Foreign Exchange Dealing with Currencies with a basic

Foreign Exchange: Dealing with Currencies with a basic introduction to the International Monetary System 9 -1

Foreign Exchange Terms Foreign exchange: money denominated in the currency of another nation or group of nations ◦ ◦ Cash Credit Bank deposits Other short-term claims (e. g. , bonds) Exchange rate: the price of a particular currency relative to another

Basic questions … What is money? How should you convert money from one currency into another? How are the values of currencies set? How can you limit foreign exchange risk (the possibility that unpredicted changes in exchange rates will have adverse consequences for the firm)? Can you predict when currency values will change? If so, how?

What is money? The “medium of exchange” ◦ that is, something widely accepted as means of payment Usually, governments declare certain pieces of paper (and bank assets) to be money ◦ But people must accept them ◦ Alternatives are inconvenient, but possible Tobacco in early American colonies U. S. dollar in Russia when ruble collapsed

If you sell abroad, and you may receive payment in foreign currency Buy abroad, and you may have to pay in foreign currency Travel abroad, you must spend foreign currency A foreign direct investment will have to pay expenses in foreign currency

How should you convert money from one currency into another? Current values of major foreign currencies are available on the Web Most businesspeople normally buy from or sell to a bank ◦ The bank often gives less than the rates offered on the Web, but handles all details ◦ Banks may vary a lot in how good a deal they give But they know they have to be competitive with other banks

A business with significant foreign activity creates a stable relationship with one or a few banks Nowadays, you can do your own currency trading

How are the values of currencies set? There are two basic ways ◦ “Fixed” or “Pegged” exchange rates Governments decide the value of currency Example: Hong Kong’s government keeps the value of its dollar at roughly US$0. 129 (US$1=HK$7. 75) With a ‘fixed rate’, there is absolutely no variability. A ‘pegged’ rate implies small variability

The major developed-country currencies float against each other ◦ Supply and demand sets values This is how exchange rates are set for the US dollar vs. Euro, Japanese yen, British pound, Swiss franc, etc.

Fixed exchange rates have important benefits They make business predictable In some very prosperous periods, most major exchange rates have been fixed ◦ The late 19 th century ◦ 1945 -1971

The gold standard made the benefits of fixed rates clear Before WW I, all major currencies were convertible into gold ◦ UK £ 1=113 grains gold (. 2354 oz) ◦ US $1= 23. 22 grains (. 0484 oz) ◦ So, £ 1=4. 87 Everyone knew what everything was and would be worth

But a fixed exchange rate requires discipline in the government – and a willingness to create pain ◦ Example: Suppose your nation’s economy is very prosperous, but exports are growing only slowly Your people will have money to buy imports Their demand foreign currencies will put upward pressure on their exchange rates Government has to slow the domestic economy to prevent change in exchange rate Higher taxes, higher interest rates, lower government spending

Many economists say if a country is having difficulty maintaining a fixed exchange rate, the economy is ‘overheated’ ◦ They say higher interest rates or higher taxes might be better for the economy in the long run in those circumstances ◦ But politicians don’t like to take pain U. S. abandoned fixed exchange rates when the Vietnam War created strong inflation

It seems that the more complicated an economy, the more difficult it is to maintain fixed/pegged rates ◦ Many small countries succeed Hong Kong, Bangladesh, Fiji ◦ Few propose them for the largest developed countries today Many developing countries including China restrict who can own their money ◦ ‘Hot’ investments in ‘emerging’ currencies have often caused problems when foreigners changed their minds

China maintains a pegged exchange rate ◦ For long periods it kept the rate at less than an equilibrium price Its government had to buy lots of surplus dollars that its exports brought in ◦ In June 2012 China had $3, 240 billion US dollars

When an economy has recently grown, it may be hard to spend There is poor transportation infrastructure People live in the countryside or in tiny urban apartments, so they have little space for things So more money may come in from exports than people want to spend

It’s easier to manage a currency’s level if you have a trade surplus than a trade deficit ◦ You can simply use the surplus to buy up the foreign exchange that comes into the country China fears that if the value of the Yuan rises, declining sales of manufacturers will hurt employment

US per capita GDP is $48, 400 China’s per capita GDP at current Yuan exchange rate is $5400 ◦ Thus, a US worker must ordinarily be 9 times as productive as a Chinese worker to sell internationally China’s nominal per capita income up 46% in 3 years! For the US and Europe, a low Yuan and Chinese import restrictions make recovery from recession harder ◦ But Americans get to consume more

Most international business involves currencies with floating rates Buyers and sellers establish prices in markets like those for tea and wheat $1, 200, 000, 000 in foreign exchange is traded every day US dollar is most widely traded ◦ involved in 90% of all transactions London is the main foreign-exchange market

Foreign-Exchange Trading Terms Bid: the rate at which a trader will buy foreign currency from you Offer (or Ask): the rate at which a trader will sell foreign currency to you Spread: the difference between bid and offer rates; the profit margin for the trader 9 -6

Market Rhythms 9 -13

Insuring Against Foreign Exchange Risk Businesses use the foreign exchange market to provide insurance against foreign exchange risk A firm that protects itself against foreign exchange risk is hedging You can buy or sell using 1. spot exchange rates 2. forward exchange rates 3. currency swaps

Insuring Against Foreign Exchange Risk 1. Spot Exchange Rates The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day ◦ Spot rates are determined by the interaction between supply and demand, and so change continually

Insuring Against Foreign Exchange Risk 2. Forward Exchange Rates A forward exchange occurs when two parties agree to exchange currency at some specific future date ◦ Forward rates are typically quoted for 30, 90, or 180 days into the future ◦ Forward rates are typically the same as the spot rate plus or minus an adjustment for the interest the parties will pay/receive

Insuring Against Foreign Exchange Risk 3. Currency Swaps A currency swap is the simultaneous purchase and sale of an amount of foreign exchange on two different dates ◦ Swaps are used when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk For example, you have accepted an order in Japanese yen and you must manufacture the product using components you must purchase in Japanese yen

How can you predict when currency values will change? Business decisions demand you look far ahead ◦ If exchange rates will change and you don’t hedge adequately, your whole calculation will be off ◦ Some foreign currencies have lost 90% or more of their value in a year Argentine peso went from $1=1 peso to $1=3. 5 pesos in one jump

‘Fundamental analysis’ involves examining basic economic data How fast are prices rising in the country? Is there a trade surplus or deficit? Is the government running budget deficits? How much? How do interest rates in the countries compare? How has the government been managing the currency?

Technical analysis involves examining trends in exchange rates One principle: Trends once established often tend to continue ◦ ‘The trend is your friend’ But if “everyone” agrees something will happen, it may not happen ◦ When ‘everyone’ thinks the dollar will go down, ‘everyone’ has already sold dollars ◦ If the news changes, many may quickly change their minds and want to buy

Foreign exchange can be the difference between profit and loss HSBC Bank in Argentina ◦ They entered Argentina at a time when it appeared the government was starting to manage the economy effectively ◦ But they continued investing as government became more irresponsible ◦ They lost big

Material below here is not required

Foreign-Exchange Convertibility Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts ◦ “Hard currencies” are fully convertible ◦ “Soft currencies” (or weak currencies) are not fully convertible Typically from developing countries Known as “exotic currencies” 9 -10