Chapter 9
The Foreign Exchange
Market
1

Introduction
Question: What is the foreign exchange market?
¦ The foreign exchange market is a market for converting
the currency of one country into that of another country
Question: What is the exchange rate?
¦ The exchange rate is the rate at which one currency is
converted into another
2

The Functions of the FX Market
Question: What is the purpose of the foreign exchange
market?
¦ The foreign exchange market
1. Enables the conversion of the currency of one
country into the currency of another
2. Provides some insurance against foreign exchange
risk - the adverse consequences of unpredictable
changes in exchange rates
3

The Functions of the FX Market
¦ The spot exchange rate - the rate at which a foreign
exchange dealer converts one currency into another
currency on a particular day
¦ A forward exchange rate - the exchange rate governing a
transaction in which two parties agree to exchange
currency and execute the deal at some specific date in
the future
¦ A currency swap - the simultaneous purchase and sale of
a given amount of foreign exchange for two different
value dates
4

The Nature of the FX Market
¦ The foreign exchange market is a global network of
banks, brokers, and foreign exchange dealers connected
by electronic communications systems
¦ The market is always open somewhere in the world
¦ if exchange rates quoted in different markets were not
essentially the same, there would be an opportunity for
arbitrage - the process of buying a currency low and
selling it high
¦ Most transactions involve U.S. dollars on one side
¦ the U.S. dollar is a vehicle currency
5

Theories of Exchange Rate
Determination
Question: What factors are important to future
exchange rates?
¦ Three factors that have an important impact on future
exchange rate movements are
1. A country’s price inflation
2. A country’s interest rate
3. Market psychology
6

Theories of Exchange Rate
Determination
Question: How are prices related to exchange rate
movements?
¦ To understand how prices and exchange rates are linked,
we need to understand
¦ the law of one price
¦ the theory of purchasing power parity
7

Theories of Exchange Rate Determination
Question: How do interest rates affect 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 (l)
¦ in other words, i = r + I
¦ The International Fisher Effect suggests that 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
8

Theories of Exchange Rate Determination
Question: How are exchange rates influences by investor
psychology?
¦ The bandwagon effect occurs when expectations on the
part of traders turn into self-fulfilling prophecies, and
traders join the bandwagon and move exchange rates
based on group expectations
¦ governmental intervention can prevent the bandwagon
from starting, but is not always effective
9

Exchange Rate Forecasting
Question: Should companies invest in exchange rate
forecasting services to help with decision-making?
¦ The efficient market school argues that forward exchange
rates are the best predictors of future spot exchange
rates
¦ investing in forecasting services would be a waste of
money
¦ The inefficient market school argues that companies
should invest in forecasting services
¦ forward rates are not the best predictor of future spot
rates
10

Exchange Rate Forecasting
Question: How should exchange rate forecasts be
prepared?
¦There are two approaches to exchange rate forecasting
1. Fundamental analysis
2. Technical analysis
11

Currency Convertibility
Question: Are all currencies freely convertible?
¦ A currency is freely convertible when both residents and
non-residents can purchase unlimited amounts of foreign
currency with the domestic currency
¦ A currency is externally convertible when only non-
residents can convert their holdings of domestic currency
into a foreign currency
¦ A currency is nonconvertible when both residents and
non-residents are prohibited from converting their
holdings of domestic currency into a foreign currency
12

Implications for Managers
Question: What does the foreign exchange market mean
for international firms?
¦ Firms must understand the influence of exchange rates
on the profitability of trade and investment deals
¦ This exchange rate risk can be divided into
1. Transaction exposure
2. Translation exposure
3. Economic exposure
13

Implications for Managers
Question: How can firms minimize translation and
transaction exposure?
¦ Firms can
¦ buy forward
¦ use swaps
¦ lead and lag payables and receivables - paying
suppliers and collecting payment from customers early
or late depending on expected exchange rate
movements
14

Implications for Managers
Question: How can a firm reduce economic exposure?
¦ To reduce economic exposure firms need to distribute
productive assets to various locations so the firm’s long-
term financial well-being is not severely affected by
changes in exchange rates
¦ This requires that the firm’s assets are not overly
concentrated in countries where likely rises in currency
values will lead to damaging increases in the foreign
prices of the goods and services they produce
15

Implications for Managers
Question: Are there other strategies to manage foreign
exchange risk?
¦ To further manage foreign exchange risk, firms should
1. establish central control to protect resources and
ensure that each subunit adopts the correct mix of
tactics and strategies
2. distinguish between transaction, translation, and
economic exposure
3. attempt to forecast future exchange rates
4. establish good reporting systems
5. produce monthly foreign exchange exposure reports
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