Global Business 3e

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.

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WHAT DETERMINES FOREIGN
EXCHANGE RATES?

Foreign exchange rate

Price of one currency in terms of another

Purchasing power parity (PPP)

Conversion that determines the equivalent amount of
goods and services different currencies can purchase

Conversion is usually used to capture differences in cost

of living between countries
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© 2014 Cengage Learning. All Rights
Reserved. May not be scanned, copied
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Reserved. May not be scanned, copied
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PRODUCTIVITY AND BALANCE
OF PAYMENTS
Balance of payments
A country’s international transaction statement,
which includes merchandise trade, service trade,
and capital movement
Current Account balance
Current account = balance of trade + net factor
income from abroad + net unilateral transfers
from abroad

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EXCHANGE RATE POLICIES
Floating (or flexible) exchange rate policy
Willingness of a government to let demand and supply
conditions determine exchange rates

Clean (or free) float

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
Target exchange rates (crawling bands)
Specified upper or lower bounds within which an exchange
rate is allowed to fluctuate

Fixed rate policy

Setting the exchange rate of a currency relative to other
currencies

Peg
Stabilizing policy of linking a developing country’s
currency to a key currency

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INVESTOR PSYCHOLOGY
bandwagon effect
Effect of investors moving in the same direction at the
same time

capital flight
Phenomenon in which a large number of individuals and
companies exchange domestic currencies for a foreign
currency

? Can you recall a recent example of a bandwagon

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EVOLUTION OF THE INTERNATIONAL
MONETARY SYSTEM

Gold standard
System in which the value of most major currencies
was maintained by fixing their prices in terms of
gold

Common denominator
Currency or commodity to which the value of all
currencies are pegged

Bretton Woods system

System in which all currencies were pegged at a fixed
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EVOLUTION OF THE INTERNATIONAL
MONETARY SYSTEM

Post-Bretton Woods system

System of flexible exchange rate regimes with no
official common denominator

Quota
Weight a member country carries within the IMF,
which determines the amount of its financial
contribution (its “subscription”), and its capacity to
borrow from the IMF, and its voting power

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 Strategies for Financial Companies
Foreign exchange market
Market where individuals, firms, governments, and banks
buy and sell currencies of other countries

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STRATEGIES FOR
FINANCIAL COMPANIES

Spot transaction
Classic single-shot exchange of one currency for another

Forward transaction
Foreign exchange transaction in which participants buy
and sell currencies now for future delivery

Currency hedging
Transaction that protects traders and investors from
exposure to the fluctuations of the spot rate

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STRATEGIES FOR
FINANCIAL COMPANIES
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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STRATEGIES FOR
FINANCIAL COMPANIES
Currency swap
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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STRATEGIES FOR
FINANCIAL COMPANIES
Offer rate
Price at which a bank is willing to sell a currency

Bid rate
Price at which a bank is willing to buy a currency

Spread
Difference between the offer price and the bid price

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STRATEGIES FOR
NONFINANCIAL COMPANIES
Currency risk
Potential for loss associated with fluctuations in the
foreign exchange market

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 VS FLOATING EXCHANGE
RATES
Currency board
Coins convertible into a key foreign currency
Monetary authority that issues notes at a fixed
exchange rate

? Which exchange rate do you think is better?

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A STRONG DOLLAR VS A WEAK
DOLLAR

International Monetary Fund (IMF)

An international organization established to
promote international monetary cooperation,
exchange stability, and orderly exchange
arrangements

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© 2014 Cengage Learning. All Rights
Reserved. May not be scanned, copied
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© 2014 Cengage Learning. All Rights
Reserved. May not be scanned, copied
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