Urgent 5 questions- answers needed

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Chapter 7, Dealing with Foreign Exchange

Dealing with Foreign Exchange

Learning Outcomes

List the factors that determine foreign exchange rates

Articulate and explain the steps in the evolution of the international monetary system

Identify strategic responses firms can take to deal with foreign exchange movements

Identify three things you need to know about currency when doing business internationally

LEARNING OUTCOMES

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Foreign Exchange Rate

Price of one currency in terms of another

Appreciation: Increase in currency value

Depreciation: Loss in currency value

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A foreign exchange rate is the price of one currency, such as the dollar ($), in terms of another, such as the euro (€). An appreciation is an increase in the value of the currency, and a depreciation is a loss in the value of the currency.

7.3 - What Determines Foreign Exchange Rates?

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Exhibit

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Supply and Demand of Foreign Exchange

Basic economic theory

Commodity’s price is fundamentally determined by its supply and demand

Strong demand will lead to price hikes

Oversupply will result in price drops

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Relative Price Differences

Purchasing power parity (PPP)

Determines the equivalent amount of goods and services different currencies can purchase

Captures the differences in cost of living between countries

Argues that exchange rates should move toward levels that would equalize the prices of an identical basket of goods in any two countries in the long run

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Some countries have expensive prices, and others have cheap prices. The effect of these differences on the exchange rate is measured by the purchasing power parity (PPP), a conversion that determines the equivalent amount of goods and services that different currencies can purchase.

Interest Rates and Money Supply

High interest rates enhance exchange value

Exchange rate is influenced by:

Rate of inflation

Money supply

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If a country’s interest rates are high, it will attract foreign funds. Also, a country’s inflation, an expansion of its money supply, affects its exchange rate. To avoid losses from holding assets in a depreciated currency, investors sell them for assets denominated in other currencies. Such massive sell-offs may worsen the depreciation.

Productivity and Balance of Payments

Increase in productivity:

Improves a country’s competitive position in international trade

Increases the value of home currency

Changes balance of trade

Affects balance of payment (BOP)

Current account surplus leads to currency appreciation

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A rise in a country’s productivity relative to other countries will improve its competitive position in international trade and attract more FDI, fueling demand for its currency.

Exchange Rate Policies

Floating (flexible) exchange rate policy

Fixed rate policy

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Floating Exchange Rate Policy

Willingness of a government to let demand and supply conditions determine exchange rates

Clean float: Pure market solution to determine exchange rates

Dirty float: Uses selective government intervention to determine exchange rates

Target exchange rate: Specified upper or lower bounds within which an exchange rate is allowed to fluctuate

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Floating (flexible) exchange rate policy is the willingness of a government to let demand and supply conditions determine exchange rates. The policy can involve either a clean (free) float, which is a pure market solution, or a dirty (managed) float, which includes selective governmental interventions.

Severity of intervention is a matter of degree. Heavier intervention moves the country closer to a fixed exchange rate policy, and less intervention enables a country to approach the free float ideal. A main objective for intervention is to prevent erratic fluctuations that may trigger macroeconomic turbulence. Some countries do not adhere to any particular rates.

Target exchange rates are also known as crawling bands.

Fixed Rate Policy

Setting exchange rate of a currency relative to other currencies

Pegging - Setting exchange rate of domestic currency in terms of another currency

Stabilizes import and export prices

Restrains domestic inflation when pegged to a country with relatively low inflation

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A country adopting a fixed rate policy fixes the exchange rate of its domestic currency relative to other currencies. A specific version of fixed rate policy involves pegging the domestic currency, which means to set the exchange rate of the domestic currency in terms of another currency (the peg).

Investor Psychology

Predicts short-run movements of exchange rates

Bandwagon effect: Effect of investors moving in the same direction at the same time, like a herd

Capital flight: Phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency

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History of the International Monetary System - Eras

The gold standard (1870–1914)

The Bretton Woods system (1944–1973)

The post–Bretton Woods system (1973–Present)

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The Gold Standard (1870–1914)

Value of major currencies was maintained by fixing their prices in terms of gold

Global peg system

Less volatile

Highly predictable and stable

Abandoned when World War I combatant countries printed excessive amounts of currency

LO 2

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Gold was used as the common denominator for all currencies, which means that all currencies were pegged at a fixed rate to gold.

The Bretton Woods System (1944–1973)

All currencies were pegged at a fixed rate to the US dollar

Reflected the higher US productivity level

Rising productivity in the world and US inflationary policies led to its demise

LO 2

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The Post–Bretton Woods System (1973–Present)

System of flexible exchange rate regimes

No official common denominator

Characterized by the diversity of exchange rates

Drawbacks

Turbulence and uncertainty

LO 2

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International Monetary Fund (IMF)

International organization

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

Core responsibility - Lending

Collects funds from member countries

Member countries are assigned a quota

Quota determines the amount of financial contribution, capacity to borrow, and voting power

LO 2

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Strategic Responses of Financial Companies

Primary strategic goal is to profit from the foreign exchange market

Foreign exchange market: The market where individuals, firms, governments, and banks buy and sell currencies of other countries

Functions

To service the needs of trade and investment

To trade in its own commodity

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Foreign exchange market has no central, physical location. The market is truly global and transparent. It is the largest and most active market in the world.

Strategic Responses of Financial Companies (continued 1)

Types of foreign exchange transactions

Spot transaction: Classic single-shot exchange of one currency for another

Forward transaction: Participants buy and sell currencies now for future delivery

Currency hedging: 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

LO 3

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Strategic Responses of Financial Companies (continued 2)

Forward premium: Forward rate of one currency relative to another currency is lower than the spot rate

Currency swap: Conversion of one currency into another at Time 1

Includes an agreement to revert it to the original currency at a specified Time 2 in the future

LO 3

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Strategic Responses of Financial Companies (continued 3)

Banks make money through trading money

Capture the spread, which is the difference between offer rate and bid rate

Offer rate: Price at which a bank is willing to sell a currency

Bid rate: Price at which a bank is willing to buy a currency

LO 3

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Outcome of Integrated Nature of the Foreign Exchange Market

Razor-thin spread

Quick decisions on buying and selling

Ever-increasing volume in order to make more profits

LO 3

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Strategic Responses of Nonfinancial Companies

Companies cope with currency risks by:

Invoicing in their own currencies

Currency hedging

Strategic hedging: Spreading out activities across different currency zones to offset currency losses in one region through gains in other regions

LO 3

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Currency risk: The potential for loss associated with fluctuations in the foreign exchange market

7.6 - Implications for Action

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Exhibit

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Debate: International Monetary Fund (IMF) versus New Development Bank (NDB) and Contingency Reserve Arrangement (CRA)

IMF

Facilitates moral hazard due to lack of accountability

One-size-fits-all strategy

Promotes fiscal spending

NDB and CRA

Set up in response to the IMF’s enforcement of conditions on countries seeking emergency loans

NDB focuses on infrastructure and sustainable development projects

Designed to provide protection against global liquidity pressures

LO 4

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Key Terms

Foreign exchange rate

Appreciation

Depreciation

Balance of payments

Floating exchange rate policy

Clean float

Dirty float

Target exchange

Fixed exchange rate policy

Bandwagon effect

Capital flight

Gold standard

Common denominator

Bretton Woods system

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KEY TERMS

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Key Terms (Continued)

Post–Bretton Woods system

International Monetary Fund

Quota

Foreign exchange market

Spot transaction

Forward transaction

Currency hedging

Forward discount

Forward premium

Currency swap

Offer rate

Bid rate

Spread

Currency risk

Strategic hedging

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KEY TERMS (continued)

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Summary

Factors that determine foreign exchange rates

Supply and demand, relative price differences, and purchasing power parity

Interest rates, money supply, productivity, balance of payments, exchange rate policies, and investor psychology

Eras in the history of the international monetary system

Gold standard, Bretton Woods system, and post–Bretton Woods system

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SUMMARY

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Summary (Continued 2)

Managers should develop firm-specific resources and capabilities in order to protect their firms from negative currency movements

Managers should:

Foster foreign exchange literacy

Develop a currency risk management strategy

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SUMMARY

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