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The Foreign Exchange Market (How Are Exchange Rates Determined?…
The Foreign
Exchange Market
Do Exchange Rates Differ
Between Markets?
High-speed computer linkages between
trading centers --> no significant difference
not essentially the same --> there would be an opportunity for arbitrage
Most transactions involve dollars on one
side—it is a vehicle currency
How Are Exchange Rates
Determined?
Determined by the
demand and supply for different
currencies
Three factors
A country’s price inflation
A country’s interest rate
Market psychology
law of one price
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
Purchasing power parity theory (PPP)
given relatively efficient markets
the price of a “basket of goods” should be roughly equivalent in each country
A positive relationship exists between the
inflation rate and the level of money supply
PPP theory suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run
International Fisher Effect
[(S1 - S2) / S2 ] x 100 = i $ - i ¥
Bandwagon effect
when expectations on the part of traders turn into selffulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations
Forecasting
Should?
Efficient market school
Prices reflect information
Should not waste money on forecasting services
Inefficient market school
Prices do not reflect information
Forecasting services is not good
How?
Fundamental analysis (economic factors)
Technical analysis
(past trends and waves)
Currencies Convertible
Freely convertible
Purchase unlimited amounts of foreign with the domestic currency
Restrict amount of money can be converted
Externally convertible
Non-residents can convert currency
residents is limited
Preserve foreign exchange reserves
prevent capital flight
Nonconvertible
Prohibited from converting
Countertrade
Why is it important?
convert the currency
provides some insurance against foreign exchange risk
exchange rate
When use?
receive the payments or the income
pay a foreign company for products or services
they have spare cash that they wish to invest for short terms in money markets
currency speculation
Exchange rate mean for manager
Transaction exposure
Translation exposure
Economic exposure
Managers minimize exchange rate risk
Buy forward
Use swaps
Lead and lag payables and receivables
Minimize exchange rate risk
Lead strategy
Lag strategy
Hedge Against Foreign Exchange Risk
FEM provides insurance to protect against foreign exchange risk
hedging
Spot Rates & Forward Rates
spot exchange rate
forward exchange rate
Currency Swap
what?
simultaneous purchase
sale of foreign exchange
Swaps are transacted
international businesses & their banks
banks
governments
The nature
a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems