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Chapter 10: The Foreign Exchange Market - Coggle Diagram
Chapter 10: The Foreign Exchange Market
Market for converting currency of one country into that of another country
Foreign Exchange Rate Risk
Translation exposure: The impact of currency exchange rate changes on the reported financial statements of a company.
Economic exposure: The extent to which a firm’s future international earning power is affected by changes in exchange rates.
Transaction exposure: The extent to which the income from individual transactions is affected by fluctuations in foreign exchange values.
Forward exchange: occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.
Functions
Convert the currency of one country into the currency of another
Provide some insurance against foreign exchange risk
Forward exchange rates: The exchange rate governing a forward exchange transaction
Money supply and price inflation
The growth rate of a country’s money supply determines its likely future inflation rate.
Inflation: money supply increases faster than output increases.
An increase in the money supply makes it easier to borrow, which increases demand for goods and services.
A country with a high inflation rate will see depreciation in its currency exchange rate.
A currency swap: The simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.
Forecasting
Fundamental Analysis
Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.
Technical Analysis
Uses price and volume data to determine past trends, which are expected to continue into the future
Currency convertibility
Externally convertible: Can limit domestic companies’ ability to invest abroad, but not foreign companies wishing to do business in that country
Nonconvertible: Not desirable for international business
Freely convertible:Not universal
The Fisher effect
Nominal interest rates (i) in each country equal the required real rate of interest (r) and the expected rate of inflation over the period of time for which the funds are to be lent (l). That is, i = r + l.
Reducing Translation and Transaction Exposure
Lead strategy: when a foreign currency is expected to depreciate and paying foreign currency payables before they are due when a currency is expected to appreciate.
Lag strategy Delaying the collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if that currency is expected to depreciate.