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Chapter
9 Outline
Chapter 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 business. This chapter made the following points:
- One function of the foreign exchange market is to convert
the currency of one country into the currency of another.
- International businesses participate in the foreign exchange
market to facilitate international trade and investment, to invest spare
cash in short-term money market accounts abroad, and to engage in currency
speculation.
- A second function of the foreign exchange market is to
provide insurance against foreign exchange risk.
- The spot exchange rate is the exchange rate at which
a dealer converts one currency into another currency on a particular
day.
- 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.
- 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.
- 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.
- 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.
- 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 the existence of 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.
- Interest rates reflect expectations about inflation.
In countries where inflation is expected to be high, interest rates
also will be high.
- 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.
- 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.
- In many countries, the ability of residents and nonresidents
to convert local currency into a 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.
- Particularly bothersome for international business is
a policy of nonconvertibility, which prohibits residents and nonresidents
from exchanging local currency for foreign currency. A policy of 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.
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