Final Exam Study Notes - Chapter 9-The Foreign Exchange Market

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12 Oct 2010
MGT491 FINAL EXAM NOTES ± Chapter 9: The Foreign Exchange Market
x Most enterprises in the global economy are affected by changes in the value of currencies on the foreign exchange
x What happens in the foreign exchange market can have a serious impact on sales, profits and strategy of an
x Very important for managers to understand the working of the foreign exchange market and the potential impact of
changes in currency exchange rates for their enterprise
x Foreign exchange market ± a market for converting the currency of one country into that of another country
x Exchange rate ± the rate at which one currency is converted into another
x Without the foreign exchange market, international trade and international investment on a large scale as we see
today would be impossible ± companies would have to resort to bartering
x International trade and investment have risks ± some of which exist because future exchange rates cannot be
perfectly predicted
x One function of the foreign exchange market is to provide some insurance against the risks that arise from such
volatile changes in exchange rates ± foreign exchange risk
x Not unusual for international businesses to suffer losses because of unpredicted changes in exchange rates ±
currency fluctuations can make seemingly profitable trade and investment deals become unprofitable, and vice
The Functions of the Foreign Exchange Market
x 2 main functions ± convert the currency of one country into the currency of another, and provide some insurance
against foreign exchange risk (adverse consequences of unpredictable changes in exchange rates)
Currency Conversion
x Each country has a currency in which the prices of goods and services are quoted
x In general, within the borders of a particular country, one must use the national currency
x When you change one currency into another, you are participating in the foreign exchange market ± the exchange
rate is the rate at which the market converts one currency into another
x Exchange rate allows us to compare the relative prices of goods and services in different countries
x Tourists are minor participants in the foreign exchange market ±companies engaged in international trade and
investments are major players
x International businesses have 4 main uses of foreign exchange markets:
o 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 convHUWWKHPWRLWVKRPHFRXQWU\VFXUUHQF\
o When they have spare cash that they wish to invest for short terms in money markets ± rate of return it
earns on this investment depends not only on the interest rate in the country it invests in but also on
o Currency speculation ± typically involves the short-term movement of funds from one currency to
another in the hopes of profiting from shifts in the exchange rates ± ex. suspect that the value of the
dollar will fall against that of the yen, company will exchange a certain amount of dollars into yen, wait
until the exchange rate improves, and then change the money back into the dollar ± however this is
dangerous because companies cannot know for sure what will happen to exchange rates, and while
they could profit significantly if the speculation turns out to be correct, they could also lose a lot of
money if it turns out to be wrong
Insuring against Foreign Exchange Risk
x Foreign exchange risk ± the possibility that unpredicted changes in future exchange rates will have adverse
consequences for the firm
x When a firm insures itself against foreign exchange risk ± hedging
x Spot Exchange Rates ± the rate at which a foreign exchange dealer converts one currency into another currency
on a particular day
o Reported on a real-time basis
o Spot rates change continually, even minute by minute
o Value of the currency is determined by the interaction between demand and supply of that currency
relative to the demand and supply of other currencies
x Forward Exchange Rates:
o Changes in spot rates can be problematic for international businesses ± ex. expecting a shipment of
computers from Japan in 30 days, will have to pay in Japanese currency, but will not know what the
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exchange rate will be 30 days from now ± could end up being more or less expensive than they had
planned on
o To insure or hedge against this risk of not knowing the value of the exchange, the company importing
from Japan may want to engage in a forward exchange
o Forward exchange ± occurs when two parties agree to exchange currency and execute the deal at a
specific date in the future
o Exchange rates governing such future transactions are referred to as forward exchange rates
o For most major currencies, forward rates are quoted for 30 days, 90 days and 180 days into the future
o 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
o Although many firms routinely enter into forward exchange contracts to hedge their foreign exchange
x Currency Swaps:
o Most forward exchanges are not the way that they are described above, most of them are used in a
more sophisticated manner ± currency swaps
o Currency swap ± simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates
o 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
o Common kind of swap is a spot against forward ± enables the company to insure itself against foreign
exchange risk by knowing exactly how much they will be getting in the future
The Nature of the Foreign Exchange Market
x Global network of banks, brokers and foreign exchange dealers connected by electronic communications systems
x When companies wish to convert currencies, they typically go through their own banks rather than entering the
market directly
x Growing at a rapid pace reflecting general growth in the volume of cross-border trade and investment
x Most important trading centers ± London, New York, Tokyo and Singapore
o Central position between Tokyo and Singapore and New York has made it a critical link between the
East Asian and New York markets.
o Due to differences in time zones, London opens soon after Tokyo closes for the night and is still open
for the first few hours of trading in New York
x 2 particular features of the foreign exchange market:
o The market never sleeps ± Tokyo, London and New York are all shut for only 3/24 hours
During these hours, trading continues in a number of minor centers
o Integration of the various trading centers ± high speed computer linkages between the trading centres
around the globe have effectively created a single market
Implies that there can be no significant difference in exchange rates quoted in the trading
If there were differences in the rates quoted around the world, it would lead to opportunities for
arbitrage ± buying a currency low and selling it high immediately after
Because foreign exchange dealers are always watching their computer screens for arbitrage
opportunities, the few that arise tend to be small and disappear quickly
x Another feature is the important role played by the US dollar ± although foreign exchange transactions can involve
any two currencies, most transactions involve the dollar on one side ± true even when a dealer wants to sell a
nondollar currency and buy another nondollar currency
o Usually will sell one currency for dollars and then use the dollars to buy the other currency
o Cheaper than trying to find a holder of one currency who wants to buy the other currency
o Because the volume of international transactions involving dollars is so great it is not hard to find
dealers who wish to trade dollars for nondollar currencies
x Dollar is called a vehicle currency because of its central role in so many foreign exchange deals ± 89% of all
foreign exchange transactions involve dollars on one side of the transaction
o Next is the euro, Japanese yen, and the British pound
Economic Theories of Exchange Rate Determination
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