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exchange market: A market for converting the currency of one country into the currency of another. Exchange rate: The rate at which one currency is converted into another.
Foreign exchange risk: The risk that arises from changes in exchange rates: the likelihood that unpredictable or unexpected changes in exchange rates will have an impact (positive or negative) on the value of various activities of a companys business. Examples: An unexpected change in exchange rates will change the home currency value of foreign currency cash payment that is expected from a foreign source; An unexpected change in exchange rates will change the amount of home currency needed to make a payment or service a debt that requires payment in a foreign currency.
2 MM/1CM
1MM/1CM
4MM/1CM
Cable is the exchange rate between US Dollars and Pounds Sterling Canadian dollar is a loonie French franc used to be known as Paris New Zealand dollar is a kiwi Australian dollar is an aussi Swiss Franc is a Swissie Singapore dollar is a Sing dollar
Forex deals with exchange, so the value of one currency is often discussed in comparison to another currency. (e.g. value of currency A against currency B) APPRECIATION (rise): a currency increases in value against a foreign currency in response to market demand; it is getting stronger, therefore, less of this currency is needed to convert to a weaker foreign currency; in other words, the currency that is appreciating will buy more of a weaker currency. DEPRECIATION(fall): a currency decreases in value against another currency in response to market forces; it is growing weaker, therefore, more of this currency is needed to convert to a stronger foreign currency; in other words, the currency that is depreciating will buy less of a stronger currency. UNDERVALUED: a currency is too weak against another currency; is not as strong as it should be. OVERVALUED: a currency is too strong against another currency; should have less value than it does.
HOW TO CONVERT
EXAMPLE: You arrive at the train station in Switzerland early in the morning. You go to the exchange office to trade your U.S. dollars for Swiss francs. You ask the exchange office: How many Swiss francs do I receive for every dollar? The clerk answers: The rate is 1.5625 Swiss Francs per dollar. You exchange US$50.00. How many Swiss francs do you receive? A. US$50 x SF1.5625 = SF 78.13 You stop for a moment and think to yourself, Well, then, how many dollars are in one Swiss franc? A. ____1USD__ = US$0.6400/SF SF 1.5625/S You are back at the train station and it is time to leave Switzerland and you have a bunch of Swiss francs in your pocket which you want to convert into Euros. You are told that the exchange rate for SF to Euros is: SF1.5466/Euro. So how many Euros do you get for the 152 Swiss Francs you have? A. ____152SF____ = 98.28 Euros SF 1.5466/Euro
CURRENCY CONVERSION
Fundamentally, currency conversion involves a transfer of purchasing power: this is necessary because international trade and capital transactions usually involve parties living in different countries with different national currencies. Countries either transfer power to or from their home currency in order to be active in the global economy. When a company is importing goods from another country, it will usually give up its domestic currency in the foreign exchange market to get the foreign currency needed to pay for the import. Result: demand for the foreign currency increases, supply in the foreign exchange market of the home currency increases.
CURRENCY CONVERSION:WHEN
Companies receiving payment in foreign currencies need to convert these payments to their home currency
EXAMPLE: A Japanese components manufacturer receives payment in US$ from their U.S. customer ; the manufacturer may want to convert it so it can be spent in Japan.
EXAMPLE: A U.S. company must obtain Japanese yen to pay for an order they received because the contract specified payment in yen.
CURRENCY CONVERSION:WHEN
Companies investing spare cash for short terms in money market accounts
U.S. company has dollars that they want to invest short term, but the interest rate is only 2% in U.S. but 12% in South Korea. So, the company changes dollars into won and invests in the money market of South Korea Rate of return will depend on the interest rate and the value of the Korean won at the time they exchange the won back into dollars and bring back their money to the U.S.
CURRENCY CONVERSION:WHEN
Companies taking advantage of changing exchange rates (Speculation = short term moment of funds from one currency to another, seeking to profit from changes in exchange rates) U.S. company has $10 million to invest. The company thinks that the dollar is too strong against the yen (it is overvalued), and that it will lose its value over time (depreciate). Assume exchange rate is $1 = Yen 120 Company changes money and receives 1.2 billion Yen ($10 million x 120 yen) Over next three months value of the dollar drops, so that one dollar buys less yen and now the exchange rate is $1 = Yen 100. Now the company exchanges the 1.2 billion Yen back into dollars and because of the new exchange rate receives $12 million.
REDUCING RISK
Insuring against foreign exchange risk: protecting against unexpected or unpredictable changes in exchange rates through hedging transactions.
REDUCING RISK
Spot exchange rate: rate of currency exchange on a particular day Forward exchange rate: rate of currency exchange on a specific future date
Spot exchange rate: rate of currency exchange on a particular day Spot exchange: when two parties agree to exchange currency and execute the transaction immediately. Example: tourist changing money at the airport Spot rates for most currencies change throughout the day, depending on supply and demand.
A SPOT FX DEAL
A 25 second deal Source: REUTERS FORWARD EXCHANGE and MONEY MARKET,John Wiley & Sons, 1999.
TERMS:
Forward exchange : An agreement to buy/sell a foreign currency for future delivery at a price set now (the "forward exchange rate"). Purpose: to hedge against the possibility that future exchange movements will make a transaction unprofitable by the time that transaction has been executed. (a means to protect against loss of profit) Forward exchange rate: exchange rate governing forward exchanges. Exchange rate is established at time of agreement but payment and delivery are not required until maturity Forward exchange rates: usually quoted in 30, 90, 180 day increments - Payment for forward exchange contracts are usually made on the second business day after the event-month anniversary of the trade. Example: a two-month forward transaction entered on March 18 will be for a value date of May 20 (or next business day if May 20 is on a weekend or holiday).
FORWARD EXCHANGE
Buying forward or Selling forward: securing a forward contract Discount on forward: the spot rate is stronger than the forward rate (the target currency as valued by the forward rate is weaker than the spot rate); the expectation is that the currency is depreciating. S>F Premium on forward: the spot rate is weaker than the forward rate (the target currency as valued by the forward rate is stronger than the spot rate); the expectation is that the currency is appreciating. F>S
FORWARD EXCHANGE
EXAMPLE: U.S. company buys computers from Japan and must pay 200,000 yen for each computer in 30 days. Company wants to lock into an exchange rate that is known to protect against possible depreciation of the U.S. Dollar. Current spot rate is $1 = Yen 120, which means each computer costs in US$ 1,667. (200,000/120 = $1,667). Assume that future one-month rate is $1 = Yen 110. This means that dollar is selling at a discount on the future market (that is, dollar is selling on the future rate for less than it is selling on the spot rate). If U.S. company locks into this rate, when it actually pays in 30 days, it means it would have to pay $1,818 per computer (200,000/110 = $1,818). (Dollar is depreciating). Assume that future one-month rate is $1 = Yen 130. This means that the dollar is selling for a premium on the future market (that is, dollar is selling on the future rate for more than it is selling on the spot rate). If U.S. company locks into this rate, when it actually pays in 30 days, it means it would only have to pay $1,538 per computer (200,000/130 = $1,538). (Dollar is appreciating).
FORWARD EXCHANGE
Currency swap: simultaneous purchase and sale of a given amount of foreign exchange for two different value dates Purpose: to manage foreign currency requirements and minimize foreign exchange risk by moving out of one currency into another for a limited period when exchange rates are favorable. FX swaps have two value dates, or legs, when exchange of funds occur. Spot against Forward Forward against Forward Short Dates (less than one month) Foreign currency futures: standardized contracts traded in organized exchanges with fixed maturities. Foreign currency options: contracts giving the option, but not the obligation, to buy or sell a given amount of foreign exchange at a fixed price per unit for a specified time period; traded OTC or on organized exchanges
Foreign exchange market is not a single place but a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems that exchange currencies 24/7. Most important trading centers include London, New York, Tokyo, and Singapore Londons dominance is explained by: History (capital of the first major industrialized nation). Geography (between Tokyo/Singapore and New York). Two major features of the foreign exchange market: The market never sleeps. Market is highly integrated. Dollar is a vehicle currency: in 2004, 89% of all Forex involved dollars on one side of the transaction.
Two Tiers:
Interbank/Wholesale market: usually large amounts in multiples of a million units Retail Market: usually specified amounts Banks and non bank foreign exchange dealers/brokers Individual and firms conducting commercial and investment transactions (including tourists) Speculators and Arbitrageurs Central Banks and Treasuries
Participants:
SOURCE: Eitman, David K., Stonehill, Arthur L., Moffet, Michael H. MULTINATIONAL BUSINESS FINANCE. Addison Westley: New York, 2001. p.101
CENTERS OF FOREX
EXCHANGE SIGHTS
Mexico City
24 hours Many players Presence of risk Action happening all the time
Many different theories exist. No true consensus exists. If the factors which influence the value of exchange rates can be identified, then we may be able to forecast exchange rate fluctuations and movements. This knowledge, in turn, can help companies to protect against foreign exchange risk and preserve profitability of international trade and investment and manage price competitiveness.
Source: REUTERS FORWARD EXCHANGE and MONEY MARKET,John Wiley & Sons, 1999.
Supply and Demand: At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. The demand and supply of currencies is fueled by the supply and demand of goods and services. What can affect the supply and demand of goods and services?
Changes in Income Changes in prices, especially those brought about by differences in money supply and price inflation : Law of One Price Purchasing Power Parity (PPP) Changes in Interest rates
The spot exchange rate depends on supply and demand for a foreign currency throughout the day. This is in response to the changes in the supply and demand for goods and services. Differences in spot rates reflect differences in supply and demand for currencies. These differences will affect the value of the currency.
Example: If spot demand for U.S. dollars is high and U.S. dollars are in short supply but the spot demand for British pounds is low and the supply of British pounds is plentiful, the dollar will most likely appreciate against the pound. This reflects the supply and demand for U.S. and British goods.
ARBITRAGE: moments of opportunity which impact supply and demand for FOREX
Arbitrage: a trading strategy based on the purchase of foreign exchange in one market at one price while simultaneously selling it in another market at a more advantageous price in order to obtain a risk-free profit on the price differential. Buy low/sell high. Arbitrage in foreign exchange takes advantage of the disequilibrium (imbalance) which exists in foreign exchange markets. It overcomes differences in geography, currency type, and time.
Example: At 8:00 a.m. in New York, the Swiss franc is quoted for sale at $.46 and in Zurich at that same time for $.48. Traders and arbitrageurs will buy Swiss francs in New York and sell then in Zurich. Demand in New York would increase and raise the price in New York and the increased supply in Zurich would cause the price to lower. Eventually, these trades would cause the price to be stabilized.
FOREIGN CURRENCY
HOME CURRENCY
Changes in income due to increased employment, more workers in the workforce, periods of economic growth etc. give residents of a country more expendable income. An increase in domestic income of a country will usually encourage residents to spend a portion of their additional income on imports. When income of a nation grows rapidly, imports tend to rise rapidly. Results: More domestic currency is traded for more foreign currency and the domestic currency will usually depreciate.
If incomes in both trading partners are increasing, the country with the faster growing income will increase demand for imports relatively more. This may lead to a depreciation in currency of the more rapidly growing national economy
How is the exchange rate between two currencies determined? In theory, the exchange rate should be the medium to transfer and equalize purchasing power from one currency to another. What is the relationship between prices and exchange rates? We must examine two theories: The Law of One Price and Purchasing Power Parity. LAW OF ONE PRICE Basic premise: If an identical product or service can be sold in two different markets, and no restrictions exist on the sale or transportation costs of moving the product between markets, the products price should be the same in both markets. therefore :Price currency A = Price currency B x exchange rate How would this come about? This is the result of the occurrence of arbitrage and markets seeking equilibrium. Prices that are different will tend to equalize in markets free of transportation costs and trade barriers.
Example: US/British pound exchange rate: $1.50/ 1 A jacket selling for US$75 in New York should sell for 50 in London ($75/1.50) If jackets in London sell for 40, demand would increase, and price would go up in London while extra supply would lower the price in New York. (this explains why companies exportto take advantage of differences in price)
PURCHASING POWER PARITY: in theory, the ideal is that the exchange rate should represent equivalence of purchasing power between two currencies. Basic premise: If the Law of One Price were true for all goods and services, the PPP could be found from any individual set of prices, assuming the market is efficient.
Thus, E$/ = P$/P By extension: In relatively efficient markets (few impediments to trade and investment) then a basket of goods should be roughly equivalent in each country.
Extension of PPP/Law of One Price: applicable to a basket of goods and their prices.
If relative prices change in a basket of goods, the exchange rates should change to reflect the difference in purchasing power for a given currency PPP. Example: Jan 1: a basket of goods costs U.S. $200 and Japan 20,000 Dec 1: the same basket of goods costs $200 and Japan 22,000
Result: it takes 10% more yen to buy the same basket of goods(22,000/20,000) so the value of the yen is depreciating by 10%. The dollar is appreciating and will buy 10% more. The change is reflected in both the price of the goods and the price of the currencies.
Extension of PPP/Law of One Price: if it is known that prices are going to change in the future, can we project what the forward rate will be?
Example: Two countries, Great Britain and United States produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain, it is 3.70 per pound. According to PPP theory, what should the $/ be?
Answer: 2.80/3.70 = .76$/ .
Suppose the price of beef is expected to rise at the end of a year to $3.10 in the U.S. and to .4.65 in Britain. What would the one-year $/ . Forward exchange rate probably be? Answer: 3.10/4.65 = .67$/ .
Hill, p. 349
Switzerland
5.05
2.06 +65
Big Mac Index provides general comparison of currencies against a base currency (US$) to determine which are under-valued or over-valued against the base currency
FULL COVERAGE: China Yahoo.com July 21, 2005 China Severs Its Currency's Link to Dollar AP - 41 minutes ago BEIJING - China dropped its politically volatile policy of linking its currency to the U.S. dollar on Thursday, adopting a more flexible system based on a basket of foreign currencies that could push up the price of Chinese exports to the United States and Europe. The government also strengthened the state-set exchange rate to 8.11 yuan to the dollar from 8.277 yuan, where it had been fixed for more than a decade in a surprise announcement on state television's evening news.
