IB Chapter 10

Three factors impact future exchange rate movements

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

To minimize transaction and translation exposure, managers should

Buy forward Use swaps Lead and lag payables and receivables lead and lag strategies can be difficult to implement

To reduce economic exposure, managers should

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

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

Economic exposure -

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

Fundamental analysis

In general, managers should

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

investor psychology and bandwagon effects greatly influence

short term exchange rate movements

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

spot exchange rate

Spot exchange rates can 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. A quote for a spot rate is for immediate action, but immediate means two days

Exchange rates are determined by

the demand and supply for different currencies

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

currency speculation

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

currency swap

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

exchange rate

is used to convert the currency of one country into the currency of another provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates

foreign exchange market

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

foreign exchange risk

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

forward exchange

is the rate used for these transactions rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

forward exchange rate

To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in

forward exchanges

A firm that insures itself against foreign exchange risk is

hedging

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

is not always effective

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

lag strategy

Most countries today practice free convertibility but

many countries impose restrictions on the amount of money that can be converted

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

Lead Strategy

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

Technical analysis

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

The foreign exchange market

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

Transaction exposure

the impact of currency exchange rate changes on the reported financial statements of a company concerned with the present measurement of past events gains or losses are "paper losses" they are unrealized

Translation exposure -

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

arbitrage

the process of buying a currency low and selling it high

arbitrage

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

bandwagon effect

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

Countries limit convertibility to preserve foreign exchange reserves and prevent

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

capital flight

When a currency is nonconvertible, firms may turn to

countertrade

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

countertrade

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

spot rates change continually depending on

the supply and demand for that currency and other currencies

High-speed computer linkages between trading centers mean

there is no significant difference between exchange rates in the differing trading centers

Most transactions involve dollars on one side—it is a

vehicle currency