Chapter 10: Foreign Exchange Market

What 3 factors influence / impact future exchange rate movement?

-These 3 factors help determine exchange rates 1. A countries price inflation 2. A countries interest rate 3. Market psychology

What is the Bandwagon Effect?

1. The bandwagon effect 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

What is spot rates?

1. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day. - Spot rates change continually depending on the supply and demand for that currency and other currencies. - 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

How does psychology and bandwagon effect perform in the short/long run?

1. They greatly influence short term exchange rate movements. 2. Government intervention can prevent the bandwagon from starting, but is not always effective

What is forward exchange rate?

1. To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges. - Two parties agree to exchange currency and execute the deal at some specific date in the future. - A forward exchange rate is the rate used for these transactions - Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future

What is vehicle currency?

1. Transactions that involve dollars on one side - Currency that is dominantly used, like the US dollar is used in 85% of the world, even between countries that don't include the US.

What is the Fisher Effect and International Fisher Effect?

>>Fisher effect: 1. Interest rates reflect expectations about likely future inflation rates. 2. Any difference in interest rates is due to different expectations about inflation rates >>International Fisher Effect: 1. The spot exchange rate at the beginning of the period and the spot exchange rate at the end of the period

What is hedging?

Hedging = To insure A firm that insures itself against foreign exchange risk

What is arbitrage?

The process of buying a currency low and selling if for a high price

What is currency speculation?

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

Should companies use exchange rate forecasting services?

Two schools of thought: 1. Efficient market school 2. Inefficient market school

What is the equation for Nominal Interest Rate?

*Fisher effect* i = r + l [Nominal interest rate = Real interest rate + Expected rate of inflation]

How does the PPP theory and the Law of One Price influence/determine exchange rates?

- How prices influence exchange rates: 1. The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency - Otherwise there is an opportunity for arbitrage until prices equalize between the two markets 2. Purchasing power parity theory (PPP) argues that given relatively efficient markets (a market with few impediments to the free flow of goods and services) the price of a "basket of goods" should be roughly equivalent in each country - Predicts that changes in relative prices will result in a change in exchange rates 3. A positive relationship exists between the inflation rate and the level of money supply - When growth of money supply is > growth goods/services = Inflation occurs 3. PPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run - A country with high inflation should see its currency depreciate relative to others

When/How is foreign exchange market used?

- International companies use the foreign exchange market when: 1. 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. 2. They must pay a foreign company for its products or services (e.g. supplies) in its country's currency. 3. They have spare cash that they wish to invest for short terms in money markets. 4. 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. - The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems

What is currency swap?

1. A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different dates. - E.x. Apple computers and Japan supplier/buyer 2. Swaps are transacted between: - International businesses and their banks. - Banks - & Governments when it is desirable to move out of one currency (e.x. Argentina) into another for a limited period without incurring foreign exchange rate risk

Inefficient Market School

1. Companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services. - An inefficient market is one in which prices do not reflect all available information - In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates - CONSIDER investing in forecasting services; BUT reputation isn't good

How are exchange rates determined?

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

What is an efficient market school?

1. 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. - An efficient market is one in which prices reflect all available information - If foreign exchange market is efficient then forward exchange rates should be unbiased predictors of future spot rates - SHOULDN'T waste $ on forecasting services

Do exchange rates differ between markets?

1. High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers 2. If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage

How does PPP Theory perform in the short/long run?

1. It is more accurate in the long-run, for countries with high inflation and underdeveloped capital markets. 2. It is less useful for predicting short-run term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates.

What are the theories of how exchange rates are determined?

1. PPP theory & law of one price 2. Fisher effect and international fisher effect 3. Bandwagon effect

How does interest rates influence exchange rates?

1. PPP theory = Connection between inflation & exchange rate 2. Fisher effect = Connection between inflation and interest rates

How well does PPP theory work?

Empirical testing of PPP theory suggests that: 1. It is most accurate in the long run, and for countries with high inflation and underdeveloped capital markets 2. it is less useful for predicting short term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates