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Introduction Like many enterprises in the global economy, Billabong is impacted by changes in the value of currencies on the foreign exchange market. As detailed in the opening case, during late 2008 and early 2009 it looked as if the weak Australian dollar would help to boost Billabong’s exports of surf wear to markets like the United States, and it is- sued bullish profit forecasts. By May 2009, an unanticipated rise in the value of the Australian dollar forced the company to revise its earnings forecasts for 2009 down- ward. As stated in the case, every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. When the Australian dollar appreciates again the U.S. dollar, Billabong’s products became more expensive in U.S. dollar terms, effectively putting the company at a price disadvantage in the United States, its major foreign market. As at Billabong, what happens in the foreign exchange market can have a funda- mental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the working of the foreign exchange market,

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Chapter Nine The Foreign Exchange Market 313

and what the impact of changes in currency exchange rates might be for their enter- prise. With this in mind, the current chapter has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates, and to discuss the degree to which it is possible to pre- dict future exchange rate movements. The third objective is to map the implications for international business of exchange rate movements. This chapter is the first of two that deal with the international monetary system and its relationship to international business. In the next chapter, we will explore the institutional structure of the interna- tional monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional struc- ture of the international monetary system can exert a profound influence on the devel- opment of foreign exchange markets. The foreign exchange market is a market for converting the currency of one coun- try into that of another country. An exchange rate is simply the rate at which one cur- rency is converted into another. For example, Billabong uses the foreign exchange market to convert the dollars it earns from selling surf wear in the United States into Australian dollars. Without the foreign exchange market, international trade and inter- national investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other. We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly pre- dicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001 one U.S. dollar bought 1.065 euros, but by the start of 2010, one U.S. dollar bought only 0.74 euro. The dollar had fallen sharply in value against the euro. This made American goods cheaper in Europe, boosting export sales. At the same time, it made European goods more expensive in the United States, which hurt the sales and profits of European companies that sold goods and services to the United States. One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for international businesses to suffer losses because of unpredicted changes in ex- change rates. Currency fluctuations can make seemingly profitable trade and invest- ment deals unprofitable, and vice versa. We begin this chapter by looking at the functions and the form of the foreign ex- change market. This includes distinguishing among spot exchanges, forward ex- changes, and currency swaps. Then we will consider the factors that determine exchange rates. We will also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies; that is, when its currency is not convertible. The chapter closes with a discussion of these things in terms of their im- plications for business.

The Functions of the Foreign Exchange Market The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, by which we mean the adverse consequences of unpredictable changes in exchange rates. 1

Foreign Exchange Market A market for converting the currency of one country into that of another country.

Exchange Rate The rate at which one currency is converted into another.

LEARNING OBJECTIVE 1 Describe the functions of

the foreign exchange market.

Foreign Exchange Risk The risk that changes in exchange rates will hurt the profitability of a business deal.

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314 Part Four Global Money System

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