International Business
Chapter Ten
The Determination of
Exchange Rates
Chapter Objectives
• To describe the International Monetary Fund and its role
•
•
•
•
•
in the determination of exchange rates
To discuss the major exchange rate arrangements that
countries use
To explain how the European Monetary System works
and how the euro came into being as the currency of
the euro zone
To identify the major determinants of exchange rates
To show how managers try to forecast exchange rate
movements
To explain how exchange rate movements influence
business decisions
10-2
The International Monetary Fund
International Monetary Fund (IMF): a multi-
national institution established in 1945 as
part of the Bretton Woods Agreement to
maintain order in the international monetary
system
• Initially the Bretton Woods Agreement estab-
lished a system of fixed exchange rates under
which each IMF member country set a par value
[benchmark] for its currency quoted in terms of
gold and the U.S. dollar.
10-3
Objectives of the IMF
• To promote exchange rate stability
• To facilitate the international flow of currencies
and hence the balanced growth of international
trade
• To promote international monetary cooperation
• To establish a multilateral system of payments
• To make resources available to member nations
experiencing balance-of-payments difficulties*
*IMF loan criteria are designed to help stabilize
a country’s economy. However, they are often
unpopular with affected constituencies.
10-4
The IMF Quota
IMF Quota: the sum of the total assessments
levied on member countries to form the pool
of money from which the IMF draws to make
loans to member nations
• National quotas are based upon countries’
•
national incomes, monetary reserves, trade
balances, and other economic indicators.
Quotas form the basis for the voting power
of each member nation—the higher the quota,
the greater the number of votes.
10-5
Special Drawing Rights
Special Drawing Rights (SDRs): an artificial
international reserve asset created in 1969
to supplement IMF members’ existing reserves
of gold and foreign exchange
• The SDR is used as the IMF’s unit of account for
purposes of financial record-keeping, but it has not
assumed the role of gold as a primary reserve asset.
• The value of the SDR is based upon the weighted
average of a basket of four currencies.
Weights as of Dec. 31, 2004
U.S. dollar
Euro
Japanese yen
British pound
39%
36%
13%
12%
10-6
The Evolution to Floating Exchange
Rates
• The Smithsonian Agreement of 1971:
a restructuring of the international monetary
system that widened exchange rate flexibility
from 1 percent to 2.25 percent from par value
• The Jamaica Agreement of 1976:
an amendment to the original IMF rules
that eliminated the concept of fixed exchange
rates and par values in order to accommodate
greater exchange rate flexibility via a spectrum
of exchange rate regimes
10-7
Exchange Rate Arrangements:
Broad Categories
• Peg the exchange rate to another currency or
basket of currencies with little or no flexibility
[Ecuador, El Salvador, Finland, Niger]
• Peg the exchange rate to another currency or
•
basket of currencies with trading occurring
within a band
[Denmark, Cyprus, Hungary]
Allow the currency to float in value against other
currencies, either managed or not managed
[Britain, Brazil, India, Norway, Turkey, So. Africa, USA]
IMF member countries are permitted to select and maintain
their exchange rate regimes, but they must be open and act
responsibly with respect to their exchange rate policies.
10-8
Exchange Rate Regimes: 2004
REGIMES
Arrangements with no separate legal tender
Currency board arrangements
Other conventional fixed peg arrangements
Pegged exchange rates within horizontal bands
Crawling pegs
Exchange rates within crawling bands
Managed float with no pronounced path
Independently floating
Total
NO. OF
COUNTRIES
41
7
41
4
5
5
49
35
187
Source: International Monetary Fund, IMF Annual Report, 2004, pp. 118-120.
10-9
The Role of Central Banks
• Each country has a central bank responsible for the
policies affecting the value of its currency.
[The NY Fed, one of 12 of a system of regional Federal Reserve
Banks, intervenes in foreign exchange markets on behalf of both
the Federal Reserve and the U.S. Treasury.]
• Central banks intervene in currency markets by
buying or selling a particular currency in order to
affect its price; central banks are primarily
concerned with liquidity.
SDRs
[Selling a currency puts downward pressure on its value;
buying a currency puts upward pressure on its value.]
• Central banks keep their reserve assets in three
major forms: gold, foreign exchange, and IMFrelated assets (SDRs).
[continued]
10-10
• Depending on market conditions, a central bank
may:
– coordinate its actions with other central banks or
go it alone
– aggressively enter the market to change attitudes
about its views and policies
– call for reassuring action to calm markets
– intervene to reverse, resist, or support a market trend
– be very visible or be very discrete
– operate openly or operate indirectly through brokers
The Bank for International Settlements (BIS) in
Basel, Switzerland, acts as the central bankers’
central bank and also serves as a place to gather
to discuss monetary cooperation.
10-11
Map 10.2: Exchange Rate
Arrangements, 2004
10-12
The Euro
• European Monetary System (EMS): established by
the EU (then the EC) in 1979 as a means of creating
exchange rate stability within the bloc
• European Central Bank: established by the EU on
July 1, 1998, to set monetary policy and to administer the euro
• Euro: the common European currency established
on Jan. 1, 1999 as part of the EU’s move toward
monetary union as called for by the Treaty of
Maastricht of 1992
• European Monetary Union (EMU): a formal
arrangement linking many but not all of the
currencies of the EU
[continued]
10-13
• The Exchange Rate Mechanism (ERM), i.e., the
Stability and Growth Pact that defines the criteria
that EU member nations must meet to qualify for
adoption of the euro, requires:
– an annual government deficit not to exceed 3% of GDP
– total outstanding government debt not to exceed 60% of
GDP
– rates of inflation within 1.5% of the three best performing
EU countries
– average nominal interest rates within 2% of the average
rate in the three countries with the lowest inflation rates
– exchange rate stability, i.e., for at least two years, exchange rate fluctuations within the “normal” margins of
the ERM
The UK, Sweden, and Denmark are the only members of the
initial group of 15 that opted not to adopt the euro.
10-14
Exchange Rate Determination:
Fixed to Floating Regimes
Floating rate regimes: currencies float freely, i.e.,
free from government intervention, in response
to demand and supply conditions
Managed fixed rate regimes: a nation’s central
bank intervenes in the foreign exchange market
in order to influence its currency’s relative price
• Demand for a country’s currency is a function of
the demand for that country’s goods, services, and
financial assets.
Equilibrium exchange rates are achieved
when supply equals demand.
[continued]
10-15
Fig. 10.1: The Equilibrium
Exchange Rate
10-16
• The prices of tradable products, when expressed
in a common currency, will tend to equalize across
countries as a result of exchange rate changes.
• If economic policies and intervention are ineffective,
governments may be forced to revalue or devalue
their currencies.
• A currency that is pegged is usually changed on a
formal basis.
• The G8 group of finance ministers meets often to
discuss global economic issues, including exchange
rate values and policies.
Black markets closely approximate prices based on supply and
demand for currencies, rather than government-controlled prices.
10-17
Purchasing Power Parity:
The Concept
Purchasing power parity: the number of units
of a country’s currency required to buy the
same amount of goods and services in the
domestic market that one unit of income
would buy in another country
Purchasing power parity [PPP] is estimated by calculating
the value of a universal “basket of goods” that can be
purchased with one unit of a country’s currency.
10-18
Purchasing Power Parity:
The Theory
• Purchasing power parity predicts that the ex-
change rate will change if relative prices change.
• A change in the comparative rates of inflation in two
countries necessarily causes a change in their relative
exchange rates in order to keep prices fairly similar.
– An example: If the domestic inflation rate is lower than the rate
in the foreign country, the domestic currency should be stronger
than the currency of the foreign country.
– The alternative example: If the domestic inflation rate is higher
than the rate in the foreign country, the domestic currency
should be weaker than the currency of the foreign country.
Inflation represents a monetary phenomenon in which
a nation’s money supply increases faster than its stock
of goods and services, thus causing prices to rise.
[continued]
10-19
• Purchasing power parity seeks to define the
relationships between currencies.
• While PPP may be a reasonably good long- term
indicator of exchange rate movements, it is less
accurate in the short run because:
– the theory falsely assumes that no barriers to trade
exist and that transportation costs are zero
– it is difficult to determine an appropriate basket of
commodities for comparative purposes
– profit margins vary according to the strength of
competition
– different tax rates have different effects upon prices
10-20
The Big Mac Index: Under/Over
Valuation Against the U.S. Dollar
United States
Brazil
Britain
Canada
China
Denmark
Egypt
Euro Area
Japan
Russia
South Africa
Price in
Local
Currency
2.90
5.39
4.47
3.19
10.41
27.75
10.01
3.07
261.87
42.05
12.41
Price in
Dollars
2.90
1.70
3.37
2.33
1.26
4.46
1.62
3.28
2.33
1.45
1.86
Implied
PPP of
the US$
1.86
1.54
1.10
3.59
9.57
3.45
1.06
90.30
14.50
4.28
Exchange
Rate:
20/05/04
3.1350
1.7825
1.3770
8.2869
6.1959
6.2294
1.2010
113.00
28.995
6.7707
Under[-]/
Over[+]
Valuation
- 41
+16
- 20
- 57
+54
- 44
+13
- 20
- 50
- 36
Source: “The Big Mac Index: Food for Thought,” The Economist, 2004, pp. 71-72.
10-21
The Role of Interest Rates
Fisher Effect Theory: [links interest rates and inflation]
r: the nominal interest rate, i.e.,
the actual rate of interest earned on an investment
R: the real interest rate, i.e.,
the nominal interest rate less inflation
A country’s nominal interest rate r is determined by the
real interest rate R and the inflation rate i as follows:
(1 + r) = (1 + R)(1 + i).
International Fisher Effect Theory (IFE):
[links interest rates and exchange rates]
The currency of the country with the lower interest rate
will strengthen in the future because the interest rate
differential is an unbiased predictor of future changes
in the spot exchange rate.
[continued]
10-22
• Like PPP, the International Fisher Effect is not a
particularly good predictor of short-run changes
in spot exchange rates.
• An example of the Fisher Effect: Because the
interest rate should be the same in every country,
the country with the higher interest rate should
have higher inflation.
Thus, if R = 5%, the U.S. inflation rate is 2.9%,
and the Japanese inflation rate is 1.5%,
the nominal interest rates are:
rus = (1.05)(1.029) – 1 = .08045 or 8.045%
rj = (1.05)(1.015) – 1 = .06575 or 6.575%
On the other hand, if inflation rates were the same,
investors would place their money in countries with
higher interest rates in order to get higher real returns.
10-23
Forecasting Exchange Rates:
Fundamental vs. Technical Approaches
Fundamental forecasting: trend analyses and
econometric models that use economic variables
to predict future exchange rates
Technical forecasting: analyses that use past
trends in exchange rate movements to predict
future exchange rates
• Forecasters need to provide ranges or point
estimates within subjective probabilities based on
available date and subjective interpretations.
10-24
Forecasting Exchange Rates:
Factors to Monitor
• The institutional setting—the extent and nature
•
•
•
•
of government intervention
Fundamental factors—PPP rates, balance-ofpayments levels, macroeconomic data, levels of
foreign exchange reserves, fiscal and monetary
policies, etc.
Confidence factors
Critical events, e.g., 9/11
Technical factors—expectations and market
trends
10-25
Operational Implications of
Exchange Rate Fluctuations
Exchange rate changes can affect:
• marketing decisions, i.e., demand for a firm’s
•
•
products, both at home and abroad
production decisions, i.e., production site
locations, insourcing vs. outsourcing
financial decisions, i.e., sourcing of funds (debt
and equity), the timing and level of the remittance of funds, and the reporting of financial
results
10-26
Implications/Conclusions
• Central banks are the key institutions in
countries that opt to intervene in foreign
exchange markets to influence currency
values.
• Exchange rates affect business operations in
three primary areas: marketing, production,
and finance.
[continued]
10-27
• A country may change the exchange rate regime that it uses, so managers must monitor
country policies carefully.
• A country that strictly controls and regulates
the convertibility of its currency is likely to
have a black market that maintains a currency exchange rate which is much more
indicative of supply and demand than is the
official rate.
10-28