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
• 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 utilized by any country
  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.

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
• Affect the profit structure of global firms
• Overseas subsidiaries, exporters, and importers.
• In short affect the financial performance of a
  global firm.

5
Foreign Exchange Rate Quotations

• There are two generally accepted ways of quoting
  a currencys foreign exchange rate.
• American terms quote The amount of U.S. dollars
  per 1 unit of a foreign currency.
• For Example 1.90 per 1 British pound
• European terms quote The amount of a foreign
  currency per 1 U.S. dollar
• For Example 115 yen 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.

6
Exchange Rate Regimes Today

• Current exchange rate regimes fall along a
  spectrum as represented by national government
  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
7
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
Pegged Rate
Floating Rates
8
Classification of Exchange Rate Regimes

• Floating Currency Regime
• No (or minimal) government involvement in foreign
  exchange markets
• Market forces i.e., demand and supply
  determine foreign exchange rate (price).
• 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).

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.
• Note As we will see, the distinction between
  these three categories is sometimes difficult to
  distinguish.

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 The distinction between float, managed and
  pegged is often difficult to see. Chinese yuan
  can float no more than 0.03 per day.
• For currency symbols see http//www.xe.com/symbol
  s.htmlist

11
Floating Currencies

• Private market forces determine these exchange
  rates.
• Financial institutions (global banks, investment
  firms), multinational firms, speculators (hedge
  funds), exporters, importers, etc.
• Market forces originate from two possible
  sources
• Real factors
• Demand and supply for currencies by global
  businesses relating to their global commercial
  activities.
• Investment/Speculation
• Entities involved on their own behalf taking
  positions with and against currencies Hedge
  funds, commercial banks

12
Floating Currencies

• Governments using floating rate regimes
  historically intervened under extreme market
  forces circumstances.
• Essentially intervention is buying or selling
  currency on fx markets.
• Occurred if a situation produced exchange rate
  volatility which was seen as too disruptive to
  financial market stability.
• For example, U.S. intervened immediately after
  the attempted assassination of President Reagan
  on March 30, 1981.
• But did NOT around the 9/11/2001 terrorist
  attack.
• 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).
• Why? Historical record on intervention by major
  central banks is mixed and long term intervention
  is seen as very costly.

13
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.

14
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.

15
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.

16
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
  

17
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

18
Factors Increasing the Demand for a Currency
and/or Decreasing the Supply of Dollars

• What do you think these might be?
• Increase demand for U.S. dollars (Hint comes
  from foreign sources)
• Decrease supply for U.S. dollars (Hint results
  from U.S. sources)

19
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

20
Factors Decreasing the Demand for a Currency
and/or Increasing the Supply of U.S. Dollars

• What do you think these might be?
• Decrease demand for U.S. dollars (Hint comes
  from foreign sources).
• Increase supply for U.S. dollars (Hint results
  from U.S. sources)

21
Factors That Affect the Equilibrium Exchange
Rate Floating Rate Regime

• Relative rates of (short-term) interest.
• Affects the demand for financial assets.
• Relative rates of inflation.
• Affects the demand for real assets.
• Relative economic growth rates.
• Affects longer term investment flows in real
  assets and financial assets (stocks and bonds).
• Relative political and economic risk.
• Markets prefer less riskier assets.

22
Whats What in Japans Financial System, 1988
Explaining the Exchange Rate
23
Issues of Floating Currencies

• Present the greatest ongoing risk for global
  firms.
• Why?
• Difficult to predict their long term trends (and
  changes in trends) and shorter term movements.
• Difficult to predict changes in demand and
  supply.
• Long term trend change implications
• This complicates 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.

24
Trend Changes Pound Against the U.S. Dollar,
January 1997 to August 2006

• 1999-2002 -12 2002 2005 31

25
Discussion Slide

• Look at the previous slide and offer explanations
  as to why the pound
• Weakened from 1999 to 2000
• Strengthened from 2000 to 2004
• Note Use demand and supply model developed
  earlier in this lecture.

26
Issues of Floating Currencies

• Data also show that these currencies are
  potentially very volatile over the short term
  (e.g., day to day basis).
• Subject to large percentage changes 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, overseas subsidiaries.
• What will be the costs and returns associated
  with different markets?
• Thus, global firms need to pay close attention to
  their floating currency exposures and utilize
  appropriate risk management tools.

27
Observed Short Term Volatility of the Pound The
last 91 days
28
Managed Currencies (Dirty Float)

• Governments intervening in foreign exchange
  markets to manage their currency to offset (or
  moderate) market forces.
• When demand factors or supply factors are seen as
  creating undesirable exchange rate moves.
• Affect a countrys trade balance, rate of
  inflation, etc.
• Management may occur on a daily basis or only
  when governments feel conditions warrant their
  intervention.
• Intervention commonly referred to as currency
  support policies.
• These interventions are likely to be used by
  emerging countries.

29
Managed Currencies

• Why do some emerging country governments manage
  their currencies?
• Issue of Weak Currency
• Concern of Government Price of imported goods
  will rise may cause domestic inflation.
• Issue of a Strong Currency
• Concern of Government Exports will become too
  costly overseas a country will lose overseas
  markets slow down exports and reduce economic
  growth (higher unemployment).

30
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.

31
Empirical Findings of Intervention by
Emerging/Developing Countries

• Conclusion 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 central banks felt that intervention was
  more effective in influencing the fx rate over
  short periods of time
• 2 to three days to one week.

32
Managed Currencies Interest Rate Adjustments

• Some countries also use interest rate adjustments
  to manage their currencies.
• When a currency become too weak
• Governments will raise short term interest rates
  to attract short term foreign capital inflows.
• When a currency becomes too strong
• Governments will lower short term interest rates
  to discourage short term foreign capital inflows.
• What is the potential problem with this policy?

33
Managed Currencies

• Long term, somewhat risky for global firms
• But not as risky as floating currencies.
• These currencies are subject to trend moves and
  trend changes (similar to floating rate
  currencies).
• But since these moves are being managed they
  are generally likely to be more gradual.
• Still, global companies need to assess exposure
  and risk, over the intermediate term and long
  term.
• Trend changes will affect their FDI positions and
  longer term export and import situations

34
Longer term Trend Changes in the Singapore dollar
(Inverted Scale)

• 1999 - 2002 - 9 2002-2006 12

35
Managed Currencies

• Over the short term, these currencies are not
  likely to be as volatile as floating currencies.
• Reason Government management tends to moderate
  short term volatility.
• 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.
• See next lecture slide series for currency
  attacks.

36
Observed Short Term Volatility of the Singapore
dollar The last 91 days
37
Pegged Currencies Ultimate Currency Management

• Governments link their national currency to a key
  international currency (usually the dollar or
  some combination of currencies).
• Why?
• Seen as a necessary condition to promote
  confidence in the currency and in the country.
• May encourage foreign direct investment.
• Seen as important to promoting economic growth.
• Through supporting the countrys export sector
  setting an undervalued currency.

38
Pegged Currencies

• Governments maintain pegs through very tight
  financial market controls, such as
• Controlling who participates in the currency
  market
• Using licenses
• Controlling the type of exchange transactions
  allowed.
• Not allowing speculative transactions.
• Only allowing real factor transactions
• Restricting capital account transactions.
• Capital outflows and inflows
• Restricting the daily change in the exchange rate
• Ongoing intervention in foreign exchange markets
  to maintain peg.

39
Pegged Currencies

• Smallest daily risk to global firms.
• But firms must be on the alert for potential
  changes!
• Countries can either (1) abandon the peg or (2)
  adjust the peg.
• These changes do occur either by
• Governments orderly change in the peg.
• Peg coming under successful market attack.
• Peg changes can have a substantial impact on the
  financial situation for the global firm when they
  do occur.
• Especially if the firm did not take advanced
  steps to protect itself.

40
Saudi Arabian Riyal, 1999 - Present
41
Observed Short Term Volatility of the Riyal The
last 91 days
42
Argentina Peso Pegged Currency, 1996 to December
2001
43
Argentina Abandoning the Peg Moving to a
Floating Regime Jan 2002
44
Abandoning a Pegged Rate and the Currency
Weakens RISKS for Global Firms

• As noted, these changes in exchange rate regimes
  pose potential risks for global firms.
• What do you think happened to foreign
  multinationals located in and selling in
  Argentina after the peso weakened?
• For Example McDonalds profits in Argentina?
• What do you think happened to foreign
  multinationals exporting to Argentina after the
  peso weakened?
• For example Boeing exporting airplanes to
  Argentina?

45
Abandoning a Pegged Rate and the Currency
Weakens OPPORTUNITIES for Global Firms

• Changes in exchange rate regimes also offer
  potential opportunities for global firms.
• What do you think happened to foreign
  multinationals importing from Argentina after the
  peso weakened?
• For Example Wal-Mart importing goods from
  Argentina?
• What do you think happened to foreign
  multinationals considering expanding FDI into
  Argentina after the peso weakened?
• For Example The cost for Ford setting up a
  production facility in Argentina?

46
Chinas Currency Regime 1978 -2005

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

47
China Moves to a Managed Float

• July 21, 2005, government announced it was moving
  to a managed float with an immediate adjustment
  of the rate to 8.11
• Represented a strengthening of the currency, by
  2.0 against the U.S. dollar.
• Regime is now a managed float against a market
  basket of currencies (including the U.S. dollar,
  Euro and Japanese yen).
• Government will manage 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.

48
Chinese Yuan Before And After Regime Change
49
Longest Running Peg Hong Kong Dollar October
1983 Present _at_ HKD7.8/USD
50
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