exposure?
Firms can
buying forward
using swaps
leading and lagging payables andreceivables (paying suppliers andcollecting payment from customersearly or late depending on expectedexchange rate movements)
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Reducing Translationand Transaction Exposure
A lead strategy involves attempting to collectforeign currency receivables early when aforeign currency is expected to depreciate andpaying foreign currency payables before theyare due when a currency is expected toappreciate
A lag strategy involves delaying collection offoreign currency receivables if that currency isexpected to appreciate and delaying payables ifthe currency is expected to depreciate
Lead and lag strategies can be difficult toimplement
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Reducing Economic Exposure
Question: How can a firm reduce economicexposure?
To reduce economic exposure firms need todistribute productive assets to various locationsso the firm’s long-term financial well-being is notseverely affected by changes in exchange rates
This requires that the firm’s assets are notoverly concentrated in countries where likelyrises in currency values will lead to damagingincreases in the foreign prices of the goods andservices they produce
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Other Steps for ManagingForeign Exchange Risk
Question: Are there other strategies tomanage foreign exchange risk?
To further manage foreign exchangerisk, firms should
1.establish central control to protectresources efficiently and ensure thateach subunit adopts the correct mixof tactics and strategies
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Other Steps for ManagingForeign Exchange Risk
2.distinguish between transaction andtranslation exposure on the one hand, andeconomic exposure on the other hand
3.attempt to forecast future exchange rates
4.establish good reporting systems so thecentral finance function can regularlymonitor the firm’s exposure position
5.produce monthly foreign exchangeexposure reports
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Critical Discussion Question
Reread the Management Focus feature on Volkswagen inthis chapter, then answer the following questions:
a) Why do you think management at Volkswagen decided tohedge only 30 percent of their foreign currency exposurein 2003? What would have happened if they had hedged70 percent of their exposure?
b) Why do you think the value of the U.S. dollar declinedagainst that of the Euro in 2003?
c) Apart from hedging through the foreign exchange market,what else can Volkswagen do to reduce its exposure tofuture declines in the value of the U.S. dollar against theeuro?