THE FOREIGN EXCHANGE MARKET

1. Compare and contrast the differences among translation, transaction, and economic exposure, and explain the implications for management practice

1.1. 3 types of foreign exchange risk: transaction exposure, translation exposure, & economic exposure

1.1.1. Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values includes obligations for the purchase or sale of goods and services at the previously agreed prices and the borrowing or lending of funds in foreign currencies Translation exposure - the impact of currency exchange rate changes on the reported financial statements of a company concerned with the present measurement of past events gains or losses are “paper losses” they are unrealized Economic exposure - the extent to which a firm’s future international earning power is affected by changes in exchange rates concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

2. How can managers minimize exchange rate risk?

2.1. Buy forward Use swaps Lead and lag payables and receivables → can be difficult to implement . Lead strategy - collecting currency receivables early when depreciated & paying currency payables before dues when appreciated . Lag strategy - delaying collecting current receivables when appreciated & paying current payables when depreciated Reducing economic exposure: . Distribute productive assets to various locations → the firm’s long-term financial well-being is not severely affected by changes in exchange rates . Ensure assets are not too concentrated in countries where likely rises in currency values → increases in the foreign prices of the goods and services the firm produces In general, managers should Have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand Attempt to forecast future exchange rates Establish good reporting systems so the central finance function can regularly monitor the firm’s exposure position Produce monthly foreign exchange exposure reports

3. Describe the functions of the foreign exchange market

3.1. The foreign exchange market 1. is used to convert the currency of one country into the currency of another 2. provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates The exchange rate is the rate at which one currency is converted into another → events in the foreign exchange market affect firm sales, profits, and strategy

4. Understand what is meant by spot exchange rates

4.1. The foreign exchange market provides insurance to protect against foreign exchange risk (unpredicted changes in future exchange rates → possible adverse consequences) Hedging: a firm insuring itself against foreign exchange risk Spot exchange rate: the rate at which a foreign exchange dealer converts one currency into another currency on a particular day Change continually depending on the supply and demand for that currency and other currencies Spot exchange rates can be quoted as the amount of foreign currency one U.S. dollar can buy the value of a dollar for one unit of foreign currency

5. Recognize the role that forward exchange rates play in insuring against foreign exchange risk

5.1. Forward exchange rates allow companies to lock in a rate for future transactions and mitigate foreign exchange risk. A forward exchange rate is an agreement to exchange a specific amount of currency at a predetermined rate on a future date. Advantages of using forward exchange rates include providing certainty for future transactions, better budgeting and planning, and mitigating potential losses. Disadvantages of using forward exchange rates include missing out on potential gains, potential costs, and the risk of counterparty default. Other methods for managing foreign exchange risk include hedging with options contracts, diversification, and maintaining cash reserves. A combination of methods is recommended for managing foreign exchange risk. Companies conducting cross-border transactions should consider using forward exchange rates to ensure success in their business operations.

6. Understand the different theories explaining how currency exchange rates are determined and their relative merits

6.1. There are several theories that explain how currency exchange rates are determined in international business. The Purchasing Power Parity (PPP) theory states that exchange rates should reflect differences in inflation rates between countries. The Interest Rate Parity (IRP) theory suggests that exchange rates adjust to reflect differences in interest rates between two countries. The Asset Market Model (AMM) suggests that exchange rates are determined by supply and demand for assets denominated in different currencies. The Balance of Payments (BOP) theory suggests that exchange rates are determined by the balance of payments between two countries. The merits of PPP theory include its simplicity and usefulness for long-term forecasting. The merits of IRP theory include its usefulness for short-term forecasting. The merits of the AMM include its ability to incorporate a wide range of factors that affect exchange rates. The merits of BOP theory include its ability to explain long-term exchange rate trends and the impact of economic policies on exchange rates. Understanding these theories can help businesses make informed decisions about currency risk management and international trade

7. Identify the merits of different approaches toward exchange rate forecasting

7.1. Different approaches to exchange rate forecasting have their respective merits in international business. Fundamental analysis analyses underlying economic, financial, and political factors to predict long-term currency movements. Technical analysis focuses on analysing historical price and volume data to identify short-term trends and trading signals. Sentiment analysis looks at news articles, social media posts, and other sources of market sentiment to predict market behavior and identify trading opportunities. Artificial intelligence and machine learning use algorithms and models to analyze vast amounts of data and identify hidden patterns and trends to improve forecasting accuracy over time. Combining multiple approaches to exchange rate forecasting can provide more accurate and comprehensive insights into currency risk management and international trade. Accurate exchange rate forecasting can help businesses make informed decisions, mitigate currency risk, and maximize profits in international trade.