UNIVERSITY OF SOUTHERN MINDANAO

The Foreign Exchange Market

Prepared by: R. Panaguiton
Business Administration Department
College of Business, Development Economics, and Management
 Chapter Objectives
1. Describe the functions of the foreign exchange market.
2. Understand what is meant by spot exchange rates.
3. Recognize the role that forward exchange rates play in insuring
against foreign exchange risk.
4. Understand the different theories explaining how currency
exchange rates are determined and their relative merits.
5. Identify the merits of different approaches toward exchange rate
forecasting. L06 Compare and contrast the differences between
translation, transaction, and economic exposure, and what
managers can do to manage each type of exposure.
 Why Is The Foreign
Exchange Market Important?
The foreign exchange market
1. is used to convert the currency of one country into the
currency of another
2. provides some insurance against foreign exchange risk - the
adverse consequences of unpredictable changes in
exchange rates
• The exchange rate is the rate at which one currency is
converted into another
• events in the foreign exchange market affect firm sales,
profits, and strategy
 When Do Firms Use The Foreign Exchange
Market?
• International companies use the foreign exchange market when
• the payments they receive for exports, the income they receive
from foreign investments, or the income they receive from
licensing agreements with foreign firms are in foreign
currencies
• they must pay a foreign company for its products or services in
its country’s currency
• they have spare cash that they wish to invest for short terms in
money markets
• they are involved in currency speculation - the short-term
movement of funds from one currency to another in the hopes
of profiting from shifts in exchange rates
 How Can Firms Hedge Against Foreign
Exchange Risk?
• The foreign exchange market provides insurance to
protect against foreign exchange risk
• the possibility that unpredicted changes in future
exchange rates will have adverse consequences for
the firm
• A firm that insures itself against foreign exchange risk is
hedging
 What Is The Difference Between 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
• spot rates change continually depending on the supply
and demand for that currency and other currencies
• Spot exchange rates can be quoted as the amount of
foreign currency one U.S. dollar can buy, or as the value
of a dollar for one unit of foreign currency
What Is The Difference Between Spot Rates
And Forward Rates?
Value of the U.S. Dollar Against Other Currencies 2/12/11
 What Is The Difference Between Spot Rates
And Forward Rates?
• To insure or hedge against a possible adverse foreign
exchange rate movement, firms engage in forward
exchanges
• two parties agree to exchange currency and execute
the deal at some specific date in the future
• A forward exchange rate is the rate used for these
transactions
• rates for currency exchange are typically quoted for 30,
90, or 180 days into the future
 What Is A 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
• between governments when it is desirable to move out
of one currency into another for a limited period without
incurring foreign exchange rate risk
 What Is The Nature Of The
Foreign Exchange Market?
• The foreign exchange market is a global network of banks,
brokers, and foreign exchange dealers connected by electronic
communications systems
• the average total value of global foreign exchange trading in
March, 1986 was just $200 billion, in April, 2010 it hit $4 trillion
per day
• the most important trading centers are London, New York,
Zurich, Tokyo, and Singapore
• the market is always open somewhere in the world—it never
sleeps
 Do Exchange Rates Differ Between Markets?

• High-speed computer linkages between trading centers

mean there is no significant difference between exchange
rates in the differing trading centers
• If exchange rates quoted in different markets were not
essentially the same, there would be an opportunity for
arbitrage
• the process of buying a currency low and selling it high
 Do Exchange Rates Differ Between Markets?

• Most transactions involve dollars on one side—it is a

vehicle currency
• 85% of all foreign exchange transactions involve the
U.S. dollar
• other vehicle currencies are the euro, the Japanese
yen, and the British pound
• China’s renminbi is still only used for about 0.3% of
foreign exchange transactions
 How Are Exchange Rates Determined?

• Exchange rates are determined by the demand and

supply for different currencies
• Three factors impact future exchange rate movements
1. A country’s price inflation
2. A country’s interest rate
3. Market psychology
 How Do Prices
Influence Exchange Rates?
• The law of one price states that in competitive markets
free of transportation costs and barriers to trade, identical
products sold in different countries must sell for the same
price when their price is expressed in terms of the same
currency
• otherwise there is an opportunity for arbitrage until
prices equalize between the two markets
 How Do Prices
Influence Exchange Rates?
• Purchasing power parity theory (PPP) argues that given
relatively efficient markets (a market with no impediments
to the free flow of goods and services) the price of a
“basket of goods” should be roughly equivalent in each
country
• predicts that changes in relative prices will result in a
change in exchange rates
 How Do Prices
Influence Exchange Rates?
• A positive relationship exists between the inflation rate
and the level of money supply
• when the growth in the money supply is greater than
the growth in output, inflation will occur
• PPP theory suggests that changes in relative prices
between countries will lead to exchange rate changes, at
least in the short run
• a country with high inflation should see its currency
depreciate relative to others
 How Do Prices
Influence Exchange Rates?
Question: How well does PPP work?
• Empirical testing of PPP theory suggests that
• it is most accurate in the long run, and for countries
with high inflation and underdeveloped capital markets
• it is less useful for predicting short term exchange rate
movements between the currencies of advanced
industrialized nations that have relatively small
differentials in inflation rates
 How Do Interest Rates
Influence Exchange Rates?
• 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
• In other words:
[(S1 - S2) / S2 ] x 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
 How Does Investor Psychology
Influence Exchange Rates?
The bandwagon effect occurs when expectations on the
part of traders turn into self-fulfilling prophecies - traders
can join the bandwagon and move exchange rates based
on group expectations
• investor psychology and bandwagon effects greatly
influence short term exchange rate movements
• government intervention can prevent the bandwagon
from starting, but is not always effective
 Should Companies Use Exchange Rate
Forecasting Services?
There are two schools of thought
1. The efficient market school - forward exchange rates
do the best possible job of forecasting future spot
exchange rates, and, therefore, investing in forecasting
services would be a waste of money
2. The inefficient market school - companies can improve
the foreign exchange market’s estimate of future
exchange rates by investing in forecasting services
 Should Companies Use Exchange Rate
Forecasting Services?
1. An efficient market is one in which prices reflect all
available information
• if the foreign exchange market is efficient, then
forward exchange rates should be unbiased
predictors of future spot rates
• Most empirical tests confirm the efficient market
hypothesis suggesting that companies should not
waste their money on forecasting services
 Should Companies Use Exchange Rate
Forecasting Services?
2. An inefficient market is one in which prices do not
reflect all available information
• in an inefficient market, forward exchange rates will
not be the best possible predictors of future spot
exchange rates and it may be worthwhile for
international businesses to invest in forecasting
services
• However, the track record of forecasting services is not
good
 How Are Exchange
Rates Predicted?
• Two schools of thought on forecasting:
1. Fundamental analysis draws upon economic factors like
interest rates, monetary policy, inflation rates, or
balance of payments information to predict exchange
rates
2. Technical analysis charts trends with the assumption
that past trends and waves are reasonable predictors of
future trends and waves
 Are All Currencies
Freely Convertible?
• A currency is 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
• A currency is externally convertible when non-residents 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 non-
residents are prohibited from converting their holdings of
domestic currency into a foreign currency
 Are All Currencies
Freely Convertible?
• Most countries today practice free convertibility
• but many countries impose restrictions on the amount
of money that can be converted
• Countries limit convertibility to preserve foreign exchange
reserves and prevent capital flight
• when residents and nonresidents rush to convert their
holdings of domestic currency into a foreign currency
• most likely to occur in times of hyperinflation or
economic crisis
 Are All Currencies
Freely Convertible?
• When a currency is nonconvertible, firms may turn to
countertrade
• barter-like agreements where goods and services are
traded for other goods and services
• was more common in the past when more currencies
were nonconvertible, but today involves less than 10%
of world trade
 What Do Exchange Rates
Mean For Managers?
Managers need to consider three types of foreign
exchange risk
1. Transaction exposure - the extent to which the income
from individual transactions is affected by fluctuations
in foreign exchange values
• includes obligations for the purchase or sale of goods
and services at previously agreed prices and the
borrowing or lending of funds in foreign currencies
 What Do Exchange Rates
Mean For Managers?
2. Translation exposure - the impact of currency
exchange rate changes on the reported financial
statements of a company
• concerned with the present measurement of past
events
• gains or losses are “paper losses”
• they are unrealized
 What Do Exchange Rates
Mean For Managers?
3. Economic exposure - the extent to which a firm’s future
international earning power is affected by changes in
exchange rates
• concerned with the long-term effect of changes in
exchange rates on future prices, sales, and costs
 How Can Managers
Minimize Exchange Rate Risk?
• To minimize transaction and translation exposure,
managers should
1. Buy forward
2. Use swaps
3. Lead and lag payables and receivables
• lead and lag strategies can be difficult to implement
 How Can Managers
Minimize Exchange Rate Risk?
• Lead strategy - attempt to collect foreign currency
receivables early when a foreign currency is expected
to depreciate and pay foreign currency payables before
they are due when a currency is expected to appreciate
• Lag strategy - delay collection of foreign currency
receivables if that currency is expected to appreciate
and delay payables if the currency is expected to
depreciate
 How Can Managers
Minimize Exchange Rate Risk?
To reduce economic exposure, managers should
1. Distribute productive assets to various locations so the
firm’s long-term financial well-being is not severely
affected by changes in exchange rates
2. Ensure assets are not too concentrated in countries
where likely rises in currency values will lead to
increases in the foreign prices of the goods and
services the firm produces
 How Can Managers
Minimize Exchange Rate Risk?
In general, managers should
1. Have central control of exposure to protect resources efficiently
and ensure that each subunit adopts the correct mix of tactics
and strategies
2. Distinguish between transaction and translation exposure on the
one hand, and economic exposure on the other hand
3. Attempt to forecast future exchange rates
4. Establish good reporting systems so the central finance function
can regularly monitor the firm’s exposure position
5. Produce monthly foreign exchange exposure reports
 References

[1] Geringer, M., McNett, J., Minor, M., & Ball, D. (2015). International Business - Standalone book
(1st ed.). McGraw-Hill Education.
[2] Griffin, R., & Pustay, M. (2014). International Business: A Managerial Perspective (8th ed.).
Pearson.
[3] Hill, C. (2014). International Business: Competing in the Global Marketplace (9th ed.). McGraw-
Hill Education.
[4] Hill, C., & Hult, T. G. M. (2018). International Business: Competing in the Global Marketplace
(12th ed.). McGraw-Hill Education.
[5] Hill, J. (2008). International Business: Managing Globalization. SAGE Publications, Inc.