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Chap09 - FX Market

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Chap09 - FX Market Powered By Docstoc
					Chapter 9

              The Foreign
            Exchange (FX)
                   Market
         Introduction

 Question: What is the FX (FX) market?

The FX market is a market for converting
 the currency of one country into that of
 another country
Where is it located?

 Question: What is the exchange rate?

The exchange rate is the rate at which
 one currency is converted into another
                                          9-2
      The Functions of
the Foreign Exchange Market

  Question: FX market?

 The FX market:
  1. enables the conversion of the
     currency of one country into the
     currency of another
  2. provides some insurance against FX
     risk (the adverse consequences of
     unpredictable changes in exchange
     rates) How?
                                      9-3
    Currency Conversion
              (1 of 2)


International firms use FX markets
   to convert export receipts, income
     received from foreign investments, or
     income received from licensing
     agreements
   to pay a foreign firm for products or
     services
     Seller always wants to be paid in its
      currency.
     Why?
                                              9-4
 Currency Conversion
            (2 of 2)


to invest spare cash for short terms in
 money markets China, Japan, Russia,
 & Saudi Arabia in US. Why?
for currency speculation (the short-
 term movement of funds from one
 currency to another in the hopes of
 profiting from shifts in exchange rates)
 How to make small fortune..


                                       9-5
        Insuring Against
          FX Risk (1 of 3)

 The FX market can be used to provide
  insurance to protect against FX risk (the
  possibility that unpredicted changes in future
  exchange rates will have adverse
  consequences for the firm) *
 A firm that protects itself against FX risk is
  hedging Rancher pre-sells cattle. Why?
 The market performs this function using:
  1. spot exchange rates Explain
  2. forward exchange rates Explain
  3. currency swaps Explain
                                               9-6
        The Nature of the
           FX Market

 The FX market is a global network of banks,
  brokers, and FX dealers connected by
  electronic communications systems
 The market is always open somewhere in the
  world
 If exchange rates quoted in different markets
  were not essentially the same, there would be
  an opportunity for arbitrage (the process of
  buying a currency low and selling it high)
 Most transactions involve US dollars on one
  side Why?
   The $ US is a invoicing currency (?)
   Pros & Cons for US & others

                                              9-7
   Economic Theories of
Exchange Rate Determination

    Question: What 3 factors are
   important to future exchange
   rates?




                                   9-8
Prices and Exchange Rates (1)

   Question: How are prices related to
   exchange rate movements?

 Explain PPP




                                         9-9
Prices and Exchange Rates (2)

 The law of one price states that the
  same currency…
 PPP theory argues that given
  relatively efficient markets (markets
  in which few impediments to
  international trade and investment
  exist) the price of a “basket of
  goods” …
  (See next slide.)
                                     9-10
Prices and Exchange Rates (3)

  How get identical basket of food Germany &
   Japan?
  What one food is consumed in almost every
   country?


  PPP predicts that changes in relative prices will
   result in changes in exchange rates
    When inflation is relatively high, a currency
      should depreciate Why?


                                                 9-11
Prices and Exchange Rates (4)

     The growth of a country’s money
      supply determines its likely future
      inflation rate
     Why?
     Unless what else happens?




                                            9-12
Prices and Exchange Rates (5)

   Question: How well does PPP theory
   work?




                                        9-13
Interest Rates and Exchange Rates


     Question: How do interest rates
      affect exchange rates?
  1. Show how broker in London
      purchases Icelandic bonds
  2. Show why a country offers a high
      interest rate on its government
      bonds.


                                        9-14
  Investor Psychology and
     Bandwagon Effects

  Question: How are exchange rates
   influences by investor
   psychology?

1. The bandwagon effect occurs
2. China moved from pegging its currency
    from $US to …? What happened &
    why?

                                       9-15
Exchange Rate Forecasting

   Question: Should firms invest in
  exchange rate forecasting services
  to help with decision-making?




                                   9-16
The Efficient Market School

An efficient market is one in which prices
 reflect all available information
If the FX market is efficient, forward
 exchange rates should be unbiased
 predictors of future spot rates
Most empirical tests confirm the efficient
 market hypothesis suggesting that
 companies should not waste their money
 on forecasting services, but some recent
 studies have challenged the theory

                                        9-17
The Inefficient Market School

 An inefficient market is one in which
  prices do not reflect all available
  information
 In an inefficient market, forward
  exchange rates are not the best
  predictors of future spot exchange rates
  and it may be worthwhile for international
  businesses to invest in forecasting
  services
 However, the track record of forecasting
  services is questionable
                                         9-18
  Currency Convertibility

  Question: Are all currencies freely convertible?

 A currency is freely convertible when both
  residents and non-residents can purchase
  unlimited amounts of foreign currency with the
  domestic currency
 A currency is externally convertible when only
  non-residents can convert their holdings of
  domestic currency into a foreign currency
 A currency is nonconvertible when both
  residents and non-residents are prohibited from
  converting their holdings of domestic currency
  into a foreign currency

                                                9-19
 Currency Convertibility

  Question: Countries limit currency
 convertibility
     Why do this?
     Profit reparations
In the case of a nonconvertible currency,
 firms may turn to countertrade (barter
 like agreements by which goods and
 services can be traded for other goods
 and services) to facilitate international
 trade More on this later
                                        9-20
Implications for Managers

  Question: What does the FX market
  mean for international firms?
 Firms must understand the influence of
  exchange rates on the profitability of
  trade and investment deals
 This exchange rate risk can be divided
  into
  1. Transaction exposure
  2. Translation exposure
  3. Economic exposure

                                      9-21
  Transaction Exposure

Transaction exposure is the extent to
 which the income from individual
 transactions is affected by fluctuations in
 FX values
It can lead to a real monetary loss
  How can you mitigate this risk?




                                          9-22
  Translation Exposure

Translation exposure is the impact of
 currency exchange rate changes on the
 reported financial statements of a firm
it deals with the present measurement of
 past events – like on a balance sheet
Gains and losses from translation
 exposure are reflected only on paper
  Give example.




                                       9-23
   Economic Exposure
            (1 of 3)


What Does Economic Exposure
 Mean?
 An exposure to fluctuating
 exchange rates, which affects a
 firm’s earnings, cash flow, and
 foreign investments.



                                   9-24
   Economic Exposure
             (2 of 3)


 Most large firms attempt to
 minimize the risk of fluctuating
 exchange rates by hedging with
 positions in the FX market.
Firms that do a lot of business in
 many countries, such as
 import/export firms, are at particular
 risk for economic exposure.

                                     9-25
   Economic Exposure
             (3 of 3)


The likelihood that events, including
 economic mismanagement, will
 cause drastic changes in a
 country’s business climate.
These changes will adversely affect
 the P&L and other goals of a
 particular business enterprise.
  Hugo Chavez in Venezuela & Evo
   Morales in Bolivia for example.

                                     9-26
Reducing Economic Exposure

  Question: How can a firm reduce economic
  exposure?

  To reduce economic exposure firms need to
   distribute productive assets to various
   countries, so the firm’s long-term financial well-
   being is not severely affected by changes in
   exchange rates
  This requires that the firm’s assets are not
   overly concentrated in countries where likely
   rises in currency values will lead to damaging
   increases in the foreign prices of the goods and
   services they produce How do you know?

                                                  9-27
The end of chapter 9.




                        9-28

				
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