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MGT 302 Chapter 10

VW, Subaru, and Embraer
Hurt or Helped?
VW: Hurt, lost 1.2 billion euros because the euro went up. Failed to hedge foreign exchange risk (40%)
Subaru: Helped because the yen went down. Subaru continued to export in japan and therefore made their exports cheap in US
Embraer: Hurt because they’re selling their plants for dollars.
Foreign Exchange Market
A market for converting the currency of one country into that of another country
2 main functions of Foreign Exchange Market
1. Convert currency
2. Hedge (insurance) against foreign exchange risk
4 main uses by international business for foreign exchange market
1. Payments for exports and imports are in foreign currencies
2. Must pay products or services in foreign currency
3. Spare cash to invest for short term in money markets
4. Currency Speculation: short-term movement of funds from one currency to another
Spot Exchange Rate
Foreign exchange dealer converts one currency into another on a particular day
Spot Exchange rates can be quoted in 2 ways
1. The amount of foreign currency in one U.S. dollar
2. The value of a dollar for one unit of foreign currency
To insure or hedge against spot exchange rates
Forward exchange rates
Forward Exchange rates
Two parties agree to exchange currency and execute the deal at some specific date in the future
– Quoted 30, 90, and 180 days into the future
Dominate location of foreign exchange market?
London
Selling at a discount?
In the future. Worth less than on the sport market.
Selling at a premium?
Will be more worthy later on. Worth more than on the spot market
Currency Swap
Purchase and sale of a given amount of foreign exchange for two different value dates
-Swap the currency
Spot against forward
Enables a company to ensure itself against foreign exchange risk
-A common kind of swap.
Exchange rate determined by…?
Supply and demand of one currency relative to the demand and supply of another
Law of one price
Identical products when expressed in different currencies must have sell for the same price in terms of the same currency even if its not the case
International Fisher Effect
For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in normal interest rates between the two countries
Fisher Effect
Strong relationship between inflation rates and interest rates
Purchasing Power Parity
-Rate could be found from any individual set of prices
-Changes in relative prices will result in a change in exchange rates
– When the growth in a country’s money supply is faster than the growth in its output, price infliction is fueled
Big Mac Index
The price of a big mac in two markets compared with the dollar
– “Basket of goods”
– average of two markets/big mac in US
– Over 1: overvalued
-Under 1: under value
Exchange Rate Forecasting
Companies need to predict future exchange rate variations raises the issue of whether it is worthwhile for the company to invest in exchange rate forecasting services to aid decision making.
Efficient Market (School)
One in which prices reflect all available public information
Inefficient Market (School)
One in which prices do not reflect all available information
Fundamental Analysis
Construct econometric models for predicting exchange rate movements
Ex. Relative money supply growth rates, inflation rates, and interest rates
Technical Analysis
Price and volume data to determine past trends, which are expected to continue into the future.
– Gained favor in recent years
Freely Convertible currency
Country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it
Externally convertible Currency
Only nonresidents may convert it into a foreign currency without any limitations
Nonconvertible currency
Neither residents nor nonresidents are allowed to convert into a foreign currency
Transaction Exposure
Extent to which the income for individual transactions is affected by fluctuations in foreign exchange values
Translation Exposure
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
Lead strategy
Collect early before it depreciates
Lag strategy
Collect later when it appreciates

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