International Business Chapter 10

A weaker currency makes exports inexpensive

(or at least cheaper) to foreigners, which can lead to higher exports and job creation in the export sector.

Interest Rates and Exchange Rates(Exchange Rate Determination)

1.Fisher effect 2. International Fisher effect

Various Types of Currencies

1.Freely convertible residents 2.Externally convertible 3.Nonconvertible

Approaches to Forecasting

1.Fundamental Analysis: Draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates 2.Technical Analysis: Uses price and volume data to determine past trends that are expected to continue—many economists are skeptical of this type of analysis

Prices and Exchange Rates(Exchange Rate Determination)

1.Law of one price 2.Purchasing power parity (PPP)

Economic Theories of Exchange Rate Determination

1.Prices and Exchange Rates 2.Interest Rates and Exchange Rates 3.Investor Psychology and Bandwagon Effects

Exchange Rate Forecasting

1.The Efficient Market School 2.The Inefficient Market School 3.Approaches to Forecasting

service its international debt commitments and to purchase imports

A country needs an adequate supply of these reserves to

Hedging

A firm that protects itself against foreign exchange risk is called

Foreign Exchange Market

A market is a market for converting the currency of one country into that of another country.

Reducing Translation and Transaction Exposure

Buy Forward-Use Swaps(Lead and Lag Strategy)

Lead Strategy

Collect foreign currency receivables early when a foreign currency is expected to depreciate Paying foreign currency payables before they are due when a currency is expected to appreciate

Lag Strategy

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

Fundamental Analysis

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

Functions of the Foreign Exchange Market

Enables the conversion of the currency of one country into the currency of another Provides some insurance against foreign exchange risk

Foreign Exchange Rate Risk

Firms must understand the influence of exchange rates on the profitability of trade and investment deals 1. Transaction Exposure 2. Translation Exposure 3. Economic Exposure

The Inefficient Market School(Exchange rate Forecasting)

Forward exchange rates are not the best predictors of future spot exchange rates Companies should invest in forecasting services to take advantage The track record of professional forecasting services however, is not that good

foreign exchange reserves

Governments limit convertibility to preserve their

Foreign Exchange Rate

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) Most transactions involve U.S. dollars on one side:the U.S. dollar is a vehicle currency

Money Supply and Price Inflation(Exchange Rate Determination)

If we can predict inflation rates, we can predict how a currency's value might change The growth of a country's money supply determines its likely future inflation rate When the growth in the money supply is greater than the growth in output, inflation will occur

The Efficient Market School (Exchange Rate Forecasting)

Many economists believe the foreign exchange market is efficient at setting forward rates. Forward exchange rates best predictors of future spot exchange rates. A company cannot beat the market by investing in forecasting services.

Bandwagon Effects

Movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions. When expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations.

Investor Psychology and Bandwagon Effects(Exchange Rate Determination)

Movement of traders like a herd, all in the same direction and at the same time, in response to each other's perceived actions. When expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations.

Summary of Exchange Rate Theories

Poor predictors of short-run due to psychological factors, investor expectations and bandwagon effects International businesses should pay attention to countries' differing monetary growth, inflation, and interest rates

Summary of Exchange Rate Theories

Relative monetary growth, relative inflation rates, and nominal interest rate differentials Moderately good predictors of long-run changes in exchange rates, but poor predictors of short term changes

Currency speculation is another use of foreign exchange markets

Short-term movement of funds from one currency to another to profit from shifts in exchange rates

Currency Swaps

Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Swaps are used when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

Spot Exchange Rate

The exchange rate at which a foreign exchange dealer will convert one currency into another that particular day.

Economic Exposure

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

Transaction Exposure

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

Translation Exposure

The impact of currency exchange rate changes on the reported financial statements of a company

Hedging

The market performs this function using spot exchange rates, forward exchange rates and currency swaps to protect against foreign exchange risks

Exchange Rate

The rate at which one currency is converted into another.

Foreign Exchange Risk

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

Foreign Exchange Risk

The risk that changes in exchange rates will hurt the profitability of a business deal.

Exchange rates are critically important in the global economy

They affect the price of every country's imports and exports, companies' foreign direct investment, and—directly or indirectly— people's spending behaviors.

capital flight

This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency called

Currency Conversion

To convert export receipts, income received from foreign investments, or income received from licensing agreements To pay a foreign company for products or services To invest spare cash for short terms in money markets Exploit=Currency Speculation

Technical Analysis

Uses price and volume data to determine past trends that are expected to continue—many economists are skeptical of this type of analysis

Foreign exchange markets

are made up of banks, commercial companies, central banks, investment management firms, hedge funds, and retail forex brokers and investors.

Purchasing Power Parity (PPP)

assumes away transportation costs, trade barriers and government intervention which can be significant

Carry trade

borrows one currency where interest rates are low and invests these in another currency where interest rates are high

The foreign exchange market

can provide insurance against foreign exchange risk

In the case of a nonconvertible currency

firms may turn to countertrade (barter like agreements by which goods and services can be traded for other goods and services) to facilitate international trade.

Purchasing power parity (PPP) states

given relatively efficient markets (few impediments to international trade and investment exist) the price of a "basket of goods" should be roughly equivalent in each country

that large-scale currency speculation

has the potential to adversely affect global markets.

foreign exchange reserves

limit convertibility to preserve their______________. A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports.

It can be argued that Currency speculation

may have a strong negative effect on some countries' economic foundation (e.g., Iceland). For years, Iceland was a respected country for its unmatchable standards of living.

Purchasing Power Parity theory (PPP)

may not hold if many national markets are dominated by a handful of multinational enterprises

A forward exchange

occurs when two parties agree to exchange currency and execute the deal at some specific date in the future _______________ rates are typically quoted for 30, 90, or 180 days into the future Can sometimes work against a company

Externally convertible

only non-residents can convert their holdings of domestic currency into a foreign currency

Purchasing power parity (PPP)

predicts that changes in relative prices will result in changes in exchange rates When inflation is relatively high, a currency should depreciate and vice-versa

Countertrade

refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country's currency is nonconvertible.

Nonconvertible

residents and non-residents prohibited from converting holdings of domestic currency into foreign

Freely convertible

residents*non-residents can purchase any amounts of foreign currency with the domestic currency

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). That is, i = r + I. For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. The real rate is the nominal rate minus inflation.

Purchasing Power Parity(PPP) puzzle

the failure to find a strong link between inflation and exchange rate movements

Governments typically impose convertibility restrictions on their currency

when they fear that free convertibility will lead to a run on their foreign exchange reserves

The foreign exchange market

is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems The market is always open somewhere in the world

The foreign exchange market

is considered the largest financial market in the world.

Inefficient market

is one in which prices do not reflect all available information

An efficient market

is one in which prices reflect all available public information.

The foreign exchange market

is the market in which participants are able to buy, sell, exchange and speculate on currencies.

The International Fisher Effect

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 rates between countries. More formally, (S1 - S2) / S2 x 100 = i $ - i ¥

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 price is expressed in terms of the same currency