Quiz 10: The Foreign Exchange Market
Billabong is an Australian company manufacturing various kinds of surf wear. 80 percent of its sales are overseas, with the US market accounting for 50 percent of its total sales turnover. This heavy reliance on the US market means that the relative movements of the Australian Dollar (AUD) against the US dollar (USD) will have a heavy impact on the earnings of the company. If the AUD falls against the USD it means that prices of their products become cheaper when translated into USD. Alternatively if the USD prices remain the same then the AUD realization increases. In practice the Australian seller would go half-way to get the competitive benefit of lower prices in the US market and a better realization for his US sales in AUD. Therefore a fall in the AUD would benefit Billabong.
From the Fisher effect, we know that the real interest rate in both the US and South Korea is 2%. The international Fisher effect suggests that the exchange rate will change in an equal amount but opposite direction to the difference in nominal interest rates. Hence since the nominal interest rate is 3% higher in the US than in South Korea, the dollar should depreciate by 3% relative to the South Korean Won. Using the formula from the book: (S 1 - S 2 )/S 2 x 100 = i $ - i Won and substituting 7 for i $ , 4 for i Won , and 1200 for S 1, yields a value for S 2 of $1=W1165.
International businesses need to use the foreign exchange market they have to ultimately get all earning into the home country. Now if it is operating a host country where the currency is different from that of the home country then it needs to exchange that currency form its home country currency. When a Japanese company sells its goods in the EU and the US it gets paid in euros and US dollars respectively. To repatriate these earnings to Japan it needs to exchange the euros and US dollars for Japanese yen to bring them into Japan. Conversely when a one buys goods or services from another country one has to pay that person in his currency by exchanging your currency for his currency. For example when Apple buys iPhones from Foxcomm in China it exchanges US dollars for Yuan. The third reason is one which one will not discuss here is currency speculation. This is when one buys a certain currency expecting it to rise in value against the currency one exchanged to buy it so that by exchanging it back at a later date one can make a profit.