Foreign Exchange Market

THAPAR UNIVERSITY,
1 August 2019
Foreign Exchange Market
Learning Outcomes:

• How foreign exchange market works?

• What are the forces that influence exchange rates?
• To what extent, it is possible to predict foreign exchange rate movements?
• What are the implications for international business of exchange rate movements?
Foreign Exchange Market
• The foreign exchange market
is a market to convert the currency of one country into that of another.
provides some insurance against foreign exchange risk - the adverse
consequences of unpredictable changes in exchange rates.

• The exchange rate is the rate at which one currency is converted into another
• events in the foreign exchange market affect firm sales, profits, and strategy
 Functions of Foreign Exchange Market :
currency Conversion
• International companies use the foreign exchange market to
• use funds (earned from foreign country) in home country against payments
received in foreign currencies from exports, foreign investments, or licensing
agreements with foreign firms

• pay to a foreign company for its products or services in its country’s currency

• invest spare cash for short term in money markets in a foreign country that offers
better interest rate

• enter into currency speculation - the short-term movement of funds from one
currency to another in the hopes of profiting from shifts in exchange rates.
Carry trade as a currency speculation is borrowing in one currency
where interest rates are low and then using the proceeds to invest in
another country where interest rates are high
Functions of Foreign Exchange Market :
Insuring Against Foreign Exchange Risk

• The foreign exchange market provides insurance to protect against foreign

exchange risk.

• Foreign exchange risk is the possibility that unpredicted changes in future exchange
rates will have adverse consequences for the firm.

• A firm insuring itself against foreign exchange risk is engaging in hedging.

Functions of Foreign Exchange Market :
Insuring Against Foreign Exchange Risk
• 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 depending on the
supply and demand for that currency and other currencies. Spot exchange rates can be
quoted as the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar
for one unit of foreign currency.

• To insure or hedge against a possible adverse foreign exchange rate movement, firms
engage in forward exchanges. The two parties agree to exchange currency and execute the
deal at some specific date in the future. A forward exchange rate is the rate used for these
transactions. Rates for currency exchange are typically quoted for 30, 90, or 180 days into
the future.

• 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.
Nature Of The
Foreign Exchange Market
• The foreign exchange market is a global network of banks, brokers, and foreign exchange
dealers connected by electronic communications system.

• The average total value of global foreign exchange trading in 1980s was less than $200 billion
per day. But now it is more than $5 trillion per day.

• The most important trading centers are London, New York, Zurich, Tokyo, and Singapore. Major
secondary trading centres are Frankfurt, Paris, Hong Kong & Sydney.

• The market is always open somewhere in the world—it never sleeps.

• High-speed computer linkages between trading centers mean there is no significant difference
between exchange rates in the differing trading centers and there is no opportunity for arbitrage .

• Most transactions (85%) involve dollars on one side—called vehicle currency. Other vehicle
currencies are the euro, the Japanese yen, and the British pound. Dollar plays a very important
role in foreign exchange transactions
 Exchange Rates Determination :
Economic Theories
• Exchange rates are determined by the demand and supply for different currencies.

• The forces that determine exchange rates are complex and no theoretical
consensus exists even among economists who study the phenomenon every day.
However, all economic theories generally point at the below noted three factors
that impact future exchange rate movements:

1. A country’s price inflation

2. A country’s interest rate
3. Market psychology
 Price Inflation & Exchange Rates
• The law of one price states that in competitive markets free of transportation costs and barriers
to trade (efficient markets), identical products sold in different countries must sell for the same
price when their price is expressed in terms of the same currency. Otherwise, there is an
opportunity for arbitrage until prices equalize between the two markets. Poor predictor of short
run change in exchange rate

• Purchasing power parity theory (PPP) argues that given relatively efficient markets (a market
with few impediments to the free flow of goods and services) the price of a “basket of goods”
should be roughly equivalent in each country. It predicts that changes in relative prices will result
in a change in exchange rates. Poor predictor of short run change in exchange rate
For a basket of goods, if Price ($) = 500 & Price (Rs.) = 30,000 ;
then as per PPP theory, Exchange Rate (Rs/ USD) = 30,000/ 500 = Rs. 60 per dollar
The exchange rate will change if there is a relative change in prices. A country with high
inflation should see its currency depreciate relative to others.
If Price ($) = 500 & Price (Rs.) = 35,000 ;
Exchange Rate (Rs/ USD) = 35,000/ 500 = Rs. 70 per dollar
Price Inflation & Exchange Rates

• A positive relationship also exists between the inflation rate and the level of money
supply. When the growth in the money supply is greater than the growth in output,
inflation will occur. Hence, money supply is linked with inflation which is further linked
to exchange rate movement.

