International Business 7eby Charles W.L. HillMcGraw-Hill/Irwin Copyright 2009 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter 9 The Foreign Exchange Market9-3Introductionv A firms sales, profits, and strategy are affected by events in the foreign exchange market v The foreign exchange market is a market for converting the currency of one country into that of another country v The exchange rate is the rate at which one currency is converted into another9-4The Functions Of The Foreign Exchange MarketThe foreign exchange market: v is used to convert the currency of one country into the currency of another v provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)9-5Currency ConversionInternational companies use the foreign exchange market when: v the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies v they must pay a foreign company for its products or services in its countrys currency v they have spare cash that they wish to invest for short terms in money markets v they are involved in currency speculation (the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates)9-6Insuring Against Foreign Exchange Riskv The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm) v A firm that insures itself against foreign exchange risk is hedging 9-7Insuring Against Foreign Exchange Riskv The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day v Spot rates change continually depending on the supply and demand for that currency and other currencies 9-8Classroom Performance SystemThe _ is the rate at which one currency is converted into another.a) Exchange rateb) Cross ratec) Conversion rated) Foreign exchange market9-9Insuring Against Foreign Exchange Riskv To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges v A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future v A forward exchange rate is the rate governing such future transactions v Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future9-10Insuring Against Foreign Exchange Riskv A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates v 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 9-11The Nature Of The Foreign Exchange Marketv The foreign exchange market is a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systemsit is not located in any one place v The most important trading centers are London, New York, Tokyo, and Singapore v The markets is always open somewhere in the worldit never sleeps9-12The Nature Of The Foreign Exchange Marketv High-speed computer linkages between trading centers around the globe have effectively created a single market there is no significant difference between exchange rates quotes in the differing trading centers v If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage (the process of buying a currency low and selling it high), and the gap would close v Most transactions involve dollars on one sideit is a vehicle currency along with the euro, the Japanese yen, and the British pound9-13Classroom Performance SystemThe _ is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.a) Currency swap rateb) Forward ratec) Specific rated) Spot rate9-14Economic Theories Of Exchange Rate Determinationv Exchange rates are determined by the demand and supply for different currencies.Three factors impact future exchange rate movements: v a countrys price inflation v a countrys interest rate v market psychology 9-15Prices And Exchange Ratesv The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency v Purchasing power parity (PPP) theory argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist)