INTERNATIONAL INTERNATIONAL FINANCIAL MARKET FINANCIAL MARKET

& & INTERNATIONAL INTERNATIONAL

MONETARY SYSTEMMONETARY SYSTEM

2

IntroductionIntroduction

• Fundamental difference between payment transactions

• Domestic transaction—use only one curency• Foreign transaction—use two or more currencies

• Foreign exchange— money denominated in the currency of another group of nations

• Exchange rate—price of a currency• Number of units of one currency that buys one unit of another

currency• Exchange rate can change daily

• International financial market comprise of:– International Capital Market

• Obtaining external financing.

• Main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently.

– Foreign-Exchange Market—made up of:– over-the-counter (OTC)

» commercial and investment banks

» majority of foreign-exchange activity

– security exchanges

» trade certain types of foreign-exchange instruments

Essential Terms

• Security - a contract that can be assigned a value and traded (stocks, bonds, derivatives and other financial assets)

• Stocks – A instrument representing ownership

• Bonds - a debt agreement

• Derivatives - the rights to ownership (financial instruments; futures, forwards, options, swaps)

• Stock exchange, share market or bourse - is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities

• Over-the-counter (OTC) trading - is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

Essential Terms II

Capital Market

Debt: Repay principal plus interest Bond has timed principal & interest payments

Equity: Part ownership of a company Stock shares in financial gains or losses

• System that allocates financial resources according to their most efficient uses

• Common capital market intermediaries:•Commercial Banks•Investment Banks

International Capital Market (ICM)

Network of people, firms, financial institutions and governments borrowing and investing internationally

Borrowers

Expands money supply Reduces cost of money

Borrowers

Expands money supply Reduces cost of money

Lenders

Spread / reduce risk Offset gains / losses

Lenders

Spread / reduce risk Offset gains / losses

Purposes

International CapitalMarket Drivers

Information technologyInformation technology

DeregulationDeregulation

Financial instruments

(securitization)

Financial instruments

(securitization)

World Financial CentersWorld Financial Centers

• At present, the three main financial centers are London, New York and Tokyo

• London is one of the three leading world financial centres. It is famous for its banks and Europe's largest stock exchange, that have been established over hundreds of years (e.g. Lloyd's of London, London Stock Exchange). The financial market of London is also commonly referred to as the City. It has historically been situated around the part of London called Square Mile, but in the 1980's and 1990's a large part of the City of London's wholesale financial services relocated to Canary Wharf.

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Operational centerExtensive financial activity

and currency trading

Operational centerExtensive financial activity

and currency trading

Booking centerMostly for bookkeeping

and tax purposes

Booking centerMostly for bookkeeping

and tax purposes

Offshore Financial Centers

IMF defines OFC as:

• Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents;

• Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and

• More popularly, centers which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

Main Components of ICM: International Bond Market

Foreign bond Interest ratesEurobond

Bond that is issued outside the country in whose currency the bond is denominated

Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold

Driving growth are differential interest rates between developed and developing nations

Market of bonds sold by issuing companies, governments and others outside their own countries

International Equity Market

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

Factors contributing towards growth:

•Spread of Privatization

•Economic Growth in Developing Countries

•Activities of Investment Banks

•Advent of Cybermarkets

Governments Commercial banks International companies Wealthy individuals

Eurocurrency Market

Unregulated market of currencies banked outside

their countries of origin

Introduction

• Foreign exchange market: a market for converting the currency of one country into the currency of another.

• Exchange rate: the rate at which one currency is converted into another

• Foreign exchange risk: the risk that arises from changes in exchange rates

Foreign Exchange Market

Foreign Exchange Market

Conversion: To facilitate sale or purchase, or invest directly abroad

Hedging: Insure against potential losses from adverse exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit

Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit

Market in which currencies are bought and soldand their prices are determined

The Functions of the The Functions of the Foreign Exchange MarketForeign Exchange Market

• The foreign exchange market serves two main functions:– Convert the currency of one country into the

currency of another

– Provide some insurance against foreign exchange risk• Foreign exchange risk: the adverse

consequences of unpredictable changes in the exchange rates

Currency Conversion

• Consumers can compare the relative prices of goods and services in different countries using exchange rates

