• Fundamental difference between payment
     • 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
     • Exchange rate can change daily

• 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
• 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
• 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

 Expands money supply
 Reduces cost of money

 Spread / reduce risk
 Offset gains / losses
International Capital
   Market Drivers
            Information technology


            Financial instruments
             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

• 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

   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
• The spot exchange rate is
  the rate at which a foreign
  exchange dealer converts
  one currency into another
  currency on a particular
   – 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
   – 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
• 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

Trends in Foreign-Exchange Trading

         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
   – 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
Restrictions used to conserve scarce foreign exchange
       • Licensing—government regulates all foreign-exchange
            – 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
  Speculation—buying or selling foreign currency has both risk and high
    profit potential

Foreign-Exchange Trading Process

  Companies work through their local banks to settle foreign-exchange
      • 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

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
          – exotic currency—currency of a developing country
               » often unstable, weak, and unpredictable
      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
• 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

 money supply       Trade Surplus
= price decline.

                   As prices decline, exports
                    increase and trade goes
                       into equilibrium.

                          Gold                  money supply
                                                  = price
              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
   – Dollar worth less?
• Other countries followed suit and devalued their
              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
• 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
• 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
• 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
• 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
• 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
      • 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
• 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
    – 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’
    – Based on the weighted average of four

•   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
• 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
      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
                                   • 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
From pegged to floating currencies
   • Broad IMF categories for exchange-rate
       – 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
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
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
    • 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

• 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
   – 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
  lowers        export prices

                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
 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
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
    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
• 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

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