IB Exam 2
Economic/Structural Risk (Future)
(LONG TERM) The extent to which a firm's future international earning power (or costs) will be affected by changes in exchange rates. Ex: Nestle has 98% of sales outside of switzerland. Concerned with long run effect of changes in exchange rates on future revenue and costs
Transaction Risk (Current, Open)
(SHORT TERM)The extent to which income from individual transactions is affected by fluctuations in foreign exchange. i.e. receipt of revenue or payments due in foreign currency ex: Mondelez pays its invoices on 120 day terms
Free Float
- Closest approach to perfect competition - aggregate supply and demand for currency affects exchange rates - not government intervention - Equilibrium follows from overall macroeconomic indicators - Governments focus more on interest rates and fiscal policy -the US uses interest rates, economic policy, and talking points as an indirect way to adjust our currency -rate changes each time there is a transaction in the forex market, responding to supply and demand
Facets of Monetary Systems
- Currency (discussed previously) - Exchange controls/convertibility - Exchange rate regime - Reserve asset (often a blend of the below today) - Gold - U.S. dollar and/or other "hard" currencies - SDRs (see later slides)
Fixed/Hard Peg Regime
- Eliminate foreign exchange risk (but what is the long-term record?) - Make trade more "fair." Alternatives allow governments to skew country competitiveness by encouraging "currency wars" and competitive devaluations to spur jobs and exports. - Easier for consumers and businesses to compare prices *the idea is that it is supposed to be a fixed rate, but there are jumps in exchange over time. But they have to control inflation, interest rates, and the economy so the exchange rate does not change that often. -controlled by government: they set the exchange rate and manage the economy in an effort to support the rate
International Fisher Effect
- For any two countries, the spot exchange rate and future exchange rate should change in an equal amount, but in the opposite direction, to the difference in nominal interest rates between the two countries. - The theory assumes the real rate of interest is fixed globally. (Is the same everywhere since capital can move freely between markets.) So differences in nominal interest rates can be traced to the differences in expectations about inflation between markets.
Convertibility
- Freely convertible (no restrictions) - Externally convertible (non-residents can convert) *to make the currencies appealing for FDI* this occurs because countries are encouraged to exchange their money in the local currency, and invest there, but also keep it there. -Example: non-residents can remit local currency profits home (FDI), it just isn't unlimited (there is a restriction on how much) - Non-convertible (no one can convert): you are stuck in there (ex: Cuba) - In reality, these countries allow convertibility by government license for current account transactions.
Currency classification by mobility/liquidity
- Hard currencies: Currencies of major industrial countries that can be easily traded. They are convertible, liquid, widely accepted (serve as vehicle currencies) and stable day-to-day (high worldwide demand gives them global acceptance and "safe haven" appeal). - Soft (lesser traded) currencies: Officially tradable currencies, but are often illiquid and difficult to trade (not universally accepted). - Non-tradable currencies: Conversion (trade) restricted by their issuing governments.
The Original Role of the IMF
- IMF maintained exchange rate - Discipline - National governments had to manage inflation through their money supply - Excessive drawing from IMF funds came with IMF supervision of monetary and fiscal policies - "conditionality" - Flexibility - Provides loans to help members states with temporary balance-of-payment deficit - Allows time to bring down inflation - Relieves pressures to devalue - Members allowed 10% devaluations and more with IMF approval
Strategies for better intercultural experiences
- Intercultural communication generally involves a greater investment of time - most of that additional time should be spent listening - allow for pauses and silence - allow speakers time to finish his or her thoughts, avoid interjecting during pauses - Recognize that the speaker may be having difficulty expressing his/her thoughts with fluency - Keep context and non-verbals in mind - e-mail is difficult; try another method of communication - Avoid yes and no questions - *in some cultures yes may mean "we will try" and you may never get an obvious "no" response. - phrase questions so that the person has to give a response that conveys meaning - Restate key messages using different words and phrases: "overcommunicate": state something, and follow up in another channel
Crawling/Adjustable Peg
- The rate is revalued/devalued at regular intervals to align with fundamentals *not leaving it completely open to when the rate changes, it changes at regular intervals, so you know when it is coming. It is not a huge surprise. In China, it is a revised rate every day. It is a fixed exchange rate only until the next evaluation day. It happens 12 different times over a year to get to the SAME DROP that happens in ONE day on a fixed exchange rate regime. -controlled by government: sets the exchange rate and makes adjustments at intervals of time that it determines
How did the U.S. dollar become central to this system, to become the world's largest central reserve asset and vehicle currency?
