Course Code and Title: FINE 6 – Global Finance with Electronic Banking

Professor: Dave Kieth J. Lappay

Lesson Number: 3
Topic: International Financial Management (1)

Learning Objectives:

At the end of this lesson, the student should be able to:

1. discuss the concept of exchange rates,
2. comprehend the nature and uses of exchange rates, and
3. apply the exchange rates in managing the risk of international business.

Pre-Assessment
Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.

1. What are the types of exchange rates?

2. Why is the US dollar used as a universal currency?
3. Is currency the only determinant to judge a country’s economy? Explain.

Lesson Presentation:

International finance, sometimes known as

international macroeconomics, is the study of
monetary interactions between two or more
countries, focusing on
areas such as foreign direct investment and
currency exchange rates (Kagan, International
finance, 2020).

International financial management, also

known as international finance, is a well
known term in today’s world. It simply means
financial management in an international
business environment. It is different from
financial management because of the different
Photo Credit: By Elmer Hubert Harper, International Financial Management. Link:
factors involved like currency, political situations, https://slideplayer.com/slide/5735255/
imperfect markets, and diversified opportunity sets.

An exchange rate is the value of one nation's currency versus the currency of another nation or economic zone.
For example, how many U.S. dollars does it take to buy one euro? As of July 31, 2020, the exchange rate is
1.18, meaning it takes $1.18 to buy €1 (Chen, 2020).

Exchange rates affect our economy and each of us because:

1. When the dollar appreciates (strong dollar), the dollar becomes more valuable relative to other
currencies.
a. Foreign products become cheaper to us.
b. U.S. products become more expensive overseas.

Currency prices can be determined in two main ways: a floating rate or a fixed rate. A floating rate is
determined by the open market through supply and demand on global currency markets. Therefore, if the
demand for the currency is high, the value will increase. If demand is low, this will drive that currency price
lower.2
Of course, several technical and fundamental factors will determine what people perceive is a fair exchange
rate and alter their supply and demand accordingly (Banton, 2021).

The currencies of most of the world's major economies were allowed to float freely following the collapse of the
Bretton Woods system between 1968 and 1973. 4 Therefore, most exchange rates are not set but are
determined by on-going trading activity in the world's currency markets.
What Was the Bretton Woods Agreement and System?

The Bretton Woods Agreement was negotiated in July 1944 by delegates from 44 countries at the United
Nations Monetary and Financial Conference held in Bretton Woods, New Hampshire. Thus, the name “Bretton
Woods Agreement.
Under the Bretton Woods System, gold was the basis for the U.S. dollar and other currencies were pegged to
the U.S. dollar’s value. The Bretton Woods System effectively came to an end in the early 1970s when
President Richard M. Nixon announced that the U.S. would no longer exchange gold for U.S. currency (Chen,
Bretton woods agreement and system, 2021).

Types of Exchange Rates

• Free Floating
A free-floating exchange rate rises and falls due to
changes in the foreign exchange market.
• Restricted Currencies
Some countries have restricted currencies, limiting their
exchange to within the countries' borders. Also, a
restricted currency can have its value set by the
government.
• Currency Peg
Photo Credit: By Pavel Bobrovskiy, Currency Exchange.
Link: https://www.shutterstock.com/image-photo/currency-exchange-98660465 another nation. For instance, the Hong Kong dollar is
Sometimes a country will peg its currency to that of
pegged to the U.S. dollar in a range of 7.75 to 7.85.2 This means the value of the Hong Kong dollar to
the U.S. dollar will remain within this range.
• Onshore Vs. Offshore
Exchange rates can also be different for the same country. In some cases, there is an onshore rate and
an offshore rate. Generally, a more favorable exchange rate can often be found within a country’s
border versus outside its borders. China is one major example of a country that has this rate structure.
Additionally, China's yuan is a currency that is controlled by the government. Every day, the Chinese
government sets a midpoint value for the currency, allowing the yuan to trade in a band of 2% from the
midpoint.
• Spot vs. Forward
Exchange rates can have what is called a spot rate, or cash value, which is the current market value.
Alternatively, an exchange rate may have a forward value, which is based on expectations for the
currency to rise or fall versus its spot price. Forward rate values may fluctuate due to changes in
expectations for future interest rates in one country versus another. For example, let's say that traders
have the view that the eurozone will ease monetary policy versus the U.S. In this case, traders could
buy the dollar versus the euro, resulting in the value of the euro falling.
• Quotation
Typically, an exchange rate is quoted using an acronym for the national currency it represents. For
example, the acronym USD represents the U.S. dollar, while EUR represents the euro. To quote the
currency pair for the dollar and the euro, it would be EUR/USD. In this case, the quotation is euro to
dollar, and translates to 1 euro trading for the equivalent of $1.13 if the exchange rate is 1.13. In the
case of the Japanese yen, it's USD/JPY, or dollar to yen. An exchange rate of 100 would mean that 1
dollar equals 100 yen.

Factors that influence currency exchange rates are important for various reasons. For countries, these factors
can affect how one country trades with another. For individuals, these factors affect how much money one can
get when exchanging one currency for another. Although it is not always easy to understand, track, or even
anticipate these factors, it pays to know them, especially if you are interested in foreign currency. It is worth
noting that these factors affect currency exchange rates at a macroeconomic level, meaning they affect global
currency exchange rates and not local exchange rates.