• PPP theory found empirically true in respect of Argentina, Iran, Bolivia, Turkey, Sudan,
Zimbabwe and Venezuela.

• Role of govt. policy is controlling money supply

Price Inflation & Exchange Rates

• Failure of PPP theory

• Transportation cost & trade barriers

• Only handful MNEs
• Govt intervention in foreign exchange markets
• Investor psychology
Interest Rates & Exchange Rates
• Interest rates reflect expectations about future inflation and hence linked with
exchange rates- International Fisher Effect

• Interest rates will be high in a country with high inflation

• Poor predictor of short run change in exchange rate

Investor Psychology & Exchange Rates
• Investor psychology & bandwagon effect influence exchange rates. Bandwagon effect
occurs when traders join the bandwagon and move exchange rates based on group
expectations. Traders move as a herd in the same direction at the same time i.e. they
sell a particular currency expecting it to fall and purchase another currency expecting
it to improve. Investor psychology and bandwagon effects greatly influence short term
exchange rate movements .
 Exchange Rate Forecasting
There are two schools of thought:
• The efficient market school - forward exchange rates do the best possible job of
forecasting future spot exchange rates, and, therefore, investing in forecasting
services would be a waste of money. Forward exchange rates represent market
participants’ collective prediction of likely spot exchange rates at specified future
dates. An efficient market is one in which prices reflect all available public
information.

• The inefficient market school - companies can improve the foreign exchange
market’s estimate of future exchange rates by investing in forecasting services.

Two schools of thought on forecasting:

 Fundamental analysis draws upon economic factors like interest rates,
monetary policy, inflation rates, or balance of payments information to predict
exchange rates.

 Technical analysis charts trends with the assumption that past trends and
waves are reasonable predictors of future trends and waves.
Currency Convertibility
• A currency is 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. Minor or major restrictions

• A currency is 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 e.g. restricting amount of foreign currency they may
take along out of country on trip.

• A currency is nonconvertible when both residents and non-residents are prohibited

from converting their holdings of domestic currency into a foreign currency
Currency Convertibility
• Most countries today practice free convertibility but many countries impose
restrictions on the amount of money that can be converted.

• Countries limit convertibility to preserve foreign exchange reserves to service

international debt commitments & to purchase imports. They fear capital flight
• when residents and nonresidents rush to convert their holdings of domestic
currency into a foreign currency
• most likely to occur in times of hyperinflation or economic crisis

• When a currency is nonconvertible, firms may turn to countertrade which are barter-
like agreements where goods and services are traded for other goods and services.
It was more common in the past when more currencies were nonconvertible, but
today involves less than 10% of world trade
 Implications of Exchange Rates
Three types of foreign exchange risk
1. Transaction exposure - the extent to which the income from individual transactions is affected by
fluctuations in foreign exchange values. It includes obligations for the purchase or sale of goods
and services at previously agreed prices and the borrowing or lending of funds in foreign
currencies.
2. Translation exposure - the impact of currency exchange rate changes on the reported financial
statements of a company. It is concerned with the present measurement of past events resulting
accounting gains or losses..
3. Economic exposure - the extent to which a firm’s future international earning power is affected
by changes in exchange rates. It is concerned with the long-term effect of changes in exchange
rates on future prices, sales, and costs.
In order to minimize transaction and translation exposure, managers should buy forward, use
swaps & implement lead and lag strategies.
E.g. If a US company has got Indian buyer/ seller
If INR is expected to appreciate, US company should try to pay early & delay receipt of payment
If INR is expected to depreciate, US company should try to pay late & receive payment earlier