Chapter 10

Power parity puzzle

Failure to find link between inflation rates and exchange rates

Inflation

.when the money supply increases faster than output increases. increase in the money supply makes it easier to borrow, which increases demand for goods and services. A country with a high inflation rate will see depreciation in its currency exchange rate. Gov policy determines growth rate

foward exchange rate

.when two parties agree to exchange currency and execute the deal at some specific date in the future. Usually quoted for 30, 90, and 180 days.

Empirical tests of P P P theory:

•Exchange rates are determined by relative prices; changes in relative prices result in a change in exchange rates. •Accurate in the long run, but not a strong predictor of short-run movements in exchange rates five years or less. •Best predicts exchange rate changes for countries with high rates of inflation and underdeveloped capital markets.

Ineicent market

•Inefficient market is when prices do not reflect all available information. •Forward exchange rates will not be the best possible predictors of future spot exchange rates.

Currency swaps:

•Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. •Transacted between international businesses and their banks, between banks, and between governments. •Common type: spot against forward.

Technical analysis:

•Uses price and volume data to determine past trends, which are expected to continue. •There are analyzable market trends and waves that can be used to predict future trends and waves. •Has gained favor in recent years.

Business use the forgein exchange market to...

1. Convert payments received for its exports, income received from foreign investments, or income received from licensing agreements with foreign firms. 2.Make payment to a foreign company for its products or services in its country's currency. 3.Invest cash for short terms in foreign money markets. 4.Engage in currency speculation. •Carry trade.

Reducing Translation and Transaction Exposure

1. Forward exchange rate contracts. 2.Buying swaps. 3.Lead strategy. •Collect foreign currency receivables early. 1.Lag strategy. •Delay the collection of foreign currency receivables.

Three forms of currency convertibility:

1. Freely convertible 2. Externally convertible 3. Nonconvertible

Reasons for power parity puzzle

Assumes away transportation costs and barriers to trade, while these factors are significant and create price differentials between countries. •Price discrimination by dominant enterprises. •Governments attempt to influence the value of their currencies.

Future Exchange Rate

Cannot be accurately predicted

The law of one price:

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.

Limited convertibility

Governments limit convertibility to preserve their foreign market reserves. Capital flight occurs when there is a rush to convert domestic currency into foreign currency. •Most likely to occur when domestic currency value is depreciating rapidly.

Purchasing power parity (P P P):

Relative ability of two countries' currencies to buy the same "basket" of goods in those two countries Comparison of prices of identical products determine the real or P P P exchange rate. •An efficient market has no impediments to the free flow of goods and services. •The price of a "basket of goods" should be roughly equivalent in each country. •Big Mac Index.

The Foreign Exchange Market

a market in which currencies of different countries are bought and sold provides some insurance against foreign exchange risk.

Transaction Exposure

currency risk that firms face when outstanding accounts receivable or payable are denominated in foreign currencies

Economic Exposure

extent to which a firm's future international earning power is affected by changes in exchange rates. Reduce it by... 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.

Translation Exposure

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

Interest rates

reflect expectations about likely future inflation rates.

Arbitrage

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

Fisher effect

the relationship between nominal returns, real returns, and inflation

Exchange rate

the value of a currency in one country compared with the value in another