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AOF Business in a Global Economy

Lesson 7Foreign Exchange and

International Financial Markets

Student Resources

Resource Description

Student Resource 7.1 Partner Practice: Currency Rates and Conversions

Student Resource 7.2 Anticipation Guide: The Foreign Exchange Market

Student Resource 7.3 Reading: The Foreign Exchange Market

Student Resource 7.4 Notes: Why Exchange Rates Fluctuate

Student Resource 7.5 Reading: Currency Exchange Fluctuations

Student Resource 7.6 Predictions: Currency Exchange Fluctuations

Student Resource 7.7 Scenarios: Minimizing Foreign Exchange Risk

Copyright © 20092016 NAF. All rights reserved.

AOF Business in a Global EconomyLesson 7 Foreign Exchange and International Financial Markets

Student Resource 7.1

Partner Practice: Currency Rates and ConversionsStudent Names:_______________________________________________________ Date:___________

Directions: Before you begin, record the name of the currency exchange rate source you are using and today’s exchange rates. (Abbreviations for each currency are provided in parentheses.) Then work with a partner to calculate the exchange rates for these problems before answering the questions. Be ready to share your answers with the class.

Currency Exchange Rate Source:____________________ Today’s Date:___________Cur

Currency Japanese Yen

(JPY)

British Pound

(GBP)

Indian Rupee

(SR)

Brazilian Real

(BRL)

S. African Rand

(ZAR)

Exchange Rate (1 USD = ?)

1. Sample Problem: I am going to visit my cousin in England this year. He said I should take at least 400 British pounds worth of spending money. How many US dollars is that?

2. Our shipping company is buying an apartment in Brazil for visiting executives to stay in. It is unfurnished. The accountant is trying to figure out if it would be cheaper to buy the furnishings in the United States and ship them to Brazil, or if it would be cheaper to buy them there. Shipping will total 10% of the cost of the items if they are bought in the United States. Using today’s exchange rate, calculate the costs of these items from US dollars (USD) to Brazilian real (BRL). Then add the shipping costs and figure out which option will be more cost-effective. The items you must buy and their costs in each country are:

a. Couch USD Price 1,000 BRL Price 4,200

b. Bed USD Price 2,200 BRL Price 4,000

c. Refrigerator USD Price 1,250 BRL Price 3,050

d. Bedding USD Price 100 BRL Price 25

e. Washer and dryer USD Price 950 BRL Price 2,200

Do your calculations on a separate sheet of paper and write your recommendation here:



3. You have been assigned to visit some clients in a few different countries for 10 days. Your boss would like an expense report in US dollars when you return. Calculate the cost of your meals and hotels for the expense report for your boss and the total cost of the trip.

Cape Town, S. Africa: days 1–3 Bangalore, India: days 4–7 Leeds, England: days 8–10

Hotel Costs: 942 ZAR Hotel Costs: 750 SR Hotel Costs: 984 GBP

Meal Costs: 431 ZAR Meal Costs: 194 SR Meal Costs: 329 GBP

Total Spent: Total Spent: Total Spent:

US Dollar Conversion: US Dollar Conversion: US Dollar Conversion:

Total spent on the trip in US dollars:

4. Your firm has asked you to research a new supplier for its raw materials of rubber, copper, and wood. Calculate the cost of the materials and recommend the country it would be most cost-effective to get each from.

rubber India: 3 SR/kilo S. Africa: 12 ZAR/kilo Brazil: 12 BRL/kilo

cost in USD

copper Japan: 42 JPY/troy ounce India: 22 SR/troy ounce Brazil: 14 BRL/troy ounce

cost in USD

wood England: 655 GBP/cord Brazil: 389 BRL/cord S. Africa: 545 ZAR/cord

cost in USD

From which country should your firm get each raw material, based on the cost of buying it in the country it comes from?

Can you think of any other costs that should also be taken into account and that might influence which country you advise your firm to choose?




Anticipation Guide: The Foreign Exchange MarketStudent Name:_______________________________________________________ Date:___________

Directions: For each of the statements below, underline “I agree” if you think the statement is accurate or “I disagree” if you disagree with it. Write one reason to explain your guess. After you read Student Resource 7.3, Reading: The Foreign Exchange Market, check your answers, correct them if necessary, and fill in the “I learned” section for each statement.

