Final Project-Part 1 ( Global Business)

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After you have read this chapter you should be able to:

1 Describe the functions of the foreign exchange market.

2 Understand what is meant by spot exchange rates.

3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk. 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits. 5 Identify the merits of different approaches toward exchange rate forecasting.

6 Compare and contrast the differences between translation, transaction, and economic exposure, and explain what managers can do to manage each type of exposure.

part 4 Global Money System

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opening case

B illabong is a quintessential Australian company. The maker of “surf wear” from wet suits and board shorts to T-shirts and watches has a powerful brand name that is recognized by surfing enthusiasts around the globe. The company is a major exporter. Some 80 percent of its sales are generated outside of Australia through a network of 10,0000 outlets in more than 100 countries. Not surprisingly given the history of surfing, the largest foreign market for Billabong is the United States, which accounts for about 50 percent of the company’s $800 million in annual sales. As a result, Billabong’s fortunes are closely linked to the value of the Australian dollar against the U.S. dollar. When the Australian dollar falls against the U.S. dollar, Billabong’s products become less expensive in U.S. dollars, and this can drive sales forward. Conversely, if the Australian dollar rises in value, this can raise the price of Billabong’s products in terms of U.S. dollars, which impacts sales negatively. Billabong’s CEO has stated that every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. During the second half of 2008 it looked as if things were going Billabong’s way. The Australian dollar fell rapidly in value against the U.S. dollar. In June 2008 one Australian dollar was worth $0.97. By October 2008 it was worth only $0.60. The fall in the value of the Australian dollar was in part due to a fear among currency traders that as the world slipped into a recession, global demand for many of the raw materials pro- duced in Australia would decline, exports would slump, and Australia’s trade bal- ance would deteriorate. In anticipation of this, institutions sold Australian dollars, driving down its value on foreign exchange markets. For Billabong, however, this was something of a blessing. The cheaper Australian dollar would give it a pricing advantage and help to promote sales in the United States and elsewhere. When sales in U.S. dollars were translated back

Billabong

The Foreign Exchange Market

9 c h a p t e r

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into Australian dollars, their value increased as the Australian dollar fell. An- ticipating this, in February 2009 Billabong’s CEO affirmed that he expected the company to increase its profits by as much as 10 percent in 2009, despite the weak global retail environment. Currency markets, however, can be difficult to predict, and sharp reversals do occur. Between March and November 2009 the Australian dollar surged in value, rising all the way back to $0.94. The cause was twofold. First, there was a global sell-off of the American dollar as the full impact of the global financial crisis became apparent, and as the scale of debt in the United States became clearer. Second, despite a recession in the United States and Europe, the emerging economies of China and India continued to grow, and this helped to support demand for many of the basic commodities that Australia exports, which led to a strengthening of the Australian dollar. For Billabong, the sharp reversal was an embarrassment. The strong Australian dollar eradicated any pricing advantage Billabong might have enjoyed. Also, now the amount of Australian dollars that the company received for every sale made in U.S. dol- lars was declining. In February 2009 every $1 earned in U.S. currency could be exchanged for 1.66 Australian dollars. By October 2009 every $1 earned in U.S. currency could only be exchanged for 1.06 Australian dollars. In May 2009, with the Australian dollar rising rapidly, the CEO was forced to revise his previ- ously bullish forecast for sales and earnings. Now he said, a combination of weaker than expected demand in the United States plus a strengthening Australian dollar would lead to a 10 percent decline in profits for 2009. • Sources: C. Marriott, “Caught in the Impact Zone,” Australian FX , January 2010, pp. 11–12; R. Donkin, “Billabong Seeks $290 Million, Slashes Forecast, Stores,” The Western Australian , May 19, 2009; and “Billabong Ready to Ride the Currency Wave,” The Australian , October 29, 2008, p. 40.

Introduction Like many enterprises in the global economy, Billabong is impacted by changes in the value of currencies on the foreign exchange market. As detailed in the opening case, during late 2008 and early 2009 it looked as if the weak Australian dollar would help to boost Billabong’s exports of surf wear to markets like the United States, and it is- sued bullish profit forecasts. By May 2009, an unanticipated rise in the value of the Australian dollar forced the company to revise its earnings forecasts for 2009 down- ward. As stated in the case, every 1 cent movement in the U.S. dollar/Australian dollar exchange rate means a 0.6 percent change in profit for Billabong. When the Australian dollar appreciates again the U.S. dollar, Billabong’s products became more expensive in U.S. dollar terms, effectively putting the company at a price disadvantage in the United States, its major foreign market. As at Billabong, what happens in the foreign exchange market can have a funda- mental impact on the sales, profits, and strategy of an enterprise. Accordingly, it is very important for managers to understand the working of the foreign exchange market,

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and what the impact of changes in currency exchange rates might be for their enter- prise. With this in mind, the current chapter has three main objectives. The first is to explain how the foreign exchange market works. The second is to examine the forces that determine exchange rates, and to discuss the degree to which it is possible to pre- dict future exchange rate movements. The third objective is to map the implications for international business of exchange rate movements. This chapter is the first of two that deal with the international monetary system and its relationship to international business. In the next chapter, we will explore the institutional structure of the interna- tional monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional struc- ture of the international monetary system can exert a profound influence on the devel- opment of foreign exchange markets. The foreign exchange market is a market for converting the currency of one coun- try into that of another country. An exchange rate is simply the rate at which one cur- rency is converted into another. For example, Billabong uses the foreign exchange market to convert the dollars it earns from selling surf wear in the United States into Australian dollars. Without the foreign exchange market, international trade and inter- national investment on the scale that we see today would be impossible; companies would have to resort to barter. The foreign exchange market is the lubricant that enables companies based in countries that use different currencies to trade with each other. We know from earlier chapters that international trade and investment have their risks. Some of these risks exist because future exchange rates cannot be perfectly pre- dicted. The rate at which one currency is converted into another can change over time. For example, at the start of 2001 one U.S. dollar bought 1.065 euros, but by the start of 2010, one U.S. dollar bought only 0.74 euro. The dollar had fallen sharply in value against the euro. This made American goods cheaper in Europe, boosting export sales. At the same time, it made European goods more expensive in the United States, which hurt the sales and profits of European companies that sold goods and services to the United States. One function of the foreign exchange market is to provide some insurance against the risks that arise from such volatile changes in exchange rates, commonly referred to as foreign exchange risk. Although the foreign exchange market offers some insurance against foreign exchange risk, it cannot provide complete insurance. It is not unusual for international businesses to suffer losses because of unpredicted changes in ex- change rates. Currency fluctuations can make seemingly profitable trade and invest- ment deals unprofitable, and vice versa. We begin this chapter by looking at the functions and the form of the foreign ex- change market. This includes distinguishing among spot exchanges, forward ex- changes, and currency swaps. Then we will consider the factors that determine exchange rates. We will also look at how foreign trade is conducted when a country’s currency cannot be exchanged for other currencies; that is, when its currency is not convertible. The chapter closes with a discussion of these things in terms of their im- plications for business.

The Functions of the Foreign Exchange Market The foreign exchange market serves two main functions. The first is to convert the currency of one country into the currency of another. The second is to provide some insurance against foreign exchange risk, by which we mean the adverse consequences of unpredictable changes in exchange rates. 1

Foreign Exchange Market A market for converting the currency of one country into that of another country.

Exchange Rate The rate at which one currency is converted into another.

LEARNING OBJECTIVE 1 Describe the functions of

the foreign exchange market.

Foreign Exchange Risk The risk that changes in exchange rates will hurt the profitability of a business deal.

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CURRENCY CONVERSION Each country has a currency in which the prices of goods and services are quoted. In the United States, it is the dollar ($); in Great Britain, the pound (£); in France, Germany, and other members of the euro zone it is the euro (€); in Japan, the yen (¥ ); and so on. In general, within the borders of a par- ticular country, one must use the national currency. A U.S. tourist cannot walk into a store in Edinburgh, Scotland, and use U.S. dollars to buy a bottle of Scotch whisky. Dollars are not recognized as legal tender in Scotland; the tourist must use British pounds. Fortunately, the tourist can go to a bank and exchange her dollars for pounds. Then she can buy the whisky. When a tourist changes one currency into another, she is participating in the for- eign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of €1 5 $1.30 specifies that one euro buys $1.30 U.S. dollars. The exchange rate allows us to compare the relative prices of goods and services in different countries. Our U.S. tourist wishing to buy a bottle of Scotch whisky in Edinburgh may find that she must pay £30 for the bottle, knowing that the same bottle costs $45 in the United States. Is this a good deal? Imag- ine the current pound/dollar exchange rate is £1.00 5 $2.00 (i.e., one British pound buys $2.00). Our intrepid tourist takes out her calculator and converts £30 into dollars. (The calculation is 30 3 2). She finds that the bottle of Scotch costs the equivalent of $60. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland (alcohol is taxed heavily in Great Britain). Tourists are minor participants in the foreign exchange market; companies engaged in international trade and investment are major ones. International businesses have four main uses of foreign exchange markets. First, the payments a company receives for its exports, the income it receives from foreign investments, or the income it re- ceives from licensing agreements with foreign firms may be in foreign currencies. To use those funds in its home country, the company must convert them to its home country’s currency. Consider the Scotch distillery that exports its whisky to the United States. The distillery is paid in dollars, but since those dollars cannot be spent in Great Britain, they must be converted into British pounds. Similarly, Billabong sells its surfing products in the United States for dollars; it must convert the U.S. dollars it receives into Australian dollars to use them in Australia. Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country’s currency. For example, Dell buys many of the components for its computers from Malaysian firms. The Malaysian companies must be paid in Malaysia’s currency, the ringgit, so Dell must convert money from dollars into ringgit to pay them.

Third, international businesses also use foreign exchange markets when they have spare cash that they wish to invest for short terms in money mar- kets. For example, consider a U.S. company that has $10 million it wants to invest for three months. The best interest rate it can earn on these funds in the United States may be 4 percent. Investing in a South Korean money market account, however, may earn 12 percent. Thus, the company may change its $10 million into Korean won and invest it in South Korea. Note, however, that the rate of return it earns on this investment depends not only on the Korean interest rate, but also on the changes in the value of the Korean won against the dollar in the intervening period.

Another Per spect i ve

How Foreign Exchange Challenges Business Travel Ethics In preparation for a trip to Japan, you exchange U.S. dol- lars for yen in late May, just before you leave. For $1,000, your bank gives you ¥104,000. During your time in Osaka, the dollar weakens against the yen, to ¥99.5 to the dollar. Meanwhile, you enjoyed Japanese hospitality and spent only ¥10,000. Back home, you take your remaining ¥94,000 to the bank to convert back to dollars. How much have you spent on your trip?

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Currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one cur- rency to another in the hopes of profiting from shifts in exchange rates. Consider again a U.S. company with $10 million to invest for three months. Suppose the company suspects that the U.S. dollar is overvalued against the Japanese yen. That is, the company expects the value of the dollar to depreciate (fall) against that of the yen. Imagine the current dollar/yen exchange rate is $1 5 ¥120. The company ex- changes its $10 million into yen, receiving ¥1.2 billion ($10 million 3 120 5 ¥1.2 billion). Over the next three months, the value of the dollar depreciates against the yen until $1 5 ¥100. Now the company exchanges its ¥1.2 billion back into dollars and finds that it has $12 million. The company has made a $2 million profit on cur- rency speculation in three months on an initial investment of $10 million! In gen- eral, however, companies should beware, for speculation by definition is a very risky business. The company cannot know for sure what will happen to exchange rates. While a speculator may profit handsomely if his speculation about future currency movements turns out to be correct, he can also lose vast amounts of money if it turns out to be wrong. A kind of speculation that has become more common in recent years is known as the carry trade. The carry trade involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high. For example, if the interest rate on borrowings in Japan is 1 percent, but the interest rate on deposits in American banks is 6 percent, it can make sense to bor- row in Japanese yen, then convert the money into U.S. dollars and deposit it in an American bank. The trader can make a 5 percent margin by doing so, minus the trans- action costs associated with changing one currency into another. The speculative ele- ment of this trade is that its success is based upon a belief that there will be no adverse movement in exchange rates (or interest rates for that matter) that will make the trade unprofitable. However, if the yen were to rapidly increase in value against the dollar, then it would take more U.S. dollars to repay the original loan, and the trade could fast become unprofitable. The dollar-yen carry trade was actually very significant during the mid-2000s, peaking at over $1 trillion in 2007, when some 30 percent of trade on the Tokyo foreign exchange market was related to the carry trade. 2 This carry trade declined in importance during 2008–09 precisely because the Japanese yen was in- creasing in value against the dollar, making the trade riskier (in addition, interest rate differentials were falling as U.S. rates came down, making the trade less profitable even if exchange rates were stable).

INSURING AGAINST FOREIGN EXCHANGE RISK A second function of the foreign exchange market is to provide insurance against foreign exchange risk, which is the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm. When a firm insures itself against foreign exchange risk, we say that is it engaging in hedging. To explain how the market performs this function, we must first distinguish among spot exchange rates, forward exchange rates, and currency swaps.

Spot Exchange Rates When two parties agree to exchange currency and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such “on the spot” trades are referred to as 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. Thus, when our U.S. tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day.

LEARNING OBJECTIVE 2 Understand what is meant

by spot exchange rates.

Spot Exchange Rate The exchange rate at which a foreign exchange dealer will convert one currency into another currency on a particular day.

Currency Speculation Involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Carry Trade Involves borrowing in one currency where interest rates are low, and then using the proceeds to invest in another currency where interest rates are high.

Hedging The process of insuring one’s business against foreign exchange risk by using forward exchanges or currency swaps.

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Spot exchange rates are reported on a real-time basis on many financial Web sites. Table 9.1 shows the exchange rates for a selection of currencies traded in the New York foreign exchange market as of 1:11 p.m. February 18, 2009. An exchange rate can be quoted in two ways: as the amount of foreign cur- rency one U.S. dollar will buy, or as the value of a dollar for one unit of foreign currency. Thus, one U.S. dollar bought €0.7954 on February 18, 2009, and one euro bought $1.2572 U.S. dollars.

Spot rates change continually, often on a minute- by-minute basis (although the magnitude of changes over such short periods is usually small). The value of a currency is determined by the interaction be- tween the demand and supply of that currency rela- tive to the demand and supply of other currencies.

For example, if lots of people want U.S. dollars and dollars are in short supply, and few people want British pounds and pounds are in plentiful supply, the spot exchange rate for converting dollars into pounds will change. The dollar is likely to appreciate against the pound (or the pound will depreciate against the dollar). Imagine the spot exchange rate is £1 5 $2.00 when the market opens. As the day progresses, dealers demand more dollars and fewer pounds. By the end of the day, the spot exchange rate might be £1 5 $1.98. Each pound now buys fewer dollars than at the start of the day. The dollar has appreciated, and the pound has depreciated.

Forward Exchange Rates Changes in spot exchange rates can be problematic for an international business. For example, a U.S. company that imports laptop com- puters from Japan knows that in 30 days it must pay yen to a Japanese supplier when a shipment arrives. The company will pay the Japanese supplier ¥200,000 for each laptop computer, and the current dollar/yen spot exchange rate is $1 5 ¥120. At this rate, each computer costs the importer $1,667 (i.e., 1,667 5 200,000y120). The importer

Currency U.S. $ ¥en Euro Can $ U.K. £ AU $ Swiss Franc Last Trade N/A 1:22pm ET 1:22pm ET 1:22pm ET 1:22pm ET 1:20pm ET 1:22pm ET

1 U.S. $ 5 1 92.3550 0.7954 1.2641 0.7034 1.5736 1.1736

1 ¥en 5 0.0108 1 0.0086 0.0137 0.0076 0.0170 0.0127

1 Euro 5 1.2572 116.114 1 1.5893 0.8843 1.9784 1.4755

1 Can $ 5 0.7911 73.0599 0.6292 1 0.5564 1.2448 0.9284

1 U.K. £ 5 1.4217 131.290 1.1308 1.7971 1 2.2371 1.6685

1 AU $ 5 0.6355 58.6903 0.5055 0.8033 0.4470 1 0.7458

1 Swiss Franc 5 0.8521 78.6938 0.6777 1.0771 0.5994 1.3408 1

Major Currency Cross Rates

table 9.1

Value of the U.S. Dollar against other Currencies, February 18, 2009

Source: Yahoo! Finance.

Using insurance to protect against forward exchange rates helps companies hedge against financial risk.

LEARNING OBJECTIVE 3 Recognize the role that forward exchange rates play in insuring against foreign exchange risk.

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knows she can sell the computers the day they arrive for $2,000 each, which yields a gross profit of $333 on each computer ($2,000 2 $1,667). However, the importer will not have the funds to pay the Japanese supplier until the computers have been sold. If over the next 30 days the dollar unexpectedly depreciates against the yen, say, to $1 5 ¥95, the importer will still have to pay the Japanese company ¥200,000 per computer, but in dollar terms that would be equivalent to $2,105 per computer, which is more than she can sell the computers for. A depreciation in the value of the dollar against the yen from $1 5 ¥120 to $1 5 ¥95 would transform a profitable deal into an unprofitable one. To insure or hedge against this risk, the U.S. importer might want to engage in 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. Exchange rates gov- erning such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future. In some cases, it is possible to get forward exchange rates for several years into the future. Returning to our computer importer example, let us assume the 30-day forward exchange rate for converting dollars into yen is $1 5 ¥110. The im- porter enters into a 30-day forward exchange transaction with a foreign exchange dealer at this rate and is guaranteed that she will have to pay no more than $1,818 for each computer (1,818 5 200,000y110). This guarantees her a profit of $182 per com- puter ($2,000 2 $1,818). She also insures herself against the possibility that an unan- ticipated change in the dollar/yen exchange rate will turn a profitable deal into an unprofitable one. In this example, the spot exchange rate ($1 5 ¥120) and the 30-day forward rate ($1 5 ¥110) differ. Such differences are normal; they reflect the expectations of the foreign exchange market about future currency movements. In our example, the fact that $1 bought more yen with a spot exchange than with a 30-day forward exchange indicates foreign exchange dealers expected the dollar to depreciate against the yen in the next 30 days. When this occurs, we say the dollar is selling at a discount on the 30-day forward market (i.e., it is worth less than on the spot market). Of course, the opposite can also occur. If the 30-day forward exchange rate were $1 5 ¥130, for ex- ample, $1 would buy more yen with a forward exchange than with a spot exchange. In such a case, we say the dollar is selling at a premium on the 30-day forward market. This reflects the foreign exchange dealers’ expectations that the dollar will appreciate against the yen over the next 30 days. In sum, when a firm enters into a forward exchange contract, it is taking out insur- ance against the possibility that future exchange rate movements will make a transac- tion unprofitable by the time that transaction has been executed. Although many firms routinely enter into forward exchange contracts to hedge their foreign ex- change risk, there are some spectacular examples of what happens when firms don’t take out this insurance. An example is given in the accompanying Management Focus, which explains how a failure to fully insure against foreign exchange risk cost Volkswagen dearly.

Currency Swaps The discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies en- gaged in international trade—and you would be right. By April 2007, the latest date for which information is available, forward instruments accounted for some 69 percent of all foreign exchange transactions, while spot exchanges accounted for 31 percent. 3 However, the vast majority of these forward exchanges were not forward exchanges of the type we have been discussing, but rather a more sophisticated instrument known as currency swaps.

Forward Exchange When two parties agree to exchange currency and execute the deal at some specific date in the future.

Forward Exchange Rate The exchange rate governing forward exchange transactions.

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Management FOCUS

Volkswagen’s Hedging Strategy

In January 2004, Volkswagen, Europe’s largest car maker, reported a 95 percent drop in 2003 fourth-quarter profits, which slumped from €1.05 billion to a mere €50 million. For all of 2003, Volkswagen’s operating profit fell by 50 percent from the record levels attained in 2002. Although the profit slump had multiple causes, two factors were the focus of much attention—the sharp rise in the value of the euro against the dollar during 2003, and Volkswagen’s decision to only hedge 30 percent of its foreign currency exposure, as opposed to the 70 percent it had traditionally hedged. In total, currency losses due to the dollar’s rise are estimated to have reduced Volkswagen’s operating profits by some €1.2 billion ($1.5 billion). The rise in the value of the euro during 2003 took many companies by surprise. Since its introduction January 1, 1999, when it became the currency unit of 12 members of the European Union, the euro had recorded a volatile trading history against the U.S. dollar. In early 1999 the exchange rate stood at €1 5 $1.17, but by October 2000 it had slumped to €1 5 $0.83. Although it recovered, reach- ing parity of €1 5 $1.00 in late 2002, few analysts predicted a rapid rise in the value of the euro against the dollar dur- ing 2003. As so often happens in the foreign exchange markets, the experts were wrong; by late 2003 the ex- change rate stood at €1 5 $1.25. For Volkswagen, which made cars in Germany and ex- ported them to the United States, the fall in the value of the dollar against the euro during 2003 was devastating. To un- derstand what happened, consider a Volkswagen Jetta built in Germany for export to the United States. The Jetta costs €14,000 to make in Germany and ship to a dealer in the United States, where it sells for $15,000. With the exchange rate standing at around €1 5 $1, the $15,000 earned from the sale of a Jetta in the United States could be converted into €15,000, giving Volkswagen a profit of €1,000 on every Jetta sold. But if the exchange rate changes during the

year, ending up at €1 5 $1.25 as it did during 2003, each dollar of revenue will now buy only €0.80 (€1y$1.25 5 €0.80), and Volkswagen is squeezed. At an exchange rate of €15$1.25, the $15,000 Volkswagen gets for the Jetta is now worth only €12,000 when converted back into euros, mean- ing the company will lose €2,000 on every Jetta sold (when the exchange rate is €1 5 $1.25, $15,000y1.25 5 €12,000). Volkswagen could have insured against this adverse movement in exchange rates by entering the foreign ex- change market in late 2002 and buying a forward contract for dollars at an exchange rate of around $1 5 €1 (a forward contract gives the holder the right to exchange one cur- rency for another at some point in the future at a predeter- mined exchange rate). Called hedging , the financial strategy of buying forward guarantees that at some future point, such as 180 days, Volkswagen would have been able to ex- change the dollars it got from selling Jettas in the United States into euros at $1 5 €1, irrespective of what the actual exchange rate was at that time . In 2003 such a strategy would have been good for Volkswagen. However, hedging is not without its costs. For one thing, if the euro had de- clined in value against the dollar, instead of appreciating as it did, Volkswagen would have made even more profit per car in euros by not hedging (a dollar at the end of 2003 would have bought more euros than a dollar at the end of 2002). For another thing, hedging is expensive since foreign exchange dealers will charge a high commission for selling currency forward. Volkswagen decided to hedge just 30 percent of its anticipated U.S. sales in 2003 though for- ward contracts, rather than the 70 percent it had historically hedged. The decision cost the company over a €1 billion. For 2004, the company announced that it would revert back to hedging 70 percent of its foreign currency exposure.

Sources: Mark Landler, “As Exchange Rates Wwing, Car Makers Try to Duck,” The New York Times , January 17, 2004, pp. B1, B4; N. Boudette, “Volkswagen Posts 95% Drop in Net,” The Wall Street Journal, February 19, 2004, p. A3; and “Volkswagen’s Financial Mechanic,” Corporate Finance , June 2003, p. 1.

A currency swap is the simultaneous purchase and sale of a given amount of for- eign exchange for two different value dates. Swaps are transacted between interna- tional businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incur- ring foreign exchange risk. A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that

Currency Swap Simultaneous purchase

and sale of a given amount of foreign exchange for two

different value dates.

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Chapter Nine The Foreign Exchange Market 319

buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 5 ¥120 and the 90-day forward exchange rate is $1 5 ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day for- ward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 milliony110 5 $1.09 million). Since the yen is trading at a pre- mium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against for- eign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

The Nature of the Foreign Exchange Market The foreign exchange market is not located in any one place. It is a global network of banks, brokers, and foreign exchange dealers connected by electronic communica- tions systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly. The foreign exchange mar- ket has been growing at a rapid pace, reflecting a general growth in the volume of cross-border trade and investment (see Chapter 1). In March 1986, the average total value of global foreign exchange trading was about $200 billion per day. According to the tri-annual survey by the Bank of International Settlements, by April 1995, it was more than $1,200 billion per day, by April 2004 it reached $1.8 trillion per day, and by April 2007 it had surged to $3.21 trillion per day. 4 The most important trading centers are London (34 percent of activity), New York (16 percent of activity), and Zurich, Tokyo, and Singapore (all with around 6 percent of activity). 5 Major second- ary trading centers include Frankfurt, Paris, Hong Kong, and Sydney. London’s dominance in the foreign exchange mar- ket is due to both history and geography. As the capi- tal of the world’s first major industrial trading nation, London had become the world’s largest center for international banking by the end of the nineteenth century, a position it has retained. Today London’s central position between Tokyo and Singapore to the east and New York to the west has made it the criti- cal link between the East Asian and New York mar- kets. Due to the particular differences in time zones, London opens soon after Tokyo closes for the night and is still open for the first few hours of trading in New York. 6 Two features of the foreign exchange market are of particular note. The first is that the market never sleeps. Tokyo, London, and New York are all shut for only 3 hours out of every 24. During these three

Another Per spect i ve

Key into Exchange Rate Language The language used to describe exchange rates can be confusing, even though the ideas themselves are simple. Here’s why: Any given observation describes a changing relationship (the movement in the currencies) that itself describes two relationships (the exchange rates for both currencies). The important thing to remember is that an exchange rate is described in terms of other exchange rates. The language we use to describe these moving phenom- ena works in a similar, dual way: The euro gains against the dollar, so the euro is strengthening, or becoming dearer, from a dollar perspective. Meanwhile, the same observation indi- cates its mirror image, that the dollar is weakening, becom- ing cheaper against the euro, from a euro perspective

Even though the British pound has declined in its importance as a vehicle currency, London remains the key location for global foreign exchange.

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320 Part Four Global Money System

hours, trading continues in a number of minor centers, particularly San Francisco and Sydney, Australia. The second feature of the market is the integration of the various trading centers. High-speed computer linkages between trading centers around the globe have effectively created a single market. The integration of financial centers implies there can be no significant difference in exchange rates quoted in the trading centers. For example, if the yen/dollar exchange rate quoted in London at 3 p.m. is ¥120 5 $1, the yen/dollar exchange rate quoted in New York at the same time (10 a.m. New York time) will be identical. If the New York yen/dollar exchange rate were ¥125 5 $1, a dealer could make a profit through arbitrage, buying a cur- rency low and selling it high. For example, if the prices differed in London and New York as given, a dealer in New York could take $1 million and use that to purchase ¥125 million. She could then immediately sell the ¥125 million for dollars in London, where the transaction would yield $1.046666 million, allowing the trader to book a profit of $46,666 on the transaction. If all dealers tried to cash in on the opportunity, however, the demand for yen in New York would rise, resulting in an appreciation of the yen against the dollar such that the price differential between New York and London would quickly disappear. Because foreign exchange dealers are always watch- ing their computer screens for arbitrage opportunities, the few that arise tend to be small, and they disappear in minutes. Another feature of the foreign exchange market is the important role played by the U.S. dollar. Although a foreign exchange transaction can involve any two currencies, most transactions involve dollars on one side. This is true even when a dealer wants to sell a nondollar currency and buy another. A dealer wishing to sell Korean won for Brazilian real, for example, will usually sell the won for dollars and then use the dollars to buy real. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of real who wants to buy won. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for won or real. Due to its central role in so many foreign exchange deals, the dollar is a vehicle cur- rency. In 2007, 86 percent of all foreign exchange transactions involved dollars on one side of the transaction. After the dollar, the most important vehicle currencies were the euro (37 percent), the Japanese yen (16.5 percent), and the British pound (15 percent)— reflecting the importance of these trading entities in the world economy. The euro has replaced the German mark as the world’s second most important vehicle currency. The British pound used to be second in importance to the dollar as a vehicle currency, but its importance has diminished in recent years. Despite this, London has retained its leading position in the global foreign exchange market.

Economic Theories of Exchange Rate Determination At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another. For example, if the de- mand for dollars outstrips the supply of them and if the supply of Japanese yen is greater than the demand for them, the dollar/yen exchange rate will change. The dol- lar will appreciate against the yen (or the yen will depreciate against the dollar). However, while differences in relative demand and supply explain the determination of exchange rates, they do so only in a superficial sense. This simple explanation does not tell us what factors underlie the demand for and supply of a currency. Nor does it tell us when the demand for dollars will exceed the supply (and vice versa) or when the supply of Japanese yen will exceed demand for them (and vice versa). Neither

Arbitrage The purchase of

securities in one market for immediate resale in another to profit from a

price discrepancy.

LEARNING OBJECTIVE 4 Understand the different theories explaining how currency exchange rates are determined and their relative merits.

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Chapter Nine The Foreign Exchange Market 321

does it tell us under what conditions a currency is in demand or under what condi- tions it is not demanded. In this section, we will review economic theory’s answers to these questions. This will give us a deeper understanding of how exchange rates are determined. If we understand how exchange rates are determined, we may be able to forecast exchange rate movements. Because future exchange rate movements influence export opportunities, the profitability of international trade and investment deals, and the price competitiveness of foreign imports, this is valuable information for an interna- tional business. Unfortunately, there is no simple explanation. The forces that deter- mine exchange rates are complex, and no theoretical consensus exists, even among academic economists who study the phenomenon every day. Nonetheless, most eco- nomic theories of exchange rate movements seem to agree that three factors have an important impact on future exchange rate movements in a country’s currency: the country’s price inflation, its interest rate, and market psychology. 7

PRICES AND EXCHANGE RATES To understand how prices are related to exchange rate movements, we first need to discuss an economic proposition known as the law of one price. Then we will discuss the theory of purchasing power parity (PPP), which links changes in the exchange rate between two countries’ currencies to changes in the countries’ price levels.

The Law of One Price The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. 8 For example, if the exchange rate between the British pound and the dollar is £1 5 $2.00, a jacket that retails for $80 in New York should sell for £40 in London (since $80y2.00 5 £40). Consider what would happen if the jacket cost £30 in London ($60 in U.S. currency). At this price, it would pay a trader to buy jackets in London and sell them in New York (an example of arbitrage ). The com- pany initially could make a profit of $20 on each jacket by purchasing it for £30 ($60) in London and selling it for $80 in New York (we are assuming away transportation costs and trade barriers). However, the increased demand for jackets in London would raise their price in London, and the increased supply of jackets in New York would lower their price there. This would continue until prices were equalized. Thus, prices might equalize when the jacket cost £35 ($70) in London and $70 in New York (assuming no change in the exchange rate of £1 5 $2.00).

Purchasing Power Parity If the law of one price were true for all goods and services, the purchasing power parity (PPP) exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different cur- rencies, it would be possible to determine the “real” or PPP exchange rate that would exist if markets were efficient. (An efficient market has no impediments to the free flow of goods and services, such as trade barriers, and prices reflect all available public information.) A less extreme version of the PPP theory states that given relatively efficient markets—that is, markets in which few impediments to international trade exist—the price of a “basket of goods” should be roughly equivalent in each country. To express the PPP theory in symbols, let P$ be the U.S. dollar price of a basket of particular goods and P¥ be the price of the same basket of goods in Japanese yen. The PPP the- ory predicts that the dollar/yen exchange rate, E$y¥, should be equivalent to:

E$y¥ 5 P$yP¥

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.

