International Monetary System

Each country has developed its own money system with its own currency Each country has developed its own money system with its own currency Ours is the dollar Ours is the dollar

World Currency

Israel a. Ruges b. Pesos c. Shekels d. Pounds

Egypt a. Punt b. Pounds c. Dollars d. Drachmas

South Korea a. Yen b. Won c. Renminbi d. Rupee

Poland a. Zloty b. Riyal c. Dinar d. Schilling

France a. Pounds b. Euro c. Franc d. Lira

Canada a. Peso b. Dollar c. Riyal d. Krone

History By 1880’s, most countries had backed their currencies with gold, which was recognized throughout the world as having value By 1880’s, most countries had backed their currencies with gold, which was recognized throughout the world as having value During the time of 1914 (WWI) to WWII (1944), countries printed money to help finance war efforts During the time of 1914 (WWI) to WWII (1944), countries printed money to help finance war efforts Having depleted gold reserves, 44 countries met at Bretton Woods, New Hampshire in 1944 Having depleted gold reserves, 44 countries met at Bretton Woods, New Hampshire in 1944

Bretton Woods Agreement Countries agreed to peg their currencies to the U.S. dollar, which would still be backed by gold at $35 per ounce Countries agreed to peg their currencies to the U.S. dollar, which would still be backed by gold at $35 per ounce Created the International Monetary Fund (IMF) to maintain order in the monetary system and the World Bank to promote economic development Created the International Monetary Fund (IMF) to maintain order in the monetary system and the World Bank to promote economic development

By the late 1960’s there were problems and in the early 1970’s the U.S. refused to continue to keep its exchange rate fixed By the late 1960’s there were problems and in the early 1970’s the U.S. refused to continue to keep its exchange rate fixed It had depleted its gold reserves and President Nixon said that we would not continue It had depleted its gold reserves and President Nixon said that we would not continue

1976 Jamaica Agreement that lead to a floating exchange rate system where currencies are traded for each other 1976 Jamaica Agreement that lead to a floating exchange rate system where currencies are traded for each other Gold is no longer backing currencies Gold is no longer backing currencies

Free floating currency Free floating currency Currency value determined by market forces Currency value determined by market forces Dirty float Dirty float Gov’t influences value of currency by buying or selling but hasn’t declared it fixed Gov’t influences value of currency by buying or selling but hasn’t declared it fixed Pegged or fixed currency Pegged or fixed currency Currency value tied to another currency Currency value tied to another currency Gov’t buys or sells currency to maintain rate Gov’t buys or sells currency to maintain rate

Korean won tied to U.S. dollar Korean won tied to U.S. dollar Chinese yuan tied to basket of currencies Chinese yuan tied to basket of currencies

How exchanging works Foreign exchange market Foreign exchange market Over $1 trillion exchanged each day Over $1 trillion exchanged each day Traders and government central banks buy and sell just like stock Traders and government central banks buy and sell just like stock

Exchange rates

Fluctuations in Currency Value U.S. dollar compared to the Japanese yen U.S. dollar compared to the Japanese yen 1/1/20081/1/2009 $1 = 75 yen $1 = 85 yen U.S. dollar is increasing in value against the yen because it can buy more The yen is decreasing against the dollar because it’s worth less.

12/1/200812/1/2009 $1 = 75 yen $1 = 85 If you wanted to see a movie that cost 1,250 yen, what would it cost you in 2009 compared to 2008? If you wanted to see a movie that cost 1,250 yen, what would it cost you in 2009 compared to 2008? What would happen to the cost of importing goods from Japan to the U.S.? What would happen to the cost of importing goods from Japan to the U.S.? What would happen to the cost of exporting from the U.S. to Japan? What would happen to the cost of exporting from the U.S. to Japan?

U.S. dollar compared to the Japanese yen U.S. dollar compared to the Japanese yen 1/1/20091/1/2010 $1 = 85 yen$1 = 80 yen U.S. dollar is decreasing in value against the yen because it buys less The yen is increasing against the dollar because it’s worth more.

12/1/200912/1/2010 $1 = 85 yen$1 = 80 yen If you wanted to see a movie that cost 1,250 yen, what would it cost you in compared to 2009? If you wanted to see a movie that cost 1,250 yen, what would it cost you in compared to 2009? What would happen to the cost of importing goods from Japan to the U.S.? What would happen to the cost of importing goods from Japan to the U.S.? What would happen to the cost of exporting from the U.S. to Japan? What would happen to the cost of exporting from the U.S. to Japan?

Currency12/2/1997Units/US$12/1/2010Units/US$ Percent Change in Value of Currency South Korean Won South Korean Won % Japanese Yen Japanese Yen (25.17%) Great Britain Pound % Source: Pacific FX Database, 12/2/2010

Trade with Japan Impact (Figures in millions) Exports = $ 51, Exports = $ 51, Imports = $95, Imports = $95, Total Value of Goods Traded= $ 146, Total Value of Goods Traded= $ 146, % change in value of currency = $36, million ($36,734,480,000) worth of impact on goods 25% change in value of currency = $36, million ($36,734,480,000) worth of impact on goods

Impact of currency value changes can be visually seen Impact of currency value changes can be visually seen

What causes exchange rates to change? Supply and Demand for a currency Supply and Demand for a currency Inflation rates Inflation rates Interest rates Interest rates Strength of economy Strength of economy Political system Political system Political events Political events

Companies use Foreign Exchange Payments for exports or foreign investments Payments for exports or foreign investments Purchase supplies Purchase supplies Invest in another country Invest in another country Speculate on exchange rates Speculate on exchange rates

JAL airlines Purchase airlines from Boeing Purchase airlines from Boeing Prices range from $35 – 160 million Prices range from $35 – 160 million Order aircraft 2-6 years in advance Order aircraft 2-6 years in advance 10% down and rest when aircraft delivered 10% down and rest when aircraft delivered 1985, Boeing placed order for $100 million 747 aircraft 1985, Boeing placed order for $100 million 747 aircraft $1= ¥240 in 1985 $1= ¥240 in ,000,000 US$ = ¥ 21,600,000,000 90,000,000 US$ = ¥ 21,600,000,000

What if exchange rate changed? What if exchange rate changed? Total cost of ¥2.4 billion Total cost of ¥2.4 billion If rate changes to $1= ¥300, price raises to ¥3.0 billion - a 25% increase! If rate changes to $1= ¥300, price raises to ¥3.0 billion - a 25% increase! If rate changes to $1 = ¥200, price decreases to ¥2.0 billion. If rate changes to $1 = ¥200, price decreases to ¥2.0 billion.

Exchange Rate Risk The chance of loss due to changing exchange rates The chance of loss due to changing exchange rates Ideas on managing the risk Ideas on managing the risk Assume risk and deal in foreign currency Assume risk and deal in foreign currency Only deal in your currency Only deal in your currency Transfer risk to someone else through hedging Transfer risk to someone else through hedging Countertrade Countertrade

Hedging Buy a currency in the future at a price set today so the risk is minimized Buy a currency in the future at a price set today so the risk is minimized Example: Buy euros 120 days into the future – forward contract Example: Buy euros 120 days into the future – forward contract

JAL Purchased right to buy dollars for next ten years for a set rate of $1 = ¥185 Purchased right to buy dollars for next ten years for a set rate of $1 = ¥185 forward exchange contract forward exchange contract Allows company to know what they will pay and plan ahead Allows company to know what they will pay and plan ahead Looked like a great deal when $1 = ¥240 Looked like a great deal when $1 = ¥240

1994 contracts executed 1994 contracts executed Yen had risen against dollar Yen had risen against dollar $1 = ¥99 $1 = ¥99 JAL admitted that they were paying 86% more than necessary JAL admitted that they were paying 86% more than necessary Mistake of $450 million or ¥45 million Mistake of $450 million or ¥45 million

Countertrade Form of payment in which a seller accepts something other than money in compensation Form of payment in which a seller accepts something other than money in compensation

Types Barter – products exchanged Barter – products exchanged 1990, State Trading Corp. of India exchanged wheat to Turkmenistan for cotton 1990, State Trading Corp. of India exchanged wheat to Turkmenistan for cotton Pepsi sold soft drinks in China in exchange for mushrooms for Pizza Hut pizzas Pepsi sold soft drinks in China in exchange for mushrooms for Pizza Hut pizzas

Counterpurchase Buyer and seller purchase goods from each other Buyer and seller purchase goods from each other Business A sells to Business Z for cash. At the same time, Business A agrees to buy stuff from Business Z for an equal amount. Business A sells to Business Z for cash. At the same time, Business A agrees to buy stuff from Business Z for an equal amount. Most common form of countertrade Most common form of countertrade

McDonnell Douglas has bought hams, irons, and rubber bumper guards McDonnell Douglas has bought hams, irons, and rubber bumper guards

Offset Part of exported good is produced in the importing country Part of exported good is produced in the importing country General Dynamics sold military jets to Belgium, Norway and Denmark and allowed them to offset the cost by producing 40% of the value of the aircraft in their countries General Dynamics sold military jets to Belgium, Norway and Denmark and allowed them to offset the cost by producing 40% of the value of the aircraft in their countries

Different risk is that of not getting paid Letter of credit is used to remove this risk Letter of credit is used to remove this risk Letter issued by a bank at the request of an importer Letter issued by a bank at the request of an importer Promise by the bank to pay a specified sum of money to a beneficiary (exporter) on presentation of certain documents Promise by the bank to pay a specified sum of money to a beneficiary (exporter) on presentation of certain documents

Types of Letters of Credit Irrevocable – terms can only be modified if both exporter and importer agree Irrevocable – terms can only be modified if both exporter and importer agree Revocable – Issuing bank can modify terms without approval from the exporter or importer Revocable – Issuing bank can modify terms without approval from the exporter or importer

Importer Importer’s Bank Exporter’s Bank Importer applies for LC from its bank I. bank issues LC to E. bank Bank notifies exporter that it has LC Exporter ships Exporter delivers documents to E. bank Exporter --Buy/sell goods-- Bank checks documents and pays exporter E. Bank delivers documents to I. Bank Importer pays for goods Bank sends payment to exporter’s bank I. Bank delivers documents to importer

Purchasing Power Parity Theory that a dollar should buy the same amount in all countries Theory that a dollar should buy the same amount in all countries Economist measures with “Big Mac Index” Economist measures with “Big Mac Index”Big Mac IndexBig Mac Index NationMaster has index NationMaster has indexindex