When a firm insures itself against foreign exchange risk, it is

Module 3 Readings and Assignments

Complete the following reading before starting work on the assignments:

Module 3 online lectures

From your course text, Global Business Today,9th read the following:

Regional Economic Integration

The Foreign Exchange Market

The International Monetary System

From the Argosy University online library:

Drucker, P. F. (2004). What makes an effective executive. Harvard Business Review. 82(6), 58–63.

Heifetz, R. A. & Linsky, M. (2002). A survival guide for leaders. Harvard Business Review, 80(6) 65-72.

https://myclasses.argosy.edu/d2l/le/content/17886/viewContent/740034/View

learning objectives

10-1 Describe the functions of the foreign exchange market.

10-2 Understand what is meant by spot exchange rates.

10-3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

10-4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

10-5 Identify the merits of different approaches toward exchange rate forecasting.

10-6 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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The Foreign Exchange Market

Embraer and the Wild Ride of the Brazilian Real

opening case

For many years Brazil was a country battered by persistently high inflation. As a result the value of its currency, the real, depreciated steadily against the U.S. dollar. This changed in the early 2000s when the Brazilian government was successful in bringing down annual inflation rates into the single digits. Lower inflation, coupled with policies that paved the way for the expansion of the Brazilian economy, resulted in a steady appreciation of the real against the U.S. dollar. In May 2004, 1 real bought $0.3121; by August 2008, 1 real bought $0.65, an appreciation of more than 100 percent.

The appreciation of the real against the dollar was a mixed bag for Embraer, the world’s largest manufacturer of regional jets of up to 110 seats and one of Brazil’s most prominent industrial companies. Embraer purchases many of the parts that go into its jets, including the engines and electronics, from U.S. manufacturers. As the real appreciated against the dollar, these parts cost less when translated into reals, which benefited Embraer’s profit margins. However, the company also prices its aircraft in U.S. dollars, as do all manufacturers in the global market for commercial jet aircraft. So, as the real appreciated against the dollar, Embraer’s dollar revenues were compressed when exchanged back into reals.

To try and deal with the impact of currency appreciation on its revenues, in the mid-2000s Embraer started to hedge against future appreciation of the real by buying forward contracts (forward contracts give the holder the right to exchange one currency—in this case dollars—for another—in this case reals—at some point in the future at a predetermined exchange rate). If the real had continued to appreciate, this would have been a great strategy for Embraer because the company could have locked in the rate at which sales made in dollars were exchanged back into reals. Unfortunately for Embraer, as the global financial crisis unfolded in 2008, investors fled to the dollar, which they viewed as a safe haven, and the real depreciated against the dollar. Between August 2008 and November 2008, the value of the real fell by almost 40 percent against the dollar. But for the hedging, this depreciation would have actually increased Embraer’s revenues in reals. Embraer, however, had locked itself into a much higher real/dollar exchange rate, and the company was forced to take a $121million loss on what was essentially a bad currency bet.

Page 286Since the shock of 2008, Embraer has cut back on currency hedging, and most of its dollar sales and purchases are not hedged. This makes Embraer’s sales revenues very sensitive to the real/dollar exchange rate. By 2010, the Brazilian real was once more appreciating against the U.S. dollar, which pressured Embraer’s revenues. By 2012, however, the Brazilian economy was stagnating, while inflation was starting to increase again. This led to a sustained fall in the value of the real, which fell from 1 real = $0.644 in July 2011 to 1 real = $0.40 by January 2014, a depreciation of 38 percent. What was bad for the Brazilian currency, however, was good for Embraer, whose stock price surged to the highest price since February 2008 on speculation that the decline on the real would lead to a boost in Embraer’s revenues when expressed in reals. images

Sources: D. Godoy, “Embraer Rallies as Brazilian Currency Weakens,” Bloomberg, May 31, 2013; K. Kroll, “Embraer Fourth Quarter Profits Plunge 44% on Currency Woes,” Cleveland.com, March 27, 2009; “A fall from Grace: Brazil’s Mediocre Economy,” The Economist, June 8, 2013; and “Brazil’s Economy: The Deterioration,” The Economist, December 7, 2013.

Introduction

Like many enterprises in the global economy, the Brazilian aircraft manufacturer Embraer is affected by changes in the value of currencies on the foreign exchange market. As described in the opening case, Embraer’s revenues are helped when the Brazilian currency is weak against the U.S. dollar, and vice versa. The case illustrates that what happens in the foreign exchange market can have a fundamental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the foreign exchange market, and what the impact of changes in currency exchange rates might be for their enterprise.

This 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 predict 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. The next chapter explores the institutional structure of the international monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional structure of the international monetary system can exert a profound influence on the development of foreign exchange markets.

The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. For example, Toyota uses the foreign exchange market to convert the dollars it earns from selling cars in the United States into Japanese yen. Without the foreign exchange market, international trade and international 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 predicted. 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 early 2014 one U.S. dollar only bought 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.

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.

Page 287images global EDGE Database of International Business Statistics

With Chapter 10, we begin a two-chapter series focused on issues related to what we call the “global money system.” The broad topics that are covered include the foreign exchange market and international monetary system. These are critically important topics that can have a significant effect on how companies operate globally. Often times, companies have to deal with exchange rates, monetary systems, and the capital market on both country and regional levels. But the influences of countries on the regional and global money system are significant (i.e., countries set the tone for the parameters of the foreign exchange market and the international monetary system). The global EDGE Database of International Business Statistics (DIBS) includes time-series data beginning in the 1990s until today and covers more than 200 countries and more than 5,000 data variables. Countries, regions, and the world use these types of data points to drive the global money system, and everyone who is interested in better understanding the global capital market needs to know about them! Register free on globalEDGE to gain access to the DIBS database right now; students have free access to DIBS!

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 exchange rates. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa.

We begin this chapter by looking at the functions and the form of the foreign exchange market. This includes distinguishing among spot exchanges, forward exchanges, and currency swaps. Then we consider the factors that determine exchange rates. We 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 implications 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, or the adverse consequences of unpredictable changes in exchange rates.1

Foreign Exchange Risk

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

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Describe the functions of the foreign exchange market.

Should Countries Be Free to Set Currency Policy?

Exchange rates are critically important in the global economy. They affect the price of every country’s imports and exports, companies’ foreign direct investment, and—directly or indirectly—people’s spending behaviors. In recent years, disagreements among countries over exchange rates have become much more widespread. Some government officials and analysts even suggest that there is a “currency war” among certain countries. The main issue is whether or not some countries are using exchange rate policies to undermine free currency markets and whether they intentionally, in essence, devalue their currency to gain a trade advantage at the expense of other countries. A weaker currency makes exports inexpensive (or at least cheaper) to foreigners, which can lead to higher exports and job creation in the export sector.

Source: R. M. Nelson, “Current Debates over Exchange Rates: Overview and Issues for Congress,” Congressional Research Service, November 12, 2013.

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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 the other 15 members of the euro zone it is the euro (€); in Japan, the yen (¥); and so on. In general, within the borders of a particular 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 foreign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 = $1.30 specifies that 1 euro buys 1.30 U.S. dollars. Page 288The 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? Imagine the current pound/dollar exchange rate is £1.00 = $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 × 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 receives 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 because those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Toyota sells its cars in the United States for dollars; it must convert the U.S. dollars it receives into Japanese yen to use them in Japan.

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.

Every time a tourist changes money in a foreign country they are participating in the foreign exchange market.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. 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 2 percent. Investing in a South Korean money market account, however, may earn 6 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.

Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency 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 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥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 currency speculation in three months on an initial investment of $10 million! In general, 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 he turns out to be wrong.

Currency Speculation

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

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 borrow in Japanese yen, 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 transaction costs associated with changing one currency into another. The speculative element of this trade is that its success is based on 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 more than $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 2008–2009 because interest rate differentials were falling as U.S. rates came down, making the trade less profitable.

Carry Trade

A kind of speculation that 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.

Page 289INSURING 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, it is 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.

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Understand what is meant by spot exchange rates.

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.

Spot Exchange Rate

The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day.

Spot exchange rates are reported on a real-time basis on many financial websites. An exchange rate can be quoted in two ways: as the amount of foreign currency one U.S. dollar will buy or as the value of a dollar for one unit of foreign currency. Thus, on January 20, 2014, at 1:11 p.m., Eastern Standard Time, one U.S. dollar bought €0.74, and one euro bought $1.36.

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 between the demand and supply of that currency relative 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 = $2.00 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 = $1.98. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

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

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For example, a U.S. company that imports high-end cameras from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each camera, and the current dollar/yen spot exchange rate is $1 = ¥120. At this rate, each camera costs the importer $1,667 (i.e., 1,667 = 200,000/120). The importer knows she can sell the camera the day they arrive for $2,000 each, which yields a gross profit of $333 on each ($2,000 − $1,667). However, the importer will not have the funds to pay the Japanese supplier until the cameras are sold. If, over the next 30 days, the dollar unexpectedly depreciates against the yen, say, to $1 = ¥95, the importer will still have to pay the Japanese company ¥200,000 per camera, but in dollar terms that would be equivalent to $2,105 per camera, which is more than she can sell the cameras for. A depreciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform a profitable deal into an unprofitable one.

Page 290To insure or hedge against this risk, the U.S. importer might want to engage in a forward exchange. A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Exchange rates governing such future transactions are referred to as forward exchange rates. The Brazilian aircraft manufacturer Embraer entered into a forward exchange when it tried to hedge against further appreciation of the Brazilian real against the U.S. dollar (see the opening case). For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our camera importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 = ¥110. The importer enters into a 30-day forward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each camera (1,818 = 200,000/110). This guarantees her a profit of $182 per camera ($2,000 − $1,818). She also insures herself against the possibility that an unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one.

Forward Exchange

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

Forward Exchange Rate

The exchange rates governing forward exchange transactions.

In this example, the spot exchange rate ($1 = ¥120) and the 30-day forward rate ($1 = ¥110) differ. Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 = ¥130, for example, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days.

Currency Swap

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign exchange risk, there are some spectacular examples of what happens when firms don’t take out this insurance. An example is given in the accompanying Management Focus, which explains how a failure to fully insure against foreign exchange risk cost Volkswagen dearly.

Currency Swaps The preceding discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international trade—and you would be right. According to the most recent data, forward instruments account for almost two-thirds of all foreign exchange transactions, while spot exchanges account for about one-third.3 However, the vast majority of these forward