Lecture_9 international business

Topic 9 (Part 1)

The Foreign The Foreign Exchange MarketExchange Market

Introduction

Question: What is the foreign exchange market? Answer:

The foreign exchange market is a market for converting the currency of one country into that of another country

Question: What is the exchange rate? Answer:

The exchange rate is the rate at which one currency is converted into another

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The Functions of Foreign Exchange Market

The purpose of foreign exchange market

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

2. provides some insurance against foreign exchange risk - the adverse consequences of unpredictable changes in exchange rates

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

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When do Firms Use the Foreign Exchange Market?

International companies use the foreign exchange market when

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

they must pay a foreign company for its products or services in its country’s currency

they have spare cash that they wish to invest for short terms in money markets

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

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Insuring Against Foreign Exchange Risk

The foreign exchange market provides insurance to protect against foreign exchange risk - the possibility that unpredicted changes in future exchange rates will have adverse consequences for the firm

A firm that insures itself against foreign exchange risk is hedging

To insure or hedge against a possible adverse foreign exchange rate movement, firms engage in forward exchanges - two parties agree to exchange currency and execute the deal at some specific date in the future

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Insuring Against Foreign Exchange Risk

The market performs this function using:1. spot exchange rates

2. forward exchange rates

3. currency swaps

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What is the Difference between Spot Rates and Forward Rates?

1. Spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day spot rates change continually depending on the supply and

demand for that currency and other currencies

2. Forward exchange rate occurs when two parties agree to exchange currency and execute the deal at some specific date in the future To insure or hedge against a possible adverse foreign exchange

rate movement, firms engage in forward exchanges forward rates for currency exchange are typically quoted for 30,

90, or 180 days into the future

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What is a Currency Swap?

3. Currency swap is 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 between governments when it is desirable to move

out of one currency into another for a limited period without incurring foreign exchange rate risk

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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 are London, New York, Tokyo, and Singapore

the market is always open somewhere in the world—it never sleeps

Most transactions involve U.S. dollars on one side

the U.S. dollar is a vehicle currency

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Do Exchange Rates Differ Between Markets?

High-speed computer linkages between trading centers mean there is no significant difference between exchange rates in the differing trading centers

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

Most transactions involve dollars on one side—it is a vehicle currency along with the euro, the Japanese yen, and the British pound

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How are Exchange Rates Determined?

Exchange rates are determined by the demand and supply for different currencies

Three factors impact future exchange rate movements:1. A country’s price inflation 2. A country’s interest rate3. Market psychology There is another factor. What is it? Sp.

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How do Prices Influence Exchange Rates?

To understand how prices and exchange rates are linked, we need to understand the law of one price, and the theory of purchasing power parity

The law of one price states that 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

Purchasing power parity theory (PPP) argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) 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

Big Mac Index 2012

Source: The Economist

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Prices and Exchange Rates A positive relationship exists between the inflation rate and the

level of money supply PPP predicts that changes in relative prices will result in

changes in exchange rates, at least in the short run when inflation is relatively high, a currency should depreciate

So, if we can predict inflation rates, we can predict how a currency’s value might change the growth of a country’s money supply determines its likely future

inflation rate when the growth in the money supply is greater than the growth in

output, inflation will occur Empirical testing of PPP theory suggests that it is most accurate

in the long run, and for countries with high inflation and underdeveloped capital markets

Interest Rates and Exchange Rates

Question: How do interest rates affect exchange rates? Answer:The Fisher Effect states that a country’s nominal interest rate (i) is the sum of the required real rate of interest (r ) and the expected rate of inflation over the period for which the funds are to be lent (l )

in other words, i = r + ISo, if the real interest rate is the same everywhere, any difference in interest rates between countries reflects differing expectations about inflation rates

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Interest Rates and Exchange Rates

The International Fisher Effect states that for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries

In other words: (S1 - S2) / S2 x 100 = i $ - i ¥

where i $ and i ¥ are the respective nominal interest rates in two countries (in this case the US and Japan), S1 is the spot exchange rate at the beginning of the period and S2 is the spot exchange rate at the end of the period

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How does Investor Psychology Influence Exchange Rates?

The bandwagon effect occurs when expectations on the part of traders turn into self-fulfilling prophecies - traders can join the bandwagon and move exchange rates based on group expectations

government intervention can prevent the bandwagon from starting, but is not always effective

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Exchange Rate Forecasting

Question: Should companies invest in exchange rate forecasting services to help with decision-making?There are two schools of thought1.The efficient market school argues that 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 moneyAn efficient market is one in which prices reflect all available information

if the foreign exchange market is efficient, then forward exchange rates should be unbiased predictors of future spot rates

Most empirical tests confirm the efficient market hypothesis suggesting that companies should not waste their money on forecasting services

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Exchange Rate Forecasting

2. The inefficient market school argues that companies can improve the foreign exchange market’s estimate of future exchange rates by investing in forecasting services

An inefficient market is one in which prices do not reflect all available information

in an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates and it may be worthwhile for international businesses to invest in forecasting services

However, the track record of forecasting services is not good

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Approaches to Forecasting

Question: How are exchange rates predicted?There are two approaches to exchange rate forecasting:

1.Fundamental analysis draws upon economic factors like interest rates, monetary policy, inflation rates, or balance of payments information to predict exchange rates

2.Technical analysis charts trends with the assumption that past trends and waves are reasonable predictors of future trends and waves

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Currencies Convertibility

Question: Are all currencies freely convertible?A currency is freely convertible when a government of a country allows both residents and non-residents to purchase unlimited amounts of foreign currency with the domestic currencyA currency is 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 wayA currency is nonconvertible when both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency

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Currencies Convertibility

Most countries today practice free convertibility, although many countries impose some restrictions on the amount of money that can be converted

Countries limit convertibility to preserve foreign exchange reserves and prevent capital flight - when residents and nonresidents rush to convert their holdings of domestic currency into a foreign currency

When a country’s currency is nonconvertible, firms may turn to countertrade - barter like agreements by which goods and services can be traded for other goods and services

Chapter 9 (Part 2)

The International Monetary System

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What is the International Monetary System?

The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates

A floating exchange rate system exists when a country allows the foreign exchange market to determine the relative value of a currency Examples - the U.S. dollar, the European Union’s euro,

the Japanese yen, and the British pound A dirty float exists when the value of a currency is

determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency

- China adopted this policy in 2005

What is the International Monetary System?

A fixed exchange rate system exists when countries fix their currencies against each other countries fix their currencies against each other at a

mutually agreed upon valueprior to the introduction of the euro, some European

Union countries operated with fixed exchange rates within the context of the European Monetary System (EMS)

A pegged exchange rate system exists when a country fixes the value of its currency relative to a reference currency Many developing countries have pegged exchange rates

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Gold Standard The gold standard refers to a system in which

countries peg currencies to gold and guarantee their convertibility the gold standard dates back to ancient times when gold

coins were a medium of exchange, unit of account, and store of valuepayment for imports was made in gold or silver

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

in the 1880s, most nations followed the gold standard$1 = 23.22 grains of “fine” (pure) goldunder the gold standard one U.S. dollar was defined as equivalent

to 23.22 grains of "fine (pure) gold The exchange rate between currencies was based on the

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

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Strength of the Gold Standard

The great strength of the gold standard was that it contained a powerful mechanism for achieving balance-of-trade equilibrium - when the income a country’s residents earn from its exports is equal to the money its residents pay for imports

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 People lost confidence in the system

demanded gold for their currency putting pressure on countries' gold reserves, and forcing them to suspend gold convertibility

The Gold Standard ended in 1939

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Bretton Woods System In 1944, representatives from 44 countries met at

Bretton Woods, New Hampshire, to design a new international monetary system The goal was to build an enduring economic order that

would facilitate postwar economic growth Under the Bretton Woods Agreement

a fixed exchange rate system was established all currencies were fixed to gold, but only the U.S.

dollar was directly convertible to gold devaluations could not to be used for competitive

purposes a country could not devalue its currency by more than

10% without IMF approval

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What Institutions were Established at Bretton Woods?

The Bretton Woods agreement also established two multinational institutions1.The International Monetary Fund (IMF) to maintain order in the international monetary system through a combination of discipline and flexibility

requiring fixed exchange rates stopped competitive devaluations and brought stability to the world trade environment

fixed exchange rates imposed monetary discipline on countries, limiting price inflation

in cases of fundamental disequilibrium, devaluations were permitted

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

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What Institutions were Established at Bretton Woods?

2. The World Bank to promote general economic development - also called the International Bank for Reconstruction and Development (IBRD)

Countries can borrow from the World Bank in two ways

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 only to the poorest countries

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The Collapse of the Fixed System Bretton Woods worked well until the late 1960s The collapse of the Bretton Woods system can be traced to U.S.

macroeconomic policy decisions (1965 to 1968) It collapsed when huge increases in 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 came under speculative attack

The Bretton Woods Agreement collapsed in 1973

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Which is Better – Fixed Rates or Floating Rates?

Floating exchange rates provide:1.Monetary policy autonomy

removing the obligation to maintain exchange rate parity restores monetary control to a government

2.Automatic trade balance adjustments under Bretton Woods, if a country developed a

permanent deficit in its balance of trade that could not be corrected by domestic policy, the IMF would have to agree to a currency devaluation

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Which is Better – Fixed Rates or Floating Rates?

But, a fixed exchange rate system 1.Provides monetary discipline

ensures that governments do not expand their money supplies at inflationary rates

2.Minimizes speculationcauses uncertainty

3.Reduces uncertaintypromotes growth of international trade and

investment

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Exchange Rate Regimes in Practice

Currently, there are several different exchange rate regimes in practice

In 2006: 14% of IMF members follow a free float policy 26% of IMF members follow a managed float

system 28% of IMF members have no legal tender of

their own the remaining countries use less flexible

systems such as pegged arrangements, or adjustable pegs

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Exchange Rate Regimes in Practice

Exchange Rate Policies, IMF Members, 2006

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Pegged Exchange Rate System

A country following a pegged exchange rate system, pegs the value of its currency to that of another major currency

popular among the world’s smaller nations adopting a pegged exchange rate regime can

moderate inflationary pressures in a country

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Currency Board

Countries using a currency board commit to converting their domestic currency on demand into another currency at a fixed exchange rate

the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued

the currency board can issue additional domestic notes and coins only when there are foreign exchange reserves to back them

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