Chapter

10

The Foreign Exchange

Market
 Learning Objectives
10-1 Describe the functions of the foreign exchange market.
10-2 Understand what is meant by spot exchange rates.
10-3 Recognize the role that forward exchange rates play in insuring
against foreign exchange risk.
10-4 Understand the different theories explaining how currency
exchange rates are determined and their relative merits.
10-5 Identify the merits of different approaches toward exchange rate
forecasting.
10-6 Compare and contrast the differences among translation,
transaction, and economic exposure, and explain the implications
for management practice.
 1. The Functions of the Foreign Exchange
Market 1

Currency Conversion
vIn general, within the borders of a country, one must use
the national currency.
vBusinesses use the foreign exchange market to:
1. Convert the payments received for its exports, the income
received from foreign investments, or the income
received from licensing agreements with foreign firms.
2. Make payment to a foreign company for its products or
services in its country’s currency.
3. Invest cash for short terms in foreign money markets.
4. Engage in currency speculation.
v Carry trade.
Checking your knowledge

5-4
The rate at which one currency is
converted into another is the:
v
A. replacement percentage.
B. resale rate.
C. exchange rate.
D. interchange ratio.

9-5
The risks that arise from volatile changes
in exchange rates are commonly referred
to as:

vA. interest rate risks.

B. basis risks.
C. operational risks.
D. foreign exchange risks.

9-6
The foreign exchange market serves
two main functions. These are:
vA. collect duties on imported products and convert
the currency of one country into the currency of
another.
B. insure companies against foreign exchange risk
and set interest rates charged to foreign investors.
C. collect duties on imported products and set
interest rates charged to foreign investors.
D. convert the currency of one country into the
currency of another and provide some insurance
against foreign exchange risk.

10-7
vA pair of shoes costs £30 in Britain. The
identical pair costs $45 in the United States.
The exchange rate is £1 = $1.80. In terms of
cost of the shoes:

vA. the U.S. offers a better deal.

B. the deal is the same in both countries.
C. Britain offers a better deal.
D. the U.S. deal is comparatively worse.

10-8
An exchange rate of €1 = $1.30
indicates that:
v
A. $1 is worth 1.30 euros.
B. one could sell 1.30 euros for $1.
C. one euro buys $1.30.
D. there are 1.30 euros for every dollar.

10-9
vThe _____ helps us to compare the relative
prices of goods and services in different
countries.

vA. interest rate

B. customs rate
C. exchange rate
D. tariff rate

10-10
 2. Spot Exchange Rates:
vRate at which a foreign exchange dealer
converts one currency into another
currency on a particular day.
vChange continually.
vValue determined by supply and
demand.
 3. Forward Exchange Rates
3

continued

vWhen two parties agree to

exchange currency and execute the
deal at some specific date in the
future.
vUsually quoted for 30, 90, and 180 days.
Checking your knowledge

5-13
When two parties agree to exchange
currency and execute the deal
immediately, the transaction is a:
v
A. point-in-time exchange.
B. temporal exchange.
C. spot exchange.
D. forward exchange.

10-14
_____ are exchange rates governing
some specific future date foreign
exchange transactions.

vA. Spot exchange rates

B. Forward exchange rates
C. Future exchange rates
D. Currency swaps

10-15
vAssuming the 30-day forward exchange rate
were $1 = ´130 and the spot exchange rate
were $1 = ´120, the dollar is selling at a
_____ on the 30-day forward market.

vA. premium
B. margin
C. discount
D. subsidy

10-16
 4. Currency Swaps

Insuring Against Foreign Exchange Risk

continued

vSimultaneous purchase and sale of a

given amount of foreign exchange for
two different value dates.
vTransaction between international businesses
and their banks, between banks, and between
governments.
vCommon type: spot against forward.
 5. Foreign Exchange Market
1

vGlobal network of banks, brokers, and

foreign exchange dealers connected by
electronic communications systems.
vContinues to grow at a rapid pace.
vMost important trading centers are
London (largest), New York, Zurich, Tokyo,
and Singapore.
 Foreign Exchange Market continued

vA market is open 24 hours a day.

vHigh-speed computer linkages among trading
centers around the globe have effectively created
a single market.
vArbitrage refers to the purchase of
securities in one market for immediate
resale in another to profit from a price
discrepancy.
vMost transactions involve the dollar.
Checking your knowledge

5-20
vInternational businesses use foreign
exchange markets for all of the
following reasons except:

vA. to receive payments from foreign investments

that may be in foreign currencies.
B. to pay a foreign company for its products or
services in its country's currency.
C. to invest for short terms in money markets
when they have spare cash.
D. to cover themselves from all risks involved in
currency speculation.
10-21
vThe short-term movement of funds from
one currency to another in the hopes of
profiting from shifts in exchange rates is
known as:

vA. currency arbitrage.

