Foreign exchange market Flashcards
Foreign exchange market
is the market for converting currency from one country into another country currency
exchange rate
rate at which one currency is converted into another
foreign exchange market enable
- conversion of currency 2. insures against foreign exchange risk (the adverse consequences of unpredictable changes in the exchange rate)
the spot exchange rate
the rate at which one foreign exchange dealer converts one currency into another currency on a particular day
the forward exchange rate
the exchange rate governing a transaction in which two parties agree to exchange currency and execute a deal at some specific date in the future
currency swap
the simultaneous purchase and sale of a given amount foreign exchange for two different value dates
arbitrage
the process of buying a currency low and selling it high
important factors in future exchange rates
- interest rates 2. inflation 3. market psychology
the law of one price
in competitive markets free of transportation costs and barriers to trade 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 party
asks how much money would be needed to purchase the same goods and services in two countries, and uses that to calculate an implicit foreign exchange rate
how are prices related to exchange rate movements?
law of one price, purchasing power party
how do interest rates affect exchange rates
fischer effect, international fischer effect
fischer effect
the nominal interest rate equals the real rate plus expected inflation
how are exchange rate influenced by investor technology?
bandwagon effect
international fischer effect
suggests that for any 2 countries the spot exchange rate should change in equal amount but move in opposite direction to the difference in nominal interest rates between the two countries.
bandwagon effect
when expectations of trade turn into self full-filled prophecies and traders join the bandwagon and move exchange rates based on group expectations
inefficient market school
companies should invest in forecasting services because forward rates are not the best predictor of future spot rates
efficient market school
argues that forward exchange rates are best predictors of future spot rates and thus investing in forecasting services would be a waste of time
two approaches to forecast analysis
- fundamental analysis 2. technical analysis
freely convertible
when both residents and nonresidents can purchase unlimited amounts of foreign currency with the domestic currency
externally convertible
when nonresidents can convert their holding of domestic currency into foreign currency
nonconvertible
when both nonresidents and resident are prohibited from converting their holding of domestic currency into foreign currency
translation exposure
extent to which reported consolidated results and balance sheets of a corporation are effected by fluctuations in the exchange values
exchange rate risk can be divided into:
- translation exposure 2. transaction exposure 3. economic exposure
transaction exposure
extend to which income from individual transactions is effective by fluctuations in foreign exchange market values
economic exposure
the extent to which a firms future international earning power is effected by changes in exchange rates
how can firms minimize or maximize translation and transaction exposure
Firms can buy forward exchange rates, use currency swaps, lead and lag payables and receivables (paying suppliers and collecting payments from customers early or late depending on expected exchange rate movements)
How can a firm reduce economic exposure?
firms need to distribute productive assets to various locations so the firm’s long term financial well-being is not severely affected by changes in exchange rates
This requires that the firm sassets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of goods and services they produce
Are there other strategies to manage foreign risk?
- establish central control to protect resources and ensure that each subunit adopts the correct mix of tactics and strategies 2. distinguish between transaction, translation, and economic exposure 3 attempt to forecast exchange rates 4. establish good reporting systems 5 produce montly foreign exchange exposure reports
currency speculation
involves short term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
carry trade
borrowing in one currency where interst rates are low then using hte proceeds to invest in another currency where interest rates are high
hedging
the process of insuring ones business against foriegn exhcnage risk by using forward exchanges or currency swaps
arbitrage
the purchase of securities in one market for immediate resale in another to profit from a price discrepancy
failure of PPP theory
assumes away transportion/trade barrier costs
-market dominated by handful of MNE that control market price and can control distribution channels and differentiate product offerings
-government intervention
capital flight
residents convert domestic currency into foreign currency (usually ocurs when domestic currency is depreciating rapidly)
counter trade
the trade of g/s for other g/s (barter)
-can deal with nonconvertibility with countertrade
lead strategy
Attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying a foreign currency payables before they are due when a currency is expected to appreciate.
lag strategy
Delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate
