This chapter discusses how the foreign exchange market operates within international

businesses, and the forces that determine its exchange rates. The Foreign Exchange Market is
used to convert the currency of one country into the currency of another with exchange rates.
International businesses use this market to convert export receipts, to pay foreign companies for
products or services, and to invest spare cash in money markets. It also provides insurance
against foreign exchange risks. The three types of exposure to foreign exchange risk are
transaction exposure, translation exposure, and economic exposure. These risks can be
reduced by using spot exchange rates and forward exchange rates. A spot exchange rate
converts one currency into another currency on a particular day and time and is influenced by
supply and demand. A forward exchange rate is an exchange rate governing future
transactions. Foreign exchange risk can also be reduced by engaging in currency swaps. A
swap is the simultaneous purchase and sale of a given amount of foreign exchange for two
different value dates. This chapter also discusses the law of one price and the purchasing
power parity theory. The law of one price holds that in competitive markets that are 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 the same currency. Purchasing power parity
theory states the price of a basket of particular goods should be roughly equivalent in each
country. PPP theory predicts that the exchange rate will change if relative prices change.

This exchange fluctuation can be extremely profitable for the American firm as its inputs will
become less costly, but could be costly for its subsidiary as it will now have to pay
comparatively more for its debt payments.