Ibus 311--Chapter 7: Dealing With Foreign Exchange

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IBUS Ch. 7 Learning Objectives: Foreign Exchange

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After studying this chapter, you should be able to:

1. understand the determinants of foreign exchange rates

2. track the evolution of the international monetary system

3. identify firms’ strategic responses to deal with foreign exchange movements

4. participate in three leading debates on foreign exchange movements

5. draw implications for action

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foreign exchange rate
[Factors behind foreign exchange rates]

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price of one currency in terms of another

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purchasing power parity
[Factors behind foreign exchange rates]

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theory that suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same

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balance of payments
[Factors behind foreign exchange rates]

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country’s international transaction statement

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What determines Foreign exchange rates?

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Relative price differences & PPT
Interest rates & money supply
Productivity & balance of payments
Exchange rate policies
Investor psychology

-->Supply & demand of foreign exchange

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Common Reference
[Role of the US Dollar Outside the US]

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Most international stats (such as exports, imports, and GDP) reported by national governments and international organizations (such as the UN and WTO) are expressed in US dollars.

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Intervention currency
[Role of the US Dollar Outside the US]

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Most central banks buy and sell US dollars in their respective foreign exchange markets to influence their exchange their exchange rates. Many countries peg their currencies to the dollar.

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Reserve currency
[Role of the US Dollar Outside the US]

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Most central banks hold US dollars as official reserves to intervene in their respective markets. (The US Federal US Reserve System maintains its foreign currency reserves in euros and yen).

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Vehicle currency
[Role of the US Dollar Outside the US]

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Transaction between two less commonly used ("exotic") currencies, such as the Brazilian real and the Czech koruna, is often through dollars. There is always an active market for dollars in every country.

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floating (or flexible) exchange rate policy
[Exchange Rate Policies]

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willingness of a government to let the demand and supply conditions determine exchange rates

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clean (or free) float
[Exchange Rate Policies]

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pure market solution to determine exchange rates

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dirty (or managed) float
[Exchange Rate Policies]

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common practice of determining exchange rates through selective government intervention

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target exchange rates or crawling bands
[Exchange Rate Policies]

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limited policy of intervention, occurring only when the exchange rate moves out of the specified upper or lower bounds

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fixed exchange rate policy
[Exchange Rate Policies]

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Fixing the exchange rate of a currency relative to other currencies

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peg
[Exchange Rate Policies]

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stabilizing policy of linking a developing country’s currency to a key currency

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currency board
[Exchange Rate Policies]

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monetary authority that issues notes and coins convertible into a key foreign currency at a fixed exchange rate

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bandwagon effect
[Investor Psychology]

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result of investors moving as a herd in the same direction at the same time

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capital flight
[Investor Psychology]

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phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency

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gold standard

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system in which the value of most major currencies was maintained by fixing their prices in terms of gold, which served as the common denominator

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Bretton Woods system

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system in which all currencies were pegged at a fixed rate to the US dollar

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post–Bretton Woods system

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system of flexible exchange rate regimes with no official common denominator

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International Monetary Fund (IMF)

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An international organization of 185 member countries established to:

promote international monetary cooperation, exchange stability, and orderly exchange arrangements

foster economic growth and high levels of employment

provide temporary financial assistance to countries to help ease balance of payments adjustment

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Typical IMF Conditions on Loan Recipient Countries

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Balance budget by slashing government spending (often entails cutting welfare programs)
Enhance tax revenues
Raise interests to slow monetary growth and inflation

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quota
[International Monetary Fund (IMF)]

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financial contribution, capacity to borrow, and voting power of IMF member countries that is based broadly on its relative size in the global economy

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A strategic goal for financial companies is to profit from the foreign exchange market
[Strategies for Financial Companies]

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moral hazard
foreign exchange market

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moral hazard
[Strategies for Financial Companies]

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recklessness when people and organizations (including governments) do not have to face the full consequences of their actions

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foreign exchange market
[Strategies for Financial Companies]

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market where individuals, firms, governments, and banks buy and sell foreign currencies

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spot transactions
[Foreign Exchange Transactions]

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classic single-shot exchange of one currency for another

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forward transactions
[Foreign Exchange Transactions]

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foreign exchange transaction in which participants buy and sell currencies now for future delivery, typically in 30, 90, or 180 days, after the date of the transaction

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currency hedging
[Foreign Exchange Transactions]

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transaction that protects traders and investors from exposure to the fluctuations of the spot rate

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forward discount
[Foreign Exchange Transactions]

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forward rate of one currency relative to another currency is higher than the spot rate

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forward premium
[Foreign Exchange Transactions]

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forward rate of one currency relative to another currency is lower than the spot rate

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currency swap
[Foreign Exchange Transactions]

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foreign exchange transaction in which one currency is converted into another in Time 1, with an agreement to revert it back to the original currency at a specific Time 2 in the future

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offer rate
[Foreign Exchange Transactions]

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price offered to sell a currency

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bid rate
[Foreign Exchange Transactions]

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price offered to buy a currency

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spread
[Foreign Exchange Transactions]

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difference between the offered price and the bid price

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A goal for nonfinancial companies is to ensure a neutral impact in coping with the fluctuations of the foreign exchange market

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Currency risks
Strategic hedging

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currency risks
[Strategies for Nonfinancial Companies]

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fluctuations of the foreign exchange market

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strategic hedging
[Strategies for Nonfinancial Companies]

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Spreading out activities in a
number of countries in different currency zones to offset the currency losses in certain regions through gains in other regions

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Fixed versus Floating Exchange Rates

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Since the collapse of the Bretton Woods system in the early 1970s, debate has never ended on whether fixed or floating exchange rates are better.

What are the arguments by proponents of fixed and floating exchange rates ?

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Strong Dollar versus a Weak Dollar

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Under the Bretton Woods system (1944–1973),the US dollar was the only common denominator.
Since the demise of Bretton Woods the importance of the US dollar has been in gradual decline.
This does not mean that the US dollar is no longer important; it still is (see Table 7.2).
It is the dollar’s relative importance—in particular, its value—that is at the heart of this debate.

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Panel A: Strong (Appreciating) Dollar
[A Strong Dollar Versus a Weak Dollar]

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Advantages
US Consumers benefit from low prices on imports
Lower prices on foreign goods help keep US price level and inflation level low
US tourists benefit from lower prices when traveling abroad

Disadvantages
US exporters have a hard time competing on price competitiveness abroad
US firms in import-competing industries have a hard time competing with low-cost imports
Foreign tourists find it more expensive when visiting the United States

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Panel B: Weak (Depreciating) Dollar
[A Strong Dollar Versus a Weak Dollar]

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Advantages
US exporters find it easier to compete on price competiveness abroad
US firms face less competitive pressure to keep prices low
Foreign tourists benefit from lower prices when visiting the United States

Disadvantages
US consumers face higher prices on imports
Higher prices on imports contribute to higher price level and inflation level in the United States
US tourists find it more expensive when traveling abroad

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Currency Hedging versus Not Hedging

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Given the unpredictable nature of foreign exchange rates (at least in the short run), it seems natural that firms that deal with foreign transactions - both financial and nonfinancial types, both large and small firms - would engage in currency hedging.
Firms that fail to hedge are at the mercy of the spot market. Yet, surprisingly, many firms do not bother to engage in currency hedging.
Why?

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Implications for Action

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Fostering foreign exchange literacy is a must
Risk analysis of any country must include an analysis of currency risks
A currency risk management is necessary via currency hedging strategic hedging, or both