LEARNING OBJECTIVES

After studying this chapter, you should be able to:

1. understand the determinants of foreign exchange rates

2. track the evolution of the international monetary system

3. identify firms’ strategic responses to deal with foreign exchange movements

4. participate in three leading debates on foreign exchange movements

5. draw implications for action

FACTORS BEHIND FOREIGNEXCHANGE RATES

International Monetary Fund (IMF) – An international organization that was established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.

FACTORS BEHIND FOREIGNEXCHANGE RATES

foreign exchange rate - price of one currency in terms of another

balance of payments - country’s international transaction statement, including merchandise trade, service trade, and capital movement

FACTORS BEHIND FOREIGNEXCHANGE RATES

purchasing power parity - theory that suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same (the law of one price)

FACTORS BEHIND FOREIGNEXCHANGE RATES

Interest Rates and Money Supply - short run direction of exchange rate movement.

A high interest rate will increase the demand for the home currency, thus enhancing its exchange value.

A high level of inflation is too much money chasing too few goods and would cause currency to depreciate.

The exchange rate is very sensitive to changes in monetary policy.

FACTORS BEHIND FOREIGNEXCHANGE RATES

Productivity and Balance of Payments – the change in productivity will change a country’s balance of trade.

A country experiencing a current account surplus will see its currency appreciate.

A country experiencing a current account deficit will see its currency depreciate.

Exchange Rate Policies

floating (or flexible) exchange rate policy - willingness of a government to let the supply and demand conditions determine exchange rates

clean (or free) float - pure market solution to determine exchange rates

dirty (or managed) float - common practice of determining exchange rates through selective government intervention

target exchange rates or crawling bands - limited policy of intervention, occurring only when the exchange rate moves out of the specified upper or lower bounds

Exchange Rate Policies

fixed exchange rate policy - Fixing the exchange rate of a currency relative to other currencies

peg - stabilizing policy of linking a developing country’s currency to a key currency

Investor Psychology

bandwagon effect - result of investors moving as a herd in the same direction at the same time

capital flight - phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency

EVOLUTION OF THE INTERNATIONALMONETARY SYSTEM

gold standard - system in which the value of most major currencies was maintained by fixing their prices in terms of gold, which served as the common denominator

Bretton Woods system - system in which all currencies were pegged at a fixed rate to the US dollar

post–Bretton Woods system - system of flexible exchange rate regimes with no official common denominator

International Monetary Fund (IMF)

An international organization of 185 member countries established to:

promote international monetary cooperation, exchange stability, and orderly exchange arrangements

foster economic growth and high levels of employment

provide temporary financial assistance to countries to help ease balance of payments adjustment

International Monetary Fund (IMF)

The IMF performs three primary activities:

monitoring the global economy

providing technical assistance to developing countries

lending

International Monetary Fund (IMF)

quota - financial contribution, capacity to borrow, and voting power of IMF member countries that is based broadly on its relative size in the global economy

moral hazard - recklessness when people and organizations (including governments) do not have to face the full consequences of their actions

Strategies for Financial Companies

A strategic goal for financial companies is to profit from the foreign exchange market

foreign exchange market - market where individuals, firms, governments, and banks buy and sell foreign currencies

Two Functions of the Foreign Exchange Market:1. To service the needs of trade and FDI2. To trade in its own commodity, namely, foreign

exchange.

Foreign Exchange Transactions

Three primary types of foreign exchange transactions:

spot transactions - classic single-shot exchange of one currency for another

forward transactions - foreign exchange transaction in which participants buy and sell currencies now for future delivery, typically in 30, 90, or 180 days, after the date of the transaction

currency swap - foreign exchange transaction in which one currency is converted into another in Time 1, with an agreement to revert it back to the original currency at a specific Time 2 in the future

Foreign Exchange Transactions

currency hedging - transaction that protects traders and investors from exposure to the fluctuations of the spot rate

forward discount - forward rate of one currency relative to another currency is higher than the spot rate

forward premium - forward rate of one currency relative to another currency is lower than the spot rate

Foreign Exchange Transactions

offer rate - price offered to sell a currency

bid rate - price offered to buy a currency

spread - difference between the offered price and the bid price

Strategies for Nonfinancial Companies

A goal for nonfinancial companies is to ensure a neutral impact in coping with the fluctuations of the foreign exchange market

currency risks/hedging - fluctuations of the foreign exchange market

strategic hedging - Spreading out activities in anumber of countries in different currency zones to offset the currency losses in certain regions through gains in other regions (currency diversification)

Fixed versus Floating Exchange Rates

Since the collapse of the Bretton Woods system in the early 1970s, debate has never ended on whether fixed or floating exchange rates are better.

Fixed exchange rates:1. Impose monetary discipline be preventing governments

from engaging in inflationary monetary policies (printing more money).

2. Reduce uncertainty and thus encourage trade and FDI.

Floating exchange rates:1. Market forces should take care of supply, demand, and

thus the price if any currency.2. Allow each country to make its own monetary policy.

currency board - monetary authority that issues notes and coins convertible into a key foreign currency at a fixed exchange rate

Strong Dollar versus a Weak Dollar

Under the Bretton Woods system (1944–1973),the US dollar was the only common denominator.

Since the demise of Bretton Woods the importance of the US dollar has been in gradual decline.

This does not mean that the US dollar is no longer important; it still is (see Table 7.2).

It is the dollar’s relative importance—in particular, its value—that is at the heart of this debate.

Currency Hedging versus Not Hedging

Given the unpredictable nature of foreign exchange rates (at least in the short run), it seems natural that firms that deal with foreign transactions would engage in currency hedging.Firms that fail to hedge are at the mercy of the spot market. Yet, many firms do not bother to engage in currency hedging.

Pro Hedging: increased stability of cash flows and earnings.

Con Hedging: belief that the ups and downs of various currencies balance out in the long run.