Study Guide - Chapter 10 – The Foreign Exchange Market

Every student will be familiar with the concept of foreign exchange as you will have changed money
when you travel overseas. However, it is useful to re-think what we mean by currency and what a unit
of currency actually represents. By viewing currency as a measure of value it is possible to understand
what we mean by an ‘undervalued’ or ‘overvalued’ currency, we can also better understand why
currencies change in ‘price’ or exchange rate against each other. A lot of this discussion is not covered
in the textbook, however I have found this way of introducing the topic can make it easier for students
to understand.

In class, we also take a slight deviation from the structure of the chapter – we focus more on the
managerial implications of managing exchange rate risk which is covered in the textbook chapter
conclusion.

Brief chapter summary and most important points

Introduction and chapter coverage

The chapter begins simply, talking about the purpose of the foreign exchange market and why firms,
individuals, governments and speculators make use of it. It quickly becomes more complicated when it
comes to the discussion of exchange rate risk and how this can be minimised. It discusses economic
theories of exchange rate determination and how PPP theory can explain exchange rate movements and
the link between such movements and interest rates. It then discusses whether or not it is possible to
forecast short-term exchange rate movements.

The foreign exchange market

The foreign exchange market operates in multiple locations (although the bulk of trading happens in
London, New York and Tokyo). The purpose of the ‘forex’ market is to provide foreign exchange to meet
the needs of individual travelers and organisations engaged in trade and investment. The majority of
the money that flows throw the market is however from short-term currency speculators.

Foreign exchange risk

If exchange rates did not move against each other (as they didn’t for many years after the Bretton
Woods agreement – see next chapter) then there would be no exchange rate risk. If there were no
movements in currencies then dealing with foreign exchange would be a minor inconvenience as one
simply calculates the value of dollars in pesos or whatever - but it would not be a major problem.
However, as the current financial system is based on floating rates (currencies constantly moving in
value against each other) this does create major problems and the risk caused by dealing with foreign
currencies can dissuade some businesses from engaging in international business.

The fact that currencies move against each other in fact creates three different forms of exchange rate
risk:

Transaction risk: If a company buys something in a foreign currency and agrees to make the
payment six months later but that currency significantly appreciates in value
during that time, then the buyer will end up paying more in terms of their
domestic currency than they may have thought. Similarly if a company sells
 something to a foreign company, agreeing to accept the customer’s currency at
a future date, then if that currency should depreciate in value the amount
received by the firm in terms of their domestic currency will also be less.

Translation risk: For a multinational company that reports total income and profits in terms of
the domestic currency, changing exchange rates can give a misleading view of
overall global performance. A company that does much of its sales overseas for
example would be ‘hurt’ in home country revenue/profit terms if the home
country currency appreciates (the same foreign revenues/profits now appear to
be worth less in terms of the home currency) this can impact stock price and
ability to raise capital.

Economic risk: If a company is selling to a country that sees a marked decline in the valuation
of its currency this will lead to a decline in demand for imported products.
Goods that were previously bought from overseas are now more expensive. For
the foreign seller the choices then are to accept a fall in sales or to lower the
process/profits so that consumers in the market can continue to buy.

Any of these risks can be significant to a firm operating internationally. Even small exchange rate
movements can have a significant impact on the profitability of an overseas sale or investment (see the
US investment in Korea example). Firms need to be aware of these risks and should conduct
appropriate ‘what-if’ analysis to predict profitability under different exchange rate scenarios.

As mentioned, such risks may be off-putting to some firms and may make them wary of engaging in
international business. However, as we know, trade is good and so market mechanisms have emerged
to help manage the risk and thus encourage trade. These mechanisms are collectively known as
exchange rate hedging using so-called ‘forward’ exchange rates. ‘Spot’ exchange rates are current
market rates if you were to exchange money at the bank today, ‘forward’ rates are locked-in
agreements between bank and customer to exchange a certain amount of one currency for another
currency at a future point in time at a pre-agreed exchange rate. Although neither party can be certain
of the actual spot rate at that future time, by making the agreement from the customer point of view
risk is removed. So if a customer is to receive a large amount of a particular currency in six months’ time
they could wait and see what they will receive and hope that that foreign currency doesn’t depreciate or
they could agree a forward contract to exchange that foreign currency to an agreed amount of local
currency whenever it is received, this removes the exchange rate risk.

Firms could rely upon the integrity and kindness of their bankers (haha) to engage in forward contracts,
although in reality the banks will only offer a forward exchange rate at which they believe they can make
money, although the risk has been removed for the company the bank expects compensation for
assuming this risk. For this reason it is useful for all companies to have at least some understanding on
the economic forces that lead to exchange rate movements.

Explaining exchange rate movements

The fundamental economic principle that explains exchange rate movements is the so called ‘law of one
price’. This law states that for any ‘basket of goods’ the price in any one country in that countries
currency should equal the price of that same basket of goods should cost the same in this countries
currency when converted by the market exchange rate. When the market exchange rate does not lead
to ‘the same price’ in each country then the market exchange rate will either rise or fall until it does.
The ‘equilibrium’ rate where the same prices are achieved is referred to as the PPP (purchasing power
parity) rate.

In class we will work on a number of examples of this involving the price of a ‘Big Mac’ hamburger to
explain why this principle is a ‘law’ and why it would be impossible for a currency to continually
appreciate or depreciate away from the PPP value. You will be referred to the additional reading which
contains reference to the ‘Big Mac Index’ released semi-annually by the Economist that has tracked
prices and exchange rate movements of many currencies over many years and largely supported what
PPP theory proposes.

As these examples will explain exchange rates thus adjust to the local prices of goods in each country,
and changes in the local prices of goods are measured by inflation. A country with high levels of
inflation (where the local currency buys ‘less’ of a particular good) will see that currency decrease in
value relative to other currencies. The difference in relative inflation rates between any two countries
will be reflected in the relative change in the exchange rates between them. Although future inflation
rates are not always known we can make use of a proxy measure which are relative interest rates, the
international Fisher effect suggest that by comparing differences in countries relative interest rates we
can again predict movements in their exchange rates.

Of course, other non-economic factors also play a role in exchange rate movements. Market sentiments
and investor psychology have an important role to play including the so-called bandwagon effect.
Despite this PPP theory remains the most credible explanatory tool for medium to long-term exchange
rate movements.

Predicting short term exchange rate movements

PPP theory has been widely accepted as a means of forecasting long term exchange rate movements.
The economic fundamentals on which it is based suggest that no currency can become significantly over
or undervalued for the long term without the market stepping in to return the exchange rate to
somewhere close to equilibrium.

However. what about in the short term? Is it possible to predict exchange rate movements over the next
week, day, hour or minute? Many currency speculators try to do exactly this, predicting short term
variations and making significant investments on the upward or downward movements of a currency
that they buy and sell over the extremely short term. Debate exists over whether it is actually possible
to predict short term exchange rates (or whether to do so consistently). Some economists who believe
in relatively efficient markets suggest that the current price of a currency reflects the markets true
valuation of the currency and any short term movement is just as likely to show an increase as a
decrease. The market collectively has efficiently priced the asset and no one individual or organization is
able to have a better idea then the market as a whole of future movements, in essence short-term
movements cannot be predicted. Others suggest markets are inefficient and there exists flaws within
the system that mean that some actors have access to better insight or information that the broader
market and this allows them to predict short-term movements from which they can make extensive
profits. There are two main methods which they claim allow them to do this:
Fundamental analysis: Variables which are thought to influence movements are developed in to a
regression algorithm for predicting movement. However, this method suffers
from the fact that correlation does not prove causation and any regression can
only be calculated using past data.

Technical analysis: This method does not depend on economic fundamentals but rather trends and
waves and makes use of pretty charts and graphs. There is little logical backing
for such analysis although it still is popular amongst some investors.

Short-term exchange rate forecasting is not something that is recommended for individuals or non-
specialist firms, may have lost a lot of money with such speculative ‘day-trading’.

Conclusions and managerial implications

The conclusions and managerial implications covered in the textbook have been well covered in class.
To reiterate it is movements in exchange rates that create the potential for exchange rate risk and this
risk can be critical for any business, no matter its size. Firms need to first of all recognize the risk, and
then devise plans for managing that risk, they can use so called ‘lead or lag’ strategies or engage in
currency hedging. Businesses should have some understanding of the economic forces that drive
exchange rate movements and the dangers of attempting to engage in short-term exchange rate
forecasting.

Resources supplied and required and suggested reading

View the PowerPoint files of Chapter 10 available on Moodle

Read Chapter 10 from the assigned textbook

Download a foreign exchange app such as XE or Currency Pro

Participate in the class and complete all of the examples in the tables given to you. Ask questions if you
are unsure about anything.

Review the same class session made available as a recording

Watch the YouTube video ‘The Economics of Foreign Exchange’ at the following link:

https://www.youtube.com/watch?v=ig_EO805rpA

It covers some of the material in both chapters 10 and 11.

Answer the 10 multiple choice questions covering chapter 6 that have been prepared as a turnitin
assignment available on Moodle

Take a look at the following suggested articles also available on Moodle

‘The Meaning of Seven’ The Economist August 10th 2019

The importance of the yuan-dollar exchange rate and how its movements are being very closely
watched.
‘The big mac index’ The Economist July 24th 2021

The index for 2021, indicating that again some countries appear to be manipulating their currencies.

‘McJobbers and brokers’ The Economist September 19th 2020

A study of whether it would make sense to buy BMI's most undervalued currency each year reveals
some of the strengths and limitations of the index and PP theory more generally.

‘Currencies Fair Value Open To Debate’ Wall Street Journal February 25th 2013

The Journals’ own version of the big mac index, using a Starbucks latte. Some interesting explanation of
under and overvalued currencies.

‘Japans currency wonupmanship’ The Economist March 3rd 2012

The problems that Japanese companies have competing against Korean firms given the continuing
appreciation of the Yen against the Won.
 In-class Exercises

Chapter 10: The Foreign Exchange Market

FOREIGN EXCHANGE EXERCISES (Using October 2017 rates)

Euros 800 is equal to ____________ US Dollars

UK Sterling 2,000 is equal to ___________ Philippines Pesos

HK$500 is equal to _____________ Japanese Yen

A Hong Kong firm buys goods from a Thai exporter. When the invoice arrives the bill is for 2,400,000
Baht. How much would this cost today in Hong Kong Dollars?

The Thai supplier indicates that he wants to be paid in six months time. The Thai currency is
strengthening. In six months time it is expected that the Thai Baht will increase in value so 1HK$ = 3.75
Thai Baht. The Hong Kong firm’s local bank will offer a forward contract to supply 2,400,000 Baht in six
months time in exchange for HKD $650,000. Should the firm enter into this ‘hedge’ and buy the forward
contract?

The price of a Big Mac in the United States is US$2.50. What would you expect the price to be in:

Hong Kong ______________

Philippines ______________

New Zealand ______________

The actual price of a Big Mac in Philippines is equal to 150 pesos. Under PPP what should the exchange
rate be? What does this suggest about the market value of the Philippine Peso?

The actual price of a Big Mac in New Zealand is equal to NZ$ 2.70. Under PPP what should the exchange
rate be? What does this tell you about the value of the New Zealand $?

What movements would you expect to see in the Philippine peso and New Zealand $ in the long term?

After these movements what would be the cross rate of the Philippine peso to the NZ $?