THE FOREIGN-EXCHANGE MARKET AND INTERNATIONAL
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INTERNATIONAL
FINANCIAL MARKET
&
INTERNATIONAL
MONETARY SYSTEM
Introduction
• 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
2
• 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)
Essential Terms II
• 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.
Capital Market
• System that allocates financial resources according
to their most efficient uses
• Common capital market intermediaries:
•Commercial Banks
•Investment Banks
Debt: Repay principal plus interest
Bond has timed principal & interest payments
Equity: Part ownership of a company
Stock shares in financial gains or losses
International Capital Market (ICM)
Network of people, firms, financial institutions and
governments borrowing and investing internationally
Purposes
Borrowers
Expands money supply
Reduces cost of money
Lenders
Spread / reduce risk
Offset gains / losses
International Capital
Market Drivers
Information technology
Deregulation
Financial instruments
(securitization)
World 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.
Offshore Financial Centers
Operational center
Extensive financial activity
and currency trading
Country or territory
whose financial sector
features few regulations
and few, if any, taxes
Booking center
Mostly for bookkeeping
and tax purposes
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
Market of bonds sold by issuing companies,
governments and others outside their own countries
Eurobond Foreign bond Interest rates
Bond that is Bond sold outside a Driving growth are
issued outside the borrower’s country differential interest
country in whose and denominated in rates between
currency the bond the currency of the developed and
is denominated country in which it developing nations
is sold
International Equity Market
Market of stocks bought and sold
outside the issuer’s home country
Factors contributing towards growth:
•Spread of Privatization
•Economic Growth in Developing Countries
•Activities of Investment Banks
•Advent of Cybermarkets
Eurocurrency Market
Unregulated market of
currencies banked outside
their countries of origin
Governments
Commercial banks
International companies
Wealthy individuals
Foreign Exchange Market
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
Market in which currencies are bought and sold
and their prices are determined
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
The Functions of the
Foreign 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 invest excess cash for short
•To exchange currency received in terms in foreign markets
the course of doing business • To profit from the short-term
abroad back into the currency of its movement of funds from one
home country currency to another in the
•To pay a foreign company for its hopes of profiting from shifts
products or services in its country’s in exchange rates, also called
currency currency speculation
Insuring against Foreign
Exchange 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
Exchange 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
Exchange 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
Exchange 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.
The Foreign-Exchange Market
Size of foreign-exchange market
$600 billion spot
$1.3 trillion in derivatives, ie
$200 billion in outright forwards
$1 trillion in forex swaps
$100 billion in FX options. (2004)
U.S. dollar is the most important currency because it is:
• An investment currency in many capital markets
• A reserve currency held by many central banks
• A transaction currency in many international commodity markets
• An invoice currency in many contracts
• An intervention currency employed by monetary authorities to
influence their exchange rates
25
Trends in Foreign-Exchange Trading
9-7
Quoting Currencies
Quoted currency = numerator
Base currency = denominator
(¥/$) = Japanese yen needed to buy one U.S. dollar
Yen is quoted currency, dollar is base currency
Currency Values
Change in US dollar against Change in Polish zloty against
Polish zloty US dollar
Make zloty base currency (1÷ PLZ/$)
February 1: PLZ 5/$ February 1: $.20/PLZ
March 1: PLZ 4/$ March 1: $.25/PLZ
%change = [(4-5)/5] x 100 = -20% %change = [(.25-.20)/.20] x 100 = 25%
US dollar fell 20% Polish zloty rose 25%
Cross Rate
• Exchange rate calculated using two other exchange rates
• Use direct or indirect exchange rates against a third currency
Dollar Euro Pound SFranc Peso Yen CdnDlr
Canada 1.3931 1.6466 2.4561 1.0695 0.1198 0.0122 ....
Japan 114.50 135.32 201.85 87.898 9.8420 .... 82.185
Mexico 11.633 13.749 20.510 8.9309 .... 0.1016 8.3504
Switzerland 1.3026 1.5395 2.2965 .... 0.1120 0.0114 0.9350
United Kingdom 0.5672 0.6704 .... 0.4355 0.0488 0.0050 0.4071
Euro 0.8461 .... 1.4917 0.6495 0.0727 0.0074 0.6073
United States .... 1.1819 1.7630 0.7677 0.0860 0.0087 0.7178
Cross Rate Example
Direct quote method
1) Quote on euro = € 0.8461/$
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
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 33
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 currency
Companies 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
countries
Speculation—buying or selling foreign currency has both risk and high
profit potential
34
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 market
Dealers can trade foreign exchange:
• Directly with other dealers
• Through voice brokers
• Through electronic brokerage systems
– Internet trades of currency are more popular
35
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
36
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 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 System
The Gold Standard
- In 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 Standard
• Roots in old
mercantile trade
• Inconvenient to ship
gold, changed to Japan USA
paper- redeemable
for gold
• Want to achieve
‘balance-of-trade
equilibrium
Balance of Trade Equilibrium
Decreased
money supply Trade Surplus
= price decline.
As prices decline, exports
increase and trade goes
into equilibrium.
Increased
Gold money supply
= price
inflation.
Between 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
International Monetary Fund
• 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”
Purposes 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
To serve these purposes, the IMF:
• 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.
• 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 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 Governors - IMF’s highest authority
• One representative from each member country
• Board of Executive Directors—24 persons
– handles day-to-day operations
IMF Assistance
Provides assistance to member countries
• Intended to ease balance-of-payment
difficulties
• Recipient country must adopt policies to
stabilize its economy
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 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
Fixed 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
Collapse of the
Fixed Exchange System
• 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
The 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 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 • Fixed:
– Monetary discipline
• Floating: – .Speculation
– Limits speculators
– Monetary policy
autonomy – Uncertainty
• Restores control to – Predictable rate
government movements
– Trade balance – Trade balance
adjustments adjustments
• Adjust currency to – Argue no link between
correct trade exchange rates and
imbalances
trade
• Link between savings
and investment
Exchange 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 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
IMF 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 Rates
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
Exchange 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 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 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 (cont.)
• Fisher 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) - 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 (cont.)
Other factors affecting exchange rate movements
• Confidence—safe currencies considered
attractive in times of turmoil
• Technical 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
raises
lowers export prices
raises
import prices lowers
Forecasting Exchange-Rate Movements
Managers should be concerned with the timing, magnitude, and direction
of an exchange-rate movement
• Prediction is not a precise science
Fundamental forecasting - uses trends in economic variables to
predict future rates
• Use econometric model or more subjective bases
Technical 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 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-Rate
Changes
Marketing decisions - exchange rates affect demand for
a company’s products at home and abroad
Production decisions - choice of location for production
facilities depends on strength of currency
Financial decisions - exchange rates influence the
sourcing of financial resources, the cross-border
remittance of funds, and the reporting of financial
results
Stability and Predictability
Stable Predictable
exchange rates exchange rates
Reduce surprises
Improve accuracy
of unexpected
of financial planning
rate changes
Implications 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
Implications for Managers
• 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
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
