Foreign exchange risk is the adverse consequences of unpredictable changes in

International Business 10e

By Charles W.L. Hill

Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.

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Chapter 10

The Foreign Exchange Market

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Why Is The Foreign

Exchange Market Important?

The foreign exchange market

is used to convert the currency of one country into the currency of another

provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates

The exchange rate is the rate at which one currency is converted into another

events in the foreign exchange market affect firm sales, profits, and strategy

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LO 1: Describe the functions of the foreign exchange market.

The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.

The Opening Case: The Rise (and Fall) of the Japanese Yen illustrates the dramatic fluctuation in the value of Japanese currency over the last two decades and the impact on Japanese exports.

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When Do Firms Use The Foreign Exchange Market?

International companies use the foreign exchange market when

the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies

they must pay a foreign company for its products or services in its country’s currency

they have spare cash that they wish to invest for short terms in money markets

they are involved in currency speculation - the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

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How Can Firms Hedge Against Foreign Exchange Risk?

The foreign exchange market provides insurance to protect against foreign exchange risk

the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm

A firm that insures itself against foreign exchange risk is hedging

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What Is The Difference Between 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

spot rates change continually depending on the supply and demand for that currency and other currencies

Spot exchange rates can be quoted as the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar for one unit of foreign currency

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LO 2: Understand what is meant by spot exchange rates.

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What Is The Difference Between Spot Rates And Forward Rates?

Value of the U.S. Dollar Against Other Currencies 2/12/11

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What Is The Difference Between Spot Rates And Forward Rates?

To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges

two parties agree to exchange currency and execute the deal at some specific date in the future

A forward exchange rate is the rate used for these transactions

rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

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LO 3: Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

Management Focus: Volkswagen’s Hedging Strategy examines Volkswagen’s hedging strategy and why Volkswagen lost over €1 billion in 2003.

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What Is A 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

between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

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What Is The Nature Of The

Foreign Exchange Market?

The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

the average total value of global foreign exchange trading in March, 1986 was just $200 billion, in April, 2010 it hit $4 trillion per day

the most important trading centers are London, New York, Zurich, Tokyo, and Singapore

the market is always open somewhere in the world—it never sleeps

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Do Exchange Rates Differ Between Markets?

High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers

If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage

the process of buying a currency low and selling it high

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Do Exchange Rates Differ Between Markets?

Most transactions involve dollars on one side—it is a vehicle currency

85% of all foreign exchange transactions involve the U.S. dollar

other vehicle currencies are the euro, the Japanese yen, and the British pound

China’s renminbi is still only used for about 0.3% of foreign exchange transactions

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How Are Exchange Rates Determined?

Exchange rates are determined by the demand and supply for different currencies

Three factors impact future exchange rate movements

A country’s price inflation

A country’s interest rate

Market psychology

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LO 4: Understand the different theories explaining how currency exchange rates are determined and their relative merits.

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How Do Prices

Influence Exchange Rates?

The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

otherwise there is an opportunity for arbitrage until prices equalize between the two markets

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In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

Example: U.S./Euro exchange rate: $1 = € .78

A jacket selling for $50 in New York should retail for € 39.24 in Paris (50 x.78)

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How Do Prices

Influence Exchange Rates?

Purchasing power parity theory (PPP) argues that given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a “basket of goods” should be roughly equivalent in each country

predicts that changes in relative prices will result in a change in exchange rates

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How Do Prices

Influence Exchange Rates?

A positive relationship exists between the inflation rate and the level of money supply

when the growth in the money supply is greater than the growth in output, inflation will occur

PPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run

a country with high inflation should see its currency depreciate relative to others

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Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar explores the notion of quantitative easing. The technique was used by the U.S. government to expand the money supply in 2010. The Fed pursued other rounds of quantitative easing in 2011, 2012, and possibly through 2014. Critics worried that the policy would lead to a decline in the value of the dollar—which hasn’t yet happened.

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How Do Prices

Influence Exchange Rates?

Question: How well does PPP work?

Empirical testing of PPP theory suggests that

it is most accurate in the long run, and for countries with high inflation and underdeveloped capital markets

it is less useful for predicting short term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates

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How Do Interest Rates

Influence 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

In other words:

[(S1 - S2) / S2 ] x 100 = i $ - i ¥

where i$ and i¥ are the respective nominal interest rates in two countries (in this case the U.S. and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period

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How Does Investor Psychology

Influence Exchange Rates?

The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations

investor psychology and bandwagon effects greatly influence short term exchange rate movements

government intervention can prevent the bandwagon from starting, but is not always effective

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Government restrictions can include:

A restriction on residents’ ability to convert the domestic currency into a foreign currency

Restricting domestic businesses’ ability to take foreign currency out of the country

Governments will limit or restrict convertibility for a number of reasons that include:

Preserving foreign exchange reserves

A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight

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Should Companies Use Exchange Rate Forecasting Services?

There are two schools of thought

The efficient market school - 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

The inefficient market school - companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

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LO 5: Identify the merits of different approaches toward exchange rate forecasting.

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Should Companies Use Exchange Rate Forecasting Services?

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

if the foreign exchange market is efficient, then forward exchange rates should be unbiased predictors of future spot rates

Most empirical tests confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services

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Should Companies Use Exchange Rate Forecasting Services?

An inefficient market is one in which prices do not reflect all available information

in an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting services

However, the track record of forecasting services is not good

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How Are Exchange

Rates Predicted?

Two schools of thought on forecasting:

Fundamental analysis draws 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

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Are All Currencies

Freely Convertible?

A currency is 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 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

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Are All Currencies

Freely Convertible?

Most countries today practice free convertibility

but many countries impose restrictions on the amount of money that can be converted

Countries limit convertibility to preserve foreign exchange reserves and prevent capital flight

when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency

most likely to occur in times of hyperinflation or economic crisis

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Are All Currencies

Freely Convertible?

When a currency is nonconvertible, firms may turn to countertrade

barter-like agreements where goods and services are traded for other goods and services

was more common in the past when more currencies were nonconvertible, but today involves less than 10% of world trade

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What Do Exchange Rates

Mean For Managers?

Managers need to consider three types of foreign exchange risk

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

includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies

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LO 6: Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

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What Do Exchange Rates

Mean For Managers?

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

concerned with the present measurement of past events

gains or losses are “paper losses”

they are unrealized

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What Do Exchange Rates

Mean For Managers?

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

concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

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How Can Managers

Minimize Exchange Rate Risk?

To minimize transaction and translation exposure, managers should

Buy forward

Use swaps

Lead and lag payables and receivables

lead and lag strategies can be difficult to implement

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How Can Managers

Minimize Exchange Rate Risk?

Lead strategy - attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate

Lag strategy - delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate

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How Can Managers

Minimize Exchange Rate Risk?

To reduce economic exposure, managers should

Distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates

Ensure assets are not too concentrated in countries where likely rises in currency values will lead to increases in the foreign prices of the goods and services the firm produces

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Management Focus: Dealing with the Rising Euro describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper.

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How Can Managers

Minimize Exchange Rate Risk?

In general, managers should

Have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies

Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand

Attempt to forecast future exchange rates

Establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position

Produce monthly foreign exchange exposure reports

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*

*

LO 1: Describe the functions of the foreign exchange market.

The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.

The Opening Case: The Rise (and Fall) of the Japanese Yen illustrates the dramatic fluctuation in the value of Japanese currency over the last two decades and the impact on Japanese exports.

*

*

*

LO 2: Understand what is meant by spot exchange rates.

*

*

LO 3: Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

Management Focus: Volkswagen’s Hedging Strategy examines Volkswagen’s hedging strategy and why Volkswagen lost over €1 billion in 2003.

*

*

*

*

*

LO 4: Understand the different theories explaining how currency exchange rates are determined and their relative merits.

*

In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

Example: U.S./Euro exchange rate: $1 = € .78

A jacket selling for $50 in New York should retail for € 39.24 in Paris (50 x.78)

*

*

Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar explores the notion of quantitative easing. The technique was used by the U.S. government to expand the money supply in 2010. The Fed pursued other rounds of quantitative easing in 2011, 2012, and possibly through 2014. Critics worried that the policy would lead to a decline in the value of the dollar—which hasn’t yet happened.

*

*

*

Government restrictions can include:

A restriction on residents’ ability to convert the domestic currency into a foreign currency

Restricting domestic businesses’ ability to take foreign currency out of the country

Governments will limit or restrict convertibility for a number of reasons that include:

Preserving foreign exchange reserves

A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight

*

LO 5: Identify the merits of different approaches toward exchange rate forecasting.

*

*

*

*

*

*

*

LO 6: Compare and contrast the differences among translation, transaction, and economic exposure, and what managers can do to manage each type of exposure.

*

*

*

*

*

Management Focus: Dealing with the Rising Euro describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper.

*

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