Foreign Exhange Market Hedging involves taking measures to protect

 plays a pivotal role in the global economy against potential losses arising from fluctuations
 Fluctuations in currency values can in exchange rates. This is achieved through
profoundly affect sales, profits, and various financial instruments available in the
business strategies foreign exchange market, including:
 Without the foreign exchange market,  Spot Exchange Rates - These represent the
international trade and investment would immediate exchange of currencies at the
be impractical, as companies would resort prevailing market rate. By utilizing spot
to barter. exchange rates, firms can execute currency
 Foreign exchange rates play a crucial role transactions promptly to mitigate the
in insuring against foreign exchange risk, impact of adverse exchange rate
which refers to the potential adverse movements.When a transaction occurs on
consequences for a firm resulting from the spot, it means the exchange is
unpredicted changes in future exchange executed promptly.
rates. In this context, the foreign exchange  The spot exchange rate is the specific rate
market serves as a mechanism for hedging at which a foreign exchange dealer
against such risks. converts one currency into another
 Functions of the Foreign Exchange Market: currency on a given day.
1. Currency Conversion - The primary function  Forward Exchange Rates - Forward
of the foreign exchange market is to facilitate exchange rates allow firms to lock in an
the conversion of one currency into another. exchange rate for a future date. By
This enables individuals and businesses to entering into forward contracts,
conduct transactions and trade goods and companies can hedge against the risk of
services across borders efficiently. unfavorable exchange rate movements
2. Facilitating International Trade and that may occur between the time of
Investment - By providing a platform for contract initiation and settlement.
exchanging currencies, the foreign exchange  Currency Swaps - Currency swaps involve
market enables countries with different the simultaneous purchase and sale of
currencies to engage in trade and investment foreign exchange for two different value
activities. It allows businesses to buy and sell dates. This allows firms to exchange
goods and services internationally, thereby currencies at predetermined rates, thereby
promoting economic growth and development. managing exposure to exchange rate
3. Price Determination - Exchange rates, which fluctuations over a specified period.
are determined in the foreign exchange market, Different theories on how currency exchange
play a vital role in determining the prices of rates are determined and their relative merits:
goods and services in different countries. 1. Law of One Price - Identical products in
Exchange rates reflect the relative value of different countries should have the same price
currencies and help in comparing the costs of when expressed in the same currency.Arbitrage
products and services across borders. opportunities arise if prices differ, leading to
4. Hedging Against Foreign Exchange Risk - The adjustments until prices equalize across
foreign exchange market provides a mechanism markets.Law of one price suggests exchange
for companies to hedge against foreign rates should adjust to maintain price parity for
exchange risk, which arises from unpredictable identical goods.
changes in exchange rates. Through various 2. Purchasing Power Parity - PPP theory links
hedging instruments such as forward contracts exchange rate changes to differences in price
and options, businesses can protect themselves levels between two countries. In efficient
from adverse movements in exchange rates and markets with minimal trade barriers, the prices
ensure stability in their cash flows. of a basket of goods should be similar when
5. Speculation and Investment - The foreign expressed in a common currency. Exchange
exchange market also serves as a platform for rates are expected to adjust to equalize the cost
currency speculation and investment. Traders of identical baskets of goods across countries.
and investors engage in buying and selling 3. Money Supply and Price Inflation
currencies with the aim of profiting from Inflation - Occurs when money supply grows
fluctuations in exchange rates. While faster than goods and services, causing
speculation carries risks, it also provides increased demand and price inflation.
opportunities for investors to diversify their Government policies, especially regarding
portfolios and potentially earn returns. monetary growth, are critical.
Actions like printing more money can influence future. This approach does not consider
monetary growth, but excess leads to inflation. economic fundamentals but instead focuses on
International businesses should analyze a market trends and patterns. The merit of
country's monetary policy to predict currency technical analysis lies in its simplicity and
movements; controlled monetary growth accessibility, as it provides a straightforward
reduces depreciation.Understanding these method for predicting future exchange rate
dynamics helps respond effectively to currency movements based on historical data. However,
fluctuations. it is often criticized for lacking a theoretical
4. Interest Rates and Exchange Rates - The rationale and being akin to fortune-telling.
theory explaining how currency exchange rates
are determined through interest rates revolves
around the Fisher Effect and the International
Fisher Effect.
Fisher Effect - first formalized by economist Irvin
Fisher.Nominal interest rates are determined by
real interest rates and expected inflation.
Mathematically: i = r + l
Strong relationship between inflation and
interest rates.
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 counties.
5. Investor Psychology and Bandwagon Effect
Short-term exchange rate movements
influenced by investor psychology and
bandwagon effects.
Market traders' expectations about future
exchange rates affected by psychological factors,
leading to self-fulfilling prophecies.
