Chapter 8

Foreign Exchange and International Financial Markets

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The Four Risks of International Business

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Introduction

International financial markets consist of the foreign exchange, derivative, debt and equity marketsImportant to governments and central banks in financing their fiscal and current account deficits, and to maintain their exchange ratesImportant to firms for their currency requirements, assistance in management of currency risk, and the ability to raise capital at a lower costImportant to investors to diversify their portfolios and to achieve higher rates of returns.

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Introduction

The value of national currencies is in constant flux This fluctuation means we have to keep three things in

mind:The issue whether we and our supplier agreed on an

exchange rate in advance, or if the exchange rate is to be decided on the date of the actual payment

We should keep in mind whether the purchase agreement quoted the price in our currency or in the supplier’s currency

Fluctuations in the exchange rate could cost us money or earn us money

Currency risk – arises from changes in the price of one currency relative to another

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Introduction

The foreign exchange market is where the financial instruments are traded and the price is exchange rate

The foreign exchange market is an informal market with no physical location.

All transactions are conducted over phone lines and by computer screens, and the markets are open continuously

Main participants in the foreign exchange market: Banks Brokers Multinational firms Central banks

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Foreign Exchange Market - Functions

Conversion: To facilitate sale or purchase, or invest directly abroad

Hedging: Insure against potential losses from adverse exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit

Speculation: Sequential purchase and sale (or vice versa) of a currency for profit

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I. Conversion of currencies

Companies use the foreign exchange market to convert one currency into another.

Pay for imports Foreign direct investment Repatriation of profits Tourists

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Currency Values

Change in U.S. dollar against Polish zloty

February 1: PLZ 5/$ March 1: PLZ 4/$

%change = [(4-5)/5] x 100 = -20%

U.S. dollar fell 20%

Change in Polish zloty against U.S. dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Change in Polish zloty against U.S. dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

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Cross Rate

Dollar Euro Pound SFranc Peso Yen CdnDlr

Canada 1.3931 1.6466 2.4561 1.0695 0.1198 0.0122 ....

Japan 114.50 135.32 201.85 87.898 9.8420 .... 82.185

Mexico 11.633 13.749 20.510 8.9309 .... 0.1016 8.3504

Switzerland 1.3026 1.5395 2.2965 .... 0.1120 0.0114 0.9350

United Kingdom 0.5672 0.6704 .... 0.4355 0.0488 0.0050 0.4071

Euro 0.8461 .... 1.4917 0.6495 0.0727 0.0074 0.6073

United States .... 1.1819 1.7630 0.7677 0.0860 0.0087 0.7178

• Exchange rate calculated using two other exchange rates• Use direct or indirect exchange rates against a third currency

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Cross Rate Example

Direct quote method

1) Quote on euro = € 0.8461/$2) Quote on yen = ¥ 114.50/$3) € 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥4) Costs 0.0074 euros to buy 1 yen

Indirect quote method

1) Quote on euro = $ 1.1819/€2) Quote on yen = $ 0.008734/¥3) $ 1.1819/€ ÷ $ 0.008734/¥ = € 135.32/¥4) Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥5) Costs 0.0074 euros to buy 1 yen

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II. Hedging- Insuring Against Foreign Exchange Risk

To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchangesA 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 transactionsRates for currency exchange are typically quoted for 30, 90, or 180 days into the futureThe spot exchange rate is the rate at which 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

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Example of hedging using Forward Exchange

US company imports laptop computers from Japan payable in 30 days when shipment arrives

¥200,000 per laptop Spot rate $1 = ¥120

At this rate, each laptop costs $1,667 (200,000/120) If sell at $2,000 each , make a profit of $333 But no money to pay exporter until all units have been sold

2 choices – i. sell the laptops, wait 30 days and pay exporter, or

ii. engage in a forward exchange.

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Example of hedging using Forward Exchange

If over the next 30 days, $ depreciates against ¥,

$1=¥95, What happen to the importer’s position?

If $ appreciates against ¥, $1=¥130, what happen to the importer’s position?

Forward exchange rate for 30 days is $1 = ¥110. What happen when importer enters 30 forward contract

How forward exchange market is used to insure one’s position?

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Example

If done nothingIf $1=¥95, then, importer has to pay import

200,000/95 = $2,105 (loss of $105 per unit)If $1=¥130, then importer has to pay import

200,000/130 = $1,538 (profit of $462 per unit)Question is whether to take the risk of changes in

exchange rate? If enter forward contract, 30 day forward at $1=¥110

200,000/110 = $1,818 (Guaranteed profit of $182 regardless of fluctuation in exchange rate)

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Insuring Against Foreign Exchange Risk

A currency swap is a transaction in which the same currency is bought and sold simultaneously, but delivery is made at two different points in time.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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III. Currency Arbitrage

The instantaneous purchase and sale of a currency in different markets for profits. (example: euro in Tokyo is lower than euro in New York)

High tech communication and trading systems allow the entire arbitrage transaction to occur within seconds

But if the difference between the value of the euro in Tokyo and the value in New York is not greater than the cost of conducting the transaction, the trade is not worth making.

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IV. Currency Speculation

The purchase or sale of a currency with the expectation that its value will change and generate a profit.

The shift in value might be expected to occur suddenly or over a longer period.

The foreign exchange trader may bet that a currency’s price will go up or down in the future

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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 SingaporeThe 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 centersIf 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 closeMost 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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Convertible and Nonconvertible Currencies

Convertible currency- can be readily exchanged for other currencies.

