79.
_____ is the impact of short-run currency exchange rates changes on the
reported financial statements of a company.
A.
Economic exposure
B.
Financial exposure
C.
Translation exposure
D.
Transaction exposure
Translation exposure is concerned with the present measurement of past
events.
80.
A(n) _____ involves attempting to collect foreign currency receivables early
when a foreign currency is expected to depreciate and paying foreign
currency payables before they are due when a currency is expected to
appreciate.
A.
follower strategy
B.
interim strategy
C.
lead strategy
D.
lag strategy
Leading involves accelerating payments from weak-currency to strong-
currency countries and delaying inflows from strong-currency to weak-
currency countries.
Essay Questions
81.
With the help of an example, explain how a tourist participates in the
foreign exchange market.
The foreign exchange market is a market for converting the currency of one
country into that of another country. When a tourist changes one currency
into another, the tourist is participating in the foreign exchange market. If
the euro/dollar exchange rate is €1=$1.30, then one euro buys $1.30 U.S.
dollars. If the tourist wants to buy a T-shirt in France that costs 20 euros,
the tourist can go to a bank and exchange her $26 for €20.
82.
What are the main uses of foreign exchange markets for international
business?
The foreign exchange market serves four primary functions for international
companies. First, the market is used to convert payments a company
receives in foreign currencies into the currency of its home country. Second,
the market is used to convert the currency of a company’s home country
into another currency when they must pay a foreign company for its
products and services in their currency. Third, international businesses may
use foreign exchange markets when they have spare cash that they wish to
invest for short terms in money markets (of another country). Fourth, the
market is used for currency speculation.
83.
What is the difference between a spot exchange rate and a forward
exchange rate?
The spot exchange rate is the rate at which a foreign exchange dealer
converts one currency into another currency on a particular day. Spot
exchange rates are reported on a real time basis on many financial Web
sites. Spot rates are continually changing, their value being determined by
supply and demand for that currency relative to others. 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
transactions are referred to as forward exchange rates. Most major
currencies are quoted 30, 90, and 120 days into the future.
84.
What is meant by the phrases ‘the dollar is selling at a discount’ on the 30–
day forward market and ‘the dollar is selling at a premium’ on the 30-day
forward market?
When a dollar is selling at a discount on the 30-day forward market, it is
worth less than on the spot market, or one dollar buys more foreign
currency with a spot exchange than with a 30-day forward contract. If the
dollar is selling at a premium on the 30-day forward market, foreign
exchange dealers anticipate the dollar will appreciate against the foreign
currency over the next 30 days.
85.
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, and
between governments when it is desirable to move out of one currency into
another for a limited period without incurring foreign exchange risk.
86.
Where is the foreign exchange market located? What is the nature of the
market? Is the market growing or shrinking on a global basis?
The foreign exchange market is not located in any one place. It is a global
network of banks, brokers, and foreign exchange dealers connected by
electronic communications systems. When companies wish to convert
currencies, they typically go through their own banks rather than entering
the market directly. The foreign exchange market has been growing at a
rapid pace, reflecting a general growth in the volume of cross-border trade
and investment.
87.
Discuss the nature of the foreign exchange market. How fast has it been
growing? Where are the most important trading centers?
The foreign exchange market is a global network of banks, brokers, and
foreign exchange dealers connected by electronic communications systems.
The market has been growing at a rapid pace. In April 2007, the average
total value of global foreign exchange trading was about $3.21 trillion per
day. The most important trading centers are London, New York, Zurich,
Tokyo, and Singapore.
88.
What is the law of one price?
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 prices is
expressed in terms of the same currency. If the exchange rate is £1=$1.50,
a bracelet that sells for $75 in New York should sell for £50 in London.
89.
Explain PPP. Use an example to show how PPP can help explain exchange
rates.
PPP theory states that given relatively efficient markets, the price of a
“basket of goods” should be roughly equivalent in each country. So, if a
basket of goods costs $200 in the U.S. and ¥20,000 in Japan, PPP predicts
that the dollar/yen exchange should be $200/¥20,000 or $.01 per Japanese
yen.
90.
Discuss the failure of PPP theory to predict exchange rates accurately.
What is the purchasing power puzzle?
The failure to find a strong link between inflation rates and exchange rate
movements has been referred to as the purchasing power puzzle. Several
reasons contribute to the failure of PPP as a predictive tool. First, PPP
theory assumes away transportation costs and barriers to entry, yet in
practice this is not realistic. Second, PPP theory may not hold if many
national markets are dominated by a handful of multinational enterprises
that have sufficient market power to be able to exercise some influence
over prices, control distribution channels, and differentiate their product
offerings between nations. Third, government intervention in the foreign
exchange market influences the value of currencies. Finally, investor
psychology has a role in determining exchange rates.
91.
Compare and contrast the Fisher Effect and the International Fisher Effect.
The Fisher Effect was put forth by Irvin Fisher who formalized the notion
that in countries where inflation is expected to be high, interest rates will
also be high because investors want compensation for the decline in the
value of their money. More specifically, the Fisher Effect states that a
country’s nominal interest rate is the sum of the required real rate of
interest and the expected rate of inflation over the period for which the
funds are to be lent.
The Fisher Effect was extended to incorporate the link between interest
rates and 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 the two countries.
92.
Consider the role of investor psychology and bandwagon effects on how
well PPP and the International Fisher Effect explain short-term movements
in exchange rates.
Neither PPP nor the International Fisher Effect have proven to be good at
explaining short-term movements in exchange rates. One reason for their
poor explanatory power may be the impact of investor psychology on short-
run exchange movements. Studies show that expectations about exchange
rates tend to become self-fulfilling prophecies.
A bandwagon effect occurs when investors in increasing numbers start
following the lead of someone who may be pushing the value of a currency
up or down due to psychological reasons. As a bandwagon effect builds up,
the expectations of investors become a self-fulfilling prophecy, and the
market moves in the way the investors expected.
93.
Discuss the two schools of thought on exchange rate forecasting.
There are two schools of thought on whether it is worthwhile for a firm to
invest in exchange rate forecasting services. The efficient market school
argues that forward exchange rates do the best possible job of forecasting
exchange rates and therefore, it is not necessary to invest in forecasting
services. The inefficient market, however, suggests that forward exchange
rates are not the best predictors of future spot rates and that consequently
there is value in forecasting services.
94.
Explain the difference between fundamental analysis and technical
analysis.
Fundamental analysis draws on economic theory to construct sophisticated
econometric models for predicting exchange rate movements. Technical
analysis uses price and volume data to determine past trends that are
expected to continue into the future. Both schools of thought are used to
95.
Compare and contrast currencies that are freely convertible, externally
convertible, and nonconvertible.
A country’s currency is said to be freely convertible when the country’s
government allows both residents and nonresidents to purchase unlimited
amounts of a foreign currency with it. In contrast, a currency is said to be
externally convertible if only nonresidents may convert it into a foreign
currency without limitations. Finally, a currency is nonconvertible when
neither residents nor nonresidents are allowed to convert it into a foreign
currency.
96.
What is countertrade? Why would a firm engage in countertrade?
Countertrade refers to a range of barter-like agreements by which goods
and services can be traded for other goods and services. When a country’s
currency is nonconvertible, a firm may turn to countertrade. The number of
countertrade deals has been falling in recent years as more governments
make their currencies freely convertible.
97.
What is transaction exposure? How can transaction exposure be
minimized?
Transaction exposure is the extent to which the income from various
transactions is affected by fluctuations in foreign exchange values.
Transaction exposure 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. Transaction exposure can be minimized by
entering into forward contracts or swaps, or by leading and lagging payables
98.
Describe translation exposure. How can translation exposure be
minimized?
Translation exposure is the impact of currency exchange rate changes on
the reported financial statements of a company. Translation exposure is
basically concerned with the present measurement of past events. Like
transaction exposure, translation exposure can be minimized by entering
into forward contracts or swaps, or by leading and lagging payables and
receivables.
99.
Explain the notion of economic exposure. How can economic exposure be
minimized?
Economic exposure is the extent to which a firm’s future international
earning power is affected by changes in exchange rates. Economic exposure
is concerned with the long-run effect of changes in exchange rates on
future prices, sales, and costs. To reduce economic exposure, a firm must
distribute the firm’s productive assets to various locations so the firm’s
long-run financial well-being is not severely affected by adverse changes in
exchange rates.
100.
How can a firm minimize its foreign exchange exposure?
There are several strategies a firm can follow to minimize foreign exchange
exposure. First, central control of exposure is needed to protect resources
and ensure that each subunit adopts the correct mix of tactics and
strategies. Second, firms should distinguish between transaction and
translation exposure as compared to economic exposure. Third, the firm
needs to forecast future exchange rate movements. Fourth, the firm needs
to establish a good reporting system to monitor the firm’s exposure
positions. Finally, the firm should produce monthly foreign exchange
exposure report forms.