-Because the U.S. had a lot of the world's gold at this time -In a very powerful position at the end of WWII -Tale of Keynes missed the meeting where the dollar had been put into the contracts as a placeholder for gold
Factors Influencing Currency Value: Expectation Factors
-Expectations -Forward Exchange market prices
Bretton Woods
-In 1944, representatives of the major Allied powers met at Bretton Woods, NH to plan for the future -General consensus -Stable exchange rates were desirable -Floating or fluctuating exchange rates had proved unsatisfactory -The government controls of trade, exchange and production that had developed through WWII were wasteful and discriminatory
Factors Influencing Currency Value: Political Factors
-Political party and leader philosophies -proximity of elections or change in leadership
The foreign exchange market
-almost a 24/7 market (except weekends and bank holidays) -about 5.7T exchanges daily for: trade, investments, speculation, risk management, and tourism -market is connected by high speed computers for one virtual market -London is dominant because it was the first major industrialized nation and is geographically located betwen Tokyo and New York
What were the causes of the Asian Financial Crisis?
-capital flight "contagion" from Thailand to adjacent nations -market lost faith in fixed exchange rate as it was artificially high -loans taken in foreign currency to fuel growth -weak financial institutions to regulate lending practices -Thailand lacked sufficient reserves to pay back foreign debt -speculators saw opportunity to short the Baht and make money from the currency being devalued
When a currency collapses what does that mean for citizens of that nation? How are businesses forced to cope?
-could not sell a unit when the crisis hit (for one owners' condos) -people's salaries were cut -cost of living rises: water, electricity, necessities but cost of living was still rising
Present day controversies of the IMF
-crises keep happening -Moral hazard: if you really want governments to be self reliant and effective at planning policies that don't lead to a financial crisis stop acting as the lender of last resort -lack of accountability: unlike democratically elected governments the executive board of the IMF doesn't face that many checks and balances and is not held responsible for their performance. The IMF also has been criticized for imposing policy with little or no consultation with the affected countries -Power divide/voting power allocation: need 85% vote for major actions, U.S. has >15% of voting power (nothing can be passed without U.S. approval)
Why is the topic of foreign exchange so important?
-currencies are fairly volatile so making short term and long term currency strategies is more important than ever -governments are actively engaged in "managing currency" to make their economies "competitive (based on export prices)
Currency Exchange Controls/Convertibility
-currency controls control converting local currency into foreign currency -if you set your currency's value really low you discourage locals from converting their currency. They may not want to buy from the outside because they will have to convert their local currency into foreign currency to buy from the world. They will buy locally instead. -Currency exchange controls - Government controls that limit the legal uses of a currency in international transactions - In general, only the relatively rich industrial countries have few or no currency exchange controls - Methods of control: - Managing official exchange rates - Example: Set your currency exchange rate at an artificially low rate such that imports are not desirable for your citizens, but exports are encouraged. This limits domestic citizens' demand (exchange) for foreign currency and yet provides foreign currency inflows (from export earnings). [Is China doing this?] - Convertibility restrictions
Individualism vs. Collectivism
-degree to which people in a country prefer to place primary emphasis of themselves as individuals (I or me) or as a member of a group (we) *Example of car with your values on it -The U.S. is very individualistic: make sure their voice is heard, praised for high confidence, told to be natural born leaders -the "others" orientation is missing from OUR culture -to other cultures, the U.S. can come across as overly confident, as not very good listeners, and not very welcoming of others' viewpoints -most of the world is in the middle of this spectrum, BUT the U.S. is high on individualism
Collapse of Bretton Woods
-devaluation pressures on dollar after 20 years -Vietnam war financing -welfare program financing -Nixon closed the gold window and ended gold convertibility of the dollar in 1971 -currencies began to float and the US dollar was devalued in 1972 (against IMF's rules)
What is culture
-facets of cultural difference in the global workplace -a system for living life in a society, including its shared value (what is right and desirable) and norms -there are strategies for more successful intercultural management
Origins of Culture
-geography & climate -technology and political economy -social institutions: family, religion, school, media, gvt -peers Consequences of culture: -consumption decisions and behaviors -management style
What the role of the IMF?
-historically worked to help countries maintain fixed exchange rate -now lending, technical assistance, and surveillance consultations -loans come with conditions
Flaws with the Big Mac Index
-isn't meant to be taken too seriously -McDonald's brand/offering position is different across markets and it is viewed differently. This affects pricing -additionally cultural issues: could the Indian big Mac not having meat affect pricing?
The USD is the dominant unit being exchange for other currencies
-main central reserve asset of many countries -the most used vehicle currency and intervention currency -great demand worldwide because of its safe haven aspect and its universal acceptance (US currency is also counterfeited and laundered the most) -other liquid or "hard" currencies include EUR, GBP, and JPY
Ignoring the importance of culture can be costly
-over half of global merges and acquisitions fail, many due to cultural issues -90% of top executives said cross-cultural leadership was their top management challenge
Managed/Dirty Float
-the government intervenes as needed when a destabilizing event occurs, justified by their need to smooth markets -no one revises the rates, but it changes each time there is a transaction. The government can act as a player on the exchange market, buying or selling the currency and thus influencing its exchange rate.
What's the purpose of SDRs?
-the supply of dollars was not unlimited; they could only print 35 more dollars for every new ounce of gold. This was limiting countries' abilities to trade in the global marketplace because they could not get access to dollars. SDR is a movement to diversify additional currencies and globalize them. The inherent problem with the dollar being the only central currency: unstable. Controlled by one government, sovereign to one country. Other currencies are used to balance the dollar when it falls. The value of the SDR tends to be very stable because if one falls, the other rises, and even it outs.
Critiques of the IMF
-they are not good at forecasting shocks -their loans don't always work -there is no accountability if the IMF fails when they give loans because the country still has to pay it back regardless
Factors Influencing Currency Value: Economic Factors
1) Balance of payments 2) interest rates 3) inflation 4) monetary and fiscal policy 5) international competitiveness6)monetary reserves 7) government controls and incentives 8) importance of currency in world
Why do countries leave change in foreign currency?
1) To use it to make investments there because there is friction in converting it and hiring people to do so 2) The US cannot tax offshore money 3) The interest rate might be higher there
The International Monetary Fund Today
188 countries, 477billion SDR (amount that can be loaned out) Areas: -lending -technical assistance -surveillance consultations
Purchasing Power Parity
A monetary measurement of development that takes into account what money buys in different countries. - Most useful in understanding how economic forces will affect exchange rates between two nations in the intermediate term— when such imbalances correct, they are usually slow to do so (over several years). Why? See reading: "When Currencies Fall, Export Growth is Supposed to Follow." - Growth of global value chains may be limiting exchange rate pass-through. - Country of origin effects and terms of trade still seem to matter - Example: Russia ruble crisis, Brexit and the pound - It takes time for firms to change sourcing and investments to take advantage of (or avoid) currency fluctuations. - In the short term, exchange rates (for floating currencies) are determined by various other factors (news cycle, bandwagon effects, market psychology—see earlier)
Natural Hedging
A natural hedge is the reduction in risk that can arise from an institution's normal operating procedures. A company with significant sales in one country holds a natural hedge on its currency risk if it also generates expenses in that currency. Another example is a company that opens a subsidiary in another country and borrows in the foreign currency to finance its operations, even though the foreign interest rate may be more expensive than in its home country: by matching the debt payments to expected revenues in the foreign currency, the parent company has reduced its foreign currency exposure.
NPR: Dollar at the center of the world
Britain economist: John Maynard Keynes *Harry Dexter white outwit Keynes and put the US dollar at the center of the world -Bancor: Keynes idea (gold bank)- a central currency (utopian idea) -Harry White: changed "gold convertible currency" to "US dollar" - euphemism for the dollar
Many SMEs fail to grasp foreign exchange risk
Broad array of risks: higher energy costs, rising operating costs, anemic growth in the UK economy and eurozone crisis -Finance officers in SME's do not usually understand or efficiently hedge the risk of currency volatility's effect on profit -they usually do not have a forex expert, and no risk management systems/software -"unless companies have suffered a significant FX loss, they do not hedge. While they know there is a risk, they do not have a formal policy. It's really reactive." -a third of the companies reported gains or losses of $1m -SMEs focus on selling and planning cash flow, but not so much on protecting their margins
BMW: How they dealt with foreign exchange risk
Challenge: despite rising revenues, its profits were severely eroded by changes in exchange rates (-2.4b from 2005-2009!) Their strategy: two approaches -One strategy was to use a "natural hedge" - meaning it would develop ways to spend money in the same currency as where sales were taking place, meaning revenues would also be in the local currency. The first involved establishing factories in the markets where it sold its products; the second involved making more purchases denominated in the currencies of its main markets. By moving production to foreign markets the company not only reduces its foreign exchange exposure but also benefits from being close to its customers. In addition, sourcing parts overseas, and therefore closer to its foreign markets, also helps to diversify supply chain risks. However, not all exposure could be offset in this way, so BMW decided it would also use formal financial hedges. To achieve this, BMW set up regional treasury centres . The centres were instructed to review the exchange rate exposure in their regions on a weekly basis and report it to a group treasurer. The group treasurer team then consolidates risk figures globally and recommends actions to mitigate foreign exchange risk.
Persuading: Concept-First or Application-First
Concept-first: individuals have been trained to first develop the concept before presenting a fact, statement, or opinion. Build theoretical argument before conclusion Application-first: Individuals are trained to begin with a fact, statement or opinion first followed by concepts to back up the conclusion if necessary. Discussions are practical and concrete. Theoretical or philosophical discussions are avoided in a business manner.
Disagreeing: Confrontational vs. Avoids Confrontation
Confrontational: Debate is positive, appropriate. Avoids confrontation: debate or disagreement is inappropriate and negative for group harmony.
Four major hard currencies
Dollar Euro Yen Pound
Culture: Leading
Egalitarian: low distance between subordinate and boss. Flat hierarchies. Hierarchical: high distance between subordinate and boss. Status is important. Org structures are multi-layered and fixed.
Interest Rates and Exchange Rates
Fisher effect --> i=r+I i=nominal interest rate r=real rate of interest l=expectations about inflation
Jamaica Agreement 1976
Floating rates declared acceptable, and gold was abandoned as reserve asset. - IMF returned gold reserves to members at current prices - Proceeds placed in trust fund to help poor nations - IMF quotas - member country contributions - increased - Less-developed, non-oil exporting countries given more access to IMF - IMF continued its role of helping countries cope with macroeconomic and exchange rate problems
Challenges to the Bretton Woods System
From 1958 through 1971, United States cumulative deficit was $56 billion - Vietnam War - Deficit was financed partly by use of the U.S. gold reserves - Deficit partly financed by incurring liabilities to foreign central banks - By 1971, many more dollars were in the hands of foreign central banks than the gold held by the U.S. Treasury, if they all showed up to the U.S. treasury asking for gold they would not be able to complete it. The U.S. did not have that gold to honor that commitment. Nixon closes the gold window.
A reduced currency value means...
Higher costs for import for that nation because of inflation
Universalism vs. Particularism
How does relationship and context determine how the rules are applied? Universalism: people place a high importance on laws, rules, values, and obligations. They try to deal fairly with people based on these rules, but rules come before relationships Particularism: people believe that each circumstance, and each relationship, dictates the rules that they live by. Their response to a situation may change based on what's happening in the moment and who is involved.
Moral Hazard
If you really want governments to be self reliant and effective at planning policies that don't lead to a financial crisis, stop acting as their lender and giving them insurance.
Culture Preference for Time
Linear time: One thing at a time. No interruptions. The focus is on the deadline, emphasis is on promptness and good organization over flexibility (Limited) -Germany, Japan Flexible time: Fluid manner, dealt with at once and interruptions accepted, the focus is on adaptability and flexibility is valued over organization (Adequate) -Kenya, Saudi Arabia, Mexico
Why do currencies change in value? (long term)
Macro factors: interest, inflation, and trade balance --> a trade surplus sees increasing demand for currency --> low inflation leads to appreciation in currecy -->offering higher interest rates will see higher demand for its currency
Why limit convertibility?
Service international debt: their debt is usually in dollars - Allow government to have funds to make imports: to buy from the outside, it is usually priced in dollars. They need to hold on their dollars. - Government afraid of capital flight: where everyone runs to the banks and exchanges the local currency for another countries' currency - Political decision as well as an economic decision: some of the sovereignty would be lost to the US if every Indian held dollars instead of rupees. They would have more control in terms of interest rates and other aspects. - Many countries have some kind of restrictions (rare to have full convertibility without any restrictions)
Normative vs. Pragmatic
Short Term (Normative): Describes the U.S. pretty well - Absolute truth: objective truth. Everyone should be treated equally and have access to the same information. - Great respect for traditions: we have lots of idioms and saying garnered from our sports that we use in our everyday language. We have done very limited changes to our constitution - Quick results: lots of companies on stock exchanges, measured on quarterly indexes - Small propensity to save for the future Long Term (Pragmatic) - Truth depends on situation, context and time: the answer is different depending on your relationship. - Ability to adapt traditions to changed conditions - Strong propensity to save and invest - Perseverance
On the Streets, New IMF Is Getting Same Pushback as Old One
Since the financial crisis the IMF, long resented for supporting austerity (sternness), has devoted more attention to how the benefits of growth are shared. To some extent, the problem is baked in. Countries only turn to the Fund for cash if their economies are already in trouble -- so the conditions for unrest are already there before the first IMF delegation touches down. "We get called in when someone needs to be brought to the emergency room. And you can't say, at that moment, 'I'll do surgery if you fill a list of 12 things you'll never do that brought you here' One problem is that success is measured by indicators like growth, inflation or fiscal balances "to the exclusion of almost everything else, As a result, "the programs rarely get a buy-in from the general public," he said. "The risk of popular backlash is material." "The question is whether the IMF becomes a thought leader or just adapts to new trends in the global economy."
What is the debt death spiral?
Something causes a country not be able to pay back its debt (i.e. recession, conflict), so they devalue their currency, but their increases the weight of their debt so they must raises taxes and cut spending, which leads to economic slowdown, inflation. The government then takes out more foreign currency loans, etc, etc.
What are SDRs?
Special Drawing Right (way forward for greater balance in official reserves?): an artificial currency that only exists within the IMF and IMF countries. No physical from. An excel worksheet on a website. Consists of 5 currencies that are given a certain weight of that basket and based on their exchange rates the value of the basket changes every day, but minimally.
Culture: Trusting
Task-based: trust is built through business related activities. If you do work good work consistently, you are reliable. Relationship-based: Trust is built by doing stuff together and are built over time as you get to know someone.
Big Mac Index
Tool for calculating purchasing power parity that compares prices of a Big Mac throughout the world. (actual-implied)/actual
Gold Standard (1870-1914)
When countries agree to buy or sell gold for an established number of currency units (fixed value of exchange) - Also a government could not create money not backed by gold - Convertibility guaranteed - By 1880 most countries on gold standard - System broke down in 1914 - Failed resumption after WWI - Great Depression
Exchange rate spread
ask = offer ( to sell it at)the lowest price a seller is willing to sell at bid = the highest price a buyer has offered *market makers get the best price: big banks, forex traders Low: Combination of U.S. dollar, euro, japanese yen, british pound High: turkish Lira, Egyptian pounds
Are there similarities between the Asian Financial Crisis and the recent Great Recession in the U.S.(2008-2009)? Did we set new policy precedents? If so, what?
everyone had a lot of debt -Government bailed out banks and private companies, etc. in the Great Recession Long term capital management: a specific type of hedge fund. One investment that had a huge effect on the global economy. A private fund so the government could not impose a solution. It was in the hands of bankers. Brazil: cut spending and enacted reforms? It worked and their markets gradually returned to normal. Countries that took ownership of Brazil (Korea, Brazil) were able to recover. Not only did they include the aggressive use of standard monetary and fiscal policy tools, but new tools were invented and implemented on the fly in late 2008 and early 2009.
forward exchange rate
forward the current relationship between two currencies +/- premium for a future trade date -trading at a premium: when a currency s forward rate is stronger than spot (vs the other currency) *one currency is always trading at a discount and the other a premium in the forward market unless there is absolutely no different in the forward market than the spot rate
What defines a "hard" currency?
hard currency = safe haven currency = strong currency -a globally traded currency that has a reliable and stable value. -Stability arises from their BREADTH OF USE and GLOBAL ACCEPTANCE as well as the DEEP FINANCIAL POOLS THAT BACK THEM (LIQUIDITY). these currencies serve as reserve assets for many governments. Additional factors contributing to hard currency status are FULLY CONVERTIBLE, FREELY FLOATING, and the issuing country's (or group- EU) geopolitical importance.
Example of Fisher Effect
i=r+I=i=r+I country 1 = country 2 1.0* [1+(.02/2)] = .82 * [1+(.035/2)] 1.01 = .83 **now divide both sides by 1.01 and you end up with 1.00 = .8260
law of one price
the notion that a good should sell for the same price in all markets in their respective currencies -this is flawed because cultural issues can influence the price of a product
Spot exchange rates
the rate at which a foreign exchange dealer converts one currency into another currency on a particular day -2 business days for most spots deals -1 for USD with Canada or Mexico
Why do currencies change in value? (short term)
they change with market expectations and the news cycle
Translation Risk (Past)
translation exposure is the impact of currency exchange rate variances between foreign currency holdings and the value of those holdings as reported on the financial statements of a company. The resulting accounting gains or losses are unrealized until the foreign currency holdings are converted to the home country's currency (when real gains or losses from exchange occurs)
Future and Net Present Value
xUSD * [1+(rate/time)] Example: xUSD * [1+ (.02/3] = $5,000,000 xUSD * (1.00666666667) = $5,000,000 xUSD = $4,966,887.4172
