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The Foreign-exchange Market Introduction Characteristics,Foreign Exchange Installments

The Foreign-exchange Market Introduction Characteristics,Foreign Exchange Installments

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Published by anu ranjan
The Foreign-exchange Market Introduction Characteristics,Foreign Exchange Installments
The Foreign-exchange Market Introduction Characteristics,Foreign Exchange Installments

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Published by: anu ranjan on Oct 02, 2009
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© Copy Right: Rai University
All things are obedient to money.
-English Proverb
To learn the fundamentals of foreign exchange
To identify the major characteristics of the foreign-exchangemarket and how governments Control the flow of currenciesacross national borders
To understand why companies deal in foreign exchange
To describe how the foreign-exchange market works
To examine the different institutions that deal in foreignexchange
Foreign Exchange Losses at JAL
One of the world’s largest airlines, Japan Air lines (JAL), is alsoone of the best customers of Boeing, the world’s biggestmanufacturer of commercial airplanes. Every year JAL needs toraise about $800 million to purchase aircraft from Boeing.Boeing aircraft are priced in U.S. dollars, with prices rangingfrom about $35 million for a 737 to $160 million for a top-of-the-line 747-400. JAL orders an aircraft two to six-years beforethe plane is actually needed and normally pays Boeing a 10percent deposit when ordering. The bulk of the payment ismade when the aircraft is delivered.The long lag between placing an order and making a fi’1alpayment presents a conundrum for JAL. Most of JAL’srevenues are in Japanese yen, not U.S. dollars (which is notsurprising for a Japanese airline). When purchasing Boeingaircraft, JAL must change its yen into dollars to pay Boeing. Inthe interval between placing an order and making final payment,the value of the yen against the dollar may change. This canincrease or decrease the cost of an aircraft. Consider an orderplaced for a 747 aircraft that was to be delivered in five years. Thedollar value of this order was $100 million. Suppose theprevailing exchange rate at the time of ordering was $1 = ¥240(i.e., one dollar was worth 240 yen), making the price of the 747 ¥2:4 billion. When final payment is due, however, the dollar/ yen exchange rate might have changed. The yen might havedeclined in value against the dollar. For example, the dollar/yenexchange rate might be $1 =¥300. If this occurs, the price of the.7 47 would go from ¥2.4 billion to ¥3.0 billion, a 25percent increase: Another (more favorable) scenario is that theyen might rise in value against the dollar to $1 =¥200. If thisoccurs, the yen price of the 747 would fall 16.7 percent to ¥2.0billion.JAL has no way of knowing what the value of the yen will beagainst the dollar in five years. However, JAL can enter into acontract with foreign exchange traders to purchase dollars fiveyears hence based on the assessment of those traders as to whatthey think the dollar/yen exchange rate will be then. This iscalled entering into a forward exchange contract. The advantageof entering into a forward exchange contract is that JAL knowsnow what it will have to pay for the 747 in five years. Forexample, if the value of the yen is expected to increase againstthe dollar, foreign exchange traders might offer a forwardexchange contract that allows JAL to purchase dollars at a rateof $1 =¥185 in five years, instead of the $1 =¥240 rate thatprevailed at the time of ordering. At this forward exchange rate,the 747 would only cost ¥1.85 billion, a 23 percent saving overthe yen price implied at time of ordering.JAL was confronted with just this scenario in 1985 when itentered into a 1O-year forward exchange contract with a totalvalue of about $3.6 billion. This contract gave JAL the right tobuy, U.S. dollars from a consortium of foreign exchange tradersat various points during the next 10 years for an averageexchange rate of $1 =¥185. This looked like a great deal to JALgiven the 1985 exchange rate of $1 =¥240. However, bySeptember 1994 when the bulk of the contract had beenexecuted; it no longer looked like a good deal. To everyone’ssurprise, the value of the yen had surged against the dollar. ‘By1992, the exchange rate stood at $1 =¥120, and by 1994, it was$1 =¥99. Unfortunately, JAL could not take advantage of thismore favorable exchange rate. Instead, JAL was bound by theterms of the contract to purchase dollars at the contract rate of $1 =¥185, a rate that by 1994 looked outrageously expensive.This misjudgment cost JAL dearly. In 1994, JAL was paying 86percent more than it needed to for each Boeing aircraft boughtwith dollars purchased via the forward exchange -contract! InOctober 1994, JAL admitted publicly that the loss in its mostrecent financial year from this misjudgment amounted to $450million, or ¥45 billion. Furthermore, foreign exchange tradersspeculated that JAL had probably lost ¥155 billion ($1.5billion) on this contract since 1988.Sources: W. Dawkins, “JAL to Disclose Huge Currency HedgeLoss,” Financial Times, October 4, 1994, p. 19; and W. Dawkins“Tokyo to Lift Veil on Currency Risks,” Financial Times,October 5, 1994, p. 23.
The first is to explain how the foreign exchange market works.The second is to examine the forces that determine exchangerates and to discuss the degree to which it is possible to predictfuture exchange rate movements. The third objective is to mapthe implications for international business of exchange ratemovements and the foreign exchange market. This chapter isthe first of three that deal with the international monetarysystem and its relationship to international business. Theinstitutional structure is the context within which the foreignexchange market functions. As we shall see, changes in theinstitutional structure of the international monetary system canexert a profound influence on the development of foreignexchange markets. The foreign exchange market is a market forconverting the currency of one country into that of another
© Copy Right: Rai University
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country. An exchange rate is simply the rate at which onecurrency is converted into another. We saw in the opening casehow JAL used the foreign exchange market to convert Japaneseyen into U.S. dollars. Without the foreign exchange market,international trade and international investment on the scalethat we see today would be impossible; companies would haveto resort to barter. The foreign exchange market is the lubricantthat enables companies-based in countries that use differentcurrencies to trade with each other.We know from earlier chapters that international trade andinvestment have their risks. As the opening case illustrates,some of these risks exist because future exchange rates cannotbe perfectly predicted. The rate at which one currency is con-verted into another typically changes over rime. One function of the foreign exchange market is to provide some insuranceagainst the risks that arise from changes in exchange rates,commonly referred to as foreign exchange risk. Although theforeign exchange market offers some insurance against foreignexchange risk, it cannot provide complete insurance. JAL’s lossof $1.5 billion on foreign exchange transactions is an extremeexample of what can happen, but it is not unusual for interna-tional businesses to suffer losses because of unpredictedchanges in exchange rates. Currency fluctuations can makeseemingly profitable trade and investment deals unprofitable,and vice versa. . The opening case contains an example of this.In addition to altering the value of trade deals and foreigninvestments, currency movements can also open or close exportopportunities and alter the attractiveness of imports. Forexample, consider what occurred following the introduction of the euro in January 2000 to the profits and sales of many U.S.companies that made substantial exports to Europe. Initiallythe euro/dollar exchange rate was E1 =$1.08, signifying thatone euro was worth about 8 percent more than one dollar. Overthe next few months the value of the euro fell sharply, and bylate 2000 one euro was worth only about 82 cents (E1 =$0.82),a 25 percent decline in value. The products that U.S. companieswere exporting to Europe, while having stable prices in termsof dollars, had increased in price by about 25 percent whenconverted into euros. As a consequence, European consumers,paying in euros, cut back their purchases of U.S. products, andby late 2000 a number of U.S. companies were reporting thattheir profits and sales would be below expectations, primarilydue to weak export sales to Europe. For example, Stem Pinball,a manufacturer of pinball machines based in Illinois, reported1999 sales of about $30 million, of which some $15 millionwere exports to European Union countries. Following the fallin the value of the euro against the dollar during 2000, Stem’sexport sales to Europe fell by some 50 percent.While the existence of foreign exchange markets is a necessaryprecondition for large-scale international trade and investment,as suggested by this example and the opening case, themovement of exchange rates introduces many risks intointernational trade and investment. Some of these risks can beinsured against by using instruments offered by the foreignexchange market, such as the forward exchange contractsdiscussed in the opening case; others cannot be.We begin this chapter by looking at the function and the formof the foreign exchange market. This includes distinguishingamong spot exchanges, forward exchanges, and currency swaps.Then we will consider the factors that determine exchange rates.We will-also look at how foreign trade is conducted when acountry’s currency cannot be exchanged for other currencies; thatis, when its currency is not convertible. The chapter closes with adiscussion of these things in terms of their implications forbusiness,
The Functions of the Foreign Exchange Market
The foreign exchange market serves two main functions. Thefirst is to convert the currency of one country into the currencyof another. The second is to provide some insurance againstforeign exchange risk, by which we mean the adverse conse-quences of unpredictable changes in exchange rates.
