Chapter 9 Outline

Introduction

This 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 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 chapter is the first of three that deal with the international monetary system and its relationship to international business. In Chapter 10, we will explore the institutional structure of the international monetary system. The institutional structure is the context within which the foreign exchange market functions. As we shall see, changes in the institutional structure of the international monetary system can exert a profound influence on the development of foreign exchange markets. In Chapter 11, we will look at the recent evolution of global capital markets and discuss the implications of this development for international businesses.

The foreign exchange market is a market for converting the currency of one country into that of another country. An exchange rate is simply the rate at which one currency is converted into another. We saw in the opening case how JAL used the foreign exchange market to convert Japanese yen into US dollars. Without the foreign exchange market, international trade and international 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. As the opening case illustrates, some of these risks exist because future exchange rates cannot be perfectly predicted. The rate at which one currency is converted into another typically changes over time. One function of the foreign exchange market is to provide some insurance against the risks that arise from 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. JAL's loss of $1.5 billion on foreign exchange transactions is an extreme example of what can happen, but it is not unusual for international businesses to suffer losses because of unpredicted changes in exchange rates. Currency fluctuations can make seemingly profitable trade and investment deals unprofitable, and vice versa. The opening case contains an example of this as it relates to trade. For an example that deals with investment, consider the case of Mexico. Between 1976 and 1987, the value of the Mexican peso dropped from 22 per US dollar to 1,500 per US dollar. As a result, a US company with an investment in Mexico that yielded an income of 100 million pesos per year would have seen the dollar value of that income shrink from $4.55 million in 1976 to $66,666 by 1987!

In addition to altering the value of trade deals and foreign investments, currency movements can also open or close export opportunities and alter the attractiveness of imports. In 1984, for example, the US dollar was trading at an all-time high against most other currencies. At that time, one dollar could buy one British pound or 250 Japanese yen, compared to 0.55 of a British pound and about 85 yen in early 1995. In the 1984 US presidential campaign, then-President Ronald Reagan boasted about how good the strong dollar was for the United States. Many US companies did not see it that way. Companies such as Caterpillar that earned their living by exporting to other countries were being priced out of foreign markets by the strong dollar. In 1980 when the dollar-to-pound exchange rate was $1 = £0.63, a $100,000 Caterpillar earthmover cost a British buyer £63,000. In 1984, with the exchange rate at $1 = £0.99, it cost close to £99,000--a 60 percent increase in four years! At that exchange rate Caterpillar's products were overpriced in comparison to those of its foreign competitors, such as Japan's Komatsu. At the same time, the strong dollar reduced the price of the earthmovers Komatsu imported into the United States, which allowed the Japanese company to take US market share away from Caterpillar.

While the existence of foreign exchange markets is a necessary precondition for large-scale international trade and investment, the movement of exchange rates introduces many risks into international trade and investment. Some of these risks can be insured against by using instruments offered by the foreign exchange market, such as the forward exchange contracts discussed in the opening case; others cannot be.

We begin this chapter by looking at the functions and the form of the foreign exchange market. This includes distinguishing among spot exchanges, forward exchanges, 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 implications for business.