Ch 20 - Currency Exchange Rates and Markets

To address transaction exposure, a firm must

1. Estimate its net cash flows in each currency for impacted transactions 2. Measure the potential effect of exposure in each currency 3. Use hedging tools to mitigate exposure to exchange rate fluctuations.

The following factors affect currency exchange rates:

1. Relative income levels (trade-related) 2. Relative interest rates (financial-related) 3. Relative inflation rates (trade-related)

Assuming that the real rate of interest is the same in both countries, if Country A has a higher nominal interest rate than Country B, the currency of Country A will likely be selling at a

Forward discount relative to the currency of Country B. If the real rates of interest are equal, the country with the higher nominal interest rate is expected to experience a higher rate of inflation. A higher rate of inflation is associated with a devaluing currency, so the currency of the country with the higher nominal interest rate will likely be selling at a forward discount.

What is the effect on prices of U.S. imports and exports when the dollar depreciates?

Import prices will increase and export prices will decrease. When the U.S. dollar depreciates, U.S. products become cheaper for consumers in foreign countries. A depreciated dollar acts as a subsidy to exports by decreasing their price. However, the opposite is true for imports. When the dollar depreciates, imports become more costly because it buys less of the foreign currency. Thus, a depreciated dollar increases the price to import goods to the U.S.

The most effective fiscal policy program to help reduce demand-pull inflation would be to

Increase taxes and decrease government spending. Demand-pull inflation results when demand for goods and services exceeds supply, thereby pulling prices upward. Increasing taxes and reducing government spending will decrease the aggregate demand (AD). When demand is reduced, prices and inflation will decline.

A domestic entity and a foreign entity purchased the same security on the foreign exchange and held the security for 1 year. The value of the foreign currency weakened against the domestic currency over this period. Comparing the returns of the two companies, what will be the domestic entity's return?

Lower return. The returns on the security are presumably paid in foreign currency. Hence, the change in the value of the foreign currency relative to the domestic currency does not affect the foreign entity's return. However, the weakening of the foreign currency reduces the amount of domestic currency it will buy, and the domestic entity's return in domestic currency is correspondingly reduced.

Fixed exchange rates

One unit of currency is set equal to a given number of units of another currency by law.

The spot rate for one Australian dollar is US $0.92685 and the 60-day forward rate is US $0.93005. What is the effect of the U.S. dollar.

The U.S. dollar is trading at a forward discount with respect to the Australian dollar. It will take more U.S. dollars in the future to buy the same amount of Australian dollars.

What is the effect when a foreign competitor's currency becomes weaker compared to the U.S. dollar?

The foreign company will have an advantage in the U.S. market. If the foreign currency weakens compared with the U.S. dollar, the U.S. dollar will have more buying power in the foreign company's country. Thus, the foreign company will be able to sell more products than the U.S. company for the same amount of dollars.

When a foreign country's currency has depreciated against the U.S. dollar, what is the effect on U.S. consumers purchasing power?

The foreign country's exports are less expensive for the United States. Thus, U.S. consumers have gained purchasing power.

A basic hedging principle: 1. When a debtor is to pay a foreign currency at some point in the future, the risk is that the foreign currency will appreciate in the meantime, making it more expensive in terms of the debtor's domestic currency.

The hedge is to purchase the foreign currency forward to lock in a definite price.

A basic hedging principle: 2. When a creditor is to receive a foreign currency at some point in the future, the risk is that the foreign currency will depreciate in the meantime, making it worth less in terms of the creditor's domestic currency.

The hedge is to sell the foreign currency forward to lock in a definite price.

Floating (flexible) exchange rates

The market is allowed to determine the exchange rates between currencies based on the principle of supply and demand.

When the U.S. dollar is expected to rise in value against foreign currencies, a U.S. company with foreign currency denominated receivables and payables should

The proper action would be to increase collections and decrease payments. Collections should be made quickly and converted into dollars to sustain the increase in their value as the dollar appreciates. Decreasing payments would be profitable because, as the company exchanges dollars for foreign currency at a later date, it will receive more of the foreign currency, thus lowering its real cost.

Equilibrium exchange rate

The rate at which the supply and demand for a currency in terms of another currency are equal.

When one currency can be exchanged for more units of another currency, the first currency is said to have

appreciated (strengthened) with respect to the second currency and the second currency is said to have depreciated (weakened) against the first.

A seller normally wants to be paid in its own currency. Thus, when the demand for a foreign country's products rise...

demand for its currency also rises. In general, the purchasing power of a currency moves in the same direction as demand for that country's output.

If the domestic currency fetches fewer units of a foreign currency in the forward market than the sport market, the domestic currency is said to be trading at a

forward discount with respect to the foreign currency.

If the domestic currency fetches more units of a foreign currency in the forward market than the sport market, the domestic currency is said to be trading at a

forward premium with respect to the foreign currency.

If the domestic currency is trading at a forward premium, then

it is expected to gain purchasing power.

If the domestic currency is trading at a forward discount, then

it is expected to lose purchasing power.

A decline in the value of the dollar relative to other currencies

lowers the price of U.S. goods to foreign consumers. Thus, exporters of domestically produced goods benefit. A low value of the dollar also decreases imports by making foreign goods more expensive.

What is the effect when a government intervenes in the foreign currency market to purchase its own currency,

that currency appreciates. When a government uses its foreign currency reserves to purchase its own currency in the foreign currency market, the effect is to decrease domestic aggregate demand.

Transaction exposure is

the exposure to fluctuations in exchange rates between the date a transaction is entered into and the settlement date.

The forward rate is

the number of units of a foreign currency that can be received in exchange for a single unit of the domestic currency at some definite date in the future.

The spot rate is

the number of units of a foreign currency that can be received today in exchange for a single unit of the domestic currency.