A good example of this mechanism occurred in
September 1992 when the famous international International Monetary System
financer George Soros made a huge bet against  refers to the institutional arrangements
the British pound. that govern exchange rates
Bandwagon effect is where traders moving as a  It is the globally accepted policies, rules,
herd in the same direction at the same time. customs and practices established by
societies worldwide to trade currency
Merits of different approaches towards smoothly
exchange rate forecasting  The gold standard had its origin in the use
1. Fundamental Analysis of gold coins as a medium of exchange,
This approach utilizes economic theory and unit of account, and store of value practice
sophisticated econometric models to predict that dates to ancient times. When
exchange rate movements. Variables such as international trade was limited in volume,
relative monetary growth rates, inflation rates, payment for goods purchased from
interest rates, and balance-of-payments another country was typically made in gold
positions are considered. The merit of or silver.
fundamental analysis lies in its comprehensive  Pegging currencies to gold and
consideration of economic fundamentals that guaranteeing convertibility is known as the
can potentially influence exchange rates in the gold standard.
long run. However, it may not always accurately  In the 1880’s, most of the world's major
predict short-term exchange rate movements trading nations, including Great Britain,
due to the complexity of factors involved and Germany, Japan, and the United States,
the influence of psychological factors. had adopted the gold standard. Given a
2. Technical Analysis common gold standard, the value of any
Unlike fundamental analysis, technical analysis currency in units of any other currency
relies on price and volume data to identify past (the exchange rate) was easy to
trends, which are expected to continue into the determine.
 The gold par value refers to the amount of 2. Adjustable parities - the adjustable parities
currency needed to purchase one ounce of system permitted countries to devalue
gold. their currency by more than 10% if the IMF
 The great strength claimed for the gold determined that the country's balance of
standard was that it contained a powerful payments was in a state of "fundamental
mechanism for achieving balance-of-trade disequilibrium.”
equilibrium by all countries.
 A country is said to be in balance-of-trade Role of the World Bank
equilibrium – when the income its  Official name of the world bank is the
residents earn from exports is equal to the International bank for reconstruction and
money its residents pay to other countries development (IBRD)
for imports ( the current account of its  Initial mission was to help finance the
balance of payments is in balance). building of Europe economy by providing
 In 1944, at the height of World War II low-interest loans
representatives from 44 countries met at The bank lends under two schemes:
Bretton Woods, New Hampshire, to design
a new international monetary system. 1. IBRD Scheme
The agreement reached at Bretton Woods Under the IBRD scheme, money is raised
established two multinational institutions: through bond sales in the international capital
 International Monetary Fund (IMF) – the market. Borrowers pay what the bank calls a
task of the IMF would be to maintain order market rate of interest—the bank’s cost of
in the international monetary system funds plus a margin for expenses.
 World Bank – would be to promote Under the IBRD (International Bank for
general economic development. Reconstruction and Development) scheme, the
 The Bretton Woods agreement also called bank offers low-interest loans to risky
for a system of fixed exchange rates that customers whose credit rating is often poor,
would be policed by the IMF. such as the governments of underdeveloped
 Under the agreement, all countries were nations.
to fix the value of their currency in terms 2. International Development Association (IDA)
of gold but were not required to exchange Resources to fund IDA loans are raised through
their currencies for gold. Fixed exchange subscriptions from wealthy members such as
rates pegged to the US Dollar. the United States, Japan, and Germany.
IDA loans go only to the poorest countries.
Role of the IMF Borrowers have 50 years to repay at an interest
 The aim of the Bretton Woods agreement, rate of 1 percent a year. The world’s poorest
of which the IMF was the main custodian, nations receive grants and no-interest loans.
was to try to avoid a repetition of that
chaos through a combination of discipline Exchange rate - Is a rate at which one currency
and flexibility. will be exchanged for another currency and
A fixed exchange rate regime imposes discipline affects trade and the movement of money
in two ways: between countries.
 The need to maintain a fixed exchange rate
puts a brake on competitive devaluations  Free-floating
and brings stability to the world trade  Fixed
environment.
 A fixed exchange rate regime imposes Case for free floating:
monetary discipline on countries, thereby  Monetary Policy Autonomy
curtailing price inflation.  Trade Balance Adjustments
Two major features of the IMF articles of Case for fixed
agreement fostered this flexibility:  Monetary Discipline
1. IMF Lending Facilities – the IMF stood  Speculation
ready to offer short-term foreign currency  Uncertainty
loans to member countries facing  Trade Balance Adjustments
balance-of-payments deficits, aiming to
prevent rapid economic tightening that  The system of fixed exchange rate
could harm domestic employment. established at Bretton Woods worked well
until the late 1960s, when it began to show
 signs of strain. The system finally collapsed The 1997 Asian financial crisis was caused by
in 1973, when it was replaced by a events that took place in the previous decade
manage-float system. including:
1. An investment boom-The wealth created
 The floating exchange rate regime that by export-led growth helped fuel an
followed the collapse of the fixed investment boom in commercial and
