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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

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INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT Lecture 2: The International Monetary System: Foreign Exchange Regimes – PowerPoint PPT presentation

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Title: INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT


1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT
  • Lecture 2
  • The International Monetary System
  • Foreign Exchange Regimes

2
What is the International Monetary System?
  • It is the overall financial environment in which
    global businesses 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

3
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!
  • Foreign currency price is
  • The foreign exchange rate (spot rate).
  • Expresses the value of a countys currency as a
    ratio of some other country.
  • Target currency (or common denominator) has
    historically (since the 1940s) been the U.S.
    dollar.
  • Look in Wall Street Journal under foreign
    exchange quotes.
  • See Appendix 1 for a discussion of exchange rate
    quotes.

4
Why are Exchange Rate Regimes Important for
Global Firms?
  • Exchange rate regimes will determine the pattern
    and potential volatility of the movement of a
    countrys exchange rate.
  • Exchange rate changes are important because they
  • Affect the competitive position of global firms
  • Especially true for exporting firms
  • Affect the cost structure of global firms
  • Especially true for importing firms and overseas
    manufacturers
  • Affect the profit structure of global firms
  • Overseas subsidiaries, exporters, and importers.
  • In short affect the financial performance of a
    global firm.

5
Exchange Rate Regimes Today
  • Current exchange rate regimes fall along a
    spectrum as represented by a national
    governments involvement in affecting (managing)
    the exchange rate for their currency.

No Involvement by Government
Very Active Involvement by Government
Market forces are Determining Exchange rate
Government is Determining or Managing the
Exchange rate
6
Exchange Rate Regimes Today
No Involvement by Government
Very 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
7
Classification of Exchange Rate Regimes
  • Floating Currency Regime
  • No (or minimal) government involvement (i.e.,
    intervention) in foreign exchange markets.
  • See Appendix 2 for a discussion of major central
    bank intervention.
  • Market forces, i.e., demand and supply, determine
    foreign exchange rates (prices).
  • Financial institutions (global banks, investment
    firms), multinational firms, speculators (hedge
    funds), exporters, importers, etc.

8
Classification of Exchange Rate Regimes
  • Managed Currency (dirty float) Regime
  • High degree of intervention of government in
    foreign exchange market.
  • Purpose to offset undesirable market forces
    and produce desirable exchange rate.
  • Usually done because exchange rate is seen as
    important to the national economy (e.g., export
    sector or the price of critical imports).

9
Classification of Exchange Rate Regimes
  • Pegged Currency Regime
  • Ultimate management by governments.
  • Governments directly linking (pegging) their
    currencys rate to another currency.
  • Occurs when governments are reluctant to let
    market forces determine rate.
  • Exchange rate seen as essential to countrys
    economic development and or trade relationships.
  • Unstable rate associated with potentially
    unstable domestic financial and economic
    situation.
  • Impact on inflation (cost of imports) or business
    activity (exports) or foreign direct investment.

10
Examples of Currencies by Regime
  • Floating Rate Currencies
  • U.S. dollar (1973), Canadian dollar (1970), Euro
    (1999), British pound (1973), yen (1973),
    Australian dollar (1985), New Zealand dollar
    (1985), Thai baht (1997), South Korean Won
    (1997), Argentina Peso (2002), Malaysian ringgit
    (2005).
  • Managed Rate Currencies
  • Singapore dollar, Egyptian pound, Israel shekel,
    Indian rupee, Chinese Yuan (since July 2005)
  • Pegged Rate Currencies (to 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)
  • Note For list of currency designations see
    http//www.xe.com/symbols.htmlist

11
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

12
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

13
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

14
Factors That Affect the Equilibrium Exchange
Rate Floating Rate Regime
  • Relative rates of (short-term) interest.
  • Affects the demand for financial assets (high
    interest rate currencies).
  • Carry trade strategies affect the supply of
    currencies (low interest rate currencies) and the
    demand for currencies (high interest rate
    currencies)
  • Relative rates of inflation.
  • Affects the demand for real (goods) and financial
    assets hence the demand for and supply of
    currencies
  • Relative economic growth rates.
  • Affects longer term investment flows in real
    capital assets (FDI) and financial assets (stocks
    and bonds).
  • Relative political and economic risk.
  • Markets prefer less riskier assets and less risky
    countries.
  • Safe Haven phenomenon.
  • Thailand since coup in 2006 (worse performing
    stock market in Asia).

15
Issues of Floating Currencies
  • Presents the greatest ongoing risk for global
    firms.
  • Why?
  • Since it is difficult to predict changes in
    demand and supply, it then becomes
  • Difficult to predict their long term trends (and
    changes in trends) and shorter term movements.
  • What are the implications of long term trend
    change for global companies?
  • They complicate the longer term FDI location
    decision (impact on costs and revenues in home
    currency).
  • Where should you set up your production
    facilities?
  • International capital budgeting decision.

16
Issues of Floating Currencies
  • Data also show that these currencies are
    potentially very volatile over the short term
    (e.g., day to day basis).
  • These currencies are subject to large percentage
    changes over the short run resulting from demand
    and supply swings.
  • Especially now that governments are staying out
    of the market.
  • Complicates doing business on an ongoing basis
    for
  • Exporters, importers, global asset managers,
    global commercial banks, overseas sales and
    manufacturing subsidiaries.
  • What will be the costs and returns associated
    with different markets and different investments?
  • Thus, global firms need to pay close attention to
    their floating currency exposures and utilize
    appropriate risk management tools.

17
Observed Short Term Volatility of the British
Pound The last 91 days
18
Managed Currencies (Dirty Float)
  • Under this regime, governments manage their
    currency to offset (i.e., counteract) market
    forces.
  • They do this when market demand factors or supply
    factors are seen as creating undesirable exchange
    rate moves.
  • Exchange rate management may occur on
  • a daily basis (e.g., China) or
  • only when governments feel conditions warrant.
  • Management involves either
  • intervention action (buying or selling
    currencies) or
  • interest rate adjustments (to make the currency
    more or less attractive).
  • See Appendix 3 for a discussion of these two
    approaches to managing a currency

19
Who Manages and Why?
  • Today, currency management is likely to be done
    by the developing and emerging countries of the
    world.
  • Recall, the major countries have stopped managing
    their currencies.
  • Why do developing and emerging countries still
    manage?
  • What is the potential issue of weak currency for
    them?
  • Concern of the Government is that the price of
    imported goods will rise may cause (or
    intensify) domestic inflation.
  • What is the potential issue of a strong currency?
  • Concern of Government is that its exports will
    become too costly overseas and they may lose
    overseas market share.
  • In addition, the slow down exports may reduce
    domestic economic growth and result in higher
    unemployment.

20
Managed Currencies
  • Over the long term, managed currencies are
    somewhat risky for global firms, but not as risky
    as floating currencies.
  • Reason since these currency moves are being
    managed their trend moves are generally likely
    to be more gradual than the currencies under
    floating rate regimes.
  • However, these currencies are still subject to
    trend moves and trend changes (similar to
    floating rate currencies).
  • So, global companies need to assess currency
    exposures and risk, over the intermediate term
    and long term.
  • Trend changes will affect their FDI positions and
    longer term export and import situations

21
Managed Currencies
  • Over the short term, these currencies are not
    likely to be as volatile as floating currencies.
  • Reason Government management is aimed at
    countering short term volatility (more so than
    trends or trend changes).
  • Thus daily and weekly changes are not potentially
    as great as with floating rate currencies.
  • Thus, there is some risk here, but not
    potentially as great as with a floating rate
    regime.
  • Potential issue
  • If governments are managing their currencies
    within ranges which markets feel are
    inappropriate, these currencies may come under
    attack.
  • Successful attacks can quickly alter a currencys
    exchange rate.
  • Example British pound was managed in the ERM
    until a speculative attack drove it out in 1992.