WHAT DOES THIS MEAN? China switched from being pegged to the U.S. dollar at 8.28 yuan to the U.S. dollar to a managed floating exchange rate regime. Currency is being revalued to 8.11 yuan to the U.S. dollar. Chinese exports will become more expensive over time. Imports into China, of products such as oil, will become less expensive over. Foreign assets will also become less expensive over time. This was done in response to pressure by the U.S. and the E.U. in particular because cheap Chinese imports into these areas were creating too much competition.
PPP theory predicts that changes in relative prices will result in a change in exchange rates. What happens when there is price inflation?
Inflation occurs when the money supply increases faster than output increases. If more money is available, banks can borrow more money from the government and consumers can borrow more from banks. More money in circulation can create more demand for goods and services that is not satisfied by supply. Prices will increase. A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate. (Deflation should cause appreciation).
In the global market, differences in interest rates can exist. Investors will trade in their home currency to obtain currency of the country offering the higher rate so that they can purchase higher yield assets. Initially this will cause more demand for the currency in the country with the higher rate and thus cause an appreciation of that currency.
Example: Japan has higher interest rates than the U.S., so U.S. investors trade in their dollars for yen in order buy higher yield assets. This increased demand for yen causes the yen to appreciate initially.
As investors transfer capital freely between countries and take advantage of interest rate differences, eventually arbitrage will equalize them.
-Example: Over time, the lower interest rate in the U.S. will attract more borrowers and the demand for money in the U.S. will raise the interest rates there. The increase in supply of money in Japan would begin to lower interest rates there. This would continue until both sets of real interest rates are equalized.
PPP theory predicts that changes in relative prices will result in a change in exchange rates; exchange rates are affected by inflation. From Fisher Effect, we know that interest rates reflect expectations about inflation Interest rates tell us about inflation inflation can cause exchange rates to change Therefore, theory says that interest rates reflect expectations about future exchange rates.
By extension, theory identifies the International Fisher Effect (IFE): If PPP holds true and real rates of interest are equal across countries, the following is assumed.
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. Example: if nominal interest rate in Japan is 10 % and in the U.S. is 6%, we would expect the yen to depreciate by 4% against the dollar.
The monetary, fiscal, and trade policies of the Government can impact the exchange rate. Examples: Creation of barriers to trade and investment
Controls on flow of foreign currency Restrictions on foreign investments Control of repatriation of profits, dividends, royalties, etc. Impositions of trade barriers blocking or discouraging imports
The monetary and fiscal policies of the Government can impact the exchange rate. Examples: Management of the money supply Management or creation of inflation Central bank intervention Management of unemployment Economic growth policies Rates of taxation
Market sentiment: based on Perception of market performance Expectation of market performance Explanation may be investor psychology and the bandwagon effect Studies suggest they play a major role in short term movements Hard to predict Shock in world politics and social events can incite investor reaction
a few hours or a day at the most. It is peoples perceptions of fundamentals that move markets. Stuart Frost, Technical Analyst
Impact of reactions by FX dealers based on What the chartists are showing What people are saying the market What central banks are doing The trend is my friend. Buy the rumour, sell the fact
Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates. Complications with empirical tests conducted on PPP or IFE:
Identical basket of goods is often not Time periods for testing are not free from government intervention, so markets are not as efficient As part of globalization, capital and financial markets have been deregulated and cross border flow has increased; this has had a considerable impact on supply and demand of currency, which is not taken into account by PPP. Transportation costs still a factor
General wisdom is: Short term (spot rates): supply and demand, investor psychology/people factor, especially for floating rates Longer term: Purchasing Power Parity (changes in prices based on impacts of changes in income, interest rate, inflation, actions of the government, etc.) Some economists maintain that that the forward rate is also a good unbiased predictor of the future spot rate.
Approaches to Forecasting
Fundamental analysis
Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. Looks at variables such as inflation rates, money supply, balance of payments, etc.
Uses price and volume data to determine trends
Technical analysis
Governments
can place restrictions on the convertibility of currency (ability to change domestic currency for foreign currency) A countrys currency is said to be freely convertible when the countrys government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency
Political decision.
Many countries have some kind of restrictions. Government restrictions can include: A restriction on residents ability to convert the domestic currency into a foreign currency Restricting domestic businesses ability to take foreign currency out of the country
Capital flight: residents and nonresidents of a country rush to convert their holdings of a domestic currency to a foreign currency. Usually occurs when the value of the currency is depreciating or economics of a country is at crisis. Result: a depletion of foreign exchange reserves and depreciation of currency (domestic currency floods the foreign exchange market)
Capital flight:
Managerial Implications
Exchange rates influence the profitability of trade and investment deals. International businesses must understand the forces that determine exchange rate and insure protection against foreign currency risk. Remember individuals (consumers, tourists, etc.) are also impacted.