Efficient Market A market which has no impediments to the free flow of goods and services, such as trade barriers, and prices reflect all available public information.

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322 Part Four Global Money System

Thus, if a basket of goods costs $200 in the United States and ¥20,000 in Japan, PPP theory predicts that the dollar/yen exchange rate should be $200/¥20,000 or $0.01 per Japanese yen (i.e., $1 5 ¥100).

Every year, the newsmagazine The Economist publishes its own version of the PPP theorem, which it refers to as the “Big Mac Index.” The Econ- omist has selected McDonald’s Big Mac as a proxy for a “basket of goods” because it is produced ac- cording to more or less the same recipe in about 120 countries. The Big Mac PPP is the exchange rate that would have hamburgers costing the same in each country. According to The Economist, com-

paring a country’s actual exchange rate with the one predicted by the PPP theorem based on relative prices of Big Macs is a test on whether a currency is undervalued or not. This is not a totally serious exercise, as The Economist admits, but it does provide us with a useful illustration of the PPP theorem. Relative currency values according to the Big Mac index for January 6, 2010, are reproduced in Table 9.2. To calculate the index The Economist converts the price of a Big Mac in a country into dollars at current exchange rates and divides that by the average price of a Big Mac in America (which was $3.58). According to the PPP theo- rem, the prices should be the same. If they are not, it implies that the currency is ei- ther overvalued against the dollar or undervalued. For example, the average price of a Big Mac in the euro area was $4.84 at the euro/dollar exchange rate prevailing in early 2010. Dividing this by the average price of a Big Mac in the United States gives 1.35 (i.e., 4.84y3.58), which suggests that the euro was overvalued by 35 percent against the U.S. dollar. The next step in the PPP theory is to argue that the exchange rate will change if rela- tive prices change. For example, imagine there is no price inflation in the United States, while prices in Japan are increasing by 10 percent a year. At the beginning of the year, a basket of goods costs $200 in the United States and ¥20,000 in Japan, so the dollar/yen exchange rate, according to PPP theory, should be $1 5 ¥100. At the end of the year, the

basket of goods still costs $200 in the United States, but it costs ¥22,000 in Japan. PPP theory predicts that the exchange rate should change as a result. More precisely, by the end of the year:

E$y¥ 5 $200y¥22,000

Thus, ¥1 5 $0.0091 (or $1 5 ¥110). Because of 10 percent price inflation, the Japanese yen has de- preciated by 10 percent against the dollar. One dol- lar will buy 10 percent more yen at the end of the year than at the beginning.

Money Supply and Price Inflation In es- sence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency de- preciate against that of countries in which inflation rates are lower. If we can predict what a country’s

Another Per spect i ve

The Law of One Price and the Internet Presently, the law of one price applies to Internet buying that crosses national borders. Internet research provides accu- rate pricing information across markets. Many American consumers are trying to invoke the law of one price in the U.S. pharmaceutical market. They see that prices for pre- scription drugs are lower in Canada, and despite U.S. law prohibiting the importation of foreign drugs, they are having their prescriptions filled in Canada. If this trend continues, the law of one price suggests that U.S. drug prices will fall.

Another Per spect i ve

Will China Revalue the Yuan? Since 2008, China has pegged its currency, the yuan, to the dollar. In recent months, however, the United States has renewed calls for China to revalue the yuan, saying it is artificially weak and responsible for the huge U.S. trade deficit with China. Industry observers say the undervalued currency of an economy the size of China’s creates a tenuous situation for all of its trading partners. So far, China has resisted revaluing the yuan, claiming the advantage bodes well for Chinese ex- ports. According to The Economist ’s Big Mac index, the yuan is running 49 percent below the benchmark. (“Exchanging Blows,” The Economist, March 17, 2010, www.economist. com; “Is a New Era Dawning for China’s Currency Policy?” Capital Spectator, March 7, 2010, www.capitalspectator.com)

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Chapter Nine The Foreign Exchange Market 323

future inflation rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change. The growth rate of a country’s money supply determines its likely future inflation rate. 9 Thus, in theory at least, we can use information about the growth in money supply to forecast exchange rate movements. Inflation is a monetary phenomenon. It occurs when the quantity of money in cir- culation rises faster than the stock of goods and services; that is, when the money sup- ply increases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted—new cars, new furniture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services

Norway

Big Mac index Local currency under (�)/over (�) valuation against the dollar, %

*At market exchange rate (January 5th) †Weighted average of member countries

Source: The Economist using McDonald‘s price data

Switzerland

Euro area

Australia

Canada

Hungary

Turkey

Britain

United States

Japan

Singapore

United Arab Emirates

South Korea

Poland

Mexico

South Africa

Egypt

Taiwan

Russia

Indonesia

Thailand

Malaysia

China

�50 �25 50 7525 100

7.02

6.30

4.84† 3.98

3.97

3.86

3.83

3.67

3.58‡ 3.50

3.19

2.99

2.98

2.86

2.50

2.46

2.38

2.36

2.34

2.24

2.11

2.08

1.83

Big Mac price*, $

‡ Average of four cities

9.2 table

The Big Mac Index, January 6, 2010

Source: The Economist, January 6, 2010, http://www.economist.com/ daily/chartgallery/displaystory. cfm?story_id515210330 .

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324 Part Four Global Money System

would respond to this upsurge in demand by rais- ing prices. The result would be price inflation.

A government increasing the money supply is analogous to giving people more money. An in- crease in the money supply makes it easier for banks to borrow from the government and for in- dividuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be infla- tion. This relationship has been observed time after time in country after country.

So now we have a connection between the growth in a country’s money supply, price infla- tion, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled . The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency

exchange rate. In one of the clearest historical examples, in the mid-1980s, Bolivia experienced hyperinflation—an explosive and seemingly uncontrollable price infla- tion in which money loses value very rapidly. Table 9.3 presents data on Bolivia’s money supply, inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. The exchange rate is actually the “black market” ex- change rate, as the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation, and the depreciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics predict. Between April 1984 and July 1985, Bolivia’s money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government instituted a dramatic stabilization plan—which included the introduction of a new currency and tight con- trol of the money supply—and by 1987 the country’s annual inflation rate was down to 16 percent. 10 Another way of looking at the same phenomenon is that an increase in a country’s money supply, which increases the amount of currency available, changes the relative demand and supply conditions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more plen- tiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth. Government policy determines whether the rate of growth in a country’s money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country’s central bank to issue more money. Gov- ernments tend to do this to finance public expenditure (building roads, paying govern- ment workers, paying for defense, etc.). A government could finance public expenditure by raising taxes, but since nobody likes paying more taxes and since politicians do not like to be unpopular, they have a natural preference for expanding the money supply. Unfortunately, there is no magic money tree. The inevitable result of excessive growth in money supply is price inflation. However, this has not stopped governments around

Another Per spect i ve

The Starbucks Index To test the Big Mac index, which applies the PPP theory using the price of a Big Mac in various markets to deter- mine the equilibrium value of the foreign currency, The Economist established a Starbucks index in 2004. Like the Big Mac, a cup of Starbucks coffee can be found in many foreign markets and can be seen as a proxy for a basket of goods. The results of the Starbucks index followed the Big Mac index in most markets, except in Asia, where the for- mer indicated that the dollar was at parity with the Chinese yuan; the Big Mac index suggested that the yuan was 56 percent undervalued. Neither of these consumer items is a good proxy for a basket of goods, but comparing their rela- tive prices with exchange rates is an interesting and play- ful approach to quickly grasping how under- or overvalued the foreign currency is against the dollar.

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Chapter Nine The Foreign Exchange Market 325

the world from expanding the money supply, with predictable results. If an interna- tional business is attempting to predict future movements in the value of a country’s currency on the foreign exchange market, it should examine that country’s policy to- ward monetary growth. If the government seems committed to controlling the rate of growth in money supply, the country’s future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the government seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate. Historically, many Latin American governments have fallen into this latter category, including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of Eastern Europe made the same mistake.

Empirical Tests of PPP Theory PPP theory predicts that exchange rates are determined by relative prices, and that changes in relative prices will result in a change in exchange rates. A country in which price inflation is running wild should expect to see its currency depreciate against that of countries with lower inflation rates. This is intuitively appealing, but is it true in practice? There are several good examples of the

Price Level Exchange Money Supply Relative to 1982 Rate (pesos Month (billions of pesos) (average 5 1) per dollar)

1984

April 270 21.1 3,576

May 330 31.1 3,512

June 440 32.3 3,342

July 599 34.0 3,570

August 718 39.1 7,038

September 889 53.7 13,685

October 1,194 85.5 15,205

November 1,495 112.4 18,469

December 3,296 180.9 24,515

1985

January 4,630 305.3 73,016

February 6,455 863.3 141,101

March 9,089 1,078.6 128,137

April 12,885 1,205.7 167,428

May 21,309 1,635.7 272,375

June 27,778 2,919.1 481,756

July 47,341 4,854.6 885,476

August 74,306 8,081.0 1,182,300

September 103,272 12,647.6 1,087,440

October 132,550 12,411.8 1,120,210

9.3 table

Macroeconomic Data for Bolivia, April 1984 to October 1985

Source: Juan-Antino Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988).

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326 Part Four Global Money System

connection between a country’s price inflation and exchange rate position (such as Bolivia). However, extensive empirical testing of PPP theory has yielded mixed re- sults. 11 While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less. 12 In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underde- veloped capital markets. The theory is less useful for predicting short-term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates. The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the purchasing power parity puzzle. Several fac- tors may explain the failure of PPP theory to predict exchange rates more accu- rately. 13 PPP theory assumes away transportation costs and barriers to trade. In practice, these factors are significant and they tend to create significant price dif- ferentials between countries. Transportation costs are certainly not trivial for many goods. Moreover, as we saw in Chapter 6, governments routinely intervene in inter- national trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by PPP theory. In addition, the PPP theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations. 14 In fact, this situation seems to prevail in a number of industries. In the detergent industry, two companies, Unilever and Procter & Gamble, dominate the market in nation after nation. In heavy earthmoving equip- ment, Caterpillar Inc. and Komatsu are global market leaders. In the market for semi- conductor equipment, Applied Materials has a commanding market share lead in almost every important national market. Microsoft dominates the market for personal computer operating systems and applications systems around the world, and so on. In such cases, dominant enterprises may be able to exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions. This is referred to as price discrimination. For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbi- trage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging. For example, even though the version of Microsoft Office sold in China may be less expensive than the version sold in the United States, the use of arbitrage to equalize prices may be limited because few Americans would want a version that was based on Chinese characters. The design differentiation between Microsoft Office for China and for the United States means that the law of one price would not work for Micro- soft Office, even if transportation costs were trivial and tariff barriers between the United States and China did not exist. If the inability to practice arbitrage were wide- spread enough, it would break the connection between changes in relative prices and exchange rates predicted by the PPP theorem and help explain the limited empirical support for this theory. Another factor of some importance is that governments also intervene in the for- eign exchange market in attempting to influence the value of their currencies. We will

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Chapter Nine The Foreign Exchange Market 327

look at why and how they do this in Chapter 10. For now, the important thing to note is that governments regularly intervene in the foreign exchange market, and this fur- ther weakens the link between price changes and changes in exchange rates. One more factor explaining the failure of PPP theory to predict short-term movements in for- eign exchange rates is the impact of investor psychology and other factors on currency purchasing decisions and exchange rate movements. We will discuss this issue in more detail later in this chapter.

INTEREST RATES AND EXCHANGE RATES Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In countries where inflation is expected to be high, interest rates also will be high, because inves- tors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. 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) . More formally,

i 5 r 1 I

For example, if the real rate of interest in a country is 5 percent and annual inflation is expected to be 10 percent, the nominal interest rate will be 15 percent. As predicted by the Fisher effect, a strong relationship seems to exist between inflation rates and interest rates. 15 We can take this one step further and consider how it applies in a world of many countries and unrestricted capital flows. When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real interest rates did emerge between countries, arbitrage would soon equalize them. For example, if the real interest rate in Japan was 10 percent and only 6 percent in the United States, it would pay investors to borrow money in the United States and invest it in Japan. The resulting increase in the demand for money in the United States would raise the real interest rate there, while the increase in the supply of for- eign money in Japan would lower the real interest rate there. This would continue until the two sets of real interest rates were equalized. It follows from the Fisher effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates. Thus, if the expected rate of inflation in the United States is greater than that in Japan, U.S. nominal interest rates will be greater than Japanese nominal interest rates. Since we know from PPP theory that there is a link (in theory at least) between inflation and exchange rates, and since interest rates reflect expectations about infla- tion, it follows that there must also be a link between interest rates and exchange rates. This link is known as the international Fisher effect (IFE). 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 between the two countries. Stated more formally, the change in the spot exchange rate between the United States and Japan, for example, can be modeled as follows:

3_S1 2 S2+yS24 3 100 5 i$ 2 i¥

where i $ and i ¥ are the respective nominal interest rates in the United States and Japan, S 1 is the spot exchange rate at the beginning of the period, and S 2 is the spot exchange rate at the end of the period. If the U.S. nominal interest rate is higher than Japan’s, reflecting greater expected inflation rates, the value of the dollar against the yen should fall by that interest rate differential in the future. So if the interest rate in the

Fisher Effect Nominal interest rates (i) in each country equal 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) ; that is, i 5 r 1 I .

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 nominal interest rates between the two countries.

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328 Part Four Global Money System

United States is 10 percent and in Japan it is 6 percent, we would expect the value of the dollar to depreciate by 4 percent against the Japanese yen.

Do interest rate differentials help predict future currency move- ments? The evidence is mixed; as in the case of PPP theory, in the long run, there seems to be a relationship between interest rate differ- entials and subsequent changes in spot exchange rates. However, con- siderable short-run deviations occur. Like PPP, the international Fisher effect is not a good predictor of short-run changes in spot exchange rates. 16

INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS Empirical evidence suggests that neither PPP theory nor the interna- tional Fisher effect are particularly good at explaining short-term move- ments in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Evidence accumu- lated over the past decade reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. 17 In turn, expectations have a tendency to become self-fulfilling prophecies.

A famous example of this mechanism occurred in September 1992 when the famous international financier George Soros made a huge bet against the British pound. Soros borrowed billions of pounds, using the

assets of his investment funds as collateral, and immediately sold those pounds for German deutsche marks (this was before the advent of the euro). This technique, known as short selling, can earn the speculator enormous profits if he can subsequently buy back the pounds he sold at a much better exchange rate, and then use those pounds, purchased cheaply, to repay his loan. By selling pounds and buying deutsche marks, Soros helped to start pushing down the value of the pound on the foreign exchange markets. More importantly, when Soros started shorting the British pound, many for- eign exchange traders, knowing Soros’s reputation, jumped on the bandwagon and did likewise. This triggered a classic bandwagon effect with traders moving as a herd in the same direction at the same time. As the bandwagon effect gained momentum, with more traders selling British pounds and purchasing deutsche marks in expectation of a decline in the pound, their expectations became a self-fulfilling prophecy. Massive sell- ing forced down the value of the pound against the deutsche mark. In other words, the pound declined in value not so much because of any major shift in macroeconomic fundamentals, but because investors followed a bet placed by a major speculator, George Soros. According to a number of studies, investor psychology and bandwagon effects play a major role in determining short-run exchange rate movements. 18 However, these effects can be hard to predict. Investor psychology can be influenced by political fac- tors and by microeconomic events, such as the investment decisions of individual firms, many of which are only loosely linked to macroeconomic fundamentals, such as relative inflation rates. Also, bandwagon effects can be both triggered and exacerbated by the idiosyncratic behavior of politicians. Something like this seems to have oc- curred in Southeast Asia during 1997 when, one after another, the currencies of Thai- land, Malaysia, South Korea, and Indonesia lost between 50 percent and 70 percent of their value against the U.S. dollar in a few months. For a detailed look at what oc- curred in South Korea, see the accompanying Country Focus. The collapse in the value of the Korean currency did not occur because South Korea had a higher infla- tion rate than the United States. It occurred because of an excessive buildup of dollar- denominated debt among South Korean firms. By mid-1997 it was clear that these

George Soros, whose Quantum Fund has been fantastically successful in managing hedge funds, has been criticized by world leaders for being able to cause huge changes in currency markets by his actions.

Bandwagon Effect When traders move like a

herd, all in the same direction and at the same time, in response to each

others’ perceived actions.

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Chapter Nine The Foreign Exchange Market 329

Anatomy of a Currency Crisis

In early 1997, South Korea could look back with pride on a 30-year “economic miracle” that had raised the country from the ranks of the poor and given it the world’s 11 th -largest economy. By the end of 1997, the Korean currency, the won, had lost a staggering 67 percent of its value against the U.S. dollar, the South Korean economy lay in tatters, and the International Monetary Fund was overseeing a $55 billion rescue package. This sudden turn of events had its roots in investments made by South Korea’s large industrial conglom- erates, or chaebol , during the 1990s, often at the bequest of politicians. In 1993, Kim Young-Sam, a populist politician, became president of South Korea. Mr. Kim took office during a mild recession and promised to boost economic growth by encouraging investment in export-oriented industries. He urged the chaebol to invest in new factories. South Korea enjoyed an investment-led economic boom in 1994–1995, but at a cost. The chaebol , always reliant on heavy borrowing, built up massive debts that were equiva- lent, on average, to four times their equity. As the volume of investments ballooned during the 1990s, the quality of many of these investments declined signifi- cantly. The investments often were made on the basis of unrealistic projections about future demand conditions. This resulted in significant excess capacity and falling prices. An example is investments made by South Korean chaebol in semiconductor factories. Investments in such facilities surged in 1994 and 1995 when a temporary global shortage of dynamic random access memory chips (DRAMs) led to sharp price increases for this product. However, supply shortages had disappeared by 1996 and excess capacity was beginning to make itself felt, just as the South Koreans started to bring new DRAM factories on stream. The results were predictable; prices for DRAMs plunged and the earnings of South Korean DRAM manu- facturers fell by 90 percent, which meant it was difficult for them to make scheduled payments on the debt they had acquired to build the extra capacity. The risk of corporate bankruptcy increased significantly, and not just in the semi- conductor industry. South Korean companies were also investing heavily in a wide range of other industries, includ- ing automobiles and steel. Matters were complicated further because much of the borrowing had been in U.S. dollars, as opposed to Korean won. This had seemed like a smart move at the time. The dollar/won exchange rate had been stable at around $1 5 won 850. Interest rates on dollar borrowings were two to three percentage points lower than rates on borrowings in Korean won. Much of this borrowing was in the form of

short-term, dollar-denominated debt that had to be paid back to the lending institution within one year. While the borrowing strategy seemed to make sense, it involved risk. If the won were to depreciate against the dollar, the size of the debt burden that South Korean companies would have to service would increase when measured in the local cur- rency. Currency depreciation would raise borrowing costs, depress corporate earnings, and increase the risk of bank- ruptcy. This is exactly what happened. By mid-1997, foreign investors had become alarmed at the rising debt levels of South Korean companies, particularly given the emergence of excess capacity and plunging prices in several areas where the companies had made huge investments, including semiconductors, automobiles, and steel. Given increasing speculation that many South Korean companies would not be able to service their debt payments, foreign investors began to withdraw their money from the Korean stock and bond markets. In the process, they sold Korean won and purchased U.S. dollars. The selling of won accelerated in mid-1997 when two of the smaller chaebol filed for bankruptcy, citing their inabil- ity to meet scheduled debt payments. The increased sup- ply of won and the increased demand for U.S. dollars pushed down the price of won in dollar terms from around won 840 5 $1 to won 900 5 $1. At this point, the South Korean central bank stepped into the foreign exchange market to try to keep the exchange rate above won 1,000 5 $1. It used dollars that it held in reserve to purchase won. The idea was to try to push up the price of the won in dollar terms and restore investor confidence in the stability of the exchange rate. This ac- tion, however, did not address the underlying debt problem faced by South Korean companies. Against a backdrop of more corporate bankruptcies in South Korea, and the gov- ernment’s stated intentions to take some troubled compa- nies into state ownership, Standard & Poor’s, the U.S. credit rating agency, downgraded South Korea’s sovereign debt. This caused the Korean stock market to plunge 5.5 percent, and the Korean won to fall to won 930 5 $1. Ac- cording to S&P, “The downgrade of . . . ratings reflects the escalating cost to the government of supporting the coun- try’s ailing corporate and financial sectors.” The S&P downgrade triggered a sharp sale of the Korean won. In an attempt to protect the won against what was fast becoming a classic bandwagon effect, the South Korean central bank raised short-term interest rates to over 12 percent, more than double the inflation rate. The bank also stepped up its intervention in the currency ex- change markets, selling dollars and purchasing won in an attempt to keep the exchange rate above won 1,000 5 $1.

3 Country FOCUS

(continued)

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330 Part Four Global Money System

companies were having trouble servicing this debt. Foreign investors, fearing a wave of corporate bankruptcies, took their money out of the country, exchanging won for U.S. dollars. As this began to depress the exchange rate, currency traders jumped on the bandwagon and speculated against the won (selling it short), and it was this that produced a collapse in the value of the won.

SUMMARY OF EXCHANGE RATE THEORIES Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moder- ately good predictors of long-run changes in exchange rates. They are poor predictors of short-run changes in exchange rates, however, perhaps because of the impact of psychological factors, investor expectations, and bandwagon effects on short-term cur- rency movements. This information is useful for an international business. Insofar as the long-term profitability of foreign investments, export opportunities, and the price competitiveness of foreign imports are all influenced by long-term movements in ex- change rates, international businesses would be advised to pay attention to countries’ differing monetary growth, inflation, and interest rates. International businesses that engage in foreign exchange transactions on a day-to-day basis could benefit by know- ing some predictors of short-term foreign exchange rate movements. Unfortunately, short-term exchange rate movements are difficult to predict.

Exchange Rate Forecasting A company’s 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. Two schools of thought address this issue. The efficient market school argues that forward exchange rates do the best possible job of forecasting fu- ture spot exchange rates, and, therefore, investing in forecasting services would be a waste of money. The other school of thought, the inefficient market school, argues that companies can improve the foreign exchange market’s estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services. In other words, this school of thought does not believe the forward exchange rates are the best possible predictors of future spot exchange rates.

THE EFFICIENT MARKET SCHOOL Forward exchange rates represent market participants’ collective predictions of likely spot exchange rates at specified future dates. If forward exchange rates are the best possible predictor of future spot rates, it would make no sense for companies to spend additional money trying to fore- cast short-run exchange rate movements. Many economists believe the foreign

The main effect of this action, however, was to rapidly de- plete South Korea’s foreign exchange reserves. These stood at $30 billion on November 1, but fell to only $15 bil- lion two weeks later. With its foreign exchange reserves almost exhausted, the South Korean central bank gave up its defense of the won November 17. Immediately, the price of won in dollars plunged to around won 1,500 5 $1, effectively increasing by 60 to 70 percent the amount of won heavily indebted Korean companies had to pay to meet scheduled payments on their dollar-denominated

debt. These losses, due to adverse changes in foreign ex- change rates, depressed the profits of many firms. South Korean firms suffered foreign exchange losses of more than $15 billion in 1997.

Sources: J. Burton and G. Baker, “The Country That Invested Its Way into Trouble,” Financial Times, January 15, 1998, p. 8; J. Burton, “South Korea’s Credit Rating Is Lowered,” Financial Times, October 25, 1997, p. 3; J. Burton, “Currency Losses Hit Samsung Electronics,” Financial Times, March 20, 1998, p. 24; and “Korean Firms’ Foreign Exchange Losses Exceed US $15 Billion,” Business Korea, February 1998, p. 55.

LEARNING OBJECTIVE 5 Identify the merits of different approaches toward exchange rate forecasting.

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Chapter Nine The Foreign Exchange Market 331

exchange market is efficient at setting forward rates. 19 As mentioned earlier, an effi- cient market is one in which prices reflect all available public information. (If forward rates reflect all available information about likely future changes in exchange rates, a company cannot beat the market by investing in forecasting services.) If the foreign exchange market is efficient, forward exchange rates should be un- biased predictors of future spot rates. This does not mean the predictions will be accurate in any specific situation. It means inaccuracies will not be consistently above or below future spot rates; they will be random. Many empirical tests have addressed the efficient market hypothesis. Although most of the early work seems to confirm the hypothesis (suggesting that companies should not waste their money on forecasting services) some recent studies have challenged it. 20 There is some evi- dence that forward rates are not unbiased predictors of future spot rates, and that more accurate predictions of future spot rates can be calculated from publicly avail- able information. 21

THE INEFFICIENT MARKET SCHOOL Citing evidence against the effi- cient market hypothesis, some economists believe the foreign exchange market is inef- ficient. An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best pos- sible predictors of future spot exchange rates. If this is true, it may be worthwhile for international businesses to invest in fore- casting services (as many do). The belief is that professional exchange rate forecasts might provide better predictions of future spot rates than forward exchange rates do. However, the track record of professional forecasting services is not that good. 22 For example, forecasting services did not predict the 1997 currency crisis that swept through Southeast Asia, nor did they predict the rise in the value of the dollar that oc- curred during late 2008, a period when the United States fell into a deep financial crisis that some thought would lead to a decline in the value of the dollar (it appears that the dollar rose because it was seen as a relatively safe currency in a time when many nations were experiencing economic trouble).

APPROACHES TO FORECASTING Assuming the inefficient market school is correct that the foreign exchange market’s estimate of future spot rates can be improved, on what basis should forecasts be prepared? Here again, there are two schools of thought. One adheres to fundamental analysis, while the other uses techni- cal analysis.

Fundamental Analysis Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements. The variables contained in these models typically include those we have discussed, such as relative money supply growth rates, inflation rates, and interest rates. In addi- tion, they may include variables related to balance-of-payments positions. Running a deficit on a balance-of-payments current account (a country is import- ing 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. 23 Consider what might happen if the United States was running a persistent current account balance-of-payments deficit (as in fact, it has been). Since the United States would be importing more than it was exporting, people in other countries would be increasing their holdings of U.S. dollars. If these people were willing to hold their dollars, the dollar’s exchange rate would not be influenced. However, if these people converted their dollars into other currencies, the supply of dollars in the foreign exchange mar- ket would increase (as would demand for the other currencies). This shift in demand

Inefficient Market One in which prices do not reflect all available information.

Fundamental Analysis Draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.

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332 Part Four Global Money System

and supply would create pressures that could lead to the depreciation of the dollar against other currencies. This argument hinges on whether people in other countries are willing to hold dol- lars. This depends on such factors as U.S. interest rates, the return on holding other dollar-denominated assets such as stocks in U.S. companies, and, most importantly, inflation rates. So, in a sense, the balance-of-payments situation is not a fundamental predictor of future exchange rate movements. For example, between 1998 and 2001, the U.S. dollar appreciated against most major currencies despite a growing balance- of-payments deficit. Relatively high real interest rates in the United States, coupled with low inflation and a booming U.S. stock market that attracted inward investment from foreign capital, made the dollar very attractive to foreigners, so they did not con- vert their dollars into other currencies. On the contrary, they converted other curren- cies into dollars to invest in U.S. financial assets, such as bonds and stocks, because they believed they could earn a high return by doing so. Capital flows into the United States fueled by foreigners who wanted to buy U.S. stocks and bonds kept the dollar strong despite the current account deficit. But what makes financial assets such as stocks and bonds attractive? The answer is prevailing interest rates and inflation rates, both of which affect underlying economic growth and the real return to holding U.S. financial assets. Given this, we are back to the argument that the fundamental deter- minants of exchange rates are monetary growth, inflation rates, and interest rates.

Technical Analysis Technical analysis uses price and volume data to determine past trends, which are expected to continue into the future. This approach does not rely on a consideration of economic fundamentals. Technical analysis is 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. Since there is no theoretical rationale for this assumption of predictability, many economists compare technical analysis to fortune-telling. Despite this skepticism, technical analysis has gained favor in recent years. 24

Currency Convertibility Until this point we have invalidly assumed that the currencies of various countries are freely convertible into other currencies. Due to government restrictions, a sig- nificant number of currencies are not freely convertible into other currencies. A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it. A currency is said to be externally convertible when only non- residents may convert it into a foreign currency without any limitations. A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency. Free convertibility is not universal. Many countries place some restrictions on their residents’ ability to convert the domestic currency into a foreign currency (a policy of external convertibility). Restrictions range from the relatively minor (such as restrict- ing the amount of foreign currency they may take with them out of the country on trips) to the major (such as restricting domestic businesses’ ability to take foreign cur- rency out of the country). External convertibility restrictions can limit domestic com- panies’ ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country. For example, even if the Japanese government tightly controlled the ability of its residents to convert the yen into U.S. dollars, all U.S. businesses with deposits in Japanese banks may at any time convert all their yen into dollars and take them out of the country. Thus, a U.S. company with a subsidiary

Technical Analysis   Uses price and volume data to determine past

trends, which are expected to continue

into the future.

Freely Convertible Currency  

A country’s currency is freely convertible when

the government of that country allows both residents and

nonresidents to purchase unlimited amounts of a

foreign currency with it.

Externally Convertible

Currency   Nonresidents can

convert their holdings of domestic currency into

foreign currency, but the ability of residents to

convert the currency is limited in some way.

Nonconvertible Currency  

A currency is not convertible when

both residents and nonresidents are

prohibited from converting their holdings

of that currency into another currency.

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Chapter Nine The Foreign Exchange Market 333

in Japan is assured that it will be able to convert the profits from its Japanese operation into dollars and take them out of the country. Serious problems arise, however, under a policy of nonconvertibility. This was the practice of the former Soviet Union, and it continued to be the practice in Russia for several years after the collapse of the Soviet Union. When strictly applied, non- convertibility means that although a U.S. company doing business in a country such as Russia may be able to generate significant ruble profits, it may not convert those rubles into dollars and take them out of the country. Obviously this is not desirable for international business. Governments limit convertibility to preserve their foreign exchange reserves. A country needs an adequate supply of these reserves to service its international debt commitments and to purchase imports. Governments typically impose convertibility restrictions on their currency when they fear that free convertibility will lead to a run on their foreign exchange reserves. This occurs when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency—a phenomenon generally referred to as capital flight. Capital flight is most likely to occur when the value of the domestic currency is depreciating rapidly because of hyperinflation, or when a country’s economic prospects are shaky in other respects. Under such circum- stances, both residents and nonresidents tend to believe that their money is more likely to hold its value if it is converted into a foreign currency and invested abroad. Not only will a run on foreign exchange reserves limit the country’s ability to service its international debt and pay for imports, but it will also lead to a precipitous depre- ciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets (thereby increasing the market supply of the country’s currency). Governments fear that the rise in import prices

To deal with nonconvertibility problems, companies will barter instead. Venezuela traded iron ore for Caterpillar construction equipment. Caterpillar sold the iron ore to Romania for farm products, which it then sold on international markets for dollars.

Capital Flight   Residents convert domestic currency into a foreign currency.

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334 Part Four Global Money System

resulting from currency depreciation will lead to further increases in inflation. This fear provides another rationale for limiting convertibility. Companies can deal with the nonconvertibility problem by engaging in countertrade. Countertrade refers to a range of barter-like agreements by which goods and services can be traded for other goods and services. Countertrade can make sense when a country’s currency is nonconvertible. For example, consider the deal that General Electric struck with the Romanian government when that country’s currency was non- convertible. When General Electric won a contract for a $150 million generator project in Romania, it agreed to take payment in the form of Romanian goods that could be sold for $150 million on international markets. In a similar case, the Venezuelan government negotiated a contract with Caterpillar under which Venezuela would trade 350,000 tons of iron ore for Caterpillar heavy construction equipment. Caterpillar subsequently traded the iron ore to Romania in exchange for Romanian farm products, which it then sold on international markets for dollars. 25 Similarly, in a 2003 deal the government of Indonesia entered into a countertrade with Libya under which Libya agreed to purchase $540 million in Indonesian goods, including textiles, tea, coffee, electronics, plastics, and auto parts, in exchange for 50,000 barrels per day of Libyan crude oil. 26 How important is countertrade? Twenty years ago, a large number of nonconvert- ible currencies existed in the world, and countertrade was quite significant. However, in recent years many governments have made their currencies freely convertible, and the percentage of world trade that involves countertrade is probably significantly below 10 percent. 27

Focus on Managerial Implications

This chapter contains a number of clear implications for business. First, it is critical that international businesses understand the influence of exchange rates on the profit- ability of trade and investment deals. Adverse changes in exchange rates can make ap- parently profitable deals unprofitable. As noted, the risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk. Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure.

Transaction Exposure Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. Such exposure includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrow- ing or lending of funds in foreign currencies. For example, suppose in 2004 an American airline agreed to purchase 10 Airbus 330 aircraft for €120 million each for a total price of €1.20 billion, with delivery scheduled for 2005 and payment due then. When the contract was signed in 2001 the dollar/euro exchange rate stood at $1 5 €1.10 so the American airline anticipated paying $1.1 billion for the 10 aircraft when they were delivered (€1.2 billiony1.1 5 $1.09 billion). However, imagine that the value of the dollar depreci- ates against the euro over the intervening period, so that one dollar buys only €0.80 in 2008 when payment is due ($1 5 €0.80). Now the total cost in U.S. dollars is $1.5 billion (€1.2 billiony0.80 5 $1.5 billion), an increase of $0.41 billion! The transaction exposure here is $0.41 billion, which is the money lost due to an adverse movement in exchange rates between the time when the deal was signed and when the aircraft were paid for.

Countertrade   The trade of goods and

services for other goods and services.

LEARNING OBJECTIVE 6 Compare and contrast the differences between translation, transaction, and economic exposure, and explain what managers can do to manage each type of exposure.

Transaction Exposure  

Extent to which income from individual

transactions is affected by fluctuations in foreign

exchange values.

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Chapter Nine The Foreign Exchange Market 335

Translation Exposure Translation exposure is the impact of currency exchange rate changes on the re- ported financial statements of a company. Translation exposure is concerned with the present measurement of past events. The resulting accounting gains or losses are said to be unrealized—they are “paper” gains and losses—but they are still important. Consider a U.S. firm with a subsidiary in Mexico. If the value of the Mexican peso depreciates significantly against the dollar this would substantially reduce the dollar value of the Mexican subsidiary’s equity. In turn, this would reduce the total dollar value of the firm’s equity reported in its consolidated balance sheet. This would raise the apparent leverage of the firm (its debt ratio), which could increase the firm’s cost of borrowing and potentially limit its access to the capital market. Similarly, if an American firm has a subsidiary in the European Union, and if the value of the euro depreciates rapidly against that of the dollar over a year, this will reduce the dollar value of the euro profit made by the European subsidiary, resulting in negative transla- tion exposure. In fact, many U.S. firms suffered from significant negative translation exposure in Europe during 2000, precisely because the euro did depreciate rapidly against the dollar. In 2002–2007, the euro rose in value against the dollar. This positive translation exposure boosted the dollar profits of American multinationals with sig- nificant operations in Europe.

Economic Exposure Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates. Economic exposure is concerned with the long-run effect of changes in exchange rates on future prices, sales, and costs. This is distinct from transaction exposure, which is concerned with the effect of exchange rate changes on individual transactions, most of which are short-term affairs that will be executed within a few weeks or months. Consider the effect of wide swings in the value of the dollar on many U.S. firms’ international competitive- ness. The rapid rise in the value of the dollar on the foreign exchange market in the 1990s hurt the price competitiveness of many U.S. producers in world markets. U.S. manufacturers that relied heavily on exports (such as Caterpillar) saw their export volume and world market share decline. The reverse phenomenon occurred in 2000–2009, when the dollar declined against most major currencies. The fall in the value of the dollar helped increase the price competitiveness of U.S. manufacturers in world markets.

Reducing Translation and Transaction Exposure A number of tactics can help firms minimize their transaction and translation expo- sure. These tactics primarily protect short-term cash flows from adverse changes in exchange rates. We have already discussed two of these tactics at length in the chapter, entering into forward exchange rate contracts and buying swaps. In addition to buying forward and using swaps, firms can minimize their foreign exchange exposure through leading and lagging payables and receivables—that is, paying suppliers and collecting payment from customers early or late depending on expected exchange rate move- ments. A lead strategy involves attempting to collect foreign currency receivables (payments from customers) early when a foreign currency is expected to depreciate and paying foreign currency payables (to suppliers) before they are due when a cur- rency is expected to appreciate. A lag strategy involves delaying collection of foreign currency receivables if that currency is expected to appreciate and delaying payables if the currency is expected to depreciate. Leading and lagging involves accelerating pay- ments from weak-currency to strong-currency countries and delaying inflows from strong-currency to weak-currency countries.

Translation Exposure   The extent to which the reported consolidated results and balance sheets of a corporation are affected by fluctuations in foreign exchange values.

Economic Exposure   The extent to which a firm’s future international earning power is affected by changes in exchange rates.

Lead Strategy   Attempting to collect foreign currency receivables early when a foreign currency is expected to depreciate and 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 and delaying payables if the currency is expected to depreciate.

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336 Part Four Global Money System

Lead and lag strategies can be difficult to implement, however. The firm must be in a position to exercise some control over payment terms. Firms do not always have this kind of bargaining power, particularly when they are dealing with important custom- ers who are in a position to dictate payment terms. Also, because lead and lag strate- gies can put pressure on a weak currency, many governments limit leads and lags. For example, some countries set 180 days as a limit for receiving payments for exports or making payments for imports.

Reducing Economic Exposure Reducing economic exposure requires strategic choices that go beyond the realm of financial management. The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well- being is not severely affected by adverse changes in exchange rates. This is a strategy that firms both large and small sometimes pursue. For example, fearing that the euro will continue to strengthen against the U.S. dollar, some European firms who do signifi- cant business in the United States have set up local production facilities in that market to ensure that a rising euro does not put them at a competitive disadvantage relative to their local rivals. Similarly, Toyota has production plants distributed around the world in part to make sure that a rising Yen does not price Toyota cars out of local markets. Caterpillar has also pursued this strategy, setting up factories around the world that can act as a hedge against the possibility that a strong dollar will price Caterpillar’s exports out of foreign markets. In 2008 and 2009, this real hedge proved to be very useful. The accompanying Management Focus discusses how two German firms tried to reduce economic exposure.

Management FOCUS

Dealing with the Rising Euro

Udo Pfeiffer, the CEO of SMS Elotherm, a German manufac- turer of machine tools to engineer crankshafts for cars, signed a deal in late November 2004, to supply the U.S. op- erations of DaimlerChrysler with $1.5 million worth of ma- chines. The machines would be manufactured in Germany and exported to the United States. When the deal was signed, Pfeiffer calculated that at the agreed price, the ma- chines would yield a profit of €30,000 each. Within three days that profit had declined by €8,000! The dollar had slid precipitously against the euro. SMS would be paid in dol- lars by DaimlerChrysler, but when translated back into eu- ros, the price had declined. Since the company’s costs were in euros, the declining revenues when expressed in euros were squeezing profit margins. With the exchange rate standing at €1 5 $1.33 in early De- cember 2004, Pfeiffer was deeply worried. He knew that if the dollar declined further to around €1 5 $1.50, SMS would be losing money on its sales to America. He could try to raise the dollar price of his products to compensate for the fall in the value of the dollar, but he knew that was unlikely to work. The market for machine tools was very competitive, and

manufacturers were constantly pressuring machine tool companies to lower prices, not raise them. Another small German supplier to U.S. automobile compa- nies, Keiper, was faring somewhat better. In 2001 Keiper, which manufactures metal frames for automobile seats, opened a plant in London, Ontario, to supply the U.S. opera- tions of DaimlerChrysler. At the time the investment was made, the exchange rate was €1 5 $1. Management at Keiper had agonized over whether the investment made sense. Some in the company felt that it was better to continue ex- porting from Germany. Others argued that Keiper would ben- efit from being close to a major customer. Now with the euro appreciating every day, it looked like a smart move. Keiper had a real hedge against the rising value of the euro. But the advantages of being based in Canada were tempered by two things; first, the U.S. dollar had also depreciated against the Canadian dollar, although not by as much as its depreciation against the euro. Second, Keiper was still importing parts from Germany, and the euro had also appreciated against the Canadian dollar, raising the costs at Keiper’s Ontario plant.

Source: Adapted from M. Landler, “Dollar’s Fall Drains Profit of European Small Business,” The New York Times, December 2, 2004, p. C1.

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Other Steps for Managing Foreign Exchange Risk The firm needs to develop a mechanism for ensuring it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure. Although there is no universal agreement as to the components of this mechanism, a number of common themes stand out. 28 First, central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies. Many companies have set up in-house foreign exchange centers. Although such centers may not be able to execute all foreign exchange deals—particularly in large, complex multinationals where myriad transactions may be pursued simultaneously—they should at least set guidelines for the firm’s subsidiaries to follow. Second, firms should distinguish between, on one hand, transaction and translation exposure and, on the other, economic exposure. Many companies seem to focus on re- ducing their transaction and translation exposure and pay scant attention to economic exposure, which may have more profound long-term implications. 29 Firms need to de- velop strategies for dealing with economic exposure. For example, Black & Decker, the maker of power tools, has a strategy for actively managing its economic risk. The key to Black & Decker’s strategy is flexible sourcing. In response to foreign exchange move- ments, Black & Decker can move production from one location to another to offer the most competitive pricing. Black & Decker manufactures in more than a dozen loca- tions around the world—in Europe, Australia, Brazil, Mexico, and Japan. More than 50 percent of the company’s productive assets are based outside North America. Although each of Black & Decker’s factories focuses on one or two products to achieve economies of scale, there is considerable overlap. On average, the company runs its factories at no more than 80 percent capacity, so most are able to switch rapidly from producing one product to producing another or to add a product. This allows a facto- ry’s production to be changed in response to foreign exchange movements. For exam- ple, if the dollar depreciates against other currencies, the amount of imports into the United States from overseas subsidiaries can be reduced and the amount of exports from U.S. subsidiaries to other locations can be increased. 30 Third, the need to forecast future exchange rate movements cannot be overstated, though, as we saw earlier in the chapter, this is a tricky business. No model comes close to perfectly predicting future movements in foreign exchange rates. The best that can be said is that in the short run, forward exchange rates provide the best pre- dictors of exchange rate movements, and in the long run, fundamental economic factors—particularly relative inflation rates—should be watched because they influ- ence exchange rate movements. Some firms attempt to forecast exchange rate move- ments in-house; others rely on outside forecasters. However, all such forecasts are imperfect attempts to predict the future. Fourth, firms need to establish good reporting systems so the central finance func- tion (or in-house foreign exchange center) can regularly monitor the firm’s exposure positions. Such reporting systems should enable the firm to identify any exposed ac- counts, the exposed position by currency of each account, and the time periods covered. Finally, on the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports. These reports should identify how cash flows and balance sheet ele- ments might be affected by forecasted changes in exchange rates. The reports can then be used by management as a basis for adopting tactics and strategies to hedge against undue foreign exchange risks. Surprisingly, some of the largest and most sophisticated firms don’t take such pre- cautionary steps, exposing themselves to very large foreign exchange risks. Thus as we have seen in this chapter, Volkswagen suffered significant losses during the early 2000s due to a failure to hedge its foreign exchange exposure.

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338 Part Four Global Money System

foreign exchange market, p. 313 exchange rate, p. 313 foreign exchange risk, p. 313 currency speculation, p. 315 carry trade, p. 315 hedging, p. 315 spot exchange rate, p. 315 forward exchange, p. 317 forward exchange rate, p. 317 currency swap, p. 318

arbitrage, p. 320 law of one price, p. 321 efficient market, p. 321 Fisher effect, p. 327 international Fisher effect, p. 327 bandwagon effect, p. 328 inefficient market, p. 331 fundamental analysis, p. 331 technical analysis, p. 332 freely convertible currency, p. 332

externally convertible currency, p. 332 nonconvertible currency, p. 332 capital flight, p. 333 countertrade, p. 334 transaction exposure, p. 334 translation exposure, p. 335 economic exposure, p. 335 lead strategy, p. 335 lag strategy, p. 335

Key Terms

Summary 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 busi- ness. 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.

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.

7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends in exchange rates, but not of short-term movements. 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.

8. Interest rates reflect expectations about inflation. In countries where inflation is expected to be high, interest rates also will be high.

9. 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.

10. 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.

11. In many countries, the ability of residents and nonresidents to convert local currency into a

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Chapter Nine The Foreign Exchange Market 339

foreign currency is restricted by government policy. A government restricts the convertibility of its currency to protect the country’s foreign exchange reserves and to halt any capital flight.

12. Problematic for international business is a policy of nonconvertibility, which prohibits residents and nonresidents from exchanging local currency for foreign currency. Nonconvertibility 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.

13. The three types of exposure to foreign exchange risk are transaction exposure, translation exposure, and economic exposure.

14. Tactics that insure against transaction and translation exposure include buying forward,

using currency swaps, leading and lagging payables and receivables, manipulating transfer prices, using local debt financing, accelerating dividend payments, and adjusting capital budgeting to reflect foreign exchange exposure.

15. Reducing a firm’s economic exposure requires strategic choices about how the firm’s productive assets are distributed around the globe.

16. To manage foreign exchange exposure effectively, the firm must exercise centralized oversight over its foreign exchange hedging activities, recognize the difference between transaction exposure and economic exposure, forecast future exchange rate movements, establish good reporting systems within the firm to monitor exposure positions, and produce regular foreign exchange exposure reports that can be used as a basis for action.

Critical Thinking and Discussion Questions 1. The interest rate on South Korean government

securities with one-year maturity is 4 percent, and the expected inflation rate for the coming year is 2 percent. The interest rate on U.S. government securities with one-year maturity is 7 percent, and the expected rate of inflation is 5 percent. The current spot exchange rate for Korean won is $1 5 W1,200. Forecast the spot exchange rate one year from today. Explain the logic of your answer.

2. Two countries, Great Britain and the United States, produce just one good: beef. Suppose the price of beef in the United States is $2.80 per pound and in Britain it is £3.70 per pound.

a. According to PPP theory, what should the dollar/pound spot exchange rate be?

b. Suppose the price of beef is expected to rise to $3.10 in the United States and to £4.65 in Britain. What should the one-year forward dollar/pound exchange rate be?

c. Given your answers to parts a and b, and given that the current interest rate in the United States is 10 percent, what would you expect the current interest rate to be in Britain?

3. Reread the Management Focus “Volkswagen’s Hedging Strategy,” then answer the following questions:

a. Why do you think management at Volkswagen decided to hedge only 30 percent

of its foreign currency exposure in 2003? What would have happened if it had hedged 70 percent?

b. Why do you think the value of the U.S. dollar declined against that of the euro in 2003?

c. Apart from hedging through the foreign exchange market, what else can Volkswagen do to reduce its exposure to future declines in the value of the U.S. dollar against the euro?

4. You manufacture wine goblets. In mid-June you receive an order for 10,000 goblets from Japan. Payment of ¥400,000 is due in mid-December. You expect the yen to rise from its present rate of $1 5 ¥130 to $1 5 ¥100 by December. You can borrow yen at 6 percent a year. What should you do?

5. You are the CFO of a U.S. firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?

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340 Part Four Global Money System

Use the globalEDGE Resource Desk (http://global EDGE.msu.edu/resourcedesk/) to complete the following exercises:

1. You are assigned the duty of ensuring the availability of 100 million Japanese yen for a payment scheduled for tomorrow. Your company possesses only U.S. dollars, so you must identify a Web site that provides real-time exchange rates and find the spot exchange rate for Japanese yen. How many dollars do you have to spend to acquire the amount of yen required?

2. Your company imports olive oil from Italy to sell in the United States. As expected, the exchange

rate has changed from the previous year has impacted your bottom line. In preparing an annual report for your company, you would like to include a one-year currency chart showing the monthly movement of the U.S. dollar versus the euro. Download the relevant data indicating the exchange rate between these two currencies once per month for the past year. Then, analyze the data and describe the pattern you see. Over the past year, has the dollar gained or lost ground versus the euro?

Research Task http://globalEDGE.msu.edu

Caterpillar Tractor

Caterpillar Tractor has long been one of America’s major ex- porters. The company sells its construction equipment, min- ing equipment, and engines to some 200 countries worldwide. As a leading exporter, Caterpillar’s fate has often been tied to the value of the U.S. dollar. In the 1980s, the U.S. dollar was strong against the Japanese yen. This gave Komatsu, Japan’s premier manufacturer of heavy construction equipment, a pricing advantage against Caterpillar. Undercutting Cater- pillar’s prices by as much as 30 percent, Komatsu grabbed market share in the United States and other markets. For Caterpillar, it was a difficult time. At one point the company was losing a million dollars a day and battling a hostile labor union that was opposed to job restructuring designed to make the company more competitive. The company seemed to be yet another example of a declining business in America’s rust belt. Fast forward to the mid-2000s, and Caterpillar was thriv- ing. Much had changed over the previous two decades. Cat- erpillar had reached deals with its unions and invested in state-of-the-art manufacturing facilities. It’s productivity, once abysmal, was now among the best in the industry. Sales, exports, and profits were all rising. There was a worldwide boom in spending on infrastructure, and Caterpillar was reaping the gains, producing record amounts of equipment. Moreover, the U.S. dollar, which for years had been strong,

weakened significantly during the mid-2000s. This reduced the price of Caterpillar’s exports, when translated into many foreign currencies, and helped the company to keep its prices down in foreign markets. At this point, Caterpillar was export- ing over half of the output of its key U.S. factories in Peoria, Illinois. Then in 2008, the dollar started to strengthen again. Even though the American economy was stumbling deep into a fi- nancial crisis that would usher in a steep economic reces- sion, foreigners invested strongly in U.S. assets, particularly Treasury bills. Their demand for dollars to purchase these as- sets pushed up the value of the dollar on the foreign exchange markets. The hunger of foreigners for dollars was based on a belief that even though things were bad in America, they were probably going to be even worse in many other developed economies, and the U.S. government at least would not de- fault on its bonds, making U.S. Treasury bills a safe haven in an economic storm. Analysts fretted that the stronger dollar would impact negatively on Caterpillar’s financial performance, since the prices of its exports were now rising when converted into many foreign currencies. The reality, however, was some- what different. As 2008 progressed, the strong dollar started to negatively impact Caterpillar’s revenues, but it had a favor- able effect on Caterpillar’s costs! What had changed over the

closing case

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past two decades is that Caterpillar had dramatically ex- panded its network of foreign manufacturing operations. While still a major exporter, some 102 of its 237 manufacturing facilities were now located outside of North America, many in countries such as China, India, and Brazil that were expand- ing their infrastructure spending. Although the revenues gen- erated by these operations in local currency, when translated back into dollars , declined as the dollar strengthened, the costs of these operations also fell, since their costs were also priced in local currencies, which reduced the impact on profit margins. Although Caterpillar’s export revenues from the United States started to fall, as one would expect, because the company now sourced many of its inputs from foreign producers, the price it paid for those inputs also fell, which again moderated the impact of the strong dollar on earnings. This is not to say that a strong dollar does not have an effect, it does, but through its globalization strategy Caterpillar has

been able to reduce the impact of fluctuations in the value of the dollar on its profits.

Sources: J. B. Kelleher, “U.S. Exporters Can Win from the Strong Dollar,” International Herald Tribune , May 9, 2008, p. 15; “Caterpillar’s Comeback,” The Economist , June 20, 1998, pp. 7–8; and A. Taylor, “Caterpillar,” Fortune , July 20, 2007, pp. 48–54.

Case Discussion Questions 1. In the 1980s a stronger dollar hurt Caterpillar’s

competitive position, but in 2008 a stronger dollar did not seem to have the same effect. What had changed?

2. How did Caterpillar use strategy as a “real hedge” to reduce its exposure to foreign exchange risk? What is the downside of its approach?

3. Explain the difference between transaction exposure and translation exposure using the material in the Caterpillar case to illustrate your answer.

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