International Financial Management 13 Edition: by Jeff Madura

International Financial Management
13th Edition
by Jeff Madura
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4 Exchange Rate Determination
Chapter Objectives
• Explain how exchange rate movements are measured.

• Explain how the equilibrium exchange rate is
determined.
• Examine factors that determine the equilibrium
exchange rate.
• Explain the movement in cross exchange rates.
• Explain how financial institutions attempt to capitalize
on anticipated exchange rate movements.
2 © 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Measuring Exchange Rate Movements
Depreciation: decline in a currency’s value

Appreciation: increase in a currency’s value
Comparing foreign currency spot rates over two points

in time, S and St-1
S  St 1
Percent  in foreign currency value 
S t 1
A positive percent change indicates that the currency

has appreciated. A negative percent change indicates
that it has depreciated. (Exhibit 4.1)
© 2018 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Exhibit 4.1 How Exchange Rate Movements and Volatility
Are Measured
Exchange Rate Equilibrium (1 of 2)
The exchange rate represents the price of a currency, or the

rate at which one currency can be exchanged for another.
Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping demand
schedule. (See Exhibit 4.2)
Supply of a currency for sale increases when the value of
the currency increases, leading to an upward sloping supply
schedule. (See Exhibit 4.3)
Equilibrium equates the quantity of pounds demanded with
the supply of pounds for sale. (See Exhibit 4.4)
Exhibit 4.2 Demand Schedule for British Pounds
Exhibit 4.3 Supply Schedule of British Pounds for
Sale
Exhibit 4.4 Equilibrium Exchange Rate Determination
Exchange Rate Equilibrium (2 of 2)
Change in the Equilibrium Exchange Rate

• Increase in demand schedule: Banks will increase the
exchange to the level at which the amount demanded is equal
to the amount supplied in the foreign exchange market.
• Decrease in demand schedule: Banks will reduce the
• Increase in supply schedule: Banks will reduce the
• Decrease in supply schedule: Banks will increase the
Factors That Influence Exchange Rates (1 of 5)
The equilibrium exchange rate will change over time as supply

and demand schedules change.
e  f (INF , INT , INC , GC, EXP)
where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
Relative Inflation Rates: Increase in U.S. inflation leads to

increase in U.S. demand for foreign goods, an increase in
U.S. demand for foreign currency, and an increase in the
exchange rate for the foreign currency. (See Exhibit 4.5)
Relative Interest Rates: Increase in U.S. rates leads to
increase in demand for U.S. deposits and a decrease in
demand for foreign deposits, leading to an increase in
demand for dollars and an increased exchange rate for the
dollar. (See Exhibit 4.6)
• Real Interest Rates
• Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate
Exhibit 4.5 Impact of Rising U.S. Inflation on the Equilibrium
Value of the British Pound
Exhibit 4.6 Impact of Rising U.S. Interest Rates on the
Equilibrium Value of the British Pound
Relative Income Levels: Increase in U.S. income

leads to an increase in U.S. demand for foreign goods,
an increased demand for foreign currency relative to
the dollar, and an increase in the exchange rate for the
foreign currency. (See Exhibit 4.7)
Government Controls via:
• Imposing foreign exchange barriers
• Imposing foreign trade barriers
• Intervening in foreign exchange markets
• Affecting macro variables such as inflation, interest
rates, and income levels
Exhibit 4.7 Impact of Rising U.S. Income Levels on
Equilibrium Value of the British Pound
Expectations:
• Impact of favorable expectations: If investors expect
interest rates in one country to rise, they may invest in that
country, leading to a rise in the demand for foreign currency
and an increase in the exchange rate for foreign currency.
• Impact of unfavorable expectations: Speculators can
place downward pressure on a currency when they expect
it to depreciate.
• Impact of signals on currency speculation: Speculators
may overreact to signals, causing currency to be
temporarily overvalued or undervalued.
Factors that Influence Exchange Rates (5 of 5)
Interaction of Factors: Some factors place upward

pressure while other factors place downward pressure. (See
Exhibit 4.8)
Influence of Factors across Multiple Currency Markets:
common for European currencies to move in the same
direction against the dollar.
Influence of Liquidity on Exchange Rate adjustment: If a
currency’s spot market is liquid then its exchange rate will
not be highly sensitive to a single large purchase or sale.
Exhibit 4.8 Summary of How Factors Affect
Exchange Rates
Movements in Cross Exchange Rates (1 of 2)
If currencies A and B move in same direction, there is no

