The Foreign Exchange Market

Chapter 10

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 Foreign Exchange (Fx)
 A commodity that consists of currencies
issued by countries other than one’s own.
 Foreign exchange market “is a
market for converting the currency of one
country into that of another country”.
 exchange rate is simply the rate at
which one currency is converted into
another.

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 Functions of the Foreign Exchange Market
Two functions:
 CURRENCY CONVERSION:
1. When a tourist changes one currency into another, He/She is participating
in the foreign exchange market.
2. international businesses use foreign exchange markets when they must
pay a foreign company for its products or services in its country’s
currency.
3. Third, international businesses also use foreign exchange markets when
they have spare cash that they wish to invest for short terms in money
markets.
 INSURING AGAINST FOREIGN EXCHANGE RISK:
A second function of the foreign exchange market is to provide insurance against
foreign exchange risk, which is the possibility that unpredicted changes in future
exchange rates will have adverse consequences for the firm. When a firm insures
itself against foreign exchange risk, it is engaging in hedging.
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 Currency Risk

 In every international transaction there is a

currency risk that runs from the date of
contract to date of payment.
 Currency exchange rates are continuously
changing.

© McGraw Hill Companies, Inc., 2000 9-7

 Reducing Risk
 Spot Exchange Rates: when two parties agree to
exchange currency and execute the deal immediately.
 Forward Exchange Rates: when two parties agree to
exchange currency and execute the deal at some specific
future date.
 Currency swap: the simultaneous purchase and sale
of a given amount of foreign exchange for two different
value dates.

© McGraw Hill Companies, Inc., 2000 9-8

 Why Convert Currency?
 Payments may be made in a foreign currency.
 Purchases may have to be paid in the supplier’s currency.
 Company may want to invest in a country.
 Currency Speculation
The Nature of the Foreign Exchange Market:
 The foreign exchange market is not located in any one place.
 It is a global network of banks, brokers, and foreign exchange dealers
connected by electronic communications systems.
 When companies wish to convert currencies, they typically go through their
own banks rather than entering the market directly.
 The foreign exchange market has been growing at a rapid pace, reflecting a
general growth in the volume of cross-border trade and investment

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 Foreign Exchange Exposure
Economic
Economic The objective is to anticipate and
influence the effect of unexpected
changes in exchange rates on a firm's
future cash flows

Transaction
Transaction Arises when payments must be
made or received in a foreign currency

Translation
Translation
Arises from consolidating assets and
liabilities measured in foreign currencies
with those in the reporting currency

© McGraw Hill Companies, Inc., 2000

9-4
 Foreign Exchange Transactions
April 1995
(Percent)
11

34

55

Figure 9.1 in text

14

Spot Other Swaps Forward

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 Share of Global Foreign Exchange
Trading Accounted for by London,
New York, and Tokyo
London
31%
Other
38%

New York
Tokyo
19%
12%

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Trading Hours of the World’s Major
Financial Centers
London

San New
Tokyo
Francisco York Bahrain
Hong Kong
Singapore

11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12
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 Economic Theories
Understand the different theories explaining how currency exchange rates are determined
and their relative merits.

1.At lowest level = supply/demand: At the most basic level,

exchange rates are determined by the demand and supply of one currency relative to the
demand and supply of another.

