This chapter explained how the foreign exchange market works, examined the forces that determine exchange rates, and then discussed the implications of these factors for international business. Given that changes in exchange rates can dramatically alter the profitability of foreign trade and investment deals, this is an area of major interest to international business. The chapter made these points:
One function of the foreign exchange market is to convert the currency of one country into the currency of another.
International businesses participate in the foreign exchange market to facilitate international trade and investment, to invest spare cash in short-term money market accounts abroad, and to engage in currency speculation.
A second function of the foreign exchange market is to provide insurance against foreign exchange risk.
The spot exchange rate is the exchange rate at which a dealer converts one currency into another currency on a particular day.
Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate is an exchange rate governing future transactions.
Foreign exchange risk can also be reduced by engaging in currency swaps. A swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
The law of one price holds that in competitive markets that are 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 the same currency.
Purchasing power parity (PPP) theory states the price of a basket of particular goods should be roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative prices change.
The rate of change in countries' relative prices depends on their relative inflation rates. A country's inflation rate seems to be a function of the growth in its money supply.
The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. The failure of PPP theory to predict exchange rate changes more accurately may be due to the existence of transportation costs, barriers to trade and investment, and the impact of psychological factors such as bandwagon effects on market movements and short-run exchange rates.
Interest rates reflect expectations about inflation. In countries where inflation is expected to be high, interest rates also will be high.
The 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.
The most common approach to exchange rate forecasting is fundamental analysis. This relies on variables such as money supply growth, inflation rates, nominal interest rates, and balance-of-payments positions to predict future changes in exchange rates.
In many countries, the ability of residents and nonresidents to convert local currency into a foreign currency is restricted by government policy. A government restricts the convertibility of its currency to protect the country's foreign exchange reserves and to halt any capital flight.
Particularly bothersome for international business is a policy of nonconvertibility, which prohibits residents and nonresidents from exchanging local currency for foreign currency. A policy of nonconvertibility makes it very difficult to engage in international trade and investment in the country.
One way of coping with the nonconvertibility problem is to engage in countertrade—to trade goods and services for other goods and services.
The three types of exposure to foreign exchange risk are transaction exposure, translation exposure, and economic exposure.
Tactics that insure against transaction and translation exposure include buying forward, using currency swaps, leading and lagging payables and receivables, manipulating transfer prices, using local debt financing, accelerating dividend payments, and adjusting capital budgeting to reflect foreign exchange exposure.
Reducing a firm's economic exposure requires strategic choices about how the firm's productive assets are distributed around the globe.
To manage foreign exchange exposure effectively, the firm must exercise centralized oversight over its foreign exchange hedging activities, recognize the difference between transaction exposure and economic exposure, forecast future exchange rate movements, establish good reporting systems within the firm to monitor exposure positions, and produce regular foreign exchange exposure reports that can be used as a basis for action.
