Chapter 10 ‒ The Foreign Exchange Market
The Foreign Exchange Market
Learning Objectives
• LO10-1: Describe the functions of
the foreign exchange market.
• LO10-2: Understand what is meant
by spot exchange rates.
• LO10-3: Recognize the role that
foreign exchange rates play in
insuring against foreign exchange
risk.
• LO10-4: Understand the different
theories explaining how currency
exchange rates are determined and
their relative merits.
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
10
Chapter 10 ‒ The Foreign Exchange Market
OUTLINE OF CHAPTER 10: THE FOREIGN EXCHANGE
MARKET
Opening Case: Managing Foreign Currency Exposure at 3M
Introduction
The Functions of the Foreign Exchange Market
Currency Conversion
Insuring Against Foreign Exchange Risk
Management Focus: Embraer and the Gyrations of the Brazilian Real
The Nature of the Foreign Exchange Market
Currency Convertibility
Focus on Managerial Implications
Foreign Exchange Risk
Reducing Translation and Transaction Exposure
Reducing Economic Exposure
Other Steps for Managing Foreign Exchange Risk
Chapter Summary
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.
OPENING CASE: Managing Foreign Exchange Exposure at 3M
Summary
The opening case explores the implications of changing currency values on 3M. With
about 60 percent of its annual revenues coming from outside the United States, 3M is
especially vulnerable to fluctuations in exchange rates. Indeed, 3M contends that adverse
QUESTION 1: Why is it so important for managers to understand how the foreign
exchange market works? How does 3M protect itself from adverse exchange rate
movements?
ANSWER 1: As described in the case, fluctuations in exchange rates can have a very real
QUESTION 2: Why is 3M so vulnerable to fluctuations in exchange rates? What long
term strategies could 3M pursue to minimize its exchange rate exposure?
ANSWER 2: 3M, a U.S. company, earns 60 percent of its annual revenues outside the
United States making it especially vulnerable to currency movements. Indeed, 3M saw its
Chapter 10 ‒ The Foreign Exchange Market
flexible production strategies could allow the company to shift production based on long-
term expectations of currency values.
QUESTION 3: How does a strong U.S. dollar affect 3M’s earnings? What are the
implications of a declining U.S. dollar?
ANSWER 3: With sales spread across some 200 countries and about 60 percent of annual
revenues coming from outside the United States, 3M is truly an international company.
LECTURE OUTLINE
This lecture outline follows the Power Point Presentation (PPT) provided along with this
instructor’s manual. The following provides a brief overview of each Power Point slide
along with teaching tips and additional perspectives.
Slide 10-3 Foreign Exchange Market
This chapter:
• Explains how the foreign exchange market works.
CONNECT
Click and Drag
Foreign Exchange Market
Summary
This activity focuses on the foreign exchange market. The foreign exchange market serves two
main functions: to convert currencies and to provide some insurance against exchange rate risk.
Chapter 10 ‒ The Foreign Exchange Market
Activity
Students are asked to match various descriptions with the correct type of exchange rate.
Class Discussion
International managers need to understand the difference between a spot exchange rate and a
forward exchange rate. Pick a few currencies and compare the spot quotes to the 90-day forward
quotes. Then discuss what the difference between the two quotes is likely to mean.
CONNECT
Click and Drag
Functions of Foreign Exchange
Summary
This activity focuses on the functions of the foreign exchange market. The foreign exchange
market facilitates trade between countries allowing for the exchange of one currency for another.
The market also facilitates foreign investments and currency speculations.
Currency Conversion
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.
Chapter 10 ‒ The Foreign Exchange Market
• 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.
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.
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.
CONNECT
Case Analysis
The Coffee Buzz: The Impact of Exchange Rates on Coffee
Summary
This activity focuses on the impact of exchange rates on the global coffee market.
Activity
Students are asked to read a short case on the impact of exchange rates on the coffee market and
then respond to a series of questions about the case.