2.Law of One Price: To understand how prices are related to exchange

rate movements, we first need to discuss an economic proposition known as the law of one
price. The law of one price states that in competitive markets free of transportation
costs and barriers to trade (such as tariffs), identical products sold in different countries
must sell for the same price when their price is expressed in terms of the same currency.
In competitive markets free of transportation costs and barriers to trade (tariffs), identical
products sold in different countries must sell for the same price when their price is
expressed in terms of the same currency.
Example: US/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York
should retail for for FFr 250 in Paris (50x5)
 Economic Theories
3. Purchasing Power Parity: theory of purchasing power
parity (PPP), which links changes in the exchange rate between two countries’
currencies to changes in the countries’ price levels.
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. By comparing the prices of identical products in different currencies, it
would be possible to determine the “real,” or PPP, exchange rate that would exist
if markets were efficient.
In relatively efficient markets (few impediments to trade and investment) then a
‘basket of goods’ should be roughly equivalent in each country.
4. INTEREST RATES AND EXCHANGE RATES:
Economic theory tells us that interest rates reflect expectations about likely future
inflation rates. In countries where inflation is expected to be high, interest rates
also will be high, because investors want compensation for the decline in the
value of their money.
5. Investor psychology: Empirical evidence suggests that
neither PPP theory nor the international Fisher effect is particularly good at
explaining short-term movements in exchange rates. One reason may be the
impact of investor psychology on short-run exchange rate movements.
Evidence reveals that various psychological factors play an important role in
determining the expectations of market traders as to likely future exchange rates

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 Exchange Rate Forecasting
 Efficient market: where prices reflect all
available public information.
 Forward exchange rates reflect market participant’s
collective predictions of likely spot exchange rates at specified
future dates.
 Inefficient market:where prices do not reflect all
available information. Forward exchange rates are not
the best predicators of future spot exchange rates.
 Use fundamental or technical analysis to predict the exchange
rates.
© McGraw Hill Companies, Inc., 1999 9-21
 The Big Mac Index
Purchasing Power Parity: 1995
Local Currency
% Over(+)
Price in Implied Actual or Under(-)
Local PPP of the Exchange Valuation
Currency Dollar Rate† Against Dollar

United States $ 2.32 (average) ---- ---- ----

Switzerland SwFr 5.90 2.54 1.13 +124
Argentina Peso 3.00 1.29 1.00 + 29
France FFr 18.50 7.97 4.80 + 66
Japan ¥ 391 169.00 84.20 +100
Brazil Real 2.42 1.04 .90 +16
Canada C $ 2.77 1.19 1.39 - 14
Hong Kong HK $ 9.50 4.09 7.73 - 47
Russia Ruble 8,100 3,491.00 4,985.00 - 30

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† As of 4/15/95
9-17
 Factors Influencing Currency Value
Economic Factors
1. Balance of Payment
2. Interest Rates
3. Inflation
4. Monetary and Fiscal Policy
5. International Competitiveness
6. Monetary Reserves
7. Government Controls and Incentives
8. Importance of Currency in World
Political Factors
9. Political Party and Leader Philosophies
10. Proximity of Elections or Change in
Leadership
Expectation Factors
11. Expectations
12. Forward Exchange Market Prices
© McGraw Hill Companies, Inc., 1999 9-22
 Currency Convertibility
 Freely convertible. when the country’s government allows both
residents and nonresidents to purchase unlimited amounts of a foreign currency with
it.
 Externally convertible. when only nonresidents may convert it into
a foreign currency without any limitations.
 Not convertible. when neither residents nor nonresidents are allowed to
convert it into a foreign currency.
 Free convertibility is not universal. Many countries place some restrictions on their
residents’ ability to convert the domestic currency into a foreign currency (a policy of
external convertibility). Restrictions range from the relatively minor (such as
restricting the amount of foreign currency they may take with them out of the country
on trips) to the major (such as restricting domestic businesses’ ability to take foreign
currency out of the country).
 External convertibility restrictions can limit domestic companies’ ability to invest
abroad, but they present few problems for foreign companies wishing to do business
in that country.
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Hill Companies, Inc., 1999
 Serious problems arise, however, under a policy of nonconvertibility. This was the
practice of the former Soviet Union, and it continued to be the practice in Russia for
several years after the collapse of the Soviet Union. When strictly applied,
nonconvertibility means that although a U.S. company doing business in a country
such as Russia may be able to generate significant ruble profits, it may not convert
those rubles into dollars and take them out of the country.
 Obviously, this is not desirable for international business.
 Preserve foreign exchange reserves.
• Service international debt.
• Purchase imports.
 Political decision.
 Many countries have some kind of restrictions.
 Countertrade.
© McGraw Hill Companies, Inc.,2000