1. Inflation
Inflation is the relative purchasing power of a currency compared to other currencies. For example, it might cost
one unit of currency to buy an apple in one country but cost a thousand units of a different currency to buy the
same apple in a country with higher inflation. Such differentials in inflation are the foundation of why different
currencies have different purchasing powers and hence different currency rates. As such, countries with low
inflation typically have stronger currencies compared to those with higher inflation rates.

2. Interest Rates
Interest rates are tightly tied to inflation and exchange rates. Different country’s central banks use interest rates
to modulate inflation within the country. For example, establishing higher interest rates attracts foreign capital,
which bolsters the local currency rates. However, if these rates remain too high for too long, inflation can start
to creep up, resulting in a devalued currency. As such, central bankers must consistently adjust interest rates
to balance benefits and drawbacks.

3. Public Debt
Most countries finance their budgets using large-scale deficit financing. In other words, they borrow to finance
economic growth. If this government debt outpaces economic growth, it can drive up inflation by deterring
foreign investment from entering the country, two factors that can devalue a currency. In some cases, a
government might print money to finance debt, which can also drive-up inflation.

4. Political Stability
A politically stable country attracts more foreign investment, which helps prop up the currency rate. The
opposite is also true – poor political stability devalues a country’s currency exchange rate. Political stability
also affects local economic drivers and financial policies, two things that can have long term effects on a
currency’s exchange rate. Invariably, countries with more robust political stability like Switzerland have
stronger and higher valued currencies.

5. Economic Health
Economic health or performance is another way exchange rates are determined. For example, a country with
low unemployment rates means its citizens have more money to spend, which helps establish a more robust
economy. With a stronger economy, the country attracts more foreign investment, which in turn helps lower
inflation and drive up the country’s currency exchange rate. It is worth noting here that economic health is more
of a catch-all term that encompasses multiple other drivers like interest rates, inflation, and balance of trade.

6. Balance of Trade
Balance of trade, or terms of trade, is the relative difference between a country’s imports and exports. For
example, if a country has a positive balance of trade, it means that its exports exceed its imports. In such a
case, the inflow of foreign currency is higher than the outflow. When this happens, a country’s foreign
exchange reserves grow, helping it lower interest rates, which stimulates economic growth and bolsters the
local currency exchange rate.

7. Current Account Deficit

The current account deficit is closely related to the balance of trade. In this scenario, a country’s balance of
trade is compared to those of its trading partners. If a country’s current account deficit is higher than that of a
trading partner, this can weaken its currency relative to that country’s currency. As such, countries that have
positive or low current account deficits tend to have stronger currencies than those with high deficits.

8. Confidence/ Speculation
Sometimes, currencies are affected by the confidence (or lack thereof) traders have in a currency. Currency
changes from speculation tend to be irrational, abrupt, and short-lived. For example, traders may devalue a
currency based on an election outcome, especially if the result is perceived as unfavorable for trade or
economic growth. In other cases, traders may be bullish on a currency because of economic news, which may
buoy the currency, even if the economic news itself did not affect the currency fundamentals.

9. Government Intervention
Governments have a collection of tools at their disposal through which they can manipulate their local
exchange rate. Primarily, central banks are known to adjust interest rates, buy foreign currency, influence local
lending rates, print money, and use other tools to modulate currency exchange rates. The primary objective of
manipulating these factors is to ensure favorable conditions for a stable currency exchange rate, cheaper
credit, more jobs, and high economic growth.
Application:

Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s. 1. What would
possibly happen to the world economy if international trading happens only to industrialized countries?

Evaluation:

Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s. 1. What
information would you use to prove that currency is not the only determinant in a country’s economic growth?

Generalization:

In general, it is essential for learners to know the importance of exchange rates as it captures a lot of economic
factors and variables and can fluctuate for various reasons. Some of the reasons that exchange rates can
fluctuate including interest rates, inflation rates, government debt, political stability, export and import activities,
recession, speculations and special considerations. Exchange rates play a crucial role in a country's level of
trade, which is critical to several free market economies around the world. Generally, exchange rates are
among the most watched, analyzed, and manipulated economic measures.

Reinforcement:
Direction: Read the questions carefully. Provide the answers in the separate sheet of paper/s.
 1. What are the current trends of the government and private companies to encourage citizens to be
exposed to exchange rates?

References:

Online:

Banton, C. (2021, March 4). International exchange rate. Retrieved from Investopedia:
https://www.investopedia.com/ask/answers/forex/how-forex-exchange-rates-set.asp Chen,
J. (2020, January 31). Exchange rate definition. Retrieved from Investopedia:
https://www.investopedia.com/terms/e/exchangerate.asp
Chen, J. (2021, April 28). Bretton woods agreement and system. Retrieved from Investopedia:
https://www.investopedia.com/terms/b/brettonwoodsagreement.asp
Kagan, J. (2020, October 17). International finance. Retrieved from Investopedia:
https://www.investopedia.com/terms/i/international-finance.asp
Kagan, J. (2020, October 17). International Finance. Retrieved from Investopedia:
https://www.investopedia.com/terms/i/international-finance.asp

Books:

Madura, J (2008). International Financial Management, Ninth Edition. U.S.: Thomson South-Western

Brigham, E (2007). Financial Management: Theory and Practice, 10th Edition. Florida, U.S.: The Dryden Press,
Hardcourt Brace College Publishers.

Brigham, E (2007). Fundamentals of Financial Management, Concise Edition. U.S.: The Dryden Press,
Hardcourt Brace College Publishers.

Gitman, L (2007). Principles of Managerial Finance. Pearson Education, Inc.