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  • The foreign exchange market is the market where currencies are bought and sold and in which currency prices are determined. It is a network of banks, brokers and dealers that exchange currencies 24 hours a day.
  • Management Focus: Volkswagen’s Hedging Strategy Summary This feature examines Volkswagen’s hedging strategy and why Volkswagen lost over € 1 billion in 2003. Discussion of the feature can revolve around the following questions: Suggested Discussion Questions 1. Why was Volkswagen so vulnerable to the rise in the value of the euro relative to the dollar? Discussion Points: Volkswagen was particularly vulnerable to the euro’s appreciation relative to the dollar for two key reasons. First, the company had decided that rather than hedging its usual 70 percent of foreign currency exposure, it would only hedge 30 percent. Second, Volkswagen made its cars in Germany, and then exported them to the United States. 2. How could Volkswagen have protected itself from the change in the value of the euro? Discussion Points: Volkswagen could have protected itself from the change in the euro’s value by hedging a greater share of its foreign currency exposure. While hedging is not without costs, in this particular case, Volkswagen would have saved a significant sum. Another strategy Volkswagen could consider is to look at alternative manufacturing options. Currently, the company manufactures all of its cars destined for the United States in Germany. If the euro is expected to maintain its current value, Volkswagen may want to consider opening a manufacturing operation in the United States. Another Perspective: To learn more about Volkswagen, go to the company’s web site at { http://www.volkswagen.com }
  • The answer is a.
  • The answer is d.
  • In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78)
  • 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 Governments will limit or restrict convertibility for a number of reasons that include: Preserving foreign exchange reserves A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight
  • Country Focus: Anatomy of a Currency Crisis Summary This feature describes South Korea’s 1997 financial crisis. In the space of a few months Korea saw its economy and currency move from prosperity to critical lows. Much of the blame for Korea’s financial collapse can be placed with the country’s chaebol (large industrial conglomerates) that had built up massive debts as they invested in new factories. Speculators, concerned about the chaebol’s ability to repay their debts, began to withdraw money from the Korean Stock and Bond markets fueling a depreciation in the Korean Won. Despite government efforts to halt the fall in the currency, the won fell some 67% relative to the dollar. Discussion of the feature can begin with the following questions. Suggested Discussion Questions 1. Discuss investor psychology and bandwagon effects and their role in accelerating Korea’s difficulties. Discussion Points: Studies show that the role of psychological factors is an important element in the strategies of currency traders. Moreover, expectations about the future of exchange rates tend to become self-fulfilling prophecies. When traders start to anticipate similar movements, the bandwagon effect of many traders all coming to the same conclusion actually has the effect of making speculation reality. Students will probably suggest that this appears to have contributed to South Korea’s situation where currency values fell very rapidly after foreign investors became alarmed when issues arose regarding the ability of South Korean companies to service their debt. 2. As a CEO of an American company, how does Korea’s situation affect your operations? Discussion Points: The situation in South Korea increased the risk for any company doing business with the nation. However, students should recognize that the effect on an American company depends on the company situation itself. For some companies, exports to South Korea may dry up if the South Korean buyer no longer exists or has significantly lower demand. However, for other companies exporting to South Korea, or actually operating in the country, the situation may actually increase opportunities as business that was formerly conducted by South Korean companies becomes available. 3. In your opinion, did the Korean government take the right steps to ease the crisis? Explain your response. Discussion Points: Some students will probably claim that the Korean government made its first mistake in the early 1990s when it encouraged the country’s chaebol to increase capacity in expectation of greater exports. The chaebol borrowed heavily, and when demand did not materialize, were stuck with excess capacity, falling prices, and debt. Some students will probably argue that the South Korean government did not act quickly enough to half the drop in the won, and then began to make desperation moves without really anticipating the reaction of investors.
  • The answer is c.
  • The answer is b.
  • The answer is d.
