Chapter 10
if the interest rate in Canada is 6.5% and the interest rate in the US is 4%, the international Fisher effect predicts that
Canada's currency will depreciate by 2.5% against the US dollar
true or false: most companies pay attention to economic exposure than translation exposure
FALSE!
major secondary trading centers include
Frankfurt, Paris, Hong Kong, and Sydney
the most important foreign exchange trading centers are
London (37 percent of activity) New York (18 percent of activity) Zurich, Tokyo, Singapore (all with around 5 to 6 percent of activity)
true or false: the gains or losses identified by translation exposure are on paper only
TRUE!
in the foreign exchange market, it is difficult to profit through ________ because few opportunities appear and they disappear just as quickly
arbitrage
according to the fisher effect, if the real interest rate in country #1 is 8% and it is 5% in country #2, an investor should
borrow from #2 and invest in #1
arbitrage
buying a currency low and selling it high // the purchase of securities in one market for immediate resale in another to profit from a price discrepancy
which type of control of exposure is MOST effective at protecting resources efficiently and ensuring that each subunit adopts the correct mix of tactics and strategies?
centralized control of exposure
_______ agreements are barter-like agreements used by countries whose currency is NOT convertible
countertrade
when general electric won a contract for a $150 million generator project in romania, it agreed to take payment in the form of romanian goods that could be sold for $150 million on international markets. this is an example of
countertrade
_________ typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
currency speculation
a ________ swap involves two parties that exchange currency with one another in order to gain exposure to a desired currency
currency swap
exchange rates are set by the interaction of ________ of one currency compared to those of another currency
demand and supply
a key to reducing economic exposure involves ______ so the firm is not severely affected by adverse changes in exchange rates
distributing a firm's productive assets to various locations
_______ exposure has a direct effect on a firm's future international earning power
economic exposure
a market in which prices reflect all available public information is considered to be ________
efficient
if the foreign exchange market is _______, forward exchange rates should be ________ predictors of future spot rates
efficient; unbiased
the rate of converting one form of currency into another country's usable currency is known as the _______ rate
exchange rate
PPP (purchasing power parity) predicts that changes in relative prices will result in a change in
exchange rates
Economic theory tells us that interest rates reflect
expectations about likely future inflation rates.
foreign exchange rates are exchange rates that govern _________ transactions
future
an efficient market
has no impediments to the free flow of goods and services, such as trade barriers // this is a market in which prices effect all available information
In countries where inflation is expected to be high,
interest rates also will be high (because investors want compensation for the decline in the value of their money). This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect.
lag strategy
involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate
volatile
liable to change rapidly and unpredictably, especially for the worse (uneasy, uncomfortable, tense)
economic exposure is concerned with the ______-term effect of changes in exchange rates on future prices, sales, and costs
long-term
the text suggests that as a way to take control of exchange rate risk, firms should produce ________ foreign exchange reports.
monthly
bandwagon effect
movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceive actions
countertrade is a logical choice when a country's currency is
nonconvertible
inefficient market
one in which prices do not reflect all available information
if the spot exchange rate is $1 to 110 Yen and the 90-day forward rate is $1 to 100 Yen, then the Yen is selling at a ______ to the dollar in the 90-day forward market.
premium
when the growth in a country's money supply is faster than the growth in its output, ________ tends to increase
price inflation
the impact of psychological factors and investor expectations make it difficult for exchange rate theories to predict _______ changes in exchange rates
short-term
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) i = r + l
three factors have an important impact on future exchange rate movements in a country's currency:
the country's price inflation, its interest rate, and market psychology
spot exchange rate
the exchange rate at which a foreign exchange dealer will convert one currency into another that particular day -the exchange rate is the spot rate for the day
forward exchange rates
the exchange rate governing a forward exchange transaction
the purchasing power parity puzzle
the failure to find a strong link between relative inflation rates and exchange rate movements
translation exposure
the impact of currency exchange rate changes on the reported financial statements of a company -Translation exposure is 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.
exchange rate
the rate at which one currency is converted into another
countertrade
the trade of goods and services for other goods and services
without the foreign exchange market,
the volume of international trade and international investment that we see today would be impossible-companies would have to resort to barter
nonconvertible currency
when neither residents nor nonresidents are allowed to convert it into a foreign currency
externally convertible currency
when only nonresidents may convert it into a foreign currency without any limitations
freely convertible currency
when the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it
forward exchange
when two parties agree to exchange currency and execute a deal at some specific date in the future
if the interest rate in country A is 8% and the interest rate in country B is 4%, the international Fisher effect predicts the value of country A's currency will depreciate by ___% against country B's currency
4%
true or false: spot against forward is a common type of currency swap
TRUE
carry trade
a kind of speculation that has become more common in recent years 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
foreign exchange market
a market for converting the currency of one country into that of another country // a decentralized market for the trading of currencies, including all aspects of buying, selling, and exchanging currencies at current or determined prices // facilitates international trade and investment by allowing conversion of currencies
hyperinflation
an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly
expectations becoming a self-fulfilling prophecy when currency traders move in the same direction at the same time is called the ______ effect
bandwagon
the PPP (purchasing power parity), according to research, seems to predict exchange rate movements best for countries in which two situations
countries with high inflation rates & countries with underdeveloped capital markets
the value of a currency is determined by the _________ of that currency relative to other currencies
demand and supply
a lead strategy occurs when a firm attempts to collect foreign currency receivables early when a currency is expected to ______ and pay foreign currency payables before they are due when a currency is expected to _______.
depreciate; appreciate
a tactic that reduces translation and economic exposure is
entering into forward exchange rate contracts
a policy of _______ convertibility is in place in some countries and places restrictions on residents' ability to convert domestic currency into a foreign currency
external convertibility
foreign exchange markets can provide some insurance against volatile changes in exchange rates, which is called foreign exchange ______
foreign exchange risk
a _______ is a special type of foreign currency transaction in which two parties agree to exchange two designated currencies at a specific time in the future
forward exchange
a firm that enters into a _______ exchange is taking out insurance against the possibility that unfavorable exchange rate movements will make transactions unprofitable
forward exchange
the method of forecasting that draws on economic theory to construct sophisticated models is called the ______ approach
fundamental approach -forecasting refers to predicting exchange rate movements. the variables that play a factor in this include relative money supply growth rates, inflation rates, and interest rates....may also include variables related to balance-of-payments positions
PPP (purchasing power parity) 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
an ________ is based on the theory which asserts that the market prices of common stocks and similar securities are not always accurately priced
inefficient market
what are the two schools of thought regarding the prediction of future exchange rates?
inefficient market school & efficient market school
when a country's money supply grows faster than the output of products/goods and services, this causes
inflation
interest rates reflect anticipated future
inflation rates
one main reason why the IFE (International Fisher Effect) is NOT good at explaining short-term exchange rate movements is the impact of _________ on those movements
investor psychology -Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. In turn, expectations have a tendency to become self-fulfilling prophecies.
lead strategy
involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables (to suppliers) before they are due when a currency is expected to appreciate
political
relating to the government or the public affairs of a country -governmental, government, local government, public, state, administrative
what are three moderately decent predictors of long-term changes in exchange rates
relative inflation rates, nominal interest rate differentials, relative monetary growth
a _________ exchange rate is the price to exchange one currency for another for immediate delivery
spot exchange
______ exposure involves the present measurement of past events using currency exchange changes on a company's financial statements
translation exposure
one function of the foreign exchange market
is to provide some insurance against the risks that arise from such volatile changes in exchange rates (commonly referred to as foreign exchange risk). however, it cannot provide complete insurance due to currency fluctuations/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 -even if a country outsources its supply to complete retail arbitrage, the country with the cheaper stock will eventually have a shortage in supply with the same amount of demand, so the prices will eventually equal each other in both nations
_____ analysis predicts the future by using price and volume data to determine past trends
technical analysis
_______ analysis is based on the premise that there are analyzable market trends and that these past trends can be used to predict future trends
technical analysis
international businesses use foreign exchange markets for what three reasons
-to convert foreign currencies it receives from transactions into its own currency -to invest spare cash for short terms in money markets -to pay a foreign company for its products or services in its country's currency
two main functions of the foreign exchange market
1. convert the currency of one country into the currency of another 2. provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates.
true or false: government intervention in the foreign exchange markets does NOT affect the ability of PPP (purchasing power parity) in predicting exchange rate movements
FALSE. -"governments routinely intervene in international trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the Page 283same product in different countries, which is required for the law of one price to hold. 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."
true or false: if we could determine how exchange rates are regulated, we might be able to identify exchange rate movements
TRUE -Because 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. Unfortunately, there is no simple explanation. The forces that determine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day.
true or false: if many national markets are controlled by a few multinational enterprises with the power to influence prices and distribution channels, PPP (purchasing power parity) theory may not hold.
TRUE. -PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations.14 In fact, this situation seems to prevail in a number of industries. In such cases, dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, 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.
currency speculation
involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates // involves buying, selling, and holding currencies in order to make a profit from favorable fluctuations in exchange rates ex. "Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million × 120 = ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 = ¥100. Now the company exchanges its ¥1.2 Page 275billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million! In general, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong."
efficient market
one in which prices reflect all available public information
identical products sold in different countries must sell for the same price in competitive markets when their price is expressed in terms of the same currency. this is called the law of
one price
the effects of investor psychology are hard to predict because it can be influenced by ________ factors
political -"Investor psychology can be influenced by political factors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behavior of politicians. Something like this seems to have occurred in Southeast Asia during 1997 when, one after another, the currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 and 70 percent of their value against the U.S. dollar in a few months."
the _______ exchange rate states that given relatively efficient markets, the price of a product should be roughly equivalent in each country
purchasing power parity (PPP)
international fisher effect (IFE)
states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries. Stated more formally, the change in the spot exchange rate between the United States and Japan, for example, can be modeled as follows: (S1−S2)/S2×100=i$−i¥ where i$ and i¥ are the respective nominal interest rates in the United States 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. If the U.S. nominal interest rate is higher than Japan's, reflecting greater expected inflation rates, the value of the dollar against the yen should fall by that interest rate differential in the future. So if the interest rate in the United States is 10 percent and in Japan it is 6 percent, we would expect the value of the dollar to depreciate by 4 percent against the Japanese yen.
spot rates
the current exchange rates at which specific currencies can be bought or sold on currency exchange markets
what currency is most commonly involved in foreign exchange transaction
the dollar!
economic exposure
the extent to which a firm's future international earning power is affected by changes in exchange rates -Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs.
transaction exposure
the extent to which 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.
If the law of one price were true for all goods and services,
the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. 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.
the fisher effect equates the nominal interest rate as
the required real interest rate + expected rate of inflation
foreign exchange risk
the risk that changes in exchange rates will hurt the profitability of a business deal
currency swap
the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
what are the two most prominent features of the foreign exchange markets?
the trading centers are integrated & the market never sleeps
_______ exposure is the risk, faced by companies involved in international trade, that currency exchange rates will change after the companies have already entered into financial obligations. such exposure to fluctuating exchange rates can lead to major losses for firms
transaction exposure
suppose a company agrees to buy products in 2014 with payment due in 2015. _______ exposure refers to money lost due to an adverse movement in exchange rates between the time the deal is signed and the time when the products are paid for
transaction exposure