Chapter 10 – The Foreign Exchange Market
The Foreign Exchange Market
Learning objectives
Describe the functions of the foreign exchange market.
Understand what is meant by spot exchange rates.
Recognize the role that foreign exchange rates play in insuring against foreign
exchange risk.
Understand the different theories explaining how currency exchange rates are
determined and their relative merits.
Identify the merits of different approaches toward exchange rate forecasting.
Compare and contrast the differences among transaction, translation, and economic
exposure, and what managers do to manage each type of exposure.
The foreign exchange market is the market where currencies are bought and sold
and currency prices are determined. It is a network of banks, brokers and dealers
that exchange currencies 24 hours a day.
Exchange rates determine the value of one currency in terms of another. While
dealing in multiple currencies is a requirement of doing business internationally, it
also creates risks and significantly impacts the attractiveness of different
investments over time.
The foreign exchange market is used for:
1. Currency conversion, 2. Currency hedging,
3. Currency arbitrage, 4. Currency speculation.
Firms can use the foreign exchange market to minimize the risk of adverse
exchange rate movement. Such arrangements can prevent them from benefiting
from favorable movements.
The opening case illustrates how a decline in the value of the Japanese yen
against the U.S. dollar led to a sharp rise in sales in the United States. The closing
case explores the effects of exchange rate fluctuations on the profit margins of
Brazilian aircraft manufacturer Embraer.
OUTLINE OF CHAPTER 10: THE FOREIGN EXCHANGE MARKET
Opening Case: Subaru’s Sales Boom Thanks to the Weaker Yen
Introduction
The Functions of the Foreign Exchange Market
Currency Conversion
Insuring Against Foreign Exchange Risk
Management Focus: Volkswagen’s Hedging Strategy
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10
Chapter 10 – The Foreign Exchange Market
The Nature of the Foreign Exchange Market
Economic Theories of Exchange Rate Determination
Prices and Exchange Rates
Country Focus: Quantitative Easing, Inflation and the Value of the U.S.
Dollar
Interest Rates and Exchange Rates
Investor Psychology and Bandwagon Effects
Summary of Exchange Rate Theories
Exchange Rate Forecasting
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
Currency Convertibility
Implications for Managers
Transaction Exposure
Translation Exposure
Economic Exposure
Reducing Translation and Transaction Exposure
Reducing Economic Exposure
Other Steps for Managing Foreign Exchange Risk
Chapter Summary
Critical Thinking and Discussions Questions
Closing Case: Embraer and the Wild Ride of the Brazilian Real
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Chapter 10 – The Foreign Exchange Market
CLASSROOM DISCUSSION POINT
Give students a copy of a recent currency exchange report from The Wall Street Journal,
The New York Times, or The Financial Times. Then, show students how to read the chart
and understand the difference between direct quotes and indirect quotes.
Next, give students some “money” (slips of paper designated with certain currency
values) and ask them to convert their money into a foreign currency at the “bank” and
purchase several things, such as a hamburger and drink.
Finally, create a shortage of a popular currency to give students a feel for how supply and
demand can affect a currency’s value.
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The PPT slides include additional notes that can be viewed by
clicking on “view”, then on “notes.” The following provides a brief overview of each
Power Point slide along with teaching tips, and additional perspectives.
Slide 10-3 Why Is the Foreign Exchange Market Important?
This chapter:
explains how the foreign exchange market works
10-3
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McGraw-Hill Education.
Chapter 10 – The Foreign Exchange Market
examines the forces that determine exchange rates and discusses the degree to
which it is possible to predict exchange rate movements
maps the implications for international business of exchange rate movements and
the foreign exchange market
The foreign exchange market is a market for converting the currency of one country
into that of another country. The exchange rate is the rate at which one currency is
converted into another.
Slide 10-4 When Do Firms Use the Foreign Exchange Market?
The foreign exchange market is used:
to convert the currency of one country into the currency of another
to provide some insurance against foreign exchange risk—the adverse
consequences of unpredictable changes in exchange rates
Companies use the foreign exchange market:
to convert payments they receive for exports, the income they receive from
foreign investments, or from licensing agreements with foreign firms
when they must pay a foreign company for products or services in a foreign
currency
when they have spare cash that they wish to invest for short terms in money
markets
for currency speculation—the short-term movement of funds from one currency
to another in the hopes of profiting from shifts in exchange rates
Another Perspective: XE.com {http://www.xe.com/} provides a real time currency
cross-rate chart, and an option to do currency conversions.
