1. International Business Environments & Operations
Daniels ● Radebaugh ● Sullivan
International Business Environments and Operations 15e by Daniels, Radebaugh, and Sullivan
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2. The Determination of Exchange Rates
Chapter 9
The Determination of Exchange Rates
Chapter 9: The Determination of Exchange Rates
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Learning Objectives
Describe the International Monetary Fund and its role in the determination of exchange rates
Discuss the major exchange-rate arrangements that countries use
Explain the European Monetary System and how the euro became the currency of the euro zone
Identify the major determinants of exchange rates
Show how managers try to forecast exchange-rate movements
Explain how exchange-rate movements influence business decisions
The Learning Objectives for this chapter are
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 became 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
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4. The International Monetary Fund-1
IMF is a multinational institution established in 1945 as part of the Bretton Woods Agreement to maintain order in the international monetary system. 187 members as of 2012.
Bank of International Settlements (BIS) does the exchange rate settlements
The Bretton Woods Agreement
established a par value, or benchmark value, for each currency initially quoted in terms of gold and the U.S. dollar
The dollar became the world benchmark for trading currencies and continues in that role today
Under the Bretton Woods system of par values, the dollar was fixed at $35 per ounce of gold. This became the benchmark against which all other currencies were valued. Under the agreement, currencies could fluctuate within a one percent band of their par value.
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Goals of IMF
The goals of the International Monetary Fund (IMF) are to
ensure stability in the international monetary system
promote international monetary cooperation and exchange-rate stability
facilitate the balanced growth of international trade
provide resources to help members in balance-of-payments difficulties or to assist with poverty reduction
The IMF, which was created in 1945, was formed to promote exchange rate stability and facilitate the international flow of currencies. The IMF monitors the global economy and also the economies of individual nations and provides recommendations as needed. Most recently, the IMF has been involved in the crisis in Greece for example.
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The IMF Today
IMF Quota: the sum of the total assessments levied on member countries to form the pool of money (about $1 trillion) from which the IMF draws to make loans to member nations. National quotas are based upon countries’ GDP, monetary reserves, trade balances, and other economic indicators.
Quotas form the basis for the voting power of each member nation—the higher the quota, the greater the number of votes. Now, 24 executive board members run IMF.
Special Drawing Rights (SDR), an artificial international reserve asset created in 1969 to supplement IMF members’ existing reserves of gold and foreign exchange. The value of the SDR is based upon the weighted average of a basket of four currencies (2010): U.S. dollar-42%, Euro-37%, Japanese yen-9%, British pound-11%.
IMF constantly monitors global economy through internal surveillance, policy suggestions are mandated accordingly. IMF lends money to ease balance-of-payments difficulties.
The IMF relies on a quota system to generate funds to lend to countries in need. Quotas, which are based on the relative size of a country within the global economy, are important because they influence the voting power of each country. The larger the quota, the higher the voting power.
The quota system was reformed in 2010 giving more quota shares to emerging markets. So, while the United States retained its top position, China now holds the number 3 spot, and the BRIC countries are among the largest shareholders in the Fund.
Special drawing rights are an international reserve asset given to each country to help increase its reserves. They are also the unit of account in which the IMF keeps its financial records.
Currencies making up the SDR basket are the U.S. dollar, the euro, the Japanese yen, and the British pound.
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7. Global Financial Crisis and the IMF
Asian Financial Crisis-late 1990s
The global crisis in raised concerns over global liquidity
prompted the G20 to inject huge amounts of cash into the IMF
Greece’s financial crisis required assistance from the IMF and the EU
the IMF required Greece to adopt very unpopular austerity measures
The G20, mindful of the global financial crisis, voted to significantly increase reserves available to the IMF to help countries in distress.
Greece has been a beneficiary of IMF funds, but continues to be quite unstable.
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8. Exchange Rate Arrangements-1
The Smithsonian Agreement
8% devaluation of the dollar
revaluation of other currencies
widening of exchange rate flexibility
The Jamaica Agreement
provided greater exchange rate flexibility
eliminated the use of par values
Under the Jamaica Agreement countries selected and maintained their own exchange rate arrangements
In the early 1970s, the United States was in trouble. The country’s large balance-of-trade deficit made it difficult to maintain the fixed exchange rate system prompting then President Richard Nixon to abandon the Bretton Woods system in A new system, the Smithsonian Agreement was then established, followed by the Jamaica Agreement in 1976.
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9. Exchange Rate Arrangements-2
Refers to the monetary system/discipline that determines the value of a currency is in international markets. Usually, weaker currencies are tied to stronger currencies. Each country declares in advance as to what it will during the year. Current system includes:
Independently floating (about 40 countries)
Pegged arrangement: hard, soft and free-float
Various forms of pegs possible, single currency, composite
Par value, band issue
Bipolar/Tripolar monetary system?-USD, Eurozone and Yen
Renminbi continues to be pegged with US Dollar

