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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. We consider each function in turn.1 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, the French franc (FFr); in Germany, the deutsche mark (DM); in Japan, the yen (¥); and so on. In general, within the borders of a particular country, one must use the national currency. A US tourist cannot walk into a store in Edinburgh, Scotland, and use US 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 foreign exchange market. The exchange rate is the rate at which the market converts one currency into another. For example, an exchange rate of $1 = ¥85 specifies that one US dollar has the equivalent value of 85 Japanese yen. The exchange rate allows us to compare the relative prices of goods and services in different countries. Returning to our example of the US tourist wishing to buy a bottle of Scotch whisky in Edinburgh, she may find that she must pay £25 for the bottle, knowing that the same bottle costs $40 in the United States. Is this a good deal? Imagine the current dollar/pound exchange rate is $1 = £0.50. Our intrepid tourist takes out her calculator and converts £25 into dollars. (The calculation is 25/0.50.) She finds that the bottle of Scotch costs the equivalent of $50. She is surprised that a bottle of Scotch whisky could cost less in the United States than in Scotland. (This is true; 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 receives 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. 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, our friend Michael runs a company called NST, a large British travel service for school groups. Each year Michael's company arranges vacations for thousands of British schoolchildren and their teachers in France. French hotel proprietors demand payment in francs, so Michael must convert large sums of money from pounds into francs to pay them. Third, international businesses use foreign exchange markets when they have spare cash that they wish to invest for short terms in money markets. For example, consider a US 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 8 percent. Investing in a French money market account, however, may earn 12 percent. Thus, the company may change its $10 million into francs and invest it in France. Note, however, that the rate of return it earns on this investment depends not only on the French interest rate, but also on the changes in the value of the franc against the dollar in the intervening period. 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. Consider again the US company with $10 million to invest for three months. Suppose the company suspects that the US dollar is overvalued against the French franc. That is, the company expects the value of the dollar to depreciate against that of the franc. Imagine the current dollar/franc exchange rate is $1 = FFr 6. The company exchanges its $10 million into francs, receiving FFr 60 million. Over the next three months, the value of the dollar depreciates until $1 = FFr 5. Now the company exchanges its FFr 60 million back into dollars and finds that it has $12 million. The company has made a $2 million profit on currency speculation in three months on an initial investment of $10 million. One of the most famous currency "speculators" is George Soros, whose Quantum Group of "hedge funds" controls about $15 billion in assets. The activities of Soros, who has been spectacularly successful, are profiled in the accompanying Management Focus. In general, however, companies should beware of speculation for it is by definition 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. For example, in 1991, Clifford Hatch, the finance director of the British food and drink company Allied-Lyons, bet large amounts of the company's funds on the speculation that the British pound would rise in value against the US dollar. Over the previous three years, Hatch had made over $25 million for Allied-Lyons by placing similar currency bets. His 1991 bet, however, went spectacularly wrong when the British pound plummeted in value against the US dollar. In February 1991, one pound bought $2; by April it bought less than $1.75. The total loss to Allied-Lyons from this speculation was a staggering $269 million, more than the company was to earn from all of its food and drink activities during 1991!2 Insuring against Foreign Exchange Risk A second function of the foreign exchange market is to provide insurance to protect against the possible adverse consequences of unpredictable changes in exchange rates (foreign exchange risk). 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
Table 9.1 Foreign Exchange Quotations 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 US tourist in Edinburgh goes to a bank to convert her dollars into pounds, the exchange rate is the spot rate for that day. Although it is necessary to use a spot rate to execute a transaction immediately, it may not be the most attractive rate. The value of a currency is determined by the interaction between the demand and supply of that currency relative to the demand and supply of other currencies. For example, if lots of people want US dollars and dollars are in short supply, and few people want French francs and francs are in plentiful supply, the spot exchange rate for converting dollars into francs will change. The dollar is likely to appreciate against the franc (or, conversely, the franc will depreciate against the dollar). Imagine the spot exchange rate is $1 = FFr 5 when the market opens. As the day progresses, dealers demand more dollars and fewer francs. By the end of the day, the spot exchange rate might be $1 = FFr 5.3. The dollar has appreciated, and the franc has depreciated. Table 9.1 lists spot exchange rate quotes for several currencies on May 14, 1998, at 11:48 am Eastern US time (note that the quotes can change by the minute). As can be seen, on this day at this time $1 could be exchanged for Australian $ 1.594, UK£ 0.6134, and so on. Table 9.1 also tells us what other currencies would purchase. For example, FFr 1 could be exchanged for DMark 0.298, the Germany currency. 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. One example was given in the opening case; here is another. A US company that imports laptop computers 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 = ¥120. At this rate, each computer costs the importer $1,667 (i.e., 1667 = 200,000/120). The importer 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 - $1667). 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 = ¥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 = ¥120 to $1 = ¥95 would transform a profitable deal into an unprofitable one. 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. (An example
of forward exchange rate quotations appears in Table 9.2.) In some cases,
it is possible to get forward exchange rates for several years into the
future. The opening case, for example, reported how JAL entered into a
contract that predicted forward exchange rates up to 10 years in the future.
Returning to our computer importer example, let us assume the 30-day forward
exchange rate for converting dollars into yen is $1 = ¥110. The importer
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 = 200,000/110). This guarantees her
a profit of $182 per computer ($2,000 - $1,818). She also insures herself
against the possibility that an unanticipated change in the dollar/yen
exchange rate will turn a profitable deal into an unprofitable one.
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
Source: The Wall Street Journal, January 18, 1999. Reprinted by permission of the Wall Street Journal, © 1999 Dwow Jones & Company, Inc. All rights reserved worldwide. Table 9.2 Spot and Forward Rates Federal Reserve Board, reveals that the majority (55 percent) of foreign exchange transactions were spot exchanges, followed by swaps (34 percent). Forward exchanges accounted for only 11 percent of all foreign exchange transactions that month, but swaps are a sophisticated kind of forward exchange. A currency swap is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates. Swaps are transacted between international Figure 9.1 Foreign Exchange Transactions, April 1995
Source: Summary of results of US Foreign Exchange Market Survey conducted April 1995 by Federal Reserve Bank of New York. 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 incurring 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 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 = ¥120 and the 90-day forward exchange rate is $1 = ¥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 forward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/110 = $1.09 million). Since the yen is trading at a premium 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 foreign 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. |
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