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Chapter 10 - The Foreign Exchange Market
The Foreign Exchange Market
Chapter Outline
OPENING CASE: The Curse of the Strong Yen
INTRODUCTION
THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
Currency Conversion
Insuring Against Foreign Exchange Risk
Management Focus: Volkswagen’s Hedging Strategy
THE NATURE OF THE FOREIGN EXCHANGE MARKET
ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION
Prices and Exchange Rates
Interest Rates and Exchange Rates
Investor Psychology and Bandwagon Effects
Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar
Summary of Exchange Rate Theories
EXCHANGE RATE FORECASTING
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
CURRENCY CONVERTIBILITY
FOCUS ON MANAGERIAL IMPLICATIONS
Transaction Exposure
Translation Exposure
Economic Exposure
Reducing Translation and Transaction Exposure
Reducing Economic Exposure
Management Focus: Dealing with the Rising Euro
Other Steps for Managing Foreign Exchange Risk
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Chapter 10 - The Foreign Exchange Market
SUMMARY
CRITICAL THINKING AND DISCUSSION QUESTIONS
CLOSING CASE: Billabong
Learning Objectives
1. Describe the functions of the foreign exchange market.
2. Understand what is meant by spot exchange rates.
3. Recognize the role that forward exchange rates play in insuring against foreign exchange risk.
4. Understand the different theories explaining how currency exchange rates are determined and their
relative merits.
5. Identify the merits of different approaches toward exchange rate forecasting.
6. Compare and contrast the differences between translation, transaction and economic exposure, and
explain what managers can do to manage each type of exposure.
Chapter Summary
This chapter focuses on the foreign exchange market. At the outset, the chapter explains how the foreign
exchange market works. Included in this discussion is an explanation of the difference between spot
exchange rates and forward exchange rates. The nature of the foreign exchange market is discussed,
including an examination of the forces that determine exchange rates. In addition, the author provides a
discussion of the degree to which it is possible to predict exchange rate movements. Other topics
discussed in the chapter include exchange rate forecasting, currency convertibility, and the implications of
exchange rate movements on business. Finally, the chapter concludes with a discussion of the
implications of exchange rates for businesses. For instance, it is absolutely critical that international
businesses understand the influence of exchange rates on the profitability of trade and investment deals.
Adverse changes in exchange rates can make apparently profitable deals unprofitable.
Opening Case: The Curse of the Strong Yen
Summary
The opening case describes the change in the value of the Japanese yen during the 2000s. In the early part
of the decade, the yen was relatively weak relative to the U.S. dollar, but strengthened at the end of the
decade as investors reacted to changes in interest rates brought on by the global financial crisis. The
changing value of the yen had direct implications for companies like Toyota. Discussion of the case can
revolve around the following questions:
Suggested Discussion Questions
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Chapter 10 - The Foreign Exchange Market
QUESTION 1: Discuss how the actions of traders in the foreign exchange market can have direct
implications for companies like Toyota. Why is it important for managers to understand the foreign
exchange market?
ANSWER 1: During the 2000s, investors in the foreign exchange market capitalized on interest rate
differentials between Japan and the United States by engaging in carry trade. However, they began to
reverse their positions after the global financial crisis hit in 2008-2009. Their actions resulted in a 40
percent increase in the value of the yen relative to the U.S. dollar, creating a disaster for companies like
Toyota that saw their exports drop and the value of their overseas profits plummet. Most students will
recognize that it is vital for managers to understand the connections between the foreign exchange market
and firm profits so they can take steps to maximize opportunities and minimize risk.
QUESTION 2: What steps can companies take to minimize their exposure to changes in exchange rates
like those outlined in the opening case?
ANSWER 2: There are several ways companies can minimize the risk associated with changing exchange
rates. In the short-run, companies can buy and sell currencies in the forward market to minimize risk
associated with specific transactions in foreign currencies. In the longer-term, when there are sustained
changes in exchanges rates, companies may want to minimize foreign exchange exposure by diversifying
production across markets, by sourcing inputs from different countries, or by targeting customers around
the world.
Lecture Note: In recent years, Toyota has faced many challenges including those associated with the value
of the yen, and also tsunami-related interruptions to its supply chain. To learn more and to extend this
case, consider {http://www.businessweek.com/stories/2011-05-04/toyota-doubles-down-on-japan}.
Video Note: The iGlobe Dollar's Falling Value Ripples Through U.S. Economy explores the effect of the
falling dollar for exporters, importers, producers, and consumers.
Chapter Outline with Lecture Notes, Video Notes, and Teaching Tips
INTRODUCTION
A) This chapter has three main objectives. The first objective is to explain how the foreign exchange
market works. The second objective is to examine the forces that determine exchange rates and to discuss
the degree to which it is possible to predict exchange rate movements. The third objective is to map the
implications for international business of exchange rate movements and the foreign exchange market.
B) The foreign exchange market is a market for converting the currency of one country into that of
another country.
C) The exchange rate is the rate at which one currency is converted into another.
D) Dealing in multiple currencies is a requirement of doing business internationally. Therefore, it is
important to understand the risks involved and how varying exchange rates affect the attractiveness of
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Chapter 10 - The Foreign Exchange Market
different investments and deals over time. Firms can use the foreign exchange market to hedge the risk of
adverse exchange rate changes, but doing so can prevent firms from benefiting from favorable changes.
THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
A) The foreign exchange market serves two main functions. The first is to convert the currency of one
country into the currency of another. The second is to provide some insurance against foreign exchange
risk (the adverse consequences of unpredictable changes in exchange rates).
Currency Conversion
B) International businesses have four main uses of foreign exchange markets. First, the payments a
company receives for its exports, the income it receives from foreign investments, or the income it
receives from licensing agreements with foreign firms may be in foreign currencies. Second, international
businesses use foreign exchange markets when they must pay a foreign company for its products or
services in its country’s currency. Third, international businesses use foreign exchange markets when they
have spare cash that they wish to invest for short terms in money markets. Finally, currency speculation is
another use of foreign exchange markets. 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.
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.
Teaching Tip: XE.com {http://www.xe.com/} provides a real time currency cross-rate chart, and an option
to do currency conversions.
Insuring Against Foreign Exchange Risk
C) A second function of the foreign exchange market is to provide insurance to protect against the
possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk.
Spot Exchange Rates
D) The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into
another currency on a particular day. Spot rates change continually, and are determined by the interaction
between the demand and supply of that currency relative to the demand and supply of other currencies.
Forward Exchange Rates
E) A forward exchange occurs when two parties agree to exchange currency and execute the deal at
some specific date in the future. A forward exchange rate occurs when two parties agree to exchange
currency and execute the deal at some specific date in the future.
F) Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future.
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Chapter 10 - The Foreign Exchange Market
Management Focus: Volkswagen’s Hedging Strategy
Summary
This feature examines the effects of Volkswagen’s decision to not properly hedge its foreign exchange
exposure in 2003. Volkswagen saw a 95 percent drop in its fourth quarter profits after an unexpected
surge in the value of the euro left the company with losses of $1.5 billion. Traditionally, Volkswagen,
which produced its vehicles in Germany and exported them to the United States, hedged some 70 percent
of its foreign exchange exposure. However, in 2003, the company made the unfortunate decision to hedge
just 30 percent of its exposure. Discussion of the feature can begin with the following questions:
Suggested Discussion Questions
1. Explain how Volkswagen’s failure to fully protect itself against foreign exchange fluctuations had a
negative effect on the company. What can Volkswagen and other companies learn from this experience?
Discussion Points: Traditionally, Volkswagen hedged 70 percent of its foreign exchange exposure, but in
2003, the company was caught off guard by a sudden rise in the value of the euro against the dollar.
Experts had failed to predict the rise in the euro, and Volkswagen, like other companies that failed to
hedge their foreign exchange exposure, was hard hit. Volkswagen lost some €1.2 billion as a result of its
decision to hedge just 30 percent of its foreign exchange exposure. Most students will recognize that the
experiences of Volkswagen underscores the volatility of the foreign exchange market and the need for
companies to take steps to protect themselves even if there are no anticipated changes in currency values.
2. Volkswagen saw its fourth quarter 2003 profits tumble 95 percent after losing €1.2 billion in currency
losses after the euro rose relative to the U.S. dollar. Why was Volkswagen so vulnerable to the change in
the value of the euro relative to the U.S. dollar?
Discussion Points: Volkswagen was especially vulnerable to the rise of the euro against the U.S. dollar in
2003 because the company manufactured its cars in Germany and then exported them to the United States.
When Volkswagen failed to adequately hedge its exposure to foreign exchange rate changes, and the eurodollar relationship shifted, the company lost out. Most students will probably recognize that had
Volkswagen produced some of its cars in the United States, the effects of the currency shift would have
been much smaller.
Teaching Tip: To learn more about Volkswagen, go to {http://www.vw.com}.
Lecture Note: To extend this case, consider discussing Volkswagen’s recent decision to focus on growing
in China and Eastern Europe. Consider {http://www.businessweek.com/ap/2012-06-02/volkswagenstrengthens-focus-on-chinese-market} and {http://www.businessweek.com/ap/2012-10-12/eastern-europegives-volkswagen-a-sales-boost}.
Currency Swaps
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Chapter 10 - The Foreign Exchange Market
G) A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two
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 rate risk.
THE NATURE OF THE FOREIGN EXCHANGE MARKET
A) The foreign exchange market is not located in any one place. Rather, it is a global network of banks,
brokers, and foreign exchange dealers connected by electronic communications systems. The most
important trading centers are London, New York, Zurich, Tokyo, and Singapore. Two significant features
of the market are (1) it never sleeps, and (2) high-speed computer linkages between trading centers around
the globe have effectively created a single market.
B) The exchange rates quoted worldwide are basically the same. If different U.S. dollar/Japanese yen rates
were being offered in New York and Tokyo, there would be an opportunity for arbitrage and the gap
would close. An illustrative example can be done showing how someone could make money through
arbitrage (buying a currency low and selling it high), and how this would affect the supply and demand
for the currencies in both markets to close the gap.
C) The U.S. dollar frequently serves as a vehicle currency to facilitate the exchange of two other
currencies.
ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION
A) At the most basic level, exchange rates are determined by the demand and supply for different
currencies. Most economic theories of exchange rate movements seem to agree that three factors have an
important impact on future exchange rate movements in a country’s currency: the country’s price
inflation, the country’s interest rate, and market psychology.
Prices and Exchange Rates
B) To understand how prices are linked to exchange rates, it is important to understand the law of one
price.
The Law of One Price
C) 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.
Purchasing Power Parity
D) 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. A less extreme version of the PPP theory
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Chapter 10 - The Foreign Exchange Market
states that given relatively efficient markets – that is, markets in which few impediments to international
trade and investment exist – the price of a “basket of goods” should be roughly equivalent in each country.
Lecture Note: The Economist informally tests this theory every year using its “Big Mac Index.” To see
the most recent example, go to {http://www.economist.com/blogs/graphicdetail/2012/07/daily-chart-17}.
Money Supply and Price Inflation
E) There is a positive relationship between the inflation rate and the level of money supply. When the
growth in a country’s money supply is greater than the growth in its output, inflation will occur. A
country with a high inflation rate will see its currency depreciate
F) Simply put, PPP suggests that changes in relative prices between countries will lead to exchange rate
changes. The empirical tests suggest that this relationship does not hold in the long run, but not in the
short run. While PPP assumes no transportation costs or barriers to trade and investment, it also assumes
that governments do not intervene to affect their exchange rates.
Empirical Tests of PPP Theory
G) Extensive empirical testing of the PPP theory has not shown it to be completely accurate in estimating
exchange rate changes.
Interest Rates and Exchange Rates
H) Interest rates also affect exchange rates. The Fisher Effect says 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).
i=r+I
I) The International Fisher Effect states 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 two
countries. Stated more formally:
(S1 - S2) / S2 x 100 = i $ - i ¥
where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the U.S. and
Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the
end of the period.
J) While interest rate differentials suggest future exchange rates, this appears to hold in the long run but
not necessarily in the short run.
Video Note: The iGlobe Bernanke: U.S. Economy Faces ‘Sluggish’ Growth Outlook explores the
relationship between inflation, interest rates, and the U.S. dollar, and fits in well with this discussion.
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Chapter 10 - The Foreign Exchange Market
Investor Psychology and Bandwagon Effects
K) Investor psychology and bandwagon effects can also influence exchange rate movements. Expectations
on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and
move exchange rates based on group expectations. This is known as the bandwagon effect. While such
changes can be important in explaining some short-term exchange rate movements, they are very difficult
to predict. At times governmental intervention can prevent the bandwagon from starting, but at other times
it is ineffective and only encourages traders.
Country Focus: Quantitative Easing, Inflation, and the Value of the U.S. Dollar
Summary
This feature describes the process of quantitative easing and its implications for the economy. The
injection of money into the market by the Federal Reserve in the fall of 2010 was designed to help
stimulate the struggling U.S. economy. The move was criticized though by those who felt the move
would actually generate inflation and a falling dollar. Time proved the critics wrong as the value of the
currency remained virtually unchanged for several months. Discussion of the feature can begin with the
following questions.
Suggested Discussion Questions
1. What does the 2010 purchase by the Federal Reserve of $600 billion in U.S. government bonds tell you
about U.S. fiscal policy? What was the Federal Reserve trying to accomplish?
Discussion Points: The decision by the Federal Reserve to purchase $600 billion in U.S. government
bonds suggests that the United States was trying to expand the money supply. A larger money supply
implies lower interest rates. Lower interest rates decrease the cost of borrowing and should therefore
increase investment in the economy. Most students will recognize that the goal of the Federal Reserve
was to stimulate the U.S. economy
2. Why did the Federal Reserve receive so much criticism for its policy of quantitative easing? Do you
agree with the critics? Was the policy simply mercantilism in disguise?
Discussion Points: Critics claim that the decision by the Federal Reserve to increase the money supply via
quantitative easing was actually a form of protectionism, and in particular, simply a mercantilist policy.
According to critics, the Federal Reserve’s policy would prompt a decline in the value of the U.S. dollar
making it easier for U.S. companies to export, and harder for foreign companies to export their products to
the United States. Most students will probably agree that the fears of the critics proved to be unfounded as
the value of the dollar against a basket of major currencies remained virtually unchanged.
Lecture Note: To extend this discussion, consider
{http://www.businessweek.com/magazine/content/10_49/b4206055411492.htm}.
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Chapter 10 - The Foreign Exchange Market
L) Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all
moderately good predictors of long-run changes in exchange rates. Consequently, international businesses
should pay attention to countries’ differing monetary growth, inflation, and interest rates.
EXCHANGE RATE FORECASTING
A) A company’s need to predict future exchange rate variations raises the issue of whether it is
worthwhile for the company to invest in exchange rate forecasting services to aid decision-making. Two
schools of thought address this issue. One school, the efficient market school, argues that forward
exchange rate do the best possible job of forecasting future spot exchange rates, and, therefore, investing
in forecasting services would be a waste of money. The other school of thought, the inefficient market
school, argues that companies can improve the foreign exchange market’s estimate of future exchange
rates (as contained in the forward rate) by investing in forecasting services.
The Efficient Market School
B) Many economists believe the foreign exchange market is efficient at setting forward rates. An
efficient market is one in which prices reflect all available information. There have been a large number
of empirical tests of 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
recent studies have challenged it.
The Inefficient Market School
C) 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.
Approaches to Forecasting
D) Two approaches to forecasting exchange rates are fundamental analysis and technical analysis.
Fundamental Analysis
E) Forecasters that use fundamental analysis draw upon economic theories to predict future exchange
rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments
information.
Technical Analysis
F) Forecasters that use technical analysis typically chart trends, and believe that past trends and waves
are reasonable predictors of future trends and waves.
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Chapter 10 - The Foreign Exchange Market
CURRENCY CONVERTIBILITY
A) Many currencies are not freely convertible into other currencies. A currency is said to be freely
convertible when a government of a country allows both residents and non-residents to purchase
unlimited amounts of foreign currency with the domestic currency.
B) A currency is said to be externally convertible when non-residents can convert their holdings of
domestic currency into a foreign currency, but when the ability of residents to convert currency is limited
in some way. A currency is nonconvertible when both residents and non-residents are prohibited from
converting their holdings of domestic currency into a foreign currency.
C) Free convertibility is the norm in the world today, although many countries impose some restrictions
on the amount of money that can be converted. The main reason to limit convertibility is to preserve
foreign exchange reserves and prevent capital flight (when residents and nonresidents rush to convert
their holdings of domestic currency into a foreign currency).
