Chapter 5

The Foreign Exchange Market

 Introduction

A firm’s sales, profits, and strategy are affected by events

in the foreign exchange market
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

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 The Functions Of The
Foreign Exchange Market

The foreign exchange market:

is used to convert the currency of one country into the
currency of another
provide some insurance against foreign exchange risk
(the adverse consequences of unpredictable changes in
exchange rates)

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 Currency Conversion

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)

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 Insuring Against Foreign Exchange Risk

The foreign exchange market can be used to provide

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

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 Insuring Against Foreign Exchange Risk

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

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 Classroom Performance System

The ________ is the rate at which one currency is

converted into another.

a) Exchange rate
b) Cross rate
c) Conversion rate
d) Foreign exchange market

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 Insuring Against Foreign Exchange Risk

To insure or hedge against a possible adverse foreign

exchange rate movement, firms engage in forward
exchanges
A forward exchange occurs when two parties agree to
exchange currency and execute the deal at some specific
date in the future
 A forward exchange rate is the rate governing such
future transactions
Rates for currency exchange are typically quoted for 30,
90, or 180 days into the future

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 Insuring Against Foreign Exchange Risk

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 to move out of one
currency into another for a limited period without incurring
foreign exchange rate risk

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 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—it is not located in
any one place
The most important trading centers are London, New
York, Tokyo, and Singapore
The markets is always open somewhere in the world—it
never sleeps

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 The Nature Of The
Foreign Exchange Market

High-speed computer linkages between trading centers

around the globe have effectively created a single market—
there is no significant difference between exchange rates
quotes 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), and the gap would close
Most transactions involve dollars on one side—it is a
vehicle currency along with the euro, the Japanese yen,
and the British pound

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 Classroom Performance System

The _______ is the rate at which a foreign exchange dealer

converts one currency into another currency on a particular
day.

a) Currency swap rate

b) Forward rate
c) Specific rate
d) Spot rate

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 Economic Theories Of
Exchange Rate Determination

Exchange rates are determined by the demand and

supply for different currencies.

Three factors impact future exchange rate movements:

 a country’s price inflation
 a country’s interest rate
 market psychology

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 Prices And 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
Purchasing power parity (PPP) theory argues that given
relatively efficient markets (markets in which few
impediments to international trade and investment exist)
the price of a “basket of goods” should be roughly
equivalent in each country
PPP theory predicts that changes in relative prices will
result in a change in exchange rates

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 Prices And Exchange Rates

A positive relationship between the inflation rate and the

level of money supply exists
 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
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

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 Investor Psychology
And Bandwagon Effects

Investor psychology also affects exchange rates

The bandwagon effect occurs when expectations on the
part of traders can turn into self-fulfilling prophecies, and
traders can join the bandwagon and move exchange rates
based on group expectations
 Governmental intervention can prevent the bandwagon
from starting, but is not always effective

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 Summary

Relative monetary growth, relative inflation rates, and

nominal interest rate differentials are all moderately good
predictors of long-run changes in exchange rates
 So, international businesses should pay attention to
countries’ differing monetary growth, inflation, and interest
rates

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 Classroom Performance System

Which of the following does not impact future exchange

rate movements?

a) A country’s price inflation

b) A country’s interest rate
c) A country’s arbitrage opportunities
d) Market psychology

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 Exchange Rate Forecasting

Should companies use exchange rate forecasting services

to aid decision-making?

The efficient market school argues that 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
The inefficient market school argues that companies can
improve the foreign exchange market’s estimate of future
exchange rates by investing in forecasting services

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 The Efficient Market School

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

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 The Inefficient Market School

An inefficient market is one in which prices do not reflect

all available information
So, 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

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 Approaches To Forecasting

There are two schools of thought on forecasting:

Fundamental analysis draw upon economic factors like
interest rates, monetary policy, inflation rates, or balance of
payments information to predict exchange rates
Technical analysis charts trends with the assumption that
past trends and waves are reasonable predictors of future
trends and waves

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 Currency Convertibility

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

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 Currency Convertibility

Most countries today practice free convertibility, although

many countries impose some 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)
When a country’s currency is nonconvertible, firms may
turn to countertrade (barter like agreements by which
goods and services can be traded for other goods and
services) to facilitate international trade

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 Classroom Performance System

When a government of a country allows both residents and

non-residents to purchase unlimited amounts of foreign
currency with the domestic currency, the currency is

a) Nonconvertible
b) Freely convertible
c) Externally convertible
d) Internally convertible

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 Reducing Translation
And Transaction Exposure

A lead strategy involves attempting to collect foreign

currency receivables early when a foreign currency is
expected to depreciate and paying foreign currency
payables before they are due when a currency is expected
to appreciate
A lag strategy involves delaying collection of foreign
currency receivables if that currency is expected to
appreciate and delaying payables if the currency is
expected to depreciate
Lead and lag strategies can be difficult to implement

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 Reducing Economic Exposure

To reduce economic exposure, firms need to:

distribute productive assets to various locations so the
firm’s long-term financial well-being is not severely affected
by changes in exchange rates
ensure 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
the firm produces

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 Classroom Performance System

Firms that want to minimize transaction and translation

exposure can do all of the following except

a) buy forward
b) have central control of exposure
c) use swaps
d) lead and lag payables and receivables

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6. Topic 6: Foreign exchange market
- Exchange rate: definition, spot and forward
exchange rates
- Factors influencing exchange rates
- Influence of exchange rates on import, export
activities.
- What tools can be taken by Vietnamese
companies to minimize the effects of exchange rate
fluctuations?
- Introduce services offered by banks in HCMC
that help companies to avoid exchange rate
fluctuations?
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