Global - Chapter 10 - Foreign Exchange Market
CUrrency Conversion
4 main uses for FOREX markets: FOREX - Functions of the Foreign Exchange Market 1) Receipt of payments though exports, investments, or licensing 2) Payments for products or services to a foreign country in its currency 3) Use of foreign exchange markets for investments when firms have spare cash 4) Currency speculation, short term movement of funds from one currency to another to profit from shifts in currency exchange
Transaction exposure
is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Impact of Foreign Exchange rates on financial statements
externally convertible
when only non-residents can covert their holdings of domestic currency into a foreign currency
PPP - Purchasing Power Party
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. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.) A less extreme version of the PPP theory states
nonconvertible
when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
freely convertible
when both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency
Currency speculation
is the practice of engaging in risky financial transactions in an attempt to profit from fluctuations in the market value of a tradable good such as a financial instrument, rather than attempting to profit from the underlying financial attributes embodied in the instrument such as capital gains, interest, or dividends
Bandwagon effect - investor psychology
occurs when traders join the bandwagon of expectations often set by idiosyncratic politicians and they move exchange rates based on group expectations governmental intervention can prevent the bandwagon from starting, but is not always effective
Interest rates and Exchange rate Determination
Interest rates reflect expectations about likely future inflation rates. If interest is high, inflation is high
What three factors are important to future exchange rates?
1. A country's price inflation 2. A country's interest rate 3. Market psychology
Inflation and FOREX market
In the foreign exchange market, this same increase in a countries money supply (US currency) as opposed to output (that people can purchase) creates: the currency to become plentiful against other currencies in the Foreign exchange market, where monetary growth is slow (output matches growth) and the US dollar then depreciates against these other currencies.
inflation
Is the rise in the general level of prices of goods and services in an economy over a period of time When the general price level rises, each unit of currency buys fewer goods and services Consequently, inflation reflects a reduction in the purchasing power per unit of money - a loss of real value in the medium of exchange and unit of account within the economy A chief measure of price inflation is the inflation rate, the annualized percentage change in a general price index over time
Positive and Negative Effects of inflation
Negative effects of inflation include an increase in the opportunity cost of holding money, uncertainty over future inflation which may discourage investment and savings, and if inflation is rapid enough, shortages of goods as consumers begin hoarding out of concern that process will increase in the future Negative effects include ensuring that central banks can adjust real interest rates and encouraging investment in non-monetary capital projects During inflation, government increases money supply, makes it easier for banks to borrow from the government and for people to borrow from the banks The increase in credit causes increase in demand for goods and services Out put of goods and services needs to grow at the same rate to avoid excess supply creating inflation
Money Supply and Price Inflation
There is a positive relationship between the inflation rate and the level of money supply. When the growth in a country's money supply is greater than the growth in its output, inflation will occur. A country with a high inflation rate will see its currency depreciate
Are there other strategies to manage foreign exchange risk?
To further manage foreign exchange risk, firms should establish central control to protect resources and ensure that each subunit adopts the correct mix of tactics and strategies distinguish between transaction, translation, and economic exposure attempt to forecast future exchange rates establish good reporting systems produce monthly foreign exchange exposure reports
Inflations and Recessions
Today, most economists favor a low and steady rate of inflation. Low (as opposed to zero or negative) inflation reduces the severity of economic recessions by enabling the labor market to adjust more quickly in a downturn. The task of keeping the rate of inflation low and stable is usually given to monetary authorities. Generally, these monetary authorities are the central banks that control monetary policy through the setting of interest rates.
How can firms minimize translation and transaction exposure?
buy forward: A forward contract in the forex market that locks in the price at which an entity can buy or sell a currency on a future date. Also known as "outright forward currency transaction", "forward outright" or "FX forward". use swaps: A swap is a derivative in which counterparties exchange cash flows of one party's financial instrument for those of the other party's financial instrument. Swaps can be used to hedge certain risks such as interest rate risk, or to speculate on changes in the expected direction of underlying prices. Lead and Lag. Payables and receivables - paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements
arbitrage
buying currency low and selling it high The U.S. dollar frequently serves as a vehicle currency to facilitate the exchange of two other currencies.
Translation exposure
is the impact of currency exchange rate changes on the reported financial statements of a company. concerned with the present measurement of past events Investments in subsidiaries in countries where the money is depreciating against the dollar, significantly reduces the value of your equity overseas , so the paper value on your balance sheet (debt/ equity ratio) changes, this could affect borrowing and access to capital markets
Carry trade
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
is a market for converting the currency of one country into that of another country
Exchange Rate
is simply the rate at which one currency is converted into another Exchange rates are determined by demand and supply of one currency relative to the demand and supply of another.
Economic exposure
is the extent to which changes in exchange rates affect a firm's future international earnings power. Firms future earning power is affected by changing exchange rate movements.
Law of one price
states that in competitive markets free 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
Forward exchange rate
the exchange rate governing a transaction in which two parties agree to exchange currency and execute the deal at some specific date in the future
Spot exchange rate
the rate at which a foreign exchange dealer converts one currency into another currency on a particular day
Currency Swap
the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