Hard currencies- most convertible currencies- universally accepted, e.g. U.S. dollar, Japanese yen, Canadian dollar, British pound, and the European euro.

Most transactions use these currencies and nations prefer to hold them as reserves because of their strength and stability.

Nonconvertible- not acceptable for international transactions

Bartering - in some developing economies, currency convertibility is so strict that firms sometimes receive payments in the form of products rather than cash.

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Economic Theories Of Exchange Rate Determination

At the most basic level, exchange rates are determined by the demand and supply for different currencies.

The greater the supply of a currency, the lower its priceThe lower the supply of a currency, the higher its priceThe greater the demand for a currency, the higher its priceThe lower the demand for a currency, the lower its price

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Foreign Exchange Rate Determination

Three other factors have an important impact on future exchange rate movements:

i. a country’s price inflation

ii. a country’s interest rate

iii. market psychology

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Exchange rate and inflation

Inflation is an increase in the price of good and services, so that money buys less than in preceding years

Countries such as Argentina, Brazil, and Zimbabwe have had prolonged periods of hyperinflation – persistent annual double digit and indeed triple digit rates of consumer price increase

In a high inflation environment, the purchasing power of a currency is constantly falling

Fundamentally, inflation occurs when: Demand grows more rapidly than supply The central bank increases the nation’s money supply faster than

output. – When disproportionate large amount of money is introduced into an economy, the result is too much money chasing a relatively fixed supply of goods and services, which causes prices to go up.

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Prices And Exchange Rates – What is a Currency worth?

At what rate should one currency be exchanged for another?

Purchasing power parity (PPP) is the relative ability of two countries’ currencies to buy the same “basket” of goods in those two countries

In essence, PPP claims that a change in relative inflation between two countries must cause a change in exchange rates in order to keep prices of goods in two countries fairly similar.

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Purchasing Power Parity

For example: Japanese inflation were 2% and U.S. inflation were 3.5%, the dollar would be expected to fall by the difference in inflation rates

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Prices And Exchange Rates

The version of PPP that estimates the exchange rate between 2 currencies using just one good or service as a measure of the proper exchange for all goods and services is called law of one price

According to 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 their price is expressed in terms of the same currency

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The Law of One Price

Example:

The Big Mac Index

Average price of Big Mac in U.S. $2.49 on 5 July 08

Average Big Mac in Canada C$=3.33 on 5 July 08

Therefore, PPP exchange rate = C$3.33/$2.49 = C$1.34/$

The actual exchange rate on 5 July 08 was C$1.57/$.

This means that each $ was actually worth 1.57 Canadian dollars, when Big Mac index indicates should have been worth 1.34 Canadian dollars.

Therefore, Canadian dollar was undervalued by 15 percent.

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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 runA country with high inflation should see its currency depreciate relative to othersEmpirical 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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Prices And Exchange Rates

Example: PPP theory argues that the exchange rate will change if relative price change.

Assume no price inflation in USA, while 10% inflation a year in Japan

At beginning of the year, a basket of goods cost $200 in the US and ¥20,000 in Japan, so exchange rate according to PPP is $1= ¥100.

At the end of the year, the exchange rate should E$/ ¥ = $200/ ¥22,000,

Thus $1= ¥110 (or ¥1=$0.0091)

Because of 10 percent price inflation, the Japanese yen has depreciated by 10 percent against the dollar.

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Interest Rates And Exchange Rates

Economy theory states that interest rates reflect expectations about likely future inflation rates.

Where inflation is expected to be high, interest rates also will be high because investors want compensation for the decline in the value of their money

Fisher Effect states that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest ( r ) and the expected inflation over the period for which the funds are to be lent (I)

i = r + I

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Interest rates and exchange rates

Since PPP theory shows that there is a link between inflation and exchange rates, and since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates.

The International Fisher Effect states that 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 two countries

In other words:

[(S1 - S2) / S2] x 100 = i $ - i ¥ where i $ and i ¥ are the respective nominal interest rates in two

countries (in this case the US 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

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Investor Psychology And Bandwagon Effects

Investor psychology, or unpredictable behavior of investors also affects exchange ratesThe 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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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 moneyThe 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 ratesMost 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 informationSo, 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 ratesTechnical 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 convertedCountries 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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Implications For Managers

Firms need to understand the influence of exchange rates on the profitability of trade and investment dealsThere are three types of foreign exchange risk:

1. Transaction exposure

2. Translation exposure

3. Economic exposure

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Transaction Exposure

Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange valuesIt includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending o funds in foreign currencies

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Translation Exposure

Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a companyIt is concerned with the present measurement of past eventsGains or losses are “paper losses” –they’re unrealized

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Economic Exposure

Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates Economic exposure is concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

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Reducing Translation And Transaction Exposure

To minimize transaction and translation exposure, firms can: buy forwarduse swapsleading and lagging payables and receivables (paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements)

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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 appreciateA 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 depreciateLead 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 ratesensure 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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Other Steps For Managing Foreign Exchange Risk

In general, firms should: have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategiesdistinguish between transaction and translation exposure on the one hand, and economic exposure on the other handattempt to forecast future exchange ratesestablish good reporting systems so the central finance function can regularly monitor the firm’s exposure positionproduce monthly foreign exchange exposure reports