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 3 sub-sectors
• 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 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.
• Look in Wall Street Journal under foreign
  exchange quotes.
• See Appendix 1 for a discussion of exchange rate
  quotes.

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

5
Exchange Rate Regimes Today

• Current exchange rate regimes fall along a
  spectrum as represented by a national
  governments 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
6
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) Regime
Pegged Rate Regime
Floating Rate Regime
7
Classification of Exchange Rate Regimes

• Floating Currency Regime
• No (or minimal) government involvement (i.e.,
  intervention) in foreign exchange markets.
• See Appendix 2 for a discussion of major central
  bank intervention.
• Market forces, i.e., demand and supply, determine
  foreign exchange rates (prices).
• Financial institutions (global banks, investment
  firms), multinational firms, speculators (hedge
  funds), exporters, importers, etc.

8
Classification of Exchange Rate Regimes

• 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 or the price of critical imports).

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 (exports) or foreign direct investment.

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 For list of currency designations see
  http//www.xe.com/symbols.htmlist

11
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
  

12
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

13
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

14
Factors That Affect the Equilibrium Exchange
Rate Floating Rate Regime

• Relative rates of (short-term) interest.
• Affects the demand for financial assets (high
  interest rate currencies).
• Carry trade strategies affect the supply of
  currencies (low interest rate currencies) and the
  demand for currencies (high interest rate
  currencies)
• Relative rates of inflation.
• Affects the demand for real (goods) and financial
  assets hence the demand for and supply of
  currencies
• Relative economic growth rates.
• Affects longer term investment flows in real
  capital assets (FDI) and financial assets (stocks
  and bonds).
• Relative political and economic risk.
• Markets prefer less riskier assets and less risky
  countries.
• Safe Haven phenomenon.
• Thailand since coup in 2006 (worse performing
  stock market in Asia).

15
Issues of Floating Currencies

• Presents the greatest ongoing risk for global
  firms.
• Why?
• Since it is difficult to predict changes in
  demand and supply, it then becomes
• Difficult to predict their long term trends (and
  changes in trends) and shorter term movements.
• What are the implications of long term trend
  change for global companies?
• They complicate 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.

16
Issues of Floating Currencies

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

17
Observed Short Term Volatility of the British
Pound The last 91 days
18
Managed Currencies (Dirty Float)

• Under this regime, governments manage their
  currency to offset (i.e., counteract) market
  forces.
• They do this when market demand factors or supply
  factors are seen as creating undesirable exchange
  rate moves.
• Exchange rate management may occur on
• a daily basis (e.g., China) or
• only when governments feel conditions warrant.
• Management involves either
• intervention action (buying or selling
  currencies) or
• interest rate adjustments (to make the currency
  more or less attractive).
• See Appendix 3 for a discussion of these two
  approaches to managing a currency

19
Who Manages and Why?

• Today, currency management is likely to be done
  by the developing and emerging countries of the
  world.
• Recall, the major countries have stopped managing
  their currencies.
• Why do developing and emerging countries still
  manage?
• What is the potential issue of weak currency for
  them?
• Concern of the Government is that the price of
  imported goods will rise may cause (or
  intensify) domestic inflation.
• What is the potential issue of a strong currency?
• Concern of Government is that its exports will
  become too costly overseas and they may lose
  overseas market share.
• In addition, the slow down exports may reduce
  domestic economic growth and result in higher
  unemployment.

20
Managed Currencies

• Over the long term, managed currencies are
  somewhat risky for global firms, but not as risky
  as floating currencies.
• Reason since these currency moves are being
  managed their trend moves are generally likely
  to be more gradual than the currencies under
  floating rate regimes.
• However, these currencies are still subject to
  trend moves and trend changes (similar to
  floating rate currencies).
• So, global companies need to assess currency
  exposures and risk, over the intermediate term
  and long term.
• Trend changes will affect their FDI positions and
  longer term export and import situations

21
Managed Currencies

• Over the short term, these currencies are not
  likely to be as volatile as floating currencies.
• Reason Government management is aimed at
  countering short term volatility (more so than
  trends or trend changes).
• 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.
• Example British pound was managed in the ERM
  until a speculative attack drove it out in 1992.

22
Observed Short Term Volatility of the Singapore
Dollar The last 91 days
23
Pegged Currency Regimes Ultimate Currency
Management

• Under a pegged currency regime, governments link
  their national currency to a key international
  currency (usually the U.S. dollar or some
  combination of currencies).
• Why do governments peg their currencies?
• A peg is seen as a necessary condition to promote
  confidence in the currency and in the country and
  promoting economic growth.
• May encourage foreign direct investment and long
  term capital inflows.
• Hong Kongs rational behind its initial (1983)
  peg.
• Or by pegging the currency at an undervalued
  currency this may support the countrys export
  sector.
• Chinas rational for its early peg.
• However, there are potential costs to governments
  in holding a peg.

24
Potential Costs to Holding a Peg

• If market forces push a pegged currency above its
  peg (i.e., the currency becomes too strong or
  overvalued) this happens because
• The market is buying the currency, then
• Government management involves either selling the
  pegged currency on foreign exchange markets
  (thus, buying hard currency) or reducing domestic
  interest rates.
• Issues If the government sells its currency this
  created to potential for expansion of its
  domestic money supply and hence inflationary
  pressures.
• On the other hand, lowering domestic interest
  rates can also stimulate domestic investment and
  economic activity which may lead to inflationary
  pressures.

25
Potential Costs to Holding a Peg

• If market forces push a pegged currency below its
  peg (i.e., the currency becomes too weak or
  undervalued) this happens because
• The market is selling the currency, then
• Government management involves either buying the
  pegged currency on foreign exchange markets
  (thus, selling hard currency or raising domestic
  interest rates.
• Issues Does the government want to give up its
  hard currency (does it have potentially better
  uses for this (e.g., buying oil or paying off
  international debts)
• On the other hand, raising domestic interest
  rates can dampen economic activity and lead to
  rising unemployment.
• Note The last two slides summarize one reason
  (i.e., the costs) why major central banks have
  probably gotten out of the currency management
  business.

26
Pegged Currencies

• As long as the peg is maintained, this regime
  presents the smallest risk to global firms
  however there is the potential for enormous risk,
  where
• Governments either (1) abandon the peg for
  another foreign currency regime or (2) adjust to
  a new peg.
• These changes occur either by
• An orderly change adopted by the government
  (e.g., China).
• Peg coming under successful market attack (e.g.,
  Argentina).
• These changes can have substantial impacts on the
  financial situation (as well as the competitive
  position) of a global firm when they do occur.
• Especially if the firm did not take advanced
  steps to protect itself.
• Thus, Global firms must be on the alert for
  changes
• See Appendix 4 for a discussion of Chinas move
  away from a peg to a managed exchange rate
  regime.

27
Observed Short Term Volatility of the Hong Kong
Dollar The last 91 days
28
Argentina Peso Pegged Currency, 1996 to December
2001
29
Argentina Abandoning the Peg Moving to a
Floating Regime Jan 2002
30
Abandoning a Pegged Rate and the Currency
Weakens RISKS for Global Firms

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

31
Abandoning a Pegged Rate and the Currency
Weakens OPPORTUNITIES for Global Firms

• However, changes in exchange rate regimes also
  offer potential opportunities for global firms.
• Again, using the Argentina example
• What do you think happened to foreign
  multinationals importing from Argentina after the
  peso weakened?
• For Example Wal-Marts U.S. dollar cost
  associated with importing goods from Argentina?
• What do you think happened to foreign
  multinationals considering expanding FDI into
  Argentina after the peso weakened?
• For Example The new U.S. dollar cost to Ford
  Motor Company considering setting up a production
  facility in Argentina?

32
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

33
Appendix 1 Quoting Currencies

• Currencies can be quoted in foreign exchange
  markets in one of two ways American terms and
  European terms.
• The following slides provide examples of both.

34
Foreign Exchange Rate Quotations

• There are two generally accepted ways of quoting
  a currencys foreign exchange rate.
• American terms and European Terms quotes
• American terms quote The amount of U.S. dollars
  per 1 unit of a foreign currency.
• For Example 1.90 per 1 British pound
• Or 1.30 per 1 European euro
• Or 0.78 per 1 Australian dollar

35
Foreign Exchange Rate Quotations

• European terms quote The amount of a foreign
  currency per 1 U.S. dollar
• For Example 115 yen per 1 U.S. dollar
• Or 7.8 Hong Kong dollars per 1 U.S. dollar
• Or 1.54 Singapore dollars 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.

36
Appendix 2 Intervention in Foreign Exchange
Markets

• While the worlds major central banks have
  essentially gotten out of the business of foreign
  exchange intervention, some developing and
  emerging country central banks still do. In
  addition, there is nothing preventing the worlds
  major central banks from intervening if they so
  desire.

37
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.

38
Intervention by Major Central Banks

• Historically, central banks of the major
  countries of the world did use intervention even
  with their floating rate regimes.
• However, they have done this in the past usually
  only under extreme market forces circumstances.
• Intervention occurred if a situation produced
  exchange rate volatility which was seen as
  potentially too disruptive to financial market
  stability.
• For example, U.S. intervened immediately after
  the attempted assassination of President Reagan
  on March 30, 1981.
• But, interestingly enough, did NOT around the
  9/11/2001 terrorist attack.
• At the present time, it appears that the 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).

39
Why Have the Major Central Banks Stopped
Intervening?

• There are a couple of reasons why this is so
• (1) The record on central bank intervention with
  regard to the major central banks of the world is
  mixed at best.
• See next two slides for intervention record since
  1985.
• (2) Intervention can be costly (see earlier
  lectures slides on this subject).
• (3) Not intervening is consistent with the
  philosophy of many central bankers today that the
  markets should function without government
  interference or government manipulations and if
  they do, the prices of currencies will be set
  efficiently and correctly.

40
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.

41
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.

42
Appendix 2 How Do Governments Manage their
Currencies?

• Governments (or central banks) using a managed
  exchange rate regime can support their currencies
  through two possible policies (1) direct
  intervention and (2) interest rate adjustments.
  The slides that follow discuss these.
• Note that when major central banks of the world
  were intervening in foreign exchange markets in
  support of their currencies, they selected from
  the same two policies.

43
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.

44
Managed Currencies Interest Rate Adjustments

• Some countries also use interest rate adjustments
  to manage their currencies.
• When a currency become too weak
• Governments can raise short term interest rates
  to attract short term foreign capital inflows.
• Higher interest rates make investments more
  attractive.
• When a currency becomes too strong
• Governments can lower short term interest rates
  to discourage short term foreign capital inflows.
• Lower interest rates will make investments less
  attactive.

45
Empirical Findings on the Use of Intervention by
Emerging/Developing Countries

• Conclusion from studies 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 emerging/developing market central banks
  felt that intervention was more effective in
  influencing the foreign exchange rate over short
  periods of time
• 2 to three days to one week.

46
Appendix 4 Chinas Old and New Exchange Rate
Regime

• On July 21, 2005, China surprised the world by
  announcing that they were moving away from a peg
  to the U.S. dollar. The following slides trace
  the peg period, the new exchange rate regime
  (which is a managed float), and the move of the
  yuan since the introduction of the new currency
  regime.

47
Chinas Currency Regime 1978 -2005

• In late 1978, the Chinese government began moving
  its economy from a centrally planned system to a
  market-based system.
• As part of this process, in 1994, China's central
  bank pegged (i.e., linked) the Chinese currency,
  the yuan (also known as the renmimbi, or
  "people's money) to the U.S. dollar.
• In 1994, the peg was set at 8.28 yuan to 1 U.S.
  dollar.

48
China Moves to a Managed Float

• July 21, 2005, the Chinese government announced
  it was changing to a managed float regime with an
  immediate adjustment of the rate to 8.11 yuan to
  the dollar.
• This represented an immediate strengthening of
  the yuan, by 2.0 against the U.S. dollar.
• Chinas currency regime is now a managed float
  against a market basket of currencies (including
  the U.S. dollar, Euro and Japanese yen although
  we dont know all the currencies and their
  weights).
• Chinese Government now manages 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.
• Thus, the yuan is now allowed to gradually move
  in relation to market forces.

49
Chinese Yuan Has Appreciated Since Moving to a
Managed Float