© 2001 Prentice Hall10-1 International Business by Daniels and Radebaugh Chapter 10 The Determination of Exchange Rates

© 2001 Prentice Hall10-2 Objectives To describe the International Monetary Fund and its role in the determination of exchange rates To discuss the major exchange-rate arrangements countries use To identify the major determinants of exchange rates in the spot and forward markets To show how managers try to forecast exchange-rate movements using factors such as balance-of-payments statistics To explain how exchange-rate movements influence business decisions

© 2001 Prentice Hall10-3 International Monetary Fund (IMF) Promotes international monetary cooperation Facilitates expansion and balanced growth of trade Promotes exchange-rate stability Establishes a multilateral system of payments Makes resources available to members experiencing balance-of- payments difficulties IMF Quotas—each member’s monetary contribution Based on national income, monetary reserves, trade balance, and other economic indicators Pool of money that can be loaned to members Basis for how much a country can borrow Determines voting rights of members Board of Governors—IMF’s highest authority One representative from each member country Board of Executive Directors—24 persons –handles day-to-day operations

© 2001 Prentice Hall10-4 IMF Assistance Provides assistance to member countries Intended to ease balance-of-payment difficulties Recipient country must adopt policies to stabilize its economy Special Drawing Rights (SDRs) An international reserve asset Used to supplement members’ existing reserves Serves as the IMF’s unit of account –unit in which the IMF keeps its records –used for IMF transactions Based on the weighted average of five currencies Evolution to Floating Exchange Rate Bretton Woods Agreement established par values Jamaica Agreement—formalized break from fixed exchange rates Accommodated floating exchange rates

© 2001 Prentice Hall10-5 Exchange-Rate Arrangements IMF permitted countries to select and maintain an exchange-rate arrangement of their choice IMF surveillance and consultation programs –designed to monitor exchange-rate policies –determine whether countries were acting openly and responsibly in exchange-rate policy From pegged to floating currencies Broad IMF categories for exchange-rate regimes –peg exchange rate to another currency or basket of currencies with only a maximum 1% fluctuation in value –peg exchange rate to another currency or basket of currencies with a maximum of 2 ¼% fluctuation –allow the currency to float in value against other currencies Countries may change their exchange-rate regime

© 2001 Prentice Hall10-6 Regimes Exchange arrangements with no separate legal tender Currency board arrangements Other conventional fixed peg arrangements Pegged exchange rates within horizontal bands Crawling pegs Exchange rates within crawling bands Managed floating with no pronounced path for exchange rate Independently floating Number Of Countries Total = 185 Exchange-Rate Regimes Second Quarter 1999

© 2001 Prentice Hall10-7 Exchange-Rate Arrangements (cont.) Black markets—exists when people are willing to pay more for dollars than the official rate Closely approximate a price based on supply and demand for a currency instead of a government-controlled price The less flexible a country’s exchange-rate arrangements, the more there will be a thriving black market Role of central banks—responsible for the policies affecting the value of a country’s currency Federal Reserve Bank of New York is the central bank in the U.S. –sells dollars to counter upward pressure on the dollar –purchases dollars to counter downward pressure The primary contact with foreign central banks

© 2001 Prentice Hall10-8 Exchange-Rate Arrangements (cont.) Role of central banks (cont.) Reserve assets kept in three major forms: gold, foreign exchange, and IMF-related assets –mix of reserve assets varies across countries –intervention countries—currencies in which a country trades the most »affects mix of currencies in reserve assets Based on market conditions, a central bank may: –coordinate actions with other central banks –take aggressive market position to change attitudes –call for reassuring action to calm markets –intervene to reverse, resist, or support market trend –act visibly or discreetly –operate openly or indirectly with brokers

© 2001 Prentice Hall10-9 Exchange-Rate Arrangements (cont.) Role of central banks (cont.) Governments vary in their intervention policies –policies affected by government administration Government intervention can occur on bilateral or multilateral basis Bank for International Settlements (BIS) –owned by central banks –purpose is to promote cooperation between central banks to facilitate international financial stability –acts as a central banker’s bank –involved in currency transactions among central banks

