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The Foreign Exchange Market
Table of Contents
Learning Objectives
Chapter Summary
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10.2 Understand what is meant by spot exchange rates.
10.4 Understand the different theories explaining how currency exchange rates are determined
and their relative merits.
10.6 Compare and contrast the differences among translation, transaction, and economic
exposure, and explain the implications for management practice.
Chapter Summary
This chapter focuses on the foreign exchange market. At the outset, the chapter explains how the
foreign exchange market works. Included in this discussion is an explanation of the difference
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https://www.marriott.com/marriott/aboutmarriott.mi would cost today in U.S. dollars in the
following cities:
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Chapter Outline
The Floating Value of the Yuan Gives Chinese Business a
1. Why were firms in the airline industry hit so hard by the change in the value of the yuan? As
an American consumer buying a ticket on a Chinese airline, what does the change in the value of
the yuan mean to you?
2016. For Chinese importers, the weak yuan meant that prices of inputs rose substantially. For
Chinese airlines, the weak yuan was a very real problem because imported airline fuel is paid for
2. What were the factors driving the appreciation in the yuan between January 2017 and April
2018? What do you think will happen to the dollar/yuan relationship going forward?
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https://www.cnbc.com/2018/07/20/trade-war-could-be-morphing-into-currency-war-if-china-is–
plays-hardba.html.
Introduction
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CONNECT
Click and Drag
Functions of Foreign Exchange
CONNECT
Video Case
Trump Deal with Mexico Targets Exchange Rates
Summary
This activity focuses on exchange rates and specifically on how exchange rates can impact a
income it receives from licensing agreements with foreign firms may be in foreign currencies.
Second, international businesses use foreign exchange markets when they must pay a foreign
company for its products or services in its country’s currency. Third, international businesses use
foreign exchange markets when they have spare cash that they wish to invest for short terms in
money markets. Finally, currency speculation is another use of foreign exchange markets.
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borrowing in one currency where interest rates are low and then using the proceeds to invest in
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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.
Class Discussion
Fluctuating exchange rates can have a very real impact on the competitiveness and profitability
of a firm. What other industries are deeply impacted by currency fluctuations?
1. Brazilian aircraft maker Embraer has been negatively impacted not only by its exposure to
changing exchange rates, but also by its attempts to limit its exposure through the use of forward
contracts. What options other than forward contracts might Embraer have used to limit its
foreign exchange rate exposure?
2. What does Embraer’s experience tell you about the forward market? Could the company’s
losses in 2008 have been prevented? Do you agree with Embraer’s decisions to stop using
forward contracts?
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Embraer had the right idea prior to the 2008 global financial crisis when it implemented
strategies designed to limit its exchange exposure, the conditions just changed very rapidly.
Some students may contend that the 2008 crisis was a one-off and therefore the company should
B) The exchange rates quoted worldwide are basically the same. If different U.S. dollar/Japanese
yen rates were being offered in New York and Tokyo, there would be an opportunity for
arbitrage and the gap would close. An illustrative example can be done showing how someone
could make money through arbitrage (buying a currency low and selling it high), and how this
would affect the supply and demand for the currencies in both markets to close the gap.
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Purchasing Power Parity
D) If the law of one price were true for all goods and services, the purchasing power parity (PPP)
exchange rate could be found from any individual set of prices. A less extreme version of the
exchange rate changes. The empirical tests suggest that this relationship does hold in the long
run, but not in the short run. While PPP assumes no transportation costs or barriers to trade and
investment, it also assumes that governments do not intervene to affect their exchange rates.
Empirical Tests of PPP Theory
G) Extensive empirical testing of the PPP theory has not shown it to be completely accurate in
1. What does the 2010 purchase by the Federal Reserve of $600 billion in U.S. government
bonds tell you about U.S. fiscal policy? What was the Federal Reserve trying to accomplish?
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2. Why did the Federal Reserve receive so much criticism for its policy of quantitative easing?
Do you agree with the critics? Was the policy simply mercantilism in disguise?
Critics claim that the decision by the Federal Reserve to increase the money supply via
quantitative easing was actually a form of protectionism, and in particular, simply a mercantilist
policy. According to critics, the Federal Reserve’s policy would prompt a decline in the value of
the U.S. dollar, making it easier for U.S. companies to export and harder for foreign companies
to export their products to the United States. Most students will probably agree that the fears of
the critics proved to be unfounded as the value of the dollar against a basket of major currencies
remained virtually unchanged. Students will probably also note that the Federal Reserve stated
that it would continue with its policy at least through 2014, which would indicate that it was
satisfied with the results.
INTEREST RATES AND EXCHANGE RATES
H) Interest rates also affect exchange rates. The Fisher Effect says that a country’s nominal
interest rate (i) is the sum of the required real rate of interest (r) and the expected rate of inflation
over the period for which the funds are to be lent (I).
i = r + I
I) The International Fisher Effect states that for any two countries, the spot exchange rate
should change in an equal amount but in the opposite direction to the difference in nominal
interest rates between two countries. Stated more formally:
(S1 – S2) / S2 × 100 = i$ – i¥
where i$ and i¥ are the respective nominal interest rates in two countries (in this case the U.S.
and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange
rate at the end of the period.
J) While interest rate differentials suggest future exchange rates, this appears to hold in the long
run but not necessarily in the short run.
Video Note: Will Falling Euro End Up Boosting Europe’s Economy? explores the relationship
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INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS
K) Investor psychology and bandwagon effects can also influence exchange rate movements.
Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can join
M) Long-term exchange rate movements influence the long-term profitability of investments,
export opportunities, and the price competitiveness of foreign imports. International businesses
therefore, should pay attention to monetary growth, inflation, and interest rates in other
countries.
Exchange Rate Forecasting
efficient market is one in which prices reflect all available information. There have been a large
number of empirical tests of the efficient market hypothesis. Although most of the early work
seems to confirm the hypothesis (suggesting that companies should not waste their money on
forecasting services), some recent studies have challenged it.
THE INEFFICIENT MARKET SCHOOL