B. currency speculation.
C. currency supposition.
D. short selling.

10-22
vIf lots of people want euros and euros are in
short supply, and a few people want
Japanese yen and yen are in plentiful
supply, the euro is likely to _____ against the
yen.

vA. depreciate
B. appreciate
C. devalue
D. stabilize

10-23
vOne function of the foreign exchange
market is to provide some insurance against
the risks that arise from changes in
exchange rates, commonly referred to as:

vA. foreign market hazard.

B. global jeopardy.
C. foreign exchange risk.
D. commerce uncertainty.

10-24
vThe simultaneous purchase and sale of a
given amount of foreign exchange for two
different value dates is referred to as a:

vA. fiscal barter.

B. liquid trade.
C. currency exchange.
D. currency swap.

10-25
vAssume that the yen/dollar exchange rate
quoted in London at 3:00 p.m. is ´120 = $1,
and the New York yen/dollar exchange rate
at the same time is ´125 = $1. A dealer
makes a profit by buying a currency low and
selling it high. The dealer has engaged in
a(n):
A. currency swap.
B. arbitrage.
C. backwardation.
D. straddle.

10-26
v If the demand for dollars outstrips its
supply and if the supply of Japanese yen is
greater than the demand for it, what will
happen?
A. The dollar will appreciate against the yen
B. The dollar will depreciate against the yen
C. The exchange rates will remain the same
D. The yen will appreciate against the dollar

10-27
 6. How Are Exchange
Rates Determined?
v Exchange rates are determined by the
demand and supply for different
currencies
v Three factors impact future exchange rate
movements
1. A country’s price inflation
2. A country’s interest rate
3. Market psychology

9-28
 7.. The Law of One Price:
vIn 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.
 8. Purchasing Power Parity:
vComparison of prices of identical products
determine the real or PPP exchange rate.
vAn efficient market has no impediments to the
free flow of goods and services.
vThe price of a “basket of goods” should be
roughly equivalent in each country.
vBig Mac Index.
9.Money Supply and Price Inflation:
vThe growth rate of a country’s money supply
determines its likely future inflation rate.
vInflation—money supply increases faster than output
increases.
vAn increase in the money supply makes it easier to
borrow, which increases demand for goods and
services.
vA country with a high inflation rate will see
depreciation in its currency exchange rate.
vGovernment policy determines growth rates.
10. Empirical Tests of PPP Theory:
vExchange rates are determined by relative
prices and changes in relative prices will result
in a change in exchange rates.
vNot a strong predictor of short-run movements in
exchange rates covering time spans of five years or
less.
vBest predicts exchange rate changes for countries
with high rates of inflation and underdeveloped
capital markets.
v Failure to find link between inflation rates and exchange rates called
the purchasing power parity puzzle.
11. Interest Rates and Exchange Rates
vInterest rates reflect expectations about likely future
inflation rates.
vThe Fisher effect:
v! = # + %
vIf the real interest rate is the same worldwide, any difference
in interest rates between countries reflects differing
expectations about inflation rates.
vThe International Fisher effect (IFE):
!!"!"
v & 100 = !$ − !¥
!"
12. Investor Psychology and Bandwagon
Effects
vNeither PPP theory nor the international
Fisher effect is particularly good at
explaining short-term movements in
exchange rates.
vImpact of investor psychology.
vBandwagon effect where traders move
like a herd.
Summary of Exchange Rate Theories
vRelative monetary growth, relative
inflation rates, and nominal interest rate
differentials are all moderately good
predictors of long-run changes in exchange
rates.
vBut they are poor predictors of short-run
changes.
Checking your knowledge

5-36
vAccording to the _____, in competitive
markets free of transportation costs and
barriers to trade, identical products sold in
different countries must sell for the same
price when their price is expressed in terms
of the same currency.
A. law of one price
B. principle of consistent pricing
C. model of fair pricing
D. principle of equitable pricing

10-37
vAccording to the law of one price, if the
exchange rate between the British pound
and the dollar is £1 = $1.50, a jacket that
retails for $75 in New York should sell for
_____ in London.
A. £40
B. £50
C. £60
D. £75

10-38
vThe _____ suggests that given relatively
efficient markets, the price of a "basket of
goods" should be roughly equivalent in each
country.
A. theory of efficient markets
B. law of one price
C. theory of price inflation
D. PPP theory

10-39
vSuppose the price of a Big Mac in New York
is $3.00 and the price of a Big Mac in Paris is
$3.75 at the prevailing euro/dollar
exchange rate, then according to PPP the
euro is:
A. undervalued by 25 percent against the
dollar.
B. overvalued by 25 percent against the
dollar.
C. appreciating relative to the dollar.
D. depreciating relative to the dollar.

10-40
Identify the incorrect statement
about the PPP theory.
v
A. It predicts that exchange rates are
determined by relative prices.
B. It yields accurate predictions in the short
run.
C. It best predicts exchange rate changes for
countries with high rates of inflation.
D. It assumes away transportation costs and
barriers to trade.
10-41
v _____ involves dominant enterprises setting
different prices in different markets to
reflect varying demand conditions.

vA. Conditional pricing

B. Dual pricing
C. Price discrimination
D. Foreign market pricing

10-42
vThe _____ states that a country's "nominal"
interest rate is the sum of the required
"real" rate of interest and the expected rate
of inflation over the period for which the
funds are to be lent.

vA. PPP theory

B. efficient market theory
C. inefficient market theory
D. Fisher Effect

10-43
 Economic theory suggests that when
inflation is expected to be high:
v
A. interest rates will be low.
B. exchange rates will be high.
C. the International Fisher Effect does not
hold.
D. interest rates will be high.

10-44
vstates 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
the two countries.

vA. The Fisher Effect

B. The International Fisher Effect
C. The efficient market theory
D. The inefficient market theory

10-45
vWhen traders move as a herd in the same
direction at the same time such as what
occurred when George Soros betted against
the British pound in 1992, a(n) _____ occurs.

vA. efficient market

B. inefficient market
C. bandwagon effect
D. Fisher Effect

10-46
 13. The Efficient Market School
vPrices reflect all available public
information.
vForward exchange rates should be
unbiased predictors of future spot rates.
vInaccuracies will be random.
 14. The Inefficient Market School

vPrices do not reflect all available

information.
vForward exchange rates will not be
the best possible predictors of future
spot exchange rates.
15. Fundamental Analysis:
vDraws on economic theory to construct sophisticated
econometric models for predicting exchange rate
movements.
vIncludes relative money supply growth rates, inflation
rates, and interest rates, and possibly balance-of-
payments positions.
vFundamental determinants of exchange rates
are monetary growth, inflation rates, and
interest rates.
 16. Technical Analysis:
4

vUses price and volume data to determine past

trends, which are expected to continue.
vThere are analyzable market trends and
waves that can be used to predict future
trends and waves.
vHas gained favor in recent years.
Checking your knowledge

5-51
vThe _____ argues that forward exchange
rates do the best possible job of forecasting
future spot rates and therefore investing in
forecasting services would be a waste of
money.

vA. inefficient market school

B. efficient market school
C. Fisher Effect
D. international Fisher Effect

10-52
v _____ draws on economic theory to
construct sophisticated econometric models
for predicting exchange rate movements.

vA. Efficient market theory

B. Inefficient market theory
C. Fundamental analysis
D. Technical analysis

10-53
v_____ uses price and volume data to
determine past trends, which are expected
to continue into the future.

vA. Technical analysis

B. Fundamental analysis
C. The Fisher Effect
D. The International Fisher Effect

10-54
 17. Currency Convertibility 1

Three forms of currency convertibility:

1. Freely convertible.
vGovernment allows both residents and nonresidents to purchase
unlimited amounts of foreign currency.
2. Externally convertible.
vOnly nonresidents can convert their holdings of
domestic currency into foreign currency without any
limitations.
3. Nonconvertible.
vResidents and nonresidents are prohibited from
converting their holdings into a foreign currency.
 Currency Convertibility 2

vGovernments limit convertibility to preserve

their foreign market reserves.
vCapital flight occurs when there is a rush to convert
domestic currency into foreign currency.
vMost likely to occur when domestic currency value is
depreciating rapidly.
vCountertrade refers to barter-like
agreements.
vCompanies use to get around nonconvertibility
issues.
Checking your knowledge

5-57
 A currency is said to be
externally convertible when:
vA. the country's government allows both
residents and nonresidents to purchase
unlimited amounts of a foreign currency with
it.
B. only nonresidents may convert it into a
foreign currency without any limitations.
C. neither residents nor nonresidents are
allowed to convert it into a foreign currency.
D. only residents may convert it internally into
a foreign currency.
10-58
vA range of barter-like agreements by which
goods and services can be traded for other
goods and services is known as:

vA. countertrade.
B. protracted trade.
C. intermediate sales.
D. countersale.

