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FOREIGN EXCHANGE MARKET

Functions of the Foreign Exchange Market
Currency Conversion

Sample currencies:

$ Dollar United States of America B$ Brunei Dollar Brunei Darussalam

£ Pound Great Britain ៛ Riel Cambodia
Italy Rp Rupiah Indonesia
Germany ₭ Kip Lao
Spain RM Ringgit Malaysia
€ Euro France K Kyat Myanmar
Portugal ₱ Peso Philippines
Greece S$ Singapore Dollar Singapore
Netherlands ฿ Baht Thailand
¥ Yen Japan ₫ Dong Vietnam
₩ Won South Korea

In general, within the borders of a particular country, one must use the national currency.

EXAMPLE: A U.S. tourist cannot walk into a store in the Philippines, and use U.S. dollars to buy souvenirs.
Dollars are not recognized as legal tender in the country; the tourist must use Philippine Peso. Fortunately,
the tourist can go to a bank and exchange her dollars for peso. Then she can buy the souvenirs.

When a tourist changes one currency into another, she is participating in the foreign exchange market. The
exchange rate is the rate at which the market converts one currency into another. For example, an exchange
rate of $1 = P49.45 specifies that 1 U.S dollar buys 49.45 pesos. The exchange rate allows us to compare the
relative prices of goods and services in different countries.

EXAMPLE: A U.S. tourist wishing to buy a bottle of Scotch whiskey in Edinburgh may find that she must pay
£30 for the bottle, knowing that the same bottle costs $35 in the United States. Is this a good deal? Imagine
the current pound/dollar exchange rate is £1.00 = $1.25 (i.e., 1 British pound buys $1.25). Our tourist takes
out her calculator and converts £30 into dollars. (The calculation is 30 × 1.25.) She finds that the bottle of
Scotch costs the equivalent of $37.50. She is surprised that a bottle of Scotch whiskey could cost less in the
United States than in Scotland despite shipping costs (alcohol is taxed heavily in Great Britain).

International businesses have four (4) main uses of foreign exchange markets.

(1) The payments a company receives for its exports, the income it receives from foreign investments or the
income it receives from licensing agreements with international firms may be in foreign currencies. To use
those funds in their home country, the company must convert them to its home country’s currency.

EXAMPLE: Consider the Scotch distillery that exports its whiskey to the Philippines. The distillery is paid in
peso, but because those pesos cannot be spent in Great Britain, they must be converted into British pounds.
Similarly, Toyota sells its cars in the United States for dollars; it must convert the U.S. dollars it receives
into Japanese yen to use them in Japan.

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(2) International businesses use foreign exchange markets when they must pay a foreign company for their
products or services in their country’s currency.

EXAMPLE: Dell buys many of the components for its computers from Malaysian firms. The Malaysian
companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into
ringgit to pay them.

(3) International businesses also use foreign exchange markets when they have spare cash that they wish to
invest for short terms in money markets.

EXAMPLE: Consider a U.S. company that has $10 million it wants to invest for three (3) months. The best
interest rate it can earn on these funds in the United States may be 2 percent. Investing in a South Korean
money market account, however, may earn 6 percent. Thus, the company may change its $10 million into
Korean won and invest it in South Korea. Note that the rate of return it earns on this investment depends
not only on the Korean interest rate but also on the changes in the value of the Korean won against the
dollar in the intervening period.

(4) Currency speculation typically involves the short-term movement of funds from one currency to another in
the hopes of profiting from shifts in exchange rates.

EXAMPLE: Consider a U.S. company again with $10 million to invest for three (3) months. Suppose the
company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company
expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/ yen
exchange rate is $1 = ¥120. The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10
million × 120 = ¥1.2 billion). Over the next three (3) months, the value of the dollar depreciates against the
yen until $1 = ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12
million. The company has made a $2 million profit on currency speculation in three (3) months on an initial
investment of $10 million! In general, however, companies should beware, for speculation, by definition is
a risky business. The company cannot know for sure what will happen to exchange rates. While a speculator
may profit handsomely if his speculation about future currency movements turns out to be correct, he can
also lose vast amounts of money if it turns out to be wrong.

A kind of speculation that has become more common in recent years is known as the carry trade. The carry
trade involves borrowing in one currency where interest rates are low and then using the proceeds to invest
in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan
is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to borrow
in Japanese yen, convert the money into U.S. dollars, and deposit it in an American bank. The trader can
earn a 5 percent margin by doing so, minus the transaction costs associated with changing one currency
into another. The speculative element of this trade is that its success is based on a belief that there will be
no adverse movement in exchange rates (or interest rates for that matter) that will make the trade
unprofitable. However, if the yen were to increase in value against the dollar rapidly, then it would take more
U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar/yen carry
trade was very significant during the mid-2000s, peaking at more than $1 trillion in 2007 when some 30
percent of trade on the Tokyo foreign exchange market was related to the carry trade. This carry trade
declined in importance during 2008–2009 because interest rate differentials were falling as U.S. rates came
down, making the trade less profitable. By late 2016, there were signs that the dollar/yen carry trade was
becoming important again as negative interest rates in Japan, coupled with rising interest rates in the United
States, were making it profitable to borrow in yen again and convert the money into U.S. dollars.

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Insuring Against Foreign Exchange Risk

Spot Exchange Rates

When two (2) parties agree to exchange currency and execute the deal immediately, the transaction is referred
to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as spot exchange
rates. The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another
currency on a particular day.
Spot exchange rates are reported on a real-time basis on many financial websites. An exchange rate can be
quoted in two (2) ways: as the amount of foreign currency one U.S. dollar will buy or as the value of a dollar for
one unit of foreign currency. Thus, on April 26, 2020, at 4:30 p.m., Eastern Standard Time, 1 U.S. dollar bought
P50.7777, and 1 Peso bought $0.0197.
Forward Exchange Rates
Changes in spot exchange rates can be problematic for international businesses. For example, a Philippine
company that imports high-end cameras from Japan knows that in 30 days, it must pay yen to a Japanese
supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each camera, and
the current dollar/yen spot exchange rate is P1 = ¥2.17. At this rate, each camera costs the importer P92,000
(i.e., 92,000 = 200,000/2.17). The importer knows she can sell the camera the day they arrive for P94,000 each,
which yields a gross profit of P3,000 on each. However, the importer will not have the funds to pay the Japanese
supplier until the cameras are sold. If, over the next 30 days, the peso unexpectedly depreciates against the
yen, say, to P1 = ¥2, the importer will still have to pay the Japanese company ¥200,000 per camera but in peso
terms that would be equivalent to P100,000 per camera, which is more than she can sell the cameras. A
depreciation in the value of the peso against the yen from P1 = ¥2.17 to P1 = ¥2 would transform a profitable
deal into an unprofitable one.
To insure or hedge against this risk, the Philippine importer might want to engage in a forward exchange. A
forward exchange occurs when two (2) parties agree to exchange currency and execute the deal at some
specific date in the future. Exchange rates governing such future transactions are referred to as forward
exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180
days into the future. In some cases, it is possible to get forward exchange rates for several years into the future.
Returning to our camera importer example, let us assume the 30-day forward exchange rate for converting
dollars into yen is P1 = ¥2.10. The importer enters into a 30-day forward exchange transaction with a foreign
exchange dealer at this rate and is guaranteed that she will have to pay no more than P95,000 for each camera.
This transaction ensures her a profit of P1,000 per camera. She also ensures herself against the possibility that
an unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one.
In this example, the spot exchange rate P1 = ¥2.17 and the 30-day forward rate P1 = ¥2.10 differ. Such
differences are typical; they reflect the expectations of the foreign exchange market about future currency
movements. In our example, the fact that P1 bought more yen with a spot exchange than with a 30-day forward
exchange indicates foreign exchange dealers expected the peso to depreciate against the yen in the next 30
days. When this occurs, we say the peso is selling at a discount on the 30-day forward market (i.e., it is worth
less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were
P1 = ¥3, for example, P1 would buy more yen with a forward exchange than with a spot exchange. In such a
case, we say the peso is selling at a premium on the 30-day forward market. This reflects the foreign exchange
dealers’ expectations that the peso will appreciate against the yen over the next 30 days.
In sum, when a firm enters into a forward exchange contract, it is taking out insurance against the possibility
that future exchange rate movements will make a transaction unprofitable by the time that transaction has been
executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign exchange
risk, sometimes this can work against the company.

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Currency Swaps
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two (2)
different value dates. Swaps are transacted between international businesses and their banks, between banks,
and between governments when it is desirable to move out of one currency into another for a limited period
without incurring foreign exchange risk.
EXAMPLE: A common kind of swap is spot against forward. Consider a company such as Apple. Imagine Apple
assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of
the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple
needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days, it
will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these
yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 = ¥120, and the 90-
day forward exchange rate is $1 = ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple
can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its
bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/110
= $1.09 million). Because the yen is trading at a premium on the 90-day forward market, Apple ends up with
more dollars than it started with (although the opposite could also occur). The swap deal is just like a
conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange
risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield
$1.09 million.
Economic Theories of Exchange Rate Determination
A. Prices and Exchange Rates
The Law of One Price
The law of one price states that in competitive markets free of transportation costs and barriers to trade (such
as tariffs), identical products sold in different countries must sell for the same price when their price is expressed
in terms of the same currency.
EXAMPLE: If the exchange rate between the British pound and the dollar is £1 = $2, a jacket that retails for $80
in New York should sell for £40 in London (because $80/$2 = £40). Consider what would happen if the jacket
cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to buy jackets in London and sell
them in New York (an example of arbitrage). The company initially could make a profit of $20 on each jacket by
purchasing it for £30 ($60) in London and selling it for $80 in New York (we are assuming away transportation
costs and trade barriers). However, the increased demand for jackets in London would raise their price in
London, and the increased supply of jackets in New York would lower their price there. This would continue until
prices were equalized. Thus, prices might equalize when the jacket cost £35 ($70) in London and $70 in New
York (assuming no change in the exchange rate of £1 = $2).
Purchasing Power Parity
If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate
could be found from any individual set of prices. By comparing the prices of identical products in different
currencies, it would be possible to determine the “real” or PPP exchange rate that would exist if markets were
efficient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers.)
A less extreme version of the PPP theory states that given relatively efficient markets— that is, markets in which
few impediments to international trade exist—the price of a “basket of goods” should be roughly equivalent in
each country. To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular
goods and P¥ be the price of the same basket of goods in Japanese yen. The PPP theory predicts that the
dollar/yen exchange rate, E$/¥, should be equivalent to:

P$
𝐸$ =
¥ P¥

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Thus, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, the PPP theory predicts that
the dollar/yen exchange rate should be $200/¥20,000 or $0.01 per Japanese yen (i.e., $1 = ¥100).
Money Supply and Price Inflation
In essence, PPP theory predicts that changes in relative prices will result in a shift in exchange rates.
Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate
against that of countries in which inflation rates are lower. If we can predict what a country’s future inflation rate
is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—
is expected to change. The growth rate of a country’s money supply determines its likely future inflation rate.
Thus, in theory, at least, we can use information about the growth in money supply to forecast exchange rate
movements.
Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the
stock of goods and services—that is when the money supply increases more quickly than output increases.
Imagine what would happen if the government suddenly gave everyone in the country $10,000. Many people
would rush out to spend their extra money on those things they had always wanted—new cars, new furniture,
better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department
stores, and other providers of products and services would respond to this upsurge in demand by raising prices.
The result would be price inflation.
A government increasing the money supply is analogous to giving people more money. An increase in the
money supply makes it easier for banks to borrow from the government and for individuals and companies to
borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless
the output of goods and services is growing, at a rate similar to that of the money supply, the result will be
inflation. This relationship has been observed time after time in country after country.
B. Interest Rates and Exchange Rates
The 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 (𝐼). More formally,
𝑖 =𝑟+𝐼
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. As predicted by the Fisher effect, a strong relationship seems to
exist between inflation rates and interest rates.
Because we know from PPP theory that there is a link (in theory, at least) between inflation and exchange rates
and because interest rates reflect expectations about inflation, it follows that there must also be a link between
interest rates and exchange rates. This link is known as the international Fisher effect. The international Fisher
effect (IFE) states that for any two (2) 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 (2) countries. Stated more
formally, the change in the spot exchange rate between the United States and Japan, for example, can be
modeled as follows:

𝑆1 − 𝑆2
× 100 = 𝑖$ − 𝑖¥
𝑆2
C. Investor Psychology and Bandwagon Effects
Empirical evidence suggests that neither the PPP theory nor the international Fisher effect is particularly good
at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology
on short-run exchange rate movements. Evidence reveals that various psychological factors play an essential
role in determining the expectations of market traders as to likely future exchange rates. In turn, expectations
tend to become self-fulfilling prophecies.
A particularly famous example of this mechanism occurred in September 1992, when the international financier
George Soros made a massive bet against the British pound. Soros borrowed billions of pounds, using the

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assets of his investment funds as collateral, and immediately sold those pounds for German Deutsche marks
(this was before the advent of the euro). This technique, known as short selling, can earn the speculator
enormous profits if he can subsequently buy back the pounds he sold at a much better exchange rate and then
use those pounds, purchased cheaply, to repay his loan. By selling pounds and buying Deutsche marks, Soros
helped start pushing down the value of the pound on the foreign exchange markets. More importantly, when
Soros started shorting the British pound, many foreign exchange traders, knowing Soros’s reputation, jumped
on the bandwagon and did likewise. This triggered a classic bandwagon effect, with traders moving as a herd
in the same direction at the same time. As the bandwagon effect gained momentum, with more traders selling
British pounds and purchasing Deutsche marks in expectation of a decline in the pound, their expectations
became a self-fulfilling prophecy. Massive selling forced down the value of the pound against the Deutsche
mark. In other words, the pound declined in value not so much because of any significant shift in macroeconomic
fundamentals but because investors followed a bet placed by a significant speculator, George Soros.
According to several studies, investor psychology and bandwagon effects play an essential role in determining
short-run exchange rate movements. However, these effects can be hard to predict. Investor psychology can
be influenced by political factors and by microeconomic events, such as the investment decisions of individual
firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates.
Also, bandwagon effects can be both triggered and exacerbated by the characteristic behavior of politicians.
Something like this seems to have occurred in Southeast Asia during 1997. When, one after another, the
currencies of Thailand, Malaysia, South Korea, and Indonesia lost between 50 and 70 percent of their value
against the U.S. dollar in a few months.
Exchange Rate Forecasting
The Efficient Market School
Forward exchange rates represent market participants’ collective predictions of likely spot exchange rates at
specified future dates. If forward exchange rates are the best possible predictor of future spot rates, it will make
no sense for companies to spend additional money trying to forecast short-run exchange rate movements. Many
economists believe the foreign exchange market is efficient at setting forward rates. An efficient market is one
in which prices reflect all available public information. (If forward rates reflect all available information about
likely future changes in exchange rates, a company cannot beat the market by investing in forecasting services.)
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 in any specific situation. It means inaccuracies will
not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed
the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting
that companies should not waste their money on forecasting services), some studies have challenged it. There
is some evidence that forward rates are not unbiased predictors of future spot rates and that more accurate
predictions of future spot rates can be calculated from publicly available information.
The Inefficient Market School
Citing evidence against the efficient market hypothesis, some economists believe the foreign exchange market
is inefficient. An inefficient market is one in which prices do not reflect all available information. In an inefficient
market, forward exchange rates will not be the best possible predictors of future spot exchange rates.
If this is true, it may be worthwhile for international businesses to invest in forecasting services (as many do).
The belief is that professional exchange rate forecasts might provide better predictions of future spot rates than
forward exchange rates do. However, the track record of professional forecasting services is not that good. For
example, forecasting services did not predict the 1997 currency crisis that swept through Southeast Asia, nor
did they foresee the rise in the value of the dollar that occurred during late 2008. It is a period when the United
States fell into a deep financial crisis that some thought would lead to a decline in the value of the dollar (it
appears that the dollar rose because it was seen as a relatively safe currency in a time when many nations were
experiencing economic trouble).

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Currency Convertibility
Free convertibility is not universal. Many countries place some restrictions on their residents’ ability to convert
the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the
relatively minor (such as restricting the amount of foreign currency they may take with them out of the country
on trips) to the major (such as limiting domestic businesses’ ability to take foreign currency out of the country).
External convertibility restrictions can limit local companies’ ability to invest abroad, but they present few
problems for international companies wishing to do business in that country. For example, even if the Japanese
government tightly controlled the ability of its residents to convert the yen into U.S. dollars, all U.S. businesses
with deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the
country. Thus, a U.S. company with a subsidiary in Japan is assured that it will be able to convert the profits
from its Japanese operation into dollars and take them out of the country.
Serious problems arise, however, under a policy of non-convertibility. This was the practice of the former Soviet
Union, and it continued to be the practice in Russia for several years after the collapse of the Soviet Union.
When strictly applied, non-convertibility means that although a U.S. company doing business in a country such
as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take
them out of the country. This is not desirable for international business.
Governments limit convertibility to preserve their foreign exchange reserves. A country needs an adequate
supply of these reserves to service its international debt commitments and to purchase imports. Governments
typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a
run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their
holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight.
Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of
hyperinflation or when a country’s economic prospects are shaky in other respects. Under such circumstances,
both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted
into a foreign currency and invested abroad. Not only will a run on foreign exchange reserves limit the country’s
ability to service its international debt and pay for imports, but it will also lead to a steep depreciation in the
exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign
exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the
rise in import prices resulting from currency depreciation will lead to further increases in inflation. This fear
provides another rationale for limiting convertibility.

REFERENCES
Hill, C. W., & Hult, G. T. (2018). International business: Competing in the global marketplace (12th ed.). New
York: McGraw-Hill Education.

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