Lecture overview
Introduction The role of foreign exchange in international marketing Foreign exchange rates The forward exchange market Exchange rate systems (regimes) Models of exchange rate behaviour Exchange controls
Learning outcomes
Define the term exchange rate and briefly explain how it is determined and its importance in international marketing Distinguish between hedging and speculation as they applies to transactions in the forward exchange market Explain the different exchange rate systems and highlight their importance for the exporter. Identify the main factors underpinning exchange rate movements Briefly explain what is meant by the balance of payments (BOP) and show how a trade transaction is recorded in the BOP List the advantages and disadvantages of exchange controls.
Introduction
With the advent of globalisation the world has become one global village. Domestic producers are increasingly forced to compete with foreign producers. With trade liberalisation, producers are increasingly being forced to compete, irrespective of whether they export or not. In this chapter we explore the concept of foreign exchange and the issues related to foreign exchange which have a bearing on a firms profitability.
The supply of dollars (= demand for Rands) in the Forex markets is due to the following:
South African exports foreigners convert their currencies into Rands to pay for goods purchased from South Africa. Foreign investment flows into South Africa. When foreigners invest in South Africa these investments are done in Rands.
The exchange rate determines the number of Rands that are received (or paid) for each US dollar, and therefore changes in the exchange rate have a direct impact on the profits of a firm.
If a firm is totally or heavily reliant on the export market for its revenue, and appreciation of the currency is likely to lead to a decline in demand for its product, there is hence a decline in export revenue.
If on the other hand, the domestic market is the major source of its revenue, an appreciation of the exchange rate could increase the profitability of the firm (since input costs decline).
The forward exchange market involves the delivery of currency at some date in the future.
Exchange rate changes can have an adverse impact on a firm's profitability. A large and sustained appreciation of the exchange rate can threaten the survival of export firms. .../
Hedging
Hedging is primarily directed at managing risks. As far as foreign exchange is concerned, hedging involves limiting the risks that could arise from fluctuations in the exchange rate. Instruments that are available for hedging include the following:
- Forward contracts - Futures contract - Option contracts
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Speculation
Speculation refers to the situation where foreign exchange is purchased or sold with the sole aim of making a profit. The profit is realised from transacting in foreign exchange rather than from a commercial transaction such as the export of goods.
The purchasing power parity (PPP) hypothesis maintains that the exchange rate between the currencies of two countries should equal the ratio of the price levels of the two countries.
Balance of payments
It reflects the economic transactions between a country and the rest of the world for a given. The balance of payments is a statistical reflection of the economic relations with the rest of the world, and is therefore an important indicator influencing domestic economic developments, particularly those in financial markets. Its role in policy formulation has increased over time, particularly with the intensification of globalisation over the last half century.
Exchange controls
Exchange controls refer to the laws that prohibit or restrict the flow of foreign currencies into or out of a country.
They entail the various forms of controls imposed by the authorities on the purchase and/or sale of foreign currencies by residents or on the purchase and/or sale of local currency by non-residents. Experience has shown that stringent exchange controls are not successful (they can lead to the creation of an informal market in foreign exchange a black market).
Summary
Exchange rate changes have a direct impact on profitability and hence are an important element underpinning a firm's production decisions. The forward exchange market in modern business practices Hedging and speculation are two practices common to the forward exchange market and its relevance in export decisions is without question. A thorough understanding of the operations of the foreign exchange market is an integral to effective decision making in businesses operating on the international market.