chapter 10 international business

international businesses have 4 main uses of foreign exchange markets

1- payments for exports, income from FDI, income from licensing may be in foreign currency 2- when they must pay a foreign company for its products or services in their currency 3- when they have spare cash that they wish to invest for short terms in money markets 4- currency speculation - involves short term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates

3 factos have an important place on future exchange rate movements in a countries currency

1.) countries price inflation 2.) interest rate 3.) market psychology

freely convertible currency

a country currency is freely convertible when the government of that country allows both residents and non residents to purchase unlimited amount of foreign currency with the domestic currency

nonconvertablie currency

a currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency not desirable for international business

government policy determines whether the growth rate in a countries money supply is greater than the growth of an output

a government can increase the money supply by sampling telling the country's central bank to issue more money an international business should examine the countries policy toward monetary growth if they want to predict future movements in the value of a country's currency on the foreign exchange market (are they committed to controlling the growth rate in money supply, or do they lack political will to control the rate of growth?)

foreign exchange market

a market for covering the currently of one country into that of another country

efficient market

a market the has no incidents to the free flow of goods and searches

forward instruments account for

almost 2/3 of all foreign exchange transactions

carry trade

another kind of speculation - involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency w high interest rates

france, germany, 15 other members of euro zone

euro

PPP theory predicts that

exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates

interest rates reflect

expectation about likely future inflation rates

international fisher effect

for any 2 countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between countries -shows the link bw interest rates and exchange rates -not a good predictor of short run changes in sport exchange rates

PPP theory best predicts

for the long run, and also for countries with high rates of inflation and underdeveloped capital markets

foreign exchange market is a

global network of banks, brokers, and foreign exchange dealers connected by electronic communication systems

law of one price

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 pressed int he same currency

hedging

insures itself against foreign exchange rates

the value of currency is determined by the

interaction between demand and supply of that currency relative to the demand and supply of other currencies

a strong relationship seems to exist between

interest rates and inflation

in countries wehre infliction is expected to be high

interest rates will also be high, because investors want competition for the decline in the value of their money

when a firm enters a forward exchange contact

it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the transaction that has been executed

externally convertible currency

limitations on the ability of residents to convert domestic currency through nonresidents can convert their holding of domestic currency into foreign currency can limit domestic companies ability to invest abroad

most important trading centers of foreign exchange marker

london (37% of activity) - dominance is due to history and geography -first major industrial trading nation - its location is a critical link between the east asian and new york markets new york (18%) zurich, Tokyo, Singapore (5% each)

not universal

many countries place some restrictions on their residents ability to convert domestic currency into a foreign currency

although a foreign exchange transaction can involve any 2 currencieS

most transactions involve US dollar on ones side.

the market that

never sleeps

fisher effect

nominal interest rates in each country equal the required real rate of interest and the expected rate ion inflation over the period of time for which the funds are to be lent i = r +I

governments limit convertibility to preserve their foreign expanse reserves; when they fear that free convertibility will lead to a run for their foreign exchange reserves

occurs when residents and nonresidents RUSH to convert domestic currency into a foreign currency - known as capital flight; most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country economic prospects are shaky in other respects

relative monetary growth, relative inflation rates and nominal interest rate differentials are moderately good predictors

of long run changes in exchange rates

spot rates change continually

often on a minute by minute basis

GREAT BRTIAIN

pound

when growth of a countries money supply is great that the growth of its input

price inflation is fueled

arbitrage

purchase of securities in one market for immediate resale in another to profit from price disprecancy

exchange rate (XR)

rate at which one currency is converted into another

an increase in money supply makes it easier for banks to borrow from the government and for individual companies to borrow from the banks

resulting in an increase in credit, causes increased in demand for goods and services unless the output of goods and services is growing at a similar rate to that of the money supply, the rest will be inflation

one function of the foreign exchange market is to provide

some insurance against the risks that arise from such volatile changes in exchange rates

international trade and investment have their risks

someone of these risks exist because future exchange rates can not be perfectly predicted

when 2 parties agree to exchange currency and execute the deal immediately it is...

spot exchange rate

simple explanation of exchange rates being determined by the supply of one currency relative to the demand and supply of another does not reveal

what factors underlie the demand for and supply of a currency

forward exchange:

when 2 parties agree to exchange currency and execute a deal at a specific date in the future (ex 30, 60, 90, 120, 150 or 180 days)

in a world of many countries and unrestricted capital flows

when investors are free to transfer capital between countries, real interest rates will be the same in every country even if there were differences, arbitrage would soon equalize them if the real interest rate is the same worldwide any difference in interest rates between countries reflects differing expectations about inflation rates

japan

yen

importance as vehicle currency goes

us - euro - yen - pound

US dollar is a

vehicle transaction

the growth rate of a countries money supply determines its likely inflation rate

we can use this information about the growth in money supply to forecast exchange rate movements

US

DOLLAR

several factors may explain the failure of PPP theory to predict exchange rates more accurately

assumes say transportation costs and barriers to trade may not hold if many national markets are dominated by a handful of MNEs that have sufficient market power to be able to exercise influence over prices, control distribution channels and differentiate their product offerings between nations -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 arbitrage by differentiation otherwise identical products among nations such as design or packaging governments also intervene in the foreign exchange market in attempting to influence the value of their currencies the impact of investor psychology and other facets on currency purchasing decisions and change rate movements

the exchange rate allows us to

compare the relative prices of goods and services in different countries

capital flight

converting domestic currency into a foreign currency

a country in which inflation is running wild should expect to see its currency

depreciate against that of countries where inflation rates are lower

extensive empirical testing yielded mixed results

does not seem to be a short predictor of short run movements in exchange rates covering time spans of 5 years or less

foreign exchange risk

the adverse consequences of unpredictable changes in exchange rates

spot exchange rate

the exchange rate at which a foreign exchange dealer will cover currency into another that particular day

PPP theory

the exchange rate that would have mcdonalds hamburgers costing the same in each country if the law of 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 of PPP exchange that would exist is markets were efficient the exchange rate will change if relative prices change

forward exchange rates

the exchange rates governing forward exchange transactions

when a tourist changes one currency into antoher, she is participating in

the foreign exchange market

poor predictors of short run changes in exchange rates because

the impact od psychological factors, investor expectations and bandwagon effects on short term currency moments

the exchange rate is the rate at which

the market converts one currency into another

currency swap

the simultaneous purchase and sale of a given amount of foreign exchange for different value dates -transacted b/w international business and their banks, between banks and bw govts when it is desirable to move out of one currency into another for for a limited period without incurring foreign exchange risk common kind of swap - spot against forward apple both buys from and sells to japan

countertrade

the trade of goods and services for other goods and services one way top deal with the nonconvertability problem not very common now, the % of world trade that involves countertrade is probably significantly below 10%

foreign exchange market series 2 main fucntions

to convert the current of one country into another country's currency to provide some insurance against foreign exchange risk