The document discusses the foreign exchange market and currency exchange. It describes how the foreign exchange market allows currencies to be converted between countries and provides insurance against exchange rate risk. Businesses use the forex market to convert payments and make payments in other currencies. Spot exchange rates are the current rates while forward rates are future rates that account for interest rate differences between countries. Theories discussed include purchasing power parity and interest rate parity. Factors like inflation rates, interest rates, and investor psychology can influence exchange rates. Currencies can have different degrees of convertibility. Foreign exchange risk is a risk businesses must manage.

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/