MAN 3600 EXAM 3

How many currencies in use worldwide

More than 150

convertible currencies

Currencies that are freely traded and accepted in international commerce; also called hard currencies

Non-convertible Currencies

Currencies that are not traded freely in the foreign exchange market

Examples of hard currencies

Canadian dollar
US dollar
Japanese Yen
British Pound
European euro

exchange rate

Price of one currency in terms of anither

How does exchange rates affect the fortunes of the firm

Through costs of inputs, sales performance, which market strategies to use

Exchange rates are constantly

fluctuating

Because exchange rates are constantly fluctuating

-the prices the firm charges can be quotes in the firm's currency or in the currency of each foreign customer

• because several months can pass between placement and delivery of an order this results in uncertainty

• firm and it's customers can use exchange rate as it stands on the date of each transaction, or they can agree to use specific exchange rates

Foreign exchange

All forms of internationally-traded monies, including foreign currencies, bank deposits, checks, and electronic transfers

Foreign Exchange Market

The global marketplace for buying and selling national currencies

Big Mac Index

Tool for calculating purchasing power parity that compares prices of a Big Mac throughout the world.

We can use the Big Mac index to

Calculate currency valuations

Formula for currency valuation

(Price local- Price U.S.)/Price U.S.

Converting local prices into dollar-based price using exchange rates

Divide price by exchange rate

(I.e. xrate=¥124/$
¥690/124=$5.56)

Purpose of exchange rates

To facilitate international purchases

Purchasing Power Parity (PPP)

Measurement tool of calculating exchange rates so that each currency buys an equal amount of goods or services as every other currency.

Idea behind the PPP

In theory, an exchange rate will equalize the price of an identical product or service in two different countries

Law of One Price (LOOP)

The principle that if two or more countries produce an identical good, the price of this good should be the same no matter which country produces it.

Exchange rates depend on

Heavily on supply and demand

Factors that influence supply and demand of currencies

Economic growth
Interest rates
Inflation
Market psychology
Government action

Economic growth

The increase in value of goods and services produced by an economy

How is economic growth measured

As the annual increase in GDP (in which the inflation rate is subtracted from growth)

Economic growth driver

Entrepreneurship and innovation

Central bank does...

Regulates the money supply
Issues currency
manages the exchange rate to accommodate economic growth

What country has the highest growth rate

Ethiopia

Interest rates relation to inflation

Positively related with inflation, high inflation forces banks to pay high interest

Investors expect to be compensated for

Inflation-induced decline in the value of their money

Inflation

Refers to increase in the prices of goods and services, thus, money buys less than before

Examples of countries that have experienced hyperinflation

Argentina, Israel, Russia

Effect of high inflation

Erodes a currency's purchasing power

Country that has had the highest inflation rate

Zimbabwe

Market psychology

Refers to investor behavior, such as herding behavior or momentum trading

Government action

Governments intervene to influence the value of their own currencies

Example of government action

The Chinese government regularly intervenes in the foreign exchange market to keep the renminbi undervalued, to help ensure exports

Trade balance (balance of payments)

The nation's balance sheet of trade, investment, and transfer payments with the rest of the world

Trade balance reflects

The difference between total amount of money coming into and going out of a country

Trade surplus

Exports exceed imports

Trade surplus may result when

The exporter's currency is undervalued (

Example of exporter currency being undervalued

China's official policy regarding its currency

Trade deficit

Imports exceed exports

How may the government act in a trade deficit

The government may devalue the nation's currency to correct a deficit

Balance of trade

The difference between the value of a nation's exports and imports

Trade balance adjustment process

Seeking equilibrium exchange rate. This only happens in hypothetical situations in which there are no external factors

Types of currency transactions

Spot
Forward outrights and swaps
Options

Spot transactions

Are for the exchange of currencies for immediate deliveries

Forward transactions

the exchange of currencies on a future date at an agreed upon exchange rate

Options

Give the holders the right but no obligation to buy or sell an underlying asset at a predetermined price or until a certain time

Which transactions are the most common

Swap, followed by spot

FX swap

An agreement to simultaneously borrow one currency and lend another at an initial date, then exchanging the amounts at maturity

Most popular foreign exchange markets

London
New York
Japan

Types of exchange rate quotations

-US terms
-European terms
-Direct quotations
-Indirect quotations
-Cross rates

US terms

Give the price of a foreign currency in units of USD needed to purchase one unit of the foreign currency (I.e. USD/Euro=1.5064 USD)

European terms

Give the price of a USD in terms of the foreign currency equivalent (I.e. Euro/USD= 0.664 euro)

European and US terms can only be used when

There is a USD involved in the quotations

Direct quotations

The form when the subject currency is stated first (I.e. $1.245/Euro for USD)

Indirect quotations

Refers to when the subject currency is stated second (I.e. $1.245/Euro for Euro)

Cross rates

Exchange rates stated without using USD as a reference currency

How to calculate exchange rate percentage change

(current-previous)/previous

Example of exchange rate percentage change

¥100/$ -> ¥150/$

(¥150/$ -¥100/$)/¥100/$ *100=
50% up for USD

Does not mean there is an equal negative percentage for ¥

The effects of exchange rate changes for consumers

If the dollar becomes more expensive in comparison to foreign currency, (less)

The cost of buying imported goods goes up,
There are less goods available for sale
The overall cost of living is higher
The overall standard of living is lower
Less foreigners travel to or study in the USA

(And vice versa)

Effects of exchange rate changes for manufacturers

If the dollar becomes more expensive in comparison to foreign currency (less)

The cost of imported materials, parts, and components goes up
The cost of finished goods goes up

(And vice versa)

Effects of exchange rate change for importers

If the dollar becomes more expensive in comparison to foreign currency (and less)

Industries that depend on imported goods suffer

(And vice versa)

Effects of exchange rate change on exporters

If dollar becomes more expensive in comparison to foreign currency (and less)

Foreign firms selling to the USA can change lower prices and still be profitable
They generate higher revenues
Foreign exporters become more profitable and can pay higher wages
Living standards improve for foreign exporters

(And vice versa)

Falling dollar supplemental video

USD devalues making American goods cheaper and therefore more sellable abroad

For US consumers this means higher prices on imported goods

floating exchange rate

Exchange rates that respond quickly to currency market forces of supply and demand

Fixed exchange rates

The official rates of exchange for currencies set by governments

Fixed exchange rates are also known as

"Adjustable peg"

How are currencies linked to each other

By the Gold Exchange Standard

Gold Standard began in

1880s

The gold standard is premised on three basic ideas

• a system of fixed rates of exchange existed between participating countries

• money issued by member countries had to be backed by gold reserves

• gold acted as an automatic adjustment

Under the gold standard, each country's currency would be set in value...

per ounce of gold

Evolution of exchange rate systems

After the Great Depression and wwII, the world economy and trading system were seeking stability

44 countries signed the Bretton woods agreement, which was dissolved in 1971

Today, advanced economy currencies float according to market forces, their value determined by supply and demand.
Most developing and emerging economies used fixed exchange rates.

Bretton Woods Agreement

established a fixed exchange rate system in which the U.S. dollar was pegged to a set value for gold ($35 per ounce), and other major currencies were pegged to the dollar.

International Monetary Fund (IMF)

The institutional framework, rules, and procedures by which national currencies are exchanged for one another

International Monetary Fund (IMF) does

Promotes exchange rate stability, monitors exchange systems, provides funding to developing countries

World Bank

The collection of financial institutions that facilitate and regulate the flows of investment and capital funds worldwide.

World Bank includes

National and international banking systems
International bond market
National stock markets

What does the world bank di

Provides loans and technical assistance to combat global poverty around the world

Purpose of the IMF

Ensure exchange rates stayed stab,e to encourage global trade

Purpose of World Bank

To give financial assistance to countries, mainly in Europe, that needed to rebuild after the world war.

Biggest contributors of IMF

China, US, Japan, and Germany

Biggest borrowers of the IMF

Greece, Ukraine, Portugal, and Pakistan

Most projects of the world bank come from

Africa and East Asia

Growing integration of financial and monetary global activity is due to:

•Evolution of monetary and financial regulations, worldwide.

•Emergence of new technologies and payment systems in global finance, e.g., the Internet.

•Increased global and regional interdependence of financial markets.

•Growing role of single-currency systems, e.g., the Euro.

Participants in Global Monetary and Financial Systems

The firm

The national stock exchange and bond markets
Commercial banks

Central banks

IMF
Bank for international settlements
World bank

The firm

international transactions require firms to deal with huge sums of foreign exchange

National Stock Exchanges and Bond Markets

facilitates for trading securities and bonds

Commercial banks

Lend money to finance business activity, play a key role on nation's money supplies, and exchange foreign currencies

Central banks

Regulate money supply, issue currency, manage exchange rates, control national reserves

Bank for International Settlements

supervises central bank monetary policy and other activities

Types of foreign exchange entry modes

Exporting
Importing
Licensing
Franchising
Interfirm cooperation
Foreign direct investment

Classifications of foreign entry modes

Export modes
Contractual modes
Investment modes
Hybrid modes

Export modes of entry

Direct and indirect

Contractual modes of entry

Licensing and franchising

Investment modes of entry

Acquisition and creating new subsidiary

Hybrid mode of entry

(Contractual and investment)
Strategic alliances and joint ventures

Modes of entry have different levels of

Risk

Export levels of risk, control, and flexibility

Low risk, low control, high flexibility
(100% externalizing)

Contractual mode levels of risk, control, and flexibility

Shared control and risk because of split ownership

Investment mode levels of risk, control, and flexibility

High risk, high control, and low flexibility
(100% internalizing)