D) Countertrade refers to a range of barter like agreements by which goods and services can be traded
for other goods and services. It can be used in international trade when a country’s currency is
nonconvertible.
Teaching Tip: The American Countertrade Association {http://www.globaloffset.org/} maintains a web
site with information for those interested in countertrade.
IMPLICATIONS FOR MANAGERS
A) First, it is absolutely critical that international businesses understand the influence of exchange rates on
the profitability of trade and investment deals. Foreign exchange risk can be divided into three main
categories: transaction exposure, translation exposure, and economic exposure.
Transaction Exposure
B) Transaction exposure is the extent to which the income from individual transactions is affected by
fluctuations in foreign exchange values.
Translation Exposure
C) Translation exposure is the impact of currency exchange rate changes on the reported financial
statements of a company. Translation exposure is basically concerned with the present measurement of
past events.
Management Focus: Dealing with the Rising Euro
Summary
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Chapter 10 - The Foreign Exchange Market
This feature describes the exchange rate exposure faced by two German companies, SMS Elotherm and
Keiper. Both companies supplied DaimlerChrysler with parts, however, SMS Elotherm, which
manufactured its parts in Germany was hit hard by the dollar’s slide relative to the euro in the mid-2000s.
Keiper, which had opened a plant in Canada, was able to avoid the negative effects of the currency swing
to a large extent. Discussion of the feature can revolve around the following questions:
Suggested Discussion Questions
1. Could SMS Elotherm have taken steps to avoid the position it now found itself in? What were those
steps? Why do you think the company did not take these steps?
Discussion Points: SMS Elotherm signed a deal in late 2004, to sell parts to Chrsyler. The company
anticipated making about €30,000 profit on each part. However, within days, the anticipated profit was
just €22,000. SMS Elotherm, which had priced its parts in dollars, but had its costs in euros, faced
transaction exposure. The company could have done several things to limit its exposure to exchange rates.
One of the easiest strategies would have involved entering forward contracts to buy euros with the dollars
it would receive from Chrysler. The company could have followed a similar strategy with options to buy
euros. A more involved strategy would have been to diversify its manufacturing so costs were spread
across more than one currency. Finally, the company might have negotiated a deal with Chrysler to price
some of its sales in dollars and others in euros.
2. Why was Keiper weathering the rise in the euro better than SMS Elotherm?
Discussion Points: Keiper was able to limit its exposure to the sudden shift in exchange rates because it
had opened a plant in Canada where its parts were being made. While the company still encountered
exchange rate exposure, because its costs were in Canadian dollars and its profits were in U.S. dollars, its
exposure was not as great.
3. In retrospect, what might Keiper have done differently to improve the value of its “real hedge” against a
rise in the value of the euro?
Discussion Points: Keiper’s decision to produce its parts in Canada proved to be a good one. However,
Keiper, like SMS Elotherm, could have further limited its exposure to exchange rate changes by using
forward contracts and options to hedge its profits in U.S. and Canadian dollars.
Video Note: The iGlobe Dollar’s Falling Value Ripples through U.S. Economy examines how various
U.S. companies are dealing with the falling dollar. The iGlobe provides an opportunity to extend the
discussion of this feature, and also the Implications for Managers section.
Economic Exposure
D) Economic exposure is the extent to which a firm’s future international earning power is affected by
changes in exchange rates. Economic exposure is concerned with the long-term effect of changes in
exchange rates on future prices, sales, and costs.
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Chapter 10 - The Foreign Exchange Market
Reducing Translation and Transaction Exposure
E) In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure
through leading and lagging payables and receivables (paying suppliers and collecting payment from
customers early or late depending on expected exchange rate movements).
F) A lead strategy involves attempting to collect foreign currency receivables early when a foreign
currency is expected to depreciate and paying foreign currency payables before they are due when a
currency is expected to appreciate. A lag strategy involves delaying collection of foreign currency
receivables if that currency is expected to appreciate and delaying payables if the currency is expected to
depreciate. Lead and lag strategies can be difficult to implement.
Reducing Economic Exposure
G) The key to reducing economic exposure is to distribute the firm’s productive assets to various locations
so the firm’s long-term financial well-being is not severely affected by changes in exchange rates. In
general, reducing economic exposure necessitates that the firm ensure its assets are not too 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.
