MODULE 8: FOREIGN EXCHANGE MARKET

FOREIGN EXCHANGE MARKETS AND RISK: CHAPTER OVERVIEW

In addition to understanding the operations of domestic financial markets, a financial manager must
also understand the operations of foreign exchange markets and foreign capital markets. Today’s U.S.–
based companies operate globally. It is therefore essential that financial managers understand how events
and movements in financial markets in other countries affect the profitability and performance of their own
companies.
Cash flows from the sale of products, services, or assets denominated in a foreign currency are
transacted in foreign exchange (FX) markets. A foreign exchange rate is the price at which one currency
(e.g., the U.S. dollar) can be exchanged for another currency (e.g., the Swiss franc) in the foreign exchange
markets. These transactions expose U.S. corporations and investors to foreign exchange risk as the cash
flows are converted into and out of U.S. dollars. The actual amount of U.S. dollars received on a foreign
transaction depends on the (foreign) exchange rate between the U.S. dollar and the foreign currency when
the nondollar cash flow is received (and exchanged for U.S. dollars) at some future date. If the foreign
currency declines (or depreciates) 1 in value relative to the U.S. dollar over the period between the time a
foreign investment is made and the time it is liquidated, the dollar value of the cash flows received will fall.
If the foreign currency rises (or appreciates) in value relative to the U.S. dollar, the dollar value of the cash
flows received on the foreign investment increase
FOREIGN EXCHANGE MARKETS

• Markets in which cash flows from the sale of products or assets denominated in a foreign currency
are transacted.
FOREIGN EXCHANGE RATE

• The price at which one currency can be exchanged for another currency.
FOREIGN EXCHANGE RISK

• Risk that cash flows will vary as the actual amount of U.S. dollars received on a foreign investment
changes due to a change in foreign exchange rates.
CURRENCY DEPRECIATION

• When a country’s currency falls in value relative to other currencies, meaning the country’s goods
become cheaper for foreign buyers and foreign goods become more expensive for foreign sellers.
CURRECNY APPRECIATION

• When a country’s currency rises in value relative to other currencies, meaning that the country’s
goods are more expensive for foreign buyers and foreign goods are cheaper for foreign sellers.
BACKGROUND AND HISTORY OF FOREIGN EXCHANGE MARKETS
The Introduction of the Euro.

• The euro is the name of the European Union’s (EU’s) single currency. It started trading on January
1, 1999, when exchange rates among the currencies of the original 11 participating countries were
fixed, although domestic currencies (e.g., the Italian lira and French franc) continued to circulate
and be used for transactions within each country. The emphasis of the EC was both political and
economic. Its aim was to break down trade barriers within a common market and create a political
union among the people of Europe. The Maastricht Treaty of 1993 set out stages for transition to
an integrated monetary union among the EC participating countries, referred to as the European
Monetary Union (EMU).
Dollarization

• Following the abandonment of the gold standard and the Bretton Woods Agreement, some
countries sought ways to promote global economic stability and hence their own prosperity. For
many of these countries, currency stabilization was achieved by pegging the local currency to a
major convertible currency. Other countries simply abandoned their local currency in favor of
exclusive use of the U.S. dollar (or another major international currency, such as the euro). The use
of a foreign currency in parallel to, or instead of, the local currency is referred to as dollarization.
The Free-Floating Yuan

• On July 21, 2005, the Chinese government shifted away from its currency’s (the yuan) peg to the
U.S. dollar, stating that the value of the yuan would be determined using a “managed” floating
system with reference to an unspecified basket of foreign currencies. The partial free-floating of
the yuan was in part the result of pressure from Western countries whose politicians argued that
China’s currency regime gave it an unfair advantage in global markets due to the relative
underpricing of the yuan with respect to the dollar and other currencies.

FOREIGN EXCHANGE RATES AND TRANSACTIONS

Foreign Exchange Rates as mentioned above, a foreign exchange rate is the price at which one currency
can be exchanged for another currency.
Foreign Exchange Transactions
There are two types of foreign exchange rates and foreign exchange transactions: spot and forward.
1. SPOT FOREIGN EXCHANGE TRANSACTIONS
• Foreign exchange transactions involving the immediate exchange of currencies at the
current (or spot) exchange rate. Spot transactions can be conducted through the foreign
exchange division of commercial banks or a nonbank foreign currency dealer
2. FORWARD FOREIGN EXCHANGE TRANSACTIONS
• It is the exchange of currencies at a specified exchange rate (or forward exchange rate) at
some specified date in the future. Forward contracts are typically written for one-, three-,
or six-month periods, but in practice they can be written over any given length of time.
Spot versus Forward Foreign Exchange Transaction

Return and Risk of Foreign Exchange Transactions

This section discusses the extra dimensions of return and risk from foreign exchange transactions. The
section also explores ways that financial institutions can hedge foreign exchange risk.
Measuring Risk and Return on Foreign Exchange Transactions
The risk involved with a spot foreign exchange transaction is that the value of the foreign currency may
change relative to the U.S. dollar over a holding period. Further, foreign exchange risk is introduced by
adding foreign currency assets and liabilities to a firm’s balance sheet. Like domestic assets and liabilities,
returns result from the contractual income from or costs paid on a security. With foreign assets and
liabilities, however, returns are also affected by changes in foreign exchange rates.
Role of Financial Institutions in Foreign Exchange Transactions
Foreign exchange market transactions, like corporate bond and money market transactions, are conducted
among dealers mainly over the counter (OTC) using telecommunication and computer networks. Foreign
exchange traders are generally located in one large trading room at a bank or other FI where they have
access to foreign exchange data and telecommunications equipment. Traders generally specialize in just a
few currencies.
Financial institution’s overall net foreign exchange (FX) exposure in any given currency can be measured
by its net book or position exposure:

Clearly, a financial institution could match its foreign currency assets to its liabilities in a given currency
and match buys and sells in its trading book in that foreign currency to reduce its foreign exchange net
exposure to zero and thus avoid foreign exchange risk. It could also offset an imbalance in its foreign asset–
liability portfolio by an opposing imbalance in its trading book so that its net exposure position in that
currency would also be zero. Notice in Table 9–5 that U.S. banks’ net foreign exchange exposures in March
2010 varied across currencies: They carried a positive net exposure position in Canadian dollars, Swiss
francs, British pounds, and euros, while they had a negative net exposure position in Japanese yen. A
positive net exposure position implies that a U.S. financial institution is overall net long in a currency (i.e.,
the financial institution has purchased more foreign currency than it has sold). The institution will profit if
the foreign currency appreciates in value against the U.S. dollar, but it also faces the risk that the foreign
currency will fall in value against the U.S. dollar, the domestic currency. A negative net exposure position
implies that a U.S. financial institution is net short (i.e., the financial institution has sold more foreign
currency than it has purchased) in a foreign currency.
Note:
NET EXPOSURE
A financial institution’s overall foreign exchange exposure in any given currency.
NET LONG(SHORT) IN A CURRENCY
A position of holding more (fewer) assets than liabilities in a given currency.

INTERACTION OF INTEREST RATES, INFLATION, AND EXCHANGE RATES

As global financial markets and financial institutions and their customers have become increasingly
interlinked, so have interest rates, inflation, and foreign exchange rates. For example, higher domestic
interest rates may attract foreign financial investment and impact the value of the domestic currency. In this
section, we look at the effect that inflation (or the change in the price level of a given set of goods and
services, defined earlier, in Chapter 2, as the variable IP) in one country has on its foreign currency
exchange rates—purchasing power parity (PPP). We also examine the links between domestic and foreign
interest rates and spot and forward foreign exchange rates—interest rate parity (IRP).
Recall from Chapter 2 that the relationship among nominal interest rates, real interest rates, and
expected inflation is often referred to as the Fisher effect, named for the economist Irving Fisher, who
identified these relationships early in the last century. The Fisher effect theorizes that nominal interest rates
observed in financial markets must (1) compensate investors for any reduced purchasing power due to
inflationary price changes and (2) provide an additional premium above the expected rate of inflation for
forgoing present consumption due to the time value of money (which reflects the real interest rate), such
that
Purchasing Power Parity
One factor affecting a country’s foreign currency exchange rate with another country is the relative inflation
rate in each country (which, as shown below, is directly related to the relative interest rates in these
countries). Specifically, in Chapter 2, we showed that:
 The theory behind purchasing power parity is that in the long run exchange rates should move
toward rates that would equalize the prices of an identical basket of goods and ser vices in any two
countries. This is also known as the law of one price, an economic concept which states that in an efficient
market, if countries produce a good or service that is identical to that in other countries, that good or service
must have a single price, no matter where it is purchased.
LAW OF ONE PRICE - An economic rule which states that, in an efficient market, identical goods and
services produced in different countries should have a single price.
INTEREST RATE PARITY THEOREM (IRPT)

• The theory that the domestic interest rate should equal the foreign interest rate minus the expected
appreciation of the domestic currency. interest rate parity theorem (IRPT) The theory that the
domestic interest rate should equal the foreign interest rate minus the expected appreciation of the
domestic currency.