Chapter 10

Purchasing Power Parity (PPP)

Argues that given relatively efficient markets the price of a "basket of goods" should be roughly equivalent in each country Predicts changes in relative prices will result in changes of exchange rates

When a currency is nonconvertible, firms may turn to

Countertrade: barter-like agreements where goods and services are traded for other goods and services. Only involves 10% of world trade, was more common in the past

How do you reduce economic exposure?

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.

How are exchange rates determined?

Exchange rates are determined by the demand and supply for different currencies

Do exchange rates differ between markets?

High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers IF exchange rates were not essentially the same, there would be an opportunity for arbitrage

Law of One Price (LOOP)

In the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual seller or buyer has the power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. (Opportunity for Arbitrage until equalized) ($1 = .78 Euro, a $50 jacket in New York should be <50 x .78> 39.24 Euro)

Currency Speculation

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

Are all currencies freely convertible?

Most countries today practice free convertibility, but many countries impose restrictions on the amount that can be converted. Countries limit convertibility to preserve foreign exchange reserves and prevent capital flight

Externally Convertible Currency

Nonresidents can convert their holdings of domestic currency into foreign currency, but the ability of residents to convert the currency is limited in some way.

Foreign Exchange Risk

The adverse consequences of unpredictable changes in exchange rates

Forward Exchange Rate

The agreed-upon exchange between two parties and execute the deal at a specific time in the FUTURE (30, 90 180) Used to hedge against possible adverse exchange rate movements

What is 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 Average in March 1986 was $200 billion, April 2010 was $4 trillion per day New York, Zurich, Tokyo, Singapore, London MARKET NEVER SLEEPS ALWAYS OPEN SOMEWHERE IN THE WORLD

Exchange Rate

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

Managers need to consider three types of foreign exchange risk...

Transaction Exposure, Translation Exposure, and Economic Exposure.

Should companies use exchange rate forecasting services?

Two schools of thought 1. Efficient Market School: forwards exchange rates do the best job of forecasting the future spot exchange rates, and therefore, investing in forecasting services would be a waste of money. 2. Inefficient Market School: Companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services.

How are exchange rates predicted?

Two schools of thought on predicting: 1. Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates 2. Technical analysis charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves

Big Mac Index

a measure created by the Economist magazine that compares the value of currencies by comparing the cost of a Big Mac hamburger in different countries. The United States is used as the baseline cost for the index

Technical Analysis

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

Inefficient Market School

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

Fundamental Analysis

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

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

Currency Swap

simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Borrow domestically than swap for lower interest rates. - Between international businesses and their banks - Between banks - Between government when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk.

Spot Exchange Rate

the exchange rate at which a foreign exchange dealer will convert one currency into another that particular day (Continually depend on the supply and demand for that currency and others)

Economic Exposure

the extent to which a firm's future international earning power is affected by changes in exchange rates (The effect of unexpected currency fluctuations on a company's future cash flows, equity, foreign investments, and earnings)

Transaction Exposure

the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values (Currency exchange rates will fluctuate after a firm has already undertaken financial obligation)

How can firms hedge against foreign exchange risk?

the foreign exchange market provides insurance to protect against foreign exchange risk Hedging (Reduces potential risk, also lowers potential gains)

Translation Exposure

the impact of currency exchange rate changes on the reported financial statements of a company (Company's assets, liabilities, or income will change in value because of exchange rate changes)

capital flight

the movement (flight) of capital from one nation to another, via jobs and resources

Arbitrage

the purchase of securities in one market for immediate resale in another to profit from a price discrepancy

Freely Convertible Currency

when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency

Nonconvertible Currency

when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency

International companies use the foreign exchange market when:

-payments they receive from exports, FDI, or licensing agreements are in other currencies -Need to pay a foreign country back in that country's currency -Spare cash they want to invest for short-term -Involved in Currency Speculation

What Three factors impact future exchange rate movements?

1. A country's inflation 2. A country's interest rate 3. Market psychology

How can managers minimize exchange rate risk?

1. Have central control of exposure 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. 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.

Vehicle Currency

A currency used as a vehicle for international trade or investment, Japanese Yen, The Euro, The British Pound, The U.S. Dollar 85% of all FOREX transactions involve U.S. Dollar

Foreign Exchange Market

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

How do prices influence exchange rates?

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. (one of the three factors)