© 2001 Prentice Hall10-10 Determination of Exchange Rates Floating rate regimes—allow changes in the exchange rates between two currencies to occur for currencies to reach a new exchange-rate equilibrium Currencies that float freely respond to supply and demand conditions No government intervention to influence the price of the currency Managed fixed-rate regime—government buys and sells its currency in the open market as a means of influencing the currency’s price Central banks holds foreign-exchange reserves –can sell these reserves to affect exchange rates for the currency Governments use fiscal or monetary policy to influence the demand for their currencies Countries may revalue or devalue their currencies if economic policies and intervention do not work

© 2001 Prentice Hall10-11 Quantity of yen Q1Q1 Exchange rate (U.S. dollars/yen) e1e1 e0e0 S’ S D’ D Equilibrium exchange rate moves from e 0 to e 1 Equilibrium Exchange Rate

© 2001 Prentice Hall10-12 Equilibrium Exchange Rate Quantity of yen Exchange rate (U.S. dollars/yen) S D Managed fixed rate system S’ D’ e1e1 Q1Q1 Q3Q3 e0e0 N.Y. Federal Reserve Bank sells yen reserves

© 2001 Prentice Hall10-13 Determination of Exchange Rates (cont.) Automatic fixed rate regime—adjustment of exchange rates is based on changes in the domestic money supply rather than government intervention Foreign-exchange markets have greater impact than domestic markets on exchange rates of freely floating currencies Not as widely used as other systems that influence exchange rates Currency boards operate in this system

© 2001 Prentice Hall10-14 Determination of Exchange Rates (cont.) Purchasing-power parity (PPP)—changes in relative inflation between two countries must cause a change in exchange rates If domestic inflation rate is lower than that in the foreign country, the domestic currency should be stronger than the foreign currency Formula to relate inflation to exchange-rate changes Anticipated future exchange rate

© 2001 Prentice Hall10-15 Determination of Exchange Rates (cont.) Interest rates—influence exchange rates Fisher Effect—links inflation and interest rates –nominal interest rate in a country is the real interest rate plus inflation –because the real interest rate should be the same in every country, the country with the higher interest rate should have higher inflation –International Fisher Effect (IFE)—links interest rates and exchange rates –the interest-rate differential is a predictor of future changes in the spot exchange rate »interest-rate differential based on differences in interest rates –currency of the country with the lower interest rate will strengthen in the future

© 2001 Prentice Hall10-16 Determination of Exchange Rates (cont.) Other factors affecting exchange rate movements Confidence—safe currencies considered attractive in times of turmoil Technical factors –release of national statistics –seasonal demands for a currency –slight strengthening of a currency following a prolonged weakness

© 2001 Prentice Hall10-17 Forecasting Exchange-Rate Movements Managers should be concerned with the timing, magnitude, and direction of an exchange-rate movement Prediction is not a precise science Fundamental forecasting—uses trends in economic variables to predict future rates Use econometric model or more subjective bases Technical forecasting—uses past trends in exchange rates to spot future trends in the rates Assumes that if current exchange rates reflect all facts in the market, then under similar circumstances future rates will follow the same patterns Good treasurers and bankers develop their own forecasts Use fundamental and technical forecasts for corroboration

© 2001 Prentice Hall10-18 Forecasting Exchange-Rate Movements (cont.) Factors to monitor—managers can monitor factors used by governments to manage their currencies Institutional setting Fundamental analysis Confidence factors Events Technical analysis Business Implications of Exchange-Rate Changes Marketing decisions—exchange rates affect demand for a company’s products at home and abroad Production decisions—choice of location for production facilities depends on strength of currency Financial decisions—exchange rates influence the sourcing of financial resources, the cross-border remittance of funds, and the reporting of financial results