Chapter : Chapter The Foreign Exchange Market 9
Case: The Axis hedges the Euro : 9-2 Case: The Axis hedges the Euro In 1999 Axis Ltd, prices sales to European customers in Euros
Euro plunges against the dollar causing lost revenues
To hedge against adverse currency movements Axis enters into forward exchange contracts
The foreign exchange market : 9-3 The foreign exchange market Foreign exchange market:
A market for converting the currency of one country into the currency of another.
Exchange rate:
The rate at which one currency is converted into another
Foreign exchange risk:
The risk that arises from changes in exchange rates
Functions of the foreign exchange market : 9-4 Functions of the foreign exchange market Two functions:
Converting currencies
Reducing risk
Currency conversion : 9-5 Currency conversion Companies receiving payment in foreign currencies need to convert these payments to their home currency
Companies paying foreign businesses for goods or services
Companies investing spare cash for short terms in money market accounts
Companies taking advantage of changing exchange rates (Speculation)
Reducing risk : 9-6 Reducing risk Insuring against foreign exchange risk
Spot exchange rate: rate of currency exchange on a particular day
Forward exchange rate: two parties agree to exchange currencies on a specific future date
Currency swap: simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
Foreign exchange quotations, June 18,2003 : 9-7 Foreign exchange quotations, June 18,2003
Foreign exchange trade growth : 9-8 $ billions Foreign exchange trade growth
The foreign exchange market (FX) : 9-9 The foreign exchange market (FX) Global network of banks, brokers and foreign exchange dealers connected by electronic communications systems
London’s dominance is explained by:
History (capital of the first major industrialized nation).
Geography (between Tokyo/Singapore and New York).
Two major features of the foreign exchange market:
The market never sleeps
Market is highly integrated
Hierarchy of international financial centers : 9-10 Hierarchy of international financial centers Note: Size of dots (squares) indicates cities’ relative importance
Economic theories of exchange rate determination : 9-11 Economic theories of exchange rate determination Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another
Price and exchange rates:
Law of One Price
Purchasing Power Parity (PPP)
Money supply and price inflation
Interest rates and exchange rates
Investor psychology and “Bandwagon” effects
Law of one price : 9-12 Law of one price In competitive markets free of transportation costs and trade barriers, 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 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78).
Purchasing power parity : 9-13 Purchasing power parity By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - 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
Slide 14: 9-14 United States $2.49 2.49 - - - - - - - - -
Argentina Peso 2.50 0.78 1.00 3.13 -68
Brazil Real 3.60 1.55 1.45 2.34 -38
Canada C $ 3.33 2.12 1.34 1.57 - 15
Euro 2.67 2.37 0.93 0.89 - 5
Hong Kong HK $11.20 1.40 4.50 7.80 - 42
Japan ¥ 262 2.01 105 130 - 19
Russia Ruble 39.00 1.25 15.7 31.2 - 50
Switzerland Sw Fr 6.30 3.81 2.53 1.66 53 Price in
Local
Currency Implied
PPP of the
Dollar Actual
Exchange
Rate
17/04/01 Local Currency
% Over(+)
or Under(-)
Valuation
Against Dollar Price in
Dollars Big Mac Prices The Big Mac Index: PPP, April 2002 Table 9.2
Money supply and inflation : 9-15 Money supply and inflation PPP theory predicts that changes in relative prices will result in a change in exchange rates
A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate
Inflation occurs when the money supply increases faster than output increases
Purchasing power parity puzzle
Interest rates and exchange rates : 9-16 Interest rates and exchange rates Theory says that interest rates reflect expectations about future exchange rates.
Fisher Effect (I = r + l).
International Fisher Effect:
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 the two countries.
Investor psychology and bandwagon effects : 9-17 Investor psychology and bandwagon effects Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates
Explanation may be investor psychology and the bandwagon effect
Studies suggest they play a major role in short term movements
Hard to predict
Exchange rate forecasting : 9-18 Exchange rate forecasting Efficient market school: Prices reflect all available public information
Inefficient market school: Prices do not reflect all available information
Use fundamental (economic theory) or technical (price/volume data) analysis to predict the exchange rate
Analysis suggest that professional forecasters are no better than forward exchange rates in predicting future spot rates
Approaches to forecasting : 9-19 Approaches to forecasting Fundamental analysis
Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements
Technical analysis
Uses price and volume data to determine trends
Currency convertibility : 9-20 Currency convertibility Political decision.
Many countries have some kind of restrictions
Governments limit convertibility to preserve foreign exchange reserves
Service international debt
Purchase imports
Government afraid of capital flight
Counter trade : 9-21 Counter trade Barter-like agreements where goods/services are traded for goods/services
Helps firms avoid convertibility issue
Managerial implications : 9-22 Managerial implications Exchange rates influence the profitability of trade and investment deals
International businesses must understand the forces that determine exchange rate
Forward exchange rate not an unbiased predictor
Inflation effects foreign exchange markets
International businesses need to take the proper precautions before trading or investing in a country