International Business Ch.10

3 factors impact future exchange rate movements

1. a country's price inflation 2. a country's interest rate 3. market psychology

3 types of foreign exchange risk

1. transaction exposure 2. translation exposure 3. economic exposure

Foreign exchange market

1. used to convert the currency of one country into the currency of another 2. provides some insurance against foreign exchange risk

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

Law of one price

states that in competitive markets free of transportation costs/barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in the terms of the same currency

Foreign exchange risk

the adverse consequences of unpredictable changes in exchange rates

3. Economic exposure

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

1. Transaction exposure

the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

2. Translation exposure

the impact of currency exchange rate changes on the reported f/s statements of a company (g/l "paper losses")

A currency is nonconvertible

when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

A currency is externally convertible

when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way

To insure/hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges

where two parties agree to exchange currency and execute the deal at some specific date in the future; rates are usually quoted 30,90,180 days into the future

Vehicle currency

dollars bc most transactions involve dollars on one side

hedging

a firm that insures itself against foreign exchange risk

Purchasing power parity theory (PPP)

argues that given relatively efficient markets the price of a "basket of goods" should be roughly equivalent in each country

When a currency is nonconvertible, firms may turn to countertrade

barter-like agreements where goods/services are traded for other goods/services

International companies use the foreign exchange market when

the pmts they receive for exports, income from investments, or licensing agreements; must pay in country's currency; spare cash to invest; involved in currency speculation

the foreign exchange market provides insurance to protect against foreign exchange risk

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

Spot exchange rate

the rate at which a foreign exchange dealer converts one currency into another on a particular day (depends on supply/demand)

Currency speculation

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

A currency is freely convertible

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