Download BM 2.07 Notes

2.07 Determine global
trade’s impact on business
decision-making to acquire
insight into the global
forces affecting business.
Describe the determinants of exchange rates and their effects on the
domestic economy
Define the terms
• Exchange Rate - The exchange, also termed foreign exchange rate, is the price of one currency in
terms of another. The currencies of different nations are regularly traded for each other over
foreign exchange markets. The price established for this exchange of currencies is the exchange
rate.
• Exchange rate quotation - is given by stating the number of units of a price currency that can be
bought in terms of 1 unit currency. For example, in a quotation that says the EUR-USD exchange
rate is 1.2 USD per EUR, the price currency is USD and the unit currency is EUR.
• Free Floating Currency - a currency that uses a floating exchange rate as its exchange rate regime.
• Pegged Currency - A currency that is controlled by the central bank in a country so that it keeps
the same value against other currencies
• Foreign exchange market - is a market that trades the domestic currency of one nation for the
domestic currency of another nation.
• Weak dollar - is weak in comparison to other paper currencies
• Strong dollar – is strong compared to other currencies. (They're all WEAK, since none of them are
backed by anything, and are mere pieces of paper with ink on them.)
Distinguish between direct and indirect
exchange-rate quotations.
• Direct quotation is where the cost of one unit of foreign currency is
given in units of local currency
• Indirect quotation is where the cost of one unit of local currency is
given in units of foreign currency.
Your local currency is EUR:
- Direct exchange rate: 1USD = 0.92819 EUR
- Indirect exchange rate: 1EUR = 1.08238 USD
Interpret exchange rates.
• If, for example, someone in the United States is willing to pay two dollars to
purchase one British pound, making the price of a British pound $2, then
the exchange rate between dollars and pounds is 2 dollars for 1 pound.
• These assorted currency exchange rates indicate the relative values of the
currencies exchanged. A British pound price of $2, and exchange rate of 2
for 1, generally indicates that the one British pound is twice as valuable as
one U.S. dollar. Currency traders give up TWO dollars for ONE pound.
• Compare this to the "exchange rate" between a U.S. dime and U.S. nickel.
Two nickels can be exchanged for one dime, an exchange rate of 2 nickels
per dime, and generating a "price" of 2 nickels. This price clearly indicates
that a dime is twice as valuable and can purchase twice as many goods and
services, as a nickel. The exchange rate between different national
currencies has much the same interpretation.
Identify factors that increase demand for
currencies
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A reduction in the interest rate.
A rise in the demand for consumer spending.
A rise in uncertainty about the future and future opportunities.
A rise in transaction costs to buy and sell stocks and bonds.
A rise in inflation causes a rise in the nominal money demand but real
money demand stays constant.
A rise in the demand for a country's goods abroad.
A rise in the demand for domestic investment by foreigners.
A rise in the belief of the future value of the currency.
A rise in the demand for a currency by central banks (both domestic and
foreign).
Explain factors that cause a currency to lose
value relative to other currencies.
• A currency will tend to become more valuable
whenever demand for it is greater than the available
supply. It will become less valuable whenever demand
is less than available supply (this does not mean
people no longer want money, it just means they
prefer holding their wealth in some other form,
possibly another currency).
• A currency will tend to lose value, relative to other
currencies, if the country's level of inflation is
relatively higher, if the country's level of output is
expected to decline, or if a country is troubled by
political uncertainty.
Discuss how economic factors affect exchange
rates
An exchange rate is determined by supply and demand factors. These are the various factors which determine the demand and
supply of a currency.
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1. Inflation
If inflation in the UK is lower than elsewhere, then UK exports will become more competitive and there will be an increase in
demand for pounds. Also foreign goods will be less competitive and so UK citizens will supply less pounds to buy foreign
goods. Therefore the rate of pound will tend to increase.
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2. Interest Rates
If UK interest rates rise relative to elsewhere, it will become more attractive to deposit money in the UK
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3. Speculation
If speculators believe the pound will rise in the future, they will demand more now to be able to make a profit. This increase in
demand will cause the value to rise.
Therefore movements in the exchange rate do not always reflect economic fundamentals, but are often driven by the
sentiments of the financial markets.
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For example, if markets see news which makes an interest rate increase more likely, the value of the Pound will probably rise
in anticipation.
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4. Change in competitiveness
If British goods become more attractive and competitive this will also cause the value of the Exchange Rate to rise. This is
important for determining the long run value of the Pound.
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5. Relative strength of other currencies
Between 1999 and 2001 the pound appreciated because the Euro was seen as a weak currency.
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6. Balance of Payments
A large deficit on the current account means that the value of imports is greater than the value of exports. If this is financed by
a surplus on the financial / capital account then this is OK. But a country who struggles to attract enough capital inflows will
see a depreciation in the currency. (For example current account deficit in US of 7% of GDP was one reason for depreciation of
dollar in 2006-07)
Explain how market psychology can affect
exchange rates.
Market psychology along with the perception of currency traders are also one of the important determinants
of currency market rates. These factors influence the currency trading market in following ways.
1.Flights to quality: This phenomenon of currency exchange market states that the various international events
taking place in different nations of the world affect the foreign exchange rates. A ‘flight to quality’ means the
traders moving their capital away from the risky investments to the safer investment options. In other words,
traders look forward to safer economic currencies and prefer that currency investment where the demand is
on higher side thus resulting in a higher price for currencies. The safest currency is considered to be The
Swiss franc during the times of political or economic uncertainty.
2. Long-term trends: The foreign exchange currency trading markets usually move in visible long-term trends.
These trends are analyzed and studied by currency exchange professionals to predict the effect of these
events on the future currency rates.
3. Economic numbers: The economic numbers are determinants of currency market rates as they are based on
economic reports of a country thus indicating the economic condition of a particular company. These
economic numbers greatly influence the market psychology and they may affect the short-term market
moves.
4.Technical trading considerations: Technical trading considerations such as the price charts are also
determinants of market exchange rate. Because many investors analyze these price charts in order to
identify various pattern over the period of time. It is an important foreign exchange currency rate
determinant.
Describe how political conditions can
influence exchange rates
• Political conditions are important determinants of currency market
rates of foreign exchange rates. International political conditions,
internal and regional events within a country affect the currency
markets greatly. All exchange rates are sensitive to political instability
and speculations about the new ruling party. Political upheaval and
instability can play a negative role in a nation's economy.
• Similarly, any country facing financial difficulties, is perceived to be
fiscally responsible can have the opposite effect. Also, events in one
country in a region may initiate positive or negative interest in a
neighboring country. And in the process, affect its currency rates.
Distinguish between free-floating and pegged
currency
• A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the
official exchange rate. A set price will be determined against a major world currency (usually
the U.S. dollar, but also other major currencies such as the euro, the yen or a basket of
currencies). In order to maintain the local exchange rate, the central bank buys and sells its
own currency on the foreign exchange market in return for the currency to which it is pegged.
• Unlike the fixed rate, a floating exchange rate is determined by the private market through
supply and demand. A floating rate is often termed "self-correcting", as any differences in
supply and demand will automatically be corrected in the market. Take a look at this simplified
model: if demand for a currency is low, its value will decrease, thus making imported goods
more expensive and stimulating demand for local goods and services. This in turn will generate
more jobs, causing an auto-correction in the market. A floating exchange rate is constantly
changing.
• In reality, no currency is wholly fixed or floating. In a fixed regime, market pressures can also
influence changes in the exchange rate. Sometimes, when a local currency does reflect its true
value against its pegged currency, a "black market", which is more reflective of actual supply
and demand, may develop. A central bank will often then be forced to revalue or devalue the
official rate so that the rate is in line with the unofficial one, thereby halting the activity of the
black market. In a floating regime, the central bank may also intervene when it is necessary to
ensure stability and to avoid inflation; however, it is less often that the central bank of a
floating regime will interfere.
Describe factors that influence free-floating
currency.
• A free-floating system has the advantage of being self-regulating. There is
no need for government intervention if the exchange rate is left to the
market.
