Chapter 7

Dealing with Foreign Exchange

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LEARNING OBJECTIVES
After studying this chapter, you should be able to:
 7-1 understand the determinants of foreign exchange
rates.
 7-2 track the evolution of the international monetary
system.
 7-3 identify firms’ strategic responses to deal with
foreign exchange movements.
 7-4 participate in three leading debates concerning
foreign exchange movements.
 7-5 draw implications for action.
© 2017 Cengage Learning®. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
FOREIGN EXCHANGE RATE
foreign exchange rate – the price of one
currency in terms of another
appreciation – an increase in value of the
currency
depreciation – a loss in the value of the
currency

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Table 7.1
Examples of Key Currency Exchange Rates

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Figure 7.1
US Dollar’s Share of World Total (%)

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Figure 7.2
What Determines Foreign Exchange Rates?

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THEORY OF PURCHASING POWER
PARITY
 Suggests that in the absence of trade barriers
(such as tariffs), the price for identical products
sold in different countries must be the same;
otherwise, traders may “buy low” and “sell
high,” eventually driving prices for identical
products to the same level around the world
 Argues that in the long run, exchange rates
should move toward levels that would equalize
the prices of an identical basket of goods in any
two countries

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Figure 7.3
The Big Mac Index

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INTEREST RATES AND MONEY SUPPLY

 If a country’s interest rate is high relative to

other countries, then the country will attract
foreign funds
 A high interest rate will also increase the
demand for the home currency, thus enhancing
its exchange value

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PRODUCTIVITY AND BALANCE OF
PAYMENTS
balance of payments (BOP) – a country’s
international transaction statement, which includes
merchandise trade, service trade, and capital
movement

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Table 7.2
The US Balance of Payments (Billion US Dollars)

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EXCHANGE RATE POLICIES
floating (or flexible) exchange rate policy –a
government policy to let supply-and-demand
conditions determine exchange rates
clean (or free) float – a pure market solution to
determine exchange rates
dirty (or managed) float – using selective
government intervention to determine exchange
rates

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EXCHANGE RATE POLICIES (cont’d)
fixed exchange rate policy – a government
policy to set the exchange rate of a currency
relative to other currencies
target exchange rate (crawling band) –
specified upper or lower bounds within which an
exchange rate is allowed to fluctuate
peg – a stabilizing policy of linking a developing
country’s currency to a key currency

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INVESTOR PSYCHOLOGY
bandwagon effect – the effect of investors
moving in the same direction at the same time,
like a herd
capital flight – a phenomenon in which a large
number of individuals and companies exchange
domestic currency for a foreign currency

? Can you recall a recent example of a bandwagon

effect?
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EVOLUTION OF THE INTERNATIONAL
MONETARY SYSTEM
 The gold standard (1870–1914)
 The Bretton Woods system (1944–1973)
 The post-Bretton Woods system (1973–
present)

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THE GOLD STANDARD (1870–1914)
gold standard – a system in which the value of
most major currencies was maintained by fixing
their prices in terms of gold
common denominator – a currency or
commodity to which the value of all currencies
are pegged

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THE BRETTON WOODS SYSTEM
(1944–1973)
Bretton Woods system – a system in which all
currencies were pegged at a fixed rate to the US
dollar

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THE POST-BRETTON WOODS SYSTEM
(1973–present)
Post-Bretton Woods system – a system of
flexible exchange rate regimes with no official
common denominator

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THE INTERNATIONAL MONETARY
FUND (IMF)
International Monetary Fund (IMF) – an
international organization that was established to
promote international monetary cooperation,
exchange stability, and orderly exchange
arrangements

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THE INTERNATIONAL MONETARY
FUND (IMF) (cont’d)
 The IMF provides loans to countries suffering
from balance-of-payments problems
◦ Each member country is assigned a quota—the
weight a member country carries within the IMF,
which determines the amount of its financial
contribution (its “subscription”), its capacity to
borrow from the IMF, and its voting power

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FOREIGN EXCHANGE MARKET
foreign exchange market – the market where
individuals, firms, governments, and banks buy and
sell foreign currencies

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FOREIGN EXCHANGE MARKET (cont’d)

The foreign exchange market has two functions:

1. To service the needs of trade and FDI
2. To trade in its own commodity—namely, foreign
exchange

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TYPES OF FOREIGN EXCHANGE
TRANSACTIONS
1. Spot transactions
2. Forward transactions
3. Swaps

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SPOT TRANSACTIONS
spot transaction – the classic single-shot
exchange of one currency for another

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FORWARD TRANSACTIONS
forward transaction – a foreign exchange transaction in which
participants buy and sell currencies now for future delivery

currency hedging – a transaction that protects traders and investors

from exposure to the fluctuations of the spot rate

forward discount – condition under which the forward rate of one

currency relative to another currency is higher than the spot rate

forward premium – condition under which the forward rate of one

currency relative to another currency is lower than the spot rate

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SWAPS
currency swap – a foreign exchange transaction
between two firms in which one currency is
converted into another at Time 1, with an
agreement to revert it back to the original
currency at a specified Time 2 in the future

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HOW BANKS MAKE MONEY
offer rate – the price to sell a currency
bid rate – the price to buy a currency
spread – the difference between the offer rate
and the bid rate

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CURRENCY RISK
currency risk – the potential for loss associated
with fluctuations in the foreign exchange market

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STRATEGIES FOR NONFINANCIAL
COMPANIES
How do nonfinancial companies deal with currency
risk?
1. Invoicing in their own currencies
2. Currency hedging
3. strategic hedging (spreading out activities in
a number of countries in different currency
zones to offset any currency losses in one
region through gains in other regions)

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FIXED VERSUS FLOATING
EXCHANGE RATES
 Proponents of fixed exchange rates argue that
fixed exchange rates impose monetary
discipline by preventing governments from
engaging in inflationary monetary policies and
that fixed exchange rates encourage trade and
FDI
 Proponents of floating exchange rates believe
that market forces should take care of supply,
demand, and the price of any currency

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FIXED VERSUS FLOATING
EXCHANGE RATE (cont’d)
currency board – a monetary authority that
issues notes and coins convertible into a key
foreign currency at a fixed exchange rate

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Table 7.3
A Strong Dollar versus a Weak Dollar

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CURRENCY HEDGING VERSUS NOT
HEDGING
 The standard argument for currency hedging is
increased stability of cash flows and earnings
 Many managers of large firms argue that
currency hedging eats into profits

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Table 7.4
Implications for Action

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