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After you have read this chapter you should be able to:

1 Describe the functions of the foreign exchange market.

2 Understand what is meant by spot exchange rates.

3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk. 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits. 5 Identify the merits of different approaches toward exchange rate forecasting.

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

part 4 Global Money System

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opening case

B illabong is a quintessential Australian company. The maker of “surf wear” from wet suits and board shorts to T-shirts and watches has a powerful brand name that is recognized by surfing enthusiasts around the globe. The company is a major exporter. Some 80 percent of its sales are generated outside of Australia through a network of 10,0000 outlets in more than 100 countries. Not surprisingly given the history of surfing, the largest foreign market for Billabong is the United States, which accounts for about 50 percent of the company’s $800 million in annual sales. As a result, Billabong’s fortunes are closely linked to the value of the Australian dollar against the U.S. dollar. When the Australian dollar falls against the U.S. dollar, Billabong’s products become less expensive in U.S. dollars, and this can drive sales forward. Conversely, if the Australian dollar rises in value, this can raise the price of Billabong’s products in terms of U.S. dollars, which impacts sales negatively. Billabong’s CEO has stated that every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. During the second half of 2008 it looked as if things were going Billabong’s way. The Australian dollar fell rapidly in value against the U.S. dollar. In June 2008 one Australian dollar was worth $0.97. By October 2008 it was worth only $0.60. The fall in the value of the Australian dollar was in part due to a fear among currency traders that as the world slipped into a recession, global demand for many of the raw materials pro- duced in Australia would decline, exports would slump, and Australia’s trade bal- ance would deteriorate. In anticipation of this, institutions sold Australian dollars, driving down its value on foreign exchange markets. For Billabong, however, this was something of a blessing. The cheaper Australian dollar would give it a pricing advantage and help to promote sales in the United States and elsewhere. When sales in U.S. dollars were translated back

Billabong

The Foreign Exchange Market

9 c h a p t e r

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312 Part Four Global Money System

into Australian dollars, their value increased as the Australian dollar fell. An- ticipating this, in February 2009 Billabong’s CEO affirmed that he expected the company to increase its profits by as much as 10 percent in 2009, despite the weak global retail environment. Currency markets, however, can be difficult to predict, and sharp reversals do occur. Between March and November 2009 the Australian dollar surged in value, rising all the way back to $0.94. The cause was twofold. First, there was a global sell-off of the American dollar as the full impact of the global financial crisis became apparent, and as the scale of debt in the United States became clearer. Second, despite a recession in the United States and Europe, the emerging economies of China and India continued to grow, and this helped to support demand for many of the basic commodities that Australia exports, which led to a strengthening of the Australian dollar. For Billabong, the sharp reversal was an embarrassment. The strong Australian dollar eradicated any pricing advantage Billabong might have enjoyed. Also, now the amount of Australian dollars that the company received for every sale made in U.S. dol- lars was declining. In February 2009 every $1 earned in U.S. currency could be exchanged for 1.66 Australian dollars. By October 2009 every $1 earned in U.S. currency could only be exchanged for 1.06 Australian dollars. In May 2009, with the Australian dollar rising rapidly, the CEO was forced to revise his previ- ously bullish forecast for sales and earnings. Now he said, a combination of weaker than expected demand in the United States plus a strengthening Australian dollar would lead to a 10 percent decline in profits for 2009. • Sources: C. Marriott, “Caught in the Impact Zone,” Australian FX , January 2010, pp. 11–12; R. Donkin, “Billabong Seeks $290 Million, Slashes Forecast, Stores,” The Western Australian , May 19, 2009; and “Billabong Ready to Ride the Currency Wave,” The Australian , October 29, 2008, p. 40.

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 underst

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