Lecture 2:The International Monetary System

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Lecture 2The International Monetary System

• A Discussion of Foreign Exchange Regimes (i.e.,
  The Arrangement by which a Countrys Exchange
  Rate is Determined)

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Where is this International Financial Center?
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What is the International Monetary System?

• It is the overall financial environment in which
  global businesses and global investors operate.
• It is represented by the following 3 sub-sectors
• International Money and Capital Markets
• Banking markets
• Bond markets
• Equity markets
• Foreign Exchange Markets
• Currency markets (and foreign exchange regimes)
• Derivatives Markets
• Forwards, futures, options
• This lecture will focus on the foreign exchange
  market

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Concept of an Exchange Rate Regime

• The exchange rate regime refers to the
  arrangement by which the price of countrys
  currency is determined within foreign exchange
  markets.
• This arrangement is determined by individual
  governments (essentially how much control if any
  they wish to exert on the actual exchange rate).
• Foreign currency price is
• The foreign exchange rate (referred to as the
  spot rate).
• Expresses the value of a countys currency as a
  ratio of some other country.
• Since the 1940s that other currency has been the
  U.S. dollar.
• Century before (and under the Classical Gold
  Standard) it was the British pound.

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Foreign Exchange Rate Quotations

• There are two generally accepted ways of quoting
  a currencys foreign exchange rate (i.e., the
  ratio of one currency to the U.S. dollar).
• American terms and European Terms quotes
• American terms quotes Expresses the exchange
  rate as the amount of U.S. dollars per 1 unit of
  a foreign currency.
• For Example 1.65 per 1 British pound
• Or 1.45 per 1 European euro
• Or 1.06 per 1 Australian dollar

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Foreign Exchange Rate Quotations

• European terms quote Expresses the exchange
  rate as the amount of foreign currency per 1 U.S.
  dollar
• For Example 76.67 yen per 1 U.S. dollar
• Or 7.80 Hong Kong dollars per 1 U.S. dollar
• Or 6.38 Chinese yuan per 1 U.S. dollar
• For reporting and trading purposes, most of the
  worlds major currencies are quoted on the basis
  of American terms (Pound and Euro) however, the
  majority of the worlds currencies are quoted on
  the basis of European terms.
• http//www.bloomberg.com/markets/currencies/

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Why are Exchange Rate Regimes Important for
Global Firms and Investors?

• As we will see in the next lecture, exchange rate
  regimes will affect the potential volatility of a
  countrys exchange rate.
• For global firms, changes in exchange rates can
  affect the home currency equivalent
• of the foreign currency cash flow
• and thus the value of the firm.
• For global investors, changes in exchange rates
• Affect the home currency returns associated with
  investments in foreign financial assets.

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A Model for Illustrating Exchange Rate Regimes

• We can think of current exchange rate regimes as
  falling along a spectrum as represented by a
  national governments involvement in affecting
  (managing) their countrys exchange rate.

No Involvement by Government
Very Active Involvement by Government
Market forces are Determining Exchange rate
Government is Determining or Managing the
Exchange rate
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Exchange Rate Regimes Today
Minimal (if any) Involvement by Government
Active Involvement by Government
Market forces are Determining Exchange rate
Government is Determining or Managing the
Exchange rate
Managed Rate (Dirty Float) Regime
Pegged Rate Regime
Floating Rate Regime
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Classification of Exchange Rate Regimes
Floating Rate Regimes

• Floating Currency Regime
• No (or at best occasional) government involvement
  (i.e., intervention) in foreign exchange markets.
• Market forces, i.e., demand and supply, are the
  primary determinate of foreign exchange rates
  (prices).
• Financial institutions (global banks, investment
  firms), multinational firms, speculators (hedge
  funds), exporters, importers, etc.
• Central banks may intervene occasionally to
  offset what they regard as inappropriate or
  disorderly exchange rate levels.

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Classification of Exchange Rate Regimes Managed
Rate Regimes

• Managed Currency (Dirty Float) Regime
• High degree of intervention of government in
  foreign exchange market (perhaps on a daily
  basis).
• Purpose to offset moderate market forces and
  produce an desirable exchange rate level or
  path.
• Usually done because exchange rate is seen as
  important to the national economy (e.g., export
  sector or the price of critical imports).
• Currencys exchange rate will be managed in
  relation to another currency (or a market basket
  of currencies)
• Preferred currencies are the US dollar and Euro.

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Classification of Exchange Rate Regimes Pegged
(Fixed) Rate Regimes

• Pegged Currency Regime
• Governments directly link (i.e., peg) their
  currencys rate to another currency.
• Government sets the exchange rate with a certain
  band (e.g., or 1) of a fixed rate or within
  a narrow margin, sometimes called a crawling peg
  (e.g., or 2) of a trend.
• Occurs when governments are reluctant to let
  market forces determine rate.
• Exchange rate seen as essential to countrys
  economic development and or trade relationships.
• Governments are also concerned about the
  potential negative impacts of a open capital
  market (i.e., disruptive flows of short term
  funds hot money.)

