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Editor's Notes

• #2: Chapter 9: The Foreign Exchange Market
• #3: You know that each country has its own currency, but how do you figure how much that foreign currency is worth in terms of your own currency? In this chapter, we’ll try to answer that question, and we’ll explain how the foreign exchange market works, explore the forces that determine exchange rates, talk about predicting exchange rates, and discuss the implications for international business of changing exchange rates and the foreign exchange market. First, let’s go over some basic definitions. The foreign exchange market is simply a market for converting the currency of one country into that of another country, and an exchange rate is the rate at which one currency is converted into another.
• #4: The foreign exchange market serves two main functions. It’s used to convert the currency of one country into the currency of another, and it’s used to provide some insurance against foreign exchange risk, or the adverse consequences of unpredictable changes in exchange rates. So, if you’ve ever converted your currency into another currency, you’ve participated in the foreign exchange market!
• #5: International companies use the foreign exchange market to convert currencies in four ways. First, they use it to convert the foreign exchange payments they receive for exports, or the income they receive from foreign investments or from licensing agreements with foreign firms in foreign currencies. Second, they use the market when they need foreign exchange to pay a foreign company for products or services. Dell for example, pays its suppliers in their local currencies. Third, it might be used for short term money market investments. If a company has a sum of money that it wants to invest for a few months, it might find that interest rates are higher in foreign locations than at home. Fourth, firms that are in engaged in currency speculation where they move funds from one currency to another in the hopes of making a profit use the foreign exchange markets.
• #6: Companies can also use the foreign exchange market to insure against foreign exchange risk which occurs when unpredicted changes in future exchange rates have adverse consequences for the firm. You may have heard the term hedging use to describe this process.
• #7: Companies can also use the foreign exchange market to insure against foreign exchange risk which occurs when unpredicted changes in future exchange rates have adverse consequences for the firm. You may have heard the term hedging use to describe this process. Let’s talk about how this works. First, though, you need to know that a spot exchange rate is the rate at which a foreign exchange dealer coverts one currency into another currency on a particular day. So, when you’re on a trip to Germany and you change dollars for euros, you’ll get the spot rate for the day. Spot rates can be quoted either in terms of how much foreign currency the dollar will buy, so using the chart in your text, you would know that one dollar would buy about .66 euros in February of 2008, or spot rates can be quoted in terms of how many dollars you get for one unit of foreign currency, so one euro would buy about 1.5 U.S. dollars. Keep in mind that spot rates are continually changing based on supply and demand for that currency.
• #8: The other thing you need to know is that a forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future using a forward exchange rate. So, if you know you’re going to need 200,000 yen in 30 days to pay for some components your company imports, rather than taking the chance that the rate might change over the 30 days, you might enter into a forward agreement to buy the yen now and lock–in the rate, and pay for them in 30 days when your need them. Forward rates are quoted 30, 90, and 180 days into the future. Sometimes, companies can be caught off guard when they don’t hedge their currencies. Volkswagen, for example, made some disastrous hedging decisions as you’ll see in the Management Focus in your text.
• #9: Sometimes forward exchanges take the form of what’s known as a currency swap, which is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Usually, swaps take place between international companies and their banks, between banks, and between governments when they want to move out of one currency into another for a limited period without incurring foreign exchange risk.
• #10: You may be wondering where the foreign exchange market is located. It’s actually not located in any single place, rather it’s a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems. The most important centers are London, New York, Tokyo, and Singapore. Remember, that the foreign exchange market never sleeps! Currencies are always being traded somewhere in the world. Thanks to high-speed computer links between trading centers around the world, there is now a single market for currencies! If there were significant differences between markets, dealers could take advantage of arbitrage opportunities where they buy the currency at a low prices in one market, and sell if for a high price in another market. Of course, as other dealers jumped on the opportunity, the gap between the markets would quickly close. Another feature of the foreign exchange market is the dollar is used as a vehicle currency to facilitate the exchange of other currencies. In other words, if you have won, but you need yen, you might first convert your won into dollars and then the dollars into yen.
• #11: So, how do the dealers figure out what a currency is worth? The answer is easy---supply and demand! The bigger question then becomes what affects the supply and demand for a currency? We say that there are three main factors that influence future exchange rates, a country’s price inflation, a country’s interest rate, and market psychology. Let’s look more closely at how each of these factors works.
• #12: To understand how prices affect exchange rates we need to explore a concept called the law of one price, and the idea of purchasing power parity.
• #13: The law of one price states that 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. In other words, if you can buy a pair of jeans in New York for $75, then you should be able to buy the same type of jeans in London for the same price after you’ve converted your dollars to pounds. Then, the theory of purchasing power parity argues that given relatively efficient markets, or markets where there are few impediments to international trade and investment, the price of a basket of goods should be roughly equivalent in each country. So, using a simplistic example, if our basket of goods is a Big Mac, we should be able to buy a Big Mac in New York, and then take the same amount of money, convert it to yen, and buy a Big Mac in Japan, or convert the money to pounds, and buy a Big Mac in London, and so on. If you can’t, then you know that one of the currencies is undervalued or overvalued!
• #14: So, basically, the theory tells us that changes in relative prices will result in changes in exchange rates. We also know that there is a positive relationship between a country’s money supply and its inflation rate. So, if the money supply is growing, we’ll see inflation going up. In other words, if a government suddenly decided to give everyone $10,000, an increase in the money supply, many people would use the money to buy more clothes, furniture, and other “stuff.” The increased demand would encourage stores, and other providers of goods to raise prices, which of course, is inflation. The increased supply of currency in the economy, would then cause the value of the currency to drop.
• #15: So, does PPP work well to predict exchange rates? Sometimes! Empirical studies show that PPP isn’t completely accurate at estimating exchange rates, especially in the short-run. There are several reasons why the theory isn’t accurate in the short run including the fact that it assumes away transportation costs and trade barriers, it doesn’t consider the power of MNEs to influence prices, control distribution channels, and differentiate their products, and the theory doesn’t consider government intervention in the foreign exchange market.
• #16: Now, let’s look at how interest rates influence exchange rates. Irvin Fisher explored this relationship and developed the concept known as the Fisher Effect which suggests that when inflation is expected to be high, interest rates will be high as well. The high interest rates are a sort of compensation for investors who are seeing a decline in the value of their money. So, again, in countries where inflation is expected to be high, interest rates will be high as well, in order to encourage investors to keep their money in the market. Otherwise, investors would simply shift their money elsewhere.
• #17: If there are no restrictions on capital flows, real interest rates must be the same everywhere, or an arbitrage situation would exist. In other words, if the real interest in France was 10 percent, but in the U.S., the real interest rate was just 6 percent, investors would borrow “cheap” dollars to invest in France. This would bring the value of the dollar up, and consequently push the real interest rate in the U.S. up. The opposite would occur in France. So, the 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.
• #18: Studies show that neither PPP, nor the International Fisher Effect are accurate at predicting short run exchange rate movements. One reason, may be investor psychology. How does investor psychology influence exchange rates? Well, the bandwagon effect occurs when expectations by traders turn into self-fulfilling prophecies, and traders join the bandwagon and exchange rates move on group expectations. We saw this happen in 1992 when George Soros, a well known international financier, made a huge bet against the British pound. He borrowed billions of pounds, and sold them for German marks. This helped push down the value of the pound on foreign exchange markets, and many other investors jumped on the bandwagon and sold pounds as well. You can learn about another situation where bandwagon effects were important in the Country Focus on the 1997 fall of the Korean Won. Sometimes, intervention by the government can stop a bandwagon from starting, but not always.
• #19: So, we can say that because relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates, companies should pay attention these factors in the markets where they do business.
• #20: Should companies use forecasting services to help predict exchange rate movements? Well, there are two schools of thought. The efficient market school and the inefficient market school.
• #21: The efficient market school argues that forward exchange rates are the best predictors future exchange rates, so investing in a forecasting service would be a waste of money, because efficient markets already reflect all available information. Most studies show that this theory is correct.
• #22: The inefficient market school of thought argues that a forecasting service can be valuable, since because the foreign exchange market isn’t efficient, prices don’t reflect all available information, and the services could be better at predicting rates. Unfortunately, the track record of forecasting companies isn’t good though.
• #23: If you do hire a forecasting service, what methods might be used to predict exchange rates? There are two main methods – fundamental analysis and technical analysis. Fundamental analysis uses economic factors like interest rates, monetary policy, and balance of payment information to predict exchange rates. The other forecasting method, technical analysis, typically charts trends and believes that past trends and waves are reasonable predictors of future trends and waves.
• #24: Fundamental analysis uses economic factors like interest rates, monetary policy, and balance of payment information to predict exchange rates. The other forecasting method, technical analysis, typically charts trends and believes that past trends and waves are reasonable predictors of future trends and waves.
• #25: Sometimes currencies can’t be changed easily. We say that a currency is freely convertible when a government of a country allows both residents and nonresidents to purchase unlimited amounts of foreign currency with it. A currency is externally convertible when only nonresidents can convert it to a foreign currency without limitations. Finally, a currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency.
