The Foreign Exchange Market Discussion Section March 9, 2007 Brian Chen

Agenda Case III due Midterm Chapter 10 Review Video: “China: Changing the Yuan/Dollar” Discussion about currency pegging

Midterm Grades Mean: 83 St Dev: th: th: 91 50th: 86 25th: 80

Common Problems 1. Not reading the question correctly / not answering the question  Name two issues that fuel the debate on globalization ≠List the cost and benefits of globalization  Administrative trade policies are a specific type of trade policy, and do not include subsidies, quotas, tariffs, etc. 2. Not explaining your answer, not providing examples where appropriate

Chapter 10 Review Two major functions of the FOREX market  Currency conversion  Insuring against currency risk Forward exchange  Contract to purchase a currency at an agreed upon rate in the future, usually 30, 60, 90 or 180 days in the future Swaps  Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates  Example:  Investopedia: For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange.

Exchange Rate Determination Purchasing power parity (PPP)  theory which states that exchange rates between currencies are in equilibrium when their purchasing power is the same in each of the two countries. This means that the exchange rate between two countries should equal the ratio of the two countries' price level of a fixed basket of goods and services. When a country's domestic price level is increasing (i.e., a country experiences inflation), that country's exchange rate must depreciated in order to return to PPP. Law of One Price  The basis for PPP is the "law of one price". In the absence of transportation and other transaction costs, competitive markets will equalize the price of an identical good in two countries when the prices are expressed in the same currency.  Arbitrage equalizes the prices (absent transaction costs) Money Supply and Inflation

FOREX: Implication for International Managers Know the differences between transaction/translation/economic exposure How to manage transaction/translation exposure?  Lead strategy  Lag strategy How to reduce economic exposure?  This goes beyond mere financial arrangements Other steps  Central control; good reporting system; importance of forecasting

Video “China: Changing the Yuan/Dollar”

Why did China peg its currency to the dollar? Stability of currency value Encourage exports

What were the costs to China of pegging its currency to the USD? Loss of some control over the value of its currency Government intervention to buy USD to sustain the peg Reduction in the purchasing power of Chinese consumers in the world market

What were the costs to the US of China ’ s currency peg? High trade deficit US largest debtor nation; China a substantial creditor nation

How is China affected by its decision to change the peg to a dirty float? - Surrender some control over the exchange rate - China yuan will likely appreciate in value - Chinese products will become more expensive in the world market - Chinese consumers will have more purchasing power in the world market - China will be under less pressure to buy large quantities of the USD in order to maintain the low value of its currency relative to the USD

How is the U.S. affected by China ’ s decision to change the peg to a dirty float? - Reduction in trade deficit - Currency vacillation may reduce trade - Possibly higher prices for products that are made in China (if Chinese manufacturers do not adjust their productivity)

Discussion Question Should China float the Yuan?

Discussion Questions 2 You are: A - A Chinese clothing manufacturer who exports worldwide; B - A Hong Kong clothing manufacturer who exports worldwide; C - A US clothing distributor who sells worldwide and who obtains ½ of its stock from Chinese manufacturers - What would you do to prepare yourself for future changes in China’s exchange rate regime? (Assume that the HKD is expected to remain pegged to the USD)