change in the cross exchange rate.
When currency A appreciates against the dollar by a
greater (smaller) degree than currency B, then currency A
appreciates (depreciates) against B.
When currency A appreciates (depreciates) against the
dollar, while currency B is unchanged against the dollar,
currency A appreciates (depreciates) against currency B
by the same degree as it appreciates (depreciates)
against the dollar.
Movements in Cross Exchange Rates (2 of 2)
Explaining Movements in Cross Exchange Rate.

• Changes are affected in the same way as types of
forces explained earlier for those that affect demand
and supply conditions between two currencies.
Exhibit 4.9 Example of How Forces Affect the Cross
Exchange Rate
Capitalizing on Expected Exchange Rate Movements (1 of 2)
Institutional speculation based on expected

appreciation: When financial institutions believe that a
currency is valued lower than it should be in the foreign
exchange market, they may invest in that currency before it
appreciates.
Institutional speculation based on expected
depreciation: If financial institutions believe that a currency
is valued higher than it should be in the foreign exchange
market, they may borrow funds in that currency and convert
it to their local currency now before the currency’s value
declines to its proper level.
Speculation by individuals: Individuals can speculate in
foreign currencies.
Capitalizing on Expected Exchange Rate Movements (2 of 2)
The “Carry Trade” — Where investors attempt to capitalize

on the differential in interest rates between two countries.
• Impact of appreciation in the investment currency:
Increased trade volume can have a major influence on
exchange rate movements over a short period.
• Risk of the Carry Trade: Exchange rates may move
opposite to what the investors expected.
SUMMARY (1 of 3)
• Exchange rate movements are commonly measured by the

percentage change in their values over a specified period,
such as a month or a year. MNCs closely monitor exchange
rate movements over the period in which they have cash
flows denominated in the foreign currencies of concern.
• The equilibrium exchange rate between two currencies at
any time is based on the demand and supply conditions.
Changes in the demand for a currency or the supply of a
currency for sale will affect the equilibrium exchange rate.
SUMMARY (2 of 3)
• The key economic factors that can influence exchange rate

movements through their effects on demand and supply
conditions are relative inflation rates, interest rates, income
levels, and government controls. When these factors lead to a
change in international trade or financial flows, they affect the
demand for a currency or the supply of currency for sale and
thus the equilibrium exchange rate. If a foreign country
experiences an increase in interest rates (relative to U.S.
interest rates), then the inflow of U.S. funds to purchase its
securities should increase (U.S. demand for its currency
increases), the outflow of its funds to purchase U.S. securities
should decrease (supply of its currency to be exchanged for
U.S. dollars decreases), and there should be upward pressure
on its currency’s equilibrium value. All relevant factors must be
considered simultaneously when attempting to predict the most
likely movement in a currency’s value.
SUMMARY (3 of 3)
• There are distinct international trade and financial flows

between every pair of countries. These flows dictate the
unique supply and demand conditions for the currencies of
the two countries, which affect the equilibrium cross
exchange rate between their currencies. Movement in the
exchange rate between two non-dollar currencies can be
inferred from the movement in each currency against the
dollar.
• Financial institutions can attempt to benefit from the
expected appreciation of a currency by purchasing that
currency. Analogously, they can benefit from expected
depreciation of a currency by borrowing that currency and
exchanging it for their home currency.
13th Edition
by Jeff Madura
7 license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
5 Currency Derivatives
Chapter Objectives
• Describe the characteristics and use of forward contracts.
• Describe the characteristics and use of currency futures
contracts.
• Describe the characteristics and use of currency call option
contracts.
• Describe the characteristics and use of currency put option
contracts.
What is a Currency Derivative?
A currency derivative is a contract whose price is

derived from the value of an underlying currency.
Examples include forwards/futures contracts and
options contracts.
Derivatives are used by MNCs to:
• Speculate on future exchange rate movements
• Hedge exposure to exchange rate risk
Forward Market (1 of 4)
A forward contract is an agreement between a

corporation and a financial institution:
• To exchange a specified amount of currency
• At a specified exchange rate called the forward
rate
• On a specified date in the future
How MNCs Use Forward Contracts

