Foreign Exchange Markets Flashcards
What is the purpose of the forex market and what is unique about it?
- Used to convert the currency of one country into the currency of another
- Provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates
- 24/7
What are the uses of the forex market for IB?
- Convert foreign earnings and profits
- Pay foreign companies
- Conversions for short term investments in money markets
- Currency specualtion
- Carry trade - involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where they are high
What kinds of exchange rates are there?
- Spot exchange rate
* Forward exchange rate
What is a spot exchange rate?
- The rate at which a foreign exchange dealer converts one currency into another on a particualr day
- Change continually depending on the supply and demand for that currency and other currencies
What is a forward exchange rate?
- To insure or hedge against a possible adverse foreign exchange movement, firms engage in forward exchanges
- Two parties agree to exchange currency and execute the deal at some specific date in the future
- The forward exchange rate is the rate used for these transactions
- Typically quotes 30, 90 or 180 days into the future
What factors impact future exchange rate movements?
- Country’s price inflation
- Country’s interest rate
- Market psychology
How does a country’s price inflation affect future exchange rate movements?
- Law of on price
- PPP
- High inflation = currency depreciation
What is the law of one price?
- Competitive markets: identical products sell in different markets for the same price when price is expressed in the same currency
- Arbitrage insures this
What is PPP?
- Argues that given relatively efficient markets, the price of a basked of goods should be roughly equivalent in each country
- Changes in relative price of two countries = changes in exchange rate
- Big Mac index
- Assumes away transport costs and barriers to trade
- Will not hold if many national markets are dominated by a handful of MNCs that are price makers to any degree to if government is involved
How does a country’s interest rate affect future exchange rate movements?
- 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 two countries
- When investors are free to trade transfer capital between countries, the real interest rate will be the same in every country - arbitrage will equalise
- It follows that if the real interest rate if the same worldwide, any differences in rates between countries will reflect differing expectations about inflation rates
How does market psychology affect future exchange rate movements?
- Bandwagon effect occurs when expectations on the part of traders turns into self-fulfilling prophesies - traders can join the bandwagon and move exchange rates based on group expectation
- Few players know everything
- Players watch each other
- Uncertainty = euporhia/panic spreads quickly
- Financial crises - lessons from history
What is true of price inflation and interest rates in predicting future exchange rate movements?
Theory of PPP and the Fisher effect are poor predictors of short-term change in exchange rates
What are the schools of though regarding forecasting?
- Efficient market school
* Inefficient market school
What is the efficient market school?
- Prices reflect all available info on public domain
- Forward rates represent market participants collective predictions of likely spot exchange rates at specified future dates - will be unbiased if exchange market is efficient, though not always accurate
What is the inefficient market school?
Prices do not reflect all available info on public domain - information asymmetry
What are the approaches to forecasting future exchange rate movements?
- Fundamental analysis
- Predictions using economic models on economic theory, B.O.P., inflation, i/r
- Technical analysis
- Extrapolcaiton/interpretaion of past trends assuming they predict future movements
- Fortune telling
- Professional forecasters are not better than forward exchange rates in predicting future spot rates
What is a currency swap and who are the parties to it?
- The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
- Parties
- International business and their banks
- Banks
- Governments
What is currency hedging?
- Insuring against losses
- Adverse variations in spot exchange rates
Why do firms use hedging instruments?
- Reduce exposure to risk associated with transfer of funds
- Protect themselves in credit transactions with time late between invoicing and receipt
How do firms hedge against exchange rate risk?
- Forward exchange rates
- Currency swaps
What is currency arbitrage and who are the players?
- Simultaneous purchase and sale of a currency in different markets
- High speed computer linkages between trading centres mean there is no significant difference between exchange rates in the different trading centres
- Players
- FX traders
- Large investors
- Allocation of forex where best rates can be had
What is currency speculation?
- Purchase or sale of a currency with expectation that its value will change
- Hedge funds - manipulation of exchange rates
What are the degrees of currency convertibility?
- Freely convetable
- Externally convertable
- Only nonresidents may convert it without any limitations
- Nonconvertable
- Neither residents nor foreigners are allowed to convert it
Why could countries make currency’s not convertible?
- Save forex reserves for
- Interest payments on foreign debt
- Payments for imports
- Protect against speculators
- Prevent capital flight
How do countries save forex reserves?
- Import licenses
- Capital controls
- Restrictions on repatriation of profits
- Limitations for residents travelling abroad
- Multiple exchange rates
- Import deposit requirements
- Quantity restrictions
What is countertrade?
Barter like agreements to overcome currency nonconvetablilty
What are the exposures of exchange rates to businesses?
- Transaction exposure
- Translation exposure
- Economic exposure
What is transaction exposure?
The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
What is translation exposure?
- The impact of currency exchange rate changes on the reported financial statements of a company
- Concerned with the present measurement of past events
- The resulting accounting gains or losses are said to be unrealised - they are paper gains and losses, but still important
What is economic exposure?
- The extent to which a firm’s future international earning power is affected by changes in exchange rates
- Concerned with the long run effect of changes in ex rates on future prices, sales and costs
How can transaction and translation exposure be minimised?
- Buy forward
- Use swaps
- Lend and lag payables and receivables
What is a lead strategy and what is it used for?
- Attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate
- To minimise transaction and translation exposure
What is a lag strategy and what is it used for?
- Delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate
- To minimise transaction and translation exposure
What is true of leading and lagging strategies?
Can both be difficult to implement - must be in a position to excercise some control over payment terms
How can economic exposure be minimised?
- Distribute productive assets to various locations so the firm’s long term financial well-being is not severely affected by changes in exchange rates
- Ensure assets are not too concentrated in countries where likely rises in the currency’s values will lead to increases int he foreign prices of goods and services the firm producers