The foreign exchange market never closes.

My guess: I agree I disagree

My reason:

I learned:

Travelers who need foreign money make up the majority of currency exchanges.


My reason:

I learned:

Banks lose money because of currency exchanges.


My reason:

I learned:

The emotions of FX traders actually impact exchange rates.


My reason:

I learned:




Reading: The Foreign Exchange Market

What is the foreign exchange market?When businesses, individuals, or governments need money (currency) to buy foreign goods or services or invest in another country, they must usually exchange their home currency for the foreign one to make the transaction. These transactions occur on the foreign exchange market, which is also called the Forex, or FX, market. It is the largest market in the world. Over $5.0 trillion are traded daily on the FX, and it is the only market that is open 24 hours per day. The FX is a worldwide network of traders who connect with each other and trade over the phone and the Internet. Because FX trading does not have a central location, trades occur all over the globe; the difference in time zones allows trading to occur all day and night, though most trading occurs in New York; London, England; and Tokyo, Japan.

Who trades on the FX market?There are four main types of traders in the FX market.

Banks are responsible for about 39% of the market trading volume. They buy and sell currency to and from each other to make profits. Banks trade currency with each other at special, unpublished rates.

Brokers are dealers who represent the banks on the FX market for some of their FX trading, finding the best exchange rates on behalf of the banks. Brokers allow banks to remain anonymous in their currency trading. They earn money by charging commissions on their transactions.

Customers of foreign exchange mostly consist of large companies who need foreign currency to make purchases or investments. Other customers are individuals or smaller firms who require foreign currency for travel or purchases.

Central banks (for example, the US Federal Reserve, the European Central Bank, and the Bank of England) sometimes participate in the FX market to influence the value of the currency they are responsible for. Central banks in some countries (notably China) buy or sell currency, or they issue new currency to keep their currency’s exchange rate near a target rate they have set.

Other participants include hedge funds as speculators, investment management firms, retail foreign exchange traders, and money transfer-remittance companies. (A remittance is a money transfer made by a foreign worker back to an individual in their home country.)

Why do they trade?There are three main reasons traders exchange currency on the FX market. The first is to earn short-term profits from fluctuations in exchange rates. Investors, both big and small, can make profits because of exchange rate fluctuations, and banks and large international corporations hire currency managers to buy and sell currencies every day. The second reason is that firms must have the correct currency to buy the goods and services needed for their operations all over the world. The third reason for FX trading is for protection from losses due to currency fluctuations. Firms dealing with large amounts of money can gain, but also lose, from even the smallest fluctuations in currency exchange rates.

Why do exchange rates fluctuate?Exchange rates fluctuate for three main reasons. The first is economic factors, including a country’s interest rates, its inflation rate, and the supply of and demand for its currency. The second reason exchange rates fluctuate is because of political conditions; generally, the more stable a country’s politics, the less widely its currency fluctuates. Finally, market psychology causes exchange rate fluctuations. Market psychology is the general feeling of the market. If there is fear or excitement about a currency, its



price will be affected. Anyone making currency trades must be aware of these three factors to minimize their trading risk.




Notes: Why Exchange Rates FluctuateStudent Name:_______________________________________________________ Date:___________

Directions: Fill in this table after you listen to (or read) the presentation Currency Exchange Fluctuations.

The foreign exchange (FX) market is where:

The value of a currency is determined by the law of:

A fixed rate is: One benefit of a fixed rate is:

A floating rate is: One benefit of a floating rate is:

Three factors affect the value of a currency.

1.

2.

3.

P_______________ Influences include:

E______________ Policy and

Conditions

include:

Market __________________ is a phenomenon when _______________________

rates

are influenced by:

Governments manage currency in different ways. One is:

A strong currency is: and is exhibited by:

A weak currency is: and is exhibited by:




Reading: Currency Exchange Fluctuations

The foreign exchange (FX) market is where traders, banks, corporations, and governments exchange currency, that is, buy or sell one country’s currency for another. This international trade in currency goes on around the world, 24 hours a day. The three main centers for FX trading are located in the United States, Japan, and the United Kingdom.

But how do those who trade in the FX market know how many dollars there are in a euro? Or yen in a rupee? Let’s look at the factors that determine currency exchange rates and cause them to fluctuate.



Currency, just like any other product for sale, follows the laws of supply and demand. Its price is its exchange rate. If demand is greater than supply for a certain currency, that currency’s price will rise. On the other hand, if there’s too much of a particular currency available compared with the demand for it, that currency’s price will fall.

The exchange rate of a country’s currency can either be floating or fixed. The value of a currency with a floating rate (e.g., the United States) is determined by the market. On the other hand, if a currency is fixed (e.g., China, until 2005), its value is pegged to another currency, group of currencies, or other measure of value, like gold. The central banks of countries with fixed exchange rates must buy and sell their own currency to maintain the fixed exchange rate.

Some governments choose fixed exchange rates to help control inflation or stabilize their currencies. But fixed exchange rates may fail to reflect the true value of a currency since they do not adjust according to market forces. If a fixed exchange rate is too different from what is consistent with market supply and demand for the currency, the result can be a financial crisis that forces a change in the fixed exchange rate. Therefore, most countries choose to let the exchange rate of their currency vary according to supply and demand in the market; that is, they have a floating exchange rate.



There are a few currencies that traders in the currency market tend to prefer over others. But why? What exactly are they looking for? Let’s compare two countries. One has a stable government and political environment. Its economy is steadily growing, and it exports a variety of products to other foreign markets. The second country is in turmoil, perhaps undergoing a civil war, with an economy that has little to offer in the way of trade. In these cases, the first country’s currency would generally be more highly valued. People, companies, and other countries will want to do business with that country and therefore will desire its currency.

Political events can greatly affect a currency’s exchange rate. For instance, when a new government comes into power, it brings up a variety of questions. Will the new government maintain the current economic policies? Will its economic policies be better or worse? Will there be internal or regional political upheaval and fighting, or is the political landscape calm and stable? Traders consider how national and international politics affect what a currency is worth and how the currency may fluctuate in the future. These potential fluctuations are what shape a trader’s excitement or fear about a currency.



The economic policies of a country (which are decided by governments) and the trends of its economy affect the value of its currency in the foreign exchange market. Central banks such as the US Federal Reserve have substantial control over interest rates, which determine the cost of borrowing money in that currency.

Whether a country’s gross domestic product (GDP) is increasing or decreasing also impacts the value of its currency. Recall that GDP is a commonly used indicator of a country's economic health. It's the monetary value of all goods and services produced within a country during a specific time period, usually a year. Countries with growing industries see a rise in employment rates and prosperity for the nation. When a country’s prosperity rises, its currency tends to appreciate, or rise, in value.

Economic conditions also influence exchange rates in other ways. One major factor influencing the value of a currency is inflation. When a country has high inflation (a general increase in the price of goods within a country), people from other countries may desire its currency less. When there’s inflation, what you can buy with a unit of a currency—its purchasing power—goes down. For example, a pack of gum that may have once cost $1 now costs $2 because of inflation. Thus, inflation in a country will cause the value of its currency to depreciate, or lessen, in relation to other countries’ money.



Like any other human endeavor, the FX market is influenced by the perceptions and emotions of the people involved. This is called market psychology. Investing in currency, as with other investments, involves taking risks. Currencies in developing countries with expanding economies are risky investments. They offer FX traders new opportunities, but these currencies often come from less economically and politically stable countries.

Rumors and expectations play a large role in the valuation of currencies. If many traders believe a positive event is going to happen in a country, that belief may be enough to raise the price of that currency. Traders also place a lot of importance on specific economic statistics, although which statistics they consider to be important may change over time. They may focus on a country’s inflation rate, trade balance, or employment figures in an attempt to predict the price of its currency in the future.

In a market this big and volatile, the traders do all they can to predict what other traders will do and how currency exchange rates will fluctuate. They may analyze a country’s economy and political environment to see if they believe a currency is overvalued or undervalued.

When traders think the current price of a currency is too low and expect it to rise, they will buy a large amount of the currency. If their expectation turns out to be right, they’ll be able to sell that currency later at a profit when the price goes up. If their expectation turns out to be wrong and the price falls, they will suffer a loss. If, on the other hand, they believe a currency is overvalued and expect its exchange rate to fall, they’ll sell it now and buy it back later when the price drops.



Because exchange rates affect the economy of a country in so many ways, governments look for ways to keep their currencies stable, in an attempt to keep them from getting too strong or too weak.

A strong currency is one that has increased in value compared with other currencies and is expected to continue to increase. A country with a booming economy and trade surplus will generally have a strong currency. A weak currency is one that has decreased in value and is expected to continue to decrease compared with other currencies. A country with a poorly performing economy or large budget deficits will generally tend to have a weak currency.

Governments usually have a view about what the exchange rate of their country’s currency ought to be, even if their economic policy also calls for a floating exchange rate. Governments often work to keep their currencies from getting too strong or too weak relative to this preferred level. Keeping a currency stable keeps prices, tourism, and business contracts stable as well. It also helps keep the market psychology toward the currency favorable.



The global FX market is a vast and turbulent place. Governments, corporations, banks, and individuals must look at an array of issues, political events, and economic statistics to try and figure out where a currency’s value is likely to go. Will it rise? Will it fall? What does the future hold?

Though FX is not an exact science, FX traders do their best to understand the economic, political, and psychological factors that influence the value of each currency today and are likely to influence it in the future. One thing is certain: this market provides an exciting and challenging world for those who choose to take part in it.




Predictions Activity: Currency Exchange FluctuationsStudent Names:_______________________________________________________ Date:___________

Directions: Read each problem and decide if you think the value of the currency under consideration will rise in value (appreciate) or fall in value (depreciate) in response to the factors described. Record your prediction and give at least one reason why. Be prepared to share your answers.

1. A country is undergoing an election. It seems likely that the political challenger will win, but many people believe that the current president will not give up power without a legal battle. It may not be a smooth transition.

We predict the value of this currency will rise fall

One reason why is:

2. Though this country has long had a stable economy, it’s going through some turbulent times. Much of its heavy industry, including auto manufacturing, is suffering. Because of this, the country’s trade deficit is growing.


One reason why is:

3. A developing country is beginning to enter the fast-growing electronics industry, making items such as DVD players and TVs as well as components for computers.


One reason why is:

4. The numbers haven’t been published yet, but rumor has it that this country’s unemployment numbers will be down and its GDP will be up.


One reason why is:

5. This country has just signed a free-trade agreement with several of its neighbors. The agreement effectively ends tariffs on trade between the nations.


One reason why is:




Scenarios Activity: Minimizing Foreign Exchange RiskStudent Names:_______________________________________________________ Date:___________

Directions: Hedging is when a firm insures itself against FX risk. Traders hedge by choosing the least risky type of currency exchange transaction. Read the descriptions of three types of FX transactions. Then, working with a partner, recommend which type of transaction the managers in the three scenarios should undertake. For each recommendation provide at least one reason why, and be ready to share your answers with the class.

Spot TransactionsA spot transaction is one in which the two parties agree to exchange the money immediately, or right on the spot. Spot transactions account for slightly more than one-third of all currency exchanges. The published exchange rates in newspapers and on websites are the spot rates.

Forward TransactionsA forward transaction is one in which the two parties exchanging currency agree to exchange it at a later, set date, at an exchange rate that they agree on in advance. Parties choose dates for many reasons, perhaps when goods arrive or when a tariff rate changes.

OptionsOptions allow traders to determine in advance a fixed, or strike, price that they will be able to exchange their currencies at. An FX option gives them the right (but not the obligation) to trade in the future before the option expires, at the strike price. If exchange rates at that future date are such that it’s not attractive to do the trade at the strike price, the holder of the option does not have to trade.

Scenarios1. You order 100 million Japanese yen worth of automobile parts to be delivered in six months. The parts must remain below a certain price or you will not be able to make a profit on the autos when you sell them in one year’s time.

Type of trade recommended:

Why:

2. You and your family are traveling to Botswana tomorrow to go on safari. You would like to have Botswanan pulas to give as tips to the drivers when you arrive.


Why:

3. Inflation is rising in your country. The economy is unstable and quite volatile, but your tree-house business is still profitable and making sales. You will need to make a large purchase of lumber sometime in the next year to replenish your stock.


Why:


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