1. 4-1 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Chapter 4 F oreign E xchange and F inance 4

2. 4-2 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Lecture/Chapter Topics Functions of the Foreign Exchange Market Nature of the Foreign Exchange Market Determinants of Exchange Rates The International Monetary System Financing Trade Managerial Implications

3. 4-3 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market What is the Foreign Exchange Market? –The foreign exchange market is a market for converting the currency of one country into that of another country. What is an Exchange Rate? –The exchange rate is the rate at which one currency is converted into another.

4. 4-4 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market The foreign exchange market serves two main functions: 1.To convert the currency of one country into the currency of another 2.To provide some insurance against foreign exchange risk (the adverse consequences of unpredictable changes in exchange rates)

5. 4-5 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market Currency Conversion –International businesses use foreign exchange markets when:  the payments they receive for exports, the income they receive from foreign investments, or the income they receive from licensing agreements with foreign firms are in foreign currencies  they must pay a foreign company for its products or services in that country’s currency

6. 4-6 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market Currency Conversion (Cont’d) –International businesses use foreign exchange markets when:  they have spare cash that they wish to invest for short terms in money markets  they are involved in currency speculation (the short-term movement of funds from one currency to another in the hope of profiting from shifts in exchange rates)

7. 4-7 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market Insuring Against Foreign Exchange Risk –The foreign exchange market can be used to provide insurance to protect against foreign exchange risk (the possible adverse consequences of unpredictable changes in exchange rates). –Spot Exchange Rates  The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day.

8. 4-8 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of the Foreign Exchange Market Insuring Against Foreign Exchange Risk (Cont’d) –Forward Exchange Rates  A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in the future.  A forward exchange rate is the prevailing rate when two parties agree to exchange currency and execute the deal at some specific date in the future.  Rates for currency exchange are typically quoted for 30, 90, or 180 days into the future.

9. 4-9 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Functions of Foreign Exchange Market Insuring Against Foreign Exchange Risk (Cont’d) –Currency Swaps  A currency swap is 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 rate risk.

10. 4-10 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. 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 Two significant features of the market are: 1.it never sleeps 2.high-speed computer linkages between trading centres around the globe have effectively created a single market

11. 4-11 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Nature of the Foreign Exchange Market If exchange rates quoted in different markets were not essentially the same, there would be an opportunity for arbitrage (the process of buying a currency low and selling it high), and the gap would close. The US dollar is often used as a vehicle currency to facilitate the exchange of other currencies.

12. 4-12 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Exchange rates are determined by the demand and supply for different currencies. Three factors impact on future exchange rate movements: 1. A country’s price inflation 2. A country’s interest rate 3. Market psychology

13. 4-13 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Prices and Exchange Rates –The Law of One Price  The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

14. 4-14 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Prices and Exchange Rates (Cont’d) –Purchasing Power Parity  PPP theory argues that given relatively efficient markets (markets in which few impediments to international trade and investment exist) the price of a ‘basket of goods’ should be roughly equivalent in each country.

15. 4-15 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Money Supply and Price Inflation –A positive relationship exists between the inflation rate and the level of money supply. –When growth in the money supply is greater than growth in output, inflation will occur.

16. 4-16 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Money Supply and Price Inflation (Cont’d) –PPP suggests that changes in relative prices between countries will lead to exchange rate changes, at least in the short run. –Empirical Tests of PPP Theory  Empirical testing of PPP theory indicates that it is not completely accurate in estimating exchange rate changes.

17. 4-17 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Interest Rates and Exchange Rates –Interest rates also affect exchange rates. –The Fisher Effect states that for any two countries the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between two countries.

18. 4-18 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Interest Rates and Exchange Rates (Cont’d) –The International Fisher Effect suggests that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.

19. 4-19 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Investor Psychology and Bandwagon Effects –Exchange rates can also be affected by investor psychology. –The bandwagon effect occurs when expectations on the part of traders can turn into self-fulfilling prophecies, and traders can get on the bandwagon and move exchange rates based on group expectations. –Governmental intervention can prevent the bandwagon effect from starting, but it is not always effective.

20. 4-20 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Determinants of Exchange Rates Relative monetary growth, relative inflation rates, and nominal interest rate differentials are all moderately good predictors of long-run changes in exchange rates. So, international businesses should pay attention to countries’ differing monetary growth, inflation and interest rates.

21. 4-21 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The international monetary system refers to the institutional arrangements that countries adopt to govern exchange rates. When the foreign exchange market determines the relative value of a currency, a floating system exists.

