CH10 Flashcards
Foreign Exchange Market
Market for converting currency of one country into that of another country.
Exchange Rate
The rate at which one currency is converted into another.
- Future exchange rates cannot be accurately predicted.
Functions of Foreign Market Exchange
- Convert the currency of one country into the currency of another.
- Provide some insurance against foreign exchange risk.
Bussinesses use the Foreign Exchange Market to:
- Convert the payments received for its exports, the income received from foreign investments, or the income received from licensing agreements with foreign firms
- Make payment to a foreign company for its products or services in its country’s currency
- To invest cash for short terms in foreign money markets.
Currency Speculation
Typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.
Carry Trade
A kind of speculation that involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another country where interests are high.
Insuring Against Foreign Exchange Risk
- Spot exchange rates
- Forward exchange rates
- Currency Swaps
Exchange Rate
Rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
Forward Exchange
Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.
Currency Swap
The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
- Transaction between international businesses and their banks, between banks, and between governments
Foreign Exchange Market
- Global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems
- Rapidly growing
- Most important trading centers are London (largest), New York, Zurich, Tokyo, and Singapore.
- A market is open 24 hours a day
- High-speed computer linkages among trading centers around the globe have effectively created a single market.
- Arbitrage
- Most transactions involve the DOLLAR.
Arbitrage
Refers to the purchase of securities in one market for immediate resale in another to profit from a price discrepancy.
Law of One Price
States that 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.
Purchasing Power Parity (PPP)
- Comparison of prices of identical products determine the real or PPP exchange rate
- The price of a “basket of goods” should be roughly equivalent in each country
- Big Mac Index
Efficient Market
Has no impediments to the free flow of goods and services, such as trade barriers. It is a market where prices reflect all available information.
Money Supply and Price Inflation
- The growth rate of a country’s money supply determines its likely future inflation rate.
Inflation – money supply increases faster than output increases.
.- An increase in the money supply makes it easier to borrow, which increases demand for goods and services. - A country with a high inflation rate will see depreciation in its currency exchange rate.
- Government policy determines growth rates.
Bandwagon Effect
Movement of traders like a herd, all in the same direction and at the same time, in response to each other’s perceived actions.
Summary of Exchange Rate Theories
- Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates.
- But they are poor predictors of short-run changes.
Approaches to Forecasting
- Fundamental Analysis
- Technical Anlysis
Fundamental Analysis
- Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements
- Includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance-of-payments positions
Techincal Analysis
- Uses price and volume data to determine past trends, which are expected to continue into the future.
- There are analyzable market trends and waves that can be used to predict future trends and waves.
Currecnies can be:
- Freely Convertible
- Externally Convertible
- Nonconvertible
Freely Convertible
A country’s currency is freely convertible when the government of that country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with the domestic currency.
Externally Convertible
Limitations on the ability of residents to convert domestic currency, though nonresidents can convert their holdings of domestic currency into foreign currency.
Nonconvertible
A currency is not convertible when both residents and nonresidents are prohibited from converting their holdings of that currency into another currency.
- Not desirable for international bussiness.
Capital Flight
Converting domestic currency into a foreign currency.
Countertrade
The trade of goods and services for other goods and services.
Foreign Exchange Rate Risk
- Transaction exposure
- Translation exposure
- Economic exposure
Transaction Exposure
The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
Translation Exposure
The impact of currency exchange rate changes on the reported financial statements of a company.
Economic Exposure
The extent to which a firm’s future international earning power is affected by changes in exchange rates.
Reducing Translation and Transaction Exposure
- Forward exchange rate contracts
- Buying swaps
- Lead strategy
- Lag strategy
Lead Strategy
Collecting foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.
Lag Strategy
Delaying the collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if that currency is expected to depreciate.