Other Steps for Managing Foreign Exchange Risk
H) To manage foreign exchange risk: (a) central control of exposure is needed to protect resources
efficiently and ensure that each subunit adopts the correct mix of tactics and strategies; (b) firms should
distinguish between transaction and translation exposure on the one hand, and economic exposure on the
other hand; (c) the need to forecast future exchange rates cannot be overstated; (d) firms need to establish
good reporting systems so the central finance function can regularly monitor the firm’s exposure position;
(e) the firm should produce monthly foreign exchange exposure reports.
Critical Thinking and Discussion Questions
1. The interest rate on South Korean government securities with one-year maturity is 4 percent and the
expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities
with one-year maturity is 7 percent and the expected rate of inflation is 5 percent. The current spot
exchange rate for Korea won is $1 = W1,200. Forecast the spot exchange rate one year from today.
Explain the logic of your answer.
Answer: From the Fisher effect, we know that the real interest rate in both the US and South Korea is 2%.
The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite
direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in
the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using
the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon and substituting 7 for i$, 4 for iWon, and
1200 for S1, yields a value for S2 of $1=W1165.
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Chapter 10 - The Foreign Exchange Market
2. Two countries, Britain and the US produce just one good: beef. Suppose that the price of beef in the
US is $2.80 per pound, and in Britain it is £3.70 per pound.
(a) According to PPP theory, what should the $/£ spot exchange rate be?
(b) Suppose the price of beef is expected to rise to $3.10 in the US, and to £4.65
in Britain. What should be the one year forward $/£ exchange rate?
(c) Given your answers to parts (a) and (b), and given that the current interest rate in the
US is 10 percent, what would you expect current interest rate to be in Britain?
Answer: (a) According to PPP, the $/£ rate should be 2.80/3.70, or .76$/£.
(b) According to PPP, the $/£ one year forward exchange rate should be 3.10/4.65,
or .67$/£.
(c) Since the dollar is appreciating relative to the pound, and given the relationship of
the international fisher effect, the British must have higher interest rates than the US.
Using the formula (S1 - S2)/S2 x 100 = i£ - i$ we can solve the equation for i£, with
S1=.76, S2=.67, I$ = 10, yielding a value of 23.4% for the British interest rates.
3. Reread the Management Focus feature on Volkswagen in this chapter, then answer the following
questions:
a) Why do you think management at Volkswagen decided to hedge only 30 percent of their foreign
currency exposure in 2003? What would have happened if they had hedged 70 percent of their exposure?
b) Why do you think the value of the U.S. dollar declined against that of the Euro in 2003?
c) Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its
exposure to future declines in the value of the U.S. dollar against the euro?
Answer:
a) When Volkswagen decided to hedge just 30 percent of its foreign exchange exposure in 2003, the
company essentially gambled that the euro would decline in value relative to the dollar. The company
hoped that by saving the cost of the commission involved in selling a currency forward, it would increase
its profit margin. This strategy of course, backfired.
b) The appreciation of the euro relative to the U.S. dollar took many people by surprise. The rise of the
euro has been attributed to record U.S. foreign trade deficits and pessimism about the future value of the
dollar.
c) In addition to using forward contracts, Volkswagen could use currency swaps, and lead and lag
payables and receivables.
4. You manufacture wine goblets. In mid June you receive an order for 10,000 goblets from Japan.
Payment of ¥400,000 is due in mid December. You expect the yen to rise from its present rate of
$1=¥130 to $1=¥100 by December. You can borrow yen at 6% per annum. What should you do?
Answer: The simplest solution would be to just wait until December, take the ¥400,000 and convert it at
the spot rate at that time, which you assume will be $1=¥100. In this case you would have $4,000 in midDecember. If the current 180 day forward rate is lower than 100¥/$, then it would be preferable since it
both locks in the rate at a better level and reduces risk. If the rate is above ¥100/$, then whether you
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Chapter 10 - The Foreign Exchange Market
choose to lock in the forward rate or wait and see what the spot does will depend upon your risk aversion.
There is a third possibility also. You could borrow money from a bank that you will pay back with the
¥400,000 you will receive (400,000/1.03 = ¥388,350 borrowed), convert this today to US$ (388,350/130 =
$2,987), and then invest these dollars in a US account. For this to be preferable to the simplest solution,
you would have to be able to make a lot of interest (4,000 - 2,987 = $1,013), which would turn out to be
an annual rate of 51% ((1,013/4000) * 2). If, however, you could lock in these interest rates, then this
method would also reduce any exchange rate risk. What you should do depends upon the interest rates
available, the forward rates available, how large a risk you are willing to take, and how certain you feel
that the spot rate in December will be ¥100 = $1.
5. You are CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts
for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United
States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent
against the dollar on the foreign exchange markets over the next year. What actions, if any, should you
take?
Answer: This question deals with the risk faced by businesses related to changes in exchange rates. If the
peso depreciates as expected peso relative to the dollar, the dollar value of the company’s Mexican
subsidiary would decrease substantially. This would then reduce the total dollar value of the firm’s
equity reported in its consolidated balance sheet, raising the apparent leverage of the firm, which could
increase the firm’s cost of borrowing and limit its access to the capital market. Most students will suggest
that the company explore the use of forward contracts and swaps to protect itself from the currency
movement for individual transactions. In addition, the company may want to engage in a lead strategy
and collect its foreign receivables early.
Closing Case: Billabong
Summary
The closing case explores the implications of changing currency values on the profits of Australian retailer
Billabong. Billabong relies on the U.S. market for a significant share of its total sales. Consequently, the
company must continually monitor and adapt to the changing relationship between the Australian dollar
and the U.S. dollar. Discussion of the case can revolve around the following questions:
Suggested Discussion Questions
QUESTION 1: Why does a fall in the value of the Australian dollar against the U.S. dollar benefit
Billabong?
ANSWER 1: The fall in the value of the Australian dollar relative to the U.S. dollar benefits Billabong
because of its effect on prices for U.S. consumers. A strong U.S. dollar can buy more products priced in a
weaker Australian dollar. The United States is Billabong’s largest foreign market, so changes in the
values of the two currencies can have a real impact on Billabong’s sales and profits. A weak Australian
dollar makes it easier for Billabong to export.
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Chapter 10 - The Foreign Exchange Market
QUESTION 2: Could the rise in the value of the Australian dollar that occurred in 2009 have been
predicted?
ANSWER 2: Most students will probably suggest that the 2009 rise in the value of the Australian dollar
would probably have been difficult to accurately predict. At the time, the global economy and global
financial markets were in turmoil, changing seemingly daily as the crisis deepened. However, many
students will probably suggest that by relying so heavily on one market, Billabong left itself exposed to
risk. Students may also note that the situation highlights the importance of recognizing the impact of
exchange rates on business.
QUESTION 3: What might Billabong have done in order to better protect itself against the unanticipated
rise in the value of the Australian dollar that occurred in 2009?
ANSWER 3: Billabong has several options to protect itself from the rise in the value of the Australian
dollar in 2009. Students may note for example that the company could have engaged in the forward
market to protect itself against transaction exposure. Billabong might also have worked to diversify its
revenues and reduce its reliance on the U.S. market. Some students may suggest that foreign production
could also have helped Billabong minimize its exposure to changing exchange rates.
QUESTION 4: The Australian dollar continued to rise by another 20 percent against the U.S. dollar in
2010 and 2011. How would this have affected Billabong? Is there anything that Billabong might have
done to limit its long-term economic exposure to changes in the value of the currency in its largest export
market?
ANSWER 4: The continued rise of the Australian dollar in 2010 and 2011 would have caused more
problems for Billabong as its exports became even more expensive for U.S. consumers. Many students
will probably suggest that long-term, Billabong should consider moving production to the United States to
decrease its exchange risk.
Teaching Tip: To learn more about Billabong, go to {http://www.billabong.com/}.
Lecture Note: To extend this case, explore some of the recent efforts to take over the struggling surf wear
company. Consider {http://www.businessweek.com/ap/2012-09-06/billabong-gets-new-offer}.
Continuous Case Concept
As the world’s automakers search around the globe for the best suppliers for their parts, and at the same
time, focus on new markets such as China and India, controlling for changes in exchange rates becomes
an important part of their financial strategies.