Chapter 10 ‒ The Foreign Exchange Market
CONNECT
Click and Drag
Predicting Exchange Rate Movements
Summary
This activity focuses on fluctuations in currency values and specifically on predicting exchange
rate movements. Movements in exchange rates can affect the short- and long-term profitability of
a firm, its opportunities to export, individual transactions, and the overall competitiveness of the
firm.
Slides 10-10 – 10-16 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, and
• Market psychology.
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.
Chapter 10 ‒ The Foreign Exchange Market
Interest Rates and Exchange Rates
The Fisher effect states that a country’s “nominal” interest rate (i) is the sum of the
required “real” rate of interest (r) and the expected rate of inflation over the period for
which the funds are to be lent (I).
The international Fisher effect (IFE) 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.
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.
CONNECT
Video Case
Did You Know? The Value of the U.S. Dollar Fluctuates Against the Value of the Euro
Summary
This activity focuses on understanding the implications of exchange rate movements on company
earnings. Fluctuating exchange rates can have profound implications for organizations.
Slides 10-17 – 10-20 Exchange Rate Forecasting
The efficient market school argues that forward exchange rates do the best possible job of
forecasting future spot exchange rates; 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.
Chapter 10 ‒ The Foreign Exchange Market
Approaches to Forecasting
Slide 10-21 – 10-22 Currency Convertibility
A currency is said to be freely convertible when a government of a country allows both
residents and nonresidents to purchase unlimited amounts of foreign currency with the
domestic currency.
A currency is said to be externally convertible when nonresidents 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 nonresidents are prohibited from
converting their holdings of domestic currency into a foreign currency.
Slides 10-23 – 10-26 Focus on Managerial Implications
Foreign Exchange Rate Risk
There are three types of foreign exchange risk:
• Transaction exposure
• Translation exposure
• Economic exposure
Transaction exposure is the extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values.
Chapter 10 ‒ The Foreign Exchange Market
Economic exposure is the extent to which a firm’s future international earning power is
affected by changes in exchange rates.
Other Steps for Managing Foreign Exchange Risk
To manage foreign exchange risk:
• Central control of exposure is needed to protect resources efficiently and to ensure
that each subunit adopts the correct mix of tactics and strategies.
• Firms should distinguish between transaction and translation exposure on the one
hand and economic exposure on the other hand.
• The need to forecast future exchange rates cannot be overstated.
• Firms need to establish good reporting systems so the central finance function can
regularly monitor the firm’s exposure position.
• The firm should produce monthly foreign exchange exposure reports.
CONNECT
Click and Drag
Managing Exchange Rate Risks
Summary
This activity focuses on exchange rates and specifically on how to manage exchange rate risk.
International managers need to understand the different types of exchange rate exposure and how
to manage each type.
Chapter 10 ‒ The Foreign Exchange Market
Class Discussion
Understanding the various tools that can help a firm manage its exposure to exchange rates is
important for international managers. Ask students to pick a company and research the impact of
exchange rates on that company and recommend how best to manage exchange rate exposure.
CONNECT
Case Analysis
Apple’s Earnings Hit by Strong Dollar
Summary
This activity focuses on understanding the implications of exchange rate movements on company
earnings. Fluctuating exchange rates can have profound implications for organizations.
CRITICAL THINKING AND DISCUSSION QUESTIONS
QUESTION 1: The interest rate on South Korean government securities with one-year
maturity is 4 percent and the expected inflation rate for the coming year is 2 percent. The
interest rate on U.S. government securities with one-year maturity is 7 percent, and the
expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is
$1 = W1,200. Forecast the spot exchange rate one year from today. Explain the logic of
your answer.
ANSWER 1: Drawing on what we know about the Fisher effect, the real interest rate in
both the U.S. and South Korea is 2 percent. The international Fisher effect suggests that
QUESTION 2: Two countries, Great Britain and the U.S., produce just one good: beef.
Suppose that the price of beef in the U.S. is $2.80 per pound, and in Britain it is £3.70 per
Chapter 10 ‒ The Foreign Exchange Market
a. According to PPP theory, what should the $/£ spot exchange rate be?
b. Suppose the price of beef is expected to rise to $3.10 in the U.S., and to £4.65 in
Britain. What should the one-year forward $/£ exchange rate be?
c. Given your answers to parts a and b, and given that the current interest rate in the
United States is 10 percent, what would you expect the current interest rate to be in
Britain?
ANSWER 2:
a. According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£.
QUESTION 3: Reread the Management Focus “Embraer and the Gyrations of the
Brazilian Real,” and then answer the following questions:
a. What does the recent economic history of Brazil tell you about the relationship
between price inflation and exchange rates? What other factors might determine
exchange rates for the Brazilian real?
b. Is a decline in value of the real against the U.S. dollar good for Embraer, bad for
Embraer, or a mixed bag? Explain your answer.
c. What kind of foreign exchange rate risks is Embraer exposed to? Can Embraer reduce
these risks? How?
d. Do you think Embraer’s decision to try and hedge against further appreciation of the
real in the early 2000s was a good decision? What was the alternative?
e. Since 2008, Embraer has significantly reduced its dollar hedging operations. Is this
wise?
f. Between mid-2014 and early 2015, the real depreciated significantly against the U.S.
dollar. What do you think the impact was on Embraer?
ANSWER 3:
a. During periods of high inflation in Brazil, the value of the Brazilian real has
b. In general, a decline in the value of the real against the dollar is good for Embraer. As
the exchange rate of the real falls, Embraer’s revenues (which are primarily paid in
dollars) gain in value. However, a depreciating real could be a sign of larger economic
Chapter 10 ‒ The Foreign Exchange Market
c. Embraer is vulnerable to transaction exposure because the profits it earns from each
sale are directly tied to the value of the dollar, which is the vehicle currency for most
transactions in the commercial aircraft industry. One method of managing its foreign
d. At the time, Embraer’s decision made sense. The Brazilian government and economic
e. Student answers will vary depending on their expectations for the U.S. and Brazilian
economies. If students expect the real to depreciate versus the dollar (which is a good bet
f. Since Embraer has reduced its hedging activities, the firm should experience an
increase in its profit margins and may see similar increases in demand for its stock.
QUESTION 4: You manufacture wine goblets. In mid-June you receive an order for
10,000 goblets from Japan. Payment of ¥400,000 is due in mid-December. You expect
the yen to rise from its present rate of $1 = ¥130 to $1 = ¥100 by December. You can
borrow yen at 6 percent per year. What should you do?
ANSWER 4: The simplest solution would be to just wait until December, take the
¥400,000 and convert it at the spot rate at that time, which you assume will be $1=¥100.
Chapter 10 ‒ The Foreign Exchange Market
QUESTION 5: You are the CFO of a U.S. firm whose wholly owned subsidiary in
Mexico manufactures component parts for your U.S. assembly operations. The subsidiary
has been financed by bank borrowings in the United States. One of your analysts told you
that the Mexican peso is expected to depreciate by 30 percent against the dollar on the
foreign exchange markets over the next year. What actions, if any, should you take?
ANSWER 5: Your financing and operating capital are in dollars, yet many of your costs
(labor) must be in peso. Your hard assets are all in peso, and their value will decline. On
CLOSING CASE: The Fluctuating Value of the Yuan Gives Chinese
Businesses a Lesson in Foreign Exchange Risk
Summary
The closing case discusses the impact of fluctuating exchange rates on businesses in
China. The value of the yuan relative to the U.S. dollar fluctuated significantly between
2015 and 2018, initially depreciating in value from August 2015 to December 2016,
before appreciating between January 2017 and April 2018. The big swings in the value of
the yuan created challenges for companies in China. In 2015, nearly a thousand listed
Chinese companies reported combined losses due to exchange rate fluctuations of 48.7
billion yuan. Discussion of the case can begin with the following questions:
QUESTION 1: Why did the Chinese yuan depreciate against the dollar between August
2015 and December 2016? What were the benefits of the depreciation for China? What
were the costs?