• Market forces also restrain large swings in demand or supply.
• Suppose, for example, that a dramatic shift in world preferences led to a
sharply increased demand for goods and services produced in Canada. This
would increase the demand for Canadian dollars, raise Canada’s exchange
rate, and make Canadian goods and services more expensive for foreigners
to buy. Some of the impact of the swing in foreign demand would thus be
absorbed in a rising exchange rate.
• In effect, a free-floating exchange rate acts as a buffer to insulate an
economy from the impact of international events.
Identify institutions that utilize the foreign
exchange market
• Governments
• Banks
• Importers
• Exporters
• Investors
• Consumers
Discuss types of financial instruments used in
foreign exchange markets
Spot
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A spot transaction is a two-day delivery transaction (except in the case of trades between the US Dollar, Canadian Dollar, Turkish Lira, EURO and
Russian Ruble, which settle the next business day), as opposed to the futures contracts, which are usually three months. This trade represents a
“direct exchange” between two currencies, has the shortest time frame, involves cash rather than a contract; and interest is not included in the
agreed-upon transaction.
Forward
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One way to deal with the foreign exchange risk is to engage in a forward transaction. In this transaction, money does not actually change hands until
some agreed upon future date. A buyer and seller agree on an exchange rate for any date in the future, and the transaction occurs on that date,
regardless of what the market rates are then. The duration of the trade can be one day, a few days, months or years. Usually the date is decided by
both parties. Then the forward contract is negotiated and agreed upon by both parties.
Swap
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The most common type of forward transaction is the FX swap. In an FX swap, two parties exchange currencies for a certain length of time and agree to
reverse the transaction at a later date. These are not standardized contracts and are not traded through an exchange.
Future
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Futures are standardized and are usually traded on an exchange created for this purpose. The average contract length is roughly 3 months. Futures
contracts are usually inclusive of any interest amounts.
Option
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A foreign exchange option (commonly shortened to just FX option) is a derivative where the owner has the right but not the obligation to exchange
money denominated in one currency into another currency at a pre-agreed exchange rate on a specified date. The FX options market is the deepest,
largest and most liquid market for options of any kind in the world.
Explain the advantages/disadvantages of a
strong U.S. dollar
Strengthening Dollar
• Advantages
• Consumer sees lower prices on foreign products/services
• Lower prices on foreign products/services help keep inflation low
• U.S. consumers benefit when they travel to foreign countries
• U.S. investors can purchase foreign stocks/bonds at "lower" prices
• Disadvantages
• U.S. firms find it hard to compete in foreign markets
• U.S. firms must compete with lower priced foreign goods
• Foreign tourists find it more expensive to visit U.S.
• More difficult for foreign investors to provide capital to U.S. in time of heavy U.S. borrowing
Describe the advantages/disadvantages of a
weak U.S. dollar
Weakening Dollar
• Advantages
• U.S. firms find it easier to sell goods in foreign markets
• U.S. firms find less competitive pressure to keep prices low
• More foreign tourists can afford to visit the U.S.
• U.S. capital markets become more attractive to foreign investors
• Disadvantages
• Consumers face higher prices on foreign products/services
• Higher prices on foreign products contribute to higher cost-of-living
• U.S. consumers find traveling abroad more costly
• Harder for U.S. firms and investors to expand into foreign markets
Explain the risks of speculating on the price of
foreign currency
• Speculation is an attempt to profit by trading on expectations about
prices in the future.
–In the foreign exchange market, one speculates by taking position on a
currency and then closing that position after the exchange rate has
moved.
–A profit results only if the rate moves in the direction that was
expected
Student Activity
• Ask the students to imagine that they are U.S. importers who are
trying to decide among three countries from which to obtain goods.
Each student should select a product and the three countries of
interest. The product that each student selects should be one of
interest to her/him, and the countries identified should actually
export the item. Each student should write a memorandum to the
company’s owner recommending one of the countries based on
exchange rates. After completing his/her memorandum, each student
should compare and discuss it with a classmate
• http://www.x-rates.com/cgi-bin/cgicalc.cgi?value=1&base=USD
• Test next class