Because learning changes everything.

Chapter 10
The Foreign Exchange
Market

naqiewei/DigitalVision Vectors/Getty Images

© 2022 McGraw Hill. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw Hill.
 Learning Objectives
10-1 Describe the functions of the foreign exchange market.
10-2 Understand what is meant by spot exchange rates.
10-3 Recognize the role that forward exchange rates play in
insuring against foreign exchange risk.
10-4 Understand the different theories explaining how currency
exchange rates are determined and their relative merits.
10-5 Identify the merits of different approaches toward exchange
rate forecasting.
10-6 Compare and contrast the differences among translation,
transaction, and economic exposure, and explain the
implications for management practice.

© McGraw Hill 2
 Opening Case
The Fluctuating Value of the Yuan Gives Chinese Business a Lesson in Foreign
Exchange Risk

Value of the yuan relative to the dollar fluctuated significantly

between 2015 to 2018
Yuan depreciated from 2015 to 2016
• Boosted exports
• Increased prices of key imports, which raised costs for companies and
resulted in losses
Yuan appreciated from 2017 to 2018
• Reduced costs for companies that import goods priced in dollars
• Raised price of exports

© McGraw Hill viper-zero/Shutterstock 3

 Introduction
Foreign Exchange Market
Market for converting the currency of one country into that of
another country.
• Can have a significant impact on the sales and profits of an enterprise.
• Managers must understand how foreign exchange market works and
its possible impact.

Exchange rate is the rate at which one currency is converted into

another.

© McGraw Hill 4
 The Functions of the Foreign Exchange
Market 1

Two Functions
1. Enables conversion of 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.

© McGraw Hill 5
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 market is always open somewhere in the world
• 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
• Most transactions involve U.S. dollars on one side

© McGraw Hill 6
 The Functions of the Foreign Exchange
Market 2

Currency Conversion
To convert export receipts, income received from foreign
investments, or income received from licensing agreements.
To pay a foreign company for products or services.
To invest spare cash for short terms in money markets.
For currency speculation: short-term movement of funds from
one currency to another in hopes of profiting from shifts in
exchange rates.
• Carry trade borrows one currency where interest rates are low and
invests these in another currency where interest rates are high.

© McGraw Hill 7
 The Functions of the Foreign Exchange
Market 3

Insuring against Foreign Exchange Risk

The foreign exchange market can provide insurance against
foreign exchange risk.
• A firm that protects itself against foreign exchange risk is hedging.

The market performs this function using:

1. Spot exchange rates.

2. Forward exchange rates.
3. Currency swaps.

© McGraw Hill 8
 The Functions of the Foreign Exchange
Market 4

Insuring against Foreign Exchange Risk continued

Spot Exchange Rates.
• Rate at which a foreign exchange dealer converts one currency into
another currency on a particular day.
• Determined by the interaction between supply and demand.
• Changes continually.

© McGraw Hill 9
Getting Spot Exchange Rates

© McGraw Hill 10
 The Functions of the Foreign Exchange
Market 5

Insuring against Foreign Exchange Risk continued

Forward Exchange Rates.
• The exchange rate governing a forward exchange.
• Forward exchange: two parties agree to exchange currency and
execute the deal at some specific date in the future.
• Forward exchange rates are typically quoted for 30, 90, or 180 days
into the future.
• Can sometimes work against a company.

© McGraw Hill 11
 The Functions of the Foreign Exchange
Market 6

Insuring against Foreign Exchange Risk continued

Currency Swaps.
• Simultaneous purchase and sale of a given amount of foreign
exchange for two different value dates.
• Swaps are used when it is desirable to move out of one currency into
another for a limited period without incurring foreign exchange rate
risk.

© McGraw Hill 12
 Economic Theories of Exchange Rate
Determination 1

Important Factors Impacting Future Exchange Rate

Movements
1. A country’s price inflation.
2. A country’s interest rate.
3. Market psychology.

© McGraw Hill 13
 Economic Theories of Exchange Rate
Determination 2

Prices and Exchange Rates

The Law of One Price.
• In competitive markets free of transportation costs and barriers to
trade, identical products sold in different countries must sell for the
same price when price is in the same currency.

Purchasing Power Parity (PPP).

• 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 predicts that changes in relative prices result in changes in
exchange rates.
• When inflation is relatively high, a currency should depreciate.

© McGraw Hill 14
 Economic Theories of Exchange Rate
Determination 3

Prices and Exchange Rates continued

Money Supply and Price Inflation.
• If we can predict inflation rates, we can predict how a currency’s value might
change.
• Growth of a country’s money supply determines its likely future inflation rate.
• When the growth in the money supply is greater than the growth in output,
inflation occurs.
• Example: Bolivian hyperinflation in mid-1980s.

