with a basic introduction to the International Monetary
System
9-1
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Foreign exchange: money denominated in the
currency of another nation or group of
nations
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Cash
Credit
Bank deposits
Other short-term claims (e.g., bonds)
Exchange rate: the price of a particular
currency relative to another
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What is money?
How should you convert money from one
currency into another?
How are the values of currencies set?
How can you limit foreign exchange risk
(the possibility that unpredicted changes in exchange rates
will have adverse consequences for the firm)?
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Can you predict when currency values will
change? If so, how?
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The “medium of exchange”
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Usually, governments declare certain
pieces of paper (and bank assets) to be money
◦ that is, something widely accepted
as means of payment
◦ But people must accept them
◦ Alternatives are inconvenient, but possible
 Tobacco in early American colonies
 U.S. dollar in Russia when ruble collapsed
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If you sell abroad, and you may receive
payment in foreign currency
Buy abroad, and you may have to pay in
foreign currency
Travel abroad, you must spend foreign
currency
A foreign direct investment will have to pay
expenses in foreign currency
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Current values of major foreign currencies are
available on the Web
Most businesspeople normally buy from or
sell to a bank
◦ The bank often gives less than the rates offered on
the Web, but handles all details
◦ Banks may vary a lot in how good a deal they give
 But they know they have to be competitive with other
banks
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A business with significant foreign activity
creates a stable relationship with one or a
few banks
Nowadays, you can do your own currency
trading
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There are two basic ways
◦ “Fixed” or “Pegged” exchange rates
 Governments decide the value of currency
 Example: Hong Kong’s government keeps the value of
its dollar at roughly US$0.129 (US$1=HK$7.75)
 With a ‘fixed rate’, there is absolutely no variability.
 A ‘pegged’ rate implies small variability
◦ Supply and demand sets values
 This is how exchange rates are set for the US dollar vs.
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Euro,
Japanese yen,
British pound,
Swiss franc, etc.
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They make business predictable
In some very prosperous periods, most major
exchange rates have been fixed
◦ The late 19th century
◦ 1945-1971
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Before WW I, all major currencies were
convertible into gold
◦ UK £1=113 grains gold (.2354 oz)
◦ US $1= 23.22 grains (.0484 oz)
◦ So, £1=4.87
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Everyone knew what everything was and
would be worth
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But a fixed exchange rate requires discipline in
the government –
and a willingness to create pain
◦ Example: Suppose your nation’s economy is very
prosperous, but exports are growing only slowly
 Your people will have money to buy imports
 Their demand for foreign currencies will put
upward pressure on their exchange rates
 Government has to slow the domestic economy to
prevent change in exchange rate
 Higher taxes, higher interest rates,
lower government spending
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Many economists say if a country is having
difficulty maintaining a fixed exchange rate, the
economy is ‘overheated’
◦ They say higher interest rates or higher taxes might be
better for the economy in the long run in those
circumstances
◦ But politicians don’t like to take pain
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U.S. abandoned fixed exchange rates when the
Vietnam War created strong inflation
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It seems that the more complicated an
economy, the more difficult it is to maintain
fixed/pegged rates
◦ Many small countries succeed
 Hong Kong, Bangladesh, Fiji
◦ Few propose them for the largest developed
countries today
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Many developing countries including China
restrict who can own their money
◦ ‘Hot’ investments in ‘emerging’ currencies have
often caused problems when foreigners changed
their minds
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China maintains a pegged exchange rate
◦ For long periods it kept the rate at less than an
equilibrium price
 Its government had to buy lots of surplus dollars that
its exports brought in
◦ In June 2012 China had $3,240 billion US dollars
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There is poor transportation infrastructure
People live in the countryside or in tiny urban
apartments, so they have little space for
things
So more money may come in from exports
than people want to spend
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It’s easier to manage a currency’s level if you
have a trade surplus than a trade deficit
◦ You can simply use the surplus to buy up the
foreign exchange that comes into the country
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China fears that if the value of the Yuan rises,
declining sales of manufacturers will hurt
employment
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US per capita GDP is $48,400
China’s per capita GDP at current Yuan
exchange rate is $5400
◦ Thus, a US worker must ordinarily be 9 times as
productive as a Chinese worker to sell
internationally
 China’s nominal per capita income up 46% in 3 years!
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For the US and Europe, a low Yuan and
Chinese import restrictions make recovery
from recession harder
◦ But Americans get to consume more
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Buyers and sellers establish prices in markets
like those for tea and wheat
$1,200,000,000,000 in foreign exchange is
traded every day
US dollar is most widely traded
◦ involved in 90% of all transactions
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London is the main foreign-exchange market
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Bid: the rate at which a trader will buy
foreign currency from you
Offer (or Ask): the rate at which a trader
will sell foreign currency to you
Spread: the difference between bid and
offer rates; the profit margin for the trader
9-6
9-13
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Businesses use the foreign exchange market to
provide insurance against foreign exchange risk
A firm that protects itself against foreign
exchange risk is hedging
You can buy or sell using
1. spot exchange rates
2. forward exchange rates
3. currency swaps
1. Spot Exchange Rates
 The spot exchange rate is the rate at which
a foreign exchange dealer converts one
currency into another currency on a
particular day
◦ Spot rates are determined by the interaction
between supply and demand, and so change
continually
2. Forward Exchange Rates
 A forward exchange occurs when two
parties agree to exchange currency at some
specific future date
◦ Forward rates are typically quoted for 30, 90, or
180 days into the future
◦ Forward rates are typically the same as the spot
rate plus or minus an adjustment for the interest
the parties will pay/receive
3. Currency Swaps
 A currency swap is the simultaneous
purchase and sale of an amount of foreign
exchange on two different dates
◦ Swaps are used when it is desirable to move out of
one currency into another for a limited period
without incurring foreign exchange rate risk
 For example, you have accepted an order in Japanese
yen and you must manufacture the product using
components you must purchase in Japanese yen
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Business decisions demand you look far
ahead
◦ If exchange rates will change and you don’t hedge
adequately, your whole calculation will be off
◦ Some foreign currencies have lost 90% or more of
their value in a year
 Argentine peso went from $1=1 peso to $1=3.5 pesos
in one jump
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How fast are prices rising in the country?
Is there a trade surplus or deficit?
Is the government running budget deficits?
How much?
How do interest rates in the countries
compare?
How has the government been managing the
currency?
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One principle: Trends once established often
tend to continue
◦ ‘The trend is your friend’
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But if “everyone” agrees something will
happen, it may not happen
◦ When ‘everyone’ thinks the dollar will go down,
‘everyone’ has already sold dollars
◦ If the news changes, many may quickly
change their minds and want to buy
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HSBC Bank in Argentina
◦ They entered Argentina at a time when it appeared
the government was starting to manage the
economy effectively
◦ But they continued investing as government
became more irresponsible
◦ They lost big
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Material below here is not required
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Fully convertible currencies are those that the
government allows both residents and
nonresidents to purchase in unlimited amounts
◦ “Hard currencies” are fully convertible
◦ “Soft currencies” (or weak currencies) are not fully
convertible
 Typically from developing countries
 Known as “exotic currencies”
9-10