10. Exchange Rate Arrangements-3
Exchange Rate Arrangements and Anchors
The Table shows different exchange rate arrangements and anchors.
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11. IMF Financial Discipline
The IMF manages global exchange rate discipline through currency pegging.
Hard peg
value is locked into something and does not change
dollarization
currency boards
Soft peg
more flexible than hard peg
Chinese Yuan is an example
Floating
floating or free floating
change according to market forces
What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating.
Countries can adopt a currency in place of their own.
Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board.
A currency board is an organization generally separate from a country’s central bank. Its responsibility is to issue domestic currency that is typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency.
Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF.
Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare.
Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country.
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12. Factors Determining the Value of a Currency
Currency is like a commodity and the laws of demand and supply will hold
A complex set of factors/variables simultaneously (thus a dynamic view) influence the value of the currency. They are:
BOP statistics (trade and reserve)
Interest rate differentials
Inflation differentials
Fiscal and monetary policy
Business cycles
Political events
Psychological (confidence) factors

13. Determining Exchange Rates
The Equilibrium Exchange Rate and How it Moves
This Figure shows the equilibrium exchange rate in the market and then a movement to a new equilibrium level as the market changes.
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14. Balance of Payments Account (BOP)
What type of arrangement do countries choose? There are three possibilities: hard peg, soft peg, or floating.
Countries can adopt a currency in place of their own.
Countries that use the dollar as an exchange arrangement with no separate legal tender are practicing dollarization of the currency. Another option for countries with a hard peg is the currency board.
A currency board is an organization generally separate from a country’s central bank. Its responsibility is to issue domestic currency that is typically anchored to a foreign currency. If it does not have deposits on hand in the foreign currency, it cannot issue more domestic currency.
Most countries following a soft peg arrangement use a conventional fixed-peg arrangement, whereby a country pegs its currency to another currency or basket of currencies and allows the exchange rate to vary plus or minus one percent from that value. It’s more similar to the original fixed exchange-rate system used by the IMF.
Floating regimes include floating systems that change according to market forces but may be subject to market intervention, or freely floating systems where intervention is rare.
Because countries can change their systems, it’s important for managers to monitor exchange regimes in each country.
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15. Interest Rate Differential
Government affects Money Supply through
Interest rate
Open market operations-buying and selling of government bonds
Reserve ratio (for deposits in banks)
The DIFFERENTIAL of the interest rates between two countries (or more) will determine the exchange rate
Also, consider money as an asset. People tend to keep assets in stronger currencies.

16. Inflation Differential
Inflation is given by the price index. It reduces the value of a currency
Generally, forward rate of a currency is determined by discounting a currency with the prevailing inflation rate
Again, DIFFERENTIAL between two (or more) countries is important

17. Fiscal and Monetary Policy
Fiscal Policy-policy of the government regarding REVENUE and EXPENDITURE
Surplus/Deficit = Revenue - Expenditure
Monetary Policy-policy of the government regarding Money Supply (see earlier slides)
Budget Deficit, Trade Deficit, and Government Debt matters-FX market respects responsible governments

18. Business Cycle, Political Events and Psychological Factors
U.S. business cycle: 5-7 years of high and 3-5 years of low
A currency is more demanded when an economy is on a rising curve (and vice versa)
Business Cycle and Politics-what is the relationship?
Political instability negatively affects a currency
Confidence and faith in the currency is important-despite a huge budget deficit, trade deficit and debt the mighty U.S. Dollar prevails-do you know why?

19. Foreign Exchange Convertibility and Controls
Hard currencies
U.S. dollar, euro, British pound, Japanese yen
Soft currencies
developing countries
Countries can control convertibility through
licenses
multiple exchange rate systems
advance import deposits
quantity controls
Fully convertible currencies can be purchased in unlimited amounts by both residents and nonresidents of a country. Hard currencies are usually fully convertible and strong or relatively stable in value compared to other currencies.
In contrast, soft currencies aren’t fully convertible. Soft currencies are sometimes called weak currencies.
Governments might try to conserve scarce foreign exchange by imposing exchange restrictions. Licensing occurs when a government requires that all foreign exchange transactions be regulated and controlled by it.
Governments can also use multiple exchange rate systems to set different rates for different types of transactions. Governments might also demand advance import deposits prior to releasing foreign exchange to pay for imports.
Finally, quantity controls can be used to limit the amount of foreign currency that can be used in a specific transaction.
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20. Exchange Rates and Purchasing Power Parity
Purchasing power parity (PPP)
a change in relative inflation between two countries must cause a change in exchange rates to keep the prices of goods in the countries fairly similar
The Big Mac Index
A black market closely approximates a price based on supply and demand for a currency instead of a government controlled price
Relative rates of inflation, differences in real rates of inflation, and confidence in the government’s ability to manage the political and economic environment all influence exchange rates.
The Big Mac Index can be used to test PPP. The theory suggests that the price of a burger should be the same from country to country after exchange rates. If prices aren’t the same, then the foreign currency is undervalued or overvalued relative to the dollar.
Note that if the domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than that of the foreign currency.
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21. Business Implications of Exchange Rate Changes
Marketing Decisions
when the value of a country’s currency rises, exporting becomes more difficult as the product becomes more expensive in foreign markets
Production Decisions
might locate production in a weak currency country because the initial investment is cheap and it will make a good base for exports
Financial Decisions
currency rates influence sourcing, cross-border remittance of funds, and the reporting of financial results
Why do firms need to bother trying to predict exchange rate changes? Well, they can dramatically affect operating strategies and profits. Exchange rates changes can affect marketing, production, and financial decisions.
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22. The Future: The Dollar, The Euro, The Yen, The Yuan
Europe
the euro should take market share away from the dollar as the prime reserve asset assuming the problems in Greece and other countries are controlled
Asia
China is moving forward to establish the yuan as a major world currency
Latin America
emerging market currencies should strengthen as commodity prices recover
The dollar, the euro, the yen, and the yuan will all play a role in the global economy in the future. At this point it is difficult to say just what will happen though. The dollar will probably maintain its position as a benchmark currency in the world, especially given that the euro continues to be a question mark given the problems in Greece and some of the other unstable EU countries like Spain, Portugal, Ireland, and Italy.
The Japanese yen will probably not have as much power as the dollar or the euro, but remains one of the most widely traded currencies in the world. However, the yuan could become a major currency. While it’s still not floating freely, it’s going through a significant liberalization process, and could become influential in the future. Similarly, the Brazilian real is emerging as a key currency in Latin America.
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23. Chapter 9: Discussion Questions
Discuss the role of IMF in a global economy.
What is IMF? What are their goals? How does it manage global monetary stability?
What is a peg rate system? Explain the current global pegging exchange rate arrangement.
What is convertibility of a currency? How governments intervene FX, and why? Explain.
How do we determine the value of a currency? Explain the factors that determine the value of a currency. I may ask you to explain one or more specific factors.

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