Documente Academic
Documente Profesional
Documente Cultură
Outline
A. B. C. D. E. F.
Foreign Exchange Market and Its Functions The Nature of Foreign Exchange Market Exchange Rate Determination Exchange Rate Forecasting Convertibility and Government Policy Managerial Implications
A market for converting the currency of one country into the currency of another. Its a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems
Exchange rate
Price determined in the FOREX market is the exchange rate. Its the rate at which one currency is converted into another The risk that arises from changes in exchange rates
4
Currency conversion Conversion: companies receive payment in foreign currencies and they have to convert these payments to their home currency Payments: companies pay foreign businesses for goods or services Investments: companies invest spare cash for short terms in money market accounts Currency Speculation: companies take advantage of changing exchange rates
The short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
6
To understand how the foreign exchange market provides insurance to protect against foreign exchange risk we need to understand
Spot exchange rate Forward exchange rate Currency swap
Spot exchange rate is determined through the interaction of relative demand and supply of that currency compared to others (discussed later).
forward exchange rates are the exchange rates governing future transactions such as when two parties agree to exchange currencies and execute the deal at some specific future date. Example: Suppose a US firm imports PCs (at 200,000 each) from Japanese supplier and can sell them immediately at $2000 in US. The firm needs to pay the Japanese supplier in in 30 days when the shipment arrives.
Suppose current spot exchange rate $1 = 120
If it buys now to pay after 30 days, then costs are $1,667 (200,000/ 120) - spot transaction But it does not have the money to pay the supplier until it can sell the computer
Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Moving out of one currency into another for a limited period without incurring foreign exchange risk. Common example of Swap: spot against forward
Spot exchange rate: $1 = 120 90-day forward exchange: $1 = 110 Convert $1 and get 120 now at spot rate ($1 = 120). Convert 120 and get $1.09 at forward rate ($1 = 110) 90 days from now Profit after 90 days: $1.09 - $1= $0.09!
10
Rent the apartment for HK$400,000/year, OR Buy the apartment for HK$5m and then resell to company for $5m after a year.
Suppose interest rate on a 1 year $5m loan in HK = 10% p.a. If she takes the loan, interest cost = 10% of $5m = $500,000 > rent Suppose interest rate in Switzerland on loan is 5%
Assume current spot exchange rate is 1CHF = 5HKD. Then, borrow CHF1m (= $5m) and pay interest cost = 5% of CHF1m = CHF 50,000 = $250,000 < rent
=> Borrow money in Swiss Francs (CHF)!! But what about future exchange or currency risk?
SUPPOSE future spot rate after one year is 1CHF = 5.2HKD. Then after one year need to pay CHF 1.05m =$5.46m. So need to pay extra ($5.46m-$5m) = $460,000 which is > rent! (Too much of currency risk!!)
Then take loan in Swiss Francs and enter into a CURRENCY SWAP
Convert CHF 1m into $5m spot transaction (at 1CHF = 5HKD) Make forward transaction of converting $5.355m into CHF 1.05m (at 1CHF = 5.1 HKD) one year from now
11
12
13
14
Example: Tokyo, London and New York exchange markets are all shut for only 3 hours out of every 24 hours.
Daily traded volumes are HUGE: $3.2 trillion in 2007 (25 times greater than volume of trade!) Londons dominance as a foreign exchange market is explained by:
History (capital of the first major industrialized nation). Geography (between Tokyo/Singapore and New York).
15
A global network of banks, brokers and foreign exchange dealers connected by electronic communications systems
Banks
Brokers
16
17
Inflation Interest Rates Monetary and Fiscal Policy Balance of Payments International Competitiveness Monetary Reserves Government Controls and Incentives Importance of Currency in World
18
Other Factors
19
Demand for a currency represents foreign residents need for that currency to complete intended transactions (buy goods or financial assets)
E.g. Japanese demand Euros () in order to buy German goods.
Supply for a currency represents domestic residents need for foreign currency to complete intended transactions with a foreign country
E.g. German demand Yen () when they want to buy Japanese goods. They need to sell in order to buy .
20
What causes shift in demand for Euros? Change in taste, e.g. Japanese want more German goods. Changes in relative national incomes, e.g. Japanese incomes rise, causing an increase in demand for German goods.
150 140 e*
e**
D/ D
Changes in relative return on financial assets, e.g. German bonds earn more than Japanese bonds. Similar reasons for supply changes.
21
60
65
Quantity of (billions)
When a currency becomes more valuable its price in terms of other currency increases, i.e. more of the other currency is needed to buy one unit of this currency and the currency is said to have appreciated. When a currency becomes less valuable its price in terms of other currency decreases, i.e. less of the other currency is needed to buy one unit of this currency and the currency is said to have depreciated.
Currency Depreciation
Note: For any currency combination, if one currency appreciates in terms of the other then the other must necessarily depreciate and vice versa.
22
The Law of One Price Purchasing Power Parity (PPP) Theory Money supply and price inflation International Fisher Effect determines the relationship between interest rates and exchange rates Exchange rate can be affected by investor psychology and Bandwagon effects
23
Investor Psychology
Identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example: 1 = $1.50. A jacket selling for $75 in New York should sell for 50 in London ($75/1.50) If the jacket costs 40 in London Convert $60 to get 40 and buy a jacket in London. Sell it in New York for $75 => Profit of $15 per jacket (arbitrage) Increased demand in London would raise their price Increased supply in New York would lower their price This will continue until prices are equalized: e.g. 44 in London and $66 in New York (at 1 = $1.50)
24
Implication of PPP
In relatively efficient markets (few impediments to trade and
investment), a basket of goods in different countries should cost roughly equivalent If a basket of goods costs $200 in US and 20,000 in Japan PPP theory predicts that the $/ exchange rate should be $200/ 20,000 or $0.01/ (or $1 = 100) 25
A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate Example:
A basket of goods costs $200 in US and 20,000 in Japan => $1 = 100 by PPP No price inflation in US but 10% in Japan => the basket of good in Japan will cost 22,000 in future. If there is no change in future exchange rate then PP is violated. => $1 = 110 in future, i.e. has depreciated by 10% against $
26
Transportation costs and trade restrictions (including non-tradable goods) Menu costs
costs to firms of updating menus, price lists, brochures, and other materials when prices change in an economy leading to sticky prices
Goods may not be perfect substitutes Other factors, such as real interest rates, etc., may dominate in the short-run
27
financial crisis has hit Eastern Europe particularly hard, leading to strong depreciation pressure on exchange rates. As a result, traditional non-tradable goods have suddenly become tradable. The Polish village of Osinow Dolny at the PolishGerman border has approx. 200 inhabitants, 100 of which are active hairdressers. Germans come from as far as Berlin (70 km) to take advantage of the zloty exchange rate, which went from 3.30 per euro in the summer of 2008 to well over 4 now. "Salon Teresa" at the end of main street charges 9 euros for ladies and 4 for men.
Illustrates the forces that tend to push exchange rates toward purchasing-power parity.
28
29
money supply increases faster than output increases a country with a high inflation rate will see depreciation in its currency exchange rate the relative demand and supply conditions in foreign exchange market
The dollar will depreciate against currencies of countries with slower monetary growth
30
nominal interest rate (i) is the sum of real interest rate (r) and expected rate of inflation (I) i = r + I real interest rates in different countries are equalized
Example:
If r in US = 10% and r in Switzerland = 6%, investors would borrow money from Switzerland and put it in US (I) Demand for money in Switzerland interest rate in Switzerland (II) Supply of money in US interest rate in US Real interest rates in US and Switzerland are equalized
31
Since interest rates reflect expectations about inflation, it follows that there must also be a link between interest rates and exchange rates
International Fisher Effect: Linkage between interest rates and exchange rates
32
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
The relationship between the changes in spot exchnage rate and nominal interest rates between any two countries/economic unions (e.g. US and EU) can be charaterized as : S1 S 2 v100 ! i$ i S2 where, S1 and S2 are the spot exchange rates at the beginning of the period and the end of the period respectively and i $ and i are the respective nominal interest rates in US and EU.
33
Suppose the current spot exchange rate is 1$ = 100 Then the spot exchange rate in the future between dollar and yen should be:
(100 S2) / S2 = (10 6)/100 => 100 (100 - S2) = 4 S2 => 104 S2 = 10000 => => S2 = 10000/104 96 in future we expect $ to depreciate by 4% against
34
Since real interest rate must be the same in all countries, hence r$ = r
=> 10 - I$ = 6 - I => I$ - I = 4
US should expect a inflation rate 4% higher than Japan. But according to PPP theory a country with a 4% higher relative inflation rate should expect a 4% depreciation in its currency.
Therefore we should expect a 4% depreciation in $ with respect to
35
36
Investors moved in a herd in response to a bet placed by George Soros who shorted the British pounds and bought German marks
It is hard to predict investor psychology and bandwagon effect Sometimes, government intervention can prevent the bandwagon from starting,
but at other times it is ineffective and only encourages traders to further speculate
37
38
If FOREX markets are efficient then forward exchange rates will be unbiased predictors of future spot rates.
Traditionally, economics and finance theories have assumed that FOREX markets are efficient, but recent studies relying on empirical evidence on markets have challenged that assumption.
39
In this case forward exchange rates are not unbiased predictors of future spot rates and hence estimates of future spot rates based on forward rates can be improved. But how? Two schools of thought: Fundamental Analysis
Use economic theory to construct sophisticated econometric models for predicting exchange rate movement.
Technical Analysis
Use technical (price/volume data) analysis to predict the exchange rates.
Analysis suggests that professional forecasters are no better than forward exchange rates in predicting future spot rates.
40
Non-residents can convert their holdings of domestic currency into a foreign currency, but the ability of residents to convert currency is limited in some way
Both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency
41
although many countries impose some restrictions on the amount of money that can be converted Preserve foreign exchange reserves
Service international debt. Purchase imports.
Prevent capital flight (when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency) a range of barter-like agreements by which goods and services can be traded for other goods and services It is used in international trade when a countrys currency is nonconvertible
42
F. Managerial Implications
International businesses must understand the influence of exchange rates on the profitability of trade and investment deals Transaction Exposure
The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
Translation Exposure
The impact of currency exchange rate changes on the reported financial statements of a company
43
E. Managerial Implications
Economic Exposure
The extent to which a firms future international earning power is affected by changes in exchange rates
If a company wants to know how the value of a particular currency will change over the long term in the foreign exchange market, it should take a close look at all those economic level fundamentals that appear to predict long run exchange rate movements Example: The growth in a countrys money supply, its inflation rate and nominal interest rates When governments restrict currency convertibility, firms must find ways to facilitate international trade and investment
44