exchange rate system was formalized in residential property, industrial assets, and
January 1976 when IMF members met in infrastructure.
Jamaica and agreed to the rules for the 2. Excess capacity- investments were based
international monetary that are in place on projections of future demand
today. conditions.
3. The Debt Bomb- investment were
 Countries using a currency board commit supported by dollar based debts
to converting their domestic currency on 4. Expanding imports- caused current
demand into another currency at a fixed account to deficits
exchange rate.
 The currency board holds reserves of Implications for Managers
foreign currency equal at the fixed The implications for international businesses fall
exchange rate to at least 100% of the into three main areas: currency management,
domestic currency issued. business strategy, and corporate government
 The currency board can issue additional relations.
domestic notes and coins only when Managers need to understand how the
foreign exchange reserves are available to international monetary system affects.
back it. This limits the ability of the 1. Currency management – the current system
government to print money and thereby is a mixed system in which a combination of
create inflationary pressures. government intervention and speculative
activity can influence the foreign exchange
 The IMF’s original function was to provide market.
a pool of money from which the members Speculative buying and selling of currencies can
could borrow, over the short term, to create very volatile movements in exchange
adjust their balance-of-payments position rates.
and maintain their exchange rate. 2. Business strategy – exchange rate
movements are difficult to predict, and yet their
There are three main types of financial crises: movement can have a major impact on the
 Currency Crisis - occurs when a speculative company’s competitive position.
attack on the currency results in a sharp To cope with this effect, managers need
depreciation, or forces authorities to strategic flexibility
expend large volumes of international 3. Corporate-government relations – businesses
currency reserves and sharply increase can influence government policy towards the
interest rates in order to defend prevailing international monetary system
exchange rates. Philippines 1982 Companies should promote a system that
 Banking Crisis - refers to a situation in facilitates the growth of international trade and
which a loss of confidence in the banking investment.
system leads to a run on the banks, as
individuals and companies withdraw their The Global Capital Market
deposits  The rapid globalization of capital markets
 Foreign Debt Crisis - a situation in which a facilitates the free flow of money around
country cannot service its foreign debt the world
obligations, whether private sector or  Traditionally, national capital markets have
government debt been separated by regulatory barriers
 global capital markets offer some benefits
The Mexican currency crisis of 1995 was a result not found in domestic capital markets
of high Mexican debts a pegged exchange rate  Capital markets bring together investors
that did not allow for a natural adjustment of and borrowers
prices  Investors include corporations with surplus
cash, individuals, and non-bank financial
institutions
 Borrowers include individuals, companies, than the one whose currency bonds is
and government denominated.
 Markets makers are the financial service Global Bond Market benefits
companies that connect investors and  Lower cost of capital
borrowers, either directly or indirectly  Access to different currency markets
 Commercial banks are indirect market  Diversification of investor base
makers, and investment banks are direct  Market development
market makers Global bond market risks
 Capital market loans can be equity (stock)  Currency risk
or debt ( cash loans or bonds)  Interest rate risk
Two factors are responsible for the growth of  Political and economic risk
capital markets:  Liquidity risk
1. Information Technology – the growth of
international communications technology and Growth in global capital markets has created
advances in data processing capabilities. opportunities for firms to borrow or invest
2. Deregulation – has facilitated growth in the internationally. Firms can often borrow at a
international capital markets lower cost than in the domestic capital market
Firms must balance the foreign exchange risk
Risks associated with global capital market associated with borrowing in foreign currencies
1. Deregulation and reduced controls - on cross against the cost savings that may exist. The
cross border capital flows have made individual growth of capital markets also offers
nations more vulnerable to speculative capital opportunities for firms, institutions, and
flows which can lead to destabilizing effects on individuals to diversify their investments and
national economies reduce risk. Again, though investors must
2. Speculative flows and inaccurate information consider foreign exchange rate risk.
- speculative flows can lead to inaccurate or
misleading information about investment
opportunities
3. Accounting principles and cross-border
investments - differences in actg. Principles and
financial reporting standards across countries
make it challenging to directly compare
cross-border investment opportunities.

Eurocurrency - any currency bank outside of its

country of origin.
 Two third of eurocurrencies are
eurodollars, other are euroyen, europound,
and euro-euro
Eurocurrency market benefits
 Regulatory freedom
 Higher interest rates for deposits
 Lower interest rates for borrowing
 Competitive edge for eurocurrency banks
Eurocurrency market risks
 Bank failure risk
 Foreign exchange risk

 Most common kind of bond is fixed-rate

bonds which gives investors fixed cash
payoffs.
 Two types of international bonds:
1. Foreign bonds- sold outside borrowers
country and are denominated in the
currency of the country in which issued
2. Eurobonds - underwritten by the syndicate
of banks and placed in countries other