Chapter 10 ‒ The Foreign Exchange Market
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The Foreign Exchange Market
Learning objectives
explaining how currency exchange
rates are determined and their
relative merits.
• Identify the merits of different
approaches toward exchange rate
The foreign exchange market is the market
where currencies are bought and sold and
currency prices are determined. It is a network
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
affected earnings at Nintendo. The closing case
explores the effects of exchange rate
fluctuations on the profit margins of
technology giant Apple.
10
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OUTLINE OF CHAPTER 10: THE FOREIGN EXCHANGE MARKET
Management Focus: Embraer and the Gyrations of the Brazilian Real
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.
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
Currency Convertibility
Focus on Managerial Implications
Critical Thinking and Discussions Questions
Closing Case: Apple’s Earnings Hit by Strong Dollar
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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.
OPENING CASE: The Mexican Peso, the Japanese Yen, and Pokémon Go
Summary
The opening case explores the implications of changing currency values on Japanese
game maker Nintendo. Nintendo’s revenues in Mexico have been affected by the falling
value of peso against the yen. Trades of Mexican pesos to Japanese yen typically require
a conversion via the U.S. dollar. In 2016, the dollar was lower against the yen, while at
the same time, the Mexican peso was lower relative to the dollar making conversions of
revenues earned in pesos worth much less when translated back to yen. Discussion of the
case can begin with the following questions:
QUESTION 1: Why is it so important for managers to understand how the foreign
exchange market works? What is the role of the U.S. dollar in the relationship between
the yen and the peso?
ANSWER 1: As described in the case, fluctuations in exchange rates can have a very real
impact on a company’s earnings. Computer-game maker Nintendo found this out the hard
QUESTION 2: Following the election of Donald Trump, the value of the Mexican peso
has fallen relative to the U.S. dollar. Why do you think this happened? What do you
expect will happen to the dollar/peso relationship going forward?
ANSWER 2: Donald Trump’s promises regarding the future of Mexico’s most important
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negative effect on Mexico’s economy, hence the downward pressure on its currency.
Most students will probably suggest that until the outcome of the NAFTA negotiations is
known, the peso/dollar relationship will continue to be strained.
QUESTION 3: What should Nintendo do now? How should the company react to the
continued pressure on the peso?
ANSWER 3: Nintendo is in a difficult position. The company’s earnings in Mexico, like
those of any company doing business in Mexico, are exposed to exchange rate risk. Short
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
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.
• 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.
Slides 10-4 – 10-7 The Functions of the Foreign Exchange Market
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:
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• to convert payments they receive for exports, the income they receive from
• for currency speculation—the short-term movement of funds from one currency
to another in the hopes of profiting from shifts in exchange rates.
One form of speculation that has been gaining in popularity is carry trade 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.
foreign exchange risk.
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
to move out of one currency into another for a limited period without incurring foreign
exchange rate risk.
Slides 10-8 – 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.
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Slides 10-10 – 10-15 Economic Theories of Exchange Rate Determination
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—
nominal interest rates between two countries.
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 10-16 – 10-18 Exchange Rate Forecasting
In an efficient market, prices reflect all available information.
In an inefficient market, prices do NOT reflect all available information.
Approaches to Forecasting
There are two approaches to forecasting exchange rates:
• Fundamental analysis—draws upon economic theories to predict future
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A currency is said to be freely convertible when a government of a country allows both
A currency is nonconvertible when both residents and nonresidents 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.
in countertrade. Also, students can learn more about countertrade at
{http://www.barternews.com/countertrade.htm}.
Slides 10-20 – 10-23 Implications for Managers
There are three types of foreign exchange risk:
• transaction exposure,
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.
Reducing Translation and Transaction Exposure
Firms can minimize their foreign exchange exposure by: