Chapter 10 – The Foreign Exchange Market
10-1
The Foreign Exchange Market
Learning objectives
• 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.
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.
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.
10
Chapter 10 – The Foreign Exchange Market
10-2
OUTLINE OF CHAPTER 10: THE FOREIGN EXCHANGE
MARKET
Opening Case: The Rise (and Fall) of the Japanese Yen
Introduction
The Functions of the Foreign Exchange Market
Currency Conversion
Insuring Against Foreign Exchange Risk
Country Focus: Quantitative Easing, Inflation and the Value of the U.S. Dollar
Exchange Rate Forecasting
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
Currency Convertibility
Implications for Managers
Chapter 10 – The Foreign Exchange Market
10-3
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.
OPENING CASE: The Rise (and Fall) of the Japanese Yen
The opening case explores the implications of changing currency values on the Japanese
yen and businesses in that Asian country. In the first half of the 2000s, the yen was
relatively weak against the U.S. dollar, which was a boon for Japan’s export-led
economy. The weakness of the yen changed sharply when the global financial crisis hit,
and the yen’s value increased significantly—causing problems for businesses such as
Toyota. Discussion of the case can revolve around the following questions:
2. Explain the concept of carry-trade and it was a boon and a bust for the Japanese
currency over the past 12 years.
3. Explain why exchange rates have been so volatile in recent years. What are the
implications of this volatility for companies such as Toyota?
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
Chapter 10 – The Foreign Exchange Market
10-4
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:
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
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.
Slide 10-9 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
Chapter 10 – The Foreign Exchange Market
10-5
to move out of one currency into another for a limited period without incurring foreign
exchange rate risk.
Slide 10-10 The Nature of the Foreign Exchange Market
About 85 percent of al foreign exchange transactions involve the U.S. dollar. It is a
vehicle currency.
Slide 10-13 Economic Theories of Exchange Rate Determination
Three factors have an important impact on future exchange rate movements in a
Slides 10-14 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.
Slide 10-19 Investor Psychology and Bandwagon Effects
Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can
joint 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
Chapter 10 – The Foreign Exchange Market
10-6
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
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.
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.
Slides 10-27 through 10-29 Implications for Managers
There are three types of foreign exchange risk:
1. Transaction 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
10-7
Translation exposure is the impact of currency exchange rate changes on the reported
financial statements of a company.
Slides 10-31 and 10-32 Reducing Translation and Transaction Exposure
Firms can minimize their foreign exchange exposure by:
• buying forward
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 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
CRITICAL THINKING AND DISCUSSION QUESTIONS
QUESTION 1: The interest rate on South Korean government securities with one-year
maturity is 4% and the expected inflation rate for the coming year is 2%. The U.S.
interest rate on government securities with one-year maturity is 7%, and the expected rate
of inflation is 5%. The current spot exchange rate for Korea 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 US and South Korea is 2%. The international Fisher effect suggests that the
Chapter 10 – The Foreign Exchange Market
10-8
QUESTION 2: Two countries, Great Britain and the US, produce just one good: beef.
Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per
pound.
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 US, 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%, what would you expect 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 on Volkswagen, then answer the
following questions:
a. Why do you think management at Volkswagen decided to hedge only 30 percent of
their foreign currency exposure in 2003? What would have happened if they had hedged
70 percent of their exposure?
b. Why do you think the value of the U.S. dollar declined against that of the euro in
2003?
c. Apart from hedging through the foreign exchange market, what else can Volkswagen
do to reduce its exposure to future declines in the value of the U.S. dollar against the
euro?
ANSWER 3:
a. When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure
in 2003, the company essentially gambled that the euro would decline in value relative to
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% per year. What should you do?
Chapter 10 – The Foreign Exchange Market
10-9
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.
QUESTION 5: You are the CFO of a US 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: Billabong
Summary
The closing case explores the implications of changing currency values on the profits of
Australian retailer Billabong, which relies on the U.S. market for a significant share of its
total sales. Discussion of the case can revolve around the following questions.
Chapter 10 – The Foreign Exchange Market
10–10
QUESTION 1: Why does a fall in the value of the Australian dollar against the U.S.
dollar benefit Billabong?
ANSWER 1: Billabong’s financial fortunes are closely linked to the value of the
QUESTION 2: Could the rise in the value of the Australian dollar that occurred in 2009
have been predicted?
ANSWER 2: Students’ answers will vary for this question. Currency markets can be
difficult to predict and sharp reversals do happen. When the value of the Australian dollar
QUESTION 3: What might Billabong had done in order to better protect itself against the
unanticipated rise in the value of the Australian dollar that occurred in 2009?
ANSWER 3: Reducing economic exposure requires companies to make strategic choices
QUESTION 4: The Australian dollar continued to rise by another 20 percent against the
U.S. dollar in between 2010 and 2012. How would this have affected Billabong? Is there
anything that Billabong might have done to limit its long-term economic exposure to
changes in the value of the currency in its largest export market?
ANSWER 4: The rise of the Australian dollar would make its products much more
expensive in the United States, which would possibly decrease global sales. One key to
Chapter 10 – The Foreign Exchange Market
10–11
INTEGRATING iGLOBES
There are several iGLOBE video clips that can be integrated with the material presented
in this chapter. In particular, you might consider the following:
Title: IMF: The Chinese…. Ask the IMF
Run Time: 3:54
Abstract: This video follows a question and answer session between Chinese citizens
and an IMF representative regarding the implications of Europe’s recession on China’s
economy, future growth prospects for the country, the value of the renminbi, and China’s
trade policy.
Notes: A representative for the International Monetary Fund (IMF) recently responded to
the queries of Chinese citizens regarding the economic future of China, how the country’s
exports and currency might fare in the coming months, and how policy decisions could
help China’s economy continue to expand despite the slowdown in the global economy.
According to Markus H. Rodlauer, Mission Chief to China, IMF, the financial crisis in
Europe has had a significant effect on China. Like other countries, China has seen its
Markus Rodlauer also addressed the issue of China’s currency, the renminbi. The value
of the renminbi has increased in recent months, something that is causing concern for
Discussion Questions and Answers
1. This video clip revolves around a question and answer session between Chinese
citizens and a representative of the International Monetary Fund (IMF). Discuss the role
of the IMF in the global economy. What does the organization do?
Answer: When the IMF was originally established as part of the Bretton Woods
Agreement in 1944, it was charged with responsibility for overseeing the stability of the
Chapter 10 – The Foreign Exchange Market
10–12
2. Consider how the globalization of markets and production has changed the nature of
policy decisions. How are events in Europe and other parts of the world influencing the
economy in China?
Answer: The process of globalization has changed the world economy. No longer do
countries operate independently of each other. Instead, a highly integrated global
3. Discuss China’s reliance on an export-led growth policy. Why is this policy no longer
effective? Why do you think the IMF is recommending a policy that increases domestic
consumption?
Answer: Markus H. Rodlauer, Mission Chief to China, IMF, believes that China needs to
embark on a new economic growth strategy – one that includes increasing domestic
consumption and producing products designed for the local market. For years, China has
4. China’s currency, the renminbi, has strengthened in recent months. Explain what a
stronger renminbi means for Chinese citizens. What does it mean for U.S. companies
that use China as a manufacturing base?
Answer: As the value of China’s currency has increased in recent months, so too has the
buying power of Chinese citizens, at least for imported goods. While some Chinese
Chapter 10 – The Foreign Exchange Market
10–13
INTEGRATING VIDEOS
There are also several longer video clips that can be integrated with the material
presented in this chapter. In particular, you might consider the following from
International Business DVD Volume 6:
Title: Young Indian Mogul
Learning Objectives
The purpose of this video is to help you:
❖ Explore the extreme contrasts in standards of living that exist within modern day
India and identify the challenges facing India as it attempts to capitalize on its
Key Words
❖ Levels of economic development
❖ Social responsibility
Synopsis
Modern day India is an example of great contrasts. At one extreme are people like Suhas
Gopinath, CEO of a firm that is worth at least $100 million. At the other end of the
spectrum are a vast number of people surviving on less than a dollar per day. Suhas
Chapter 10 – The Foreign Exchange Market
10–14
leads a relatively modest lifestyle living with his parents in Bangalore, a city that has
greatly benefitted from the technology boom, and continuing his education at a nearby
college.
Today, India is grappling with the challenges of how to capitalize on the opportunities
presented by globalization, while at the same time deal with the extreme poverty that is
so prevalent throughout the country. The country must find ways to encourage people
like Suhas Gopinath to achieve their dreams, and facilitate their success yet still ensure
that the people living in the slums of Delhi are not left behind. Attracting more foreign
investment and promoting social and economic responsibility may be the key to meeting
these challenges.
Discussion Questions
1. Discuss the vast contrasts in living standards that exist in India. What challenges do
these differences present to the Indian government?
2. How would you characterize the investment climate in India?
INCORPORATING globalEDGE™ EXERCISES
Exercise 1
Chapter 10 – The Foreign Exchange Market
10–15
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
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
Sometimes, analysts use the price of specific products in different locations to compare
currency valuation and purchasing power. For example, the Big Mac Index compares the
purchasing-power parity of many countries based on the price of a Big Mac. 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?
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.