Volkswagen’s Hedging StrategyIntroductionThe Functions of the Foreign Exchange MarketCurrency ConversionInsuring against Foreign Exchange RiskInsuring against Foreign Exchange RiskInsuring against Foreign Exchange RiskThe Nature of the Foreign Exchange MarketEconomic Theories of Exchange Rate DeterminationLaw of One Price Purchasing Power ParityBig Mac Index December 2004Money Supply and InflationInterest Rates and Exchange RatesInvestor Psychology and Bandwagon EffectsExchange Rate ForecastingApproaches to ForecastingCurrency ConvertibilityCurrency ConvertibilityImplications for ManagersImplications for ManagersReducing Translation and Transaction ExposureReducing Economic ExposureOther StepsLooking Ahead to Chapter 11Chapter TenThe Foreign Exchange Market10 - 3McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Volkswagen’s Hedging Strategy• Volkswagen, Europe’s largest carmaker, reported a 95% drop in 2003 fourth-quarter profits • The cause for the slump had many reasons but two causes stood out:- The unprecedented rise in the value of the Euro against the dollar- Volkswagen’s decision to only hedge 30% of its foreign currency exposure as opposed to the 70% it had traditionally hedged10 - 4McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Introduction• Foreign exchange market: a market for converting the currency of one country into the currency of another.• Exchange rate: the rate at which one currency is converted into another• Foreign exchange risk: the risk that arises from changes in exchange rates10 - 5McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.The Functions of the Foreign Exchange Market• The foreign exchange market serves two main functions:- Convert the currency of one country into the currency of another- Provide some insurance against foreign exchange risk• Foreign exchange risk: the adverse consequences of unpredictable changes in the exchange rates10 - 6McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Currency Conversion• Consumers can compare the relative prices of goods and services in different countries using exchange rates• International business have four main uses of foreign exchange markets- To exchange currency received in the course of doing business abroad back into the currency of its home country- To pay a foreign company for its products or services in its country’s currency- To invest excess cash for short terms in foreign markets- To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation10 - 7McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Insuring against Foreign Exchange Risk• A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately• The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day- Reported daily- Change continually10 - 8McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Insuring against Foreign Exchange Risk• Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future- Exchange rates governing such future transactions are referred to as forward exchange rates- For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future• When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed10 - 9McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Insuring against Foreign Exchange Risk• Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates • Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk10 - 10McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.The Nature of the Foreign Exchange Market• The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems• The most important trading centers include: London, New York, Tokyo, and Singapore• London’s dominance is explained by:- History (capital of the first major industrialized nation)- Geography (between Tokyo/Singapore and New York)• Two major features of the foreign exchange market:- The market never sleeps- Market is highly integrated10 - 11McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Economic Theories of Exchange Rate Determination• Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another• Price and exchange rates:- Law of One Price- Purchasing Power Parity (PPP)- Money supply and price inflation• Interest rates and exchange rates• Investor psychology and “Bandwagon” effects10 - 12McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Law of One Price• In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency• Example: US/French exchange rate: $1 = .78Eur A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78)10 - 13McGraw-Hill/IrwinInternational Business, 6/e© 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.Purchasing Power Parity• By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient• In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be