• Hedge their imports by locking in the rate at which they
can obtain the currency.
Bank Quotations on Forward Rates
• Bid/Ask Spread is wider for less liquid currencies.
• May negotiate an offsetting trade if an MNC enters into
a forward sale and a forward purchase with the same
bank.
• Non-deliverable forward contracts (NDF) can be used
for emerging market currencies where no currency
delivery takes place at settlement; instead, one party
makes a payment to the other party.
Premium or Discount on the Forward Rate

(Exhibit 5.1)
F = S(1 + p)
where:
F is the forward rate
S is the spot rate
p is the forward premium, or the percentage by
which the forward rate exceeds the spot rate.
• Arbitrage — If the forward rate was the same as the

spot rate, arbitrage would be possible.
Exhibit 5.1 Computation of Forward Rate Premiums or
Discounts
Movements in the Forward Rate over Time — The forward

premium is influenced by the interest rate differential between the
two countries and can change over time.
Offsetting a Forward Contract — An MNC can offset a forward
contract by negotiating with the original counterparty bank.
Using Forward Contracts for Swap Transactions — Involves a
spot transaction along with a corresponding forward contract that will
ultimately reverse the spot transaction.
Non-deliverable forward contracts (NDF) — Can be used for
emerging market currencies where no currency delivery takes place at
settlement; instead, one party makes a payment to the other party.
Currency Futures Market (1 of 6)
Similar to forward contracts in terms of obligation to

purchase or sell currency on a specific settlement date in
the future.
Contract Specifications: Differ from forward contracts
because futures have standard contract specifications:
• Standardized number of units per contract (See Exhibit 5.2)
• Offer greater liquidity than forward contracts
• Typically based on U.S. dollar, but may be offered on cross-
rates
• Commonly traded on the Chicago Mercantile Exchange
(CME)
Exhibit 5.2 Currency Futures Contracts Traded on the
Chicago Mercantile Exchange
Trading Currency Futures

• Firms or individuals can execute orders for currency
futures contracts by calling brokerage firms.
• Trading platforms for currency futures: Electronic
trading platforms facilitate the trading of currency futures.
These platforms serve as a broker, as they execute the
trades desired.
• Currency futures contracts are similar to forward
contracts in that they allow a customer to lock in the
exchange rate at which a specific currency is purchased
or sold for a specific date in the future.
Exhibit 5.3 Comparison of the Forward and Futures Market
Comparing Futures to Forward Contracts

• Currency futures contracts are similar to forward contracts in
that they allow a customer to lock in the exchange rate at
which a specific currency is purchased or sold for a specific
date in the future. (Exhibit 5.3)
• Pricing Currency Futures — The price of currency futures
will be similar to the forward rate
Credit Risk of Currency Futures Contracts — To minimize
its risk, the CME imposes margin requirements to cover
fluctuations in the value of a contract, meaning that the
participants must make a deposit with their respective
brokerage firms when they take a position.
How Firms Use Currency Futures

• Purchasing Futures to Hedge Payables — The
purchase of futures contracts locks in the price at which a
firm can purchase a currency.
• Selling Futures to Hedge Receivables — The sale of
futures contracts locks in the price at which a firm can sell
a currency.
• Closing Out a Futures Position (Exhibit 5.4)
• Sellers (buyers) of currency futures can close out their
positions by buying (selling) identical futures contracts prior
to settlement.
• Most currency futures contracts are closed out before the
settlement date.
Exhibit 5.4 Closing Out a Futures Contract
Speculation with Currency Futures (Exhibit 5.5)

• Currency futures contracts are sometimes purchased
by speculators attempting to capitalize on their
expectation of a currency’s future movement.
• Currency futures are often sold by speculators who
expect that the spot rate of a currency will be less than
the rate at which they would be obligated to sell it.
Exhibit 5.5 Source of Gains from Buying Currency
Futures
Speculation with Currency Futures (cont.)

• Efficiency of the currency futures market
• If the currency futures market is efficient, the futures
price should reflect all available information.
• Thus, the continual use of a particular strategy to take
positions in currency futures contracts should not lead to
abnormal profits.
• Research has found that the currency futures market
may be inefficient. However, the patterns are not
necessarily observable until after they occur, which
means that it may be difficult to consistently generate
abnormal profits from speculating in currency futures.
Currency Options Markets
Currency options provide the right to purchase or sell

currencies at specified prices.
Options Exchanges
• 1982 — Exchanges in Amsterdam, Montreal, and
Philadelphia first allowed trading in standardized foreign
currency options.
• 2007 — CME and CBOT merged to form CME group.
• Exchanges are regulated by the SEC in the U.S.
Over-the-counter market — Where currency options are
offered by commercial banks and brokerage firms. Unlike
the currency options traded on an exchange, the over-
the-counter market offers currency options that are
tailored to the specific needs of the firm.
Currency Call Options (1 of 5)
Grants the right to buy a specific currency at a

designated strike price or exercise price within a
specific period of time.
If the spot rate rises above the strike price, the owner of a
call can exercise the right to buy currency at the strike
price.
The buyer of the option pays a premium.
If the spot exchange rate is greater than the strike price,
the option is in the money. If the spot rate is equal to the
strike price, the option is at the money. If the spot rate is
lower than the strike price, the option is out of the
money.
Factors Affecting Currency Call Option Premiums
The premium on a call option (C) is affected by three factors:

• Spot price relative to the strike price (S – X): The higher the
spot rate relative to the strike price, the higher the option price
will be.
• Length of time before expiration (T): The longer the time to
expiration, the higher the option price will be.
• Potential variability of currency (σ): The greater the
variability of the currency, the higher the probability that the
spot rate can rise above the strike price.
How Firms Use Currency Call Options

• Using call options to hedge payables
• Using call options to hedge project bidding to lock in
the dollar cost of potential expenses
• Using call options to hedge target bidding of a
possible acquisition
Speculating with Currency Call Options

• Individuals may speculate in the currency options
based on their expectations of the future movements in
a particular currency.
• Speculators who expect that a foreign currency will
appreciate can purchase call options on that security.
• The net profit to a speculator is based on a comparison
of the selling price of the currency versus the exercise
price paid for the currency and the premium paid for
the call option.
Speculating with Currency Call Options (cont.)

• Break-even point from speculation
• Break even if the revenue from selling the currency equals
the payments made for the currency plus the option
premium.
• Speculation by MNCs.
• Some institutions may have a division that uses currency
options to speculate on future exchange rate movements.
• Most MNCs use currency derivatives for hedging and not
speculation.
Currency Put Options (1 of 8)
Grants the right to sell a currency at a specified strike price or

exercise price within a specified period of time.
If the spot rate falls below the strike price, the owner of a put
can exercise the right to sell currency at the strike price.
The buyer of the options pays a premium.
If the spot exchange rate is lower than the strike price, the
option is in the money. If the spot rate is equal to the strike
price, the option is at the money. If the spot rate is greater
than the strike price, the option is out of the money.
Factors Affecting Put Option Premiums
Put option premiums are affected by three factors:

• Spot rate relative to the strike price (S–X): The lower
the spot rate relative to the strike price, the higher the
probability that the option will be exercised.
• Length of time until expiration (T): The longer the time
to expiration, the greater the put option premium.
• Variability of the currency (σ): The greater the variability,
the greater the probability that the option may be
exercised.
Hedging with Currency Put Options

• Corporations with open positions in foreign currencies can
use currency put options in some cases to cover these
positions.
• Some put options are deep out of the money, meaning that
the prevailing exchange rate is high above the exercise price.
These options are cheaper (have a lower premium), as they
are unlikely to be exercised because their exercise price is
too low.
• Other put options have an exercise price that is currently
above the prevailing exchange rate and are therefore more
likely to be exercised. Consequently, these options are more
expensive.
Speculating with Currency Put Options

• Individuals may speculate with currency put options based
on their expectations of the future movements in a particular
currency.
• Speculators can attempt to profit from selling currency put
options. The seller of such options is obligated to purchase
the specified currency at the strike price from the owner who
exercises the put option.
• The net profit to a speculator is based on the exercise price
at which the currency can be sold versus the purchase price
of the currency and the premium paid for the put option.
Speculating with Currency Put Options (cont.)

