CHAPTER 10 +

Lecture
FOREIGN EXCHANGE
MARKET
Foreign Exchange Market
 Foreign exchange market:
 A market for converting the
currency of one country
into the currency of
another.
 Exchange rate:
 The rate at which one currency
is converted into another.
Foreign Exchange Market
 Foreign exchange risk:
 The risk that arises from changes in exchange rates: the
likelihood that unpredictable or unexpected changes in
exchange rates will have an impact (positive or
negative) on the value of various activities of a
company’s business.
 Examples:
 An unexpected change in exchange rates will change
the home currency value of foreign currency cash
payment that is expected from a foreign source;
 An unexpected change in exchange rates will change
the amount of home currency needed to make a
payment or service a debt that requires payment in a
foreign currency.
Foreign Exchange Market
MAD’S MONEY CLASS
MONEY

2 MM/1CM

1MM/1C
M

4MM/1C
M
FOREIGN EXCHANGE RATES
Exchange rates are quoted in two ways:
 Price of the foreign currency price in terms of
dollars [or of home currency per foreign
currency]
e.g. $0.00854/yen
Known as direct or sometimes as American quote
 Price of dollars in terms of the foreign
currency [or foreign currency per home
currency]
e.g. SF 1.562/$
Known as indirect or sometimes as European
quote
READING FOREIGN EXCHANGE
QUOTATIONS

Hill, 5th
ed.
FOREIGN EXCHANGE RATES
 Foreign exchange traders have nicknames for
currencies:
 “Cable” is the exchange rate between US Dollars and
Pounds Sterling
 Canadian dollar is a “loonie”
 French franc used to be known as “Paris”
 New Zealand dollar is a “kiwi”
 Australian dollar is an “aussi”
 Swiss Franc is a “Swissie
 Singapore dollar is a “Sing
dollar”
TERMS: CURRENCY VALUES
Forex deals with exchange, so the value of one currency is
often discussed in comparison to another currency. (e.g. value
of currency “A” against currency “B”)
 APPRECIATION (rise): a currency increases in value against a
foreign currency in response to market demand; it is getting
stronger, therefore, less of this currency is needed to convert to
a weaker foreign currency; in other words, the currency that is
appreciating will buy more of a weaker currency.
 DEPRECIATION(fall): a currency decreases in value against
another currency in response to market forces; it is growing
weaker, therefore, more of this currency is needed to convert to
a stronger foreign currency; in other words, the currency that
is depreciating will buy less of a stronger currency.
 UNDERVALUED: a currency is too weak against another
currency; is not as strong as it should be.
 OVERVALUED: a currency is too strong against another
currency; should have less value than it does.
Foreign Exchange Market
Is currency appreciating or depreciating?

Yen is 90 yen/1 US $ or US$.011 /¥1

weakening Dollar is
Dollar is 100 yen/1 US$ or US$.01/¥1
weakening
getting 120 yen/1 US $ or US$.008 /¥1 Yen is
stronger getting
stronger
 Functions of the Foreign
Exchange Market

 Twogeneral functions:
 Converting currencies
 Reducing risk
HOW TO CONVERT
 EXAMPLE: You arrive at the train station in Switzerland early in
the morning. You go to the exchange office to trade your U.S.
dollars for Swiss francs. You ask the exchange office: “How
many Swiss francs do I receive for every dollar? The clerk
answers:
“The rate is 1.5625 Swiss Francs per dollar.” You exchange
US$50.00. How many Swiss francs do you receive?
A. US$50 x SF1.5625 = SF 78.13

You stop for a moment and think to yourself, “Well, then, how
many dollars are in one Swiss franc?”
A. 1USD =
US$0.6400/SF SF 1.5625/S
You are back at the train station and it is time to leave
Switzerland and you have a bunch of Swiss francs in your pocket
which you want to convert into Euros. You are told that the
exchange rate for SF to Euros is: SF1.5466/Euro.

So how many Euros do you get for the 152 Swiss Francs you
have?
A. 152SF = 98.28 Euros
SF 1.5466/Euro
CURRENCY CONVERSION
 Fundamentally, currency conversion involves a transfer of
purchasing power: this is necessary because international
trade and capital transactions usually involve parties living
in different countries with different national currencies.
Countries either transfer power to or from their home
currency in order to be active in the global economy.
 When a company is importing goods from another country,
it will usually give up its domestic currency in the foreign
exchange market to get the foreign currency needed to pay
for the import.
 Result: demand for the foreign currency increases,
supply in the foreign exchange market of the home
currency increases.
CURRENCY
CONVERSION:WHEN
 Companies receiving payment in foreign
currencies need to convert these payments
to their home currency
 EXAMPLE: A Japanese components
manufacturer receives payment in US$ from
their U.S. customer ; the manufacturer may
want to convert it so it can be spent in
 Japan.
Companies paying foreign businesses for
goods or services
 EXAMPLE: A U.S. company must obtain
Japanese yen to pay for an order they received
because the contract specified “payment in
yen.”
CURRENCY
CONVERSION:WHEN
 Companies investing spare cash for short
terms in money market accounts
 U.S. company has dollars that they want
to invest short term, but the interest rate
is only 2% in U.S. but 12% in South
Korea.
 So, the company changes dollars into won
and invests in the money market of
South Korea
 Rate of return will depend on the interest
rate and the value of the Korean won at
the time they exchange the won back into
dollars and bring back their money to the
U.S.
CURRENCY
CONVERSION:WHEN
Companies taking advantage of changing exchange rates

(Speculation = short term moment of funds from one
currency to another, seeking to profit from changes in
exchange rates)
 U.S. company has $10 million to invest. The company
thinks that the dollar is too strong against the yen (it is
overvalued), and that it will lose its value over time
(depreciate).
 Assume exchange rate is $1 = Yen 120
 Company changes money and receives
1.2 billion Yen ($10 million x 120 yen)
 Over next three months value of the dollar drops, so
that one dollar buys less yen and now the
exchange rate is $1 = Yen 100.
 Now the company exchanges the 1.2 billion Yen back
into dollars and because of the new exchange rate
receives $12 million.
REDUCING RISK
 Insuring against foreign
exchange risk: protecting
against unexpected or
unpredictable changes in
exchange rates through
hedging transactions.
REDUCING RISK
 TERMS important in discussions of
FOREX risk issues
 Spot exchange rate: rate of currency exchange
on a particular day

 Forward exchange rate: rate of currency

exchange on a specific future date
SPOT EXCHANGE RATE
 Spot exchange rate
 Spot exchange rate: rate of currency
exchange on a particular day
 Spot exchange: when two parties agree
to exchange currency and execute the
transaction immediately. Example:
tourist changing money at the airport
 Spot rates for most currencies change
throughout the day, depending on
supply and demand.
A SPOT FX DEAL
 A 25 second deal
Source: REUTERS FORWARD
EXCHANGE and MONEY
MARKET,John Wiley & Sons,
1999.
 FORWARD EXCHANGE: Insuring
against foreign exchange risk
 TERMS:
Forward exchange : An agreement to buy/sell a foreign
currency for future delivery at a price set now (the
"forward exchange rate").
Purpose: to hedge against the possibility that
future exchange movements will make a transaction
unprofitable by the time that transaction has been
executed. (a means to protect against loss of profit)
Forward exchange rate: exchange rate governing forward
exchanges.
 Exchange rate is established at time of agreement but payment
and delivery are not required until maturity
 Forward exchange rates: usually quoted in 30, 90, 180 day
increments
- Payment for forward exchange contracts are usually made on
the second business day after the event-month anniversary of
the trade. Example: a two-month forward transaction entered
on March 18 will be for a value date of May 20 (or next
business day if May 20 is on a weekend or holiday).
FORWARD EXCHANGE
 Insuring against foreign exchange risk:
 “Buying forward” or “Selling forward”: securing a
forward contract
 Discount on forward: the spot rate is stronger than
the forward rate (the target currency as valued by the
forward rate is weaker than the spot rate); the
expectation is that the currency is depreciating. S>F
 Premium on forward: the spot rate is weaker than the
forward rate (the target currency as valued by the
forward rate is stronger than the spot rate); the
expectation is that the currency is appreciating. F>S
FORWARD EXCHANGE
 EXAMPLE: U.S. company buys computers from Japan and must pay
200,000 yen for each computer in 30 days.
 Company wants to lock into an exchange rate that is known
to protect against possible depreciation of the U.S. Dollar.
 Current spot rate is $1 = Yen 120, which means each
computer costs in US$ 1,667. (200,000/120 = $1,667).
 Assume that future one-month rate is $1 = Yen 110. This
means that dollar is selling at a discount on the future market
(that is, dollar is selling on the future rate for less than it is
selling on the spot rate).
If U.S. company locks into this rate, when it actually pays in
30 days,
it means it would have to pay $1,818 per computer
(200,000/110
 = $1,818). (Dollar is depreciating).
Assume that future one-month rate is $1 = Yen 130. This means
that the dollar is selling for a premium on the future market (that
is, dollar is selling on the future rate for more than it is selling on
the spot rate). If U.S. company locks into this rate, when it actually
pays in 30 days, it means it would only have to pay $1,538 per
computer (200,000/130 = $1,538). (Dollar is appreciating).
FORWARD EXCHANGE
 Insuring against foreign exchange risk:
Forward exchange rate
 Forward exchange rate is not necessarily a
prediction of what the future spot rate will
be.
 Forward exchange contracts are a way of
protecting against a depreciation of home
currency in the future when a payment in a
foreign currency is required. (When home
currency depreciates, more of it will be required
to convert into a currency that is stronger)
Other Risk-Hedging Instruments
 Currency swap: simultaneous purchase and sale of a given
amount of foreign exchange for two different value
 dates
Purpose: to manage foreign currency requirements
and minimize foreign exchange risk by moving out of
one currency into another for a limited period when
exchange rates are favorable.
 FX swaps have two value dates, or legs, when
exchange of funds occur.
 Spot against Forward
 Forward against Forward
  Short Dates (less than one month)
Foreign currency futures: standardized contracts traded in
 organized exchanges with fixed maturities.
Foreign currency options: contracts giving the option, but
not the obligation, to buy or sell a given amount of foreign
exchange at a fixed price per unit for a specified time
period; traded OTC or on organized exchanges
WHERE IS THE FOREIGN
EXCHANGE MARKET?
 Foreign exchange market is not a single place but a global
network of banks, brokers and foreign exchange dealers
connected by electronic communications systems that
exchange currencies 24/7.
 Most important trading centers include London, New York,
Tokyo, and Singapore
 London’s dominance is explained by:
 History (capital of the first major industrialized nation).
 Geography (between Tokyo/Singapore and New York).
 Two major features of the foreign exchange market:
 The market never sleeps.
 Market is highly integrated.
 Dollar is a vehicle currency: in 2004, 89% of all
Forex involved dollars on one side of the transaction.
 WHO PARTICIPATES IN FX
MARKET?
 Two Tiers:
 Interbank/Wholesale market: usually large amounts in
multiples of a million units
 Retail Market: usually specified amounts
 Participants:
 Banks and non bank foreign exchange dealers/brokers
 Individual and firms conducting commercial and
investment transactions (including tourists)
 Speculators and Arbitrageurs
 Central Banks and
Treasuries
Example of a Forex Trading
Combinations

SOURCE: Eitman, David K.,

Stonehill, Arthur L., Moffet, Michael
H. MULTINATIONAL
BUSINESS FINANCE.
Addison Westley: New York,
2001. p.101
 CENTERS OF FOREX
 EXCHANGE SIGHTS

Amsterdam
Hamburg
Brussels
Dusseldorf
London
Frankfurt

Toronto Zurich
Paris
Basel
Rome
San Chicago Madrid
Vienna
Francisco New Tokyo
York
Hong Kong

Mexico
City Bombay

Singapore
Sydney

Rio de Janiero
Melbourne
São Paulo
THE MARKET THAT NEVER
SLEEPS
SOURCE: Eitman, David K.,
Stonehill, Arthur L., Moffet, Michael
H. MULTINATIONAL
BUSINESS FINANCE.
Addison Westley: New York,
2001.
Foreign Exchange Market
 Think of the Foreign Exchange Market
like Las Vegas
 24 hours
 Many players
 Presence of risk
 Action happening
all the time
Economic Theories about How
Exchange Rates are Determined
 Many different theories exist. No true
consensus exists.
 If the factors which influence the value of
exchange rates can be identified, then we may
be able to forecast exchange rate fluctuations
and movements.
 This knowledge, in turn, can help companies to
protect against foreign exchange risk and preserve
profitability of international trade and investment
and manage price competitiveness.
 WHAT FACTORS INFLUENCE THE
FOREIGN EXCHANGE MARKET

Source: REUTERS FORWARD

EXCHANGE and MONEY
MARKET,John Wiley &
Sons, 1999.
 Economic Theories about How Exchange Rates
are Determined

 Supply and Demand:

At the most basic level, exchange rates
are determined by the demand and supply
of one currency relative to the demand
and supply of another. The demand and
supply of currencies is fueled by the
supply and demand of goods and services.
What can affect the supply and
demand of goods and
services?
Economic Theories about How Exchange Rates
are Determined
 Changes in Income
 Changes in prices, especially those
brought about by differences in money
supply and price inflation :
 Law of One Price

 Purchasing Power Parity (PPP)

 Changes in Interest rates

 Economic Theories about How Exchange Rates
are Determined

 Investor psychology
and “Bandwagon”
effects: the “People”
effect
 Role of the
Government
Forex: Supply and Demand
 The spot exchange rate depends on supply
and demand for a foreign currency throughout
the day. This is in response to the changes in
the supply and demand for goods and
services.
 Differences in spot rates reflect differences in
supply and demand for currencies. These
differences will affect the value of the
currency.
 Example: If spot demand for U.S. dollars is high and U.S.
dollars are in short supply but the spot demand for British
pounds is low and the supply of British pounds is
plentiful, the dollar will most likely appreciate against the
pound. This reflects the supply and demand for U.S. and
British goods.
ARBITRAGE: moments of opportunity which
impact supply and demand for FOREX
 Arbitrage: a trading strategy based on the purchase of
foreign exchange in one market at one price while
simultaneously selling it in another market at a more
advantageous price in order to obtain a risk-free profit on
the price differential. “Buy low/sell high.”
 Arbitrage in foreign exchange takes advantage of the
disequilibrium (imbalance) which exists in foreign exchange
markets. It overcomes differences in geography, currency
type, and time.
 Example: At 8:00 a.m. in New York, the Swiss franc is quoted for sale at
$.46 and in Zurich at that same time for $.48. Traders and arbitrageurs
will buy Swiss francs in New York and sell then in Zurich. Demand in New
York would increase and raise the price in New York and the increased
supply in Zurich would cause the price to lower. Eventually, these trades
would cause the price to be stabilized.
 Currency Conversion: Transfer of
Purchasing Power
Trade in home currency for
foreign currency: increases
demand for foreign currency
Foreign Exchange
[and decreases supply];
Market
increases supply of home
currency [decreases demand]
in foreign exchange market

FOREIGN
HOME
CURRENCY
CURRENCY
Forex: Supply and Demand
Supply and demand as it relates to
import/export activity.
WHEN…..
 Domestic currency is appreciating: imports tend to
increase because foreign goods are less
expensive and exports tend to decrease because
they cost more to foreigners.
 Domestic currency is depreciating: exports tend to
increase because domestic goods cost less for
foreigners and imports tend to decrease because
they cost more to local consumers in the domestic
market.
 Supply in Forex market of a domestic currency
is increased under imports.
 Demand in Forex market of a domestic currency
is increased under exports.
Forex : Changes in Income
 Changes in income due to increased
employment, more workers in the workforce,
periods of economic growth etc. give residents
of a country more expendable income.
 An increase in domestic income of a country
will usually encourage residents to spend a
portion of their additional income on imports.
 When income of a nation grows rapidly,
imports tend to rise rapidly.
 Results: More domestic currency is traded for
more foreign currency and the domestic
currency will usually depreciate.
Forex : Changes in Income
 If incomes in both trading partners are
increasing, the country with the faster
growing income will increase demand
for imports relatively more.
 This may lead to a depreciation in currency
of the more rapidly growing national
economy
Forex: Changes in Prices
Basic concept: Law of One
Price
 How is the exchange rate between two currencies determined? In
theory, the exchange rate should be the medium to transfer and
equalize purchasing power from one currency to another. What is
the relationship between prices and exchange rates? We must
examine two theories: The Law of One Price and Purchasing
Power Parity.
LAW OF ONE PRICE
 Basic premise: If an identical product or service can be sold in two
different markets, and no restrictions exist on the sale or
transportation costs of moving the product between markets, the
product’s price should be the same in both markets.
therefore :Price currency A = Price currency B x exchange rate
How would this come about?
This is the result of the occurrence of arbitrage and markets seeking
equilibrium. Prices that are different will tend to equalize in markets
free of transportation costs and trade barriers.
 Example: US/British pound exchange rate: $1.50/ £1 A jacket selling for
US$75 in New York should sell for £50 in London ($75/1.50)
If jackets in London sell for £40, demand would increase, and price would go
up in London while extra supply would lower the price in New York. (this
explains why companies export—to take advantage of differences in price)
Net result: eventually, in theory, prices will tend to equalize:
P$ = P£ x E$/£
Forex: Change in Prices
Basic concept: Purchasing Power
Parity
 PURCHASING POWER PARITY: in theory, the “ideal” is that
the exchange rate should represent equivalence of
purchasing power between two currencies.
 Basic premise: If the Law of One Price were true for all
goods and services, the PPP could be found from any
individual set of prices, assuming the market is efficient.
Thus, E$/£ = P$ / P £
 By extension: In relatively efficient markets (few
impediments to trade and investment) then a ‘basket of
goods’ should be roughly equivalent in each country.
 Forex: Change in Prices
Purchasing Power Parity (PPP)
 Extension of PPP/Law of One Price: applicable to a basket of
goods and their prices.
 If relative prices change in a basket of goods, the exchange rates
should change to reflect the difference in purchasing power for a
given currency PPP.
 Example:
 Jan 1: a basket of goods costs U.S. $200 and Japan ¥ 20,000

 Dec 1: the same basket of goods costs $200 and Japan ¥

22,000
Result: it takes 10% more yen to buy the same basket of
goods(22,000/20,000) so the value of the yen is depreciating
by 10%. The dollar is appreciating and will buy 10% more.
 The change is reflected in both the price of the goods and the
price of the currencies.
 Forex: Change in Prices
Purchasing Power Parity (PPP)
 Extension of PPP/Law of One Price: if it is known that
prices are going to change in the future, can we project
what the forward rate will be?
 Example: Two countries, Great Britain and United States
produce just one good: beef. Suppose the price of beef in the
United States is $2.80 per pound and in Britain, it is £3.70
per pound.
 According to PPP theory, what should the $/£ be?

 Answer: 2.80/3.70 = .76$/ £.

 Suppose the price of beef is expected to rise at the end of
a year to $3.10 in the U.S. and to £.4.65 in Britain. What
would the one-year $/ £. Forward exchange rate
probably be?
 Answer: 3.10/4.65 = .67$/ £.
 Big Mac Index
June 2005

The Big Mac Index

compares actual
exchange rates with
what would be the PPP
exchange rate (“ideal”
theoretical exchange
rate where purchasing
power is equal).

Hill, p. 349

Switzerland
THE BIG MAC INDEX
 Big Mac Index provides
general comparison of
currencies against a
base currency (US$) to
determine which are
under-valued or over-
valued against the
base currency
EXAMPLE: the Chinese Yuan
 FULL COVERAGE: China
 Yahoo.com July 21, 2005
 China Severs Its Currency's Link t
 AP - 41 minutes ago
 BEIJING - China dropped its
politically volatile policy of
linking its currency to the U.S.
dollar on Thursday, adopting a
more flexible system based on
a basket of foreign currencies
that could push up the price of
Chinese exports to the United
States and Europe. The
government also strengthened
the state-set exchange rate to
8.11 yuan to the dollar — from
8.277 yuan, where it had been
fixed for more than a decade
— in a surprise announcement
on state television's evening
news.
WHAT DOES THIS MEAN?
 China switched from being
pegged to the U.S. dollar at 8.28
yuan to the U.S. dollar to a
“managed floating exchange rate
regime.” Currency is being
revalued to 8.11 yuan to the U.S.
dollar.
 Chinese exports will become more
expensive over time.
 Imports into China, of products
such as oil, will become less
expensive over. Foreign assets
will also become less expensive
over time.
 This was done in response to
pressure by the U.S. and the E.U.
in particular because cheap
Chinese imports into these areas
were creating too much
competition.
Change in Prices due to Inflation
Forex: Money Supply and
Inflation
 PPP theory predicts that changes in relative prices will
result in a change in exchange rates. What happens
when there is price inflation?
 Inflation occurs when the money supply increases faster
than output increases.
 If more money is available, banks can borrow more money
from the government and consumers can borrow more
from banks.
 More money in circulation can create more demand for
goods and services that is not satisfied by supply.
Prices will increase.
 A country with high inflation should expect its currency to
depreciate against the currency of a country with a
lower inflation rate. (Deflation should cause
appreciation).
 Forex: Interest Rates
What about the relationship of inflation
and interest rates? What is the impact
on forex rates?
 Theory says that nominal interest rates
reflect expectations about future inflation
rates.
 Fisher Effect (i = r + I) Nominal
interest rates are equal to the real rate
of return plus compensation for
expected inflation.
 Example: if real interest rate in a
country is 5% and annual inflation is
expected to be 10 percent, the
nominal interest rate will be 15%.
 Forex: Interest
Rates
In the global
can exist.
market, differences in interest rates
 Investors will trade in their home currency to
obtain currency of the country offering the higher
rate so that they can purchase higher yield assets.
Initially this will cause more demand for the
currency in the country with the higher rate and
thus cause an appreciation of that currency.
 Example: Japan has higher interest rates than the U.S.,
so U.S. investors trade in their dollars for yen in order
buy higher yield assets. This increased demand for yen
causes the yen to appreciate initially.
 Forex: Interest
 As investors transfer capital freely between
countries Rates
and take advantage of interest rate
differences, eventually arbitrage will
equalize them.
-Example: Over time, the lower interest rate in the U.S.
will attract more borrowers and the demand for money
in the U.S. will raise the interest rates there. The
increase in supply of money in Japan would begin to
lower interest rates there. This would continue until both
sets of real interest rates are equalized.
 Forex: Interest Rates
 PPP theory predicts that changes in relative
prices will result in a change in exchange
rates; exchange rates are affected by
 inflation.
From Fisher Effect, we know that
interest rates reflect expectations about
inflation
 Interest rates tell us about inflation
inflation can cause exchange rates to
change Therefore, theory says that
interest rates reflect expectations about
future exchange rates.
 Forex: Interest Rates
 By extension, theory identifies the International
Fisher Effect (IFE): If PPP holds true and real
rates of interest are equal across countries, the
following is assumed.
 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.
 Example: if nominal interest rate in Japan is 10 %
and in the U.S. is 6%, we would expect the yen
to depreciate by 4% against the dollar.
 Forex: Role of
 The Government
monetary, fiscal, and trade policies
of the Government can impact the
exchange rate. Examples:
 Creation of barriers to trade and
investment
 Controls on flow of foreign currency
 Restrictions on foreign investments
 Control of repatriation of profits, dividends,
royalties, etc.
 Impositions of trade barriers blocking or
discouraging imports
Forex: Role of Government
 The monetary and fiscal policies of the
Government can impact the exchange
rate. Examples:
 Management of the money supply
 Management or creation of inflation
 Central bank intervention
 Management of unemployment
 Economic growth policies
 Rates of taxation
 Forex: Influence of