22
Observed Short Term Volatility of the Singapore
Dollar The last 91 days
23
Pegged Currency Regimes Ultimate Currency
Management
  • Under a pegged currency regime, governments link
    their national currency to a key international
    currency (usually the U.S. dollar or some
    combination of currencies).
  • Why do governments peg their currencies?
  • A peg is seen as a necessary condition to promote
    confidence in the currency and in the country and
    promoting economic growth.
  • May encourage foreign direct investment and long
    term capital inflows.
  • Hong Kongs rational behind its initial (1983)
    peg.
  • Or by pegging the currency at an undervalued
    currency this may support the countrys export
    sector.
  • Chinas rational for its early peg.
  • However, there are potential costs to governments
    in holding a peg.

24
Potential Costs to Holding a Peg
  • If market forces push a pegged currency above its
    peg (i.e., the currency becomes too strong or
    overvalued) this happens because
  • The market is buying the currency, then
  • Government management involves either selling the
    pegged currency on foreign exchange markets
    (thus, buying hard currency) or reducing domestic
    interest rates.
  • Issues If the government sells its currency this
    created to potential for expansion of its
    domestic money supply and hence inflationary
    pressures.
  • On the other hand, lowering domestic interest
    rates can also stimulate domestic investment and
    economic activity which may lead to inflationary
    pressures.

25
Potential Costs to Holding a Peg
  • If market forces push a pegged currency below its
    peg (i.e., the currency becomes too weak or
    undervalued) this happens because
  • The market is selling the currency, then
  • Government management involves either buying the
    pegged currency on foreign exchange markets
    (thus, selling hard currency or raising domestic
    interest rates.
  • Issues Does the government want to give up its
    hard currency (does it have potentially better
    uses for this (e.g., buying oil or paying off
    international debts)
  • On the other hand, raising domestic interest
    rates can dampen economic activity and lead to
    rising unemployment.
  • Note The last two slides summarize one reason
    (i.e., the costs) why major central banks have
    probably gotten out of the currency management
    business.

26
Pegged Currencies
  • As long as the peg is maintained, this regime
    presents the smallest risk to global firms
    however there is the potential for enormous risk,
    where
  • Governments either (1) abandon the peg for
    another foreign currency regime or (2) adjust to
    a new peg.
  • These changes occur either by
  • An orderly change adopted by the government
    (e.g., China).
  • Peg coming under successful market attack (e.g.,
    Argentina).
  • These changes can have substantial impacts on the
    financial situation (as well as the competitive
    position) of a global firm when they do occur.
  • Especially if the firm did not take advanced
    steps to protect itself.
  • Thus, Global firms must be on the alert for
    changes
  • See Appendix 4 for a discussion of Chinas move
    away from a peg to a managed exchange rate
    regime.

27
Observed Short Term Volatility of the Hong Kong
Dollar The last 91 days
28
Argentina Peso Pegged Currency, 1996 to December
2001
29
Argentina Abandoning the Peg Moving to a
Floating Regime Jan 2002
30
Abandoning a Pegged Rate and the Currency
Weakens RISKS for Global Firms
  • As noted, changes in exchange rate regimes pose
    potential risks for global firms.
  • Using the Argentina example, discuss the
    following
  • What do you think happened to foreign
    multinationals located in and selling in
    Argentina after the peso weakened?
  • For Example McDonalds U.S. dollar profits in
    Argentina?
  • What do you think happened to foreign
    multinationals exporting to Argentina after the
    peso weakened?
  • For example Boeing ability to export airplanes
    to Argentina?

