Global Business 3eChapter 7

Dealing with Foreign Exchange

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© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

LEARNING OBJECTIVES

After studying this chapter, you should be able to:7-1 understand the determinants of foreign exchange

rates.7-2 track the evolution of the international monetary

system.7-3 identify firms’ strategic responses to deal with

foreign exchange movements.7-4 participate in three leading debates concerning

foreign exchange movements.7-5 draw implications for action.

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WHAT DETERMINES FOREIGNEXCHANGE RATES?

Foreign exchange ratePrice of one currency in terms of another

Purchasing power parity (PPP)Conversion that determines the equivalent

amount of goods and services different currencies can purchase

Conversion is usually used to capture differences in cost of living between countries

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

PRODUCTIVITY AND BALANCE OF PAYMENTSBalance of paymentsA country’s international transaction

statement, which includes merchandise trade, service trade, and capital movement

Current Account balanceCurrent account = balance of trade +

net factor income from abroad + net unilateral transfers from abroad

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© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

EXCHANGE RATE POLICIESFloating (or flexible) exchange rate policyWillingness of a government to let demand and supply conditions determine exchange rates

Clean (or free) floatPure market solution to determine exchange

rates

Dirty (or managed) floatUsing selective government intervention to determine exchange rates

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EXCHANGE RATE POLICIESTarget exchange rates (crawling bands)Specified upper or lower bounds within which an exchange rate is allowed to fluctuate

Fixed rate policySetting the exchange rate of a currency relative to other currencies

PegStabilizing policy of linking a developing country’s currency to a key currency

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INVESTOR PSYCHOLOGY

bandwagon effectEffect of investors moving in the same

direction at the same time

capital flightPhenomenon in which a large number of

individuals and companies exchange domestic currencies for a foreign currency

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? Can you recall a recent example of a bandwagon effect?

EVOLUTION OF THE INTERNATIONALMONETARY SYSTEM

Gold standardSystem in which the value of most major

currencies was maintained by fixing their prices in terms of gold

Common denominatorCurrency or commodity to which the value

of all currencies are pegged

Bretton Woods systemSystem in which all currencies were pegged

at a fixed rate to US dollar© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

EVOLUTION OF THE INTERNATIONALMONETARY SYSTEM

Post-Bretton Woods systemSystem of flexible exchange rate regimes with no official common denominator

QuotaWeight a member country carries within the IMF, which determines the amount of its financial contribution (its “subscription”), and its capacity to borrow from the IMF, and its voting power

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© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

Strategies for Financial Companies

Foreign exchange marketMarket where individuals, firms, governments, and banks buy and sell currencies of other countries

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STRATEGIES FOR FINANCIAL COMPANIES

Spot transactionClassic single-shot exchange of one currency for another

Forward transactionForeign exchange transaction in which participants buy and sell currencies now for future delivery

Currency hedgingTransaction that protects traders and investors from exposure to the fluctuations of the spot rate

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STRATEGIES FOR FINANCIAL COMPANIESForward discountCondition under which the forward rate of one

currency relative to another currency is higher than the spot rate

Forward premiumCondition under which the forward rate of one

currency relative to another currency is lower than the spot rate

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STRATEGIES FOR FINANCIAL COMPANIESCurrency swapForeign exchange transaction between two firms in which one currency is converted into another at Time 1, with an agreement to revert it back to the original currency at a specified Time 2 in the future

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STRATEGIES FOR FINANCIAL COMPANIESOffer ratePrice at which a bank is willing to sell a

currency

Bid ratePrice at which a bank is willing to buy a

currency

SpreadDifference between the offer price and the bid price

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STRATEGIES FOR NONFINANCIAL COMPANIESCurrency riskPotential for loss associated with fluctuations

in the foreign exchange market

Strategic hedgingSpreading out activities in a number of

countries in different currency zones to offset any currency losses in one region through gains in other regions

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FIXED VS FLOATING EXCHANGE RATESCurrency boardCoins convertible into a key foreign

currency Monetary authority that issues notes at

a fixed exchange rate

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? Which exchange rate do you think is better?

A STRONG DOLLAR VS A WEAK DOLLAR

International Monetary Fund (IMF)

An international organization established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.