• International business have four main uses of foreign exchange markets

•To exchange currency received in the course of doing business abroad back into the currency of its home country•To pay a foreign company for its products or services in its country’s currency

• To invest excess cash for short terms in foreign markets

• To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation

Insuring against Foreign Insuring against Foreign Exchange RiskExchange Risk

• A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately

• The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day– Reported daily– Change continually

Insuring against Foreign Insuring against Foreign Exchange RiskExchange Risk

• Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future

– Exchange rates governing such future transactions are referred to as forward exchange rates

– For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future

• When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed

Insuring against Foreign Insuring against Foreign Exchange RiskExchange Risk

• Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

• Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk

The Nature of the Foreign The Nature of the Foreign Exchange MarketExchange Market

• The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems

• The most important trading centers include: London, New York, Tokyo, and Singapore

• London’s dominance is explained by:– History (capital of the first major industrialized nation)– Geography (between Tokyo/Singapore and New

York)• Two major features of the foreign exchange market:

– The market never sleeps– Market is highly integrated

Institutions of Foreign Exchange Market

• Interbank Market: market in which the world’s largest banks exchange currencies at spot and forward rates.– “Clearing mechanism”

• Securities Exchanges: exchange specializing in currency futures and options transactions.

• Over-the-Counter Market: Exchange consisting of a global computer network of foreign exchange traders and other market participants.

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The Foreign-Exchange MarketThe Foreign-Exchange MarketSize of foreign-exchange market

$600 billion spot $1.3 trillion in derivatives, ie

$200 billion in outright forwards $1 trillion in forex swaps$100 billion in FX options. (2004)

U.S. dollar is the most important currency because it is:• An investment currency in many capital markets• A reserve currency held by many central banks• A transaction currency in many international

commodity markets• An invoice currency in many contracts• An intervention currency employed by monetary

authorities to influence their exchange rates

Trends in Foreign-Exchange Trading

9-7

Quoting Currencies

Quoted currency = numeratorBase currency = denominatorQuoted currency = numeratorBase currency = denominator

(¥/$) = Japanese yen needed to buy one U.S. dollar(¥/$) = Japanese yen needed to buy one U.S. dollar

Yen is quoted currency, dollar is base currencyYen is quoted currency, dollar is base currency

Currency Values

Change in US dollar against Polish zloty

February 1: PLZ 5/$ March 1: PLZ 4/$

%change = [(4-5)/5] x 100 = -20%

US dollar fell 20%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Cross RateCross Rate

Dollar Euro Pound SFranc Peso Yen CdnDlr

Canada 1.3931 1.6466 2.4561 1.0695 0.1198 0.0122 ....

Japan 114.50 135.32 201.85 87.898 9.8420 .... 82.185

Mexico 11.633 13.749 20.510 8.9309 .... 0.1016 8.3504

Switzerland 1.3026 1.5395 2.2965 .... 0.1120 0.0114 0.9350

United Kingdom 0.5672 0.6704 .... 0.4355 0.0488 0.0050 0.4071

Euro 0.8461 .... 1.4917 0.6495 0.0727 0.0074 0.6073

United States .... 1.1819 1.7630 0.7677 0.0860 0.0087 0.7178

• Exchange rate calculated using two other exchange rates• Use direct or indirect exchange rates against a third currency

Cross Rate ExampleCross Rate ExampleDirect quote method

1) Quote on euro = € 0.8461/$2) Quote on yen = ¥ 114.50/$3) € 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥4) Costs 0.0074 euros to buy 1 yen

Indirect quote method

1) Quote on euro = $ 1.1819/€2) Quote on yen = $ 0.008734/¥3) $ 1.1819/€ ÷ $ 0.008734/¥ = € 135.32/¥4) Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥5) Costs 0.0074 euros to buy 1 yen

Currency Convertibility

• Governments can place restrictions on the convertibility of currency– A country’s currency is said to be freely

convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it

– A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations

– A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency

• Government restrictions can include– A restriction on residents’ ability to convert the

domestic currency into a foreign currency– Restricting domestic businesses’ ability to take

foreign currency out of the country

• Governments will limit or restrict convertibility for a number of reasons that include:– Preserving foreign exchange reserves– A fear that free convertibility will lead to a run on

their foreign exchange reserves – known as capital flight

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Governmental Restrictions on Foreign-Exchange Convertibility

Restrictions used to conserve scarce foreign exchange

• Licensing—government regulates all foreign-exchange transactions

– those who receive foreign currency required to sell it to its central bank at the official buying rate

– central bank rations foreign currency

• Multiple exchange-rate system—different exchange rates set for different transactions

• Advance import deposit—requires importers to make a deposit with central bank covering price of goods they would purchase from abroad

• Quantity controls—limit the amount of currency that resident can purchase for foreign travel

Currency controls increase the cost of international business and reduce overall international trade

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How Companies Use Foreign Exchange

Most foreign-exchange transactions involve international departments of commercial banks

• Banks buy and sell foreign currency; banks collect and pay money in transaction with foreign buyers and sellers

• Banks lend money in foreign currencyCompanies use foreign-exchange market for:

• Import and export transactions• Financial transactions such as FDI

Arbitrage—purchase of foreign currency on one market for immediate resale on another market

• Arbitragers hope to profit from price discrepancy• Interest arbitrage—investing in debt instruments in

different countriesSpeculation—buying or selling foreign currency has both risk

and high profit potential

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Foreign-Exchange Trading Process

Companies work through their local banks to settle foreign-exchange balances

• Commercial banks in major money centers became intermediaries for small banks

Most foreign-exchange activity takes place in traditional instruments

• Commercial and investment banks and other financial institutions handle spot, outright forward, and FX swaps

• Foreign-exchange market made up of about 2,000 dealer institutions worldwide

• Most foreign-exchange takes place in OTC marketDealers can trade foreign exchange:

• Directly with other dealers• Through voice brokers• Through electronic brokerage systems

– Internet trades of currency are more popular

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Commercial and Investment Banks

Greatest volume of foreign-exchange activity takes place with the big banks

• Top banks in the interbank market in foreign exchange are so ranked because of their ability to:

– trade in specific market locations– engage in major currencies and cross-trades– deal in specific currencies– handle derivatives

» forwards, options, future swaps– conduct key market research

• Banks may specialize in geographic areas, instruments, or currencies

– exotic currency—currency of a developing country

» often unstable, weak, and unpredictable

Top 10 Currency Traders (% of overall volume, May 2005 )

Rank Name % of volume

1 Deutsche Bank 17.0

2 UBS 12.5

3 Citigroup 7.5

4 HSBC 6.4

5 Barclays 5.9

6 Merrill Lynch 5.7

7 J.P. Morgan Chase 5.3

8 Goldman Sachs 4.4

9 ABN AMRO 4.2

10 Morgan Stanley 3.9

International Monetary SystemInternational Monetary System

• Rules and procedures by which different national currencies are exchanged for each other in world trade.

• Such a system is necessary to define a common standard of value for the world's currencies.

• Refer to the institutional arrangements that countries adopt to govern exchange rates– Floating– Pegged exchange rate– Dirty float– Fixed exchange rate

• Floating exchange rates occur when the foreign exchange market determines the relative value of a currency

• The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other

• Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency

• Dirty float occurs when countries hold the value of their currency within a range of a reference currency

• Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate

• Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

Evolution of International Monetary SystemEvolution of International Monetary System

The Gold StandardThe Gold Standard- In place from 1700s to 1939In place from 1700s to 1939- a monetary standard that pegs currencies to gold

and guarantees convertibility to gold- It was thought that gold standard contained an

automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries.

- The gold standard broke down during the 1930s as countries engaged in competitive devaluations

The Gold StandardThe Gold Standard

• Roots in old mercantile trade

• Inconvenient to ship gold, changed to paper- redeemable for gold

• Want to achieve ‘balance-of-trade equilibrium

USAJapan

Gold

Trade

Balance of Trade EquilibriumBalance of Trade Equilibrium

Trade Surplus

GoldIncreased

money supply = price

inflation.

Decreased money supply

= price decline.

As prices decline, exportsincrease and trade goes

into equilibrium.

Between the WarsBetween the Wars

• Post WWI, war heavy expenditures affected the value of dollars against gold

• US raised dollars to gold from $20.67 to $35 per ounce

– Dollar worth less?

• Other countries followed suit and devalued their currencies

Bretton Woods

• In 1944, 44 countries met in New Hampshire• Countries agreed to peg their currencies to

US$ which was convertible to gold at $35/oz• Agreed not to engage in competitive

devaluations for trade purposes and defend their currencies

• Weak currencies could be devalued up to 10% w/o approval

• Created the IMF and World Bank

International Monetary Fund

• The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars

• The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

• Discipline– Maintaining a fixed exchange rate imposes

monetary discipline, curtails inflation– Brake on competitive devaluations and

stability to the world trade environment• Flexibility

– Lending facility:• Lend foreign currencies to countries having

balance-of-payments problems– Adjustable parities:

• Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”

International Monetary Fund

Purposes of IMFPurposes of IMF• Promoting international monetary cooperation

• Facilitating expansion and balanced growth of international trade

• Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation

• Making the resources of the Fund temporarily available to members

• Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations

• monitors economic and financial developments and policies, in member countries and at the global level, and gives policy advice to its members based on its more than fifty years of experience.

• For example: In its annual review of the Japanese economy for 2003, the IMF Executive Board urged Japan to adopt a comprehensive approach to revitalize the corporate and financial sectors of its economy, tackle deflation, and address fiscal imbalances.

To serve these purposes, the IMF: To serve these purposes, the IMF:

• The IMF commended Mexico in 2003 for good economic management, but said structural reform of the tax system, energy sector, the labor market, and judicial system was needed to help the country compete in the global economy.

• In its Spring 2004 World Economic Outlook, the IMF said an orderly resolution of global imbalances, notably the large U.S. current account deficit and surpluses elsewhere, was needed as the global economy recovered and moved toward higher interest rates.

• lends to member countries with balance of payments problems, not just to provide temporary financing but to support adjustment and reform policies aimed at correcting the underlying problems.

• For example: During the 1997-98 Asian financial crisis, the IMF acted swiftly to help Korea bolster its reserves. It pledged $21 billion to assist Korea to reform its economy, restructure its financial and corporate sectors, and recover from recession. Within four years, Korea had recovered sufficiently to repay the loans and, at the same time, rebuild its reserves.

• In October 2000, the IMF approved an additional $52 million loan for Kenya to help it cope with the effects of a severe drought, as part of a three-year $193 million loan under the IMF's Poverty Reduction and Growth Facility, a concessional lending program for low-income countries.

• provides the governments and central banks of its member countries with technical assistance and training in its areas of expertise.

• For example: Following the collapse of the Soviet Union, the IMF stepped in to help the Baltic states, Russia, and other former Soviet countries set up treasury systems for their central banks as part of the transition from centrally planned to market-based economic systems.

IMF QuotasIMF Quotas - each member’s monetary contribution• Based on national income, monetary reserves,

trade balance, and other economic indicators• Pool of money that can be loaned to members• Basis for how much a country can borrow• Determines voting rights of members

Board of GovernorsBoard of Governors - IMF’s highest authority• One representative from each member country• Board of Executive Directors—24 persons

– handles day-to-day operations

IMF AssistanceIMF AssistanceProvides assistance to member countries

• Intended to ease balance-of-payment difficulties

• Recipient country must adopt policies to stabilize its economy

Special Drawing Rights (SDRs)Special Drawing Rights (SDRs)

• An international type of monetary reserve currency, created by the International Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of member countries.

• Created in response to concerns about the limitations of gold and dollars as the sole means of settling international accounts,

• SDRs are designed to augment international liquidity by supplementing the standard reserve

currencies.

– Serves as the IMF’s unit of account•unit in which the IMF keeps its

records•used for IMF transactions

– Some countries pegged their currencies’ value

– Based on the weighted average of four currencies

• 1986–1990: USD 42%, DEM 19%, JPY 15%, GBP 12%, FRF 12%

• 1991–1995: USD 40%, DEM 21%, JPY 17%, GBP 11%, FRF 11%

• 1996–2000: USD 39%, DEM 21%, JPY 18%, GBP 11%, FRF 11%

• 2001–2005: USD 45%, EUR 29%, JPY 15%, GBP 11%

• 2006–2010: USD 44%, EUR 34%, JPY 11%, GBP 11%

Role of the World BankRole of the World Bank

• The official name for the world bank is the International Bank for Reconstruction and Development

• Purpose: To fund Europe’s reconstruction and help 3rd world countries.

• Overshadowed by Marshall Plan, so it turns towards development– Lending money raised through WB bond sales

• Agriculture• Education• Population control• Urban development

Collapse of the Collapse of the Fixed Exchange SystemFixed Exchange System

• The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s– The US dollar was the only currency that could be

converted into gold– The US dollar served as the reference point for all

other currencies– Any pressure to devalue the dollar would cause

problems through out the world

• Factors that led to the collapse of the fixed exchange system include– President Johnson financed both the Great

Society and Vietnam by printing money– High inflation and high spending on imports– On August 8, 1971, President Nixon announces

dollar no longer convertible into gold– Countries agreed to revalue their currencies

against the dollar– On March 19, 1972, Japan and most of Europe

floated their currencies– In 1973, Bretton Woods fails because the key

currency (dollar) is under speculative attack

Collapse of the Collapse of the Fixed Exchange SystemFixed Exchange System

The Floating Exchange RateThe Floating Exchange Rate

• The Jamaica agreement revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates– Floating rates acceptable– Gold abandoned as reserve asset– IMF quotas increased

• IMF continues role of helping countries cope with macroeconomic and exchange rate problems

Exchange Rates Since 1973Exchange Rates Since 1973

• Exchange rates have been more volatile for a number of reasons including:– Oil crisis -1971– Loss of confidence in the dollar - 1977-78– Oil crisis – 1979, OPEC increases price of oil– Unexpected rise in the dollar - 1980-85– Rapid fall of the dollar - 1985-87 and 1993-95– Partial collapse of European Monetary

System - 1992– Asian currency crisis - 1997

Fixed Versus Floating Exchange Rates

• Floating:– Monetary policy

autonomy• Restores control to

government

– Trade balance adjustments

• Adjust currency to correct trade imbalances

• Fixed:– Monetary discipline

– .Speculation

– Limits speculators

– Uncertainty

– Predictable rate movements

– Trade balance adjustments

– Argue no link between exchange rates and trade

• Link between savings and investment

Exchange Rate RegimesExchange Rate Regimes

• Pegged Exchange Rates– Peg own currency to a major currency ($)– Popular among smaller nations– Evidence of moderation of inflation

• Currency Boards– Country commits to converting domestic

currency on demand into another currency at a fixed exchange rate

– Country holds foreign currency reserves equal to 100% of domestic currency issued

Exchange-Rate ArrangementsExchange-Rate Arrangements

IMF permitted countries to select and maintain an exchange-rate arrangement of their choice

• IMF surveillance and consultation programs

– designed to monitor exchange-rate policies

– determine whether countries were acting openly and responsibly in exchange-rate policy

From pegged to floating currencies• Broad IMF categories for exchange-rate

regimes– peg exchange rate to another currency

or basket of currencies with only a maximum 1% fluctuation in value

– peg exchange rate to another currency or basket of currencies with a maximum of 2 ¼% fluctuation

– allow the currency to float in value against other currencies

• Countries may change their exchange-rate regime

Exchange Rate Policies for Exchange Rate Policies for IMF Members 2004IMF Members 2004

Crisis Management by the IMF

• The IMF’s activities have expanded because periodic financial crises have continued to hit many economies– Currency crisis

• When a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency

– Banking crisis• Loss of confidence in the banking system leading

to a run on the banks– Foreign debt crisis

• When a country cannot service its foreign debt obligations

Determination of Exchange Determination of Exchange RatesRates

Floating rate regimes—allow changes in the exchange rates between two currencies to occur for currencies to reach a new exchange-rate equilibrium• Currencies that float freely respond to

supply and demand conditions• No government intervention to influence

the price of the currency

Economic Theories of Economic Theories of Exchange Rate DeterminationExchange Rate Determination

• Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another

• Price and exchange rates:

– Law of One Price– Purchasing Power Parity (PPP)– Money supply and price inflation

• Interest rates and exchange rates

Law of One PriceLaw of One Price

• In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency

• Example: US/French exchange rate: $1 = .78Eur

A jacket selling for $50 in New York should retail for 39.24Eur in Paris (50x.78)

Purchasing Power Parity

• By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient

• In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country

Big Mac IndexBig Mac Index

Money Supply and Inflation

• PPP theory predicts that changes in relative prices will result in a change in exchange rates

– A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate

– Inflation occurs when the money supply increases faster than output increases

Determination of Exchange Rates Determination of Exchange Rates (cont.)(cont.)

• Fisher EffectFisher Effect - links inflation and interest rates–nominal interest rate in a country is the real interest rate plus inflation–because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation

• International Fisher Effect (IFE)International Fisher Effect (IFE) - links interest rates and exchange rates–the interest-rate differential is a predictor of future changes in the spot exchange rate

» interest-rate differential based on differences in interest rates

–currency of the country with the lower interest rate will strengthen in the future

Determination of Exchange Rates Determination of Exchange Rates (cont.)(cont.)

Other factors affecting exchange rate movements• ConfidenceConfidence—safe currencies considered

attractive in times of turmoil• Technical factorsTechnical factors

– release of national statistics– seasonal demands for a currency– slight strengthening of a currency

following a prolonged weakness

Currency Values and Business

Exchange rates affect activities of both domestic and international firms

Devaluation Revaluation

import prices lowersraises

export priceslowersraises

Forecasting Exchange-Rate Forecasting Exchange-Rate MovementsMovements

Managers should be concerned with the timing, magnitude, and direction of an exchange-rate movement

• Prediction is not a precise science

Fundamental forecastingFundamental forecasting - uses trends in economic variables to predict future rates

• Use econometric model or more subjective bases

Technical forecastingTechnical forecasting - uses past trends in exchange rates to spot future trends in the rates

• Assumes that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns

• Good treasurers and bankers develop their own forecasts

• Use fundamental and technical forecasts for corroboration

Forecasting Exchange-Rate Forecasting Exchange-Rate Movements (cont.)Movements (cont.)

Factors to monitor—managers can monitor factors used by governments to manage their currencies• Institutional setting – float or managed?• Fundamental analysis – economics

indicator• Confidence factors• Events• Technical analysis

Business Implications of Exchange-Business Implications of Exchange-Rate ChangesRate Changes

Marketing decisionsMarketing decisions - exchange rates affect demand for a company’s products at home and abroad

Production decisionsProduction decisions - choice of location for production facilities depends on strength of currency

Financial decisionsFinancial decisions - exchange rates influence the sourcing of financial resources, the cross-border remittance of funds, and the reporting of financial results

Stability and Predictability

Stableexchange rates

Predictableexchange rates

Improve accuracyof financial planningImprove accuracy

of financial planning

Reduce surprisesof unexpectedrate changes

Reduce surprisesof unexpectedrate changes

Implications for ManagersImplications for Managers

• It is critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals

– Adverse changes in exchange rates can make apparently profitable deals unprofitable

• The risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk

– Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure

• Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values

• Translation exposure: the impact of currency exchange rate changes on the reported financial statements of a company

• Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates

Implications for ManagersImplications for Managers

Reducing Translation and Transaction Exposure

• These tactics are primarily designed to protect short-term cash flows from adverse changes in exchange rates

• Companies should use forward exchange rate contracts and buy swaps

• Firms can also use a lead strategy – An attempt to collect foreign currency receivables

when a foreign currency is expected to depreciate – Paying foreign currency payables before they are

due when a currency is expected to appreciate• Firms can also use a lag strategy

– An attempt to delay the collection of foreign currency receivables if that currency is expected to appreciate

– Delay paying foreign currency payables if the currency is expected to depreciate

Reducing Economic Exposure

• Reducing economic exposure requires strategic choices that go beyond the realm of financial management

• The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates