Topic 9

Foreign Exchange Market

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Learning Objectives
LO 9-1 Describe the functions of the foreign exchange market.
LO 9-2 Understand what is meant by spot exchange rates and their
role in currency conversion.
LO 9-3 Recognize the role that forward exchange rates play in
forward transactions and currency swaps.
LO 9-4 Examine the role of forward transactions and currency swaps
in insuring against foreign exchange risk.
LO 9-5 Understand the different theories that explain how currency
exchange rates are determined.
LO 9-6 Compare and contrast the differences among translation,
transaction, and economic exposure, and explain the
implications for management practice.
Outline
❖ Introduction to Foreign Exchange Market
❖ Functions of Foreign Exchange Market
❖ Currency Conversion
❖ Insuring against Exchange Risk
❖ Factors Affecting Exchange Rate Movements
 Inflation
 Interest Rates
 Investor Psychology
❖ Managerial Implications of Currency Volatility
Exposure

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Foreign Exchange Market
 Foreign Exchange
 Termed as the currency of another country that is needed
to carry out international transactions ($,€,₩,£,¥, 元 etc.)
 Exchange Rate
 It is the rate at which one currency is converted into
another.
 Is expressed as the amount of foreign currency
exchangeable for one unit of the domestic currency.
 e.g., Exchange rate of HK$ = 0.1288 US$ (1 US$ = 7.76
HK$)
 Foreign Exchange Market (FOREX)
 A market for converting the currency of one country
into the currency of another.

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The Nature of Foreign Exchange Market
 Largest and most liquid financial market in the world
 Daily traded volumes are HUGE: around $4 trillion in 2010 (25 times
greater than volume of trade!)
 It’s 24/7 because the market is always open somewhere in the world.
 Example: Tokyo, London and New York exchange markets are all shut
for only 3 hours out of every 24 hours.
 London is the dominant global currency market, accounting for around
37% the $4 trillion global turnover in 2010.
 Even though simultaneous and parallel, exchange rates
quoted in different FOREX markets are the same.
 If not there would be an opportunity for arbitrage which would
ensure identical exchange rates between any currency pair
 Arbitrage - the process of buying an asset low and selling it high to
make money.
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Functions of Foreign Exchange Market
 The foreign exchange market serves TWO
functions:
1. Currency Conversion
➢ Enables the conversion of the currency of one
country into the currency of another.
2. Insuring against Foreign Exchange Risk
 Foreign Exchange Risk - the risk that arises to
economic agents from unanticipated changes in
exchange rates.

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Currency Conversion
 Currency Conversion - International firms use foreign
exchange markets to convert currency for
 Receipts and Payments:
 Economic agents receive payment in foreign currencies and
they have to convert these payments to their home currency
 Economic agents sometimes pay businesses for goods or
services in foreign currencies.
 Investments: Economic agents make direct and portfolio
investments in foreign countries which require foreign
currency.
 Speculation: Economic agents take advantage of changing
exchange rates to move out of funds from one currency to
another in the hopes of profiting from shifts in exchange
rates (arbitrage).
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 Currency Conversion

Every time tourists change

money in a foreign country
they are participating in
the foreign exchange
market.
Source: © Ed Brown/Alamy Stock Photo
Insuring Against Foreign Exchange Risk
 The foreign exchange market can be used to
provide insurance to protect against foreign
exchange risk (currency hedging)
 Currency hedging - a firm, an institution or an
individual protecting themselves against foreign
exchange risk.
 To understand how the foreign exchange market
provides protection against foreign exchange risk
we need to differentiate between:
 Spot exchange rates based spot transaction
 Forward exchange rates based forward transaction
 Foreign Exchange Swaps (FX Swaps)
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Spot Exchange Rate and Transaction
 Spot exchange rate is the rate of currency
exchange at a particular time.
 determined by the interaction of current demand
and supply of that currency.
 continuous changes in demand and supply of a
currency leads to constant changes in the the spot
exchange rate.
 Spot transactions are those that involve spot
exchange rates.
 Example: When a tourist from HK goes to a bank
in London to convert HK$ into £, the resultant spot
transaction involves the exchange rate which is the
spot rate at that time.
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 Forward Exchange Rates and Transactions
 Forward Exchange Rates are the current
estimates of future exchange rates
 typically quoted for 15, 30, 90, or 180 days into the
future.
 determined by the expected future demand and
supply of a currency.

