Chapter 10
Purchasing Power Parity (PPP)
Argues that given relatively efficient markets the price of a "basket of goods" should be roughly equivalent in each country Predicts changes in relative prices will result in changes of exchange rates
When a currency is nonconvertible, firms may turn to
Countertrade: barter-like agreements where goods and services are traded for other goods and services. Only involves 10% of world trade, was more common in the past
How do you reduce economic exposure?
Distribute the firm's productive assets to various locations so the firm's long-term financial well-being is not severely affected by adverse changes in exchange rates.
How are exchange rates determined?
Exchange rates are determined by the demand and supply for different currencies
Do exchange rates differ between markets?
High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers IF exchange rates were not essentially the same, there would be an opportunity for arbitrage
Law of One Price (LOOP)
In the absence of trade frictions (such as transport costs and tariffs), and under conditions of free competition and price flexibility (where no individual seller or buyer has the power to manipulate prices and prices can freely adjust), identical goods sold in different locations must sell for the same price when prices are expressed in a common currency. (Opportunity for Arbitrage until equalized) ($1 = .78 Euro, a $50 jacket in New York should be <50 x .78> 39.24 Euro)
Currency Speculation
Involves short-term movement of funds from one currency to another in hopes of profiting from shifts in exchange rates.
Are all currencies freely convertible?
Most countries today practice free convertibility, but many countries impose restrictions on the amount that can be converted. Countries limit convertibility to preserve foreign exchange reserves and prevent capital flight
Externally Convertible Currency
Nonresidents can convert their holdings of domestic currency into foreign currency, but the ability of residents to convert the currency is limited in some way.
Foreign Exchange Risk
The adverse consequences of unpredictable changes in exchange rates
Forward Exchange Rate
The agreed-upon exchange between two parties and execute the deal at a specific time in the FUTURE (30, 90 180) Used to hedge against possible adverse exchange rate movements
What is the Nature of the Foreign Exchange Market?
The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems Average in March 1986 was $200 billion, April 2010 was $4 trillion per day New York, Zurich, Tokyo, Singapore, London MARKET NEVER SLEEPS ALWAYS OPEN SOMEWHERE IN THE WORLD
Exchange Rate
The rate at which one currency is converted into another. (Events in the foreign exchange market affect firm sales, profits and strategy)
Managers need to consider three types of foreign exchange risk...
Transaction Exposure, Translation Exposure, and Economic Exposure.
Should companies use exchange rate forecasting services?
Two schools of thought 1. Efficient Market School: forwards exchange rates do the best job of forecasting the future spot exchange rates, and therefore, investing in forecasting services would be a waste of money. 2. Inefficient Market School: Companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services.
How are exchange rates predicted?
Two schools of thought on predicting: 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 charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves
Big Mac Index
a measure created by the Economist magazine that compares the value of currencies by comparing the cost of a Big Mac hamburger in different countries. The United States is used as the baseline cost for the index
Technical Analysis
charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves
Inefficient Market School
companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services
Fundamental Analysis
draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates
Efficient Market School
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
Currency Swap
simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Borrow domestically than swap for lower interest rates. - Between international businesses and their banks - Between banks - Between government when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk.
Spot Exchange Rate
the exchange rate at which a foreign exchange dealer will convert one currency into another that particular day (Continually depend on the supply and demand for that currency and others)
Economic Exposure
the extent to which a firm's future international earning power is affected by changes in exchange rates (The effect of unexpected currency fluctuations on a company's future cash flows, equity, foreign investments, and earnings)
Transaction Exposure
the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values (Currency exchange rates will fluctuate after a firm has already undertaken financial obligation)
How can firms hedge against foreign exchange risk?
the foreign exchange market provides insurance to protect against foreign exchange risk Hedging (Reduces potential risk, also lowers potential gains)
Translation Exposure
the impact of currency exchange rate changes on the reported financial statements of a company (Company's assets, liabilities, or income will change in value because of exchange rate changes)
capital flight
the movement (flight) of capital from one nation to another, via jobs and resources
Arbitrage
the purchase of securities in one market for immediate resale in another to profit from a price discrepancy
Freely Convertible Currency
when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency
Nonconvertible Currency
when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency
International companies use the foreign exchange market when:
-payments they receive from exports, FDI, or licensing agreements are in other currencies -Need to pay a foreign country back in that country's currency -Spare cash they want to invest for short-term -Involved in Currency Speculation
What Three factors impact future exchange rate movements?
1. A country's inflation 2. A country's interest rate 3. Market psychology
How can managers minimize exchange rate risk?
1. Have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. 2. Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other. 3. Attempt to forecast future exchange rates. 4. Establish good reporting systems so the central finance function can regularly monitor the firm's exposure position. 5. Produce monthly foreign exchange exposure reports.
Vehicle Currency
A currency used as a vehicle for international trade or investment, Japanese Yen, The Euro, The British Pound, The U.S. Dollar 85% of all FOREX transactions involve U.S. Dollar
Foreign Exchange Market
A global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems
How do prices influence exchange rates?
A positive relationship exists between the inflation rate and the level of money supply. When the growth in the money supply is greater than the growth in output, inflation will occur. (one of the three factors)
