Activity 11

INTERNATIONAL BUSINESS AND TRADE

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Module 10
1. Explain how the foreign currency market works.
Foreign Exchange Market is the market where the buyers and sellers are involved in the
buying and selling of foreign currencies. Simply, the market in which the currencies of
different countries are bought and sold is called as a foreign exchange market. Transfer
Function: The basic and the most visible function of foreign exchange market is the
transfer of funds (foreign currency) from one country to another for the settlement of
payments. It basically includes the conversion of one currency to another, wherein the
role of FOREX is to transfer the purchasing power from one country to another.
For example, If the exporter of India import goods from the USA and the payment is to
be made in dollars, then the conversion of the rupee to the dollar will be facilitated by
FOREX. The transfer function is performed through a use of credit instruments, such as
bank drafts, bills of foreign exchange, and telephone transfers.
Credit Function: FOREX provides a short-term credit to the importers so as to facilitate
the smooth flow of goods and services from country to country. An importer can use
credit to finance the foreign purchases. Such as an Indian company wants to purchase
the machinery from the USA, can pay for the purchase by issuing a bill of exchange in
the foreign exchange market, essentially with a three-month maturity.
Hedging Function: The third function of a foreign exchange market is to hedge foreign
exchange risks. The parties to the foreign exchange are often afraid of the fluctuations in
the exchange rates, i.e., the price of one currency in terms of another. The change in the
exchange rate may result in a gain or loss to the party concerned.
Thus, due to this reason the FOREX provides the services for hedging the anticipated or
actual claims/liabilities in exchange for the forward contracts. A forward contract is
usually a three-month contract to buy or sell the foreign exchange for another currency
at a fixed date in the future at a price agreed upon today. Thus, no money is exchanged
at the time of the contract.
There are several dealers in the foreign exchange markets, the most important amongst
them are the banks. The banks have their branches in different countries through which
the foreign exchange is facilitated, such service of a bank are called as Exchange
Banks.
2. What are the economic and political arguments for regional economic integration?
Given these arguments, why don’t we see more substantial examples of
integration in the world economy?
Regional Economic Integration is an agreement between countries to reduce and
eventually remove tariff and non-tariff barriers to the free flow of goods, services, and
factors of production between each other. My believe is that agreement can cause lot of
problems on developing countries because they depend on developed countries to
smooth the process of doing business. The economic argument for regional economic
integration is when you put the restriction in free trade it slows down the development of
the country’s objectives and financial growth. Also, that deal decrease the surplus of the
consumer which is not good for the economic. But some people do give counter
response that those deals can increase the trade diversion. The political argument is that
those deals can build up good relationship between countries which can reduce the wars
tensions. Countries were more dependable on each other and link with each other. We
do not see more integration in the world economy because those can take lot of time
and lot of economic/pollical resources. Many developed countries can take benefits from
those deals, but the developing countries will lose everything. Also, on pollical point
countries who will be included in the deal will lose their absolutive power on those
countries.

3. What does "spot exchange rates" mean?

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.

4. Explain how forward exchange rates help to protect against foreign exchange risk.
Foreign exchange risk refers to the losses that an international financial transaction may
incur due to currency fluctuations. Also known as currency risk, FX risk and exchange-
rate risk, it describes the possibility that an investment’s value may decrease due to
changes in the relative value of the involved currencies. Investors may experience
jurisdiction risk in the form of foreign exchange risk. Foreign exchange risk arises when
a company engages in financial transactions denominated in a currency other than the
currency where that company is based. Any appreciation/depreciation of the base
currency or the depreciation/appreciation of the denominated currency will affect the
cash flows emanating from that transaction. Foreign exchange risk can also affect
investors, who trade in international markets, and businesses engaged in the
import/export of products or services to multiple countries. The proceeds of a closed
trade, whether its a profit or loss, will be denominated in the foreign currency and will
need to be converted back to the investor's base currency. Fluctuations in the exchange
rate could adversely affect this conversion resulting in a lower than expected amount.
5. Describe the various theories for determining currency exchange rates and their
relative merits.
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.
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. If we can predict what a country’s 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. Thus, in theory at least, we can use information about the growth in money
supply to forecast exchange rate movements.
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 connection between a country’s price inflation
and exchange rate position (such as Bolivia). However, extensive empirical testing of
PPP theory has yielded mixed results. 13 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.
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 (π). More formally i ≈ r + π
INVESTOR PSYCHOLOGY AND BANDWAGON EFFECTS
Empirical evidence suggests that neither PPP theory nor the international Fisher effect is
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. Evidence
reveals that various psychological factors play an important role in determining the
expectations of market traders as to likely future exchange rates.19 In turn, expectations
have a tendency to become self-fulfilling prophecies.
SUMMARY OF EXCHANGE RATE THEORIES
Relative monetary growth, relative inflation rates, and nominal interest rate differentials
are all moderately 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 currency 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
exchange 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 knowing
some predictor s of short-term foreign exchange rate movements. Unfortunately, short-
term exchange rate movements are difficult to predict.

6. Determine the advantages of various approaches to 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 future 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 forecast short-run exchange rate movements. Many economists believe
the foreign exchange market is efficient at setting forward rates. An efficient market is
one in which prices reflect all available public information.
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.
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 technical analysis.

7. Examine the distinctions between translation, transaction, and economic exposure.

and explain how it affects managerial practice.
Foreign exchange risk is usually divided into three main categories: transaction
exposure, translation exposure, and economic 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 borrowing or lending of funds in
foreign currencies. Translation exposure is the impact of currency exchange rate
changes on the reported 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. 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.
A 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. 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 reducing their transaction and translation
exposure and pay scant attention to economic exposure, which may have mor profound
long-term implications.30 Firms need to develop strategies for dealing with economic
exposure. Third, the need to forecast future exchange rate movements cannot be
overstated, although 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
predictors of exchange rate movements, and in the long run, fundamental economic
factors particularly relative inflation rates should be watched because they influence
exchange rate movements Fourth, firms need to establish good reporting systems so the
central finance function (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 accounts, 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 elements might be affected by forecasted changes in exchange rates.