Mgnt 4670 Ch 10 Foreign Exchange Fall 2007)


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  • Mgnt 4670 Ch 10 Foreign Exchange Fall 2007)

    2. 2. Foreign Exchange Market <ul><li>Foreign exchange market: </li></ul><ul><ul><li>A market for converting the currency of one country into the currency of another. </li></ul></ul><ul><li>Exchange rate: </li></ul><ul><ul><li>The rate at which one currency is converted into another. </li></ul></ul>
    3. 3. Foreign Exchange Market <ul><li>Foreign exchange risk : </li></ul><ul><ul><li>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 company’s business. </li></ul></ul><ul><ul><li>Examples: </li></ul></ul><ul><ul><ul><li>An unexpected change in exchange rates will change the home currency value of foreign currency cash payment that is expected from a foreign source; </li></ul></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
    4. 4. Foreign Exchange Market <ul><li>MAD’S MONEY </li></ul><ul><li>CLASS MONEY </li></ul><ul><li>2 MM/1CM </li></ul><ul><li>1MM/1CM </li></ul><ul><li>4MM/1CM </li></ul>
    5. 5. FOREIGN EXCHANGE RATES <ul><li>Exchange rates are quoted in two ways: </li></ul><ul><li>Price of the foreign currency price in terms of dollars [or of home currency per foreign currency] e.g. $0.00854/yen </li></ul><ul><li>Known as direct or sometimes as American quote </li></ul><ul><li>Price of dollars in terms of the foreign currency </li></ul><ul><li>[or foreign currency per home currency] </li></ul><ul><li>e.g. SF 1.562/$ </li></ul><ul><li>Known as indirect or sometimes as European quote </li></ul>
    7. 7. FOREIGN EXCHANGE RATES <ul><li>Foreign exchange traders have nicknames for currencies: </li></ul><ul><ul><li>“ Cable” is the exchange rate between US Dollars and Pounds Sterling </li></ul></ul><ul><ul><li>Canadian dollar is a “loonie” </li></ul></ul><ul><ul><li>French franc used to be known as “Paris” </li></ul></ul><ul><ul><li>New Zealand dollar is a “kiwi” </li></ul></ul><ul><ul><li>Australian dollar is an “aussi” </li></ul></ul><ul><ul><li>Swiss Franc is a “Swissie </li></ul></ul><ul><ul><li>Singapore dollar is a “Sing dollar” </li></ul></ul>
    8. 8. TERMS: CURRENCY VALUES <ul><li>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”) </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul><ul><li>UNDERVALUED: a currency is too weak against another currency; is not as strong as it should be. </li></ul><ul><li>OVERVALUED : a currency is too strong against another currency; should have less value than it does. </li></ul>
    9. 9. Foreign Exchange Market <ul><li>Is currency appreciating or depreciating ? </li></ul><ul><ul><ul><li>90 yen/1 US $ or US$.011 /¥1 </li></ul></ul></ul><ul><ul><ul><li>100 yen/1 US$ or US$.01/¥1 </li></ul></ul></ul><ul><ul><ul><li>120 yen/1 US $ or US$.008 /¥1 </li></ul></ul></ul>Dollar is weakeningYen is getting stronger Yen is weakening Dollar is getting stronger
    10. 10. Functions of the Foreign Exchange Market <ul><li>Two general functions: </li></ul><ul><ul><li>Converting currencies </li></ul></ul><ul><ul><li>Reducing risk </li></ul></ul>
    11. 11. HOW TO CONVERT <ul><li>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: </li></ul><ul><li>“ The rate is 1.5625 Swiss Francs per dollar.” You exchange US$50.00. How many Swiss francs do you receive? </li></ul><ul><li>A. US$50 x SF1.5625 = SF 78.13 </li></ul><ul><li>You stop for a moment and think to yourself, “Well, then, how many dollars are in one Swiss franc?” </li></ul><ul><li>A. ____1USD__ = US$0.6400/SF </li></ul><ul><li>SF 1.5625/S </li></ul><ul><li>You are back at the train station and it is time to leave Switzerland and you have a bunch of Swiss francs in your pocket which you want to convert into Euros. You are told that the exchange rate for SF to Euros is: SF1.5466/Euro. </li></ul><ul><li>So how many Euros do you get for the 152 Swiss Francs you have? </li></ul><ul><li>A. ____ 152SF ____ = 98.28 Euros </li></ul><ul><li>SF 1.5466/Euro </li></ul>
    12. 12. CURRENCY CONVERSION <ul><li>Fundamentally, currency conversion involves a transfer of purchasing power: this is necessary because international trade and capital transactions usually involve parties living in different countries with different national currencies. Countries either transfer power to or from their home currency in order to be active in the global economy. </li></ul><ul><li>When a company is importing goods from another country, it will usually give up its domestic currency in the foreign exchange market to get the foreign currency needed to pay for the import. </li></ul><ul><ul><li>Result: demand for the foreign currency increases, supply in the foreign exchange market of the home currency increases . </li></ul></ul>
    13. 13. CURRENCY CONVERSION:WHEN <ul><ul><li>Companies receiving payment in foreign currencies need to convert these payments to their home currency </li></ul></ul><ul><ul><ul><li>EXAMPLE: A Japanese components manufacturer receives payment in US$ from their U.S. customer ; the manufacturer may want to convert it so it can be spent in Japan. </li></ul></ul></ul><ul><ul><li>Companies paying foreign businesses for goods or services </li></ul></ul><ul><ul><ul><li>EXAMPLE: A U.S. company must obtain </li></ul></ul></ul><ul><ul><ul><li>Japanese yen to pay for an order they received because the contract specified “payment in yen.” </li></ul></ul></ul>
    14. 14. CURRENCY CONVERSION:WHEN <ul><ul><li>Companies investing spare cash for short terms in money market accounts </li></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul><ul><ul><ul><li>So, the company changes dollars into won and invests in the money market of South Korea </li></ul></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
    15. 15. CURRENCY CONVERSION:WHEN <ul><ul><li>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) </li></ul></ul><ul><ul><ul><li>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). </li></ul></ul></ul><ul><ul><ul><ul><li>Assume exchange rate is $1 = Yen 120 </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Company changes money and receives </li></ul></ul></ul></ul><ul><ul><ul><ul><li>1.2 billion Yen ($10 million x 120 yen) </li></ul></ul></ul></ul><ul><ul><ul><ul><li>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. </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Now the company exchanges the 1.2 billion Yen back into dollars and because of the new exchange rate receives $12 million. </li></ul></ul></ul></ul>
    16. 16. REDUCING RISK <ul><li>Insuring against foreign exchange risk: protecting against unexpected or unpredictable changes in exchange rates through hedging transactions. </li></ul>
    17. 17. REDUCING RISK <ul><li>TERMS important in discussions of FOREX risk issues </li></ul><ul><ul><li>Spot exchange rate : rate of currency exchange on a particular day </li></ul></ul><ul><ul><li>Forward exchange rate : rate of currency exchange on a specific future date </li></ul></ul>
    18. 18. SPOT EXCHANGE RATE <ul><li>Spot exchange rate </li></ul><ul><ul><li>Spot exchange rate: rate of currency exchange on a particular day </li></ul></ul><ul><ul><li>Spot exchange: when two parties agree to exchange currency and execute the transaction immediately. Example: tourist changing money at the airport </li></ul></ul><ul><ul><li>Spot rates for most currencies change throughout the day, depending on supply and demand. </li></ul></ul>
    19. 19. A SPOT FX DEAL <ul><li>A 25 second deal </li></ul><ul><li>Source: REUTERS FORWARD </li></ul><ul><li>EXCHANGE and MONEY </li></ul><ul><li>MARKET,John Wiley & Sons, </li></ul><ul><li>1999. </li></ul>
    20. 20. FORWARD EXCHANGE: Insuring against foreign exchange risk <ul><li>TERMS: </li></ul><ul><ul><li>Forward exchange : An agreement to buy/sell a foreign currency for future delivery at a price set now (the &quot;forward exchange rate&quot;). </li></ul></ul><ul><ul><li>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) </li></ul></ul><ul><ul><li>Forward exchange rate: exchange rate governing forward exchanges. </li></ul></ul><ul><ul><li>Exchange rate is established at time of agreement but payment and delivery are not required until maturity </li></ul></ul><ul><ul><li>Forward exchange rates: usually quoted in 30, 90, 180 day increments </li></ul></ul><ul><ul><li>- 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). </li></ul></ul>
    21. 21. FORWARD EXCHANGE <ul><li>Insuring against foreign exchange risk: </li></ul><ul><ul><li>“ Buying forward” or “Selling forward”: securing a forward contract </li></ul></ul><ul><ul><li>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 </li></ul></ul><ul><ul><li>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 </li></ul></ul>
    22. 22. FORWARD EXCHANGE <ul><li>EXAMPLE : U.S. company buys computers from Japan and must pay 200,000 yen for each computer in 30 days. </li></ul><ul><li>Company wants to lock into an exchange rate that is known to protect against possible depreciation of the U.S. Dollar. </li></ul><ul><li>Current spot rate is $1 = Yen 120, which means each computer costs in US$ 1,667. (200,000/120 = $1,667). </li></ul><ul><li>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). </li></ul><ul><li>If U.S. company locks into this rate, when it actually pays in 30 days, </li></ul><ul><li>it means it would have to pay $1,818 per computer (200,000/110 = $1,818). (Dollar is depreciating). </li></ul><ul><li>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). </li></ul>
    23. 23. FORWARD EXCHANGE <ul><li>Insuring against foreign exchange risk: </li></ul><ul><ul><li>Forward exchange rate </li></ul></ul><ul><ul><li>Forward exchange rate is not necessarily a prediction of what the future spot rate will be. </li></ul></ul><ul><ul><li>Forward exchange contracts are a way of protecting against a depreciation of home currency in the future when a payment in a foreign currency is required. (When home currency depreciates, more of it will be required to convert into a currency that is stronger) </li></ul></ul>
    24. 24. Other Risk-Hedging Instruments <ul><li>Currency swap : simultaneous purchase and sale of a given amount of foreign exchange for two different value dates </li></ul><ul><li>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 . </li></ul><ul><ul><ul><li>FX swaps have two value dates, or legs, when exchange of funds occur. </li></ul></ul></ul><ul><ul><ul><ul><li>Spot against Forward </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Forward against Forward </li></ul></ul></ul></ul><ul><ul><ul><ul><li>Short Dates (less than one month) </li></ul></ul></ul></ul><ul><li>Foreign currency futures : standardized contracts traded in organized exchanges with fixed maturities. </li></ul><ul><li>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 </li></ul>
    25. 25. WHERE IS THE FOREIGN EXCHANGE MARKET? <ul><li>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. </li></ul><ul><li>Most important trading centers include London, New York, Tokyo, and Singapore </li></ul><ul><li>London’s dominance is explained by: </li></ul><ul><ul><li>History (capital of the first major industrialized nation). </li></ul></ul><ul><ul><li>Geography (between Tokyo/Singapore and New York). </li></ul></ul><ul><li>Two major features of the foreign exchange market: </li></ul><ul><ul><li>The market never sleeps. </li></ul></ul><ul><ul><li>Market is highly integrated. </li></ul></ul><ul><ul><li>Dollar is a vehicle currency: in 2004, 89% of all </li></ul></ul><ul><ul><li>Forex involved dollars on one side of the transaction. </li></ul></ul>
    26. 26. WHO PARTICIPATES IN FX MARKET? <ul><li>Two Tiers: </li></ul><ul><ul><li>Interbank/Wholesale market: usually large amounts in multiples of a million units </li></ul></ul><ul><ul><li>Retail Market: usually specified amounts </li></ul></ul><ul><li>Participants: </li></ul><ul><ul><li>Banks and non bank foreign exchange dealers/brokers </li></ul></ul><ul><ul><li>Individual and firms conducting commercial and investment transactions (including tourists) </li></ul></ul><ul><ul><li>Speculators and Arbitrageurs </li></ul></ul><ul><ul><li>Central Banks and Treasuries </li></ul></ul>
    27. 27. Example of a Forex Trading Combinations SOURCE: Eitman, David K., Stonehill, Arthur L., Moffet, Michael H. MULTINATIONAL BUSINESS FINANCE. Addison Westley: New York, 2001. p.101
    28. 28. CENTERS OF FOREX <ul><li>EXCHANGE SIGHTS </li></ul>São Paulo Rio de Janiero Mexico City San Francisco New York Toronto Bombay Melbourne Sydney Tokyo Hong Kong Singapore Paris Zurich Frankfurt Amsterdam Vienna Madrid Hamburg Dusseldorf Rome Brussels Chicago London Basel
    29. 29. THE MARKET THAT NEVER SLEEPS <ul><li>SOURCE: Eitman, David K., </li></ul><ul><li>Stonehill, Arthur L., Moffet, Michael </li></ul><ul><li>H. MULTINATIONAL </li></ul><ul><li>BUSINESS FINANCE. </li></ul><ul><li>Addison Westley: New York, </li></ul><ul><li>2001. </li></ul>
    30. 30. Foreign Exchange Market <ul><li>Think of the Foreign Exchange Market like Las Vegas </li></ul><ul><ul><li>24 hours </li></ul></ul><ul><ul><li>Many players </li></ul></ul><ul><ul><li>Presence of risk </li></ul></ul><ul><ul><li>Action happening </li></ul></ul><ul><ul><li>all the time </li></ul></ul>
    31. 31. Economic Theories about How Exchange Rates are Determined <ul><li>Many different theories exist. No true consensus exists. </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
    33. 33. Economic Theories about How Exchange Rates are Determined <ul><li>Supply and Demand: </li></ul><ul><li>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. </li></ul><ul><li>What can affect the supply and </li></ul><ul><li>demand of goods and services? </li></ul>
    34. 34. Economic Theories about How Exchange Rates are Determined <ul><ul><li>Changes in Income </li></ul></ul><ul><ul><li>Changes in prices, especially those brought about by differences in money supply and price inflation : </li></ul></ul><ul><ul><ul><li>Law of One Price </li></ul></ul></ul><ul><ul><ul><li>Purchasing Power Parity (PPP) </li></ul></ul></ul><ul><ul><li>Changes in Interest rates </li></ul></ul>
    35. 35. Economic Theories about How Exchange Rates are Determined <ul><li>Investor psychology and “Bandwagon” effects: the “People” effect </li></ul><ul><li>Role of the Government </li></ul>
    36. 36. Forex: Supply and Demand <ul><li>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. </li></ul><ul><li>Differences in spot rates reflect differences in supply and demand for currencies. These differences will affect the value of the currency. </li></ul><ul><ul><li>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. </li></ul></ul>
    37. 37. ARBITRAGE: moments of opportunity which impact supply and demand for FOREX <ul><li>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.” </li></ul><ul><li>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. </li></ul><ul><li>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. </li></ul>
    38. 38. Currency Conversion: Transfer of Purchasing Power Foreign Exchange Market Trade in home currency for foreign currency: increases demand for foreign currency [and decreases supply]; increases supply of home currency [decreases demand] in foreign exchange market HOME CURRENCY FOREIGN CURRENCY
    39. 39. Forex: Supply and Demand <ul><li>Supply and demand as it relates to import/export activity. </li></ul><ul><li>WHEN….. </li></ul><ul><li>Domestic currency is appreciating : imports tend to increase because foreign goods are less expensive and exports tend to decrease because they cost more to foreigners. </li></ul><ul><li>Domestic currency is depreciating : exports tend to increase because domestic goods cost less for foreigners and imports tend to decrease because they cost more to local consumers in the domestic market. </li></ul><ul><li>Supply in Forex market of a domestic currency is increased under imports. </li></ul><ul><li>Demand in Forex market of a domestic currency is increased under exports. </li></ul>
    40. 40. Forex : Changes in Income <ul><li>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. </li></ul><ul><li>An increase in domestic income of a country will usually encourage residents to spend a portion of their additional income on imports. </li></ul><ul><li>When income of a nation grows rapidly, imports tend to rise rapidly. </li></ul><ul><li>Results: More domestic currency is traded for more foreign currency and the domestic currency will usually depreciate. </li></ul>
    41. 41. Forex : Changes in Income <ul><li>If incomes in both trading partners are increasing, the country with the faster growing income will increase demand for imports relatively more. </li></ul><ul><li>This may lead to a depreciation in currency of the more rapidly growing national economy </li></ul>
    42. 42. Forex: Changes in Prices Basic concept: Law of One Price <ul><ul><li>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. </li></ul></ul><ul><ul><li>LAW OF ONE PRICE </li></ul></ul><ul><ul><li>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 product’s price should be the same in both markets. </li></ul></ul><ul><ul><li>therefore :Price currency A = Price currency B x exchange rate </li></ul></ul><ul><ul><li>How would this come about? </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>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) </li></ul></ul><ul><ul><li>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 export—to take advantage of differences in price) </li></ul></ul><ul><ul><li>Net result: eventually, in theory, prices will tend to equalize: </li></ul></ul><ul><ul><li>P $ = P £ x E $/£ </li></ul></ul>
    43. 43. Forex: Change in Prices Basic concept: P urchasing P ower P arity <ul><li>PURCHASING POWER PARITY: in theory, the “ideal” is that the exchange rate should represent equivalence of purchasing power between two currencies. </li></ul><ul><li>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. </li></ul><ul><li>Thus, E $/£ = P $ / P £ </li></ul><ul><li>By extension: In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country. </li></ul>
    44. 44. Forex: Change in Prices P urchasing P ower P arity (PPP) <ul><li>Extension of PPP/Law of One Price: applicable to a basket of goods and their prices. </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Example: </li></ul></ul><ul><ul><ul><li>Jan 1: a basket of goods costs U.S. $200 and Japan ¥ 20,000 </li></ul></ul></ul><ul><ul><ul><li>Dec 1: the same basket of goods costs $200 and Japan ¥ 22,000 </li></ul></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>The change is reflected in both the price of the goods and the price of the currencies. </li></ul></ul>
    45. 45. Forex: Change in Prices P urchasing P ower P arity (PPP) <ul><li>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? </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><ul><li>According to PPP theory, what should the $/£ be? </li></ul></ul></ul><ul><ul><ul><ul><li>Answer: 2.80/3.70 = .76$/ £. </li></ul></ul></ul></ul><ul><ul><ul><li>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 $/ £. Forward exchange rate probably be? </li></ul></ul></ul><ul><ul><ul><li>Answer: 3.10/4.65 = .67$/ £. </li></ul></ul></ul>
    46. 46. Big Mac Index June 2005 The Big Mac Index compares actual exchange rates with what would be the PPP exchange rate (“ideal” theoretical exchange rate where purchasing power is equal). Hill, p. 349 Switzerland 5.05 2.06 +65
    47. 47. THE BIG MAC INDEX <ul><li>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 </li></ul>
    48. 48. EXAMPLE: the Chinese Yuan <ul><li>FULL COVERAGE: China </li></ul><ul><li> July 21, 2005 </li></ul><ul><li>China Severs Its Currency's Link to Dollar </li></ul><ul><li>AP - 41 minutes ago </li></ul><ul><li>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. </li></ul><ul><li>WHAT DOES THIS MEAN? </li></ul><ul><li>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. </li></ul><ul><li>Chinese exports will become more expensive over time. </li></ul><ul><li>Imports into China, of products such as oil, will become less expensive over. Foreign assets will also become less expensive over time. </li></ul><ul><li>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. </li></ul>
    49. 49. Change in Prices due to Inflation Forex: Money Supply and Inflation <ul><li>PPP theory predicts that changes in relative prices will result in a change in exchange rates. What happens when there is price inflation? </li></ul><ul><ul><li>Inflation occurs when the money supply increases faster than output increases. </li></ul></ul><ul><ul><li>If more money is available, banks can borrow more money from the government and consumers can borrow more from banks. </li></ul></ul><ul><ul><li>More money in circulation can create more demand for goods and services that is not satisfied by supply. Prices will increase. </li></ul></ul><ul><ul><li>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). </li></ul></ul>
