1. INTERNATIONAL FINANCIAL MARKET & INTERNATIONAL MONETARY SYSTEM

2. Introduction Fundamental difference between payment transactions
Domestic transaction—use only one curency
Foreign transaction—use two or more currencies
Foreign exchange— money denominated in the currency of another group of nations
Exchange rate—price of a currency
Number of units of one currency that buys one unit of another currency
Exchange rate can change daily

3. International financial market comprise of:
International Capital Market
Obtaining external financing.
Main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently.
Foreign-Exchange Market—made up of:
over-the-counter (OTC)
commercial and investment banks
majority of foreign-exchange activity
security exchanges
trade certain types of foreign-exchange instruments

4. Essential Terms
Security - a contract that can be assigned a value and traded (stocks, bonds, derivatives and other financial assets)
Stocks – A instrument representing ownership
Bonds - a debt agreement
Derivatives - the rights to ownership (financial instruments; futures, forwards, options, swaps)

5. Essential Terms II
Stock exchange, share market or bourse - is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities
Over-the-counter (OTC) trading - is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.

6. Capital Market System that allocates financial resources according
to their most efficient uses
Common capital market intermediaries:
Commercial Banks
Investment Banks
Debt: Repay principal plus interest
Bond has timed principal & interest payments
Equity: Part ownership of a company
Stock shares in financial gains or losses

7. International Capital Market (ICM)
Network of people, firms, financial institutions and governments borrowing and investing internationally
Purposes
Borrowers
Expands money supply
Reduces cost of money
Lenders
Spread / reduce risk
Offset gains / losses

8. International Capital Market Drivers
Information technology
Deregulation
Financial instruments
(securitization)

9. World Financial Centers
At present, the three main financial centers are London, New York and Tokyo
London is one of the three leading world financial centres. It is famous for its banks and Europe's largest stock exchange, that have been established over hundreds of years (e.g. Lloyd's of London, London Stock Exchange). The financial market of London is also commonly referred to as the City. It has historically been situated around the part of London called Square Mile, but in the 1980's and 1990's a large part of the City of London's wholesale financial services relocated to Canary Wharf.

10. Offshore Financial Centers
Country or territory
whose financial sector
features few regulations
and few, if any, taxes
Operational center
Extensive financial activity
and currency trading
Booking center
Mostly for bookkeeping
and tax purposes

12. IMF defines OFC as:
Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents;
Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and
More popularly, centers which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.

13. Main Components of ICM: International Bond Market
Market of bonds sold by issuing companies, governments and others outside their own countries
Eurobond
Foreign bond
Interest rates
Bond that is issued outside the country in whose currency the bond is denominated
Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold
Driving growth are differential interest rates between developed and developing nations

14. International Equity Market
Market of stocks bought and sold
outside the issuer’s home country
Factors contributing towards growth:
Spread of Privatization
Economic Growth in Developing Countries
Activities of Investment Banks
Advent of Cybermarkets

15. Eurocurrency Market
Unregulated market of currencies banked outside their countries of origin
Governments
Commercial banks
International companies
Wealthy individuals

16. Foreign Exchange Market
Introduction
Foreign exchange market: a market for converting the currency of one country into the currency of another.
Exchange rate: the rate at which one currency is converted into another
Foreign exchange risk: the risk that arises from changes in exchange rates

17. Foreign Exchange Market
Market in which currencies are bought and sold
and their prices are determined
Conversion: To facilitate sale or purchase, or invest directly abroad
Hedging: Insure against potential losses from adverse exchange-rate changes
Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit
Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit

18. The Functions of the Foreign Exchange Market
The foreign exchange market serves two main functions:
Convert the currency of one country into the currency of another
Provide some insurance against foreign exchange risk
Foreign exchange risk: the adverse consequences of unpredictable changes in the exchange rates

19. Currency Conversion
Consumers can compare the relative prices of goods and services in different countries using exchange rates
International business have four main uses of foreign exchange markets
To invest excess cash for short terms in foreign markets
To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation
To exchange currency received in the course of doing business abroad back into the currency of its home country
To pay a foreign company for its products or services in its country’s currency

20. Insuring against Foreign Exchange Risk
A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately
The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day
Reported daily
Change continually
The table illustrates a daily spot rate for January 11, 2005.

21. Insuring against Foreign Exchange Risk
Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future
Exchange rates governing such future transactions are referred to as forward exchange rates
For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future
When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed

22. Insuring against Foreign Exchange Risk
Currency swap: 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, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk
A common kind of swap is spot against forward. Consider a company such as Apple Computer. Apple assembles laptop computers in the United States, but the screens are made in Japan. Apple also sells some of the finished laptops in Japan. So, like many companies, Apple both buys from and sells to Japan. Imagine Apple needs to change $1 million into yen to pay its supplier of laptop screens today. Apple knows that in 90 days it will be paid ¥120 million by the Japanese importer that buys its finished laptops. It will want to convert these yen into dollars for use in the United States. Let us say today’s spot exchange rate is $1 ¥120 and the 90-day forward exchange rate is $1 ¥110. Apple sells $1 million to its bank in return for ¥120 million. Now Apple can pay its Japanese supplier. At the same time, Apple enters into a 90-day forward exchange deal with its bank for converting ¥120 million into dollars. Thus, in 90 days Apple will receive $1.09 million (¥120 million/ 110 $1.09 million). Since the yen is trading at a premium on the 90-day forward market, Apple ends up with more dollars than it started with (although the opposite could also occur). The swap deal is just like a conventional forward deal in one important respect: It enables Apple to insure itself against foreign exchange risk. By engaging in a swap, Apple knows today that the ¥120 million payment it will receive in 90 days will yield $1.09 million.

23. 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 include: London, New York, Tokyo, and Singapore
London’s dominance is explained by:
History (capital of the first major industrialized nation)
Geography (between Tokyo/Singapore and New York)
Two major features of the foreign exchange market:
The market never sleeps
Market is highly integrated

24. Institutions of Foreign Exchange Market
Interbank Market: market in which the world’s largest banks exchange currencies at spot and forward rates.
“Clearing mechanism”
Securities Exchanges: exchange specializing in currency futures and options transactions.
Over-the-Counter Market: Exchange consisting of a global computer network of foreign exchange traders and other market participants.

25. The Foreign-Exchange Market
Size of foreign-exchange market
$600 billion spot
$1.3 trillion in derivatives, ie
$200 billion in outright forwards
$1 trillion in forex swaps
$100 billion in FX options. (2004)
U.S. dollar is the most important currency because it is:
An investment currency in many capital markets
A reserve currency held by many central banks
A transaction currency in many international commodity markets
An invoice currency in many contracts
An intervention currency employed by monetary authorities to influence their exchange rates

26. Trends in Foreign-Exchange Trading
9-7

27. Quoting Currencies Quoted currency = numerator
Base currency = denominator
(¥/$) = Japanese yen needed to buy one U.S. dollar
Yen is quoted currency, dollar is base currency

28. Currency Values Change in US dollar against Polish zloty
February 1: PLZ 5/$
March 1: PLZ 4/$
%change = [(4-5)/5] x 100 = -20%
US dollar fell 20%
Change in Polish zloty against US dollar
Make zloty base currency (1÷ PLZ/$)
February 1: $.20/PLZ
March 1: $.25/PLZ
%change = [( )/.20] x 100 = 25%
Polish zloty rose 25%

29. Cross Rate Exchange rate calculated using two other exchange rates
Use direct or indirect exchange rates against a third currency

30. Cross Rate Example Direct quote method Indirect quote method
Quote on euro = € /$
Quote on yen = ¥ /$
€ /$ ÷ ¥ /$ = € /¥
Costs euros to buy 1 yen
Indirect quote method
Quote on euro = $ /€
Quote on yen = $ /¥
$ /€ ÷ $ /¥ = € /¥
Final step: 1 ÷ € /¥ = € /¥
Costs euros to buy 1 yen

31. Currency Convertibility
Governments can place restrictions on the convertibility of currency
A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it
A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations
A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency

32. Government restrictions can include
A restriction on residents’ ability to convert the domestic currency into a foreign currency
Restricting domestic businesses’ ability to take foreign currency out of the country
Governments will limit or restrict convertibility for a number of reasons that include:
Preserving foreign exchange reserves
A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight

33. Governmental Restrictions on Foreign-Exchange Convertibility
Restrictions used to conserve scarce foreign exchange
Licensing—government regulates all foreign-exchange transactions
those who receive foreign currency required to sell it to its central bank at the official buying rate
central bank rations foreign currency
Multiple exchange-rate system—different exchange rates set for different transactions
Advance import deposit—requires importers to make a deposit with central bank covering price of goods they would purchase from abroad
Quantity controls—limit the amount of currency that resident can purchase for foreign travel
Currency controls increase the cost of international business and reduce overall international trade

34. How Companies Use Foreign Exchange
Most foreign-exchange transactions involve international departments of commercial banks
Banks buy and sell foreign currency; banks collect and pay money in transaction with foreign buyers and sellers
Banks lend money in foreign currency
Companies use foreign-exchange market for:
Import and export transactions
Financial transactions such as FDI
Arbitrage—purchase of foreign currency on one market for immediate resale on another market
Arbitragers hope to profit from price discrepancy
Interest arbitrage—investing in debt instruments in different countries
Speculation—buying or selling foreign currency has both risk and high profit potential

35. Foreign-Exchange Trading Process
Companies work through their local banks to settle foreign-exchange balances
Commercial banks in major money centers became intermediaries for small banks
Most foreign-exchange activity takes place in traditional instruments
Commercial and investment banks and other financial institutions handle spot, outright forward, and FX swaps
Foreign-exchange market made up of about 2,000 dealer institutions worldwide
Most foreign-exchange takes place in OTC market
Dealers can trade foreign exchange:
Directly with other dealers
Through voice brokers
Through electronic brokerage systems
Internet trades of currency are more popular

36. Commercial and Investment Banks
Greatest volume of foreign-exchange activity takes place with the big banks
Top banks in the interbank market in foreign exchange are so ranked because of their ability to:
trade in specific market locations
engage in major currencies and cross-trades
deal in specific currencies
handle derivatives
forwards, options, future swaps
conduct key market research
Banks may specialize in geographic areas, instruments, or currencies
exotic currency—currency of a developing country
often unstable, weak, and unpredictable

37. (% of overall volume, May 2005 )
Top 10 Currency Traders
(% of overall volume, May 2005 )
Rank
Name
% of volume 1
Deutsche Bank
17.0 2
UBS
12.5 3
Citigroup
7.5 4
HSBC
6.4 5
Barclays
5.9 6
Merrill Lynch
5.7 7
J.P. Morgan Chase
5.3 8
Goldman Sachs
4.4 9
ABN AMRO
4.2 10
Morgan Stanley
3.9

38. International Monetary System
Rules and procedures by which different national currencies are exchanged for each other in world trade.
Such a system is necessary to define a common standard of value for the world's currencies.
Refer to the institutional arrangements that countries adopt to govern exchange rates
Floating
Pegged exchange rate
Dirty float
Fixed exchange rate

39. Floating exchange rates occur when the foreign exchange market determines the relative value of a currency
The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other
Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency

40. Dirty float occurs when countries hold the value of their currency within a range of a reference currency
Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate
Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention

41. Evolution of International Monetary System
The Gold Standard
In place from 1700s to 1939
a monetary standard that pegs currencies to gold and guarantees convertibility to gold
It was thought that gold standard contained an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries.
The gold standard broke down during the 1930s as countries engaged in competitive devaluations

42. Roots in old mercantile trade
The Gold Standard
Roots in old mercantile trade
Inconvenient to ship gold, changed to paper- redeemable for gold
Want to achieve ‘balance-of-trade equilibrium
Trade
USA
Japan
Gold

43. Balance of Trade Equilibrium
Trade Surplus
Gold
Increased money supply = price inflation.
Decreased money supply = price decline.
As prices decline, exports
increase and trade goes
into equilibrium.

44. Between the Wars
Post WWI, war heavy expenditures affected the value of dollars against gold
US raised dollars to gold from $20.67 to $35 per ounce
Dollar worth less?
Other countries followed suit and devalued their currencies

45. Bretton Woods In 1944, 44 countries met in New Hampshire
Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz
Agreed not to engage in competitive devaluations for trade purposes and defend their currencies
Weak currencies could be devalued up to 10% w/o approval
Created the IMF and World Bank

46. International Monetary Fund
The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars
The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility

47. International Monetary Fund
Discipline
Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation
Brake on competitive devaluations and stability to the world trade environment
Flexibility
Lending facility:
Lend foreign currencies to countries having balance-of-payments problems
Adjustable parities:
Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”

48. Purposes of IMF Promoting international monetary cooperation
Facilitating expansion and balanced growth of international trade
Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation
Making the resources of the Fund temporarily available to members
Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations

49. To serve these purposes, the IMF:
monitors economic and financial developments and policies, in member countries and at the global level, and gives policy advice to its members based on its more than fifty years of experience.
For example: In its annual review of the Japanese economy for 2003, the IMF Executive Board urged Japan to adopt a comprehensive approach to revitalize the corporate and financial sectors of its economy, tackle deflation, and address fiscal imbalances.

50. The IMF commended Mexico in 2003 for good economic management, but said structural reform of the tax system, energy sector, the labor market, and judicial system was needed to help the country compete in the global economy.
In its Spring 2004 World Economic Outlook, the IMF said an orderly resolution of global imbalances, notably the large U.S. current account deficit and surpluses elsewhere, was needed as the global economy recovered and moved toward higher interest rates.

51. lends to member countries with balance of payments problems, not just to provide temporary financing but to support adjustment and reform policies aimed at correcting the underlying problems.
For example: During the Asian financial crisis, the IMF acted swiftly to help Korea bolster its reserves. It pledged $21 billion to assist Korea to reform its economy, restructure its financial and corporate sectors, and recover from recession. Within four years, Korea had recovered sufficiently to repay the loans and, at the same time, rebuild its reserves.

52. In October 2000, the IMF approved an additional $52 million loan for Kenya to help it cope with the effects of a severe drought, as part of a three-year $193 million loan under the IMF's Poverty Reduction and Growth Facility, a concessional lending program for low-income countries.

53. provides the governments and central banks of its member countries with technical assistance and training in its areas of expertise.
For example: Following the collapse of the Soviet Union, the IMF stepped in to help the Baltic states, Russia, and other former Soviet countries set up treasury systems for their central banks as part of the transition from centrally planned to market-based economic systems.

54. IMF Quotas - each member’s monetary contribution
Based on national income, monetary reserves, trade balance, and other economic indicators
Pool of money that can be loaned to members
Basis for how much a country can borrow
Determines voting rights of members
Board of Governors - IMF’s highest authority
One representative from each member country
Board of Executive Directors—24 persons
handles day-to-day operations

55. IMF Assistance
Provides assistance to member countries
Intended to ease balance-of-payment difficulties
Recipient country must adopt policies to stabilize its economy

56. Special Drawing Rights (SDRs)
An international type of monetary reserve currency, created by the International Monetary Fund (IMF) in 1969, which operates as a supplement to the existing reserves of member countries.
Created in response to concerns about the limitations of gold and dollars as the sole means of settling international accounts,
SDRs are designed to augment international liquidity by supplementing the standard reserve currencies.

57. Serves as the IMF’s unit of account
unit in which the IMF keeps its records
used for IMF transactions
Some countries pegged their currencies’ value
Based on the weighted average of four currencies
1986–1990: USD 42%, DEM 19%, JPY 15%, GBP 12%, FRF 12%
1991–1995: USD 40%, DEM 21%, JPY 17%, GBP 11%, FRF 11%
1996–2000: USD 39%, DEM 21%, JPY 18%, GBP 11%, FRF 11%
2001–2005: USD 45%, EUR 29%, JPY 15%, GBP 11%
2006–2010: USD 44%, EUR 34%, JPY 11%, GBP 11%

58. Role of the World Bank
The official name for the world bank is the International Bank for Reconstruction and Development
Purpose: To fund Europe’s reconstruction and help 3rd world countries.
Overshadowed by Marshall Plan, so it turns towards development
Lending money raised through WB bond sales
Agriculture
Education
Population control
Urban development

59. Collapse of the Fixed Exchange System
The system of fixed exchange rates established at Bretton Woods worked well until the late 1960’s
The US dollar was the only currency that could be converted into gold
The US dollar served as the reference point for all other currencies
Any pressure to devalue the dollar would cause problems through out the world

60. Collapse of the Fixed Exchange System
Factors that led to the collapse of the fixed exchange system include
President Johnson financed both the Great Society and Vietnam by printing money
High inflation and high spending on imports
On August 8, 1971, President Nixon announces dollar no longer convertible into gold
Countries agreed to revalue their currencies against the dollar
On March 19, 1972, Japan and most of Europe floated their currencies
In 1973, Bretton Woods fails because the key currency (dollar) is under speculative attack

61. The Floating Exchange Rate
The Jamaica agreement revised the IMF’s Articles of Agreement to reflect the new reality of floating exchange rates
Floating rates acceptable
Gold abandoned as reserve asset
IMF quotas increased
IMF continues role of helping countries cope with macroeconomic and exchange rate problems

62. Exchange Rates Since 1973
Exchange rates have been more volatile for a number of reasons including:
Oil crisis -1971
Loss of confidence in the dollar
Oil crisis – 1979, OPEC increases price of oil
Unexpected rise in the dollar
Rapid fall of the dollar and
Partial collapse of European Monetary System
Asian currency crisis

63. Fixed Versus Floating Exchange Rates
Monetary discipline
.Speculation
Limits speculators
Uncertainty
Predictable rate movements
Trade balance adjustments
Argue no link between exchange rates and trade
Link between savings and investment
Floating:
Monetary policy autonomy
Restores control to government
Trade balance adjustments
Adjust currency to correct trade imbalances
Which side is right in the vigorous debate between those who favor a fixed exchange rate and those who favor a floating exchange rate? Economists cannot agree. Business, as a major player on the international trade and investment scene, has a large stake in the resolution of the debate. Would international business be better off under a fixed regime, or are flexible rates better? The evidence is not clear. We do, however, know that a fixed exchange rate regime modeled along the lines of the Bretton Woods system will not work. Speculation ultimately broke the system, a phenomenon that advocates of fixed rate regimes claim is associated with floating exchange rates! Nevertheless, a different kind of fixed exchange rate system might be more enduring and might foster the stability that would facilitate more rapid growth in international trade and investment

64. Exchange Rate Regimes Pegged Exchange Rates
Peg own currency to a major currency ($)
Popular among smaller nations
Evidence of moderation of inflation
Currency Boards
Country commits to converting domestic currency on demand into another currency at a fixed exchange rate
Country holds foreign currency reserves equal to 100% of domestic currency issued

65. Exchange-Rate Arrangements
IMF permitted countries to select and maintain an exchange-rate arrangement of their choice
IMF surveillance and consultation programs
designed to monitor exchange-rate policies
determine whether countries were acting openly and responsibly in exchange-rate policy

66. From pegged to floating currencies
Broad IMF categories for exchange-rate regimes
peg exchange rate to another currency or basket of currencies with only a maximum 1% fluctuation in value
peg exchange rate to another currency or basket of currencies with a maximum of 2 ¼% fluctuation
allow the currency to float in value against other currencies
Countries may change their exchange-rate regime

67. Exchange Rate Policies for IMF Members 2004
Figure 11.2, p. 380

68. Crisis Management by the IMF
The IMF’s activities have expanded because periodic financial crises have continued to hit many economies
Currency crisis
When a speculative attack on a currency’s exchange value results in a sharp depreciation of the currency’s value or forces authorities to defend the currency
Banking crisis
Loss of confidence in the banking system leading to a run on the banks
Foreign debt crisis
When a country cannot service its foreign debt obligations
These crises tend to have common underlying macroeconomic causes: high relative price inflation rates, a widening current account deficit, excessive expansion of domestic borrowing, and asset price inflation (such as sharp increases in stock and property prices). At times, elements of currency, banking, and debt crises may be present simultaneously, as in the 1997 Asian crisis and the 2000–2002 Argentinean crisis (see the Country Focus).

69. Determination of Exchange Rates
Floating rate regimes—allow changes in the exchange rates between two currencies to occur for currencies to reach a new exchange-rate equilibrium
Currencies that float freely respond to supply and demand conditions
No government intervention to influence the price of the currency

70. Economic Theories of Exchange Rate Determination
Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another
Price and exchange rates:
Law of One Price
Purchasing Power Parity (PPP)
Money supply and price inflation
Interest rates and exchange rates

71. Law of One Price
In competitive markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency
Example: US/French exchange rate: $1 = .78Eur
A jacket selling for $50 in New York should retail for Eur in Paris (50x.78)

72. Purchasing Power Parity
By comparing the prices of identical products in different currencies, it should be possible to determine the ‘real’ or PPP exchange rate - if markets were efficient
In relatively efficient markets (few impediments to trade and investment) then a ‘basket of goods’ should be roughly equivalent in each country

73. Big Mac Index

74. Money Supply and Inflation
PPP theory predicts that changes in relative prices will result in a change in exchange rates
A country with high inflation should expect its currency to depreciate against the currency of a country with a lower inflation rate
Inflation occurs when the money supply increases faster than output increases

75. Determination of Exchange Rates (cont.)
Fisher Effect - links inflation and interest rates
nominal interest rate in a country is the real interest rate plus inflation
because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation
International Fisher Effect (IFE) - links interest rates and exchange rates
the interest-rate differential is a predictor of future changes in the spot exchange rate
interest-rate differential based on differences in interest rates
currency of the country with the lower interest rate will strengthen in the future

76. Determination of Exchange Rates (cont.)
Other factors affecting exchange rate movements
Confidence—safe currencies considered attractive in times of turmoil
Technical factors
release of national statistics
seasonal demands for a currency
slight strengthening of a currency following a prolonged weakness

77. Currency Values and Business
Exchange rates affect activities of both domestic and international firms
Devaluation
Revaluation
export prices
lowers
raises
import prices
lowers
raises

78. Forecasting Exchange-Rate Movements
Managers should be concerned with the timing, magnitude, and direction of an exchange-rate movement
Prediction is not a precise science
Fundamental forecasting - uses trends in economic variables to predict future rates
Use econometric model or more subjective bases
Technical forecasting - uses past trends in exchange rates to spot future trends in the rates
Assumes that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns
Good treasurers and bankers develop their own forecasts
Use fundamental and technical forecasts for corroboration

79. Forecasting Exchange-Rate Movements (cont.)
Factors to monitor—managers can monitor factors used by governments to manage their currencies
Institutional setting – float or managed?
Fundamental analysis – economics indicator
Confidence factors
Events
Technical analysis

80. Business Implications of Exchange-Rate Changes
Marketing decisions - exchange rates affect demand for a company’s products at home and abroad
Production decisions - choice of location for production facilities depends on strength of currency
Financial decisions - exchange rates influence the sourcing of financial resources, the cross-border remittance of funds, and the reporting of financial results

81. Stability and Predictability
Stable
exchange rates
Predictable
exchange rates
Improve accuracy
of financial planning
Reduce surprises
of unexpected
rate changes

82. Implications for Managers
It is critical that international businesses understand the influence of exchange rates on the profitability of trade and investment deals
Adverse changes in exchange rates can make apparently profitable deals unprofitable
The risk introduced into international business transactions by changes in exchange rates is referred to as foreign exchange risk
Foreign exchange risk is usually divided into three main categories: transaction exposure, translation exposure, and economic exposure

83. Implications for Managers
Transaction exposure: the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values
Translation exposure: the impact of currency exchange rate changes on the reported financial statements of a company
Economic exposure: the extent to which a firm’s future international earning power is affected by changes in exchange rates

84. Reducing Translation and Transaction Exposure
These tactics are primarily designed to protect short-term cash flows from adverse changes in exchange rates
Companies should use forward exchange rate contracts and buy swaps
Firms can also use a lead strategy
An attempt to collect foreign currency receivables when a foreign currency is expected to depreciate
Paying foreign currency payables before they are due when a currency is expected to appreciate
Firms can also use a lag strategy
An attempt to delay the collection of foreign currency receivables if that currency is expected to appreciate
Delay paying foreign currency payables if the currency is expected to depreciate
A number of tactics can help firms minimize their transaction and translation exposure.

85. Reducing Economic Exposure
Reducing economic exposure requires strategic choices that go beyond the realm of financial management
The key to reducing economic exposure is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates