Chapter 10

The Foreign Exchange Market

Israt Jahan Dina

Lesson Outline
2

• Concept of Foreign Exchange Market

• Foreign Exchange Risk

• Functions of Foreign Exchange Market

• Nature of Foreign Exchange Market

• Exchange Rate Forecasting

• Currency Convertibility
Concept of Foreign Exchange Market
3

• Foreign Exchange Market

o A market for converting the currency of one coun­try into
that of another country

• Exchange Rate
o The rate at which one cur­rency is converted into another
Concept of Foreign Exchange Market
4

• Bid
o The rate at which traders buy foreign exchange

• Offer
o The rate at which traders sell foreign exchange

• Spread
o The difference between bid and offer rates
Foreign Exchange Risk
5

• Foreign Exchange Risk

o The possibility that unpredicted changes in future exchange
rates will have adverse consequences for the firm

• Foreign exchange risk is usually divided into three main categories

o Transaction Exposure
o Translation Exposure
o Eco­nomic Exposure
Foreign Exchange Risk
6

• Transaction Exposure
o The extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values.
o is due to a movement in FX rates between the time a transaction is
booked and the time it settles, potentially impacting the value of the
deal.
o Such exposure includes obligations for the purchase or sale of
goods and services at previously agreed prices and the bor­
rowing or lending of funds in foreign currencies.
 Foreign Exchange Risk
Transaction Exposure
7

For example, suppose in 2014 an American airline agreed to purchase

10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery scheduled
for 2018 and payment due then.

Year 2014: When the contract was signed in 2014 the dollar/euro exchange rate stood at

$1 = €1.10

so the American airline anticipated paying $1.09 billion for the 10 aircraft when they were delivered

(€1.2 billion/1.1 = $1.09 billion).

Year 2018: However, imagine that the value of the dollar depreciates against the euro over the intervening
period, so that one dollar only buys €0.80 in 2018 when payment is due

$1 = €0.80

Now the total cost in U.S. dollars is $1.5 billion (€1.2 billion/0.80 = $1.5 billion),

an increase of $0.41 billion! The transaction exposure here is $0.41 billion, which is the money lost due to
an adverse movement in exchange rates between the time when the deal was signed and when the aircraft
were paid for.
Foreign Exchange Risk
8

• Translation Exposure
o The impact of currency exchange rate changes on the
reported financial statements of a company.
o It is concerned with the present measurement of past
events.
o is the balance sheet exposure that results when a company
consolidates its financial statements and then reports the
change in the net value of its foreign currency assets.
Foreign Exchange Risk
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• Translation Exposure
o Consider a U.S. firm with a subsidiary in Mexico. If the value of the
Mexican peso depreciates signifi­cantly against the dollar this would
substantially reduce the dollar value of the Mexican subsidiary's equity. In
turn, this would reduce the total dollar value of the firm's equity reported in
its consolidated balance sheet.
Foreign Exchange Risk
10

• Economic Exposure
o The extent to which a firm's future international earning
power is affected by changes in exchange rates.
o Economic exposure is concerned with the long­run effect
of changes in exchange rates on future prices, sales, and
costs.
Foreign Exchange Risk
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• Economic Exposure
• Consider the effect of wide swings in the value of the dollar on many U.S. firms'
international competitiveness. The rapid rise in the value of the dollar on the foreign
exchange market in the 1990s hurt the price competitiveness of many U.S. producers
in world markets. U.S. manufacturers that relied heavily on exports saw their export
volume and world market share decline. The reverse phenomenon occurred in 2000-
2009, when the dollar declined against most major cur­rencies. The fall in the value
of the dollar helped increase the price competitiveness of U.S. manufacturers in
world markets.
The Functions of the Foreign Exchange Market
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• Currency Conversion

• Insuring against Foreign Exchange Risk

 Currency Conversion
13

• International companies use the foreign exchange market

o Receipt of payments and income

First, the payments a company receives for its exports, the income it receives from
foreign investments, or the income it receives from licensing agreements with foreign
firms may be in foreign currencies.
o Pay for imports

Second, international businesses use foreign exchange markets when they must pay a
foreign company for its products or services in its country's currency. For example,
Dell buys many of the components for its computers from Malaysian firms. The
Malaysian companies must be paid in Malaysia's currency, the ringgit, so Dell must
convert money from dollars into ringgit to pay them.
Currency Conversion
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o Short-term investment of spare cash

Third, international businesses also use foreign exchange markets when they have
spare cash that they wish to invest for short terms in money markets.
For example, con­sider a U.S. company that has $10 million it wants to invest for three
months. The best interest rate it can earn on these funds in the United States may be 4
percent. Investing in a South Korean money market account, however, may earn 12
percent. Thus, the company may change its $10 million into Korean won and invest it
in South Korea.
Note, however, that the rate of return it earns on this investment depends not only on
the Korean interest rate, but also on the changes in the value of the Korean won against
the dollar in the intervening period.
Currency Conversion
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o Currency speculation
Currency speculation typically involves the short-term movement of funds from one currency to another in the
hopes of profiting from shifts in exchange rates.
The company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current
dollar/yen exchange rate is
$1 = ¥120.
The company exchanges its $10 million into yen, receiving ¥1.2 billion ($10 million X 120 = ¥1.2 billion).

Over the next three months, the value of the dollar depreciates against the yen until
$1 = ¥100.
Now the company exchanges its ¥1.2 billion back into dollars (1200,000,000/100) and finds that it has $12
million. The com­pany has made a $2 million profit on currency speculation in three months on an initial
investment of $10 million!
However, companies should beware, for specula­tion by definition is a very risky business.
 Insuring Against Foreign Exchange Risk
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A second function of the foreign exchange market is to provide insurance

against foreign exchange risk, which is the possibility that unpredicted
changes in future ex­change rates will have adverse consequences for the firm.

1. Spot Exchange Rate

2. Forward Exchange Rate

3. Currency Swap
 Insuring Against Foreign Exchange Risk
(Spot Exchange Rates)
17

Spot Exchange Transaction

• When two parties agree to exchange currency and execute the deal
immediately.

• Exchange rates governing such "on the spot" trades are referred to as spot exchange
rates.

Spot Exchange Rate

• The rate at which a foreign exchange dealer converts one currency into another
currency on a par­ticular day

• Example: U.S. tourist in Edinburgh goes to a bank to convert her dol­lars into pounds,
the exchange rate is the spot rate for that day.
 Insuring Against Foreign Exchange Risk
(Spot Exchange Rates)
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• Spot Exchange Rates

• Spot exchange rates are reported on a real-time basis on many financial websites.
• An exchange rate can be quoted in two ways

i. The amount of foreign currency one U.S. dollar buy

ii. The volume of dollar for one unit of foreign currency

Example: On February 15th, 2021, at 11:25 a.m., Eastern Standard Time,

$1 bought €0.82
€1 bought $1.21
 Insuring Against Foreign Exchange Risk
(Spot Exchange Rates)
19

• Spot rates change continually, often on a minute-by-minute basis

• The value of a currency is determined by the interaction between the demand and supply
of that currency relative to the demand and supply of other currencies.

For example, if lots of people want U.S. dollars and dollars are in short supply, and few people
want British pounds and pounds are in plentiful supply, the spot exchange rate for converting
dollars into pounds will change. The dollar is likely to appreciate against the pound (or, the
pound will depreci­ate against the dollar). Imagine the spot exchange rate is £1 = $1.25 when the
market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the
end of the day, the spot exchange rate might be £1 = $1.23. Each pound now buys fewer dol­lars
than at the start of the day.
The dollar has appreciated, and the pound has depreciated.
 Insuring Against Foreign Exchange Risk
(Forward Exchange Rates)
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• Forward Exchange Rates

o Forward Exchange Transaction

 It occurs when two parties agree to exchange cur­rency

and execute the deal at some specific date in the future
o Forward Exchange Rates

 Exchange rates governing such future transactions are

referred to as forward exchange rates
 Insuring Against Foreign Exchange Risk
(Forward Exchange Rates)
21

• For example, a U.S. company that imports laptop from Japan knows that in 30 days it must pay yen to a
Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for
each laptop , and the current dollar/ yen spot exchange rate is $1 = ¥120. At this rate, each computer
costs the importer $1,667 (i.e., 1,667 = 200,000/120). The importer knows she can sell the computers
the day they arrive for $2,000 each, which yields a gross profit of $333 on each computer ($2,000 -
$1,667).

• However, the importer will not have the funds to pay the Japanese supplier until the computers have
been sold. If over the next 30 days the dollar unex­pectedly depreciates against the yen, say, to $1 =
¥95, the importer will still have to pay the Japanese company ¥200,000 per computer, but in dollar
terms that would be equiva­lent to $2,105 per computer, which is more than she can sell the
computers for.

A depre­ciation in the value of the dollar against the yen from $1 = ¥120 to $1 = ¥95 would transform a
profitable deal into an unprofitable one.
 Insuring Against Foreign Exchange Risk
(Forward Exchange Rates)
22

After adopting forward exchange rate

• Returning to our computer importer example, let us assume the 30-day forward
exchange rate for converting dollars into yen is $1 = ¥110.

• The importer enters into a 30-day forward exchange transaction with a foreign
exchange dealer at this rate and is guaranteed that she will have to pay no more than
$1,818 for each computer (1,818 = 200,000/110)

• This guarantees her a profit of $182 per computer ($2,000 - $1,818).

• She also insures herself against the possibility that an unanticipated change in the
dollar/yen exchange rate will turn a profitable deal into an unprofitable one.
 Insuring Against Foreign Exchange Risk
(Currency Swaps)
23

o The simultaneous purchase and sale of a given amount of foreign exchange for
two different value dates
o Swaps are transacted between international busi­nesses and their banks,
between banks, and between governments when it is desirable to move out of
one currency into another for a limited period without incurring foreign
exchange risk.
o A common kind of swap is spot against forward
 Insuring Against Foreign Exchange Risk
(Currency Swaps)
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Scenario: Consider a company such as Apple Computer. Apple assembles laptop computers in the
United States, but the screens are made in Japan. Apple also sells some of the finished laptops in
Japan. So, like many companies, Apple both buys from and sells to Japan.

 Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today.
 Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its
finished laptops.

It will want to convert these yen into dollars for use in the United States. Let us say today’s

spot exchange rate is $1 = ¥120

and

90-day forward exchange rate is $1 = ¥110.

Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese
supplier.
 Insuring Against Foreign Exchange Risk
(Currency Swaps)
25

At the same time, Apple enters into a 90-day forward exchange deal with its bank
for converting ¥120 million into dollars.

Thus, in 90 days Apple will receive $1.09 million

(¥120 million/110 = $1.09 million)

Since the yen is trading at a premium on the 90-day forward market, Apple ends up
with more dollars than it started with. The swap deal is just like a conventional
forward deal in one important respect: It enables Apple to insure itself against foreign
exchange risk. By engaging in a swap, Apple knows today that the ¥120 million
payment it will receive in 90 days will yield $1.09 million.
Exchange Rate Forecasting
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• There are two schools of thought

o The efficient market school

 Forward exchange rates do the best possible job of forecasting future

spot exchange rates, and, therefore, investing in forecasting services
would be a waste of money
 If forward exchange rates are the best pos­sible predictor of future
spot rates, it would make no sense for companies to spend addi­tional
money trying to forecast short-run exchange rate movements.
 An efficient market is one in which prices reflect all available public
information.
Exchange Rate Forecasting
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• If the foreign exchange market is efficient, forward exchange rates

should be unbiased predictors of future spot rates.

• This does not mean the predictions will be accurate in any specific
situation. It means inaccuracies will not be consistently above or below
future spot rates; they will be random.
 Exchange Rate Forecasting
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o The inefficient market school

 An inefficient market is one in which prices do not reflect all available
information.
 In an inefficient market, forward exchange rates will not be the best
possible predictors of future spot exchange rates.
 Companies can improve the foreign exchange market’s estimate of
future exchange rates by investing in forecasting services.
 The belief is that professional exchange rate forecasts might provide
better predictions of future spot rates than forward exchange rates do.
Approaches to Forecasting
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• Two schools of thought on forecasting:

o Fundamental Analysis

• Fundamental analysis draws on economic theory to construct

sophisticated econometric models for predicting exchange rate
movements.

• The variables contained in these mod­els are relative money supply

growth rates, inflation rates, and interest rates. In addition, they
may include variables related to bal­ance-of-payments positions.
 Approaches to Forecasting
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o Technical Analysis

• Technical analysis uses price and volume data to determine past trends, which are
ex­pected to continue into the future.

• This approach does not rely on a consideration of economic fundamentals.

Technical analysis is based on the premise that there are analysable market trends
and waves and that previous trends and waves can be used to predict future trends
and waves.

• Since there is no theoretical rationale for this assumption of predictability, many

economists compare technical analysis to fortune-telling. Despite this skepticism,
technical analysis has gained favour in recent years.
Currency Convertibility
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1. Freely Convertible

2. Externally Convertible

3. Nonconvertible
Currency Convertibility
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• Freely Convertible
o When a government of a country allows both residents and
non-residents to purchase unlimited amounts of foreign
currency with the domestic currency
Currency Convertibility
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• Externally Convertible
o When non-residents can convert their holdings of domestic
currency into a foreign currency, but when the ability of
residents to convert currency is limited in some way
Currency Convertibility
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• Nonconvertible
o When both residents and non-residents are prohibited from
converting their holdings of domestic currency into a
foreign currency
o when a currency is nonconvertible, firms may turn to
countertrade
countertrade
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• Countertrade refers to a range of barter-like agreements by which goods and

services can be traded for other goods and services.

• Countertrade can make sense when a coun­try's currency is nonconvertible.

• For example, consider the deal that General Electric struck with the Romanian
government when that country's currency was non-convert­ible. When General
Electric won a contract for a $150 million generator project in Romania, it agreed
to take payment in the form of Romanian goods that could be sold for $150
million on international markets.
Currency Convertibility
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• Capital Flight
o When assets or money rapidly flow out of a country, due to an event of
economic consequence
o 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
o Under such circumstances, both resi­dents and nonresidents tend to believe
that their money is more likely to hold its value if it is converted into a
foreign currency and invested abroad.
Reducing Translation and Transaction Exposure
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• To minimize transaction and translation exposure,

o Buy forward
o Use swaps
o Lead and lag payables and receivables
 Reducing Translation and Transaction Exposure
Lead and lag payables and receivables

38

 A lead strategy involves attempting to

Collect foreign currency receivables (payments from cus­tomers) early when a

foreign currency is expected to depreciate

and

Paying foreign cur­rency payables (to suppliers) before they are due when a currency
is expected to appreciate.
 A lag strategy involves delaying

collection of foreign currency receivables if that currency is expected to appreciate

and

payables if the currency is expected to depreciate.

Reducing Economic Exposure
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• To reduce economic exposure

o Distribute productive assets to various locations so the
firm’s long-term financial well-being is not severely
affected by changes in exchange rates
o Do not concentrate assets where likely rises in currency
values will lead to increases in the foreign prices of the
goods and services the firm produces
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