Foreign Exchange and International Financial Environment

Exchange rate systems

determines how a country values its currency relative to others.

Fixed exchange rate

The government or central bank ties the national currency to another major currency (e.g., US Dollar) or a basket of currencies, or to a commodity like gold. This creates predictability but requires substantial central bank reserves to maintain the peg.

Floating exchange rate

The currency's value fluctuates continuously based on market forces of supply and demand. Major currencies like the USD, EUR, and JPY follow a floating system.

Managed Float (Pegged Float)

: The central bank allows the currency value to float within certain boundaries but intervenes directly in the market to smooth out extreme volatility or guide exchange rates in a preferred direction.

Forex

a decentralized global network where financial institutions, corporations, governments, and retail investors trade currencies.

Forward and futures market

Contracts to buy or sell a specific currency at a predetermined rate on a specified future date.

Currency risk

occurs when financial transactions or asset valuations are affected by fluctuations in exchange rates. It is categorized into three primary types:

Transaction exposure

The risk that cash flows from settled or open contractual obligations (e.g., receivables or payables denominated in foreign currencies) will change in value due to exchange rate shifts before settlement.

Translation (Accounting) Exposure

: The risk that a foreign subsidiary's financial statements will fluctuate when converted back into the parent company's reporting currency during consolidation.

Economic (Operating) Exposure

: The long-term impact of exchange rate fluctuations on a firm's future operational cash flows, competitiveness, and overall market value.

International capital market

enable companies and governments to raise funds, borrow money, and invest across national borders.

Eurocurrency market

Financial markets where deposits are held in currencies outside their home countries (e.g., Eurodollars, which are US dollars held in banks outside the US).

oForeign Bonds:

Issued by a foreign entity in a domestic market using the local currency (e.g., Yankee bonds issued in the US in USD by non-US firms).

oEurobonds

: Bonds issued globally in a currency different from that of the country where they are issued (e.g., a USD-denominated bond issued in Europe).

International Equity Markets:

Allow multinational corporations to issue stock on foreign exchanges to access a broader base of capital (e.g., through American Depositary Receipts or ADRs).

Hedging techniques

allow businesses and investors to reduce or eliminate potential losses caused by adverse exchange rate movements.

Forward Contracts

: Customized OTC agreements between two parties to exchange currencies at a fixed rate at a set future date

oFutures Contracts

: Standardized contracts traded on organized exchanges to buy/sell currency at a future date.

oCurrency Options

Financial contracts granting the buyer the right, but not the obligation, to buy (call) or sell (put) a currency at a set rate before a specific expiration date.

Currency swaps

Agreements between two parties to exchange principal and interest payments in different currencies over a specified period.

Operational hedging

Strategic business decisions to offset risk, such as natural hedging (matching local currency revenues with local currency expenses) or diversification of supply chains across different currency regions

Direct exporting

The firm sells products directly to foreign customers or importers without intermediaries, maintaining higher control over brand and pricing.

Indirect exporting

The firm uses third-party intermediaries (e.g., export management companies or agents) located in the home country to handle international sales.

Licensing

occurs when a parent firm (licensor) grants a foreign entity (licensee) the legal right to use intellectual property (patents, technology, trademarks, or trade secrets) for a designated period in exchange for royalties or fees.

Franchising

is a specialized form of licensing where the franchisor provides a comprehensive business package—including brand name, business model, operating procedures, and training—to a foreign franchisee in exchange for upfront fees and ongoing royalties.

Joint venture

is an equity partnership formed when two or more independent businesses create a separate, legally distinct business entity in the target foreign market, sharing ownership, risks, and profits.

Strategic alliance

is a cooperative agreement between two or more firms to pursue shared strategic goals while remaining separate, independent entities without forming a new joint venture or sharing equity ownership.

Greenfield investment

is a form of Foreign Direct Investment (FDI) where a parent company builds new, wholly owned subsidiaries, production plants, offices, or facilities from the ground up in a foreign target country.

Acquisition

involves purchasing an existing foreign firm to gain immediate ownership of its operations, assets, distribution networks, supply chain, and local market share.

Balance of payments

is a systematic accounting record of all economic and financial transactions between a country's residents and the rest of the world over a specific period.

Current account

Measures the net flow of goods, services, primary income, and secondary transfers.

Trade balance

Exports minus imports of goods and services.

Net income

Remittances, cross-border earnings, and investment returns.

Capital and financial account

Measures net flows of financial capital and ownership transfers.

FDI

Long-term foreign investments in physical assets, infrastructure, or businesses.

Portfolio investment

Short-term investments in equities, bonds, or money market assets ("hot money").

Official reserve account

Tracks changes in foreign currency reserves held by the central bank to balance any surplus or deficit in the current and capital accounts.

International capital flow

describe the cross-border movement of financial capital for trade, investment, or speculative purposes.

Inflow

Capital entering a nation (foreign purchases of domestic assets, foreign borrowing).

Outflows

Capital leaving a nation (domestic purchases of foreign assets, loan repayments).

PHP

functions under a managed float exchange rate system, where its value is primarily determined by market supply and demand, with policy interventions by the BangkoSentral ng Pilipinas (BSP) when necessary.

Foreign exchange intervention

refers to deliberate transactions by a central bank in FX markets to influence its currency's exchange rate or reduce excessive market volatility.

Direct intervention

The central bank buys or sells foreign currency against its domestic currency directly in the spot or forward market.

Indirect intervention

Using monetary policy tools (such as adjusting policy interest rates or reserve requirements) to influence exchange rates.

Unsterilized

The central bank buys/sells currency without adjusting the domestic bank reserves, directly altering the national money supply.

Sterilized

The central bank executes an offsetting open market operation (e.g., buying or selling government bonds) to keep domestic bank reserves and short-term interest rates stable.