Class Chart 10/05 - The Foreign Exchange Market + International Monetary System

when did Bretton Woods end? what two things occurred for the fixed exchange rate system to collapse?

- Bretton Woods worked well until the late 1960s -It collapsed when huge increases in U.S. welfare programs and the Vietnam War were financed by increasing the money supply and causing significant inflation (other countries increased the value of their currencies relative to the U.S. dollar in response to speculation the dollar would be devalued) -However, because the system relied on an economically well managed U.S., when the U.S. began to print money, run high trade deficits, and experience high inflation, the system was strained to the breaking point ( the U.S. dollar cam under speculative attack)

what type of relationship exists between the inflation rate and the level of money supply

- a positive relationship - when the growth in the money supply is greater than the growth in output, inflation will occur

what is a floating exchange rate system? what's an example of free floating currencies?

- exists when a country allows the foreign exchange market to determine the relative value of a currency - the U.S. dollar, the EU euro, the Japanese yen, and the British pound all float freely against each other. their values are determined by market forces and fluctuate day to day

what is an intermediate/dirty/managed float. What's an example of it?

- exists when a country tries to hold the value of its currency within some range of a reference currency such as the U.S. dollar - china pegs the yuan to a basket of other currencies

what will happen to a country with a very high inflation rate

- it should see its currency depreciate relative to others - investor uncertainty will cause a move away from this currency

what type of currency do most countries practice today

- most countries practice free convertibility but many countries impose restrictions on the amount of money that can be converted

what were the benefits of the gold standard? what feature about the gold stanard continues to prompt calls to return to a gold standard

- strength of the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium by all countries( when the income a country's residents earn from its exports is equal to the money its residents pay for imports)

what does the purchasing power parity suggest

- that changes in relative prices between countries will lead to exchange rate changes, at least in the short run (a country with very high inflation should see its currency depreciate relative to others (investor uncertainty will cause move away from this currency))

what is economic (competitive) exposure? What is it concerned with?

- the extent to which a firm's future international earning power is affected by changes in exchange rates - concerned with the long-term effect of changes in exchange rates on future prices, sales, and costs

what is transaction exposure? what does it include?

- the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values - includes obligations for the purchase or sale of goods and services at previously agreed prices and the borrowing or lending of funds in foreign currencies

what is arbitrage? How does it occur?

- the process of buying a currency low and selling it high - If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage

what is the spot exchange rate? how can they be quoted?

- the rate at which a foreign exchange dealer converts one currency into another currency on a particular day - the amount of foreign currency one U.S. dollar can buy, or as the value of a dollar for one unit of foreign currency

what is capital flight. when is it most likely to occur?

- when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency - most likely to occur in times of hyperinflation or economic crisis

what two multinational monetary institutions were established by the Bretton Woods Agreement? What non-monetary institution did Bretton Woods form?

1) The International Monetary Fund (IMF): to maintain order in the international monetary system through a combination of discipline and flexibility 2) The World Bank (also International Bank for Reconstruction and Development IBRD): o promote general economic development - The General Agreement on Tariffs and Trade (GATT)/ WTO

what are the three steps in the timeline of the gold standard?

1) The gold standard worked well from the 1870s until 1914 - but, many governments financed their World War I expenditures by printing money and so, created inflation 2) People lost confidence in the system • the demand on gold for their currency put pressure on countries' gold reserves and forced them to suspend gold convertibility 3)By 1939, the gold standard was dead

What was 4 things that were implemented in the Bretton Woods System

1) a fixed exchange rate system was established 2) all currencies were fixed to gold, but only the U.S. dollar was directly convertible to gold 3)devaluations could not to be used for competitive purposes 4) a country could not devalue its currency by more than 10% without IMF approval

what three initiatives came out of the Jamaica agreement?

1) floating rates were declared acceptable 2) gold was abandoned as a reserve asset 3) total annual IMF quotas - the amount member countries contribute to the IMF - were increased to $41 billion - today they are about $767 billion

What is one benefit and one downside suggested by the empirical testing of PPP theory

1) it is most accurate in the long run, and for countries with high inflation and underdeveloped capital markets 2) it is less useful for predicting short term exchange rate movements between the currencies of advanced industrialized nations that have relatively small differentials in inflation rates

What are four reasons international companies use the foreign exchange market

1) the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies 2) when they must pay a foreign company for its products or services in its country's currency 3) when they have spare cash that they wish to invest for short terms in money markets 4) when they are involved in currency speculation

what four things does the IMF do?

1)fixed exchange rates stopped competitive devaluations and brought stability to the world trade environment 2) fixed exchange rates imposed monetary discipline on countries, limiting price inflation 3) in cases of fundamental disequilibrium, devaluations were permitted 4) the IMF lent foreign currencies to members during short periods of balance-of-payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment

what are two ways managers can reduce economic exposure

1. Distribute productive assets to various locations so the firm's long-term financial well-being is not severely affected by changes in exchange rates 2. Ensure assets are not too concentrated in countries where likely rises in currency values will lead to increases in the foreign prices of the goods and services the firm produces

What five general things managers can do to minimize exchange rate risk?

1. Have central control of exposure to protect resources efficiently and ensure that each subunit adopts the correct mix of tactics and strategies 2. Distinguish between transaction and translation exposure on the one hand, and economic exposure on the other hand 3. Attempt to forecast future exchange rates 4. Establish good reporting systems so the central finance function can regularly monitor the firm's exposure position 5. Produce monthly foreign exchange exposure reports

what two ways can countries borrow from the World Bank

1. Under the IBRD scheme, money is raised through bond sales in the international capital market (borrowers pay a market rate of interest - the bank's cost of funds plus a margin for expenses) 2. Through the International Development Agency, an arm of the bank created in 1960 (IDA loans go to the poorest countries)

what three factors impact future exchange rate movements

1. a country's price inflation 2. a country's interest rate 3. market psychology

How can managers minimize exchange rate risk?

1. buy forward contracts 2. use currency swaps 3. lead and lag payables and receivables (lead and lag strategies can be difficult to implement) 4. Options5.Spotexchangerate?

What are the three types of exchange risk that managers need to consider?

1. transaction exposure 2. translation exposure 3. economic exposure

how far into the future are rates for currency exchange quoted in the future for forward exchange rates

30, 90, or 180 days into the future

when is a currency considered nonconvertible

A currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

what is a fixed exchange rate? whats an example?

A fixed exchange rate system exists when countries fix their currencies against each other at some mutually agreed on exchange rate - the European Monetary System (EMS) prior to 1999

What are options?

Call Option: Gives the holder the right to purchase an asset for a specified exercise price on or before a specified expiration date - options differ from forward contracts because you have to pay an upfront price for an option, and you don't have to execute on it unlike forward contracts

what prevents significant differences between exchange rates in differing trading centers

High-speed computer linkages

When was the Bretton Woods system created

In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system that would facilitate postwar economic growth

what happened later in the gold standard

Later, payment was made in paper currency which was linked to gold at a fixed rate

what does the gold par value refer to?

The gold par value refers to the amount of a currency needed to purchase one ounce of gold

what does the gold standard date back to?

The gold standard dates back to ancient times when gold coins were a medium of exchange, unit of account, and store of value (payments for imports were made in gold and silver)

why do firms engage in forward engages?

To insure or hedge against a possible adverse foreign exchange rate movement,

When would a firm turn to countertrade?

When a currency is nonconvertible,

which stakeholders are involved in the foreign exchange market

a global network of banks, brokers, and foreign exchange dealers connected by electronic communications systems (primary trade centers are New York, Tokyo, and Singapore)

what is dollars considered? what are other vehicle currencies

a vehicle currency - Euro, Japanese yen, British pound

- what does the purchasing power parity theory argue - what does the purchasing power of parity (PPP) predict

argues that given relatively efficient markets (a market with no impediments to the free flow of goods and services) the price of a "basket of goods" should be roughly equivalent in each country - predicts that changes in relative prices will result in a change in exchange rates

what is a lead strategy

attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and pay foreign currency payables before they are due when a currency is expected to appreciate

what is countertrade?

barter-like agreements where goods and services are traded for other goods and services (was more common in the past when more currencies were nonconvertible, but today involves less than 10% of world trade)

what does the inefficient market school of thought state

companies can improve the foreign exchange market's estimate of future exchange rates by investing in forecasting services

what is a lag strategy

delay collection of foreign currency receivables if that currency is expected to appreciate and delay payables if the currency is expected to depreciate

what does the demand represent in the exchange rate ( use Mexico as example)

demand for pesos represent non-residents need for pesos to buy Mexican goods/assets

what do events in foreign exchange markets impact

events in the foreign exchange market affect firm sales, profits, and strategy

what is a pegged exchange rate system? What are some examples

exists when a country fixes the value of its currency relative to a reference currency - Many Gulf states peg their currencies to the U.S. dollar

What does the efficient market school of thought state

forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money

what does of the law of one price state

hat in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency - if not there is an opportunity for arbitrage until prices equalize between the two markets

how does a firm insure itself against foreign exchange risk

hedging

what is the foreign exchange market used for

is used to convert the currency of one country into the currency of another

what does the gold standard refer to?

refers to a system in which countries peg currencies to gold and guarantee their convertibility

what is the international monetary system?

refers to the institutional arrangements that countries adopt to govern exchange rates

what factors can contribute to how the spot exchange rate may change

spot rates change continually depending on the supply and demand for that currency and other currencies

what does the supply represent in the exchange rate (use Mexico as example)

supply of pesos, in part reflects Mexican residents need for dollars to conduct transactions with the U.S.

what is translation exposure?

the impact of currency exchange rate changes on the reported financial statements of a company ( concerned with the present measurement of past events, gains or losses are "paper losses" that are unrealized

what is foreign exchange risk

the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm

what is the exchange rate

the rate at which one currency is converted into another

What is currency speculation

the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates

what are currency swaps

the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates

What is the exchange rate determined by

the supply and demand for different currencies ein the market

why do countries limit convertibility

to preserve foreign exchange reserves and prevent capital flight

how do forward exchanges work?

two parties agree to exchange currency and execute the deal at some specific date in the future

what is foreign exchange hedging?

using various methods to minimize or eliminate foreign exchange risk

when is a currency considered freely convertible

when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currency

when is a currency considered externally convertible

when non-residents can convert their holdings of domestic currency into a foreign currency, but when the ability of residents to convert currency is limited in some way

What was the Jamaica Agreement?

- A new exchange rate system was established in 1976 at a meeting in Jamaica - The rules that were agreed on then are still in place today