ANSWER 1: Between August 2015 and December 2016, the yuan fell 12 percent relative
to the U.S. dollar. The depreciation of the yuan was the result of an economic slowdown
Chapter 10 ‒ The Foreign Exchange Market
QUESTION 2: Why do you think the Chinese Government tried to limit the depreciation
by using dollars to buy yuan? Why did it not stop the fall in the yuan?
ANSWER 2: The Chinse government unsuccessfully attempted to halt the depreciation of
the yuan during the mid-2015 to late 2016 time period by spending $1.5 trillion in dollar-
QUESTION 3: Why did conditions reverse in 2017, with the yuan appreciating against
the dollar? What does this tell you about how the foreign exchange market works?
ANSWER 3: In 2017, the Chinese yuan rose 10 percent against the dollar, reversing the
slide that had taken place between 2015 and 2016. Several factors contributed to the
rising yuan including a stronger Chinese economy, the election of Donald Trump and the
QUESTION 4: What could importers such as the Chinese airlines have done to limit the
negative impact of depreciation in the value of the yuan against the dollar in 2016?
Should they have done this?
ANSWER 4: Many students will suggest that Chinese companies may have been caught
off guard by the rapid slide in the value of the yuan between 2015 and 2016. Students
will likely suggest that companies could have tried to hedge their losses in the forward
market or by using a strategy of lead and lags. Other students might suggest that Chinese
QUESTION 5: If you were a Chinese exporter, what might you have done if you had
anticipated the appreciation in the value of the yuan against the dollar that occurred in
2017?
ANSWER 5: For Chinese exporters, the appreciation of the yuan in 2017 meant an end to
the cheap exports created by the decline in the value of the yuan in 2015-2016. Students
will probably suggest that had Chinese exporters had the foresight to know that the yuan
Chapter 10 ‒ The Foreign Exchange Market
MHE INTERNATIONAL BUSINESS VIDEO LIBRARY
ongoing stream of updated video suggestions correlated by key concept and major topic.
Every new clip posted is supported by teaching notes and discussion questions. Please
feel free to leave comments in the library that you feel might be helpful to your
colleagues.
CONNECT
Geography
Summary
This activity is designed to test the student’s knowledge of geography. Questions related to
chapter material are asked, requiring students to understand the topics and the locations of the
countries involved.
Activity
Students are asked to respond to a series of questions related to the geographic location of several
countries.
Class Discussion
Understanding the geographic location of countries is essential to the understanding of
international business. Ask students to discuss the implications of the geographic locations of the
countries in this exercise on the subject matter.
INCORPORATING globalEDGE™ EXERCISES
Chapter 10 ‒ The Foreign Exchange Market
Exercise 1
One of your company’s essential suppliers is located in Japan. Your company needs to
make a 1-million Japanese yen payment in six months. Considering that your company
primarily operates in U.S. dollars, you are assigned the task of deciding on a strategy to
minimize your transaction exposure. Identify the spot and forward exchange rates
between the two currencies. What factors influence your decision to use each? Which one
would you choose? How many dollars must you spend to acquire the amount of yen
required?
Exercise 2
Sometimes, analysts use the price of specific products in different locations to compare
currency valuation and purchasing power. For example, the The Economist‘s Big Mac
Index compares the purchasing power parity of many countries based on the price of a
Big Mac. Using Google, locate the latest edition of this index that is accessible. Identify
the five countries (and their currencies) with the lowest purchasing- power parity
according to this classification. Which currencies, if any, are overvalued?
Answers to Exercises
Exercise 1 Answer
The FXStreet.com website specializes in analyzing the foreign exchange market,
including news and analysis in addition to live exchange rates. Both spot rates and
forward rates can be found under the “Rates & Charts” section.
Exercise 2 Answer
The Big Mac Index was invented by The Economist in 1986 and has been updated
annually since then to provide a light-hearted demonstration of the theory of purchasing-
power-parity by comparing the price of a Big Mac in various countries around the world.