In the 1980s the value of the

Bolivian currency, the Bolivian,
depreciated rapidly due to
hyperinflation.

© McGraw Hill Carolina Cabral/Getty Images 15

 Economic Theories of Exchange Rate
Determination 5

Interest Rates and Exchange Rates

Fisher effect: a country’s nominal interest rate (i) is the sum of the
required real rate of interest (r) and the expected rate of inflation
over the period for which the funds are to be lent (I).
• In other words:
i=r+I

So, if the real interest rate is the same everywhere, any difference
in interest rates between countries reflects differing expectations
about inflation rates.

© McGraw Hill 16
 Economic Theories of Exchange Rate
Determination 6

Interest Rates and Exchange Rates continued

International Fisher effect (IFE): 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.
• In other words:

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.

© McGraw Hill 17
 Economic Theories of Exchange Rate
Determination 4

Prices and Exchange Rates continued

Empirical Tests of PPP Theory.
• Indicates it is not completely accurate in estimating exchange rate
changes in the short run but relatively accurate in the long run.
• The purchasing power parity puzzle:
• Assumes away transportation costs and barriers to trade.
• Governments routinely intervene in trade and foreign exchange market.
• Investor psychology plays a role on exchange rate movements.

© McGraw Hill 18
The ‘Big Mac’ Index
Compares the prices of a Big
Mac in different countries.
In theory the prices when
divided by exchange rates
should be equal (ppp)
However, often not, used to
show which currencies strong –
overvalued, weak-undervalued.
Historically good predictor of
currency movement.

© McGraw Hill 19
 Economic Theories of Exchange Rate
Determination 7

Investor Psychology and Bandwagon Effects

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

Investor psychology is influenced by political factors and

microeconomic events.

© McGraw Hill 20
Bandwagon effect

© McGraw Hill 21
 Economic Theories of Exchange Rate
Determination 8

Summary of Exchange Rate Theories

Relative monetary growth, relative inflation rates, and nominal
interest rate differentials are all moderately good predictors of
long-run changes in exchange rates.
• These factors are poor predictors of short-run changes.

So, international businesses should pay attention to countries’

differing monetary growth, inflation, and interest rates.

© McGraw Hill 22
 Exchange Rate Forecasting 1

The Efficient Market School

• Efficient market is one in which prices reflect all available
information.
• Forward exchange rates are the best predictors of future spot
exchange rates.
• Investing in forecasting services is a waste of money.

© McGraw Hill 23
 Exchange Rate Forecasting 2

The Inefficient Market School

• Inefficient market is one in which prices do not reflect all
available information.
• Forward exchange rates are not the best predictors of future
spot exchange rates.
• Companies should invest in forecasting services.

© McGraw Hill 24
Did You Know?
Did you know that the
U.S. dollar has been one
of the strongest
currencies in the world
since the great recession
of 2008–2009?
Click to play

© McGraw Hill 25
 Exchange Rate Forecasting 3

Approaches to 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.

• Uses price and volume data to determine past trends that are
expected to continue.
• Many economists are skeptical of technical analysis.

© McGraw Hill 26
Predicting short-term movements

© McGraw Hill 27
 Exchange Rate Forecasting 4

Currency Convertibility
• Freely convertible: both residents and nonresidents can
purchase unlimited amounts of foreign currency with the
domestic currency.
• Externally convertible: only nonresidents can convert their
holdings of domestic currency into a foreign currency.
• Nonconvertible: both residents and nonresidents are prohibited
from converting their holdings of domestic currency into a
foreign currency.

© McGraw Hill 28
 Exchange Rate Forecasting 5

Currency Convertibility continued

• Governments 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.
• In nonconvertible currency, 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.

© McGraw Hill 29
 360° View: Managerial Implications 1

Foreign Exchange Rate Risk

Firms must understand the influence of exchange rates on the
profitability of trade and investment deals.

© McGraw Hill 30
 Summary
In this chapter, we have
• Described the functions of the foreign exchange market.
• Understood what is meant by spot exchange rates.
• Recognized the role that forward exchange rates play in insuring
against foreign exchange risk.
• Understood the different theories explaining how currency
exchange rates are determined and their relative merits.
• Identified the merits of different approaches toward exchange
rate forecasting.
• Compared and contrasted the differences among translation,
transaction, and economic exposure, and understood the
implications for management practice.
© McGraw Hill 31