  • Management Focus: Dealing with the Rising Euro Summary This feature describes the exchange rate exposure faced by two German companies, SMS Elotherm and Keiper. Discussion of the feature can revolve around the following questions: Suggested Discussion Questions 1. Could SMS Elotherm have taken steps to avoid the position it now found itself in? What were those steps? Why do you think the company did not take these steps? Discussion Points: SMS Elotherm signed a deal in late 2004, to sell parts to DaimlerChrsyler. The company anticipated making about €30,000 profit on each part. However, within days, the anticipated profit was just €22,000. SMS Elotherm, which had priced its parts in dollars, but had its costs in euros, faced transaction exposure. The company could have done several things to limit its exposure to exchange rates. One of the easiest strategies would have involved entering forward contracts to buy euros with the dollars it would receive from DaimlerChrysler. The company could have followed a similar strategy with options to buy euros. A more involved strategy would have been to diversify its manufacturing so costs were spread across more than one currency. Finally, the company might have negotiated a deal with DaimlerChrysler to price some of its sales in dollars and others in euros. 2. Why was Keiper weathering the rise in the euro better than SMS Elotherm? Discussion Points: Keiper was able to limit its exposure to the sudden shift in exchange rates because it had opened a plant in Canada where its parts were being made. While the company still encountered exchange rate exposure because its costs were in Canadian dollars and its profits were in U.S. dollars, its exposure was not as great. 3. In retrospect, what might Keiper have done differently to improve the value of its “real hedge” against a rise in the value of the euro? If the U.S. dollar had appreciated against the euro and the Canadian dollar, instead of depreciating, which company would have done better? Why? Discussion Points: Keiper’s decision to produce its parts in Canada proved to be a good one. However, Keiper, like SMS Elotherm, could have further limited its exposure to exchange rate changes by using forward contracts and options to hedge its profits in U.S. and Canadian dollars. If the dollar had appreciated relative to the euro and the Canadian dollar, SMS Elotherm would have probably been better off as compared to Keiper. SMS Elotherm would have been earning profits in strong dollars while its costs were in weak euros.
  • The answer is b.

International business 7e   chapter 9 International business 7e chapter 9 Presentation Transcript

  • InternationalBusiness 7eby Charles W.L. HillMcGraw-Hill/Irwin Copyright © 2009 by The McGraw-Hill Companies, Inc. All rights reserved.
  • Chapter 9The Foreign Exchange Market
  • 9-3IntroductionA firm’s sales, profits, and strategy are affected by eventsin the foreign exchange marketThe foreign exchange market is a market for convertingthe currency of one country into that of another countryThe exchange rate is the rate at which one currency isconverted into another
  • 9-4The Functions Of TheForeign Exchange MarketThe foreign exchange market:is used to convert the currency of one country into thecurrency of anotherprovide some insurance against foreign exchange risk(the adverse consequences of unpredictable changes inexchange rates)
  • 9-5Currency ConversionInternational companies use the foreign exchange market when: the payments they receive for exports, the income they receive fromforeign investments, or the income they receive from licensingagreements with foreign firms are in foreign currencies they must pay a foreign company for its products or services in itscountry’s currency they have spare cash that they wish to invest for short terms inmoney markets they are involved in currency speculation (the short-term movementof funds from one currency to another in the hopes of profiting fromshifts in exchange rates)
  • 9-6Insuring Against Foreign Exchange RiskThe foreign exchange market can be used to provideinsurance to protect against foreign exchange risk (thepossibility that unpredicted changes in future exchangerates will have adverse consequences for the firm)A firm that insures itself against foreign exchange risk ishedging
  • 9-7Insuring Against Foreign Exchange RiskThe spot exchange rate is the rate at which a foreignexchange dealer converts one currency into anothercurrency on a particular daySpot rates change continually depending on the supplyand demand for that currency and other currencies
  • 9-8Classroom Performance SystemThe ________ is the rate at which one currency isconverted into another.a) Exchange rateb) Cross ratec) Conversion rated) Foreign exchange market
  • 9-9Insuring Against Foreign Exchange RiskTo insure or hedge against a possible adverse foreignexchange rate movement, firms engage in forwardexchangesA forward exchange occurs when two parties agree toexchange currency and execute the deal at some specificdate in the future A forward exchange rate is the rate governing suchfuture transactionsRates for currency exchange are typically quoted for 30,90, or 180 days into the future
  • 9-10Insuring Against Foreign Exchange RiskA currency swap is the simultaneous purchase and saleof a given amount of foreign exchange for two differentvalue datesSwaps are transacted between international businessesand their banks, between banks, and betweengovernments when it is desirable to move out of onecurrency into another for a limited period without incurringforeign exchange rate risk
  • 9-11The Nature Of TheForeign Exchange MarketThe foreign exchange market is a global network ofbanks, brokers, and foreign exchange dealers connectedby electronic communications systems—it is not located inany one placeThe most important trading centers are London, NewYork, Tokyo, and SingaporeThe markets is always open somewhere in the world—itnever sleeps
  • 9-12The Nature Of TheForeign Exchange MarketHigh-speed computer linkages between trading centersaround the globe have effectively created a single market—there is no significant difference between exchange ratesquotes in the differing trading centersIf exchange rates quoted in different markets were notessentially the same, there would be an opportunity forarbitrage (the process of buying a currency low and sellingit high), and the gap would closeMost transactions involve dollars on one side—it is avehicle currency along with the euro, the Japanese yen,and the British pound
  • 9-13Classroom Performance SystemThe _______ is the rate at which a foreign exchange dealerconverts one currency into another currency on a particularday.a) Currency swap rateb) Forward ratec) Specific rated) Spot rate
  • 9-14Economic Theories OfExchange Rate DeterminationExchange rates are determined by the demand andsupply for different currencies.Three factors impact future exchange rate movements: a country’s price inflation a country’s interest rate market psychology
  • 9-15Prices And Exchange RatesThe law of one price states that in competitive marketsfree of transportation costs and barriers to trade, identicalproducts sold in different countries must sell for the sameprice when their price is expressed in terms of the samecurrencyPurchasing power parity (PPP) theory argues that givenrelatively efficient markets (markets in which fewimpediments to international trade and investment exist)the price of a “basket of goods” should be roughlyequivalent in each countryPPP theory predicts that changes in relative prices willresult in a change in exchange rates
  • 9-16Prices And Exchange RatesA positive relationship between the inflation rate and thelevel of money supply exists When the growth in the money supply is greater than thegrowth in output, inflation will occur PPP theory suggests that changes in relative pricesbetween countries will lead to exchange rate changes, atleast in the short runA country with high inflation should see its currencydepreciate relative to othersEmpirical testing of PPP theory suggests that it is mostaccurate in the long run, and for countries with high inflationand underdeveloped capital markets
  • 9-17Interest Rates And Exchange RatesThere is a link between interest rates and exchange ratesThe International Fisher Effect states that for any twocountries the spot exchange rate should change in anequal amount but in the opposite direction to the differencein nominal interest rates between two countries In other words:(S1 - S2) / S2 x 100 = i $ - i ¥where i $ and i ¥ are the respective nominal interestrates in two countries (in this case the US and Japan), S1is the spot exchange rate at the beginning of the period andS2 is the spot exchange rate at the end of the period
  • 9-18Investor PsychologyAnd Bandwagon EffectsInvestor psychology also affects exchange ratesThe bandwagon effect occurs when expectations on thepart of traders can turn into self-fulfilling prophecies, andtraders can join the bandwagon and move exchange ratesbased on group expectations Governmental intervention can prevent the bandwagonfrom starting, but is not always effective
  • 9-19SummaryRelative monetary growth, relative inflation rates, andnominal interest rate differentials are all moderately goodpredictors of long-run changes in exchange rates So, international businesses should pay attention tocountries’ differing monetary growth, inflation, and interestrates
  • 9-20Classroom Performance SystemWhich of the following does not impact future exchangerate movements?a) A country’s price inflationb) A country’s interest ratec) A country’s arbitrage opportunitiesd) Market psychology
  • 9-21Exchange Rate ForecastingShould companies use exchange rate forecasting servicesto aid decision-making?The efficient market school argues that forward exchangerates do the best possible job of forecasting future spotexchange rates, and, therefore, investing in forecastingservices would be a waste of moneyThe inefficient market school argues that companies canimprove the foreign exchange market’s estimate of futureexchange rates by investing in forecasting services
  • 9-22The Efficient Market SchoolAn efficient market is one in which prices reflect allavailable informationIf the foreign exchange market is efficient, then forwardexchange rates should be unbiased predictors of futurespot ratesMost empirical tests confirm the efficient markethypothesis suggesting that companies should not wastetheir money on forecasting services
  • 9-23The Inefficient Market SchoolAn inefficient market is one in which prices do not reflectall available informationSo, in an inefficient market, forward exchange rates willnot be the best possible predictors of future spot exchangerates and it may be worthwhile for international businessesto invest in forecasting servicesHowever, the track record of forecasting services is notgood
  • 9-24Approaches To ForecastingThere are two schools of thought on forecasting:Fundamental analysis draw upon economic factors likeinterest rates, monetary policy, inflation rates, or balance ofpayments information to predict exchange ratesTechnical analysis charts trends with the assumption thatpast trends and waves are reasonable predictors of futuretrends and waves
  • 9-25Currency ConvertibilityA currency is freely convertible when a government of acountry allows both residents and non-residents topurchase unlimited amounts of foreign currency with thedomestic currency A currency is externally convertible when non-residentscan convert their holdings of domestic currency into aforeign currency, but when the ability of residents to convertcurrency is limited in some way A currency is nonconvertible when both residents andnon-residents are prohibited from converting their holdingsof domestic currency into a foreign currency
  • 9-26Currency ConvertibilityMost countries today practice free convertibility, althoughmany countries impose some restrictions on the amount ofmoney that can be convertedCountries limit convertibility to preserve foreign exchangereserves and prevent capital flight (when residents andnonresidents rush to convert their holdings of domesticcurrency into a foreign currency)When a country’s currency is nonconvertible, firms mayturn to countertrade (barter like agreements by whichgoods and services can be traded for other goods andservices) to facilitate international trade
  • 9-27Classroom Performance SystemWhen a government of a country allows both residents andnon-residents to purchase unlimited amounts of foreigncurrency with the domestic currency, the currency isa) Nonconvertibleb) Freely convertiblec) Externally convertibled) Internally convertible
  • 9-28Implications For ManagersFirms need to understand the influence of exchangerates on the profitability of trade and investment dealsThere are three types of foreign exchange risk:1. Transaction exposure2. Translation exposure3. Economic exposure
  • 9-29Transaction ExposureTransaction exposure is the extent to which the incomefrom individual transactions is affected by fluctuations inforeign exchange valuesIt includes obligations for the purchase or sale of goodsand services at previously agreed prices and the borrowingor lending o funds in foreign currencies
  • 9-30Translation ExposureTranslation exposure is the impact of currency exchangerate changes on the reported financial statements of acompanyIt is concerned with the present measurement of pasteventsGains or losses are “paper losses” –they’re unrealized
  • 9-31Economic ExposureEconomic exposure is the extent to which a firm’s futureinternational earning power is affected by changes inexchange rates Economic exposure is concerned with the long-termeffect of changes in exchange rates on future prices, sales,and costs
  • 9-32Classroom Performance SystemThe extent to which a firm’s future international earningpower is affected by changes in exchange rates is calleda) Accounting exposureb) Translation exposurec) Transaction exposured) Economic exposure
  • 9-33Reducing TranslationAnd Transaction ExposureTo minimize transaction and translation exposure, firmscan:buy forwarduse swapsleading and lagging payables and receivables (payingsuppliers and collecting payment from customers early orlate depending on expected exchange rate movements)
  • 9-34Reducing TranslationAnd Transaction ExposureA lead strategy involves attempting to collect foreigncurrency receivables early when a foreign currency isexpected to depreciate and paying foreign currencypayables before they are due when a currency is expectedto appreciateA lag strategy involves delaying collection of foreigncurrency receivables if that currency is expected toappreciate and delaying payables if the currency isexpected to depreciateLead and lag strategies can be difficult to implement
  • 9-35Reducing Economic ExposureTo reduce economic exposure, firms need to:distribute productive assets to various locations so thefirm’s long-term financial well-being is not severely affectedby changes in exchange ratesensure assets are not too concentrated in countrieswhere likely rises in currency values will lead to damagingincreases in the foreign prices of the goods and servicesthe firm produces
  • 9-36Other Steps For ManagingForeign Exchange RiskIn general, firms should:have central control of exposure to protect resourcesefficiently and ensure that each subunit adopts the correctmix of tactics and strategiesdistinguish between transaction and translation exposureon the one hand, and economic exposure on the otherhandattempt to forecast future exchange ratesestablish good reporting systems so the central financefunction can regularly monitor the firm’s exposure positionproduce monthly foreign exchange exposure reports
  • 9-37Classroom Performance SystemFirms that want to minimize transaction and translationexposure can do all of the following excepta) buy forwardb) have central control of exposurec) use swapsd) lead and lag payables and receivables