INTERNATIONAL BUSINESS

LECTURE 9
FOREIGN EXCHANGE MARKETS AND
EXCHANGE RATE SYSTEMS

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 1

LEARNING OBJECTIVES

• Be conversant with the functions of the foreign exchange market.

• Understand what is meant by spot exchange rates.
• Appreciate the role that forward exchange rates play in insuring against
foreign exchange risk.
• Understand the differences between translation, transaction and economic
exposure, and what managers can do to manage each type of exposure.
 LEARNING OUTCOMES

• Distinguish between nominal, effective, and real exchange rates.

• To explain the operation of the foreign exchange market.
• To outline the purchasing power parity (PPP) theory of exchange
rates.
• To compare and contrast different types of exchange rate system
• To identify the determinants of foreign exchange rate
 Introduction

• Changing money from one country to another and moving

it around to different parts of the world is serious
business, on both a personal and a company level.

Last Updated:Monday, October 3, 2022 4

 Definition

• When one current is traded for another, a foreign

exchange market is established.
• The foreign exchange market is the largest financial
market in the world. The amount of cash traded exceeds
the world’s stock markets.

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 5

 Key Players in Foreign Exchange Market

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 6

Features of Foreign Exchange Market
Definition

An exchange rate is the rate at which one country's currency can be

traded for another country's currency. They exist so countries and firms
can do business with each other and pay in the appropriate currency.
They also are helpful and necessary when individuals travel to other
countries and have to exchange their dollars for the local foreign
currency.

‘The number of units of one currency that

buy one unit of another currency’
 Exchange rate

• Assume you are a Malaysia importer who has agreed to purchase

2000 units of U.S. perfume.
• The current Dollar/Ringgit exchange rate is RM4 per dollar
• Each perfume is selling at $98 from the U.S. exporter
• How many dollar you need to purchase at the going market rate

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 9

Currencies and Exchange Rates
Participants
Why Is The Foreign Exchange Market Important?

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
3. Events in the foreign exchange market affect firm sales, profits,
and strategy
When Do Firms Use The Foreign Exchange Market?

• International companies use the foreign exchange market when

• the payments they receive for exports, the income they receive
from foreign investments, or the income they receive from
licensing agreements with foreign firms are in foreign currencies.
• they must pay a foreign company for its products or
services in its country’s currency.
How Can Firms Hedge Against Foreign Exchange Risk?

• The foreign exchange market provides insurance to protect against foreign

exchange risk - the possibility that unpredicted changes in future exchange
rates will have adverse consequences for the firm
• A firm that insures itself against foreign exchange risk is hedging
• To insure or hedge against a possible adverse foreign exchange rate movement,
firms engage in forward exchanges - two parties agree to exchange currency
and execute the deal at some specific date in the future
• Hedge: Future rate
 Forward Exchange Rate

• A forward exchange rate is the rate used for hedging in the

forward market
• rates for currency exchange are typically quoted for 30, 90, or
180 days into the future
• Multinational corporations, banks, and other financial
institutions enter into forward contracts to take advantage of the
forward rate for hedging purposes.

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 15

 Spot Rate

• The spot exchange rate is the rate at which a foreign exchange

dealer converts one currency into another currency on a particular
day
• spot rates change continually depending on the supply and
demand for that currency and other currencies

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 16

How Are Exchange Rates Determined?

• Exchange rates are determined by the demand and supply for

different currencies
• Factors impact future exchange rate movements
Long-term Factors

Balance of payments is the statement of

a country's trade with other nations. 
Long-term Factors
Long-term Factors

• Inflation Rates
• Changes in market inflation cause changes in currency
exchange rates. A country with a lower inflation rate than
another's will see an appreciation in the value of its currency.
The prices of goods and services increase at a slower rate
where the inflation is low. A country with a consistently lower
inflation rate exhibits a rising currency value while a country with
higher inflation typically sees depreciation in its currency and is
usually accompanied by higher interest rates
Long-term Factors

• Interest Rates
• Changes in interest rate affect currency value and dollar
exchange rate. Forex rates, interest rates, and inflation are all
correlated. Increases in interest rates cause a country's currency
to appreciate because higher interest rates provide higher rates to
lenders, thereby attracting more foreign capital, which causes a
rise in exchange rates
Long-term Factors
Short-term Factors
Short-term Factors
Short-term Factors
Question

All of the following influence the future exchange rate

movements except
A. A country’s inflation rate

B. A country’s currency rate

C. A country’s political stability

D. A country’s employment opportunities

How Do Prices influence Exchange Rates?

• The law of one price states that in competitive markets 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 terms of the same
currency
Purchasing Power Parity Theory (PPP)

• Purchasing power parity theory (PPP) argues that given relatively efficient
markets (markets in which few impediments to international trade and
investment exist) the price of a “basket of goods” should be roughly
equivalent in each country

• predicts that changes in relative prices will result in a change in

exchange rates
What Do Exchange Rates Mean For Managers?

• Managers need to consider three types of foreign exchange risk

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 previously agreed prices and the borrowing or
lending of funds in foreign currencies
What Do Exchange Rates Mean For Managers?

1. 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
 What Do Exchange Rates Mean For Managers?

1. 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

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 33

 How to Manage Foreign Exchange Rate Risk?

• Managing Transaction Risks – The most common way

to manage transaction exchange rate risk is hedging
strategies.

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 34

 How to Manage Foreign Exchange Rate Risk?

• Managing Translation Risk – The second exchange

risk, i.e., translation risk or balance sheet risk, is difficult
to hedge or control. It involves balance sheet items such
as long-term assets and liabilities, which are difficult to
hedge due to their long term nature. And this risk is
hedged very occasionally.

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 35

 How to Manage Foreign Exchange Rate Risk?

• Managing Economic Risk – The third risk, economic

risk, is also challenging to hedge as it is complicated to
quantify the risk and then hedge it. Economic risk is the
residual risk and is often hedged at last and, in many
cases, left unhedged.

Last Updated:Monday, October 3, 2022 © LMS SEGi education group 36

Tutorial

• Define what is foreign exchange and foreign exchange

market?
• What’s the difference between a spot rate and a forward
rate?
• FIVE (5) Factors affect the change of currency (should
include short-term and long-term factors)
• The theory of Purchasing power parity (PPP)
• THREE (3) Types of foreign exchange risks