Slide 10-5 Insuring Against Foreign Exchange Risk
A second function of the foreign exchange market is to provide insurance to protect
against the possible adverse consequences of unpredictable changes in exchange rates, or
foreign exchange risk.
Slides 10-6 and 10-7 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.
A forward exchange occurs when two parties agree to exchange currency and execute
the deal at some specific date in the future.
Slide 10-8 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 rate risk.
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Chapter 10 – The Foreign Exchange Market
Slide 10-9 The Nature of the Foreign Exchange Market
The foreign exchange market is not a place, but a network of banks, brokers, and dealers
that exchange currencies 24 hours/day.
Slides 10-10 and 10-11 Exchange Rates between Markets
Opportunities for arbitrage exist when exchange rates are not the same between markets.
About 85 percent of al foreign exchange transactions involve the U.S. dollar. It is a
vehicle currency.
Slide 10-12 Economic Theories of Exchange Rate Determination
Three factors have an important impact on future exchange rate movements in a country’s
currency:
the country’s price inflation
its interest rate
market psychology
Slides 10-13 through 10-17 Prices and Exchange Rates
The law of one price suggests that in competitive markets free of transportation costs and
trade barriers, identical products in different countries must sell for the same price when
their price is expressed in terms of the same currency.
A less extreme version of the PPP theory states that given relatively efficient markets—
that is, markets in which few impediments to international trade and investment exist—
the price of a “basket of goods” should be roughly equivalent in each country.
Slide 10-18 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 two countries.
Slide 10-19 Investor Psychology and Bandwagon Effects
Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can
join the bandwagon and move exchange rates based on group expectations.
Slides 10-20 through 10-22 Exchange Rate Forecasting
The efficient market school, argues that 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, while the inefficient market school, argues that companies
can improve the foreign exchange market’s estimate of future exchange rates (as
contained in the forward rate) by investing in forecasting services.
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Chapter 10 – The Foreign Exchange Market
An efficient market is one in which prices reflect all available information.
In an inefficient market, prices do not reflect all available information.
Slide 10-23 Approaches to Forecasting
There are two approaches to forecasting exchange rates:
fundamental analysis—draws upon economic theories to predict future exchange
rates, including factors like interest rates, monetary policy, inflation rates, or
balance of payments information
technical analysis—chart trends, and believe that past trends and waves are
reasonable predictors of future trends and waves
Slides 10-24 through 10-26 Currency Convertibility
A currency is said to be 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 said to be 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.
Free convertibility is the norm in the world today, although many countries impose
restrictions on the amount of money that can be converted. The main reason to limit
convertibility is to preserve foreign exchange reserves and prevent capital flight.
Countertrade refers to a range of barter like agreements by which goods and services
can be traded for other goods and services. It can be used in international trade when a
country’s currency is nonconvertible.
Another Perspective: The American Countertrade Association
{http://www.globaloffset.org} maintains a web site with information for those interested
in countertrade. Also, students can learn more about countertrade at
{http://www.barternews.com/countertrade.htm}.
Slide 10-27 Think Like a Manager: Foreign Exchange Risk
Slides 10-28 through 10-30 Implications for Managers
There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
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Chapter 10 – The Foreign Exchange Market
Transaction exposure is the extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values.
Translation exposure is the impact of currency exchange rate changes on the reported
financial statements of a company.
Economic exposure is the extent to which a firm’s future international earning power is
affected by changes in exchange rates.
Slides 10-31 and 10-32 Reducing Translation and Transaction Exposure
Firms can minimize their foreign exchange exposure by:
buying forward
using swaps
leading and lagging payables and receivables – paying suppliers and collecting
payment from customers early or late depending on expected exchange rate
movements
Firms can reduce economic exposure by ensuring assets are not too concentrated in
countries where likely rises in currency values will lead to damaging increases in the
foreign prices of the goods and services they produced.
Slide 10-33 and 10-34 Other Steps for Managing Foreign Exchange Risk
To manage foreign exchange risk:
(1) central control of exposure is needed to protect resources efficiently and ensure that
each subunit adopts the correct mix of tactics and strategies
(2) firms should distinguish between transaction and translation exposure on the one
hand, and economic exposure on the other hand
(3) the need to forecast future exchange rates cannot be overstated
(4) firms need to establish good reporting systems so the central finance function can
regularly monitor the firm’s exposure position
(5) the firm should produce monthly foreign exchange exposure reports.
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