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Over the last two decades, business and industry has become more global in nature. Increasingly, competition comes not only from domestic firms but from firms located in other countries. Furthermore, it is estimated that for large firms, more than 40% of sales are outside their country of domicile. The state of the global economy and the sensitivity of a firm's sales and profits to changes in economic activity will be important determinants of value. Political developments in various parts of the world can affect firms' performance, for example the expansion of the Euro trading block with a common currency has had a profound influence on prospects for US firms. Two important indicators of international trade and finance are the country's balance of payments accounts and the exchange rate behavior of the local currency.

4.5.1 FOREIGN EXCHANGE MARKET

Learning Objective 4.5.1 – Understand the characteristics of the Foreign Exchange Market and the manner in which exchange rates are quoted

 Spot rates

 Forward rates

 Bid - offer spreads

An important factor that affects firms and businesses is the value of their currency relative to those of other countries. This relative value is determined in the foreign exchange market or currency market. In the market the participation is dominated by the commercial banks, buying and selling currencies based on the economic fundamentals of individual countries. As the value of the domestic currency appreciates, the international competitiveness of domestic firms tends to erode. Central banks intervene in the currency markets to maintain the value of their currency within reasonable limits. In Saudi Arabia for example, SAMA stands ready to buy and sell US dollars at a price of SR 3.75, thus pegging the value of the riyal to the dollar.

There are two types of transaction conducted on the foreign exchange market:

 Spot transactions are immediate currency deals that are settled within two working days.

 Forward transactions involve currency deals that are agreed for a future date at a rate of exchange fixed now.

Exchange rates are quoted against the US dollar and can be expressed in direct or indirect terms. An example of a spot rate quote is shown below.

Direct Quote for the Euro 1.21 $/€ Indirect Quote for the Euro 0.826 €/$

The indirect quote is simply the inverse of the direct quote. Most currencies are quoted against the dollar on an indirect basis in the currency markets. From market quotes it is easy to compute cross rates, or the value of one currency relative to another without involving the dollar. For instance, given the quote for the euro above and the value of the British pound of 1.65 $/£, we can express the following:

Direct quote for the euro in terms of the pound is 0.733 £/€, and the Indirect quote for the euro in terms of the pound is 1.364 €/£.

Banks are the major dealers in the currency markets, standing ready to buy or sell the currencies that they deal in. As dealers they quote two prices: the bid which is the price at which they buy, and the ask which is the price at which they sell.

A typical quote by a Saudi Bank for the US dollar is shown below:

Bid Ask

3.74 SR/$ 3.76 SR/$

The bank is stating that it stands ready to buy dollars at SR 3.74 and sell dollars at SR 3.76. The difference SR 0.02 represents the 'bid ask' spread, and the bank's potential profit.

In addition to trading in the spot market, banks also make a market in forward trading -quoting prices today for deferred delivery in the future. The quotes on the forward market state how much must be added to, or subtracted from, the present spot rate. These are either premiums to the spot rate, or discounts to the spot rate.

The relationship between the spot exchange rate and forward exchange rate between two currencies is simply given by the differential between their respective nominal interest rates over the term being considered. The relationship is purely mathematical and has nothing to do with market expectations of the likely course that the exchange rate may take given knowledge of other factors.

4.5.2 EXCHANGE RATE REGIMES

Learning Objective 4.5.1 – Know the differences between fixed and floating exchange rate systems

A country can either follow a fixed (or pegged) exchange rate system or a floating rate system. In a pegged system, the central bank keeps the value of the domestic currency at a fixed rate of exchange against another currency. This requires the central bank to stand ready to buy or sell the peg currency at the stated pegged price.

In a freely floating rate system, the value of the currency is allowed to be determined by the forces of demand and supply in the international currency markets. However, even under floating rate regimes, central banks may intervene by buying or selling to manipulate the value of the currency. This combination of floating rate plus central bank intervention is commonly referred to as a managed float.

4.5.3 DETERMINANTS OF CURRENCY VALUE

Learning Objective 4.5.2 – Know the factors that determine the value of a currency:

 Supply and demand

 Inflation

 Interest rates

 Economic performance

The value of a currency is predominantly determined by the relative demand and supply for that currency. Demand and supply are in turn determined by a host of economic factors. The demand for dollars for example will depend on foreigner's demand for US goods or the demand to invest in dollar denominated assets. Conversely, the supply of dollars will be determined by American demand for foreign goods and foreign exchange denominated assets. Inflation has a profound influence on the value of a currency. Inflation tends to erode the value of the currency and cause the currency to depreciate. In contrast, an increase in interest rates will tend to appreciate the currency. An increase in economic performance (as measured by GDP) will help to appreciate the value of the currency.

4.5.4 BALANCE OF PAYMENTS

Learning Objective 4.5.3 – Understand basic details of the Balance of Payments accounts and their significance in the economy:

 Current account

 Capital account

 Surplus

 Deficit

 Liquidity

The balance of payments accounts record all transactions that take place between a country and the rest of the world. The accounts are divided into two broad categories. The first category, called the current account, shows the country's exports and imports of goods and services. A current account deficit means that the country is importing more than it exports. A current account surplus means that the country is exporting more than it imports. The second category, called the capital account, records the investment flows into and out of the country. Investments could be either in financial assets or in real assets, with the latter referred to as foreign direct investments. When foreigners invest in the domestic economy, it is an inflow of foreign currency, conversely when domestic residents invest abroad; it is an outflow of foreign currency. If the investment inflow exceeds the investment outflow, it is a surplus in the capital account. The individual parts of the balance of payments accounts could be in surplus or deficit, however it would be worrying if the deficit in one category is not matched by a surplus in the other. Economies that have persistent deficits in both accounts are likely to face liquidity problems in the future, with adverse effects on firms and businesses.

As an example, the US has historically run a current account deficit against Japan, (i.e. importing more from Japan than it exports to Japan), but this has been offset by a capital account surplus (i.e., Japanese investing more in the US than the US investing in Japan), thus keeping the overall accounts approximately in balance.

As a contrary example, consider the case of Malaysia during the East Asian crisis of the 1990's. Malaysia was suffering from a current account deficit precisely at a point when foreigners were withdrawing investment funds from Malaysia. This put undue pressure on the balance of payments system, finally leading to a devaluation of the Malaysian Ringgit and a prolonged contraction of the economy.