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**You are the CFO of a US firm whose wholly owned subsidiary in Mexico manufactures component parts for your U.S. assembly operations. The subsidiary has been financed by bank borrowings in the United States. One of your analysts told you that the Mexican peso is expected to depreciate by 30 percent against the dollar on the foreign exchange markets over the next year. What actions, if any, should you take?


**What would you do if the Mexican peso did not depreciate by 30%, but rather increase by 30%? How would your strategy change? Would you decrease your inventory until the peso decreased back to normal levels? How would that impact sales in the US

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INBS 561 International Financial Markets Module 5a Foreign Exchange: Basic Concepts Copyright 2017 Montclair State University Foreign Exchange: Basic Concepts • Foreign exchange market: the global marketplace for buying and selling national currencies. It is a network of banks and currency exchanges that buy and sell foreign currencies and other exchange instruments • Foreign exchange (Fx): all forms of money that are traded internationally, and electronic transfers • Exchange rates: the price of one currency in terms of another currency; e.g., $1 = ¥ 120 • Foreign exchange risk: the adverse effect of unexpected changes in exchange rate Why Firms Use the Foreign Exchange Market • To settle international business transactions, such as payments for imports, income received from foreign investments, or income received from licensing agreements with foreign firms • Hedging [loss protection]—that is, to insure against foreign exchange risk • Speculation—short-term movement of funds from one currency to another in the hopes of making a profit from shifts in exchange rates • Arbitrage [risk-free profit based on price differentials] • For investment of spare cash in money markets (Money market is a section of the financial market where financial instruments with high liquidity and short-term maturities are traded) Types of Foreign Exchange Markets Spot market: the market for converting currency into another for delivery within two business days following the date of the transaction pot market. Forward market: exchange transactions occur at a set rate for delivery beyond two business days following the date of transaction. Currency swap: the simultaneous purchase and sale of foreign exchange for two different dates. The dealer incurs no unexpected foreign exchange risk. Futures contract: an agreement between two parties to buy or sell a given currency at a given (negotiated) price on a particular future date. Option: gives the purchaser the right (but not the obligation) to buy or sell a certain amount of foreign currency at a specified exchange rate within a specified period of time INBS 561 International Financial Markets Module 5b Exchange Rate Determination Exchange Rate Determination * • Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another • Factors that affect future exchange rate movements include: * • A country’s rate of inflation: a country with high inflation should expect its currency to depreciate against the country with lower inflation rate. Inflation is the result of increases in money supply faster than output increases • Purchasing power parity (PPP): argues that the price of a basket of goods should be about the same in each country in a market with no impediments to the free flow of goods and services. Therefore, changes in relative prices will lead to a change in exchange rate, at least in the short run How Interest Rates Influence Exchange Rates The Fisher Effect Theory: link interest rates and inflation r: the nominal interest rate; i.e., the actual rate of interest earned on an investment R: the real interest rate; i.e., the nominal interest rate less inflation A country’s nominal interest rate r is determined by the real interest rate R and the inflation rate i as follows: (1 + r) = (1 + R)(1 + i) International Fisher Effect Theory (IFE): links interest rates and exchange rates. Thus, the currency of the country with the lower interest rate will strengthen in the future because the interest rate differential is an unbiased predictor of future changes in the spot exchange rate. How Interest Rates Influence Exchange Rates An example of the Fisher Effect: Because the interest rate should be the same in every country, the country with the higher interest rate should have higher inflation. Thus, if R = 5%, the U.S. inflation rate is 2.9%, and the Japanese inflation rate is 1.5%, the nominal interest rates are: rus = (1.05)(1.029) – 1 = .08045 or 8.045% rj = (1.05)(1.015) – 1 = .06575 or 6.575% On the other hand, if inflation rates were the same, investors would place their money in countries with higher interest rates in order to get higher real returns. INBS 561 International Financial Markets Module 5c Implications for Managers Implications for Managers • Adverse changes in exchange rates can make apparently profitable deals unprofitable • Foreign exchange risk is usually divided into three main categories: • Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values • Translation exposure: the impact of currency exchange rate changes on the reported financial statements of a company • Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates Reducing Translation and Transaction Exposure • Firms should use forward exchange rate contracts and buy swaps • Firms can also use a lead strategy: • collect foreign currency receivables when a foreign currency is expected to depreciate • pay foreign currency payables before they are due when a currency is expected to appreciate in value • Firms can also use a lag strategy: • delay the collection of foreign currency receivables when the foreign currency is expected to appreciate in value • delay paying foreign currency payables if that currency is expected to depreciate Reducing Economic Exposure • To reduce economic exposure, the firm should distribute its productive assets to various global locations so that the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates.
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