Foreign Exchange Market

1. International Business
Chapter Ten. The Foreign Exchange Market

2. FOREX
• Functions of the Foreign Exchange
Market
• Convert the currency of one country
into the currency of another
• Provide some insurance against
foreign exchange risk
Fuente: https://www.xtb.com/en/learn-to-trade/what-is-forex

3. Currency Conversion
• In general, within the borders of a particular country, one must use the
national currency.
• Businesses use the foreign exchange market
• To convert the payments received for its exports, the income received from foreign
investments, or the income received from licensing agreements with foreign firms
• To make payment to a foreign company for its products or services in its country’s
currency
• To invest cash for short terms in foreign money markets
• For currency speculation
• Carry trade

4. Spot Exchange Rate

5. Forward Exchange Rate
• In an AUD/SGD example:
• Home currency = SGD
Foreign currency = AUD
1Yr Home Interest Rate = 1%
1 Yr Foreign Interest Rate = 3%
Current Exchange Rate = $1.50
Therefore, 1 Yr Forward Rate = (1.01)/(1.03) x
1.50= 1.47
Fuente: http://www.sharesinv.com/articles/2013/01/23/how-
economic-strength-influences-currency-fluctuations/

6. Insuring Against Foreign Exchange Risk
Currency swaps
Transaction between
international businesses and
their banks, between banks,
and between governments
Common type: spot against
forward
Fuente: https://www.youtube.com/watch?v=Ey5nulQ-xzU

7. Largest Financial Centres in the World

8. Prices and Exchange Rates
• The law of one price
• Purchasing power parity
• Comparison of prices of
identical products
determine the real or
PPP exchange rate
• The price of a “basket of
goods” should be
roughly equivalent in
each country
• Big Mac Index
Fuente: https://www.forexlive.com/news/!/move-over-big-mac-now-its-the-latte-index-of-currency-valuation-20180328

9. Prices and Exchange Rates
• Money supply and price inflation
• The growth rate of a country’s money
supply determines its likely future
inflation rate.
• Inflation -- money supply increases
faster than output increases.
• An increase in the money supply
makes it easier to borrow, which
increases demand for goods and
services.
• A country with a high inflation rate will
see depreciation in its currency
exchange rate.
• Government policy determines growth
rates.
Fuente: https://en.wikipedia.org/wiki/Money_supply

10. Prices and Exchange Rates
Empirical tests of PPP theory
• Exchange rates are determined by relative prices and changes
in relative prices will result in a change in exchange rates.
• Not a strong predictor of short-run movements in exchange
rates covering time spans of five years or less
• Best predicts exchange rate changes for countries with high
rates of inflation and underdeveloped capital markets

11. Interest Rates and Exchange Rates
• Interest rates reflect expectations
about likely future inflation rates
• The Fisher effect
• 𝑖 = 𝑟 + 𝐼
• If the real interest rate is the same
worldwide, any difference in interest
rates between countries reflects
differing expectations about inflation
rates
• The international Fisher
effect (IFE)
•
𝑺 𝟏
−𝑺 𝟐
𝑺 𝟐
𝒙 𝟏𝟎𝟎 = 𝒊$ − 𝒊¥ Fuente: http://www.swlearning.com/finance/madura/ifm7e/powerpoint/expanded08/sld024.htm

12. Investor Psychology and Bandwagon Effects
• Neither PPP theory nor the
international Fisher effect is
particularly good at explaining
short-term movements in
exchange rates.
• Investor psychology
• Bandwagon effect
Fuente: https://kriptoakademia.com/2018/08/22/az-uj-vasarloi-piac-indulasanak-3-lehetseges-forgatokonyve

13. Summary of Exchange Rate Theories
• Relative monetary growth, relative
inflation rates, and nominal interest
rate differentials are all moderately
good predictors of long-run changes
in exchange rates.
• But they are poor predictors of short-
run changes.
Fuente: http://inflationmatters.com/keynesian-inflation-theory/

14. Efficient vs Inefficient Market Schools
The Efficient Market School
• Prices reflect all available public
information
• Forward exchange rates should
be unbiased predictors of
future spot rates
The Inefficient Market School
• Prices do not reflect all available
information.
• Forward exchange rates will not be
the best possible predictors of
future spot exchange rates

15. Approaches to Forecasting
• Fundamental Analysis
• Draws on economic theory to
construct sophisticated
econometric models for predicting
exchange rate movements
• Includes relative money supply
growth rates, inflation rates, and
interest rates, and possibly
balance-of-payments positions
• Technical Analysis
• Uses price and volume data to
determine past trends, which are
expected to continue into the
future
• There are analyzable market
trends and waves that can be used
to predict future trends and waves
Fuente: https://www.ig.com/au/trading-strategies/beginners-guide-to-fundamental-analysis-190503

16. Currencies can be…
• Freely convertible
• Externally convertible
• Nonconvertible
• Not desirable for international
business
Governments limit
convertibility to preserve their
foreign market reserves.
• Capital flight
• Countertrade
Fuente: https://www.investopedia.com/articles/forex/083115/pros-and-cons-fully-convertible-rupee.asp

17. Foreign Exchange Rate Risk
Fuente: https://appliedfinancejulianshovlin.wordpress.com/2011/12/15/how-and-why-companies-should-manage-currency-risk-topic-8/