INTERNATIONAL FINANCIAL MARKET & INTERNATIONAL MONETARY SYSTEM

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INTERNATIONAL FINANCIAL MARKET INTERNATIONAL
MONETARY SYSTEM
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Introduction

• Fundamental difference between payment
  transactions
• Domestic transactionuse only one curency
• Foreign transactionuse two or more currencies
• Foreign exchange money denominated in the
  currency of another group of nations
• Exchange rateprice of a currency
• Number of units of one currency that buys one
  unit of another currency
• Exchange rate can change daily

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• International financial market comprise of
• International Capital Market
• Obtaining external financing.
• Main purpose is to provide a mechanism through
  which those who wish to borrow or invest money
  can do so efficiently.
• Foreign-Exchange Marketmade up of
• over-the-counter (OTC)
• commercial and investment banks
• majority of foreign-exchange activity
• security exchanges
• trade certain types of foreign-exchange
  instruments

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Essential Terms

• Security - a contract that can be assigned a
  value and traded (stocks, bonds, derivatives and
  other financial assets)
• Stocks A instrument representing ownership
• Bonds - a debt agreement
• Derivatives - the rights to ownership (financial
  instruments futures, forwards, options, swaps)

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Essential Terms II

• Stock exchange, share market or bourse - is a
  corporation or mutual organization which provides
  facilities for stock brokers and traders, to
  trade company stocks and other securities
• Over-the-counter (OTC) trading - is to trade
  financial instruments such as stocks, bonds,
  commodities or derivatives directly between two
  parties. It is contrasted with exchange trading,
  which occurs via corporate-owned facilities
  constructed for the purpose of trading (i.e.,
  exchanges), such as futures exchanges or stock
  exchanges.

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Capital Market

• System that allocates financial resources
  according
• to their most efficient uses
• Common capital market intermediaries
• Commercial Banks
• Investment Banks

• Debt Repay principal plus interest
• Bond has timed principal interest payments
• Equity Part ownership of a company
• Stock shares in financial gains or losses

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International Capital Market (ICM)
Network of people, firms, financial institutions
and governments borrowing and investing
internationally
Purposes

• Borrowers
• Expands money supply
• Reduces cost of money

• Lenders
• Spread / reduce risk
• Offset gains / losses

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International CapitalMarket Drivers
Information technology
Deregulation
Financial instruments (securitization)
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World Financial Centers

• At present, the three main financial centers are
  London, New York and Tokyo
• London is one of the three leading world
  financial centres. It is famous for its banks and
  Europe's largest stock exchange, that have been
  established over hundreds of years (e.g. Lloyd's
  of London, London Stock Exchange). The financial
  market of London is also commonly referred to as
  the City. It has historically been situated
  around the part of London called Square Mile, but
  in the 1980's and 1990's a large part of the City
  of London's wholesale financial services
  relocated to Canary Wharf.

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Offshore Financial Centers
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IMF defines OFC as

• Jurisdictions that have relatively large numbers
  of financial institutions engaged primarily in
  business with non-residents
• Financial systems with external assets and
  liabilities out of proportion to domestic
  financial intermediation designed to finance
  domestic economies and
• More popularly, centers which provide some or all
  of the following services low or zero taxation
  moderate or light financial regulation banking
  secrecy and anonymity.

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Main Components of ICM International Bond Market
Market of bonds sold by issuing companies,
governments and others outside their own countries
Bond that is issued outside the country in whose
currency the bond is denominated
Bond sold outside a borrowers country and
denominated in the currency of the country in
which it is sold
Driving growth are differential interest rates
between developed and developing nations
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International Equity Market
Market of stocks bought and sold outside the
issuers home country

• Factors contributing towards growth
• Spread of Privatization
• Economic Growth in Developing Countries
• Activities of Investment Banks
• Advent of Cybermarkets

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Eurocurrency Market
Unregulated market of currencies banked outside
their countries of origin

• Governments
• Commercial banks
• International companies
• Wealthy individuals

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Introduction
Foreign Exchange Market

• Foreign exchange market a market for converting
  the currency of one country into the currency of
  another.
• Exchange rate the rate at which one currency is
  converted into another
• Foreign exchange risk the risk that arises from
  changes in exchange rates

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Foreign Exchange Market
Market in which currencies are bought and
sold and their prices are determined

• Conversion To facilitate sale or purchase, or
  invest directly abroad
• Hedging Insure against potential losses from
  adverse exchange-rate changes
• Arbitrage Instantaneous purchase and sale of a
  currency in different markets for profit
• Speculation Sequential purchase and sale (or
  vice-versa) of a currency for profit

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The Functions of the Foreign Exchange Market

• The foreign exchange market serves two main
  functions
• Convert the currency of one country into the
  currency of another
• Provide some insurance against foreign exchange
  risk
• Foreign exchange risk the adverse consequences
  of unpredictable changes in the exchange rates

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Currency Conversion

• Consumers can compare the relative prices of
  goods and services in different countries using
  exchange rates
• International business have four main uses of
  foreign exchange markets

• To invest excess cash for short terms in foreign
  markets
• To profit from the short-term movement of funds
  from one currency to another in the hopes of
  profiting from shifts in exchange rates, also
  called currency speculation

• To exchange currency received in the course of
  doing business abroad back into the currency of
  its home country
• To pay a foreign company for its products or
  services in its countrys currency

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Insuring against Foreign Exchange Risk

• A spot exchange occurs when two parties agree to
  exchange currency and execute the deal
  immediately
• The spot exchange rate is the rate at which a
  foreign exchange dealer converts one currency
  into another currency on a particular day
• Reported daily
• Change continually

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Insuring against Foreign Exchange Risk

• Forward exchanges occur when two parties agree to
  exchange currency and execute the deal at some
  specific date in the future
• Exchange rates governing such future transactions
  are referred to as forward exchange rates
• For most major currencies, forward exchange rates
  are quoted for 30 days, 90 days, and 180 days
  into the future
• When a firm enters into a forward exchange
  contract, it is taking out insurance against the
  possibility that future exchange rate movements
  will make a transaction unprofitable by the time
  that transaction has been executed

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Insuring against Foreign Exchange Risk

• Currency swap the simultaneous purchase and sale
  of a given amount of foreign exchange for two
  different value dates
• Swaps are transacted between international
  businesses and their banks, between banks, and
  between governments when it is desirable to move
  out of one currency into another for a limited
  period without incurring foreign exchange risk

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The Nature of the Foreign Exchange Market

• The foreign exchange market is a global network
  of banks, brokers and foreign exchange dealers
  connected by electronic communications systems
• The most important trading centers include
  London, New York, Tokyo, and Singapore
• Londons dominance is explained by
• History (capital of the first major
  industrialized nation)
• Geography (between Tokyo/Singapore and New York)
• Two major features of the foreign exchange
  market
• The market never sleeps
• Market is highly integrated

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Institutions of Foreign Exchange Market

• Interbank Market market in which the worlds
  largest banks exchange currencies at spot and
  forward rates.
• Clearing mechanism
• Securities Exchanges exchange specializing in
  currency futures and options transactions.
• Over-the-Counter Market Exchange consisting of a
  global computer network of foreign exchange
  traders and other market participants.

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• The Foreign-Exchange Market
• Size of foreign-exchange market
• 600 billion spot
• 1.3 trillion in derivatives, ie
• 200 billion in outright forwards
• 1 trillion in forex swaps
• 100 billion in FX options. (2004)
• U.S. dollar is the most important currency
  because it is
• An investment currency in many capital markets
• A reserve currency held by many central banks
• A transaction currency in many international
  commodity markets
• An invoice currency in many contracts
• An intervention currency employed by monetary
  authorities to influence their exchange rates

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Trends in Foreign-Exchange Trading
9-7
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Quoting Currencies
Quoted currency numerator Base currency
denominator
(/) Japanese yen needed to buy one U.S. dollar
Yen is quoted currency, dollar is base currency
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Currency Values
Change in US dollar against Polish zloty
February 1 PLZ 5/ March 1 PLZ
4/ change (4-5)/5 x 100 -20 US dollar
fell 20
Change in Polish zloty against US dollar Make
zloty base currency (1 PLZ/)
February 1 .20/PLZ March 1
.25/PLZ change (.25-.20)/.20 x 100
25 Polish zloty rose 25
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Cross Rate

• Exchange rate calculated using two other exchange
  rates
• Use direct or indirect exchange rates against a
  third currency

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Cross Rate Example

• Direct quote method
• Quote on euro 0.8461/
• Quote on yen 114.50/
• 0.8461/ 114.50/ 0.0074/
• Costs 0.0074 euros to buy 1 yen

• Indirect quote method
• Quote on euro 1.1819/
• Quote on yen 0.008734/
• 1.1819/ 0.008734/ 135.32/
• Final step 1 135.32/ 0.0074/
• Costs 0.0074 euros to buy 1 yen

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Currency Convertibility

• Governments can place restrictions on the
  convertibility of currency
• A countrys currency is said to be freely
  convertible when the countrys government allows
  both residents and nonresidents to purchase
  unlimited amounts of a foreign currency with it
• A currency is said to be externally convertible
  when only nonresidents may convert it into a
  foreign currency without any limitations
• A currency is nonconvertible when neither
  residents nor nonresidents are allowed to convert
  it into a foreign currency

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• Government restrictions can include
• A restriction on residents ability to convert
  the domestic currency into a foreign currency
• Restricting domestic businesses ability to take
  foreign currency out of the country
• Governments will limit or restrict convertibility
  for a number of reasons that include
• Preserving foreign exchange reserves
• A fear that free convertibility will lead to a
  run on their foreign exchange reserves known as
  capital flight

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• Governmental Restrictions on Foreign-Exchange
  Convertibility
• Restrictions used to conserve scarce foreign
  exchange
• Licensinggovernment regulates all
  foreign-exchange transactions
• those who receive foreign currency required to
  sell it to its central bank at the official
  buying rate
• central bank rations foreign currency
• Multiple exchange-rate systemdifferent exchange
  rates set for different transactions
• Advance import depositrequires importers to make
  a deposit with central bank covering price of
  goods they would purchase from abroad
• Quantity controlslimit the amount of currency
  that resident can purchase for foreign travel
• Currency controls increase the cost of
  international business and reduce overall
  international trade

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• How Companies Use Foreign Exchange
• Most foreign-exchange transactions involve
  international departments of commercial banks
• Banks buy and sell foreign currency banks
  collect and pay money in transaction with foreign
  buyers and sellers
• Banks lend money in foreign currency
• Companies use foreign-exchange market for
• Import and export transactions
• Financial transactions such as FDI
• Arbitragepurchase of foreign currency on one
  market for immediate resale on another market
• Arbitragers hope to profit from price discrepancy
• Interest arbitrageinvesting in debt instruments
  in different countries
• Speculationbuying or selling foreign currency
  has both risk and high profit potential

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• Foreign-Exchange Trading Process
• Companies work through their local banks to
  settle foreign-exchange balances
• Commercial banks in major money centers became
  intermediaries for small banks
• Most foreign-exchange activity takes place in
  traditional instruments
• Commercial and investment banks and other
  financial institutions handle spot, outright
  forward, and FX swaps
• Foreign-exchange market made up of about 2,000
  dealer institutions worldwide
• Most foreign-exchange takes place in OTC market
• Dealers can trade foreign exchange
• Directly with other dealers
• Through voice brokers
• Through electronic brokerage systems
• Internet trades of currency are more popular

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• Commercial and Investment Banks
• Greatest volume of foreign-exchange activity
  takes place with the big banks
• Top banks in the interbank market in foreign
  exchange are so ranked because of their ability
  to
• trade in specific market locations
• engage in major currencies and cross-trades
• deal in specific currencies
• handle derivatives
• forwards, options, future swaps
• conduct key market research
• Banks may specialize in geographic areas,
  instruments, or currencies
• exotic currencycurrency of a developing country
• often unstable, weak, and unpredictable

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Top 10 Currency Traders ( of overall volume,
May 2005 )
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International Monetary System

• Rules and procedures by which different national
  currencies are exchanged for each other in world
  trade.
• Such a system is necessary to define a common
  standard of value for the world's currencies.
• Refer to the institutional arrangements that
  countries adopt to govern exchange rates
• Floating
• Pegged exchange rate
• Dirty float
• Fixed exchange rate

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• Floating exchange rates occur when the foreign
  exchange market determines the relative value of
  a currency
• The worlds four major currencies dollar, euro,
  yen, and pound are all free to float against
  each other
• Pegged exchange rates occur when the value of a
  currency is fixed relative to a reference
  currency

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• Dirty float occurs when countries hold the value
  of their currency within a range of a reference
  currency
• Fixed exchange rate occurs when a set of
  currencies are fixed against each other at some
  mutually agreed upon exchange rate
• Pegged exchange rates, dirty floats and fixed
  exchange rates all require some degree of
  government intervention

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Evolution of International Monetary System

• The Gold Standard
• In place from 1700s to 1939
• a monetary standard that pegs currencies to gold
  and guarantees convertibility to gold
• It was thought that gold standard contained an
  automatic mechanism that contributed to the
  simultaneous achievement of a balance-of-payments
  equilibrium by all countries.
• The gold standard broke down during the 1930s as
  countries engaged in competitive devaluations

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The Gold Standard

• Roots in old mercantile trade
• Inconvenient to ship gold, changed to paper-
  redeemable for gold
• Want to achieve balance-of-trade equilibrium

Trade
USA
Japan

Gold
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Balance of Trade Equilibrium
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Between the Wars

• Post WWI, war heavy expenditures affected the
  value of dollars against gold
• US raised dollars to gold from 20.67 to 35 per
  ounce
• Dollar worth less?
• Other countries followed suit and devalued their
  currencies

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Bretton Woods

• In 1944, 44 countries met in New Hampshire
• Countries agreed to peg their currencies to US
  which was convertible to gold at 35/oz
• Agreed not to engage in competitive devaluations
  for trade purposes and defend their currencies
• Weak currencies could be devalued up to 10 w/o
  approval
• Created the IMF and World Bank

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International Monetary Fund

• The International Monetary Fund (IMF) Articles of
  Agreement were heavily influenced by the
  worldwide financial collapse, competitive
  devaluations, trade wars, high unemployment,
  hyperinflation in Germany and elsewhere, and
  general economic disintegration that occurred
  between the two world wars
• The aim of the IMF was to try to avoid a
  repetition of that chaos through a combination of
  discipline and flexibility

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International Monetary Fund

• Discipline
• Maintaining a fixed exchange rate imposes
  monetary discipline, curtails inflation
• Brake on competitive devaluations and stability
  to the world trade environment
• Flexibility
• Lending facility
• Lend foreign currencies to countries having
  balance-of-payments problems
• Adjustable parities
• Allow countries to devalue currencies more than
  10 if balance of payments was in fundamental
  disequilibrium

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Purposes of IMF

• Promoting international monetary cooperation
• Facilitating expansion and balanced growth of
  international trade
• Promoting exchange stability, maintaining orderly
  exchange arrangements, and avoiding competitive
  exchange devaluation
• Making the resources of the Fund temporarily
  available to members
• Shortening the duration and lessening the degree
  of disequilibrium in the international balance of
  payments of member nations

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To serve these purposes, the IMF

• monitors economic and financial developments and
  policies, in member countries and at the global
  level, and gives policy advice to its members
  based on its more than fifty years of experience.
  
• For example In its annual review of the Japanese
  economy for 2003, the IMF Executive Board urged
  Japan to adopt a comprehensive approach to
  revitalize the corporate and financial sectors of
  its economy, tackle deflation, and address fiscal
  imbalances.

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• The IMF commended Mexico in 2003 for good
  economic management, but said structural reform
  of the tax system, energy sector, the labor
  market, and judicial system was needed to help
  the country compete in the global economy.
• In its Spring 2004 World Economic Outlook, the
  IMF said an orderly resolution of global
  imbalances, notably the large U.S. current
  account deficit and surpluses elsewhere, was
  needed as the global economy recovered and moved
  toward higher interest rates.

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• lends to member countries with balance of
  payments problems, not just to provide temporary
  financing but to support adjustment and reform
  policies aimed at correcting the underlying
  problems.
• For example During the 1997-98 Asian financial
  crisis, the IMF acted swiftly to help Korea
  bolster its reserves. It pledged 21 billion to
  assist Korea to reform its economy, restructure
  its financial and corporate sectors, and recover
  from recession. Within four years, Korea had
  recovered sufficiently to repay the loans and, at
  the same time, rebuild its reserves.

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• In October 2000, the IMF approved an additional
  52 million loan for Kenya to help it cope with
  the effects of a severe drought, as part of a
  three-year 193 million loan under the IMF's
  Poverty Reduction and Growth Facility, a
  concessional lending program for low-income
  countries.

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• provides the governments and central banks of its
  member countries with technical assistance and
  training in its areas of expertise.
• For example Following the collapse of the Soviet
  Union, the IMF stepped in to help the Baltic
  states, Russia, and other former Soviet countries
  set up treasury systems for their central banks
  as part of the transition from centrally planned
  to market-based economic systems.

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• IMF Quotas - each members 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 - IMFs highest authority
• One representative from each member country
• Board of Executive Directors24 persons
• handles day-to-day operations

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• IMF Assistance
• Provides assistance to member countries
• Intended to ease balance-of-payment difficulties
• Recipient country must adopt policies to
  stabilize its economy

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Special Drawing Rights (SDRs)

• An international type of monetary
  reserve currency, created by the International
  Monetary Fund (IMF) in 1969, which operates as a
  supplement to the existing reserves of member
  countries.
• Created in response to concerns about the
  limitations of gold and dollars as the sole means
  of settling international accounts,
• SDRs are designed to augment international
  liquidity by supplementing the standard reserve
  currencies.

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• Serves as the IMFs unit of account
• unit in which the IMF keeps its records
• used for IMF transactions
• Some countries pegged their currencies value
• Based on the weighted average of four currencies
• 19861990 USD 42, DEM 19, JPY 15, GBP 12,
  FRF 12
• 19911995 USD 40, DEM 21, JPY 17, GBP 11,
  FRF 11
• 19962000 USD 39, DEM 21, JPY 18, GBP 11,
  FRF 11
• 20012005 USD 45, EUR 29, JPY 15, GBP 11
• 20062010 USD 44, EUR 34, JPY 11, GBP 11

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Role of the World Bank

• The official name for the world bank is the
  International Bank for Reconstruction and
  Development
• Purpose To fund Europes reconstruction and help
  3rd world countries.
• Overshadowed by Marshall Plan, so it turns
  towards development
• Lending money raised through WB bond sales
• Agriculture
• Education
• Population control
• Urban development

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Collapse of the Fixed Exchange System

• The system of fixed exchange rates established at
  Bretton Woods worked well until the late 1960s
• The US dollar was the only currency that could be
  converted into gold
• The US dollar served as the reference point for
  all other currencies
• Any pressure to devalue the dollar would cause
  problems through out the world

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Collapse of the Fixed Exchange System

• Factors that led to the collapse of the fixed
  exchange system include
• President Johnson financed both the Great Society
  and Vietnam by printing money
• High inflation and high spending on imports
• On August 8, 1971, President Nixon announces
  dollar no longer convertible into gold
• Countries agreed to revalue their currencies
  against the dollar
• On March 19, 1972, Japan and most of Europe
  floated their currencies
• In 1973, Bretton Woods fails because the key
  currency (dollar) is under speculative attack

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The Floating Exchange Rate

• The Jamaica agreement revised the IMFs Articles
  of Agreement to reflect the new reality of
  floating exchange rates
• Floating rates acceptable
• Gold abandoned as reserve asset
• IMF quotas increased
• IMF continues role of helping countries cope with
  macroeconomic and exchange rate problems

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Exchange Rates Since 1973

• Exchange rates have been more volatile for a
  number of reasons including
• Oil crisis -1971
• Loss of confidence in the dollar - 1977-78
• Oil crisis 1979, OPEC increases price of oil
• Unexpected rise in the dollar - 1980-85
• Rapid fall of the dollar - 1985-87 and 1993-95
• Partial collapse of European Monetary System -
  1992
• Asian currency crisis - 1997

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Fixed Versus Floating Exchange Rates

• Fixed
• Monetary discipline
• .Speculation
• Limits speculators
• Uncertainty
• Predictable rate movements
• Trade balance adjustments
• Argue no link between exchange rates and trade
• Link between savings and investment

• Floating
• Monetary policy autonomy
• Restores control to government
• Trade balance adjustments
• Adjust currency to correct trade imbalances

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Exchange Rate Regimes

• Pegged Exchange Rates
• Peg own currency to a major currency ()
• Popular among smaller nations
• Evidence of moderation of inflation
• Currency Boards
• Country commits to converting domestic currency
  on demand into another currency at a fixed
  exchange rate
• Country holds foreign currency reserves equal to
  100 of domestic currency issued

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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

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• 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

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Exchange Rate Policies for IMF Members 2004
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Crisis Management by the IMF

• The IMFs activities have expanded because
  periodic financial crises have continued to hit
  many economies
• Currency crisis
• When a speculative attack on a currencys
  exchange value results in a sharp depreciation of
  the currencys value or forces authorities to
  defend the currency
• Banking crisis
• Loss of confidence in the banking system leading
  to a run on the banks
• Foreign debt crisis
• When a country cannot service its foreign debt
  obligations

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Determination of Exchange Rates

• Floating rate regimesallow 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

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Economic Theories of Exchange Rate Determination

• Exchange rates are determined by the demand and
  supply of one currency relative to the demand and
  supply of another
• Price and exchange rates
• Law of One Price
• Purchasing Power Parity (PPP)
• Money supply and price inflation
• Interest rates and exchange rates

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Law of One Price

• In competitive markets free of transportation
  costs and trade barriers, identical products sold
  in different countries must sell for the same
  price when their price is expressed in terms of
  the same currency
• Example US/French exchange rate 1 .78Eur
• A jacket selling for 50 in New York should
  retail for 39.24Eur in Paris (50x.78)

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Purchasing Power Parity

• By comparing the prices of identical products in
  different currencies, it should be possible to
  determine the real or PPP exchange rate - if
  markets were efficient
• In relatively efficient markets (few impediments
  to trade and investment) then a basket of goods
  should be roughly equivalent in each country

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Big Mac Index
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Money Supply and Inflation

• PPP theory predicts that changes in relative
  prices will result in a change in exchange rates
• A country with high inflation should expect its
  currency to depreciate against the currency of a
  country with a lower inflation rate
• Inflation occurs when the money supply increases
  faster than output increases

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Determination of Exchange Rates (cont.)

• 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

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Determination of Exchange Rates (cont.)

• Other factors affecting exchange rate movements
• Confidencesafe 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

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Currency Values and Business

• Exchange rates affect activities of both
  domestic and international firms

Devaluation
Revaluation
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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

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Forecasting Exchange-Rate Movements (cont.)

• Factors to monitormanagers can monitor factors
  used by governments to manage their currencies
• Institutional setting float or managed?
• Fundamental analysis economics indicator
• Confidence factors
• Events
• Technical analysis

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Business Implications of Exchange-Rate Changes

• Marketing decisions - exchange rates affect
  demand for a companys 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

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Stability and Predictability
Stable exchange rates
Predictable exchange rates
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Implications for Managers

• It is critical that international businesses
  understand the influence of exchange rates on the
  profitability of trade and investment deals
• Adverse changes in exchange rates can make
  apparently profitable deals unprofitable
• The risk introduced into international business
  transactions by changes in exchange rates is
  referred to as foreign exchange risk
• Foreign exchange risk is usually divided into
  three main categories transaction exposure,
  translation exposure, and economic exposure

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Implications for Managers

• Transaction exposure the extent to which the
  income from individual transactions is affected
  by fluctuations in foreign exchange values
• Translation exposure the impact of currency
  exchange rate changes on the reported financial
  statements of a company
• Economic exposure the extent to which a firms
  future international earning power is affected by
  changes in exchange rates

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Reducing Translation and Transaction Exposure

• These tactics are primarily designed to protect
  short-term cash flows from adverse changes in
  exchange rates
• Companies should use forward exchange rate
  contracts and buy swaps
• Firms can also use a lead strategy
• An attempt to collect foreign currency
  receivables when a foreign currency is expected
  to depreciate
• Paying foreign currency payables before they are
  due when a currency is expected to appreciate
• Firms can also use a lag strategy
• An attempt to delay the collection of foreign
  currency receivables if that currency is expected
  to appreciate
• Delay paying foreign currency payables if the
  currency is expected to depreciate

85
Reducing Economic Exposure

• Reducing economic exposure requires strategic
  choices that go beyond the realm of financial
  management
• The key to reducing economic exposure is to
  distribute the firms productive assets to
  various locations so the firms long-term
  financial well-being is not severely affected by
  adverse changes in exchange rates