10-1 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Chapter Ten The Determination of Exchange Rates Part Four World Financial Environment

10-2 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Chapter Objectives To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements that countries use To explain how the European Monetary System works and how the euro came into being as the currency of the euro zone To identify the major determinants of exchange rates To show how managers try to forecast exchange-rate movements To explain how exchange-rate movements influence business decisions

10-3 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall The International Monetary Fund Originally organized in 1945 Objectives:  To promote international monetary cooperation, exchange stability, and orderly exchange arrangements  To foster economic growth and high levels of employment  To provide temporary financial assistance to countries to help ease balance-of-payments adjustment

10-4 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall IMF History The Bretton Woods Agreement set a fixed exchange rate against gold & the US dollar The Jamaica Agreement (1976) eliminated par values against gold and the US dollar and permitted greater flexibility. Voting is through the Quota system

10-5 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Special Drawing Right The Special Drawing Right (SDR) is a special asset the IMF created to increase international reserves The value of the SDR is based upon the weighted average of a basket of four currencies: the U.S. dollar, the euro, the Japanese yen, and the British pound.

10-6 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Exchange Rates The world can be divided into:  Countries that basically let their currencies float according to market forces with minimal or no Central Bank intervention  Countries that do not but rely on heavy Central Bank intervention and control Anyone involved in international business needs to understand how the exchange rates of countries with which they do business are determined

10-7 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall The Euro European Monetary System (EMS): established by the EU (then the EC) in 1979 as a means of creating exchange rate stability within the bloc European Central Bank: established by the EU on July 1, 1998, to set monetary policy and to administer the euro Euro: the common European currency established on Jan. 1, 1999 as part of the EU’s move toward monetary union as called for by the Treaty of Maastricht of 1992 European Monetary Union (EMU): a formal arrangement linking many but not all of the currencies of the EU

10-8 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Africa African countries are committed to establishing a common currency by 2021, but there are many obstacles to accomplishing this objective

10-9 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall The Determination Of Exchange Rates Currencies that float freely respond to supply and demand conditions free from government intervention The demand for a country’s currency is a function of the demand for its goods and services and the demand for financial assets denominated in its currency Fixed exchange rates do not automatically change in value due to supply and demand conditions but are regulated by their Central Banks

10-10 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Central Banks Central banks are the key institutions in countries that intervene in foreign-exchange markets to influence currency values The Bank for International Settlements (BIS) in Switzerland acts as a central banker’s bank. It facilitates communication and transactions among the world’s central banks A central bank intervenes in money markets by increasing a supply of its country’s currency when it wants to push the value of the currency down and by stimulating demand for the currency when it wants the currency’s value to rise

10-11 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Black Markets – The Result of Fixed Exchange Rates Many countries that strictly control and regulate the convertibility of their currency have a black market that maintains an exchange rate that is more indicative of supply and demand than is the official rate

10-12 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Foreign-Exchange Convertibility Fully convertible currencies, often called hard currencies, are those that the government allows both residents and nonresidents to purchase in unlimited amounts Currencies that are not fully convertible are often called soft currencies, or weak currencies They tend to be the currencies of developing countries

10-13 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Exchange Controls To conserve scarce foreign exchange, some governments impose exchange restrictions on companies or individuals who want to exchange money, such as  import licensing  multiple exchange rates  import deposit requirements  quantity controls

10-14 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Factors that determine exchange rates purchasing-power parity differences in real interest rates confidence in the government’s ability to manage the political and economic environment certain technical factors that result from trading

10-15 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Forecasting Exchange-Rate Movements Fundamental forecasting uses trends in economic variables to predict future rates. The data can be plugged into an econometric model or evaluated on a more subjective basis. Technical forecasting uses past trends in exchange rates themselves to spot future trends in rates.

10-16 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Factors to Monitor Major factors that managers should monitor when trying to predict the timing, magnitude, and direction of an exchange- rate change include  the institutional setting  fundamental analysis  confidence factors  events  technical analysis

10-17 Copyright © 2009 Pearson Education, Inc. publishing as Prentice Hall Business Implications of Exchange- Rate Changes Exchange rates can affect business decisions in three major areas:  Marketing  Production  Finance