Ch 10 mgmt 470

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 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

countertrade

(barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade

Purchasing power parity theory

- given relatively efficient markets the price of a "basket of goods" should be roughly equivalent in each country

International firms use foreign exchange markets:

-To convert export receipts, income received from foreign investments, or income received from licensing agreements -To pay a foreign company for products or services -To invest spare cash for short terms in money markets -For currency speculation -For carry trade

Two countries, Great Britain and the US, produce just one good: beef. Suppose that the price of beef in the US is $2.80 per pound, and in Britain it is £3.70 per pound. (a) According to PPP theory, what should the $/£ spot exchange rate be? (b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65 in Britain. What should be the one year forward $/£ exchange rate? (c) Given your answers to parts (a) and (b), and given that the current interest rate in the US is 10%, what would you expect current interest rate to be in Britain?

....

How should exchange rate forecasts be prepared?

1. Fundamental analysis 2. Technical analysis

This exchange rate risk can be divided into

1. Transaction exposure 2. Translation exposure 3. Economic exposure

Forward rates are typically quoted for

30, 90, or 180 days into the future

What factors are important to future exchange rates?

A country's price inflation A country's interest rate Market psychology

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 can firms minimize translation and transaction exposure?

Buy forward Use swaps Lead and lag payables and receivables -

Lead strategy

Collecting foreign currency receivables early when a foreign currency is expected to depreciate Paying foreign currency payables before they are due when a currency is expected to appreciate

Lag strategy

Delaying collection of foreign currency receivables if that currency is expected to appreciate Delaying payables if the currency is expected to depreciate

How well does PPP theory work?

Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run

What is the purpose of the foreign exchange market?

Enables the conversion of the currency of one country into the currency of another Provides some insurance against foreign exchange risk

What does the foreign exchange market mean for international firms?

Firms must understand the influence of exchange rates on the profitability of trade and investment deals

An inefficient market

one in which prices do not reflect all available information

An efficient market

one in which prices reflect all available information

Lead and lag payables and receivables -

paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements

However, the track record of forecasting services is

questionable

Spot Exchange Rate

rate at which a foreign exchange dealer converts one currency into another currency on a particular day

Gains and losses from translation exposure are

reflected only on paper and they are unrealized gains or losses

The 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 rate of inflation over the period for which the funds are to be lent (I) - In other words, i = r + I

The International Fisher Effect suggests 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 the two countries

foreign exchange risk

the adverse consequences of unpredictable changes in exchange rates

Should companies invest in exchange rate forecasting services to help with decision-making?

the efficient market school the inefficient market school

Forward Exchange Rates -

the exchange rate governing a forward exchange

Economic exposure

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

Transaction exposure

the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

How do interest rates affect exchange rates?

the fisher effect

Translation exposure

the impact of currency exchange rate changes on the reported financial statements of a company

spot exchange rate is determined by

the interaction between supply and demand

Nonconvertible

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

Freely convertible

when both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency

Externally convertible

when only non-residents can convert their holdings of domestic currency into a foreign currency

capital flight

when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency

Swaps are used when it is

desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

So, if the real interest rate is the same everywhere, any difference in interest rates between countries reflects

differing expectations about inflation rates

Fundamental Analysis

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

The bandwagon effect

effect occurs when expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations

Governmental intervention can prevent the bandwagon from starting, but is not always

effective

Most empirical tests confirm the

efficient market hypothesis

Technical Analysis

focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves

Companies should not waste their money on

forecasting services

The foreign exchange market can be used to provide insurance to protect against

foreign exchange risk

The efficient market school

forward exchange rates are the best predictors of future spot exchange rates

Forward rates are not the best predictor of

future spot rates

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

A firm that protects itself against foreign exchange risk is

hedging

So, if we can predict inflation rates, we can predict

how a currency's value might change

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

When the growth in the money supply is greater than the growth in output,

inflation will occur

It may be worthwhile for international businesses to

invest in forecasting services

carry trade

involves borrowing one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high

What is the foreign exchange market?

is a market for converting the currency of one country into that of another country

The growth of a country's money supply determines

its likely future inflation rate

transaction exposure can

lead to a real monetary loss

efficient markets

markets in which few impediments to international trade and investment exist

Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all

moderately good predictors of long-run changes in exchange rates, but poor predictors of short term changes

In an inefficient market, forward exchange rates are

not the best predictors of future spot exchange rates

The market performs this function using:

Spot exchange rates Forward exchange rates Currency swaps

The interest rate on South Korean government securities with one-year maturity is 4% and the expected inflation rate for the coming year is 2%.

The US interest rate on government securities with one-year maturity is 7% and the expected rate of inflation is 5%. The current spot exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today.

How are exchange rates influenced by investor psychology?

The bandwagon effect

Why do countries limit currency convertibility?

The main reason is to preserve foreign exchange reserves and prevent capital flight

Are there other strategies to manage foreign exchange risk?

To further manage foreign exchange risk, firms should 1. Establish central control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies 2. Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand 3. Attempt to forecast future exchange rates 4. Establish good reporting systems so the central finance function can regularly monitor the firm's exposure position 5. Produce monthly foreign exchange exposure reports

How can a firm reduce 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 rates This requires that the firm's assets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce

How are prices related to exchange rate movements?

To understand how prices and exchange rates are linked, we need to understand the law of one price, and the theory of purchasing power parity

Most transactions involve

U.S. dollars on one side

When inflation is relatively high,

a currency should depreciate

Investing in forecasting services is

a waste of money

The market is

always open somewhere in the world

If exchange rates quoted in different markets were not essentially the same, there would be

an opportunity for arbitrage

The foreign exchange market is a global network of

banks, brokers, and foreign exchange dealers connected by electronic communications systems

PPP predicts that changes in relative prices will result in

changes in exchange rates

The inefficient market school

companies should invest in forecasting services

spot exchange rate changes

continually

In the case of a nonconvertible currency, 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

countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade

So, international businesses should pay attention to

countries' differing monetary growth, inflation, and interest rates

foreign exchange risk

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

translation exposure deals with

the present measurement of past events

arbitrage -

the process of buying a currency low and selling it high

What is the exchange rate?

the rate at which one currency is converted into another

Drawing on what we know about the Fisher effect,

the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but in an opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for S2 of $1=W1165.

currency speculation

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

Currency Swap

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

A forward exchange occurs when

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

If the foreign exchange market is efficient, forward exchange rates should be

unbiased predictors of future spot rates

The U.S. dollar is a

vehicle currency