IB MODULE 8

Historically, gold has been used as a way for people to store value because of its: A. purity and scarcity. B. high transportation and security costs. C. lack of interest-earning ability. D. all of the above.

A. purity and scarcity.

THE GOLD STANDARD

Based on its scarcity and easily assessed level of purity, gold has been trusted since ancient times as a way for people to store, exchange, and measure value.

LO 8-5 Explain the significance of the balance of payments to international business decisions.

By monitoring balance of payments data, the firm can build a sense of a possible future. If a country is exporting more than it imports, there will be a high demand for its currency in other countries in order to pay for the exported goods. This demand might be expected, via supply and demand, to cause the currency to strengthen. Conversely, when a country imports more than it exports, the currency might be expected to weaken, either in the market or through government action. Faced with a trade deficit, a government might lean toward restrictive monetary or fiscal policies and introduce currency or trade controls. The BOP trend over time also helps managers predict what sort of changes in the economic environment might develop in the country and possibly affect their choice of strategic risks to take there.

IMF - eight types of currency exchange arrangements

Exchange arrangement with no separate legal tender Currency board arrangement Conventional fixed-peg arrangement Stabilized arrangement: Pegged exchange rate within a horizontal band Crawling peg Crawling band Managed floating Free floating exchange rates

fixed exchange rate

Exchange rate regime in which the currency's value is tied to the value of another currency or gold.

floating exchange rates

Exchange rates determined by supply and demand that allow currency values to float against one another.

_________ policies address the collecting and spending of money by the government.

Fiscal

bid price

Highest-priced buy order currently in the market.

The Bank for ____________ _____________ is an international organization of central banks that exists to build cooperation in order to foster monetary and financial stability.

International Settlements (BIS)

The efficient market approach assumes that current prices fully reflect

all available relevant information

Foreign reserves are used to

cover foreign debt, import purchases, and other demands for foreign currency that banks might encounter.

The random walk hypothesis, which holds that because the factors that influence prices are

unpredictable, stock market prices evolve much like a random walk, turning here and there without a controlling logic, so that the best predictor of tomorrow's prices is today's prices. A forecasting theory related to the efficient market approach

When the law of one price is applied to interest rates, it suggests that

varying interest rates take into account anticipated differences in inflation rates.

Triffin paradox

A problem in which a national currency that is also a reserve currency will eventually run a deficit, leading to lack of confidence in the reserve currency and a financial crisis.

LO 8-2 Describe today's floating currency exchange rate system, including the IMF currency arrangements.

Floating currency exchange rates are rates that are allowed to float against other currencies and are determined by market forces. The IMF now uses eight categories to describe the ways countries position their currencies in relationship to other currencies, characterized by their degree of flexibility. They are now separate legal tender, currency board arrangements, fixed peg, peg within a horizontal band, crawling peg, crawling band, managed float, and independent float.

Free floating exchange rates

Free floating exchange rates rely on the market. Governments may intervene, but to moderate the rate of change rather than to establish the currency's level. Countries following this approach are: Canada, the United Kingdom, the United States, Sweden, Japan, and the EU countries.

LO 8-4 Discuss financial forces governments can exert.

Governments can restrict the exchange of their currency for other currencies, set tax rates, and, through monetary policy, influence interest and inflation rates. Currency controls limit the number of foreign currency purchases or exchanges made inside the country and may limit the firm's ability to pay for imports and repatriate profits. Governments set currency exchange controls to reduce depletion of their foreign currency reserves. Differences in taxation and inflation rates can influence the firm greatly, so they must be monitored and predicted constantly. Taxes increase the firm's costs, whether they are value-added taxes or income taxes. Inflation is a sustained price increase. It is measured by the consumer price index and accompanied by higher interest rates.

The ____________ ______________ that established the rules for the floating system was both worked out and accepted by IMF members after the fact, in 1976.

Jamaica Agreement

ask price

Lowest-priced sell order currently in the market

_________ policies control the amount of money in circulation, whether it is growing, and, if so, at what pace.

Monetary

Who took the United States off the gold system?