 Peopleof market performance
Market sentiment: based on
Perception
 Expectation of market performance
 Explanation may be investor psychology and the
bandwagon effect
 Studies suggest they play a major role in short
term movements
 Hard to predict
 Shock in world politics and social
events can incite investor reaction
“Unexpected events may move markets for a matter of a
few hours or a day at the most. It is peoples perceptions
of fundamentals that move markets.” Stuart Frost,
Technical Analyst
EXAMPLE of Factors affecting Forex
Invester’s Business Daily, Vol.
21, No 170. Friday, Dec 10,
2004 p. A1 (faster-growing
economy in U.S.)
San Jose Mercury News, Dec
4, 2004, p. C-1 (U.S.
employment data weaker than
expected)
 Forex: Influence of People
 Impact of reactions by FX dealers
based on
 What the chartists are showing
 What people are saying the
market
 What central banks are doing
 “The trend is my friend.”
 “Buy the rumour, sell the fact”
 What are Good Predictors of
Forex Rates?
 Evidence suggests that neither PPP nor the International
Fisher Effect are good at explaining short term movements
in exchange rates.
 Complications with empirical tests conducted on PPP or
IFE:
 Identical “basket of goods” is often not
 Time periods for testing are not free from government
intervention, so markets are not as efficient
 As part of globalization, capital and financial markets have been
deregulated and cross border flow has increased; this has had
a considerable impact on supply and demand of currency,
which
 is not taken into account by PPP.
Transportation costs still a factor
 What are Good Predictors of
Forex Rates?
 General wisdom is:
 Short term (spot rates): supply and demand,
investor psychology/people factor, especially for
floating rates
 Longer term: Purchasing Power Parity (changes
in prices based on impacts of changes in
income, interest rate, inflation, actions of the
government, etc.)
 Some economists maintain that that the
forward rate is also a good unbiased
predictor of the future spot rate.
 Approaches to Forecasting
 Fundamental analysis
 Draws on economic theory to construct
sophisticated econometric models for predicting
exchange rate movements.
 Looks at variables such as inflation rates,
money supply, balance of payments,
etc.
 Technical analysis
 Uses price and volume data to determine
trends
 Special Issue: Currency
Convertibility

 Governments can place restrictions on the convertibility

of currency (ability to change domestic currency for
foreign currency)
 A country’s currency is said to be freely convertible
when the country’s government allows both
residents and nonresidents to purchase unlimited
amounts of a foreign currency with it
 A currency is said to be externally convertible
when only nonresidents may convert it into a foreign
currency without any limitations
 A currency is nonconvertible when neither residents
nor nonresidents are allowed to convert it into a
foreign currency
Special Issue: Currency
Convertibility
 Political decision.  Governments limit
 Many countries have some convertibility to preserve
kind of restrictions. foreign exchange
Government restrictions reserves in order to:
can include:
 A restriction on
 Service international
residents’ ability to debt
convert the domestic  Purchase imports
currency into a foreign  Government afraid of
currency

capital flight
Restricting domestic
businesses’ ability to take
foreign currency out of the
country
Special Issue: Currency Convertibility
 Capital flight: residents and nonresidents
of a country rush to convert their holdings
of a domestic currency to a foreign
currency.
 Usually occurs when the value of the
currency is depreciating or economics of a
country is at crisis.
 Result: a depletion of foreign exchange
reserves and depreciation of currency
(domestic currency floods the foreign
exchange market)
Special Issue: Currency Convertibility
 Capital flight:
 Counter trade – alternative to
convertibility issues
 Barter-like
agreements where
goods/services
are traded for
goods/services =
 Helps firms avoid
convertibility issue
 Managerial Implications
 Exchange rates influence the profitability
of trade and investment deals.
 International businesses must understand
the forces that determine exchange rate
and insure protection against foreign
currency risk.
 Remember individuals (consumers,
tourists, etc.) are also impacted.