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

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University of Toronto Mississauga

MGT491 FINAL EXAM NOTES Chapter 9: The Foreign Exchange Market N Most enterprises in the global economy are affected by changes in the value of currencies on the foreign exchange market N What happens in the foreign exchange market can have a serious impact on sales, profits and strategy of an enterprise N 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 N Foreign exchange market a market for converting the currency of one country into that of another country N Exchange rate the rate at which one currency is converted into another N 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 N International trade and investment have risks some of which exist because future exchange rates cannot be perfectly predicted N 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 N 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 versa The Functions of the Foreign Exchange Market N 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 N Each country has a currency in which the prices of goods and services are quoted N In general, within the borders of a particular country, one must use the national currency N 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 N Exchange rate allows us to compare the relative prices of goods and services in different countries N Tourists are minor participants in the foreign exchange market companies engaged in international trade and investments are major players N 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 conv0799K0294L98K420.4:3978.:7703. o :K039K02:895,,1470LJ3.425,3147L98574:.9847807;L.08L3L98.4:3978.:7703. 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 .K,3J08L39K0;,O:0419K,9.4:3978.:7703.,J,L3899K0K420.4:3978.:7703.:7L3J9K,9507L4 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 N Foreign exchange risk the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm N When a firm insures itself against foreign exchange risk hedging N 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 N 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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