1. Dealing with Foreign Exchange Karen Macalinao MBA 105

2. WHAT IS FOREIGN EXCHANGE RATE? foreign exchange rate – the price of one currency in terms of another appreciation – an increase in the value of the currency depreciation – a loss in the value of the currency

3. WHAT DETERMINES FOREIGN EXCHANGE RATES?

4. 1.Relative Price Differences and Purchasing Power Parity (PPP) PPP- “the law of one price” the theory suggests that in the absence of trade barriers (such as tariffs), the price for identical products sold in different countries must be the same. WHAT DETERMINES FOREIGN EXCHANGE RATES

5. 2. Interest rates and money supply * As the supply of a given currency increases while the demand stays the same, the per unit value of that currency goes down. Therefore the exchange rate is highly sensitive to changes in monetary policy. It responds swiftly to changes in money supply.

6. 3. Productivity and Balance of Payments * A rise in a country’s productivity relative to other countries will improve its competitive position in international trade (theories of absolute & comparative advantage) *balance of payments (BOP) – a country’s international transaction statement, which includes merchandise trade, service trade, and capital movement. WHAT DETERMINES FOREIGN EXCHANGE RATES

7. *A BOP deficit means the country imports more goods, service and capital than it exports. (depreciate) *A BOP surplus means the country exports more than it imports. (appreciate)

8. 4. Exchange rate policies 2 major exchange rate policies: 1.Floating (flexible) exchange rate policy is the willingness of a government to let demand & supply conditions determine exchange rate. *clean (or free) float - pure market solution to determine exchange rates *dirty (or managed) float using selective government intervention to determine exchange rates WHAT DETERMINES FOREIGN EXCHANGE RATES

9. Exchange rate policies… *target exchange rates or crawling bands - limited policy of intervention, occurring only when the exchange rate moves out of the specified upper or lower bounds. 2. Fixed exchange rate policy – fixes the exchange rate of its domestic currency relative to other currencies *Peg - stabilizing policy of linking a developing country’s currency to a key currency. WHAT DETERMINES FOREIGN EXCHANGE RATES

10. 5. Investor Psychology * bandwagon effect- the effect of investors moving in the same direction at the same time, like a herd. *capital flight – a phenomenon in which a large number of individuals and companies exchange domestic currency for a foreign currency. WHAT DETERMINES FOREIGN EXCHANGE RATES

11. International monetary system refers to a system that forms rules and standards for facilitating international trade among the nations. It is the global network of the government and financial institutions that determine the exchange rate of different currencies for international trade. Divided in 3 eras: 1.The gold standard 2.The Bretton Woods system 3.The post-Bretton Woods system EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM (IMS)

12. The Gold standard (1870-1914) – A system in which the value of most major currencies was maintained by fixing their prices in terms of gold, which served as the common denominator. EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM (IMS)

13. Bretton Woods system (1944-1973) – A system in which all currencies were pegged at a fixed rate to the US dollar. EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM (IMS)

14. Post–Bretton Woods system (1973-Present) – A system of flexible exchange rate regimes with no official common denominator EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM (IMS)

15. IMF was created in 1945 and is governed by and accountable to its 188 member countries. It strives to ensure the international monetary system's stability. 3 main functions: 1.overseeing the economies of member countries 2. lending to countries with balance of payments issues balance of payments 3.offering technical assistance to its member countries. THE INTERNATIONAL MONETARY FUND (IMF)

16. Foreign exchange market – is where individuals, firms, government, and banks buy and sell currencies of other countries. 2 functions: 1.to service the needs of trade and investment 2.to trade in its own commodity- namely foreign exchange. FOREIGN EXCHANGE TRANSACTIONS

17. Three primary types: 1.Spot transactions – are the classic single-shot exchange of one currency for another. 2.Forward transactions- allow participants to buy and sell currencies now for future delivery. -the primary benefit is to protect traders and investors from being exposed to the unfavorable fluctuations of the spot rate, an act known as currency hedging. FOREIGN EXCHANGE TRANSACTIONS

18. forward discount - forward rate of one currency relative to another currency is higher than the spot rate forward premium - forward rate of one currency relative to another currency is lower than the spot rate. Example: if the forward rate the euro = spot rate (the euro is flat) if the forward rate of the euro/dollar > spot rate (forward discount) if the forward rate of the euro/dollar < spot rate (forward premium) FOREIGN EXCHANGE TRANSACTIONS

19. 3. Currency swap – a foreign exchange transaction between two firms in which one currency is converted into another at Time 1, with an agreement to revert it back to the original currency at a specified Time 2 in the future. *offer rate - price offered to sell a currency * bid rate - price offered to buy a currency * spread - difference between the offered price and the bid price FOREIGN EXCHANGE TRANSACTIONS

20. *currency risks – the potential for loss associated with fluctuations in the foreign exchange market. Three primary strategies: 1.Invoicing in their own currencies 2.Currency hedging 3.Strategic hedging – spreading out activities in a number of countries in different currency zones to offset any currency losses in one region through gains in other regions. STRATEGIES FOR NONFINANCIAL COMPANIES

21. 1.Fostering foreign exchange literacy is a must. 2.Risk analysis of any country must include an analysis of its currency risks. 3.A currency risk management strategy is necessary--- via invoicing in one’s own currency, currency hedging, or strategic hedging. IMPLICATIONS FOR ACTION