The strongest of the five forces in most industries is

CURRENCY CONVERSION Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and other members of the euro zone it is the euro (€); in Japan, the yen (¥ ); and so on. In general, within the borders of a par- ticular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky. When a tourist changes one currency into another, she is participating in the for- eign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 5 $1.30 specifies that one euro buys $1.30 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imag- ine the current pound/dollar exchange rate is £1.00 5 $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 3 2). She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain). Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it re- ceives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but since those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Billabong sells its surfing products in the United States for dollars; it must convert the U.S. dollars it receives into Australian dollars to use them in Australia. Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money mar- kets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 4 percent. Investing in a South Korean money market account, however, may earn 12 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate, but also on the changes in the value of the Korean won against the dollar in the intervening period.

Another Per spect i ve

How Foreign Exchange Challenges Business Travel Ethics In preparation for a trip to Japan, you exchange U.S. dol- lars for yen in late May, just before you leave. For $1,000, your bank gives you ¥104,000. During your time in Osaka, the dollar weakens against the yen, to ¥99.5 to the dollar. Meanwhile, you enjoyed Japanese hospitality and spent only ¥10,000. Back home, you take your remaining ¥94,000 to the bank to convert back to dollars. How much have you spent on your trip?

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Chapter Nine The Foreign Exchange Market 315

Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one cur- rency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 5 ¥120. The company ex- changes its $10 million into yen, receiving ¥1.2 billion ($10 million 3 120 5 ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 5 ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on cur- rency speculation in three months on an initial investment of $10 million! In gen- eral, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong. A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to bor- row in Japanese yen, then convert the money into U.S. dollars and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the trans- action costs associated with changing one currency into another. The speculative ele- ment of this trade is that its success is based upon a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar-yen carry trade was actually very significant during the mid-2000s, peaking at over $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade. 2 This carry trade declined in importance during 2008–09 precisely because the Japanese yen was in- creasing in value against the dollar, making the trade riskier (in addition, interest rate differentials were falling as U.S. rates came down, making the trade less profitable even if exchange rates were stable).

INSURING AGAINST FOREIGN EXCHANGE RISK A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, we say that is it engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

LEARNING OBJECTIVE 2 Understand what is meant

by spot exchange rates.

Spot Exchange Rate The exchange rate at which a foreign exchange dealer will convert one currency into another currency on a particular day.

Currency Speculation Involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Carry Trade Involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high.

Hedging The process of insuring one’s business against foreign exchange risk by using forward exchanges or currency swaps.

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316 Part Four Global Money System

Spot exchange rates are reported on a real-time basis on many financial Web sites. Table 9.1 shows the exchange rates for a selection of currencies traded in the New York foreign exchange market as of 1:11 p.m. February 18, 2009. An exchange rate can be quoted in two ways: as the amount of foreign cur- rency one U.S. dollar will buy, or as the value of a dollar for one unit of foreign currency. Thus, one U.S. dollar bought €0.7954 on February 18, 2009, and one euro bought $1.2572 U.S. dollars.

Spot rates change continually, often on a minute- by-minute basis (although the magnitude of changes over such short periods is usually small). The value of a currency is determined by the interaction be- tween the demand and supply of that currency rela- tive to the demand and supply of other currencies.

For example, if lots of people want U.S. dollars and dollars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 5 $2.00 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By