Currency Conversion
Each country has a currency in which the prices of goods andservices are quoted. In the United States, it is the dollar ($); inGreat Britain, the pound (£)j in France, Germany, and othermembers of the euro zone it is the euro (E); in Japan, the yen)j and so on. In general, within the borders of a particularcountry, one must use the national currency. AU .S. touristcannot walk into a store in Edinburgh, Scotland, and use U.S.dollars to buy a bottle of Scotch whisky. Dollars are notrecognized as legal tender in Scotland; the tourist must useBritish pounds. Fortunately, the tourist can go to a bank andexchange her dollars for pounds. Then she can buy the whisky.When a tourist changes one currency into another, she isparticipating in the foreign exchange market. The exchange rateis the rate at which the market converts one currency intoanother. For example, an exchange rate of $1 = ¥120 specifiesthat one U.S. dollar has the equivalent value of 120 Japaneseyen. The exchange rate allows us to compare the relative pricesof goods and services in different countries. Our U.S. touristwishing to buy a bottle of Scotch whisky in Edinburgh, mayfind that she must pay £30 for the bottle, knowing that thesame bottle costs $40 in the United States. Is this a good deal?Imagine the current pound/dollar exchange rate is £1.00 =$1.50. Our intrepid tourist takes out her calculator and converts£30 into dollars. (The calculation is 25 X 1.5) She finds that thebottle of Scotch costs the equivalent of $45. She is surprisedthat a bottle of Scotch whisky could cost less in the UnitedStates than in Scotland. (This is true; alcohol is taxed heavily inGreat Britain.)Tourists are minor participants in the foreign exchange market;companies engaged in international trade and investment aremajor ones. International businesses have four main uses of foreign exchange markets. First, the payments a companyreceives for its exports, the income it receives from foreigninvestments, or the income it receives from licensing agreementswith foreign firms may be in foreign currencies. To use thosefunds in its home country, the company must convert them toits home country’s currency. Consider the Scotch distillery thatexports its whisky to the United States. The distillery is paid indollars, but since those dollars cannot be spent in Great Britain,they must be converted into British pounds.
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Second, international businesses use foreign exchange marketswhen they must pay a foreign company for its products orservices in its country’s currency. For example, our friend Michaelruns a company called NST, a large British travel service forschool groups. Each year Michael’s company arranges vacationsfor thousands of British schoolchildren and their teachers inFrance. French hotel proprietors demand payment in euros, soMiChael must convert large sums of money from pounds intoeuros to pay them.Third, international businesses use foreign exchange marketswhen they have spare cash that they wish to invest for shortterms in money market. For example, consider a U.S. companythat has $10 million it wants to invest for three months. Thebest interest rate it can earn on these funds in the United Statesmay be 8 percent. Investment in a South Korean: moneymarket account, however, may earn 12 percent. Thus, thecompany may change its $10 million into Korean won andinvest it in South Korea. Note, however, that the rate of returnit earns on this investment depends not only on the Koreaninterest rate, but also on the changes in the value of the Koreanwon against the dollar in the intervening period.Finally, currency speculation is another use of foreign exchange,markets. Currency speculation typically involves the short-termmovement of funds from one currency to another in the hopesof profiting from shift in exchange rates. Consider again theU.S. Company with $10 million to invest for three months.Suppose the company suspects that the U.S. dollar is overval-ued against the Japanese yen. That is, the company expects thevalue of the dollar to depreciate against that of the yen. Imaginethe current dollar/yen exchange rate is $1 == ¥120. Thecompany exchanges its $10 million into yen, receiving ¥1.2billion. Over the next three months, the value of the dollardepreciates 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 specula-tion in three months on an initial investment of $10 million.One of the most famous currency “speculators” is GeorgeSoros, whose Quantum Group of “hedge funds” controlsabout $15 billion in assets. The activities of Soros, who hasbeen’ spectacularly successful, are profiled in the accompanyingManagement Focus. In general, however, companies shouldbeware of speculation for it is a very risky business. Thecompany cannot know for sure what will happen to exchangerates. While a speculator may profit handsomely if his specula-tion about future currency movements turns out to be correct,he can also lose vast amounts of money if it turns out to bewrong. For example, in 1991, Clifford Hatch, the financedirector of the British food and drink company Allied-Lyons,bet large amounts of the company’s funds on the speculationthat the British pound would rise in value against the U.S.dollar. Over the previous three years, Hatch had made over $25million for Allied-Lyons by placing similar currency bets. His1991 bet, however, went spectacularly wrong when the Britishpound plummeted in value against the U.S. dollar. In February1991, one pound bought $2; by April it bought less than $1.75.The total loss to Allied-Lyons from this speculation was astaggering $269 million, more’ than the company was to earnfrom all of its food and drink activities during 1991!
George Soros-The Man Who Moved CurrencyMarkets
George Soros, a Hungarian-born financier, is the principalpartner of the Quantum Group, which controls a series of hedge funds with assets of about $15 billion. A hedge fund isan investment fund that not only buys financial assets (such asstocks, bonds, and currencies) but also sells them short. Snortselling occurs when an investor places a speculative bet that thevalue of a financial asset will decline and then profits from thatdecline. A common variant at short selling occurs when aninvestor borrows stock from his broker and sells that stock. Theshort seller has to ultimately pay back that stock to his broker.However, he hopes that in the intervening period the value of the, stock will decline so that the cost of repurchasing the stock to pay back the broker is significantly less than the income hereceived from the initial sale of the stock. For example, imaginethat a short seller borrows 100 units of IBM stock and sells it inthe market at $150 per share, yielding a total income of $15,000.In one year, the short seller has to give the 100 units of IBMstock back to his broker. In the intervening period, the value of the IBM stock falls to $50. Consequently, it now costs theshortselleronly $5,000 to repurchase the 100 units of IBM stock for his broker. The difference between the initial sales price($150) and the repurchase price’ ($50) represents the shortseller’s profit, which in the case is $100 per unit of stock for atotal profit of $ 10,000.Short selling was originally developed asa mean of reducing risk (of hedging), but it, is often used forspeculation.Along with other hedge funds, Soros’s Quantum Fund oftentakes a short position in currencies that he expects to decline invalue. Fort example, if ,Soros expects the British pound todecline against the U.S. dollar, he may borrow 1 billion poundsfrom a currency trader and immediately sell those for U.S.dollars. Soros will then hope that the value of the pound willdecline against the dollar, so that when he has to repay the 1billion pounds it will cost him considerably less (in U.S. dollars)than he received from the initial sale.Since the 1970s,Soroshas consistently earned huge returns bymaking such speculative bets. His most spectacular triumphcame in September 1992. He believed the British pound waslikely to decline in value against major currencies, particularly theGerman deutsche mark. The prevailing exchange rate was £1=Dm2.80. The British government was obliged by a EuropeanUnion agreement on monetary policy to try to keep the poundabove DM2.77. Soros doubted that the British could do this,so he shorted the pound, borrowing billions of pounds (usingthe assets of the Quantum Fund as collateral) and immediatelybegan selling them for German deutsche marks. His simulta-neous sale of pounds and purchase of marks were so large thatit helped drive down the value of the pound against the mark.Other currency traders, seeing Soros’s market moves and.knowing his reputation for making successful currency bets, jumped on the bandwagon and started to sell pounds shortand buy deutsche marks. The resulting bandwagon effect putenormous pressure on the pound. The British Central Bank, at

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