The Foreign Exchange Market

Introduction

This 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 predict future exchange rate movements. The third objective is to map the implications for international business of exchange rate movements and the foreign exchange market. This is the first of three that deal with the international monetary system and its relationship to international business.

The Functions of the Foreign Exchange Market

Currency Conversion

When a tourist changes one currency into another, she is participating in the foreign exchange market. The exchange rate is the rate at which the market converts one currency into another. 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 receives from licensing agreements with foreign firms may be in foreign currencies.

Second, international businesses use foreign exchange markets when they must pay a foreign company for its products or services in its country's currency. Third, international businesses use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets.

Finally, currency speculation is another use of foreign exchange markets. Currency speculation typically involves the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.

Insuring against Foreign Exchange Risk .

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

Forward Exchange Rates

The fact that spot exchange rates change continually as determined by the relative demand and supply for different currencies can be problematic for an international business. To avoid this risk, the US 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 governing 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.

Currency Swaps

The above discussion of spot and forward exchange rates might lead you to conclude that the option to buy forward is very important to companies engaged in international trade--and you would be right. But Figure 9.1, which shows the nature of foreign exchange transactions in April 1995 for a sample of US banks surveyed by the

The Nature of the Foreign Exchange Market

So far we have dealt with the foreign exchange market only as an abstract concept. It is now time to take a closer look at the nature of this 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 communications systems. When companies wish to convert currencies, they typically go through their own banks rather than entering the market directly

Two features of the foreign exchange market are of particular note. The first is that the market never sleeps.

The second feature of the market is the extent of integration of the various trading centers. Direct telephone lines, fax, and 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. Another feature of the foreign exchange market is the important role played by the US dollar. Although a foreign exchange transaction can in theory involve any two currencies, most transactions involve dollars. This is true even when a dealer wants to sell one nondollar currency and buy another. A dealer wishing to sell Dutch guilders   for Italian lira, for example, will usually sell the guilders for dollars and then use the dollars to buy lira. Although this may seem a roundabout way of doing things, it is actually cheaper than trying to find a holder of lira who wants to buy guilders. Because the volume of international transactions involving dollars is so great, it is not hard to find dealers who wish to trade dollars for guilders or lira.

Economic Theories of Exchange Rate Determination

Prices and Exchange Rates

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.

 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 currencies, it would be possible to determine the "real" or PPP exchange rate that would exist if markets were efficient. A less extreme version of the PPP theory states that given relatively efficient markets--that is, markets in which few impediments to international trade and investment exist--the price of a "basket of goods" should be roughly equivalent in each country.

Money Supply and Price Inflation

In essence, 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 depreciate against that of countries in which inflation rates are lower. Because the growth rate of a country's money supply and its inflation rates are closely correlated,⁷ we can predict a country's likely inflation rate. Then we can use this information to forecast exchange rate movements.

A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals 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 inflation. 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 inflation, 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 a depreciation in its currency exchange rate. 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 US money supply is growing more rapidly than US output, dollars will be relatively more  plentiful 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.

Empirical Tests of PPP Theory

PPP theory predicts 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.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. In addition, the theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped 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.

Several factors may explain the failure of PPP theory to predict exchange rates more accurately. PPP theory assumes away transportation costs and barriers to trade and investment. In practice, these factors are significant, and they tend to create price differentials between countries. Another factor of some importance is that governments also intervene in the foreign exchange market in attempting to influence the value of their currencies.

Perhaps the most important factor explaining the failure of PPP theory to predict short-term movements in foreign exchange rates, however, 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 investors 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 = r + I

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.

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,

(S₁ - S₂)/S₂ * 100 = i_$ - i_DM

Investor Psychology and Bandwagon Effects

Empirical evidence suggests that neither PPP theory nor the International Fisher Effect are particularly good at explaining short-term movements in exchange rates. One reason may be the impact of investor psychology on short-run exchange rate movements. Increasing evidence reveals that various psychological factors play an important role in determining the expectations of market traders as to likely future exchange rates. In turn, expectations have a tendency to become self-filling prophecies.

According to a number of recent studies, investor psychology and bandwagon effects play a major role in determining short-run exchange rate movements. However, these effects can be hard to predict. Investor psychology can be influenced by political factors 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.

The Inefficient Market School

Citing evidence against the efficient market hypothesis, some economists believe the foreign exchange market is inefficient. 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 possible predictors of future spot exchange rates.

If this is true, it may be worthwhile for international businesses to invest in forecasting services. The belief is that professional exchange rate forecasts   might provide better predictions of future spot rates than forward exchange rates do. It should be pointed out, however, that the track record of professional forecasting services is not that good.

Approaches to Forecasting

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 addition, they may include variables related to balance-of-payments positions.

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.¹⁹

Currency Convertibility

Convertibility and Government Policy

Due to government restrictions, a significant 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 nonresidents 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 the exception rather than the rule. Many countries place some restrictions on their residents' ability to convert the domestic currency into a foreign currency. Restrictions range from the relatively minor to the major. External convertibility restrictions can limit domestic companies' ability to invest abroad, but they present few problems for foreign companies wishing to do business in that country.

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 circumstances, 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 depreciation in the exchange rate as residents and nonresidents unload their holdings of domestic currency on the foreign exchange markets .

Countertrade

Countertrade refers to a range of barterlike 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.

Implications for Business

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 profitability of trade and investment deals. Adverse changes in exchange rates can make apparently profitable deals unprofitable. The risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk. Means of hedging against foreign exchange risk are available. Forward exchange rates and currency swaps allow companies to insure against this risk.

International businesses must also understand the forces that determine exchange rates. This is particularly true in light of the increasing evidence that forward exchange rates are not unbiased predictors. If a company wants to know how the value of a particular currency is likely to change over the long term on the foreign exchange market, it should look closely at those economic fundamentals that appear to predict long-run exchange rate movements.