International Business 9e By Charles W.L. HillMcGraw-Hill/Irwin Copyright 2013 by The McGraw-Hill Companies Inc! "ll rights reser#e$!Chapter 10The Foreign Exchange Market10-3Why Is The Foreign Exchange Market Important?The foreign exchange market 1. is used to convert the currency of one country into the currency of another2. provides some insurance against foreign exchange riskthe adverse conse!uences of unpredicta"le changes in exchange ratesThe exchange rate is the rate at #hich one currency is converted into another.events in the foreign exchange market affect firm sales$ profits$ and strategy10-4When o Firms !se The Foreign Exchange Market?%nternational companies use the foreign exchange market #hen the payments they receive for exports$ the income they receive from foreign investments$ or the income they receive from licensing agreements #ith foreign firms are in foreign currenciesthey must pay a foreign company for its products or services in its country&s currencythey have spare cash that they #ish to invest for short terms in money marketsthey are involved in currency speculationthe shortterm movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates10-5What Is The i"erence Bet#een $pot %ates &n' For#ar' %ates?The spot exchange rate is the rate at #hich a foreign exchange dealer converts one currency into another currency on a particular dayspot rates change continually depending on the supply and demand for that currency and other currencies 'pot exchange rates can "e !uoted as the amount of foreign currency one (.'. dollar can "uy$ or as the value of a dollar for one unit of foreign currency10-6What Is The i"erence Bet#een $pot %ates &n' For#ar' %ates?)alue of the (.'. *ollar +gainst ,ther Currencies 2-12-1110-7What Is The i"erence Bet#een $pot %ates &n' For#ar' %ates?To insure or hedge against a possi"le adverse foreign exchange rate movement$ firms engage in for#ard exchanges t#o parties agree to exchange currency and executethe deal at some specific date in the future + for#ard exchange rate is the rate used for these transactionsrates for currency exchange are typically !uoted for ./$ 0/$ or 11/ days into the future + currency s#ap is the simultaneous purchase and sale of a given amount of foreign exchange for t#o different value dates10-8What Is The (ature )* TheForeign Exchange Market?The foreign exchange market is a glo"al net#ork of "anks$ "rokers$ and foreign exchange dealers connected "y electronic communications systemsif exchange rates !uoted in different markets #ere not essentially the same$ there #ould "e an opportunity for ar"itrage2uture exchange rates are affected "y1.+ country&s price inflation2.+ country&s interest rate..3arket psychology10-9+o# o ,rices In-uence Exchange %ates?The la# of one pricein competitive markets free of transportation costs and "arriers to trade$ identical products sold in different countries must sell for the same price #hen their price is expressed in terms of the same currency4urchasing po#er parity theory 54446 argues that given relatively efficient markets the price of a 7"asket of goods8 should "e roughly e!uivalent in each countrypredicts that changes in relative prices #ill result in a change in exchange rates10-10+o# o Interest %ates In-uence Exchange %ates?The %nternational 2isher 9ffect states that for any t#o countries the spot exchange rate should change in an e!ual amount "ut in the opposite direction to the difference in nominal interest rates "et#een t#o countries %n other #ords: ;5'1'26 - '2 < x 1// = i >i ? #herei> andi? are the respective nominal interest rates in t#o countries 5in this case the (.'. and @apan6$ '1 is the spot exchange rate at the "eginning of the period and '2 is the spot exchange rate at the end of the period10-11+o# oes In.estor ,sychology In-uence Exchange %ates?The "and#agon effect occurs #hen expectations on the part of traders turn into selffulfilling propheciestraders can Aoin the "and#agon and move exchange rates "ased on group expectationsinvestor psychology and "and#agon effects greatly influence short term exchange rate movements government intervention can prevent the "and#agon from starting$ "ut is not al#ays effective10-12$houl' Companies !se Exchange %ate Forecasting $er.ices?There are t#o schools of thought1. The efficient market schoolfor#ard exchange rates do the "est possi"le Ao" of forecasting future spot exchange rates$ and$ therefore$ investing in forecasting services #ould "e a #aste of money2. The inefficient market schoolcompanies can improve the foreign exchange market&s estimate of future exchange rates "y investing in forecasting services10-13+o# &re Exchange %ates ,re'icte'?T#o schools of thought on forecasting:1. 2undamental analysis dra#s upon economic factors like interest rates$ monetary policy$ inflation rates$ or "alance of payments information to predict exchange rates2. Technical analysis charts trends #ith the assumption that past trends and #aves are reasona"le predictors of future trends and #aves 10-14&re &ll Currencies Freely Con.erti/le?+ currency is freely converti"le #hen a government of a country allo#s "oth residents and nonresidents to purchase unlimited amounts of foreign currency #ith the domestic currency+ currency is externally converti"le #hen nonresidents can convert their holdings of domestic currency into a foreign currency$ "ut #hen the a"ility of residents to convert currency is limited in some #ay+ currency is nonconverti"le #hen "oth residents and nonresidents are prohi"ited from converting their holdings of domestic currency into a foreign currency#hen a currency is nonconverti"le$ firms may turn to countertrade10-15What o Exchange %ates Mean For Managers?3anagers need to consider three types of foreign exchange risk1. Transaction exposurethe extent to #hich the income from individual transactions is affected "y fluctuations in foreign exchange values2. Translation exposurethe impact of currency exchange rate changes on the reported financial statements of a company.. 9conomic exposurethe extent to #hich a firm&s future international earning po#er is affected "y changes in exchange rates10-16+o# Can Managers Minimi0e Exchange %ate %isk?To minimiBe transaction and translation exposure$ 1. Buy for#ard2. (se s#aps.. Lead and lag paya"les and receiva"lesTo reduce economic exposure1. *istri"ute productive assets to various locations so the firm&s longterm financial #ell"eing is not severely affected "y changes in exchange rates2. *o not concentrate assets #here likely rises in currency values #ill lead to increases in the foreign prices of the goods and services the firm produces10-17+o# Can Managers Minimi0e Exchange %ate %isk?%n general$ managers should 1. Have central control of exposure to protect resources efficiently and ensure that each su"unit adopts the correct mix of tactics and strategies2. *istinguish "et#een transaction and translation exposure on the one hand$ and economic exposure on the other hand.. +ttempt to forecast future exchange ratesC. 9sta"lish good reporting systems so the central finance function can regularly monitor the firm&s exposure positionD. 4roduce monthly foreign exchange exposure reports