Foreign Exchange Market

1
Chapter 9

• Foreign Exchange Market

2
Globalization

• Globalization of US economy (indeed all
  economies) have led to increased importance of
  foreign exchange
• enormous market! Important market.
• In past, exchange rates were fixed, not the
  market sets the price in most countries

3
Definition

• Exchange rate is the number of units of a foreign
  currency that can be acquired with one unit of
  domestic money.
• Example yen/dollar exchange rate is 100. This
  means that a US dollar can be exchanged for 100
  yen

4
Foreign exchange continued

• Remember Exchange rate is the number of units of
  a foreign currency that can be acquired with one
  unit of domestic money.
• What does it mean to have the dollar fall?
• That the dollar cannot be exchanged for as many
  foreign units. Thus a move to 90 yen would be a
  decline in the US dollar.

5
Simple example

• Suppose yen/dollar exchange rate is 100. You
  want to buy a Walkman that Sony is selling for
  5000 yen.
• How much would this cost you in dollars?
• US dollar price
• foreign price/exchange rate
• 5,000/100 50

6
Walkman example continued

• Suppose now the US dollar goes up in value
  relative to the Yen. The new exchange rate is
  110.
• Same price in yen 5000
• new price in dollars
• 5000/11045.45

7
Walkman example continued

• What if the dollar falls?
• Same price in yen 5000
• new price in dollars is 90 yen per dollar
• 5000/9055.45

8
Effects of changing fore-ex rates

• Movements in the foreign exchange markets have
  effects on the product markets
• Now suppose a US manufacturer of portable stereos
  is in the market and they make a identical
  product to the Walkman.
• Which do you buy?

9
Foreign exposure

• US firm sells their product for 50.
• As US dollar falls, they
• a. could raise their prices
• b. maintain their prices and sell more product
  since it is now RELATIVELY cheaper.
• Either way the value of the US firm should
  increase

10
Effects of changing Fore-Ex prices

• This change in value tied to fore-ex markets has
  been an important new risk facing all firms. No
  longer must you be selling internationally, even
  domestic firms have fore-ex exposure
• This has led to many new financial products and
  strategies to reduce exposure.

11
What causes currency fluctuations?

• Largely a function of changes in demand for
  currency. Example changes in Demand for US
  dollars.
• Function of foreign demand for US goods,
  services, and securities.
• Thus by changing interest rates, central bankers
  can change demand for currency.
• (see FT article on Japan)

12
Suggested problems

• 11-15