Transcript Foreign Exchange and the International Monetary System

International Business
Dealing with Currencies
(Foreign Exchange)
with summary of international organizations and
basic introduction to the International Monetary
System
9-1
The international economy
so far…
 Huge cultural differences between
countries
 Big differences in political economic
systems
 Getting narrower
 Reduction in restrictions accelerates
growth in trade
 Technology ties world together
 WTO addresses disputes
 Enormous increase in wealth
 Effects for businesses not in
international trade:
huge increase in competition
 Not everyone benefits
 Median incomes in developed world not
increasing
 Benefits in poorer countries are
unevenly spread
Today’s tasks…
 Understand the use of currencies in
international trade
 Get a basic sense of the international
monetary system
 Summarize international
organizations
 Discuss the midterm
 Maybe … watch a video that captures
what this is doing in the fastest
changing countries
Foreign Exchange Terms
 Foreign exchange: money
denominated in the currency of
another nation or group of nations
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Cash
Credit
Bank deposits
Other short-term claims (e.g., bonds)
 Exchange rate: the price of a
particular currency relative to another
Basic questions …
 What is money?
 How should you convert money from one
currency into another?
 How are the values of currencies set?
 How can you limit foreign exchange risk
(the possibility that unpredicted changes in exchange
rates will have adverse consequences for the firm)?
 Can you predict when currency values will
change? If so, how?
What is money?
 The “medium of exchange”
 that is, something widely accepted
as means of payment
 Usually, governments declare certain
pieces of paper to be money
 But people must accept them
 Alternatives are inconvenient, but
possible
 Tobacco in early American colonies
 U.S. dollar in Russia when ruble collapsed
 Sell abroad, and you may receive
payment in foreign currency
 Buy abroad, and you may have to
pay in foreign currency
 Travel abroad, you must spend
foreign currency
 A foreign direct investment will have
to pay expenses in foreign currency
How should you convert money
from one currency into another?
 Current values of major foreign
currencies are available on the Web
 Most businesspeople normally buy
from or sell to a bank
 The bank takes a bigger ‘spread’ than
the rates offered on the Web, but
handles all details
 Banks may vary a lot in how good a
deal they give
 A business with significant foreign
activity creates a stable relationship
with one or a few banks
 Nowadays, you can do your own
currency trading
How are the values of currencies
set?
 There are two basic ways
 “Fixed” or “Pegged” exchange rates
 Governments decide the value of currency
 Example: Hong Kong’s government keeps
the value of its dollar at roughly US$0.129
(US$1=HK$7.75)
 With a ‘fixed rate’, there is absolutely no
variability.
 A ‘pegged’ rate implies small variability
Most key world currencies float
against each other
 Supply and demand sets values
 This is how exchange rates are set for the
US dollar vs.
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Euro,
Japanese yen,
British pound,
Swiss franc, etc.
Insuring Against
Foreign Exchange Risk
 Businesses use the foreign exchange market
to provide insurance against foreign exchange
risk
 Protecting yourself against foreign exchange
risk is called hedging
 You can buy or sell using
1. spot exchange rates
2. forward exchange rates
3. currency swaps
Insuring Against
Foreign Exchange Risk
1. 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
 Spot rates are determined by the
interaction between supply and demand,
and so change continually
Insuring Against
Foreign Exchange Risk
2. Forward Exchange Rates
 A forward exchange occurs when two
parties agree to exchange currency at
some specific future date
 Forward rates are typically quoted for
30, 90, or 180 days into the future
 Forward rates are typically the same as
the spot rate plus or minus an
adjustment for the interest the parties
will pay/receive
Insuring Against
Foreign Exchange Risk
3. Currency Swaps
 A currency swap is the simultaneous
purchase and sale of an amount of
foreign exchange on two different dates
 Swaps are used when it is desirable to
move out of one currency into another
for a limited period without incurring
foreign exchange rate risk
Fixed exchange rates have
important benefits
 They make business predictable
 In some very prosperous periods,
most major exchange rates have
been fixed
 The late 19th century
 1945-1971
The gold standard made the
benefits of fixed rates clear
 Before WW I, all major currencies
were convertible into gold
 UK £1=113 grains gold (.2354 oz)
 US $1= 23.22 grains (.0484 oz)
 So £1=4.87
 Everyone knew what everything
was and would be worth
 The gold standard system had broken
down after WW I
 The Bretton Woods conference in
1944 created a new system of
fixed rates
 The International Monetary Fund
(IMF) managed the system
 It can lend to countries in fiscal crisis
 But it usually demands dramatic cuts in
government spending, etc., in return
 However, fixed exchange rates require
discipline in the government –
and a willingness to create pain
 Example: Suppose your nation’s economy is
very prosperous
 Your people will have money to buy imports
 Their demand for foreign currencies will put
upward pressure on their exchange rates
 Government has to slow the domestic economy
to prevent change in exchange rate
 Higher taxes, higher interest rates, lower spending
 Many economists say if a country is having
difficulty maintaining a fixed exchange rate,
the economy is ‘overheated’
 They say higher interest rates or higher taxes
might be better for the economy in the long run
in those circumstances
 But politicians don’t like to take pain
 U.S. abandoned fixed exchange rates when
the Vietnam War created strong inflation
 It seems that the more complicated
an economy, the more difficult it is to
maintain fixed/pegged rates
 Many small countries succeed
 Hong Kong, Bangladesh, Fiji
 Few propose them for the largest
developed countries today
 But China maintains a pegged
exchange rate
 Its government buys all surplus dollars
in the country
 In June 2012 China had $3,240 billion
US dollars
Most international business involves
currencies with floating rates
 Buyers and sellers establish prices in
markets like those for tea and wheat
 $5,000,000,000,000 in foreign
exchange is traded every day
 US dollar is most widely traded
 involved in 90% of all transactions
 London is the main foreign-exchange
market
Key Foreign-Exchange Terms
 Bid: the rate at which a trader will buy
foreign currency from you
 Offer: the rate at which a trader will
sell foreign currency to you
 Spread: the difference between bid
and offer rates;
 The spread is the profit margin for the
trader
9-6
Market Rhythms
9-13
How can you predict when currency
values will change?
 Business decisions demand you look
far ahead
 If exchange rates will change and you
don’t hedge adequately, your whole
calculation will be off
 Some foreign currencies have lost 90%
or more of their value in a year
 Argentine peso went from $1=1 peso to
$1=3.5 pesos in one jump
‘Fundamental analysis’ involves
examining basic economic data
 These forces can drive changes in
exchange rates:
 How fast are prices rising in the
country?
 If prices are rising the currency may fall
 Is there a trade surplus or deficit?
 Is the government running budget
deficits? How much?
 If the government or its people are
borrowing too much the currency may fall
 How do interest rates in the countries
compare?
 If a country’s interest rates are high, its
currency may rise
 How has the government been
managing the currency?
 Is it buying or selling foreign currency?
 Is it running out of resources for pursuit of
a strategy it has been following?
Technical analysis involves
examining trends in exchange rates
 One principle: Trends once
established often tend to continue
 ‘The trend is your friend’
 But if “everyone” agrees something
will happen, it may not happen
 When ‘everyone’ thinks the dollar will
go down, ‘everyone’ has already sold
dollars
 If the news changes, many may quickly
change their minds and want to buy
Foreign exchange can be the
difference between profit and loss
 HSBC Bank in Argentina
 They entered Argentina at a time when it
appeared the government was starting
to manage the economy effectively
 But they continued investing as
government became more irresponsible
 They lost big
International organizations:
a summary
 Biggest driver of free trade has been
the treaty created from the 1944
Bretton Woods conference: the
General Agreement on Tariffs and
Trade
 To strengthen it, countries created
the World Trade Organization in
1995
 WTO judges trade disputes
 International Monetary Fund was
also created at Bretton Woods to
keep the world’s currency system
reasonably stable
These won’t be on the test, but
are good to know…
 World Bank – founded at Bretton Woods to
lend to needy countries
 United Nations – a basically political
organization founded just after WW II
principally as a forum for discussions to
prevent war
 Organization for Economic Cooperation
and Development – set up by North
American and European nations after WW II, it
is now a cooperation group of almost all the
rich countries
 Material below here is not required
Foreign-Exchange Convertibility
 Fully convertible currencies are those that
the government allows both residents and
nonresidents to purchase in unlimited
amounts
 “Hard currencies” are fully convertible
 “Soft currencies” (or weak currencies) are not
fully convertible
 Typically from developing countries
 Known as “exotic currencies”
9-10