Chapter 10 The Foreign Exchange Market
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• A quote in American terms (US$/Fx) is always the reciprocal of a quote in European terms (Fx/US$).
$1.00/¥.009430 ¥106.04/$1.00
• Base currency: the quoted, underlying, or fixed currency
�Traders always quote:Base currency (the denominator) first, followed by the Terms currency (the numerator).
An example:Dollar-yen quote: dollar = base, yen = terms
Sep. 10, 2011 April 9, 2013¥76.78/$1.00 ¥99.13/$1.00
The dollar (base) strengthened; the yen (terms) weakened
American & European Terms
Direct and Indirect Quotes
"European Terms" - Foreign Currency Price per U.S. Dollar
European Terms were adopted in 1978
Used for MOST countries
Indirect Quote in the U.S = European Terms
Example – Euro 0.76/ 1 USD
"American Terms" - U.S. Dollar per Foreign Currency Price
Used for U.K. Pound Sterling
Direct Quote in U.S. = American Terms
Example - USD 1.30/ 1 Euro
The U.K. pound sterling for centuries was divided into 20 shillings, each of which had 12 pence. This non-decimal method was difficult to convert. The U.K. converted to decimals in 1971, but "American Terms" are still used.
Exchange ProblemForm Informal Groups
1. You have 2 buckets – 3 gallon bucket and 5 gallon bucketYou have infinite amounts of waterWhat will you do to measure exactly 4 gallons?
Solution
1. Fill the 5 gallon and empty into the 3 gallon (this leaves 2 gallons in the 5 gallon bucket)
2. Spill out the 3 gallon and fill the 3 gallon with the 2 gallons (from the 5 gallon bucket)
3. Fill the 5 gallon bucket and then fill the 3 gallon bucket (with an additional 1 gallon) from the 5 gallon bucket
4. The 5 gallon bucket now has 4 gallons in it
Exchange Rate Arbitrage – 3 Currencies
A. USD B. Vietnam Dong C. Argentine Peso(A to B)
1000 USD -> Vietnam Dong = 16,625,000 (@16.625)(B to C)
16,625,000 Vietnam Dong -> Argentine Peso = 3,027.5006125 (@0.0001821)(C to A)
3,027.5006125 Argentine Peso = 1000.0002USD (@0.3303)(A to C)
1000 USD -> Argentine Peso = 3,027.4999 (@3.0275)
(A to B)*(B to C) should = (A to C)(16.625)(0.0001821) = 0.0030274 – Yes = 0.0030275
Trade A for B, B for C and C for A is known as a currency cycle.
Most of the time all the exchange rates are synchronized Occasionally - out of sync (arbitrageurs can make a profit)
Want to be a Billionaire?
It depends on where …In Zimbabwe (2008-2009)
$100 billion will buy 3 eggs (2008)
Hyperinflation made Money meaningless(2008)
Zimbabwe
$100 trillion – largest bank note ever made (2008 in Zimbabwe)
“Inflation will increase when money supply growth exceeds the expansion of real economic activity …”Source: 2011 Annual Report, Federal Reserve Bank of Dallas
Current Situation – 2013 forecast …
Is the Global Economy on the Verge of Another Meltdown?
Global Economist speaks: FILM (10)
(PPP) – Purchasing Power Parity theory
� Theory states: In ideally efficient markets, identical goods should have only one price� More useful in comparing differences in living
standards
� PPP takes into account the relative cost of living
and the inflation rates of different countries (Not just GDP)
PPP – revisited (9/2008)
PPP – revisited (9/2008)
International Comparison Program, 2005 Round (PPP)
�Determine price levels within nations
�Direct price comparisonsof about 1,000 goods and services
�Number of participating countries has increasedfrom 118 in the previous round (1993) to 146 now
GDP versus PPP
Source: http://www.gapminder.org/world/
Look at the relationship between:- GDP (US$) vs.- GDP (PPP$)
Chart Explanation* 3 different slopes
Nominal Interest Rate – Intl Fisher Effect
Nominal Interest Rate
� Interest rate + Inflation (expected annual rate)
International Fisher Effect
�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
� In other words, if the nominal interest rate in one country is higher than another we expect the currency to depreciate
� In the long term – tends to be accurate
� In the short term – not accurate
Investment Returns?
European Euros/ Dollar
Month Year Rate
March 2004 0.815March 2005 0.758March 2006 0.814March 2007 0.755March 2008 0.644
Trends:
Nearly 21% depreciation (weakening) of US $, with a trend toward a weaker Dollar.
If we invested in bonds in Euros, factoring in interest rates AND currency fluctuation trends . . .
Approaches To Forecasting
Two schools of thought on forecasting:
�Fundamental analysis draw upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates
�Technical analysis charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves
Reducing Translation And Transaction Exposure
�A lead strategy involves attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate
�A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate
�Lead and lag strategies can be difficult to implement
The International Monetary System
Chapter 11
The Bretton Woods System
The Bretton Woods agreement (1944) established two multinational institutions:
�the International Monetary Fund (IMF) to maintain order in the international monetary system
�the World Bank to promote general economic development
A STRONG Dollar – (10/1/2016)
Dollar Strength – Film (11 min)
Please answer these questions while watching the film:
Consider a STRONG dollar
1. How does a strong dollar impact business?
2. How does the strong dollar affect consumers? In your opinion, is the strong dollar a good or bad thing?
FILM
Go to: http://instruction2.mtsac.edu/rjagodka
Click “International Business Resources” -> “Country Data” (first link on page)
ConsultaPedia.com – (1) Click on your assigned country
(2) Click on tabs for details about your country
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