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Why Convert Currency?
Payments may be made in a foreign currency.
Purchases may have to be paid in the supplier’s currency.
Company may want to invest in a country. Currency Speculation
© McGraw Hill Companies, Inc., 2000 9-2
Foreign Exchange (Fx)
A commodity that consists of currencies issued by countries other than one’s own.
© McGraw Hill Companies, Inc., 2000 9-3
Foreign Exchange Exposure
EconomicEconomic The objective is to anticipate and
influence the effect of unexpected
changes in exchange rates on a firm's
future cash flows
Arises when payments must be
made or received in a foreign currency
TransactionTransaction
Arises from consolidating assets and
liabilities measured in foreign currencies
with those in the reporting currency
TranslationTranslation
© McGraw Hill Companies, Inc., 20009-4
© McGraw Hill Companies, Inc.,2000
Exchange Market/Exchange Rate
The Foreign Exchange Market: a market for converting the currency of one country into the currency of another country.
An Exchange Rate: is the rate at which one currency is converted into another.
9-5
Functions of the Foreign Exchange Market
Two functions: Converting currencies Reducing risk
© McGraw Hill Companies, Inc., 2000 9-6
Currency Risk
In every international transaction there is a currency risk that runs from the date of contract to date of payment.
Currency exchange rates are continuously changing.
© McGraw Hill Companies, Inc., 2000 9-7
Reducing Risk
Spot Exchange Rates: when two parties agree to exchange currency and execute the deal immediately.
Forward Exchange Rates: when two parties agree to exchange currency and execute the deal at some specific future date.
Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
© McGraw Hill Companies, Inc., 2000 9-8
Foreign Exchange Transactions April 1995
(Percent)
55
14
34
11
Spot Other Swaps Forward
© McGraw Hill Companies, Inc., 2000 9-9
Figure 9.1 in text
© McGraw Hill Companies, Inc.,2000
The Hierarchy of International Financial Centers
Note: Size of dots (squares) indicates cities’ relative importance
São PauloRio de Janiero
MexicoCity
SanFrancisco New
York
Toronto
Bombay
Melbourne
Sydney
Tokyo
Hong Kong
Singapore
London
Paris ZurichFrankfurt
Amsterdam
ViennaMadrid
HamburgDusseldorf
RomeBasel
Brussels
Chicago
9-10
Share of Global Foreign Exchange Trading Accounted for by London,
New York, and Tokyo
Other38%
Tokyo12%
New York19%
London31%
© McGraw Hill Companies, Inc., 2000 9-11
© McGraw Hill Companies, Inc.,2000
Fx Market Turnover in Major Centers
050
100150200250300350400450500
Paris Zurich Singapore New York
Apr-89Apr-92Apr-95
9-12Figure 9.2
© McGraw Hill Companies, Inc.,2000
Trading Hours of the World’s Major Financial Centers
New York
San Francisco
London
BahrainTokyo
Hong Kong
Singapore
11 10 9 8 7 6 5 4 3 2 1 0 1 2 3 4 5 6 7 8 9 10 11 12
9-13
Economic Theories
At lowest level = supply/demand. Law of One Price and Purchasing
Power Parity. Interest rates. Investor psychology.
© McGraw Hill Companies, Inc., 2000 9-14
© McGraw Hill Companies, Inc.,2000
Law of One Price
In competitive markets free of transportation costs and barriers to trade (tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.
Example: US/French exchange rate: $1 = FFr 5. A jacket selling for $50 in New York should retail for for FFr 250 in Paris (50x5)
9-15
© McGraw Hill Companies, Inc.,2000
Purchasing Power Parity
By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient.
In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country
9-16
The Big Mac IndexPurchasing Power Parity: 1995
United States $ 2.32 (average) - - - - - - - - - - - -
Switzerland SwFr 5.90 2.54 1.13 +124
Argentina Peso 3.00 1.29 1.00 + 29
France FFr 18.50 7.97 4.80 + 66
Japan ¥ 391 169.00 84.20 +100
Brazil Real 2.42 1.04 .90 +16
Canada C $ 2.77 1.19 1.39 - 14
Hong Kong HK $ 9.50 4.09 7.73 - 47
Russia Ruble 8,100 3,491.00 4,985.00 - 30
Price inLocal
Currency
ImpliedPPP of the
Dollar
ActualExchange
Rate
Local Currency% Over(+)or Under(-)Valuation
Against Dollar†
† As of 4/15/95© McGraw Hill Companies, Inc., 2000 9-17
Japanese Big Mac Valuation (Yens Over (+) or UNDER (-) Valuation Against the
Dollar)
-40
-20
0
20
40
60
80
100
120
1989 90 91 92 93 94 95 96 97 98
Percent
© McGraw Hill Companies, Inc., 2000 9-18
East Asian Big Mac Valuation
-70
-60
-50
-40
-30
-20
-10
0
10
20
30
1993 94 95 96 97 98 S. KoreaThailandIndonesiaMalaysia
© McGraw Hill Companies, Inc., 20009-19
Inflation and the Money Supply
45
40
35
30
25
20
15
10
5
00 5 10 15 20 25 30 35 40 45 50
Turkey
Ecuador
Poland
ColombiaChina
Portugal
Great Britain
United States
Japan
Growth in moneysupply,1985 -1989 %
Consumer prices, 1984 - 1989 (%)
© McGraw Hill Companies, Inc., 2000 9-20
Exchange Rate Forecasting Efficient market: where prices reflect all
available public information. Forward exchange rates reflect market participant’s
collective predictions of likely spot exchange rates at specified future dates.
Inefficient market:where prices do not reflect all available information. Forward exchange rates are not the best predicators of future spot exchange rates. Use fundamental or technical analysis to predict the exchange
rates.© McGraw Hill Companies, Inc., 1999 9-21
Factors Influencing Currency ValueEconomic Factors
1. Balance of Payment
2. Interest Rates
3. Inflation
4. Monetary and Fiscal Policy
5. International Competitiveness
6. Monetary Reserves
7. Government Controls and Incentives
8. Importance of Currency in World
Political Factors
9. Political Party and Leader Philosophies
10. Proximity of Elections or Change in Leadership
Expectation Factors
11. Expectations
12. Forward Exchange Market Prices© McGraw Hill Companies, Inc., 1999 9-22