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Examples of Currencies by Regime

• Floating Rate Currencies
• Canadian dollar (1970), U.S. dollar (1973),
  Japanese yen (1973), British pound (1973), yen
  (1973), Australian dollar (1985), New Zealand
  dollar (1985), South Korean Won (1997), Thailand
  baht (1997), Euro (1999), Brazilian real (1999),
  Chile peso (1999), Argentina Peso (2002).
• Managed Rate Currencies
• Singapore dollar, 1981 (Euro), Costa Rica colon
  (U.S. dollar), Malaysia ringgit (2005, Market
  Basket), Vietnam dong (11/08 U.S. dollar).
• Pegged Rate Currencies to a fixed rate (against
  the U.S. dollar or market basket)
• Hong Kong dollar, since 1983 (7.8KGD 1USD),
  Saudi Arabia riyal (3.75SAR 1USD), Oman rial
  (0.385OMR 1USD)
• Pegged Rate Currencies (Crawling Peg) to a
  trend (against the U.S. dollar or market basket)
• China yuan (7/05 Market Basket), Bolivia
  boliviano (U.S. dollar)
• Note The IMF notes that 66 out of 192 countries
  they classify use the U.S. dollar as a anchor.
  Data above as of 2009.

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Changing Exchange Rate Regimes 1970 -2010 (IMF
Classifications)

• by Number of Countries

• by GDP of Countries

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Simplified Model of Floating Exchange Rates
(Market Determined Rates)

• The market equilibrium exchange rate at any
  point in time can be represented by the point at
  which the demand for and supply of a particular
  foreign currency produces a market clearing
  price, or
• Supply (of a
  certain FX)
• Price
• Demand (for a
  certain FX)
• Quantity of FX

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Simplified Model Strengthening FX

• Any situation that increases the demand (d to d)
  for a given currency will exert upward pressure
  on that currencys exchange rate (price).
• Any situation that decreases the supply (s to s)
  of a given currency will exert upward pressure on
  that currencys exchange rate (price).
• s
  s s
• p p
• d d
  d
  
• q q

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Simplified Model Weakening FX

• Any situation that decreases the demand (d to d)
  for a given currency will exert downward pressure
  on that currencys exchange rate (price).
• Any situation that increases the supply (s to s)
  of a given currency will exert downward pressure
  on that currencys exchange rate (price).
• s
  s s
• p p
• d d
  d
  
• q q

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Factors That Affect the Equilibrium Exchange
Rate Changes in Demand

• Relative (short-term) interest rates.
• Affects the demand for financial assets (increase
  demand for high interest rate currencies).
• Relative rates of inflation.
• Affects the demand for real (goods) and financial
  assets hence the demand for currencies
• Low inflation results in increase global demand
  for a countrys goods.
• Low inflation results in high real returns on
  financial assets.
• Relative economic growth rates.
• Affects longer term investment flows in real
  capital assets (FDI) and financial assets (stocks
  and bonds).
• Changes in global and regional risk.
• Safe Haven Effects Foreign exchange markets seek
  out safe haven countries during periods of
  uncertainty.

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Safe Haven Effect September 11, 2001
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Factors That Affect the Equilibrium Exchange
Rate Government Intervention

• Foreign exchange intervention policy if a
  government feels its currency is too weak
• Government will buy their currency in foreign
  exchange markets
• Create demand and push price up.
• Foreign exchange intervention policy if
  government feels its currency is too strong
• Government will sell their currency in foreign
  exchange markets
• Increase supply to bring price down.

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Factors That Affect the Equilibrium Exchange
Rate Government Interest Rate Adjustments

• Some governments may also use interest rate
  adjustments to influence their currencies.
• When a currency become too weak
• Governments might raise short term interest rates
  to encourage short term foreign capital inflows.
• Higher interest rates make investments more
  attractive and increase demand for the currency.
• When a currency becomes too strong
• Governments might lower short term interest rates
  to discourage short term foreign capital inflows.
• Lower interest rates will make investments less
  attractive and reduce the demand for the
  currency.

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Factors That Affect the Equilibrium Exchange
Rate Carry Trade Strategies

• Carry trade strategy A foreign exchange trading
  strategy in which a trader sells a currency with
  a relatively low interest rate and uses the funds
  to purchase a different currency yielding a
  higher interest rate. This strategy offers profit
  not only from the interest rate difference
  (overnight interest rate) but additionally from
  the currency pairs fluctuation.
• An example of a "yen carry trade" A trader
  borrows Japanese yen from a Japanese bank,
  converts the funds into Australian dollars and
  buys an Australian bond for the equivalent
  amount. If we assume that the bond pays 4.5 and
  the Japanese borrowing rate is 1.0, the trader
  stands to make a profit of 3.5 as long as the
  exchange rate between the countries does not
  change.
• In this example, the trader is short on yen and
  long on Australian dollars.

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Impact of Carry Trades on Exchange Rates

• Carry trades can result in a huge amount of
  capital flows in and out of currencies.
• High interest rate currency will experience
  increase demand.
• Low interest rate currency will experience
  increase in supply.
• Combined this will result in a strengthening of
  the high interest rate currency against the low
  interest rate currency.
• However, when traders reverse their positions,
  the opposite exchange rate effects will occur.
• When do they reverse During periods of
  increasing global uncertainty about interest
  rates and exchange rates.
• For a case which combines carry trade and
  government intervention, please see Case Study
  New Zealand Central Bank Intervention in the
  Foreign Exchange Market, June 11, 2007 (posted on
  course web site).