CH 10 & 11
Law of One Price: US/Euro exchange rate
$1 = Euro 0.80
Gold Standard: Strength of the Gold System
- A major argument in favor of the gold standard was it contained a powerful mechanism for achieving balance of trade equilibrium by all countries
Floating: Arguments in Favor: MONETARY POLICY AUTONOMY
- Allows a country to expand or contract it money supply - Restores control to government to manage inflation and exchange rate parity
Translation Exposure
- Also well known as accounting exposure - The exposure is due to translation of books of accounts into the home currency.
Spot Exchange Rates are quoted as the
- Amount of foreign currency one U.S. dollar will buy - Value of U.S. dollar for a one unit of foreign currency
Insuring Against Foreign Exchange Risk
- Attempt to reduce the risk of adverse consequences on the firm due to unpredicted changes in future exchange rates - Hedging is a way to reduce risk
Functions of the Foreign Exchange Market
- Convert currency of one country into another currency - Provide some insurance against foreign exchange risk - 65% of all foreign exchange transactions are forward instruments - 35% of all foreign exchange transactions are spot exchanges
Characteristics of Currency Board
- Country holds foreign currency reserves equal at the fixed exchange rate to at least 100% of domestic currency issued - Country can issue additional domestic money only when there are foreign exchange reserves to back it - Limits country from printing money and causing inflation - Interest rates adjust automatically - Transparency through publication of foreign exchange reserves
International Monetary System Implications for Business (...next 3 cards...)
- Currency Management - Business Strategy - Government Relations
Exchange Rate Forecasting: Two Schools of Thought
- Efficient Market School - Inefficient Market School
Fisher Effect
- Equation: (i = r+I) - Nominal Interest Rate = real interest rate + expected inflation rate
Currency Conversion (further understanding)
- Firms paying foreign firms in foreign currencies for goods or services they have purchased - Firms invest spare cash in short-term money market accounts - Firms making a foreign direct investment
Development of the International Monetary System
- Gold Standard - Bretton Woods System of Fixed Exchange Rates - Floating Exchange Rates - Fixed versus Floating Exchange Rates
Fixed: Arguments in Favor
- Monetary Discipline - Speculation and Uncertainty - Trade Balance Adjustments
Floating: Arguments in Favor
- Monetary policy autonomy - Automatic trade balance adjustments
Economic Exposure
- The impact and importance of this type of exposure is much higher compared to the other two. - Economic exposure directly impacts the value of a firm. - That means, the value of the firm is influenced by the foreign exchange.
Transaction Exposure
- The simplest kind of foreign currency - Pertains to the exposure due to an actual transaction taking place in business involving foreign currency.
3 types of Foreign Exchange Exposure
- Transaction Exposure - Translation Exposure - Economic Exposure
Pegged Exchange Rate
- Value of the currency is fixed relative to a reference currency, such as the US-Dollar or the Euro - Exchange rate between that currency and the other currencies is determined by the reference currency exchange rate - Requires government intervention
Mutually Fixed Exchange Rates
- Values of a set of currencies are fixed against each other at some mutually agreed-on exchange rate - European Monetary System (EMS) operated with this system before the introduction of the Euro - For 25 years after WWII, industrial nations belonged to fixed exchange rate system before its collapse in 1973
Floating Exchange Rate
- When the foreign exchange market forces determine the relative value of a currency - Government intervention possible, but not required
Fixed: Arguments in Favor: TRADE BALACE ADJUSTMENTS
exchange rates and trade balance are not always linked trade deficits are result of the balance between savings and investment and not by the external value of a its currency
Fixed: Arguments in Favor: SPECULATION AND UNCERTAINTY
limits destabilizing effects of speculation nurtures predictable exchange rate movements promotes growth of international trade and investment
Currency Board
Country commits to converting its currency on demand into another currency at a fixed exchange rate
Floating: Arguments in Favor: AUTOMATIC TRADE BALANCE ADJUSTMENTS
Currency adjusts to correct trade imbalances
Forward Exchange Rates are basically...
Exchange rates governing such future transactions
Forward Exchange Rates: Selling at a Premium
Expectation that the dollar will APPRECIATE against the yen over the next 30 days: - Spot Rate: $1 = Y80 - 30 days Forward: $1 = Y90 - ( $= US; Y= yen)
Forward Exchange Rates: Selling at a Discount:
Expectation that the dollar will DEPRECIATE against the yen over the next 30 days: - Spot Rate: $1 = Y80 - 30 days Forward: $1 = Y70
Currency Management
Firms must recognize the volatility of the system and adjust their foreign exchange transactions and policies
Currency Conversion (purpose)
Firms receiving payment in foreign currencies need to convert into their home currency - payments for exports - income from foreign investments or licensing fees
Forward Exchange Rates are used by firms to...
Insure or hedge against foreign exchange risk that can make a transaction unprofitable
Floating Exchange Rates
Jamaica Agreement - 1976 - Revised the IMF Articles of Agreement ---floating rates acceptable ---gold abandoned as reserve asset ---IMF annual quotas increased IMF continued role of helping countries cope with macroeconomic and exchange rate problems
Foreign Exchange Market
Market for converting the currency of one country into the currency of another
Gold Standard
Pegging the value of currencies to gold and guaranteeing their convertibility
Spot Exchange Rates are determined by...
the interaction between the demand and supply of that currency relative to the demand and supply of other currencies
Forward Exchange Rates
Two parties agree to exchange currency and execute the deal at some specific date in the future
Hedging
When a firm insures itself against foreign exchange risk
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
Bretton Woods System: This international monetary system entailed the...
- creation of World Bank and International Monetary Fund - fixed exchange rate system policed by the IMF - nations pegging their currencies to the US dollar - US dollar (only) was convertible into gold at $35 per ounce - nations would defend their currency to maintain its value within 1% of the par value nations would not devalue currency for trade purposes - if a currency was too weak to defend, a devaluation of no more than 10% was allowed ....larger than 10% required IMF approval
Managed-Float or "Dirty Float"
- currency is allowed to fluctuate on the market - BUT the country's central bank will intervene in the foreign exchange market
Swaps are transacted between...
- international firms and their banks - between banks - between governments
Most economic theories of exchange rate movements seem to agree that three factors impact the future exchange rate movements in a country's currency. The 3 factors are....
- the country's price inflation - the country's interest rate - market psychology
Forward Exchange Rates can be quoted for..
... for 30 days, 60 days, 90 days, 180 days or longer into the future
Managed-Float or "Dirty Float" attempts to...
... maintain the value of its currency against: - an important reference currency - or basket of currencies (Yuan to Euro, US$, Yen) - within some trading range
Forward Exchange insures against...
...Foreign exchange risk for a limited period
Purchasing Power Parity (PPP): In relatively efficient markets...
...a 'basket of goods' should be roughly equivalent in each country
In countries where inflation is expected to be high, interest rates will...
...also be high because investors want compensation for the decline in the value of their money
Purchasing Power Parity (PPP) predicts thats...
...changes in relative prices will result in a change in exchange rates
The forces that determine exchange rates are...
...complex and no theoretical consensus exists
If we understand how exchange rates are determined, we may be able to...
...forecast exchange rate movements
Currency Swap insures against...
...foreign exchange risk for a limited period
Research suggests that neither PPP theory nor the International Fisher Effect are....
...good at explaining short- term movements in exchange rates
Gold Standard: International trade grew and it became...
...inconvenient to ship and transport gold coins - changed to paper currency redeemable for gold - governments converted paper currency into gold on demand at a fixed exchange rate - by 1880, most of the world's major trading nations had adopted the gold standard
Economic theory says that...
...interest rates reflect expectations about likely future inflation rates
Increasing evidence supports the role of....
...investor psychology and the bandwagon effect -Studies suggest they play a major role in determining short-run exchange rate movements -But these factors are hard to predict!
At the most basic level, exchange rates are determined by...
...the demand and supply of one currency relative to the demand and supply of another
Gold Standard: Strength of the Gold System occurs when...
...the residents' income of a country earned from exports is equal to the money it's residents pay to other countries for imports. (Current Account of the Balance of Payments is in balance)
But exchange rates do not tell us...
...what underlying factors and/or conditions determine the demand and supply of a currency
Spot Exchange Rates are reported on...
A real-time basis (on a minute-by-minute basis)
Determining the Purchasing Power Parity (PPP)
By comparing the prices of identical products in different currencies, it should be possible to determine the "real" or PPP exchange rate.... only if markets were efficient (no impediments to trade)
Fixed: Arguments in Favor: MONETARY DISCIPLINE
Government required to maintain fixed exchange parity and control monetary supply and inflation
Bretton Woods System
During WWII, 44 countries met in New Hampshire and agreed to an international monetary system.
Spot Exchange Rates
Exchange rate of one currency into another currency on a particular day
International Fisher Effect
For any two nations, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two nations
Economic Theories of Exchange Rate Determination (inflation)
Prices and Exchange Rates - Law of One Price - Purchasing Power Parity (PPP) Interest Rates and Exchange Rates Investor Psychology and Bandwagon Effects
Currency Conversion: Speculation
Profiting from short-term exchange rate changes
Government Relations
Promote a stable international monetary system
Business Strategy
Pursue strategies that provide flexibility to change and reduce economic exposure - dispersing production to different locations - contracting out manufacturing and shifting suppliers
Exchange Rate
Rate at which one currency is converted into another
Foreign Exchange Risk
Risk that arises from changes in exchange rates
Managing Foreign Exchange Risk
Risk that future changes in a country's exchange rate will hurt the firm
Law of One Price: A suit selling for $150 in Corvallis...
Should retail for Euro 120 in Bad Mergentheim (US$ 150 x 0.80 EUR/US$ = EUR 120 )
Currency Swap
Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates
