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Intr. business
Test 3
| Question | Answer |
|---|---|
| What is the foreign exchange market? | The foreign exchange market is a market for converting the currency of one country into that of another country |
| What is the exchange rate? | The exchange rate is the rate at which one currency is converted into another |
| What is the purpose of the foreign exchange market? | Enables the conversion of the currency of one country into the currency of another Provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates |
| International firms use foreign exchange markets: | Ch 10 slide 5 |
| foreign exchange risk | the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm |
| Hedging | A firm that protects itself against foreign exchange risk |
| The market performs this function using: | 1. Spot exchange rated. 2. Forward exchange rates. 3. Currency swaps |
| Spot Exchange Rate | the rate at which a foreign exchange dealer converts one currency into another currency on a particular day..Determined by the interaction between supply and demand Changes continually |
| Forward Exchange Rates | the exchange rate governing a forward exchange |
| A Forward Exchange Occurs when... | two parties agree to exchange currency and execute the deal at some specific date in the future |
| Currency Swap | the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates |
| Currency Swaps are used when: | used when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange rate risk |
| What factors are important to future exchange rates? | A country’s price inflation, A country’s interest rate, Market psychology |
| How are prices related to exchange rate movements? | To understand how prices and exchange rates are linked, we need to understand the law of one price, and the theory of purchasing power parity |
| The law of one price - in competitive markets 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 terms of the same currency |
| Purchasing power parity theory | given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a “basket of goods” should be roughly equivalent in each country |
| PPP predicts.... | that changes in relative prices will result in changes in exchange rates When inflation is relatively high, a currency should depreciate |
| How well does PPP theory work? | Empirical testing of the PPP theory indicates that it is not completely accurate in estimating exchange rate changes in the short run, but is relatively accurate in the long run |
| How do interest rates affect exchange rates? | The Fisher Effect states that a country’s nominal interest rate (i) is the sum of the required real rate of interest (r ) and the expected rate of inflation over the period for which the funds are to be lent (I) In other words, i = r + I |
| The International Fisher Effect | suggests 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 between the two countries In other words:(S1 - S2) / S2 x 100 = i $ - i ¥ |
| How are exchange rates influenced by investor psychology? | The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies, and traders join the bandwagon and move exchange rates based on group expectations |
| Should companies invest in exchange rate forecasting services to help with decision-making? | The efficent market school and the inefficient market school. |
| The efficient market school | forward exchange rates are the best predictors of future spot exchange rates Investing in forecasting services is a waste of money |
| The inefficient market school | Companies should invest in forecasting services Forward rates are not the best predictor of future spot rates |
| An efficient market | one in which prices reflect all available information If the foreign exchange market is efficient, forward exchange rates should be unbiased predictors of future spot rates |
| An inefficient market | one in which prices do not reflect all available information |
| How should exchange rate forecasts be prepared? | Fundamental analysis Technical analysis |
| Fundamental Analysis | draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates |
| Technical Analysis | focuses on trends and believes that past trends and waves are reasonable predictors of future trends and waves |
| Currencies are: | Freely convertible, Externally convertible, and nonconvertible. |
| Why do countries limit currency convertibility? | preserve foreign exchange reserves and prevent capital flight. In the case of a nonconvertible currency, firms may turn to countertrade to facilitate international trade |
| Capital Flight | when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency |
| What does the foreign exchange market mean for international firms? | Firms must understand the influence of exchange rates on the profitability of trade and investment deals This exchange rate risk can be divided into Transaction exposure Translation exposure Economic exposure |
| Transaction Exposure | the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values Can lead to a real monetary loss |
| Translation Exposure | the impact of currency exchange rate changes on the reported financial statements of a company Deals with the present measurement of past events Gains and losses from translation exposure are reflected only on paper |
| Economic Exposure | the extent to which a firm’s future international earning power is affected by changes in exchange rates Concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs |
| How can firms minimize translation and transaction exposure? | Buy forward Use swaps Lead and lag payables and receivables - paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements |
| Lead Strategy | Collecting foreign currency receivables early when a foreign currency is expected to depreciate Paying foreign currency payables before they are due when a currency is expected to appreciate |
| Lag Strategy | Delaying collection of foreign currency receivables if that currency is expected to appreciate Delaying payables if the currency is expected to depreciate |
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