    50. 50. Forex: Interest Rates <ul><li>What about the relationship of inflation and interest rates? What is the impact on forex rates? </li></ul><ul><li>Theory says that nominal interest rates reflect expectations about future inflation rates. </li></ul><ul><ul><li>Fisher Effect (i = r + I) Nominal interest rates are equal to the real rate of return plus compensation for expected inflation. </li></ul></ul><ul><ul><li>Example: if real interest rate in a country is 5% and annual inflation is expected to be 10 percent, the nominal interest rate will be 15%. </li></ul></ul>
    51. 51. Forex: Interest Rates <ul><li>In the global market, differences in interest rates can exist. </li></ul><ul><li>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. </li></ul><ul><ul><li>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 . </li></ul></ul>
    52. 52. Forex: Interest Rates <ul><li>As investors transfer capital freely between countries and take advantage of interest rate differences, eventually arbitrage will equalize them. </li></ul><ul><ul><li>-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. </li></ul></ul>
    53. 53. Forex: Interest Rates <ul><li>PPP theory predicts that changes in relative prices will result in a change in exchange rates; exchange rates are affected by inflation. </li></ul><ul><li>From Fisher Effect, we know that interest rates reflect expectations about inflation </li></ul><ul><li>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. </li></ul>
    54. 54. Forex: Interest Rates <ul><li>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. </li></ul><ul><ul><ul><li>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. </li></ul></ul></ul><ul><ul><ul><li>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. </li></ul></ul></ul>
    55. 55. Forex: Role of Government <ul><li>The monetary, fiscal, and trade policies of the Government can impact the exchange rate. Examples: </li></ul><ul><ul><li>Creation of barriers to trade and investment </li></ul></ul><ul><ul><ul><li>Controls on flow of foreign currency </li></ul></ul></ul><ul><ul><ul><li>Restrictions on foreign investments </li></ul></ul></ul><ul><ul><ul><li>Control of repatriation of profits, dividends, royalties, etc. </li></ul></ul></ul><ul><ul><ul><li>Impositions of trade barriers blocking or discouraging imports </li></ul></ul></ul>
    56. 56. Forex: Role of Government <ul><li>The monetary and fiscal policies of the Government can impact the exchange rate. Examples: </li></ul><ul><ul><li>Management of the money supply </li></ul></ul><ul><ul><li>Management or creation of inflation </li></ul></ul><ul><ul><li>Central bank intervention </li></ul></ul><ul><ul><li>Management of unemployment </li></ul></ul><ul><ul><li>Economic growth policies </li></ul></ul><ul><ul><li>Rates of taxation </li></ul></ul>
    57. 57. Forex: Influence of People <ul><li>Market sentiment: based on </li></ul><ul><ul><li>Perception of market performance </li></ul></ul><ul><ul><li>Expectation of market performance </li></ul></ul><ul><li>Explanation may be investor psychology and the bandwagon effect </li></ul><ul><ul><li>Studies suggest they play a major role in short term movements </li></ul></ul><ul><ul><li>Hard to predict </li></ul></ul><ul><ul><li>Shock in world politics and social </li></ul></ul><ul><ul><li>events can incite investor reaction </li></ul></ul><ul><ul><li>“ Unexpected events may move markets for a matter of a few hours or a day at the most. It is peoples perceptions of fundamentals that move markets.” Stuart Frost, Technical Analyst </li></ul></ul>
    58. 58. EXAMPLE of Factors affecting Forex Invester’s Business Daily , Vol. 21, No 170. Friday, Dec 10, 2004 p. A1 (faster-growing economy in U.S.) San Jose Mercury News, Dec 4, 2004, p. C-1 (U.S. employment data weaker than expected)
    59. 59. Forex: Influence of People <ul><li>Impact of reactions by FX dealers based on </li></ul><ul><ul><li>What the chartists are showing </li></ul></ul><ul><ul><li>What people are saying the market </li></ul></ul><ul><ul><li>What central banks are doing </li></ul></ul><ul><ul><li>“ The trend is my friend.” </li></ul></ul><ul><ul><li>“ Buy the rumour, sell the fact” </li></ul></ul>
    60. 60. What are Good Predictors of Forex Rates? <ul><li>Evidence suggests that neither PPP nor the International Fisher Effect are good at explaining short term movements in exchange rates. </li></ul><ul><li>Complications with empirical tests conducted on PPP or IFE: </li></ul><ul><ul><li>Identical “basket of goods” is often not </li></ul></ul><ul><ul><li>Time periods for testing are not free from government intervention, so markets are not as efficient </li></ul></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>Transportation costs still a factor </li></ul></ul>
    61. 61. What are Good Predictors of Forex Rates? <ul><li>General wisdom is: </li></ul><ul><ul><li>Short term (spot rates): supply and demand, investor psychology/people factor, especially for floating rates </li></ul></ul><ul><ul><li>Longer term: Purchasing Power Parity (changes in prices based on impacts of changes in income, interest rate, inflation, actions of the government, etc.) </li></ul></ul><ul><ul><li>Some economists maintain that that the forward rate is also a good unbiased predictor of the future spot rate. </li></ul></ul>
    62. 62. Approaches to Forecasting <ul><li>Fundamental analysis </li></ul><ul><ul><li>Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. </li></ul></ul><ul><ul><li>Looks at variables such as inflation rates, money supply, balance of payments, etc. </li></ul></ul><ul><li>Technical analysis </li></ul><ul><ul><li>Uses price and volume data to determine trends </li></ul></ul>
    63. 63. Special Issue: Currency Convertibility <ul><li>Governments can place restrictions on the convertibility of currency (ability to change domestic currency for foreign currency) </li></ul><ul><ul><li>A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it </li></ul></ul><ul><ul><li>A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations </li></ul></ul><ul><ul><li>A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency </li></ul></ul>
    64. 64. Special Issue: Currency Convertibility <ul><li>Political decision. </li></ul><ul><ul><li>Many countries have some kind of restrictions. Government restrictions can include: </li></ul></ul><ul><ul><li>A restriction on residents’ ability to convert the domestic currency into a foreign currency </li></ul></ul><ul><ul><li>Restricting domestic businesses’ ability to take foreign currency out of the country </li></ul></ul><ul><li>Governments limit convertibility to preserve foreign exchange reserves in order to: </li></ul><ul><ul><li>Service international debt </li></ul></ul><ul><ul><li>Purchase imports </li></ul></ul><ul><ul><li>Government afraid of capital flight </li></ul></ul>
    65. 65. Special Issue: Currency Convertibility <ul><li>Capital flight : residents and nonresidents of a country rush to convert their holdings of a domestic currency to a foreign currency. </li></ul><ul><li>Usually occurs when the value of the currency is depreciating or economics of a country is at crisis. </li></ul><ul><li>Result: a depletion of foreign exchange reserves and depreciation of currency (domestic currency floods the foreign exchange market) </li></ul>
    66. 66. Special Issue: Currency Convertibility <ul><li>Capital flight : </li></ul>
    67. 67. Counter trade – alternative to convertibility issues <ul><ul><li>Barter-like agreements where goods/services are traded for goods/services </li></ul></ul><ul><ul><li>Helps firms avoid convertibility issue </li></ul></ul>=
    68. 68. Managerial Implications <ul><li>Exchange rates influence the profitability of trade and investment deals. </li></ul><ul><li>International businesses must understand the forces that determine exchange rate and insure protection against foreign currency risk. </li></ul><ul><li>Remember individuals (consumers, tourists, etc.) are also impacted. </li></ul>