• #26: While free convertibility is the norm in the world today, many countries have some restrictions on the amount of money that can be converted. There are various reasons to limit convertibility including the preservation of foreign exchange reserves, and preventing the capital flight that occurs when residents and nonresidents rush to convert their holdings of a domestic currency into a foreign currency because the domestic currency is rapidly losing value perhaps because of hyperinflation or other economic concerns. In situations where a currency is nonconvertible, firms might choose to use countertrade to facilitate international transactions. Countertrade refers to a variety of barter-like agreements by which goods and services are traded for other goods and services. These types of arrangements were more common twenty years ago when more countries maintained nonconvertible currencies.
• #27: So, what are the implications of the foreign exchange market for companies? Well, it’s essential that companies understand the influence of exchange rates on the profitability of trade and investment deals because an adverse shift in the value of a currency can make a deal that had appeared to be profitable, a bad choice. Companies need to protect themselves against three types of foreign exchange risk, transaction exposure, translation exposure, and economic exposure. Let’s talk about each one.
• #28: Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. So for example, if a company agrees to purchase components priced in the foreign currency with the payment due in 180 days, and then within the 180 days, the domestic currency depreciates, the price of the foreign components will rise because it will take more units of the domestic currency to buy the agreed upon amount of foreign currency.
• #29: Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. Many American companies with significant investments in Europe experienced positive translation exposure between 2002 and 2007 when the euro rose against the dollar.
• #30: The third type of foreign exchange exposure, economic exposure, is the extent to which a firm’s future international earning power is affected by changes in exchange rates. This is different from transaction exposure because it’s concerned with the long-term effect of changes in exchanges rates on future prices, sales, and costs. Many American firms were affected by this type of exposure in the 1990s when the rise in the dollar made it difficult to be globally competitive. Now, just the opposite has happened. Take the dollar/euro exchange rate for example. In 2002, a product that was priced at 46 euros would have cost about $42. By 2007, the product, still priced at 46 euros, would cost about $60 thanks to the depreciation of the dollar. But by 2010, the euro had depreciated again making the product relatively less expensive in dollars. The Management Focus in the text shows how one German manufacturer, SMS Elotherm, reacted to the rising value of the euro relative to the dollar.
• #31: How can firms minimize their exposure? There are several ways. We’ve already talked about using forward contracts and swaps. Firms can also use a strategy of leading and lagging payables and receivables where they pay suppliers or collect payments early or late depending on anticipated exchanged rate movements.
• #32: A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they’re due when a currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate, and delaying payables if the currency is expected to depreciate. While this type of strategy can be effective, it’s difficult to implement because the firm has to be in a position of power over payment terms.
• #33: Reducing economic exposure goes beyond simple financial transactions, and requires the firm to distribute productive assets to various locations so that the firm’s financial well-being isn’t severely affected by changing exchange rates. In other words, as you’ll see in the Closing Case, Caterpillar Tractor is minimizing its economic exposure by moving some production from the United States to Asia as a hedge against the possibility that the euro continues to appreciate relative to the dollar. Reducing economic exposure requires firms to be sure that assets aren’t concentrated in countries where likely rises in currency values will mean significant increases in the prices of the goods and services produced.
• #34: There are some other steps a firm can take to minimize foreign exchange risk. Firms can implement a system of centralized control to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. For example, some companies set up in-house foreign exchange centers to execute most foreign exchange deals.
• #35: Second, firms need to distinguish between transaction, translation, and economic exposure. Many firms focus on transaction and translation exposure, but fail to consider economic exposure. Third, firms need to try to forecast future exchange rates, however, remember that it’s difficult to do. Fourth, firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position. Finally, firms need to produce monthly foreign exchange exposure reports that can be used as the basis for hedging strategies.
• #36: Now, let’s see how well you understand the material in this chapter. I’ll ask you a few questions. See if you can get them right. Ready? Question 1: The rate at which one currency is converted into another is the Exchange rate Cross rate Conversion rate Foreign exchange market If you picked A, you’re right!
• #37: Question 2: The rate at which a foreign exchange dealer converts one currency into another currency on a particular day is the Currency swap rate Forward rate Specific rate Spot rate If you picked D, you’re correct!
• #38: Question 3: All of the following impact future exchange rate movements except A country’s price inflation A country’s interest rate A country’s arbitrage rate Market psychology The correct answer is C. Did you get it right?
• #39: Question 4: The extent to which income from individual transactions is affected by fluctuations in foreign exchange values is Translation exposure Accounting exposure Transaction exposure Economic exposure Did you pick C? I hope so!