Dealing with Foreign Exchange - Chapter 7 PDF

CHAPTER 7: Dealing with Foreign Exchange Wade C. Roberts, Ph.D. C211 GLOBAL BUSINESS INTRODUCTION… Course Mentor: Wade Roberts Education: PhD in Economics – University of Utah Expert Fields: Development, Labor, Pu...

CHAPTER 7: Dealing with Foreign Exchange Wade C. Roberts, Ph.D. C211 GLOBAL BUSINESS INTRODUCTION… Course Mentor: Wade Roberts Education: PhD in Economics – University of Utah Expert Fields: Development, Labor, Public, Health, Gender Current Research (Cambodia): Microfinance, Poverty, Inequality, Socioeconomics LEARNING OBJECTIVES After studying this chapter, you should be able to: 7-1 Understand the determinants of foreign exchange rates. 7-2 Track the evolution of the international monetary system. 7-3 Identify firms’ strategic responses to deal with foreign exchange movements. 7-4 Participate in three leading debates concerning foreign exchange movements. 7-5 Draw implications for action. WHAT DETERMINES FOREIGN EXCHANGE RATES? Foreign exchange rate Price of one currency in terms of another Purchasing power parity (PPP) Conversion that determines the equivalent amount of goods and services different currencies can purchase Conversion is usually used to capture differences in cost of living between countries PRODUCTIVITY AND BALANCE OF PAYMENTS Balance of payments A country’s international transaction statement, which includes merchandise trade, service trade, and capital movement Current Account balance Current account = balance of trade + net factor income from abroad + net unilateral transfers from abroad EXCHANGE RATE POLICIES Floating (or flexible) exchange rate policy Willingness of a government to let demand and supply conditions determine exchange rates Clean (or free) float Pure market solution to determine exchange rates Dirty (or managed) float Using selective government intervention to determine exchange rates EXCHANGE RATE POLICIES Target exchange rates (crawling bands) Specified upper or lower bounds within which an exchange rate is allowed to fluctuate Fixed rate policy Setting the exchange rate of a currency relative to other currencies Peg Stabilizing policy of linking a developing country’s currency to a key currency  INVESTOR PSYCHOLOGY Bandwagon Effect Effect of investors moving in the same direction at the same time Capital Flight Phenomenon in which a large number of individuals and companies exchange domestic currencies for a foreign currency QUESTION: Can you recall a recent example of a bandwagon effect? EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM Gold standard System in which the value of most major currencies was maintained by fixing their prices in terms of gold Common denominator Currency or commodity to which the value of all currencies are pegged Bretton Woods system System in which all currencies were pegged at a fixed rate to US dollar EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM Post-Bretton Woods system System of flexible exchange rate regimes with no official common denominator Quota Weight a member country carries within the IMF, which determines the amount of its financial contribution (its “subscription”), and its capacity to borrow from the IMF, and its voting power Strategies for Financial Companies Foreign exchange market Market where individuals, firms, governments, and banks buy and sell currencies of other countries STRATEGIES FOR FINANCIAL COMPANIES Spot transaction Classic single-shot exchange of one currency for another Forward transaction Foreign exchange transaction in which participants buy and sell currencies now for future delivery Currency hedging Transaction that protects traders and investors from exposure to the fluctuations of the spot rate STRATEGIES FOR FINANCIAL COMPANIES Forward discount Condition under which the forward rate of one currency relative to another currency is higher than the spot rate Forward premium Condition under which the forward rate of one currency relative to another currency is lower than the spot rate STRATEGIES FOR FINANCIAL COMPANIES Currency swap Foreign exchange transaction between two firms in which one currency is converted into another at Time 1, with an agreement to revert it back to the original currency at a specified Time 2 in the future STRATEGIES FOR FINANCIAL COMPANIES Offer rate Price at which a bank is willing to sell a currency Bid rate Price at which a bank is willing to buy a currency Spread Difference between the offer price and the bid price STRATEGIES FOR NONFINANCIAL COMPANIES Currency risk Potential for loss associated with fluctuations in the foreign exchange market Strategic hedging Spreading out activities in a number of countries in different currency zones to offset any currency losses in one region through gains in other regions  FIXED VS FLOATING EXCHANGE RATES Currency board Coins convertible into a key foreign currency Monetary authority that issues notes at a fixed exchange rate QUESTION: Which exchange rate do you think is better? A STRONG DOLLAR VS A WEAK DOLLAR International Monetary Fund (IMF) An international organization established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements