IB: Chapter 10 - The Foreign Market Exchange

Money supply

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

Currency value =

Currency value is a function of import/export, price (inflation), interest rate, and psychology (e.g., greed and fear)

Two forecasting methods

Fundamental- often sophisticated econometric models are used for prediction interest rates, monetary policy Technical- past trends were projected into the future. past trends and waves

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 interest rates between two countries In other words: [(S1 - S2) / S2 ] x 100 = i $ - i ¥

Law of one price

states that in competitive markets free of transportation cost and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency otherwise there is an opportunity for arbitrage until prices equalize between the two markets

International companies use the foreign exchange market when:

the payments they receive for exports, the income they receive from foreign investments, or the income they receive the licensing agreements with foreign firms are in foreign currencies they must pay a foreign company for its products or services in its country's currency they have spear cash that they wish to invest for short terms in money markets they are involved in currency speculation-the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

How are exchange rates determines

determined by the demand and supply for different currencies

Three Currency Convertibility

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

Psychology

investor psychology and bandwagon effects greatly influence short term exchange rate movements

Inefficient market

is one in which prices do not reflect all available information Forecasting is needed but still not correct. Forecasters missed 1997 Asian crisis, 2008-dollar strength as opposed to prediction of weakness. Why fail? Due to uncontrollable and often unpredictable environmental and psychological factors.

Efficient market

is one in which prices reflect all available information no need for forecasting if forward rate is correct; forward rate is based on markets' participant predictions

Spot Exchange Rates

is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day it chances continually depending on the supply and demand for that currency and other currencies Spot exchange rates can be quoted as the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar for one unit of foreign currency

Exchange rate

is the rate at which one currency is converted into another events in the foreign exchange market affect firm sales, profits, and strategy

Currency Swap

is the simultaneous purchase and sale of a given amount of foreign exchange foe two different value dates between intl businesses and their banks between banks between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk

The foreign exchange market

is used to convert the currency of one country into the currency of another it provides some insurance against foreign exchange risk- the adverse consequences of unpredictable changes in exchange rates

Vehicle currency

most transactions involve dollars on one side 85% of all foreign exchange transactions involve the U.S. dollar

The 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

3 factors impact future exchange rate movements

a country's price inflation a country's interest rate market psychology

Purchasing power parity theory (PPP)

argues that given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a "basket of goods" should be roughly equivalent in each country

Foreign Exchange risk

the possibility that unpredicted changes in future exchanges rates will have adverse consequences for the firm foreign exchange market provides insurance to protect against foreign exchange risk a firm that insures itself against foreign exchange risk is called HEDGING

Arbitrage

the process of buying a currency low and selling it high

Three (3) Min Foreign Exchange Risk:

transaction exposure --- the income for individual transactions is affected by fluctuations in foreign exchange value translation exposure---The impact of currency exchange rate changes on the reported financial statements. Economic exposure ---- A firm's future earning power is affected by the exchange rate changes.

Forward exchanges

two parties agree to exchange currency and execute the deal at some specific date in the future is a rate used for these transactions: rate for currency exchange are typically quoted for 30,90,or 180 days into the future