Because currencies trade in markets all over the world, exchange rates may differ in different markets. When exchange rates do differ, there is an opportunity to make money by buying lower and selling higher. In fact, the word “arbitrage” means buy low and sell high.
Suppose the exchange rate for the Mexican peso and the US dollar was 40.5 peso/dollar in New York. However, in Tokyo the exchange rate was 40.75 peso/dollar. If both markets are open and there are no restrictions on trade, there is an arbitrage opportunity. Arbitrageurs with substantial dollars or with substantial credit lines in dollars can purchase more pesos per dollar in Tokyo and then immediately sell the pesos in New York for more dollars than they paid. For example, $1,000,000 would buy 40,750,000 pesos in Tokyo. These pesos could then buy $1,006,173 in New York (40,750,000 pesos/40.5 = $1,006,173) for a profit of $6,173.
Of course, when arbitrage opportunities exist, currency traders move quickly to take advantage of the exchange-rate difference. Because an increase in demand for the cheaper currency will cause its value to rise, markets quickly adjust, eliminating arbitrage opportunities. Because rates often differ by a very small amount, it takes very large transactions to show a profit. Although it is mostly currency speculators that try to take advantage of arbitrage, MNCs also do so when opportunities arise.
C H A P T E R R E V I E W
To buy, sell, or invest across national borders, MNCs must be able to exchange their home currencies for the currencies of the nations in which they do business. The foreign exchange market is where these currency exchanges take place. The foreign exchange market is the biggest in the world. The dollar value of daily exchanges exceeds $1.8 trillion. Thus, having a basic understanding of how cur- rency exchange works is an important step in conducting international business.
The price of one currency in terms of another represents the exchange rate between the two currencies. Major business publications publish the ending daily exchange rates among major currencies each day. However, the values of currencies change continuously, often up to 20 times a minute.
Early efforts to manage and stabilize exchange rates among currencies led to the development of the gold standard. When countries used the gold standard, they set the value of their currency in terms of an ounce of gold. The US set the price of gold at $20.646, and technically you could buy an ounce of gold from the US Treasury at that price. This system broke down after World War II and many countries then fixed the value of their currencies to the US dollar. Although some countries still fix the value of their money to the US dollar or to several other currencies, most major economies in the world now use a floating-rate system. Market forces set the value of currencies.
People and companies tend to buy and invest in other countries where their own currency has greater buying power, so they need more of the foreign currency to do this. This is the demand side of the currency market. The supply of a currency is also influenced by the exchange rate since if you need less of currency X to buy currency Y then the supply of currency available increases. When the demand and supply curves of a currency cross, that is the equilibrium point and reflects the exchange rate. However, other market forces that deter- mine the value of currencies include a country’s inflation rate, interest rates, income levels, and government controls. These factors shift the supply and demand curves and thus change the exchange rates.
Because exchange rates change so much, MNCs face exchange-rate risks. When a company buys or sells something and gives or takes payments in the future, costs or income from these exchanges are often different from those existing at the time of the initial agreement. This is called transaction exposure. Similarly, the values of investments and debts in other countries vary with the exchange rates. This is called translation exposure. To hedge against these variations, MNCs can fix the rates of exchange in the future by buying forward exchange contracts or currency future contracts.
Because the foreign exchange market is a worldwide operation and because markets do not always value currencies at the same rates, there exist opportu- nities for foreign exchange arbitrage. This means that one buys the currency in one market at a cheaper price and then sells in another market at a higher price. Since currency values change continuously, arbitrage opportunities are often fleeting and companies must move very fast with large amounts of money to succeed before the markets adjust.
All international business people must keep a vigil on the foreign exchange market as it affects all cross-border transactions as well as the value of one’s
company. Tactics such as hedging allow managers to have some reducibility in their transnational operations. However, in parts of the world where currencies are highly unstable, the exchange-rate risks can make international business a challenging financial management problem.
DISCUSSION QUESTIONS
1. Describe the foreign exchange market. Discuss why it exists and why it is necessary for international trade and commerce.
2. What is an exchange rate and how does it relate to the bid and the ask spread?
3. Compare and contrast the basic types of foreign exchange transactions. 4. Explain how the gold standard worked and why it led to stable exchange
rates. What might be some advantages and disadvantages of returning to the gold standard?
5. Describe the relationship between purchasing power parity and the Big Mac Index.
6. What is derived demand and how does this relate to the value of one currency in terms of another?
7. What are the advantages of hedging for an MNC? How do MNCs hedge?