22. 4-22 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Exchange Rate Regimes in Practice

23. 4-23 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Exchange Rate Regimes in Practice (Cont’d) –When the value of a currency is fixed to a reference country and then the exchange rate between that currency and other currencies is determined by the reference currency exchange rate, a pegged exchange rate system exists.

24. 4-24 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Exchange Rate Regimes in Practice (Cont’d) –A dirty float or managed flow system occurs when the value of a currency is determined by market forces, but with central bank intervention if it depreciates too rapidly against an important reference currency. –Countries that adopt a fixed exchange rate system fix their currencies against each other.

25. 4-25 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Exchange Rate Regimes in Practice (Cont’d) –Currency Boards  A country that introduces a currency board commits itself to converting its domestic currency on demand into another currency at a fixed exchange rate.  To make this commitment credible, the currency board holds reserves of foreign currency equal at the fixed exchange rate to at least 100% of the domestic currency issued.

26. 4-26 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Motives for Managing Foreign Exchange Rates –Controlling inflation –Enhancing the international competitiveness of domestic industries –Correcting balance-of-payments deficits and limiting the impact on the economy of external financial crises.

27. 4-27 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Means for Managing Foreign Exchange Rates –Foreign Exchange Reserves  These are reserves such as foreign currencies, gold, special credits and reserve positions with the IMF that central banks use to intervene in the foreign exchange market –Internal Balance  When the economy is operating at full capacity with near full employment and price stability

28. 4-28 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Means for Managing Foreign Exchange Rates (Cont’d) –External Balance  When the current account balance is such that foreign debt obligations into the future are sustainable for a country or its trading partners.

29. 4-29 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Functions of International Monetary System –Adjustment  An international monetary system needs to provide an adjustment mechanism by which countries can correct internal and external imbalances.

30. 4-30 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Functions of International Monetary System (Cont’d) –Liquidity  An international monetary system must also provide sufficient international liquidity. –Confidence-Building  Confidence or credibility in a financial system underpins its stability.

31. 4-31 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Bretton Woods System and the IMF –In 1944, representatives from 44 countries met at Bretton Woods, New Hampshire, to design a new international monetary system. –The goal was to build an enduring economic order that would facilitate postwar economic growth.

32. 4-32 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Bretton Woods System and the IMF (Cont’d) –The agreement established two multinational institutions: i.The International Monetary Fund (IMF), to maintain order in the international monetary system ii.The World Bank, to promote general economic development

33. 4-33 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Under the Bretton Woods System : –The US dollar was the only currency to be convertible to gold, and other currencies would set their exchange rates relative to the dollar. –Devaluations were not to be used for competitive purposes. –A country could not devalue its currency by more than 10% without IMF approval.

34. 4-34 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Role of the IMF –The IMF was responsible for executing the main goal of the Bretton Woods agreement: avoiding a repetition of the chaos that occurred between the wars with a combination of discipline and flexibility.

35. 4-35 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Discipline –A fixed exchange rate regime imposes discipline in two ways: i.The need to maintain a fixed exchange rate puts a brake on competitive devaluations and brings stability to the world trade environment. ii.A fixed exchange rate regime imposes monetary discipline on countries, thereby curtailing price inflation.

36. 4-36 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System Flexibility –Although monetary discipline was a central objective of the agreement, it was recognised that a rigid policy of fixed exchange rates would be too inflexible. –The IMF stood ready to lend foreign currencies to members to tide them over during short periods of balance-of- payments deficit, when a rapid tightening of monetary or fiscal policy would hurt domestic employment.

37. 4-37 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Demise of the Bretton Woods System –The special role of the US dollar  The US dollar occupied a central place in the Bretton Woods system The Bretton Woods system was vulnerable as the system could not work if its key reserve currency came under speculative attack.

38. 4-38 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Demise of the Bretton Woods System (Cont’d) –The adjustment mechanism  One shortcoming of the adjustment process, even though the Bretton Woods system’s ‘rules of the game’ required both surplus and deficit countries to share the burden of adjustment, was that in practice the pressure and burden for adjustment fell on the deficit countries.

39. 4-39 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Demise of the Bretton Woods System (Cont’d) –The adjustment mechanism (cont’d)  A second shortcoming, building from the first, was that the process of adjusting the exchange rate or peg was a discrete adjustment when a ‘fundamental disequilibrium’ was evident.

40. 4-40 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Demise of the Bretton Woods System (Cont’d) –The impossible trinity  The impossible trinity argument holds that it is not possible for a country simultaneously to have a fixed exchange rate regime, free cross border capital flows and an independent monetary policy dedicated to domestic goals.

41. 4-41 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System The Floating Exchange Rate Regimes of Australia and New Zealand –Australia and New Zealand adopted freely floating exchange rate regimes in 1983 and 1985, respectively. –Both have adopted inflation control as the target for their monetary policy in contrast with targeting monetary policy at the goal of attaining and maintaining a particular exchange rate.

42. 4-42 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System A Role for the IMF –Surveillance  Part of the IMF’s role involves monitoring and consulting members with regard to the national and international consequences of their economic and financial policies. –Lending  IMF lending provides financial assistance to countries with balance-of-payments difficulties.

43. 4-43 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. International Monetary System A Role for the IMF (Cont’d) –Technical assistance  This assistance includes the provision of research, expertise and training. –Future role  Where does all this leave the role of the IMF in the current international monetary system?  Reform may be needed.

44. 4-44 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade International business ventures can be put at risk as a result of unexpected changes in the exchange rate. Conducting international business is much more complex than domestic business. A problem that can be particularly acute in international trade is the lack of trust that exists when one must put faith in a stranger.

45. 4-45 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Lack of Trust –The seller (the exporter) and the buyer (the importer) have conflicting interests. –Advance payment  Payment prior to the exporter shipping the products. –Open account  Payment at some future date after the products have been delivered.

46. 4-46 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Advance Payment: Preference of the Australian Exporter

47. 4-47 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Open Account: Preference of the French Importer

48. 4-48 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade The problem is solved by using a third party trusted by both –Letter of Credit  A document issued by a bank indicating that it will make payments to a beneficiary upon presentation of particular documents. –Draft or Bill of Exchange  A draft, sometimes referred to as a bill of exchange, is the instrument normally used in international commerce to effect payment.

49. 4-49 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Using a third party trusted by both (Cont’d) –Draft or Bill of Exchange (cont’d)  A draft is simply an order written by an exporter (the drawer) instructing an importer, or an importer’s agent (the drawee), to pay a specified amount of money at a specified time.

50. 4-50 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Use of a Third Party

51. 4-51 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade Using a third party trusted by both (Cont’d) –Bill of Lading  A document issued to an exporter by the carrier transporting the merchandise.  Serves as a receipt, a contract, and a document of title.

52. 4-52 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Financing Trade A Typical International Trade Transaction

53. 4-53 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Foreign Exchange Risks –Transaction exposure is the extent to which the income from individual transactions is affected by fluctuations in foreign exchange values. –Translation exposure is the impact of currency exchange rate changes on the reported financial statements of a company. –Economic exposure is the extent to which a firm’s future international earning power is affected by changes in exchange rates.

54. 4-54 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Strategies for reducing Translation and Transaction Exposure –Lead Strategy  An attempt to collect foreign currency receivables early when a foreign currency is expected to depreciate and to pay foreign currency payables before they are due when a currency is expected to appreciate.

55. 4-55 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Strategies for reducing Translation and Transaction Exposure (Cont’d) –Lag Strategy  An attempt to delay collection of foreign currency receivables if that currency is expected to appreciate and to delay payables if that currency is expected to depreciate.

56. 4-56 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Strategies for 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 that the firm’s long-term financial wellbeing is not severely affected by adverse changes in exchange rates.

57. 4-57 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Other Steps for Managing Foreign Exchange Risk –Central control of exposure is needed to protect resources efficiently and ensure that each subunit adopts the correct mix of strategies. –Firms should distinguish between, on the one hand, transaction and translation exposure and, on the other, economic exposure. –The need to forecast future exchange rate movements cannot be overstated, though this is a tricky business.

58. 4-58 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Managerial Implications Other Steps for Managing Foreign Exchange Risk (Cont’d) –Firms need to establish good reporting systems so the central finance function (or the in-house foreign exchange centre) can regularly monitor the firm’s exposure positions. –On the basis of the information it receives from exchange rate forecasts and its own regular reporting systems, the firm should produce monthly foreign exchange exposure reports.

59. 4-59 Copyright  2007 McGraw-Hill Australia Pty Ltd PPTs t/a Global Business Today 1e by Hill. Slides prepared by Fuming Jiang. Summary of Main Points This chapter explained how foreign exchange markets work, the forces that determine exchange rates, the functions and workings of different parts of the international monetary system and the methods of payment and finance of trade. Given that changes in exchange rates, international monetary instability and the lack of trust that may exist between a seller (the exporter) and a buyer (the importer) in an international transaction can dramatically alter the profitability of foreign trade and investment deals, these are issues of major interest to international business.