➔ Review

◆ One function of the foreign exchange market is to convert the currency of one
country into the currency of another. The exchange rate allows individuals to
compare the relative prices of goods and services in different countries.
● The exchange rate allows us to compare the relative prices of goods and
services in different countries. In doing so, the foreign exchange market is
the mechanism that transfers purchasing power from one country to
another.
● Also when they want to make investments in another country
● Henry from Washington D.C. has returned from his trip to Europe. He has
81 € that he wants to exchange back to US-dollars. He goes into a bank in
Washington.
○ At the time being the exchange rate of euro is 137.51.
○ How many US-dollars will he get, if we pretend that there is no
exchange fee?
○ (The exchange rate of US-dollars is 100)
{81*137.51}{100}=111.38
◆ The second function of the foreign exchange market is to provide insurance against
foreign exchange risk.
● Exchange Rate: The rate at which one currency is converted into
another.
○ Risk Speculation
◆ Spot Exchange:Exchange rate of one currency to another
on a particular day and is for delivery on the earliest value
date
● The term “Spot” signifies the current price
● Generally, the spot rate is set by the forex market,
but some countries actively set or influence spot
exchange rates.
● Currency traders follow spot exchange rates to
identify trading opportunities.

◆ Forward Exchange: When two actors agree to exchange

currency on a particular future date. A forward foreign
exchange is a contract to purchase or sell a set amount of
a foreign currency at a specified price for settlement at a
predetermined future date (closed forward) or within a
range of dates in the future (open forward). Contracts can
be used to lock in a currency rate in anticipation of its
increase at some point in the future. The contract is
binding for both parties.
 ● allowing you to protect costs on products and
services bought abroad; protect profit margins on
products and services sold overseas;

◆ SWAP Exchange: Simultaneous purchase of foreign

exchange for two different value dates
● Purpose is to hedge against foreign exchange risk
for a particular transaction at a specific time
● The purpose of engaging in a currency swap is
usually to procure loans in foreign currency at more
favorable interest rates than if borrowing directly in
a foreign market. In a currency swap, each party
continues to pay interest on the swapped principal
amounts throughout the length of the loan. When
the swap is over, principal amounts are exchanged
once more at a pre-agreed rate (which would avoid
transaction risk) or the spot rate.
◆ Fisher Effect
● C= r+I Nominal rate = real interest rate + inflation
◆ International Fisher Effect
● (S1-S2)/S2 x 100 = is-iy
● Begin rate - ending rate
◆ The law of one price is the economic theory that states the price of an identical
security, commodity or asset traded anywhere should have the same price
regardless of location when currency exchange rates are taken into
consideration, if it is traded in a free market with no trade restrictions. Basically,
an asset, security or commodity will have one price across markets, even when
taking into consideration the exchange rates. In efficient markets, the law of one
price should dominate. Ultimately, when the law of one price plays out correctly,
the result is purchasing power parity
◆ 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.
● When the law of one price works the way it should, buyers will have the same
purchasing power across markets, regardless of the currency or exchange rate.
● In practice, consumers across markets do not exactly have absolute purchasing
power parity.
● Some buyers are limited in their access to goods and services, and this makes
purchasing power parity very difficult to achieve in the real world.
➔ Approaches to forecasting
◆ Fundamental Analysis: method of evaluating securities by attempting to measure the
intrinsic value of a stock. Earnings, expenses, assets, and liabilities are all important
characteristics to fundamental analysts. Running a deficit on a balance-of-payments current
 account (a country is importing more goods and services than it is exporting) creates
pressures that may result in the depreciation of the country's currency on the foreign
exchange market
◆ Technical Analysis: Technical analysis differs from fundamental analysis in that the stock's
price and volume are the only inputs. based on the premise that there are analyzable market
trends and waves and that previous trends and waves can be used to predict future trends
and waves. The core assumption is that all known fundamentals are factored into price, thus
there is no need to pay close attention to them.

➔ Foreign Exchange Market : A market for changing or converting currency of one country
to another
◆ Currency Types
● USD, GBP, Euro, Yen, Peso, Real, Rand
◆ Exchange Rate: The rate at which one currency is converted into another
◆ Foreign Exchange Risk: The risk that changes in exchange rates will hurt the
profitability of a business deal
● What are some examples of foreign exchange risk in business
transactions?
○ Exporting/ Importing
○ FDI
● What are some examples of foreign exchange and the consumer market?
● Buying consumer goods in a foreign country as compared to your home
country
○ e.g. France and the UK with Wine, the US and the UK with
Clothes, Europe and Africa with Cars, etc.
◆ Currency Speculation: Short-term currency movements that take advantage of
currency valuations for a profit
● Arbitrage: Using overvalued currency to buy depreciated currency and
then reinvest in the overvalued currency once it depreciates in value
○ The purchase of securities in one market for immediate resale in
another to profit from a price discrepancy
● Other Types of Currency Speculation
 ○ Carry Trade: Taking advantage of the differentiation in interest
rates between currencies
◆ Hedging: Insuring against foreign exchange risk
● Tools such as forward exchange and currency swaps can be used to
protect against foreign exchange risk
◆ Spot Exchange Rate: Exchange rate of one currency to another on a particular
day
● The term “Spot” signifies the current price
◆ Forward Exchange: When two actors agree to exchange currency on a
particular future date.
◆ Forward Exchange Rate: The exchange of the forward exchange
◆ Currency Swaps: Simultaneous purchase of foreign exchange for two different
value dates
● Purpose is to hedge against foreign exchange risk for a particular
transaction at a specific time

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 the
following points:
1. One function of the foreign exchange market is to convert the currency of one country
into the currency of another. A second function of the foreign exchange market is to
provide insurance against foreign exchange risk.
2. The spot exchange rate is the exchange rate at which a dealer converts one currency into
another currency on a particular day.
3. 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.
4. 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.
5. 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.
a. yields relatively accurate predictions of long-term trends in exchange rates
b. The failure of PPP theory to predict exchange rate changes more accurately may be due
to 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.
6. 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.
 a. Interest rates reflect expectations about inflation. In countries where inflation is expected
to be high, interest rates also will be high.
7. 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.
8. 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.
9. Nonconvertibility of a currency 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.
10. The three types of exposure to foreign exchange risk are transaction exposure,
translation exposure, and economic exposure.
11. Tactics that insure against transaction and translation exposure include buying forward,
using currency swaps, and leading and lagging payables and receivables.
12. Reducing a firm's economic exposure requires strategic choices about how the firm's
productive assets are distributed around the globe.