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CHAPTER 10
The Foreign Exchange
Market
9-2
Learning Objectives



McGraw-Hill/Irwin
Japan Airline’s experience in foreign exchange
markets
Thai Bhat crises
How is exchange rate determined?
 Price level, PPP
 Interest rate
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
2
9-3
Learning Objectives


McGraw-Hill/Irwin
How is exchange rate determined?
 Investors Psychology
 Balance of Payment Deficits
What are the implications of currency
convertibility for the business firms?
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
3
9-4
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-5
Chapter Focus



McGraw-Hill/Irwin
Explain how the foreign exchange
(FX) market works.
Examine the forces that determine
the exchange rates and whether it is
possible to determine future rates
movement.
Map the implications for businesses.
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
5
9-6
Functions of the Foreign Exchange Market

Currency Conversion
 Companies receiving
payment in foreign
currencies need to
convert to their home
currency.
 Companies paying foreign
businesses for goods or
services.
 Companies invest spare
cash for short terms in
money market accounts.
 Speculation: taking
advantage changing
exchange rates.
McGraw-Hill/Irwin

Insuring Against FX Risk
 Spot exchange rate: rate
of currency exchange on
a particular day.
 Forward exchange rate:
two parties agree to
exchange currencies on
a specific future date.
 Currency
swap:simultaneous
purchase and sale of a
given amount of FX for
two different value
dates.
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
6
9-7
FX Transactions
Forward Exchange*
Spot Exchange
* Most forward exchanges
are currency swaps.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-8
Foreign Exchange Trade Growth
$ billions
1500
1000
500
0
1986
McGraw-Hill/Irwin
1995
1998
2001
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-9
The Foreign Exchange Market



It is a 24/7 market.
The markets are integrated. Connected by high-speed
computers, it creates one virtual market.
London’s dominance is explained by:
 History (capital of the first major industrialized
nation).
 Geography (between Tokyo/Singapore and New
York).
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9
9-10
Factors Influencing Currency Value
Economic Factors
1.
2.
3.
4.
5.
6.
7.
8.
Balance of Payments
Interest Rates
Inflation
Monetary and Fiscal Policy
International Competitiveness
Monetary Reserves
Government Controls and Incentives
Importance of Currency in World
Political Factors
9. Political Party and Leader Philosophies
10. Proximity of Elections or Change in leadership
Expectation Factors
11. Expectations
12. Forward Exchange Market Prices
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-11
Economic Theories of Exchange Rate
Determination




McGraw-Hill/Irwin
Base level: rates are determined by the
demand/supply of one currency relative to
the demand/supply of another.
Price and Exchange Rates:
 Law of One Price
 Purchasing Power Parity (PPP)
Interest Rates and Exchange Rates.
Investor Psychology and Bandwagon
Effects.
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
11
9-12
Price and Exchange Rates
Law of One Price:
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 = FFr 5. A jacket
selling for $50 in New York should retail for FFr 250 in Paris
(50x5).
Purchasing Power Parity
By comparing the prices of identical products in different
currencies, it should be possible to determine the ‘real’ or PPP
exchange rate - if markets were efficient.
In relatively efficient markets (few impediments to trade and
investment) then a ‘basket of goods’ should be roughly
equivalent in each country.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-13
Money Supply and Inflation


PPP theory predicts that changes in relative prices
will result in a change in exchange rates.
 A country with high inflation should expect its
currency to depreciate against the currency of a
country with a lower inflation rate.
 Inflation occurs when the money supply increases
faster than output increases.
Purchasing Power Parity Puzzle.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
13
The Big Mac Index
Purchasing Power Parity: April 2001
Big Mac Prices
Table 9.3
Price in
Local
Currency
United States $2.54
Argentina
Peso 2.50
Brazil
Real 3.60
Canada
C $ 3.33
Euro
2.57
France
FFr 18.5
Hong Kong HK $10.70
Japan
¥ 294
Russia
Roule 35.00
Switzerland SwFr 6.30
Price in
Dollars
2.54
2.50
1.64
2.14
2.27
2.49
1.37
2.38
1.21
3.65
Implied
PPP of the
Dollar
--0.98
1.42
1.31
0.99
7.28
4.21
116
13.8
2.48
© 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Local Currency
% Over(+)
Actual
or Under(-)
Exchange
Valuation
Rate
17/04/01 Against Dollar
--1.00
2.19
1.56
0.88
7.44
7.80
124
28.9
1.73
---2
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-2
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44
9-15
Interest Rates and Exchange Rates

Theory says that interest rates reflect expectations
about future exchange rates.
 Fisher Effect (I = r+l).
 International Fisher Effect:
 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.
McGraw-Hill/Irwin
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15
9-16
Investor Psychology and Bandwagon
Effects


Evidence suggests that neither PPP nor the
International Fisher Effect are good at explaining
short term movements in exchange rates.
Explanation may be investor psychology and the
bandwagon effect.
 Studies suggest they play a major role in short
term movements.
 Hard to predict.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
16
9-17
Exchange Rate Forecasting
Efficient market: where prices reflect all available public
information.
Early studies seem to confirm the efficient market
theory, but recent studies have challenged it.
Inefficient market: where prices do not reflect all
available information.
Use fundamental (economic theory) or technical
(price/volume data) analysis to predict the
exchange rates.
Analysis suggest that professional forecasters are
no better than forward exchange rates in
predicting future spot rates.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
9-18
Currency Convertibility
Freely convertible.
Externally convertible.
Not convertible.
Preserve foreign exchange reserves.
Service international debt.
Purchase imports.
Government afraid of capital flight.
Political decision.
Many countries have some kind of restrictions.
Countertrade.
Barter-like agreements where goods/services are traded for
goods/services.
Helps firms avoid convertibility issue.
McGraw-Hill/Irwin
© 2003 The McGraw-Hill Companies, Inc., All Rights Reserved.