Chapter 10 - Forex market Flashcards
foreign exchange market
a market for converting the currency of one country into that of another country
-without it, international trade/investment would be impossible
exchange rate
the rate at which one currency is converted into another.
It can change over time.
fiscal policies
what governments can influence by making decisions on how to spend money, tariffs, subsidies
monetary policy
people who control money make policies on interest rates and inflation
functions of forex market
- converts currency of one into another
- for businesses to: convert money from operations, make payments, invest short term cash, currency speculation (carry-trade)
Currency speculation
Involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.
Carry-trade
Involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where interest rates are high. Based on belief that there will be no adverse movements that would lead to losing money
Spot exchange rate
The rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
Ex: When a tourist goes to a bank to convert her money, the exchange rate is the spot rate for that day.
Forward exchange rates
Occurs when two parties agree to exchange currency and execute the deal at some specific date in the future. Like a speculation on what you think will be the future rate (30,90,180 days)
Currency swaps
The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
i.e. transactions between international businesses and banks, banks and banks, and governments
Example of forward exchange rate
Embraer’s jets sold in US dollars to be exchanged back into reals when sold to determine profit margin. As the real was worth more, the company made less money so Embraer bet that it would increase and locked in the current price. However, it decreased so they had to pay the higher price.
Nature of forex market
Global network of banks and brokers connected by electronic communication system rapidly growing the market never sleeps most transactions have dollars arbitrage: buy low, sell high
Theory of exchange rate determination
demand and supply of one currency compared to another
- -> the law of one price
- -> Purchasing power parity
- -> money supply and price inflation
- -> Empirical tests and PPP theory
The law of one price
if no transportation cost/tariffs, products that are identical, should sell for the same price regardless of the country
Purchasing power parity
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 accounting for difference in exchange
a change in relative price = a change in exchange rate
Money supply
The growth rate of a country’s money supply determines its likely future inflation rate
Inflation
money supply increases faster than outputs
too little inflation is good but does not stimulate economy
high inflation leads to
depreciation in foreign exchange value of currency
Government influence on money supply
could just tell the bank to supply more money usually for infrastructures, but they could also use tax revenues
empirical tests and PPP theory
Exchange rates are determined by relative prices and changes in relative prices will result in a change in exchange rates
works best with countries with high inflation and underdeveloped capital markets
Failure of PPP
ignores tariffs, transportation costs, barriers to trade to maintain the law of one price
many multinational companies that have influence over the prices in that industry
Interest rates and exchange rates
strong relationship explained by The fisher effect: i=r+I
States that a country’s “nominal” interest rate (i) is the sum of the required “real” rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I)
therefore if same real interest rate worldwide: the difference reflects different expectations about inflation
International fisher effect
States that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries
Exchange rate between the U.S and Japan can be modeled as follows:
(S1 - S2)/S2 x 100 = i$ - iyen
S = Spot exchange rate, i = nominal interest rates
Investor psychology
explain short term movement
Evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates
Bandwagon effect
explain short term movement
With traders moving as a herd in the same direction at the same time, one decides to do something others will follow which will make the market go even lower/higher
Exchange rate forecasting (efficient market school)
- Prices reflect all available public information
- Forward exchange rates should be unbiased predictors of future spot rates
BUT in reality: Inefficient Market School NOT TRUE
Approaches to forecasting
Fundamental analysis and technical analysis
Fundamental analysis
Draws on economic theory to construct sophisticated economic models for predicting exchange rate movements
Includes relative money supply growth rates, inflation rates, and interest rates, and possibly balance of payment positions
Technical 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
Currency convertibility
freely convertible (not universal) externally convertible nonconvertible
Freely convertible
When the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it
externally convertible
When only nonresidents may convert it into a foreign currency without any limitations (Venezuela)
–>can limit domestic companies’ ability to invest abroad, but not foreign companies wishing to do business in that country
Nonconvertible
When neither residents nor nonresidents are allowed to convert it into a foreign currency (often temporary)
capital flight
Capital flies out: Most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation or when a country’s economic prospects are shaky in other respects
Counter trade
goods and services can be traded for other goods and services
Makes sense when a country’s currency is nonconvertible
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. For example you agree on a transaction now at a certain exchange rate and the rate changes = one will lose from this the other will win
Translation exposure
concerned with present measurement of past performance
mostly when subsidiary performance outside of the country in another currency which depreciates or appreciates
economic exposure
The extent to which a firm’s future international earning power is affected by changes in exchange rates
Concerned with long run effects of changes in exchange rates on future prices sales and costs.
Reducing transaction/translation exposure
- Forward exchange rate contracts
- Buying swaps: locking in a price for a good or currency
- Lead strategy: predict the future
- Lag strategy: follow the events, wait to see what happens and capitalize on it
Reducing economic exposure
Distribute the firm’s productive assets to various locations so the firm’s long term financial well-being is not severely affected by adverse changes in exchange rate
other steps to manage forex risk
- central control of exposure
- should distinguish between translation/transaction and economic
- high need to forecast future exchange rate movement
- good reporting systems
- monthly foreign exchange exposure reports