Nixon

Exchange arrangement with no separate legal tender

One country adopts the currency of another, or a group of countries adopt a common currency Examples of the first strategy are the adoption of the U.S. dollar in Ecuador An example of the second arrangement, a common currency, is the euro, the shared currency in 19 EU member-countries.

LO 8-3 Describe the factors that influence exchange rate movement.

Since 1973, the relative values of floating currencies have been set by market forces, influenced by many factors. These factors include supply and demand forecasts for the two currencies; relative inflation in the two countries; relative productivity and unit labor cost changes; political developments, such as expected election results; expected government fiscal, monetary, and currency exchange market actions; balance-of-payments accounts; and a psychological aspect. What actually determines exchange rates is wide and potentially complex, such that economists have not yet developed an accepted theory to explain them. Economists have been able to determine several parity relationships—that is, relationships of equivalence—among some of the various factors in exchange rate movements. These include interest rate parity and purchasing power parity.

TRUE

T/F The fundamental approach to exchange rate prediction looks at the underlying forces that help determine exchange rates and develops various econometric models to capture them and their correct relationships

Jamaica Agreement

The 1976 IMF agreement establishing flexible exchange rates among IMF members

CURRENT CURRENCY ARRANGEMENTS

The IMF now recognizes eight types of currency exchange arrangements that describe the way countries position their currencies in relationship to other currencies, and they vary in their degree of flexibility

spot rate

The exchange rate between two currencies for delivery within two business days.

LO 8-1 Describe the international monetary system's history.

The gold standard operated to support trade until 1914. Currencies were pegged to gold and adjustments were made by the exchange of gold. Next, followed a period of fixed rates under the Bretton Woods system, with the U.S. dollar exchangeable for gold. This pushed the United States into a persistent deficit and reduced gold in the U.S. reserves. The United States stopped the exchange of dollars for gold, and the dollar was allowed to float freely against other currencies on the open market. This began the period of floating exchange rates, which is where we are now. The IMF's Smithsonian Agreement worked out the rules and exchange regimes for the floating system, ranging from free floats to dirty floats to pegged currencies. Meanwhile, the World Bank established the SDR (special drawing rights) as a reserve currency.

crawling peg

a currency is readjusted periodically at a fixed, preannounced rate or in response to changes in indicators

The efficient market approach assumes that current prices fully reflect

all available relevant information. This assumption also suggests that forward exchange rates are the best possible predictor of future spot rates because they will have taken into account all the available information

Conventional fixed-peg arrangement

allows a currency's exchange rates with one or a basket of currencies to fluctuate around a fixed rate within a narrow band of less than 1 percent.

The forward currency market

allows purchasers to lock in purchases of currencies at known rates.

Withholding tax is

an indirect tax levied on passive income.

When a government requires a permit to purchase foreign currency, the exchange rates

are set by the government, often above the free market rate.

A purchase of foreign goods from the United States (requiring importing) will

be recorded in the BOP as a debit in the current account.

Currency board arrangement

commits the country's government to hold foreign reserves of a specific currency in an amount equal to its domestic currency supply and exchange the two at a fixed rate

the financial forces, external to the firm and largely uncontrollable, that influence the context in which international managers make decisions

currency exchange rate fluctuation and exchange risk, currency exchange controls, taxation, inflation, and national-level balance-of-payments account balances.

Currency exchange controls are found most frequently in:

developing countries.

Sir Isaac Newton put England on the gold standard when he

established a fixed equivalency between gold and the British currency.

The present floating exchange rate system was

established after several trials in which central bankers set rates incorrectly and speculators corrected them in the markets, and it was formalized after the fact in the IMF's Jamaica Agreement.

The Triffin paradox suggests that

eventually, reserve currencies will run deficits, which will lead to lack of confidence in the currency.

Governments can exert financial forces that affect companies, including currency _________ __________ and _________________. Through their monetary policy, governments also influence ___________ and ______________ ______________.

exchange controls and taxation. inflation and interest rates

Stabilized arrangement: Pegged exchange rate within a horizontal band

exchange rate fluctuations greater than 1 percent are allowed.

Arbitrage functions to:

exploit price differences between markets, so as to profit with no risk.

One attribute of the U.S. tariff schedule is

how specific it is.

Taxation is a financial force in that:

if the firm can achieve a lower tax burden than its competitors, it can generate higher revenues and then lower its prices or pay higher wages and dividends.

Exchange rate forecasting is:

important because exchange rates influence all aspects of business.

Market forces that set the relative prices of currencies are

influenced by many forces including forces external to business, such as world events.

The international monetary system consists of

institutions, agreements, rules, and processes that allow for the payments, currency exchange, and cross-border movements of capital required for international transactions

used by central banks to intervene in the foreign currency exchange markets.

intervention currency

The Fisher effect states that the real interest rate:

is the nominal rate minus the expected inflation rate.

What is appealing about the gold standard is

its simplicity.

The current account on the BOP has three subaccounts

merchandise, services, and unilateral transfers.

With increasing inflation, borrowing becomes

more attractive because repayment can be made with cheaper money

A value-added tax is actually a sales tax that is

paid in stages along the process from raw materials to consumer and then credited after final sale.

Crawling bands

readjusts the country's currency to maintain fluctuation margins around a central rate known as "a snake in the tunnel" in the London foreign exchange markets.

a currency that is quoted as dollars per unit of currency instead of in units of currency per dollar.

reciprocal currency

the international Fisher effect, says that the interest rate differentials for any two currencies will

reflect the expected change in their exchange rates.

The shock of Nixon's announcement led currency exchange markets to

remain closed for several days, and when they reopened, they began to develop a new system for which few rules existed. Currencies were floating, their values based on market forces

Every member of the IMF keeps a ___________ account, a bit like a savings account, with holdings the country can draw on when needed to finance trade or investments or to intervene in currency markets.

reserve

Balance-of-payments data

reveal demand for a country's currency.

If the Japanese yen is strengthening against the U.S. dollar, and the Japanese government wanted to boost exports, the central bank of Japan might well

sell massive amounts of Japanese yen in the FX markets.

arbitrage

simultaneous buying and selling to make a profit with no risk

The present floating exchange rate system is not a totally free float because

some central banks from time to time intervene in the market to buy or sell large amounts of currency to affect the supply and demand of a particular currency.

The SDR is

special drawing rights, an international reserve asset.

law of one price

states that in an efficient market, like products will have like prices.

Managed floating

the currency fluctuates, while the country's monetary authority actively intervenes on the exchange market without specifying or making public its goals and targets

There are several approaches to forecasting, and three of the main ones are

the efficient market approach, the fundamental approach, and technical analysis

Bretton Woods led to an exchange rate agreement known as the Bretton Woods System or:

the gold exchange standard and the fixed-rate system

In 1717, Sir Isaac Newton took Britain from the silver standard (pounds sterling) to

the gold standard, with fixed rates.

Purchasing power parity is a way to compare

the purchasing power of several currencies.

The inflation rate determines

the real cost of borrowing in capital markets.

Fixed-rate relationships among currencies could not stay fixed, according to Obstfeld and Rogoff, because

the volume of global transactions started to exceed most countries' foreign exchange reserves, so governments couldn't intervene to sustain the value of their currency.

Countries put limitations on the convertibility of their currency when they are concerned that:

their foreign reserves could be depleted.

Financial forces such as inflation and taxation are considered uncontrollable because

they are external forces beyond the influence of the firm, around which a manager can manage.

A currency that is used for international trade or investment. For example, the diamond market uses the U.S. dollar as a vehicle currency

vehicle currency

Technical analysis approach, looks at history and then, assuming that

what was past will be future, projects these trends forward. Technical analysts think in terms of waves and trends. There is no theoretical underpinning to the technical approach, and while academic studies tend to dismiss it, it appears that traders often use it.