The Foreign Exchange Market: Chapter 10 PowerPoint for International Management Course. Material to teach class for two days.

1. The Foreign Exchange Market-
Chapter 10
Maria G. Perez, Trevor Mcdonald, Mike Spalding,
Lydia Gellis, Ricardo Cantu, Kevin Calderon,
Andrew Mitchell

2. • Foreign Exchange Market: is a market for
converting the currency of one country into that
of another country.
• Exchange Rate: is simply the rate at which one
currency is converted into another.
• Ex: an exchange rate of 1 euro= $1.30 specifies
that 1 euro buys 1.30 U.S dollars

3. Foreign Exchange Market
Two main functions:
1) Convert the currency of one country into the currency of
another.
2) Provide some insurance against foreign exchange risk, or
the adverse consequences of unpredictable changes in
exchange rates.
• Without the foreign exchange market, international trade &
international investment on the scale that we see today would be
impossible; companies would have to resort to barter.
• The foreign exchange market is the lubricant that enables
companies based in countries that use different currencies to
trade with each other.

4. Risks
• International trade and investment have risks.
• Some of these risks exist because future
exchange rates cannot be perfectly predicted.
• The rate at which one currency is converted into
another can change over time.

5. Currency Conversion
• Each country has a currency in which the prices
of goods and services are quoted.
• U.S: Dollar
• Great Britain: Pound
• France, Germany, & the other 15 members of the
euro zone: Euro
• Japan: Yen

6. Foreign Exchange Market
participation
Italian Wine
Must
use
National
Currenc
y

7. Currency Speculation
is another use of foreign exchange markets. It
involves short-term movement of funds from one
currency to another in the hopes of profiting from
shift in exchange rates.
• Very risky business: the company cannot know
what will happen to exchange rates.

8. Carry Trade
• A kind of speculation that has become more
common in recent years.

9. Spot Exchange Rate
• The rate at which a foreign exchange dealer
converts one currency into another on a
particular day.
• They are reported on a real-time basis on many
financial websites, they change continually.

10. Forward Exchange Rates
• Occurs when two parties agree to exchange
currency and execute the deal at some specific
date in the future.
• They are the exchange rate governing forward
exchange transaction.

11. Currency Swaps
• A currency swap is the simultaneous purchase &
sale of a given amount of foreign exchange for
two different value dates.
• Swaps are transacted between international
businesses & their banks, between banks,
&between governments when it is desirable to
move out of one currency into another for a
limited period without incurring foreign exchange
risk.
• A common kind of swap is spot against forward.

12. The Foreign Exchange Market
is?
A) A market where all money is stored and invested.
B) A kind of speculation that has become more
common in recent years.
C) A market for converting the currency of one country
into that of another country.
D) The simultaneous purchase & sale of a given
amount of foreign exchange for two different value
dates.

13. Volkswagen’s Hedging
Strategy
Volkswagen reported a 95% drop in Q4 profits in
2003
Two factors were focused on as the main causes
The sharp rise in the value of the euro against the
dollar
Volkswagen’s decision to hedge 30% of its foreign
currency exposure instead of 70%; like in the past

14. Exchange Rate: euro vs.
dollar
€1=$1 in late 2002
Quickly rose to €1=$1.25 by the end of 2003

15. Exchange rate affecting
Volkswagen
Volkswagen made cars in Germany, exported them to
The United States, sold them in dollars, then brought
the money back to Germany and exchanged them for
euros
When the euro got stronger against the dollar it
reduced the amount of euros VW got back for their
cars sold in the U.S.
At a 1:1 ratio in 2002 VW made roughly €1,000 for
every Jetta sold in U.S.
At 1:1.25 ratio in 2003, VW lost roughly €2,000

16. Hedging against changing
exchange rates
Companies can lower risk of doing business in
foreign currency by buying a forward contract that
allows them to exchange two currencies in the future
(in 180 days for example) at the current exchange
rate
Upside:
In the example of VW, the weaker the euro was in
2002 would have helped them make more money in
2003
Downside:
If the euro gets weaker against the dollar and VW has
a contract in place, they miss out on more profits by
having to exchange at the contract rate

17. The Nature of the Foreign Exchange Market
Foreign Exchange Market: A network of banks, brokers,
and foreign exchange dealers connected by electronic
communications systems
• Rapid growth of the foreign exchange market
• March 1986: $200 billion exchanged per day
• April 1995: $1,200 billion per day
• April 2007: $3.21 trillion per day
• April 2010: $4 trillion per day
• Activity centers
• London (37% of trading activity)
• New York (18% of trading activity)
• Zurich, Tokyo, Singapore (5% respectively)

18. The Nature of the Foreign Exchange
Market
Most transactions are done with the dollar on one side of the
equation, even if that is not the end goal of the person making
the transaction
Example: a broker wanting to trade Bazillion real for
Korean won will trade real for dollars, then dollars for
won

19. Economic Theories of
Exchange Rate Determination
The Law of One Price
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 the same currency
According to this theory differences in price will work
themselves out based on the law of supply and
demand
Higher demand will increase the price in one market
and reduced demand in the other market will lower the
price till they reach equilibrium
This theory keeps brokers from buying goods in one
country and then selling those goods in another where
the exchange rates gives them a profitable advantage

20. Economic Theories of
Exchange Rate Determination
(cont.)
Purchasing Power Parity
Given a relatively efficient market (market with
few impediments to trade) and a basket of
predetermined goods in two currencies, one can
determine the exchange rate with the following
formula

21. Purchasing Power Parity
(cont.)
So; given a basket of goods in dollars, and the
same basket of goods in yen, the exchange rate
can be easily found using the formula
$200
¥20,000
Exchange rate (S)=$200/¥20,000
$1=¥100

22. Money Supply &
Price Inflation
A country with a high rate of inflation should
expect its’ currency to depreciate against the
currency of another country where the inflation
rate is lower
A country with a high growth rate of money
supply should expect high inflation
Thus, a country with a high growth rate of money
supply should expect a weaker exchange rate

23. Inflation
Occurs when the amount of currency in
circulation grows at a rate greater than the output
of goods and services, causing businesses to
increase the prices due to the increase in
demand

24. Government Role in
Controlling the Money Supply
Governments often increase the money supply to
pay for large public expenditures (building roads,
etc.), instead of increasing taxes to pay for them
This may be more popular in the short-term to
avoid paying higher taxes, it can lead to long-
term inflation

25. Quantitative Easing in the
U.S.
Fall 2010: the Federal Reserve decided to pump
$600 billion into the economy by purchasing
government bonds
Critics argued that this action would lead to a weaker
dollar and higher inflation levels
The FED was very afraid of deflation at the time and
the extra money would help to kick-start the economy
by increasing demand and putting people back to
work
When looking at QE from the beginning of 2010 to
the beginning of 2011, the exchange rate remained
relatively unchanged when compared to other major
currencies in the foreign market

26. Empirical Tests of PPP
Theory
Purchasing Power Parity Theory predicts that exchange
rates are determined by relative prices and that changes in
relative prices will result in a change in exchange rates.
While PPP theory seems to yield relatively accurate
predictions in the long run, it does not appear to be a
strong predictor of short-run movements in exchange rates
covering time spans of five years or less.
The theory seems to best predict exchange rate changes
for countries with:
High rates of inflation
Underdeveloped capital markets

27. Empirical Tests of PPP
Theory
PPP theory is less useful for predicting:
Short-term exchange rate movements between the currencies of
advanced industrialized nations that have relatively small differentials
in inflation rates.
Purchasing Power Parity Puzzle: The failure to find a
strong link between relative inflation rates and exchange
rate movements.
Several factors may explain the failure of PPP theory to
predict exchange rates more accurately:
Assumes away transportation costs and barriers to trade
Governments routinely intervene in international trade (tariff and
nontariff barriers)
Many national markets are dominated by a handful of
multinational enterprises that have sufficient market power.
(Example on next slide)

28. Empirical Tests of PPP
Theory
Example: This dominance situation presents
itself in a number of industries:
Detergent: Unilever and Procter & Gamble
Heavy earthmoving equipment: Caterpillar and
Komatsu
Semiconductor equipment: Applied Materials
In such cases, dominant enterprises may be able
to exercise a degree of pricing power, setting
different prices in different markets to reflect
varying demand conditions (Price
discrimination).

29. Interest & Exchange Rates
Economic theory tells us that interest rates reflect
expectations about likely future inflation rates.
In countries where inflation is expected to be high,
interest rates also will be high.
This relationship was first formalized by economist
Irvin Fisher and is referred to as the Fisher effect.
Fisher effect: states that a country’s “nominal” interest
rate (i) is the sum of the required “real” rate of interest
(r) and the expected rate of inflation over the period
for which the funds are to be lent.
More formally i = r + I

30. Interest & Exchange Rates
For example:
If the real rate of interest in a country is 5 percent and annual
inflation is expected to be 10 percent, the nominal interest rate
will be 15 percent (i = 5 + 10).
As predicted by the Fisher effect, a strong relationship
seems to exist between inflation rates and interest rates.
Application in a world of many countries and unrestricted capital
flows:
When investors are free to transfer capital between countries, real interest
rates will be the same in every country. If differences in real interest rates
did emerge between countries, arbitrage would soon equalize them.
For example, if the real interest rate in Japan was 10% and
only 6% in the U.S., it would pay investors to borrow
money in the U.S. and invest it in Japan.

31. Interest & Exchange Rates
The International Fisher effect: 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 countries.
For example: the change in the spot exchange rate
between the U.S. and Japan, can be modeled as
follows:
[(S1 – S2) / S2] X 100 = i$ – IY
Where i$ and iY are the respective nominal interest rates in the
U.S. and Japan, S1 is the spot exchange rate at the beginning
of the period, and S2 is the spot exchange rate at the end of the
period.

32. Interest & Exchange Rates
Do interest rate differentials help predict future
currency movements?
The evidence is mixed
PPP theory, in the long run, there seems to be a
relationship however, considerable short-run deviation
occur. Like PPP, the international Fisher effect is not a
good predictor of short-run changes in spot exchange
rates.

33. Investor Psychology &
Bandwagon Effects
Evidence reveals that various psychological
factors play an important role in determining the
expectations of market traders as to likely future
exchange rates.
A famous example:
In 1992, George Soros made a huge bet against the
British pound.
He immediately sold those pounds for German
deutsche marks (before the advent of the euro).
Known as short-selling (can earn enormous profits if
he can subsequently buy back the pounds he sold at a
much better exchange rate).

34. Investor Psychology &
Bandwagon Effects
Example (cont.)
By selling pounds and buying deutsche marks, Soros
helped to start pushing down the value of the pound.
When Soros started shorting the pound, many foreign
exchange traders, knowing Soros’s reputation, jumped
on the bandwagon and did likewise.
Bandwagon effect: when traders move like a
herd, all in the same direction and at the same
time, in response to each others’ perceived
actions.

35. Investor Psychology &
Bandwagon Effects
Investor psychology & bandwagon effects play
an important role in determining short-run
exchange rate movements.
However, these effects can be hard to predict.
Investor psychology can be influenced by:
Political factors
Macroeconomic fundamentals (such as relative
inflation rates)

36. 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; they are poor predictors
of short-run changes.
However, poor predictors of short-run changes can be
influenced by psychological factors, investor
expectations, and bandwagon effects on short-term
currency movements.
The long-term profitability of foreign investments, export
opportunities, and the price competitiveness of foreign imports
are all influenced by long-term movements in exchange rates,
international businesses would be advised to pay attention to:
Countries’ differing monetary growth
Inflation
Interest rates

37. Exchange Rate
ForecastingA company’s need to predict future exchange rate
variations raises the issue of whether it is worthwhile for
the company to invest in exchange rate forecasting
services to aid decision making.
Two schools of thought address this issue:
The Efficient Market School: argues that forward exchange
rates do the best possible job of forecasting future spot
exchange rates, therefore, investing in forecasting services
would be a waste of money.
The Inefficient Market School: argues that companies can
improve the foreign exchange market’s estimate of future
exchange rates by investing in forecasting services. This
school of thought does not believe the forward exchange rates
are the best possible predictors of future spot exchange rates.

38. The Efficient Market
School
Many economists believe the foreign exchange
market is efficient at setting forward rates.
Efficient Market: a market in which prices reflect
all available public information.
If the foreign exchange market is efficient,
forward exchange rates should be unbiased
predictors of future spot rates
This does not mean the predictions will be accurate; it
means inaccuracies will not be consistently above or
below future spot rates. They will be random.

39. The Inefficient Market
School
Inefficient Market: on in which prices do not
reflect all available information.
Forward exchange rates will not be the best
possible predictors of future spot exchange rates.
If true, it may be worthwhile for international
businesses to invest in forecasting services.
Professional exchange rate forecasts might provide
better predictions of future spot rates, however,
professional forecasting services are not that good.
Example: forecasting services did not predict the rise of the
dollar that occurred during late 2008 during the financial crisis.
Many thought it would decline.

40. Approaches to Forecasting
Fundamental analysis: draws on economic theory to
construct sophisticated econometric models fore
predicting exchange rate movements.
Variables included in fundamental analysis include: relative
money supply growth rates, inflation rates, balance-of-
payments, and interest rates.
Example: running a deficit on a balance-of-payments current
account (imports exceed exports) creates pressure that may
result in the depreciation of the country's currency on the
foreign exchange market.
Technical analysis: uses price and volume data to
determine past trends, which are expected to continue
into the future.
Based on the premise that there are analyzable market trends
and waves and that previous trends and waves can be used to

41. Currency Convertibility
Freely Convertible
- Japanese yen (¥)
Externally Convertible Currency
- Capital Flight - Fear restrictions, due to
depreciation of a country’s currency - limit investing
abroad
- Rise on Import Prices
- Depleting Foreign Exchange Reserves – N/A pay
debts
Nonconvertible Currency
- Soviet Union
- Russia

42. QUESTION?
Nonresidents can convert their holdings of
domestic currency into foreign currency, but the
ability of residents to convert the currency is
limited in some way
Externally Convertible Currency
Goal: Keep domestic currency in home country,
i.e. avoiding losing value of their currency.

43. Currency Convertibility
Cont.
Nonconvertible Currency
- Countertrade (Bartering) - “eye for an eye”
- Romanian Government – General Electric
- Venezuela Government – Caterpillar
- Indonesia Government (goods) – Libya ( oil)
Nonconvertible currency >10% ALL Govts.

44. Another Perspective
Billion’s of dollars are leaving Pakistan through
Unofficial Channels
State Bank of Pakistan failed to control this
Politicians, Officials and Money Chargers involed
Money being transferred to Dubai and some
other countries because the people of Pakistan
are afraid to invest in their own country.

45. Managerial
Implications

46. Transaction Exposure
Transaction Exposure – Individual transactions affect
foreign exchange values
- Project in 2004 cost $1 billion - ($1 = € 1.10) (€
1.2/1.1 = $1.09 billion)
- Same project completed in 2008 – Now
($1 = € 0.80) (€1.2/.80 = $1.5 billion)
An Increase ^ of $ 0.41 Billion

47. Question?
Why should you forecast contractual
agreements?
A. Because it is cool
B. Appreciation and Depreciation Reasoning
C. Product Life Cycle Theory
D. Porters 5 Forces

48. Translation Exposure
Translation Exposure – Individual short term
transactions
EX: A US subsidiary in Mexico, and the Peso
Depreciates = reduced $ value of firms equity
= Increased debt ratio & cost of borrowing & limit
to capital market

49. Question?
The US has multiple firms/acquisitions/mergers
located in Mexico. 5 of the largest Coca-Cola
factories burn down, and in response the value of
the Peso depreciates rapidly. What
effects/outcomes should the US expect?
Decrease on ALL of their investments within
Mexico

50. Economic Exposure
Economic Exposure – Earning power affected
by exchange rates
EX: ^ value of US $ in 1990s hurt the price
competitiveness of US producers in world
markets
EX: Reverse Phenomena value of US $ declined &
increased price competitiveness for US
manufactures in world markets

51. Question?
In world markets, the fall in the value of the dollar
benefits whom , in terms of price
competitiveness?
A. My Mommy
B. USA
C. Producers
D. Manufactures

52. Reducing Translation and
Transaction Exposure
• Protect short-term cash flows = forward
exchange rate contracts and buying swaps
Lead Strategy – Collect money for projects
initially (if currency is predicted to depreciate)
Lag Strategy – The opposite (currency is
expected to appreciate)

53. Question?
The USA wants to build the first highly efficient
refinement factory in Cameroon, refining oil/gas,
but their currency is expected to appreciate after
the project is completed. What strategy should
the USA implement?
Lag Strategy

54. Reducing Economic
Exposure
Strategically disperse Country’s assets
EX: Rising yen = Toyota has production facilities across globe
= affirms price of Toyota’s are still suitable for local markets
EX: Caterpillar = Global Production Facilities=
Acts as a hedge against possibility that a strong dollar will
price their goods out of foreign markets

55. Video on Hedging
http://www.investopedia.com/video/play/hedging/
Dispersing productive assets to various
locations, to avoid adverse exchange rates
Being an asset heavy company is Not profitable,
i.e. all assets depreciate at a constant rate,
The minute you drive your new car off the lot

56. Other Steps For Managing
Foreign Exchange Risk
Central Control of Exposure
Flexible Sourcing – Black & Decker = economies
of scale (narrow product differentation)
WATCH Future movements in foreign exchange
rates
Good Reporting System of Currency Fluctuations
– balance reports

57. Question?
Economies of Scale
A. Average cost As scale of production
B. Average cost As scale of production
C. Are Monopolies
Economies of Scope
A. Diverting risk by creating hedge funds
B. Lowering the average cost for producing 2+ goods and
services
C. Decreasing the average cost on one product line

59. • Foreign Exchange Market – a market for converting
the currency of one country into that of another
country.
• Exchange Rate – the rate at which one country is
converted into another.
• Foreign Exchange Risk – the risk that changes in
exchange rates will hurt the profitability of a business
deal.
• Currency Speculation – involves short term
movement of funds from one currency to another in
hopes of profiting from shifts in exchange rates.
• Carry Trade – involves borrowing in one currency
where interest rates are low and then using the
proceeds to incest in another currency where interest
rates are high
• Spot Exchange Rate – the exchange rate at which a
foreign exchange dealer will convert one currency
into another that particular day.

60. • Forward Exchange – when two parties agree to
exchange currency and execute a deal at some
specific date in the future.
• Forward Exchange Rate – the exchange rate
governing forward exchange transactions.
• Currency Swap – simultaneous purchase and sale
of a given amount of foreign exchange for two
different value dates.
• Arbitrage – the purchase of securities in one market
for immediate resale in another to profit from a price
discrepancy.
• Law of One Price – 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 the same
currency.

61. • Efficient Market –few impediments to
international trade and investment exist.
• Fisher Effect –Interest Rate (i) = Real Rate of
Interest (r) + Lent Funds (l)
• International Fisher Effect – the spot exchange
rate should change in an equal amount but in the
opposite direction to the difference in nominal
interest rates between countries.
• Bandwagon Effect – when traders move like a
herd, all in the same direction and at the same
time, in response to each others perceived
actions.
• Inefficient Market –prices do not reflect all
available information

62. • Freely Convertible Currency – a country’s currency
is freely convertible when the government of that
country allows both residents and nonresidents to
purchase unlimited amounts of foreign currency with
the domestic currency
• Externally Convertible Currency – nonresidents
can convert their holdings of domestic currency into
foreign currency, but the ability of residents to convert
the currency is limited in some way.
• Nonconvertible Currency – a currency is not
convertible when both residents and nonresidents are
prohibited from converting their holdings of that
currency into another currency.
• Capital Flight – residents convert domestic currency
into a foreign currency.
• Countertrade – the trade of goods and services for
other goods and services.

64. Indian Rupee
The Indian rupee has slipped to 20th in 2013 from
15th in 2010 in the global foreign exchange
market turnover
The Indian rupee slide to a record low, dropping
from 56.51 rupees per dollar to 58.41
The Rupee falls when money is coming into the
country rather than what is leaving

65. Indian Rupee
A falling rupee is a concern because it is a signal
of weakness to the external world; a weaker
currency makes it more expensive to buy
imported goods like oil, which in turn aggravates
the problem of inflation
A softening rupee increases the implicit cost of
India’s high foreign debt

66. Indian Rupee
One fundamental factor involves the country’s
trade deficit, which is becoming a more serious
problem, judging by the government’s mounting
concern about gold imports.
Finance Minister P. Chidambaram pleased the
Indians to stop buying gold. Gold and oil
constitute around 45% of imports, and with oil
price remaining steady, evidently gold imports
have upset the status quo

67. Indian Rupee
Rupee depreciation does have its advantages
since it makes Indian goods cheaper overseas
and therefore more attractive customers, which
benefits exporters. In fact, some importers of
Indian goods are asking exporters to lower their
prices on account of this price advantage

68. Reporting by: Jamie Chisholm in London, Patrick McGee in Hong
Kong and Vivianne Rodrigues in New York

69. Debt Ceiling
Oct 17th a deal was reached
Debt ceiling is to last till February 7th
Meetings in December and January to resolve

70. Good News and Bad News
The shut down and last minute deal
The damage it has done
The dollar value
Under pressure
International markets
Stocks rising
Investors
Americas credit damaged
Dagong creditagency

71. Question?
What are the main factors that effect exchange
rates in both the long run and short run?

72. Short run exchange rates
Monetary growth
Inflation rates
Nominal interest rates
Psychological factors
Dagong credit
Dollar value

74. Australia's Currency Conversion
Deal
Australian Prime Minister Julia Gillard traveled to Beijing to
secure a currency conversion deal with her nation’s most
important trading partner, China.
Currently Chinese and Australian companies must use the U.S.
dollar as an intermediary for trade.
The deal’s important ramifications:
It provides a step towards full convertibility of the Yuan on
international markets.
It will dent the primacy of the U.S. dollar as the world
reserve’s currency of choice.
The Australian dollar would become directly convertible to the
Chinese Yuan, overcoming the need to first convert to U.S.
dollars. This removes expensive exchange rate issues.

75. Australia’s relations with
China & the U.S.
Gillard must perform the difficult task of assuring
China that their relationship with the U.S. will
post no threat to China, or Beijing.
Australia has recently started growing defense
agreements with the U.S. which permits American
naval and aircraft access to Australia.
The visit was deliberately scheduled shortly after
the recent leadership change in China.
This reflects the importance of the rapidly growing
relationship with China.

76. Greater Economic
interaction with Asia
The currency conversion deal is primarily aimed
as furthering the Australian government’s
ambition for greater engagement with Asia.
“Australia in the Asia Century”, a major policy
essay released before the proposed deal was
released, acknowledged that Australia’s
economic prosperity was tied to Asia.
The key of their prosperity would be to take
advantage of the rise of a massive Asian middle
class.

77. Australian economic
dependence on China
Australian dependence on China to
become an economic power has been
clear for many years.
In 2011-12, China was Australia’s
largest two-way trading partner for
goods and services, with trade topping
$128 Billion.
China accounts for 14.7% of total trade
goods and services and takes 25% of
Australian exports.

78. Possible Outcomes
The Chinese economy is expected to grow 8%
this year. This deal would boost the struggling
Gillard government in an election year, & thus
make it possible for Australia to improve their
economic relations with other Asian countries.
The Australian dollar will remain high due to
Chinese demand & the perception that Australia
is a safe currency haven.
The Australian dollar to U.S. dollar exchanges
are now estimated to be the fifth highest traded
currencies in the world.

79. True or False?
• The newly proposed currency conversion deal
between Australia and China will have no affect
on the U.S. dollar being the world reserve’s
currency of choice.
• Australia’s main economic trading partner is
South Korea, while China is a close second.