Exchange rates display, seen at Suvarnabhumi International Airport, Thailand (Photo credit: Wikipedia)
Image used to convey the idea of currency conversion (originally from en.wikipedia). The signs are (clockwise from top-left): dollar, euro, pound, shekel, đồng, yen. (Photo credit: Wikipedia)
Why is the Foreign Exchange Market Important?
“The foreign exchange market (forex, FX, or currency market) is a global decentralized market for the trading of currencies. In terms of volume of trading, it is by far the largest market in the world.[1] The main participants in this market are the larger international banks.
Financial centres around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. The foreign exchange market determines the relative values of different currencies.[2]
The foreign exchange market works through financial institutions, and it operates on several levels. Behind the scenes banks turn to a smaller number of financial firms known as “dealers,” who are actively involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market”, although a few insurance companies and other kinds of financial firms are involved.
The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from the European Union member states, especially Eurozone members, and pay euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies, and the carry trade, speculation based on the interest rate differential between two currencies.[3]
In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying for some quantity of another currency. The modern foreign exchange market began forming during the 1970s after three decades of government restrictions on foreign exchange transactions (the Bretton Woods system of monetary management established the rules for commercial and financial relations among the world’s major industrial states after World War II), when countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed as per the Bretton Woods system.”
This chapter:
- explains how the foreign exchange market works
- examines the forces that determine exchange rates and discusses the degree to which it is possible to predict exchange rate movements
- maps the implications for international business of exchange rate movements and the foreign exchange market
The foreign exchange market is a market for converting the currency of one country into that of another country. The exchange rate is the rate at which one currency is converted into another.
When Do Firms Use the Foreign Exchange Market?
The foreign exchange market is used:
- to convert the currency of one country into the currency of another
- to provide some insurance against foreign exchange risk – the adverse consequences of unpredictable changes in exchange rates
Companies use the foreign exchange market:
- to convert payments they receive for exports, the income they receive from foreign investments, or from licensing agreements with foreign firms
- when they must pay a foreign company for products or services in a foreign currency
- when they have spare cash that they wish to invest for short terms in money markets
- for currency speculation – the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates
Another Perspective: XE.com {http://www.xe.com/} provides a real time currency cross-rate chart, and an option to do currency conversions.
Insuring Against Foreign Exchange Risk
A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates, or foreign exchange risk.
Spot Rates and Forward Rates
The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.
A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. 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 rate risk.
The Nature of the Foreign Exchange Market
The foreign exchange market is not a place, but a network of banks, brokers, and dealers that exchange currencies 24 hours/day.
Exchange Rates between Markets
Opportunities for arbitrage exist when exchange rates are not the same between markets.
About 85 percent of al foreign exchange transactions involve the U.S. dollar. It is a vehicle currency.
Economic Theories of Exchange Rate Determination Three factors have an important impact on future exchange rate movements in a country’s currency:
- the country’s price inflation
- its interest rate
- market psychology
Another Perspective: To find out more about how various factors affect, or are affected by, exchange rates, go to {http://www.fxcm.com/docs_pdfs/dailyfx-article/The_5_Things_that_Move_the_Currency_Markets.pdf}.
Prices and Exchange Rates
The law of one price suggests that in competitive markets free of transportation costs and trade barriers, identical products in different countries must sell for the same price when their price is expressed in terms of the same currency.
A less extreme version of the PPP theory states that given relatively efficient markets – that is, markets in which few impediments to international trade and investment exist – the price of a “basket of goods” should be roughly equivalent in each country.
Interest Rates and Exchange Rates
The International Fisher Effect states that 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 two countries.
Investor Psychology and Bandwagon Effects
Expectations on the part of traders can turn into self-fulfilling prophecies, and traders can joint the bandwagon and move exchange rates based on group expectations.
Exchange Rate Forecasting
The efficient market school, argues that 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, while the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services.
An efficient market is one in which prices reflect all available information.
In an inefficient market, prices do not reflect all available information.
Approaches to Forecasting
There are two approaches to forecasting exchange rates:
- fundamental analysis – draws upon economic theories to predict future exchange rates, including factors like interest rates, monetary policy, inflation rates, or balance of payments information
- technical analysis – chart trends, and believe that past trends and waves are reasonable predictors of future trends and waves
Currency Convertibility
A currency is said to be freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency.
A currency is said to be externally convertible 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.
A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency.
Free convertibility is the norm in the world today, although many countries impose restrictions on the amount of money that can be converted. The main reason to limit convertibility is to preserve foreign exchange reserves and prevent capital flight.
Countertrade refers to a range of barter like agreements by which goods and services can be traded for other goods and services. It can be used in international trade when a country’s currency is nonconvertible.
Another Perspective: The American Countertrade Association {http://www.globaloffset.org} maintains a web site with information for those interested in countertrade. Also, students can learn more about countertrade at {http://www.barternews.com/countertrade.htm}.
Implications for Managers
There are three types of foreign exchange risk:
1. Transaction exposure
2. Translation exposure
3. Economic exposure
Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company.
Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates.
Reducing Translation and Transaction Exposure
Firms can minimize their foreign exchange exposure by:
- buying forward
- using swaps
- leading and lagging payables and receivables – paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements
Firms can reduce economic exposure by ensuring assets are not too concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produced.
Other Steps for Managing Foreign Exchange Risk
To manage foreign exchange risk:
(a) central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies
(b) firms should distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand
(c) the need to forecast future exchange rates cannot be overstated
(d) firms need to establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position
(e) the firm should produce monthly foreign exchange exposure reports.
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