Ask students to identify the types of exposure to foreign exchange rates auto makers are likely to
encounter.

Then, ask students to develop a plan for controlling for the exposure. Discuss why a company
might choose one hedging strategy over another. South Korea’s weak won has given Hyundai
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Chapter 10 - The Foreign Exchange Market
Motor an advantage over rivals over the couple of years, but the company may find that as the
currency strengthens, this advantage will disappear. In contrast, Japanese automakers including
Honda, Nissan, and Toyota have struggled with a strong yen which has limited their ability to
expand globally.

Finally, ask students to consider what exchange rates mean to companies that draw a significant
percentage of their revenues from foreign countries. How do the strategies of these companies
differ from those of companies that can rely on their domestic market for the majority of their
sales?
This feature ties in well with the discussion of both the opening case and especially, the closing case, as
well as with the Management Focus on Dealing with the Rising Euro, and Volkswagen’s Hedging
Strategy. The case can be used to supplement the closing case, or to extend the discussion of these other
features. This feature could also be expanded into a mini-case by asking students to identify companies
that have reported losses or gains due to exchange rate movements, and then, exploring the strategic
responses of the firms involved.
globalEDGE Exercises
Use the globalEDGE Resource Desk {http://globalEDGE.msu.edu/ResourceDesk/} to complete the
following exercises.
Exercise 1
The currency exchange rates can be accessed via a variety of sources. A list of these sources is available
http://globaledge.msu.edu/Reference-Desk and can be accessed by searching the term "real-time exchange
rates and charts". One resource listed under this search is the FX Street, located under the globalEDGE
categories "Global" and "Finance". This site offers daily updated information about foreign exchange
markets as forex news, market reports, forecasts, and real-time exchange rates and charts. A currency
converter and historical tables are also available.
Search Phrase: "real-time exchange rates and charts"
Resource Name: FX Street
Resource Link: http://globaledge.msu.edu/global-resources/resource/1157
globalEDGE Categories: "Global" and "Finance"
Exercise 2
The currency chart can be accessed by searching for the phrase "comprehensive currency website" at
http://globaledge.msu.edu/Reference-Desk. "XE" is a resource that provides up-to-date exchange rates and
additional tools about the foreign exchange market, including currency charts. It can also be found under
the globalEDGE categories "Currency" and "Standards and Conversions." Once on the XE website, click
on "Tools" and then on "Currency Charts". Select both EUR and USD and download the data for the
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Chapter 10 - The Foreign Exchange Market
EUR/USD pair once monthly for the entire previous year. This provides sufficient information to evaluate
the quarterly data required for the exercise.
Search Phrase: "comprehensive currency website"
Resource Name: XE: Currency and Foreign Exchange
Resource Link: http://globaledge.msu.edu/global-resources/resource/1022
globalEDGE Categories: "Currency" and "Standards and Conversions"
Additional Readings and Sources of Information
Volkswagen Sales Rise 11.9 percent in July
http://www.businessweek.com/ap/2012-08-22/volkswagen-sales-rise-11-dot-9-percent-in-july
Billabong Falls after Surprise Wipe-Out
http://www.businessweek.com/videos/2012-08-26/billabong-falls-after-surprise-wipe-out
Why Hasn’t the Euro Fallen More in the Crisis?
http://www.businessweek.com/articles/2012-04-25/why-hasnt-the-euro-fallen-more-in-the-crisis
More Downside Seen for Billabong Shares
http://www.businessweek.com/videos/2012-10-11/more-downside-seen-for-billabong-shares
How China’s Yuan Can Become a Global Currency
http://www.businessweek.com/globalbiz/content/sep2009/gb20090915_651661.htm
Dollar as Reserve Currency: Mixed Signals
http://www.businessweek.com/globalbiz/content/jan2010/gb20100122_964613.htm
Dizzy, Dollar Investors Lack Conviction
http://www.businessweek.com/investor/content/apr2009/pi20090424_033334.htm
The U.S. Dollar Rally: What Investors Should Be Watching
http://www.businessweek.com/investor/content/jan2010/pi20100120_622348.htm
Dollar falls; it's the euro's day
http://www.businessweek.com/ap/2012-06-29/dollar-falls-its-the-euros-day
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