MGMT 3225 Lecture Notes - Lecture 8: Foreign Exchange Market, Foreign Exchange Risk, Foreign Exchange Spot
Chapter 8: Foreign Exchange Market
Introduction
Three main objectives:
1. Explain how the foreign exchange market works
2. Examine the forces that determine the exchange rates and discuss the degree to which it is
possible to predict future exchange rate movements
3. Map the implications for international business of exchange rate movements
● Foreign Exchange Market- market for converting the currency of one country into that of
another country
● Exchange Rate: The rate at which one currency is converted into another
● Ex: Toyota uses the foreign exchange market to convert the dollars it earns from selling cars
in the United States into Japanese yen.
● Foreign exchange market is the lubricant that enables companies based in countries that use
different currencies to trade with each other.
● One function of the foreign exchange market is to provide some insurance against the risks
that arise from such volatile changes in exchange rates, commonly referred to as foreign
exchange risk
Functions of the Foreign Exchange Market
The foreign exchange market serves two main functions:
1. Convert the currency of one country into the currency of another.
2. Provide some insurance against foreign exchange risk,
● Foreign Exchange Risk: The adverse consequences of unpredictable changes in exchange
rates.
● The exchange rate allows us to compare the relative prices of goods and services in different
countries
International Business Four main uses of Foreign Exchange Market:
1. The payments a company receives for its exports, the income it receives from foreign
investments, or the income it receives from licensing agreements with foreign firms
may be in foreign currencies. To use those funds in its home country, the company
must convert them to its home country's currency.
2. International businesses use foreign exchange markets when they must pay a
foreign company for its products or services in its country's currency.
3. International businesses also use foreign exchange markets when they have spare
cash that they wish to invest for short terms in money markets
4. Currency speculation: The short-term movement of funds from one currency to
another in the hopes of profiting from shifts in exchange rates.
● Very risky business
● Speculator can make profit if speculation about future currency movements is
correct. If speculation not correct can lose money instead
● Carry Trade: Borrowing in one currency where interest rates are low and then using the
proceeds to invest in another currency where interest rates are high
○ Speculative element of this trade is that its success is based on a belief that there will
be no adverse movement in exchange rates (or interest rates for that matter) that will
make the trade unprofitable
● Spot Exchange: Two parties agree to exchange currency and execute the deal immediately
● Spot Exchange Rate: Rate at which a foreign exchange dealer converts one currency into
another on a particular day
○ Reported on a real-time basis on financial websites
○ Can be quoted in two ways:
1. The amount of foreign currency one U.S. dollar will buy
2. The value of a dollar for one unit of foreign currency
● The value of a currency is determined by the interaction between the demand and supply of
that currency relative to the demand and supply of other currencies
● To insure or hedge against this risk, the U.S. importer might want to engage in a forward
exchange.
○ Forward Exchange: When two parties agree to exchange currency and execute a
deal at some specific date in the future.
○ Forward Exchange Rates: Exchange rates governing such future transactions
○ For most major currencies, forward exchange rates are quoted for 30 days, 90 days,
and 180 days into the future.
○ In some cases, it is possible to get forward exchange rates for several years into the
future.
○ When a firm enters into a forward exchange contract, it is taking out insurance
against the possibility that future exchange rate movements will make a transaction
unprofitable by the time that transaction has been executed
○ Forward instruments account for almost two-thirds of all foreign exchange
transactions, while spot exchanges account for about one-third
● Currency Swap: Simultaneous purchase and sale of a given amount of foreign exchange for
two different value dates
○ Swaps are transacted between international businesses and their banks, between
banks, and between governments when it is desirable to move out of one currency
into another for a limited period without incurring foreign exchange risk
○ Common kind of swap is spot against forward
Nature of the Foreign Exchange Market
● The most important trading centers are London (37 percent of activity), New York (18
percent of activity), and Zurich, Tokyo, and Singapore (all with around 5 to 6 percent of
activity). Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney.
Two features of Foreign Exchange Market:
1. The market never sleeps
○ Tokyo, London, and New York are all shut for only 3 hours out of every 24
○ During these three hours, trading continues in a number of minor centers, particularly
San Francisco and Sydney, Australia
2. Integration of the various trading centers
● Arbitrage: The purchase of securities in one market for immediate resale in another to profit
from a price discrepancy.
Economic Theories of Exchange Rate Determination
● At the basic level exchange rates are determined by the demand and supply of one currency
relative to the demand and supply of another
○ Ex: If the demand for dollars outstrips the supply of them and if the supply of
Japanese yen is greater than the demand for them, the dollar/yen exchange rate will
change. The dollar will appreciate against the yen (or the yen will depreciate against
the dollar)
● Understanding how exchange rates are determined helps us forecast the exchange rate
movements
● Future exchange rate movements influence export opportunities, the profitability of
international trade and investment deals, and the price competitiveness of foreign imports,
this is valuable information for an international business
Three factors that impact future exchange rates in a country’s currency:
1. Country's price inflation
2. Interest rate
3. Market psychology
● Law of one price: In competitive markets free of 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
Document Summary
Chapter 8: foreign exchange market: explain how the foreign exchange market works, examine the forces that determine the exchange rates and discuss the degree to which it is possible to predict future exchange rate movements. Map the implications for international business of exchange rate movements. Foreign exchange market- market for converting the currency of one country into that of another country. Exchange rate: the rate at which one currency is converted into another. Ex: toyota uses the foreign exchange market to convert the dollars it earns from selling cars in the united states into japanese yen. Foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other. One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk.
