Foreign Exchange Markets

Question 1

What is the purpose of the forex market and what is unique about it?

Answer 1

• Used to convert the currency of one country into the currency of another
• Provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates
• 24/7

Question 2

What are the uses of the forex market for IB?

Answer 2

• Convert foreign earnings and profits
• Pay foreign companies
• Conversions for short term investments in money markets
• Currency specualtion
  
  • Carry trade - involves borrowing in one currency where interest rates are low and then using the proceeds to invest in another currency where they are high

Question 3

What kinds of exchange rates are there?

Answer 3

• Spot exchange rate

* Forward exchange rate

Question 4

What is a spot exchange rate?

Answer 4

• The rate at which a foreign exchange dealer converts one currency into another on a particualr day
• Change continually depending on the supply and demand for that currency and other currencies

Question 5

What is a forward exchange rate?

Answer 5

• To insure or hedge against a possible adverse foreign exchange movement, firms engage in forward exchanges
• Two parties agree to exchange currency and execute the deal at some specific date in the future
• The forward exchange rate is the rate used for these transactions
• Typically quotes 30, 90 or 180 days into the future

Question 6

What factors impact future exchange rate movements?

Answer 6

• Country’s price inflation
• Country’s interest rate
• Market psychology

Question 7

How does a country’s price inflation affect future exchange rate movements?

Answer 7

• Law of on price
• PPP
• High inflation = currency depreciation

Question 8

What is the law of one price?

Answer 8

• Competitive markets: identical products sell in different markets for the same price when price is expressed in the same currency
• Arbitrage insures this

Question 9

What is PPP?

Answer 9

• Argues that given relatively efficient markets, the price of a basked of goods should be roughly equivalent in each country
• Changes in relative price of two countries = changes in exchange rate
• Big Mac index
• Assumes away transport costs and barriers to trade
• Will not hold if many national markets are dominated by a handful of MNCs that are price makers to any degree to if government is involved

Question 10

How does a country’s interest rate affect future exchange rate movements?

Answer 10

• International Fisher Effect
  
  • States that 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 two countries
  • When investors are free to trade transfer capital between countries, the real interest rate will be the same in every country - arbitrage will equalise
  • It follows that if the real interest rate if the same worldwide, any differences in rates between countries will reflect differing expectations about inflation rates

Question 11

How does market psychology affect future exchange rate movements?

Answer 11

• Bandwagon effect occurs when expectations on the part of traders turns into self-fulfilling prophesies - traders can join the bandwagon and move exchange rates based on group expectation
• Few players know everything
• Players watch each other
• Uncertainty = euporhia/panic spreads quickly
• Financial crises - lessons from history

Question 12

What is true of price inflation and interest rates in predicting future exchange rate movements?

Answer 12

Theory of PPP and the Fisher effect are poor predictors of short-term change in exchange rates

Question 13

What are the schools of though regarding forecasting?

Answer 13

• Efficient market school

* Inefficient market school

Question 14

What is the efficient market school?

Answer 14

• Prices reflect all available info on public domain
• Forward rates represent market participants collective predictions of likely spot exchange rates at specified future dates - will be unbiased if exchange market is efficient, though not always accurate

Question 15

What is the inefficient market school?

Answer 15

Prices do not reflect all available info on public domain - information asymmetry

Question 16

What are the approaches to forecasting future exchange rate movements?

Answer 16

• Fundamental analysis
  
  • Predictions using economic models on economic theory, B.O.P., inflation, i/r
• Technical analysis
  
  • Extrapolcaiton/interpretaion of past trends assuming they predict future movements
  • Fortune telling
• Professional forecasters are not better than forward exchange rates in predicting future spot rates

Question 17

What is a currency swap and who are the parties to it?

Answer 17

• The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
• Parties
  
  • International business and their banks
  • Banks
  • Governments

Question 18

What is currency hedging?

Answer 18

• Insuring against losses

- Adverse variations in spot exchange rates

Question 19

Why do firms use hedging instruments?

Answer 19

• Reduce exposure to risk associated with transfer of funds

- Protect themselves in credit transactions with time late between invoicing and receipt

Question 20

How do firms hedge against exchange rate risk?

Answer 20

• Forward exchange rates

- Currency swaps

Question 21

What is currency arbitrage and who are the players?

Answer 21

• Simultaneous purchase and sale of a currency in different markets
  
  • High speed computer linkages between trading centres mean there is no significant difference between exchange rates in the different trading centres
• Players
  
  • FX traders
  • Large investors
• Allocation of forex where best rates can be had

Question 22

What is currency speculation?

Answer 22

• Purchase or sale of a currency with expectation that its value will change
• Hedge funds - manipulation of exchange rates

Question 23

What are the degrees of currency convertibility?

Answer 23

• Freely convetable
• Externally convertable
  
  • Only nonresidents may convert it without any limitations
• Nonconvertable
  
  • Neither residents nor foreigners are allowed to convert it

Question 24

Why could countries make currency’s not convertible?

Answer 24

• Save forex reserves for
  
  • Interest payments on foreign debt
  • Payments for imports
  • Protect against speculators
  • Prevent capital flight

Question 25

How do countries save forex reserves?

Answer 25

- Import licenses - Capital controls - Restrictions on repatriation of profits - Limitations for residents travelling abroad - Multiple exchange rates - Import deposit requirements - Quantity restrictions

Question 26

What is countertrade?

Answer 26

Barter like agreements to overcome currency nonconvetablilty

Question 27

What are the exposures of exchange rates to businesses?

Answer 27

* Transaction exposure * Translation exposure * Economic exposure

Question 28

What is transaction exposure?

Answer 28

The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

Question 29

What is translation exposure?

Answer 29

- The impact of currency exchange rate changes on the reported financial statements of a company - Concerned with the present measurement of past events - The resulting accounting gains or losses are said to be unrealised - they are paper gains and losses, but still important

Question 30

What is economic exposure?

Answer 30

- The extent to which a firm’s future international earning power is affected by changes in exchange rates - Concerned with the long run effect of changes in ex rates on future prices, sales and costs

Question 31

How can transaction and translation exposure be minimised?

Answer 31

- Buy forward - Use swaps - Lend and lag payables and receivables

Question 32

What is a lead strategy and what is it used for?

Answer 32

- Attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate - To minimise transaction and translation exposure

Question 33

What is a lag strategy and what is it used for?

Answer 33

- Delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate - To minimise transaction and translation exposure

Question 34

What is true of leading and lagging strategies?

Answer 34

Can both be difficult to implement - must be in a position to excercise some control over payment terms

Question 35

How can economic exposure be minimised?

Answer 35

- Distribute productive assets to various locations so the firm’s long term financial well-being is not severely affected by changes in exchange rates - Ensure assets are not too concentrated in countries where likely rises in the currency’s values will lead to increases int he foreign prices of goods and services the firm producers