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 FOREIGN
EXCHANGE RATES
International Monetary Fund (IMF) – An
international organization that was established
to promote international monetary
cooperation, exchange stability, and orderly
exchange arrangements.
FACTORS BEHIND FOREIGN
EXCHANGE 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 FOREIGN
EXCHANGE 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 FOREIGN
EXCHANGE 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 FOREIGN
EXCHANGE 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 INTERNATIONAL
MONETARY 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 FDI
2. 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 a
number 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.