31
Abandoning a Pegged Rate and the Currency
Weakens OPPORTUNITIES for Global Firms
  • However, changes in exchange rate regimes also
    offer potential opportunities for global firms.
  • Again, using the Argentina example
  • What do you think happened to foreign
    multinationals importing from Argentina after the
    peso weakened?
  • For Example Wal-Marts U.S. dollar cost
    associated with importing goods from Argentina?
  • What do you think happened to foreign
    multinationals considering expanding FDI into
    Argentina after the peso weakened?
  • For Example The new U.S. dollar cost to Ford
    Motor Company considering setting up a production
    facility in Argentina?

32
Web Sites for Foreign Exchange Rates
  • Intra-day quotes (and charts)
  • http//www.fxstreet.com/
  • Historical Data (and charts)
  • University of British Columbia
  • http//fx.sauder.ubc.ca/
  • More Historical Data
  • Federal Reserve Board
  • http//www.federalreserve.gov/releases/
  • Daily commentary and analysis
  • http//www.cnb.com/business/international/fxfiles/
    fxarchive/fxarchive.asp

33
Appendix 1 Quoting Currencies
  • Currencies can be quoted in foreign exchange
    markets in one of two ways American terms and
    European terms.
  • The following slides provide examples of both.

34
Foreign Exchange Rate Quotations
  • There are two generally accepted ways of quoting
    a currencys foreign exchange rate.
  • American terms and European Terms quotes
  • American terms quote The amount of U.S. dollars
    per 1 unit of a foreign currency.
  • For Example 1.90 per 1 British pound
  • Or 1.30 per 1 European euro
  • Or 0.78 per 1 Australian dollar

35
Foreign Exchange Rate Quotations
  • European terms quote The amount of a foreign
    currency per 1 U.S. dollar
  • For Example 115 yen per 1 U.S. dollar
  • Or 7.8 Hong Kong dollars per 1 U.S. dollar
  • Or 1.54 Singapore dollars per 1 U.S. dollar
  • Most of the worlds major currencies are quoted
    on the basis of American terms, but the majority
    of the worlds currencies are quoted on the basis
    of European terms.

36
Appendix 2 Intervention in Foreign Exchange
Markets
  • While the worlds major central banks have
    essentially gotten out of the business of foreign
    exchange intervention, some developing and
    emerging country central banks still do. In
    addition, there is nothing preventing the worlds
    major central banks from intervening if they so
    desire.

37
Monitoring FX Intervention
  • Most major central banks provide timely
    information regarding their intervention
    activities in foreign exchange markets.
  • As on example see
  • http//www.ny.frb.org/markets/foreignex.html
  • This site provides a quarterly report on both the
    U.S. dollar and intervention activities on behalf
    of the dollar.
  • Go to archives, July 30, 1998 to view
    intervention activity.

38
Intervention by Major Central Banks
  • Historically, central banks of the major
    countries of the world did use intervention even
    with their floating rate regimes.
  • However, they have done this in the past usually
    only under extreme market forces circumstances.
  • Intervention occurred if a situation produced
    exchange rate volatility which was seen as
    potentially too disruptive to financial market
    stability.
  • For example, U.S. intervened immediately after
    the attempted assassination of President Reagan
    on March 30, 1981.
  • But, interestingly enough, did NOT around the
    9/11/2001 terrorist attack.
  • At the present time, it appears that the major
    countries have gotten out of currency
    intervention.
  • U.S. has been out of the intervention market for
    a long time (only two interventions in the 1990s
    last intervention in 1998) as has the U.K.
  • Japan recently moved away (March 2004).

39
Why Have the Major Central Banks Stopped
Intervening?
  • There are a couple of reasons why this is so
  • (1) The record on central bank intervention with
    regard to the major central banks of the world is
    mixed at best.
  • See next two slides for intervention record since
    1985.
  • (2) Intervention can be costly (see earlier
    lectures slides on this subject).
  • (3) Not intervening is consistent with the
    philosophy of many central bankers today that the
    markets should function without government
    interference or government manipulations and if
    they do, the prices of currencies will be set
    efficiently and correctly.

40
Currency Intervention A Mixed Record
  • Date Players Goal Result
  • Sept 1985 U.S., U.K. Weaken
    Success
  • Japan, France
    falls 18
  • Germany
    within year
  • Feb 1987 G7 Stabilize
    Failure

  • falls 10

  • within year.
  • Sept 1992 UK Maintain
    Failure

  • in ERM out of ERM

  • within days.

41
Currency Intervention A Mixed Record
  • Date Players Goal Result
  • July 1995 Japan, U.S. Halt rising
    Success

  • drops 26

  • within a year.
  • June 1998 Japan, U.S. Strengthen
    Success

  • rises 17

  • within a year.

42
Appendix 2 How Do Governments Manage their
Currencies?
  • Governments (or central banks) using a managed
    exchange rate regime can support their currencies
    through two possible policies (1) direct
    intervention and (2) interest rate adjustments.
    The slides that follow discuss these.
  • Note that when major central banks of the world
    were intervening in foreign exchange markets in
    support of their currencies, they selected from
    the same two policies.

43
Managed Currencies Direct Intervention Policy
  • Intervention policy when a currency becomes too
    weak
  • Government will buy their currency in foreign
    exchange markets
  • Create demand and push price up.
  • Intervention policy when a currency becomes too
    strong
  • Government will sell their currency in foreign
    exchange markets
  • Increase supply to bring price down.

44
Managed Currencies Interest Rate Adjustments
  • Some countries also use interest rate adjustments
    to manage their currencies.
  • When a currency become too weak
  • Governments can raise short term interest rates
    to attract short term foreign capital inflows.
  • Higher interest rates make investments more
    attractive.
  • When a currency becomes too strong
  • Governments can lower short term interest rates
    to discourage short term foreign capital inflows.
  • Lower interest rates will make investments less
    attactive.

45
Empirical Findings on the Use of Intervention by
Emerging/Developing Countries
  • Conclusion from studies Many emerging/developing
    countries still intervene in foreign exchange
    markets to influence currency values.
  • A survey of emerging/developing countries showed
    that
  • One third intervene regularly (more than 50 of
    trading days).
  • Most emerging/developing market central banks
    felt that intervention was more effective in
    influencing the foreign exchange rate over short
    periods of time
  • 2 to three days to one week.

46
Appendix 4 Chinas Old and New Exchange Rate
Regime
  • On July 21, 2005, China surprised the world by
    announcing that they were moving away from a peg
    to the U.S. dollar. The following slides trace
    the peg period, the new exchange rate regime
    (which is a managed float), and the move of the
    yuan since the introduction of the new currency
    regime.

47
Chinas Currency Regime 1978 -2005
  • In late 1978, the Chinese government began moving
    its economy from a centrally planned system to a
    market-based system.
  • As part of this process, in 1994, China's central
    bank pegged (i.e., linked) the Chinese currency,
    the yuan (also known as the renmimbi, or
    "people's money) to the U.S. dollar.
  • In 1994, the peg was set at 8.28 yuan to 1 U.S.
    dollar.

48
China Moves to a Managed Float
  • July 21, 2005, the Chinese government announced
    it was changing to a managed float regime with an
    immediate adjustment of the rate to 8.11 yuan to
    the dollar.
  • This represented an immediate strengthening of
    the yuan, by 2.0 against the U.S. dollar.
  • Chinas currency regime is now a managed float
    against a market basket of currencies (including
    the U.S. dollar, Euro and Japanese yen although
    we dont know all the currencies and their
    weights).
  • Chinese Government now manages the yuan within a
    daily trading range of 0.03 against this basket.
  • The 0.03 range is established each trading day
    based on the previous close.
  • Thus, the yuan is now allowed to gradually move
    in relation to market forces.

49
Chinese Yuan Has Appreciated Since Moving to a
Managed Float
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