Chapter 10 The Foreign Exchange Market

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2 types of quotes:• American terms (US$/Fx)• European terms (Fx/US$) - reciprocal of

$1.00/¥.009430 ¥106.04/$1.00• Traders always quote:

Base currency - the quoted, underlying, or fixedcurrency (the denominator) first, followed by theTerms currency (the numerator).

An example:Dollar-yen quote (European Terms): dollar=base, yen=terms

Sep. 10, 2011 October 15, 2018¥76.78/$1.00 ¥111.82/$1.00

The dollar (base) strengthened; the yen (terms) weakened

American & European Terms

Direct and Indirect Quotes"European Terms" - Foreign Currency Price per U.S. DollarEuropean Terms were adopted in 1978 Used for MOST countries Indirect Quote in the U.S = European TermsExample – Euro 0.86/ 1 USD

"American Terms" - U.S. Dollar per Foreign Currency PriceUsed for U.K. Pound SterlingDirect Quote in U.S. = American TermsExample - USD 1.16/ 1 Euro

The U.K. pound sterling for centuries was divided into 20 shillings, each of which had 12 pence. This non-decimal method was difficult to convert. The U.K. converted to decimals in 1971, but "American Terms" are still used.

Exchange ProblemForm Informal Groups1. You have 2 buckets – 3 gallon bucket and 5 gallon bucket

You have infinite amounts of waterWhat will you do to measure exactly 4 gallons?

Exchange Rate Arbitrage – 3 CurrenciesA. USD B. Vietnam Dong C. Argentine Peso(A to B)

1000 USD -> Vietnam Dong = 16,625,000 (@16.625)(B to C)

16,625,000 Vietnam Dong -> Argentine Peso = 3,027.5006125 (@0.0001821)(C to A)

3,027.5006125 Argentine Peso = 1000.0002USD (@0.3303)(A to C)

1000 USD -> Argentine Peso = 3,027.4999 (@3.0275)

(A to B)*(B to C) should = (A to C)(16.625)(0.0001821) = 0.0030274 – Yes = 0.0030275

Trade A for B, B for C and C for A is known as a currency cycle.

Most of the time all the exchange rates are synchronized Occasionally - out of sync (arbitrageurs can make a profit)

How Companies Hedge Against Fx RiskPlease write:FILM1. Why would a firm use an Fx Forward contract?2. How does it work?

WINDOW FORWARDS If you are unsure of the exact date you will need funds or expect to

draw funds multiple times during the life of a contract, then windowforwards might be the best solution for you. Similar to fixed-dateforwards, window forwards allow you to buy or sell currency withdelivery for a time in the future, out to two years. However, instead ofone specific date, window forwards allow you to draw funds as often asyou like within a set timeframe. This gives you complete paymentflexibility to access your funds as they are needed without having tocommit to a specific date. The funds can be drawn at any point in thewindow or until the window forward is due on the settlement date.

Want to be a Billionaire? It depends on where …In Zimbabwe (2008-2009)

$100 billion will buy 3 eggs (2008)

Hyperinflation made money meaningless (2008)

Zimbabwe

$100 trillion – largest bank note ever made (2008 in Zimbabwe)

“Inflation will increase when money supply growth exceeds the expansion of real economic activity …”Source: 2011 Annual Report, Federal Reserve Bank of Dallas

In 2008 they declared inflation illegal –Raise your prices and go to jail …

Zimbabwe

Inflation 2017 back up to 348%/year (based on Old Mutual Implied Rate (OMIR)Official inflation rate is just: 2.68% (March 2018)What a difference …. (based on PPP stock exchange value)

GDP versus PPP

Source: http://www.gapminder.org/toolsGDP (PPP) > GDP (US$) can mean undervalued currency. GDP (PPP) < GDP (US$) can mean overvalued currency. But not always …

Look at the relationship between:- GDP (US$) vs.- GDP (PPP$)

Chart Explanation• 3 different

slopes

What Influences Exchange Rates?

FILM (2)

List and describe each of the 6 factors that influence exchange rates.Please be sure to describe each

Nominal Interest Rate – Intl Fisher Effect

Nominal Interest Rate Interest rate + Inflation (expected annual rate)International Fisher EffectThe spot exchange rate should change in an

equal amount but in the opposite direction to thedifference in nominal interest rates between twocountries

In other words, if the nominal interest rate in onecountry is higher than another we expect thecurrency to depreciate

In the long term – tends to be accurate In the short term – not accurate

Investment Returns? European Euros/ Dollar

Month Year RateMarch 2004 0.815March 2005 0.758March 2006 0.814March 2007 0.755March 2008 0.644

Trends:Nearly 21% depreciation (weakening) of US $, with a trend toward a weaker Dollar.

If we invested in bonds in Euros, factoring in interest rates AND currency fluctuation trends . . .

Approaches To Forecasting

Two schools of thought on forecasting:Fundamental analysis draw uponeconomic factors like interest rates,monetary policy, inflation rates, or balanceof payments information to predict exchangeratesTechnical analysis charts trends with theassumption that past trends and waves arereasonable predictors of future trends andwaves

Reducing Translation And Transaction Exposure

A lead strategy (Collect or Pay early …)Collect foreign currency receivables early when a foreigncurrency is expected to depreciate, and Paying foreign currency payables early when a currencyis expected to appreciate

A lag strategy (Collect or Pay late …)Collect foreign currency receivables later if that currencyis expected to appreciate andPaying foreign currency payables later if the currency isexpected to depreciate

Lead and lag strategies can be difficult to implement

The International Monetary System

Chapter 11

The Bretton Woods System

The Bretton Woods agreement (1944) established two multinational institutions:the International Monetary Fund (IMF) to

maintain order in the internationalmonetary systemthe World Bank to promote general

economic development

Is the U.S. Dollar Strong or Weak?

Source: https://www.bloomberg.com/quote/DXY:CUR

As if 4/14/2019

Dollar Strength – Film (11 min)

Please answer these questions while watching the film:

Consider a STRONG dollar1. How does a strong dollar impact business?2. How does the strong dollar affect consumers? In your

opinion, is the strong dollar a good or bad thing?FILM

Go to: http://instruction2.mtsac.edu/rjagodka

Click “International Business Resources” -> “Country Data” (first link on page) ConsultaPedia.com – (1) Click on your assigned country

(2) Click on tabsfor details aboutyour country

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