10-59
Countries might be forced to use
countertrade when a currency is:
v
A. freely convertible.
B. externally convertible.
C. internally convertible.
D. nonconvertible.

10-60
 19. Focus on Managerial Implications 1

vForeign Exchange Rate Risk

vTransaction exposure—extent to which the income
from individual transactions is affected by
fluctuations in foreign exchange values.
vTranslation exposure—impact of currency exchange
rate changes on the reported financial statements
of a company.
vEconomic exposure—extent to which a firm’s future
international earning power is affected by
changes in exchange rates.
 Focus on Managerial Implications 2

Reducing Translation and Transaction Exposure

1. Forward exchange rate contracts.
2. Buying swaps.
3. Lead strategy.
vCollect foreign currency receivables early.
4. Lag strategy.
vDelay the collection of foreign currency receivables.
 Focus on Managerial Implications 3

Reducing Economic Exposure

vDistribute the firm’s productive
assets to various locations so the
firm’s long-term financial well-being
is not severely affected by adverse
changes in exchange rates.
 Focus on Managerial Implications 4

Other Steps for Managing Foreign Exchange Risk

1. Central control of exposure is needed to protect resources
efficiently and ensure that each subunit adopts the correct mix
of tactics and strategies.
2. Firms should distinguish between, on one hand, transaction and
translation exposure and, on the other, economic exposure.
3. The need to forecast future exchange rate movements cannot be
overstated.
4. Firms need to establish good reporting systems so the central
finance function (or in-house foreign exchange center) can
regularly monitor the firm’s exposure positions.
5. Firms should produce monthly foreign exchange exposure
reports.
Checking your knowledge

5-65
vA(n) _____ 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.

vA. follower strategy

B. interim strategy
C. lead strategy
D. lag strategy
10-66
vA(n) _____ involves delaying collection of
foreign currency receivables if that currency
is expected to appreciate and delaying
payables if the currency is expected to
depreciate.

vA. follower strategy

B. interim strategy
C. lead strategy
D. lag strategy

10-67
 Assignment 6

Please submit your answer sheet to:

Ib503exam@zhumingxia.com
 Review Question
1. The ________ is the rate at which one
currency
is converted into another.

a) Exchange rate
b) Cross rate
c) Conversion rate
d) Foreign exchange market
9-69
 Review Question
2.The _______ is the rate at which a foreign
exchange dealer converts one currency into
another currency on a particular day.

a) Currency swap rate

b) Forward rate
c) Specific rate
d) Spot rate
9-70
 Review Question
3.Which of the following does not impact
future
exchange rate movements?

a) A country’s price inflation

b) A country’s interest rate
c) A country’s arbitrage opportunities
d) Market psychology
9-71
 Review Question
4. When a government of a country allows both
residents and non-residents to purchase unlimited
amounts of foreign currency with the domestic
currency, the currency is

a) Nonconvertible
b) Freely convertible
c) Externally convertible
d) Internally convertible
9-72
 Review Question
5.The extent to which a firm’s future
international earning power is affected by
changes in exchange rates is called

a) Accounting exposure
b) Translation exposure
c) Transaction exposure
d) Economic exposure
9-73
 Review Question
6.Firms that want to minimize transaction and
translation exposure can do all of the
following except

a) buy forward
b) have central control of exposure
c) use swaps
d) lead and lag payables and receivables
9-74
v7._____ is most likely to occur when the value
of the domestic currency is depreciating
rapidly because of hyperinflation or when a
country's economic prospects are shaky in
other respects.

vA. The bandwagon effect

B. The Fisher Effect
C. The International Fisher Effect
D. Capital flight

10-75
v8.The extent to which the income from
individual transactions is affected by
fluctuations in foreign exchange values is
known as:

vA. economic exposure.

B. financial exposure.
C. translation exposure.
D. transaction exposure.

10-76
v9._____ is the impact of currency exchange
rates changes on the reported financial
statements of a company.

vA. Economic exposure

B. Financial exposure
C. Translation exposure
D. Transaction exposure

10-77
v10.The extent to which a firm's future
international earning power is affected by
changes in exchange rates is known as:

vA. translation exposure.

B. financial exposure.
C. economic exposure.
D. transaction exposure.

10-78