Chapter 10

Hyperinflation

A very rapid rise in the price level; an extremely high rate of inflation. an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly. -ex: mid-1980s, Bolivia -Bolivia's money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent

If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates. This means that:

A. the predictions will be accurate in any specific situation. B. inaccuracies will not be consistently above or below future spot rates; they will be random. C. more accurate predictions of future spot rates can be calculated from publicly available information. D. market participants' collective predictions about future spot rates cannot be incorrect.

Lag Strategy

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

If an international business is attempting to predict future movements in the value of a country's currency on the foreign exchange market, it should examine

country's policy toward monetary growth. -government seems committed to controlling the rate of growth in money supply-->future inflation rate may be low and currency should not depreciate too much on the foreign exchange market -gov. lack the political will to control the rate of growth in money supply---> future inflation rate may be high, which is likely to cause its currency to depreciate.

future exchange rate movements influence

export opportunities, the profitability of international trade and investment deals, and the price competitiveness of foreign imports, this is valuable information for an international business.

Reducing Translation and Transaction Exposure

forward exchange rate contracts and buying swaps. -firms can minimize their foreign exchange exposure through leading and lagging payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements purpose is to protect short-term cash flows from adverse changes in exchange rates.

bandwagon effects can be both triggered by

idiosyncratic behavior of politicians.

poor predictors of short-run changes in exchange rates bc

impact of psychological factors, investor expectations, and bandwagon effects on short-term currency movements

The most important trading centers

London, New York, Zurich, Tokyo, and Singapore. Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney

bandwagon effect

Movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions. -ex. George Soros bet on the british pound

inefficient market

One in which prices do not reflect all available information. -forward exchange rates will not be the best possible predictors of future spot exchange rates. bc of this it may be worthwhile for international businesses to invest in forecasting services

Hedging

When a firm insures itself against foreign exchange risk, it is engaging

there seems to be a relationship between

interest rate differentials and subsequent changes in spot exchange rates.

Reducing Economic Exposure

is to distribute the firm's productive assets to various locations so the firm's long-term financial well-being is not severely affected by adverse changes in exchange rates.

government why chooses convertibility restrictions

limit convertibility to preserve their foreign exchange reserves -impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. -to prevent capital flight- causes a run on foreign exchange reserves limit the country's ability to service its international debt and pay for imports, and lead to a depreciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country's currency). -could lead to further increases in inflation.

Arbitrage

the process of buying a currency low and selling it high

exchange rate

the rate at which one currency is converted into another.

positives of PPP

the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets.

factors impacting whether people in other countries are willing to hold dollars.

U.S. interest rates, the return on holding other dollar-denominated assets such as stocks in U.S. companies, and, most important, inflation rates.

Big Mac Index

-Tool for calculating purchasing power parity that compares prices of a Big Mac throughout the world. -proxy for a "basket of goods" because it is produced according to more or less the same recipe in about 120 countries. -a test of whether a currency is undervalued or not. -To calculate the index, The Economist converts the price of a Big Mac in a country into dollars at current exchange rates and divides that by the average price of a Big Mac in America. -According to the PPP theorem, the prices should be the same. If they are not, it implies that the currency is either overvalued against the dollar or undervalued. -the exchange rate will change if relative prices change

Government intervenes in the foreign exchange market bc

-can increase the money supply simply by telling the country's central bank to issue more money. Governments tend to do this to finance public expenditure (building roads, paying government workers, paying for defense, etc.). -attempting to influence the value of their currencies. further weakens the link between price changes and changes in exchange rates

downside of PPP

-does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less. -less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates. -failure of PPP theory to predict short-term movements in foreign exchange rates is the impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements.

price discrimination

-dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. -enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging. -arbitrage must be limited for this to happen

three features of the foreign exchange market:

-the market never sleeps -integration of the various trading centers. High-speed computer linkages among trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers -important role played by the U.S. dollar. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for won or real.

Government policy determines

-the rate of growth in a country's money supply is greater than the rate of growth in output.

factors why the failure of PPP theory to predict exchange rates

-theory assumes away transportation costs and barriers to trade. In practice, these factors are significant, and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods. -Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory.

Approaches to Forecasting exchange rates

1. Fundamental Analysis -sophisticated econometric models for predicting exchange rate movements with relative money supply growth rates, inflation rates, and interest rates 2. Technical Analysis- uses price and volume data to determine past trends, which are expected to continue into the future. Based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves. -compare technical analysis to fortune-telling

Other Steps for Managing Foreign Exchange Risk

1. central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. 2. firms should distinguish between transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on reducing their transaction and translation exposure and forget to pay attention to economic exposure, which is bad. 3. need to forecast future exchange rate movements cannot be overstated. Forward exchange rates provide the best predictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influence exchange rate movements 4. firms need to establish good reporting systems so the central finance function (or in-house foreign exchange center) can regularly monitor the firm's exposure positions. 5. firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet elements might be affected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks.

International businesses four main uses of foreign exchange markets

1.the payments a company receives for its exports, the income it receives from foreign investments, or the income it receives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country's currency. 2. when they must pay a foreign company for its products or services in its country's currency. 3. when they have spare cash that they wish to invest for short terms in money markets. 4. Currency speculation- typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

freely convertible

A country's currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.

lead strategy

Collecting 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 appreciate.

capital flight

Converting domestic currency into a foreign currency. -most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country's economic prospects are shaky in other respects. Under such circumstances, both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad.

how to deal with nonconvertibility

Countertrade- refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country's currency is nonconvertible -many governments have made their currencies freely convertible, and the percentage of world trade that involves countertrade is probably significantly below 5 percent.

good predictors of long-run changes in exchange rates

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

forces that determine the future exchange rate movements in a country's currency

The country's price inflation, its interest rate, and market psychology.

foreign exchange risk

The risk that changes in exchange rates will hurt the profitability of a business deal. adverse consequences of unpredictable changes in exchange rates

An exchange rate can be quoted in two ways:

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

Running a deficit on a balance-of-payments current account

a country is importing more goods and services than it is exporting

Carry Trade

a kind of currency speculation that involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high

Why London?

both history and geography. As the capital of the world's first major industrial trading nation, London had become the world's largest center for international banking by the end of the nineteenth century, a position it has retained. Today, London's central position between Tokyo and Singapore to the east and New York to the west has made it the critical link between the East Asian and New York markets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York.6

The value of a currency is determined by

the interaction between the demand and supply of that currency relative to the demand and supply of other currencies

theory of purchasing power parity (PPP)

links changes in the exchange rate between two countries' currencies to changes in the countries' price levels. -By comparing the prices of identical products in different currencies, it would be possible to determine the "real" or PPP exchange rate that would exist if markets were efficient. -less extreme version of the PPP theory states that given relatively efficient markets—that is, markets in which few impediments to international trade exist, the price of a "basket of goods" should be roughly equivalent in each country -price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. -the exchange rate will change if relative prices change -can predict what a country's future inflation rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change.

influenced by long-term movements in exchange rates

long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports

efficient market

no impediments to the free flow of goods and services, such as trade barriers -one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, a company cannot beat the market by investing in forecasting services.)

Inflation

occurs when the quantity of money in circulation rises faster than the stock of goods and services—that is, when the money supply increases faster than output increases. -The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be inflation.

Investor psychology influenced by:

political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates.

what makes financial assets such as stocks and bonds attractive?

prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets

difference between....

spot exchanges: When two parties agree to exchange currency and execute the deal immediately. the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. -change continually, often on a minute-by-minute basis (although the magnitude of changes over such short periods is usually small). -one-third of all foreign exchange transactions forward exchanges: when two parties agree to exchange currency and execute the deal at some specific date in the future. -To insure or hedge against risk, the U.S. importer engages in a forward exchange -forward exchange rate- the exchange rate governing a forward exchange transaction. -For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. -when a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed. -two-thirds of all foreign exchange transactions, currency swaps: simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. -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 risk. -common kind of swap is spot against forward

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). a strong relationship seems to exist between inflation rates and interest rates. i=r+I expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates will be greater than Japanese nominal interest rates.

international Fisher effect (IFE)

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 the two countries link between inflation and exchange rates and because interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates. -not a good predictor of short-run changes in spot exchange rates

law of one price

states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

psychological factors play an important role in determining

the expectations of market traders as to likely future exchange rates. -expectations have a tendency to become self-fulfilling prophecies

Foreign exchange risk three main categories:

transaction exposure -extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure 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. -concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. translation exposure- ASK -the impact of currency exchange rate changes on the reported financial statements of a company. concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized—they are "paper" gains and losses—but they are still important. economic exposure- -a firm's future international earning power is affected by changes in exchange rates. concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs.

Foreign Exchange Market

two main functions 1st function: market for converting the currency of one country into that of another country. Enables companies based in countries that use different currencies to trade with each other. 2nd function: provide some insurance against the risks from such volatile changes in exchange rates, aka foreign exchange risk.

is it worthwhile for the company to invest in exchange rate forecasting services to aid decision making?

two thoughts: -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. -companies can improve the foreign exchange market's estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services aka do not believe the forward exchange rates are the best possible predictors of future spot exchange rates

nonconvertible

when neither residents nor nonresidents are allowed to convert it into a foreign currency.

externally convertible

when only nonresidents may convert it into a foreign currency without any limitations -can limit domestic companies' ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country.

quantitative easing

when the Fed buys longer-term government bonds or other securities -U.S. Federal Reserve decided to promote growth by expanding the U.S. money supply using this technique