 Forward transactions - executing a currency

exchange at some specific future date but at a
currently specified forward exchange rate.
 frequently used to hedge against currency
movement risks.

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Hedging Through Forward Transaction:
Illustration
 A US firm imports PC’s (at ¥120,000) from a Japanese
supplier and expects to sell them at $1200. The firm needs
to pay (in ¥) in 30 days when the shipment arrives.
 Suppose current spot exchange rate (on Day 1) is $1 = ¥120 =>
Current expected cost = $1000 (¥120,000 / ¥120)
 But the firm has to wait till it secures payment for the
computers in order to pay the supplier.
 Suppose there is an unanticipated depreciation in the value
of US$ and after 30 days $1 = ¥95!
 Without Forward Transaction
 After 30 days when the shipment arrives, the US firm pays
¥120,000 (or $1263) to the Japanese supplier.
 Unexpected loss of $63/computer
 With Forward Transaction
 Suppose the 30-day forward exchange rate is $1 = ¥110
 On Day 1, the US firm enters into a 30-day forward
exchange contract at $1 = ¥110.
 After 30 days when the shipment arrives, the US firm pays
¥120,000 (or $1090) to the Japanese supplier.
 Profit = $110/computer
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Foreign Exchange Swap Transactions (FX Swap)
 FX Swap
 The simultaneous purchase and sale of a given
amount of foreign exchange for two different
value dates.
 Examples of FX swap
 spot against forward
 forward against forward

 FX swaps are desirable to protect against the

foreign exchange risk, that arises when one
needs to take a position on a foreign currency
for a limited period of time.
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FX Swap Illustration: Spot against Forward
 Swiss national on a one-year transfer to HK office -
wants to live in the convenient company apartment.
 Firm gives her two options:
 Rent the apartment for HK$400,000/year, OR
 Buy the apartment for HK$5m and then resell to
company for $5m after a year.
 Suppose interest rate on a 1 year $5m loan in HK =
10% p.a.
 If she takes the loan, interest cost = 10% of $5m =
$500,000 > Rent
 Suppose interest rate in Switzerland on loan is 5%
 Assume current spot exchange rate is 1CHF = 5HKD.
Then, borrow CHF1m (= $5m) and pay interest cost =
5% of CHF1m = CHF 50,000 = $250,000 < rent
 => Borrow money in Swiss Francs (CHF)!
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FX Swap Illustration: Spot against Forward
 But what about future currency risk?
 SUPPOSE future spot rate after one year is 1CHF =
5.2HKD.
 After a year she needs to pay CHF 1.05m =$5.46m.
 => pay extra ($5.46m-$5m) = $460,000 which is > rent
(Currency movement risk)
 Suppose one year forward exchange rate is 1CHF =
5.1HKD.
 => take loan in Swiss Francs and enter into a FX SWAP
 Convert CHF 1m into $5m spot transaction (at 1CHF =
5HKD)
 Make ONE year forward transaction of $5.355m into CHF
1.05m (at 1CHF = 5.1 HKD)
 => With FX swap, net cost of owning apartment =
$355,000 < RENT
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Foreign Exchange Market: Composition of Turnover

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Economic Theories of Exchange Rate
Determination
 The main factors that have an important
impact on future exchange rate movements
are:
 Inflation
 InterestRates
 Investor Psychology

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Fundamental Factors Affecting Exchange
Rate Movements
 Inflation or changes in price level is related to
exchange rate movements through
 The Law of One Price
 Purchasing Power Parity (PPP) Theory
 Money Supply and Price inflation
 Interest rate and exchange rates are linked
through
 International Fisher Effect
 which determines the relationship between interest rates
and exchange rates
 Investor Psychology
 Exchange rate movements, especially in the short-run
are affected by investor psychology through
“bandwagon” effects.
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Exchange Rate Movements: Law of One Price
 In competitive markets where transportation costs
are assumed to negligible and there are no trade
barriers, Law of One Price states that:
 Identical products sold in different countries must
sell for the same price when their price is expressed
in terms of the same currency.
 If exchange rates are flexible, then we will expect the
exchange rates to adjust in order to equalize prices.
 If exchange rates are fixed, then we will expect prices
itself to adjust.

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 Illustration of Law of One Price
Example (Flexible Exchange Rates): £1 = $1.50. A phone selling for
$75 in New York should sell for £50 in London ($75/1.50)
• If the phone costs £40 in London
→ Convert $60 to get £40 in order to buy a phone in London and sell
in New York for $75 => Profit of $15 per phone (arbitrage opportunity)
→ Increased demand for £ would raise its price
→ Increased supply for $ would lower its price
This exchange rate movement will continue until prices are equalized:
i.e. £1 = $1.875 (£40 in London and $75 in New York)
Example (Fixed Exchange Rates) : £1 = $1.50. A phone selling for
$75 in New York should sell for £50 in London ($75/1.50)
• If the phone costs £40 in London
→ Convert $60 to get £40 and buy a phone in London. Sell it in New
York for $75 => Profit of $15 per phone (arbitrage opportunity)
→ Increased demand in London would raise their price
→ Increased supply in New York would lower their price
This price movement will continue until prices are equalized:
e.g. £44 in London and $66 in New York (at £1 = $1.50)
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Exchange Rate Movements: Purchasing
Power Parity (PPP) Theory
 In relatively efficient markets, a ‘basket of similar
(tradable) goods’ in different countries should cost
roughly equivalent (follows from law of one price)
 Illustration: If a basket of goods costs $200 in US and ¥20,000 in
Japan PPP theory predicts that the $/ ¥ exchange rate should be
$200/ ¥20,000 or $0.01/ ¥ (or $1 = ¥100)
 Implication of PPP Theory

Possible to determine the

By comparing the prices ‘real’ or PPP exchange rate –
of identical products in if law of one price was true
different currencies for all
goods and services

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Implication of PPP based Exchange Rates
 How do we compare living standards of people
across countries?
 Most common: Use GDP per capita
 Need to convert to a common currency (usually $)
 Exchange rate for conversion?
 Market exchange rates don’t reflect true
purchasing power of currency across countries
 market exchange rates are based on tradable
goods, services and assets
 Need a purchasing power corrected exchange
rate (i.e. PPP based rate)
 https://www.worldometers.info/gdp/gdp-per-capita/
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Big Mac Index: An example of an informal
“PPP” based Exchange Rate

 Big Mac index is based on the

notion that a given amount of
any currency (say US$) should
buy the same amount of Big
Mac burgers in all countries.
 The Big Mac index uses
McDonald's Big Mac as the
"basket” of identical goods
 Comparing actual exchange
rates with PPP based ones, like
Big Mac index, gives an
indication of whether a currency
is under- or overvalued.
 Big Mac Index
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Discussion Question: Big Mac Index
 Suppose a Big Mac burger is HK$20 (in Hong
Kong) and US$4 (in US). Assume 1US$ = 8
HK$. According to the Big Mac Index, does
the actual exchange rate of HKD/USD over-
or under- valued and by what %?

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PPP Theory: Prices and Exchange Rates
 PPP Theory postulates that changes in relative prices
will result in a change in exchange rates
 A country with high inflation should expect its currency
to depreciate against the currency of a country with a
lower inflation rate
 Example:
 A basket of goods costs $200 in US and ¥20,000 in Japan
=> $1 = ¥100 by PPP
 No price inflation in US but 10% in Japan => the basket of
good in Japan will cost ¥22,000 in future.
 If there is no change in future exchange rate then PPP is
violated
 Therefore for PPP theory to hold => $1 = ¥110 in future, i.e.
¥ has depreciated by 10% against $
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Exchange Rate Movements: Money Supply and
Price Inflation
 According to quantity theory of money (QTM),
inflation occurs when:
 money supply increases faster than increase in
output.
 PPP Theory tells us that:
 a country with a relatively high inflation rate will
experience depreciation of its currency
 Therefore, QTM and PPP theory together imply
that:
 a currency will depreciate against currencies of other
countries which have relatively slower monetary
growth.
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Factors behind Departure from PPP Theory
 Empirical testing of the PPP theory indicates that it is
not completely accurate in estimating exchange rate
changes in the short run, but is relatively accurate in
the long run.
 In real life departure from the predictions of PPP
theory are most commonly due to:
 Transportation costs and trade restrictions
 Non-tradable goods
 E.g. of non-tradable goods: haircuts, dining in restaurants etc.
Example: Haircuts in India
 Menu costs
 costs to firms of updating menus, price lists, brochures, and
other materials when prices change in an economy leading to
“sticky” prices
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Exchange Rate Movements: Interest Rates and
Exchange Rates
 Interest rates affect expectations about future
exchange rates.
 Fisher Effect states that:
 nominal interest rate (i) is the sum of real interest
rate (r) and expected rate of inflation (I)
 i.e., i = r + I => r = i - I
 In the long-run, real interest rates in different
countries gets equalized over time
Illustration: If r in US = 10% and r in Switzerland = 6%, investors
would borrow from Switzerland and then put it in US:
=> (I) Demand for loanable funds in Switzerland increases
→ real interest rate in Switzerland rises
=> (II) Supply of loanable funds in US increases
→ real interest rate in US falls
=> Real interest rates in US and Switzerland are equalized
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Exchange Rate Movements: Interest Rates
and Exchange Rates
 PPP Theory provides linkage between inflation and exchange
rates
 Fisher Theory provides link between interest rates and
inflation
 => PPP + Fisher Theory = International Fisher Theory
provides a link between interest rates and exchange rates
 Since interest rates reflect expectations about inflation, it follows
that there must also be a link between interest rates and
exchange rates

International Fisher Effect: Demonstrates the

linkage between interest rates and exchange rates

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Exchange Rate Movements: International
Fisher Effect
 International Fisher Effect Example: Suppose the nominal
interest rate is 10% in US and 6% in Japan. If the currently
1$ = 100¥, determine the future rate between dollar and yen.

 From Fisher effect we have

For US: 10 = r$ + I$ => r$ = 10 - I$
For Japan: 6 = r¥ + I¥ => r¥ = 6 - I¥
 Real interest rate must be the same in all countries, hence r$ = r¥
=> 10 - I$ = 6 - I¥
=> I$ - I¥ = 4
 US should expect a inflation rate 4% higher than Japan. But
according to PPP theory a country with a 4% higher relative
inflation rate should expect a 4% depreciation in it’s
currency.
 Therefore we should expect a 4% depreciation in $ with
respect to ¥, i.e. 1$ = 96¥ in the future.

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Exchange Rate Movements: Investor
Psychology and Bandwagon Effects
 Evidence suggests that neither PPP Theory nor International
Fisher Effect are really good at explaining short-term movements
in exchange rates.
 One possible explanation is:

Investor Psychology Bandwagon Effect

or Sentiments

 Bandwagon Effect
 Occurs when expectations on the part of traders turn into self-
fulfilling prophecies and creates a bandwagon which other
traders join.
 As the bandwagon effect builds up it further strengthens the
initial effect and moves exchange rates based on those initial
expectations.
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Exchange Rate Movements: Bandwagon Effects
 The underlying cause behind the creation of
bandwagon effects are expectations of traders that turn
into self-fulfilling prophecies
 Self-fulfilling prophecies are expectations such that
acting on them brings those expectations to reality, even
though they might have been erroneous to begin with.
 Example: Investors moved in a herd in response to a bet
placed by George Soros who shorted the British pounds
and bought German marks.
 It is hard to predict investor psychology leading to
bandwagon effect.
 Sometimes, government intervention can prevent the
bandwagon from starting, but at other times it is
ineffective and only encourages traders to further speculate.

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Managerial Implications
 International businesses face three important types of exposure to
exchange rate volatility and uncertainty that affects their
profitability
 Transaction Exposure
 The extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values.
 Can lead to a real monetary loss
 Translation Exposure
 The impact of currency exchange rate changes on the reported
financial statements of a company, as it impacts the present
measurement of past events.
 Gains and losses from translation exposure are reflected only on paper
 Economic Exposure
 The extent to which a firm’s future international earning power is
affected by changes in exchange rates
 Concerned with the long-term effect of changes in exchange rates on
future revenues and costs
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Managerial Implications
 In the short-term managers can protect themselves
from translation and transaction exposure
 By hedging through forward market transactions and
currency swaps.
 Through lead and lag strategies.
• paying suppliers and collecting payment from customers
early or late depending on expected exchange rate
movements
 In the longer-term managers can protect themselves
from economic exposure by
 dispersing production to different locations
 diversifying their revenues by tapping into
markets in different countries
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 Summary
In this topic we have
✓ Described the functions of the foreign exchange market.
✓ Understood what is meant by spot exchange rates.
✓ Recognized the role that forward exchange rates play in
forward transactions and currency swaps.
✓ Examined the role of forward transactions and currency
swaps in insuring against foreign exchange risk.
✓ Understood the different theories explaining how currency
exchange rates are determined and their relative merits.
✓ Compared and contrasted the differences among
translation, transaction, and economic exposure, and what
managers can do to manage each type of exposure.