IB CH 10

lead strategy

- attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate

lag strategy

- delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate

economic exposure is

- the extent to which a firm's future international earning power is affected by changes in exchange rates

transaction exposure is

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

translation exposure is

- the impact of currency exchange rate changes on the reported financial statements of a company -gains and losses are paper losses, they are unrealized

government intervention can prevent the bandwagon from starting, but is not always effective. government restrictions can include

-A restriction on residents' ability to convert the domestic currency into a foreign currency -Restricting domestic businesses' ability to take foreign currency out of the country

To minimize transaction and translation exposure, managers should

-Buy forward -Use swaps -Lead and lag payables and receivables

countertrade is

-barter-like agreements where goods and services are traded for other goods and services -was more common in the past when more currencies were nonconvertible, but today involves less than 10% of world trade

swaps are transacted

-between international businesses and their banks -between banks -between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

how well does the PPP theory work? empirical testing of PPP theory suggets that

-it is most accurate in the long run, and for countries with high inflation and underdeveloped capital markets -it is less useful for predicting short term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates

international companies use the foreign exchange market when

-the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies -they must pay a foreign company for its products or services in its country's currency -they have spare cash that they wish to invest for short terms in money markets -they are involved in currency speculation

countries limit convertibility to preserve foreign exchange reserves and precent capital flight

-when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency -most likely to occur in times of hyperinflation or economic crisis

to reduce economic exposure, managers should

1. Distribute productive assets to various locations so the firm's long-term financial well-being is not severely affected by changes in exchange rates 2. Ensure assets are not too concentrated in countries where likely rises in currency values will lead to increases in the foreign prices of the goods and services the firm produces

three factors impact future exchange rate movements

1. a countrys price inflaiton 2. a countrys interest rate 3. market psychology

How are exchange rates predicted? 2 schools of through

1. fundamental analysis 2. technical analysis

the foreign exchange market does two things

1. is used to convert 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

should companies use exchange rate forecasting services? there are two schools of thought

1. the efficient market school 2. inefficient market school

managers need to consider three types of foreign exchange risk

1. transaction exposure 2. translation exposure 3. economic exposure

an inefficient market is one in which

prices do not reflect all available information, are not a good predictor of future spot exchange rates, worthwhile for businesses to invest in forecasting services

an efficient market is one in which

prices reflect all available information, should be unbiased predictors of future spot rates

forward exchange rate is the rate used for these transaction

rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must

sell for the same price when their price is expressed in terms of the same currency Example: U.S./Euro exchange rate: $1 = € .78 A jacket selling for $50 in New York should retail for € 39.24 in Paris (50x.78)

the international fisher effect states that

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

the law of one price states

that 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, otherwise there is an opportunity for arbitrage until prices equalize between the two markets

a currency is freely convirtable when

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 nonconvertible when

when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

a currency is externally convertible when

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 positive relationship exists between the inflation rate and the level of money supply

when the growth in the money supply is greater than the growth in output, inflation will occur

[(S1 - S2) / S2 ] x 100 = i $ - i ¥

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

exchange rates are

determined by the demand and supply for different currencies

fundamental analysis

draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates

PPP theory suggests that changes in relative prices between countries will lead to

exchange rate changes, at least in the SR- a country with high inflation should see its currency depreciate relative to others

the bandwagon effect occurs when

expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations (greatly influence short term exchange rate movements)

the foreign exchange market provides insurance against what

foreign exchange risk-the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm

the efficient market school

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 money

most countries today practice

free convertibility, but many countries impose restrictions on the amount of money that can be converted

purchasing power parity theory argues that

given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a "basket of goods" should be roughly equivalent in each country, predicts that changes in relative prices will result in a change in exchange rates

the foreign exchange market is

is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

governments will limit or restrict convertibility for a number of reasons that include

Preserving foreign exchange reserves A fear that free convertibility will lead to a run on their foreign exchange reserves - known as capital flight

hedging is what

a firm that insures itself against foreign exchange risk

most transactions involve dollars on one side, which is

a vehicle currency

how can spot exchange rates be quoted

as the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar for one unit of foreign currency

technical analysis

charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves

the inefficient market school

companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services

when a currency is nonconvertible firms may turn to

countertrade

If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage, which is

the process of buying a currency low and selling it high

spot exchange rates

the rate at which a foreign exchange dealer converts one currency into another currency on a particular day -change continually depending on the supply and demand for that currency and other currencies

the exchange rate is

the rate at which one currency is converted into another (events in the foreign exchange market affect firm sales, profits and strategy )

what is currency speculation

the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

a currency swap is

the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

what are forward exchange rates

two parties agree to exchange currency and execute the deal at some specific date in the future