• Speculating with combined put and call options
• Straddle — Uses both a put option and a call option at
the same exercise price.
• Good for when speculators expect strong movement in
one direction or the other.
• Efficiency of the currency options market
• Research has found that, when transaction costs are
controlled for, the currency options market is efficient.
• It is difficult to predict which strategy will generate
abnormal profits in future periods.
Contingency graph for the caller of a call option

• Compares price paid for the option to the payoffs received under
various exchange rate scenarios. (Exhibit 5.6)
Contingency graph for the seller of a call option
• Compares premium received from selling the option to the payoffs
made to the options buyer under various exchange rate scenarios.
(Exhibit 5.6)
Contingency graph for the buyer of a put option
• Compares premium paid for put option to the payoffs received
under various exchange rate scenarios. (Exhibit 5.7)
Contingency graph for the seller of a put option
• Compares premium received for put option to the payoffs made
under various exchange rate scenarios. (Exhibit 5.7)
Exhibit 5.6 Contingency Graphs for Currency Call
Options
Exhibit 5.7 Contingency Graphs for Currency Put
Options
Conditional Currency Options (Exhibit 5.8)

• A currency option can be structured with a conditional
premium, meaning that the premium paid for the option
is conditioned on the actual movement in the currency’s
value over the period of concern.
• Firms also use various combinations of currency
options.
Exhibit 5.8 Comparison of Conditional and Basic
Currency Options
European Currency Options

• European-style currency options must be exercised
on the expiration date if they are to be exercised at all.
• They do not offer as much flexibility; however, this is
not relevant to some situations.
• If European-style options are available for the same
expiration date as American-style options and can be
purchased for a slightly lower premium, some
corporations may prefer them for hedging.
SUMMARY (1 of 4)
• A forward contract specifies a standard volume of a

particular currency to be exchanged on a particular
date. Such a contract can be purchased by a firm to
hedge payables or sold by a firm to hedge
receivables. A currency futures contract can be
purchased by speculators who expect the currency to
appreciate; it can also be sold by speculators who
expect the currency to depreciate. If the currency
depreciates then the futures contract declines,
allowing those speculators to benefit when they close
out their positions.
SUMMARY (2 of 4)
• Futures contracts on a particular currency can be

purchased by corporations that have payables in that
currency and wish to hedge against the possible
appreciation of that currency. Conversely, these
contracts can be sold by corporations that have
receivables in that currency and wish to hedge against
the possible depreciation of that currency and wish to
hedge against its possible depreciation.
SUMMARY (3 of 4)
• Call options allow the right to purchase a specified

currency at a specified exchange rate by a specified
expiration date. They are used by MNCs to hedge future
payables. They are commonly purchased by speculators
who expect that the underlying currency will appreciate.
• Put options allow the right to sell a specified currency at
a specified exchange rate by a specified expiration date.
They are used by MNCs to hedge future receivables.
They are commonly purchased by speculators who
expect that the underlying currency will depreciate.
SUMMARY (4 of 4)
• Call options on a specific currency can be purchased

by speculators who expect that currency to appreciate.
Put options on a specific currency can be purchased by
speculators who expect that currency to depreciate.
13th Edition
by Jeff Madura
6 license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6 Government Influence on Exchange Rates
Chapter Objectives
• Describe the exchange rate system used by various

governments.
• Describe the development and implications of a single

European currency.
• Explain how governments can use direct intervention to

influence exchange rates.
• Explain how governments can use indirect intervention to

influence exchange rates.
Exchange Rate Systems (1 of 9)
Exchange rate systems can be classified

according to the degree of government control
and fall into the following categories:
• Fixed
• Freely floating
• Managed float
• Pegged
Fixed Exchange Rate System

• Exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
• Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
• Central bank can also revalue or increase the value of
its currency against other currencies.
Fixed Exchange Rate System (cont.)

• Bretton Woods Agreement 1944 – 1971 — Each
currency was valued in terms of gold.
• Smithsonian Agreement 1971 – 1973 — called for a
devaluation of the U.S. dollar by about 8% against other
currencies.
• Advantages of fixed exchange rates
• Insulate country from risk of currency appreciation.
• Allow firms to engage in direct foreign investment without
currency risk.
• Disadvantages of fixed exchange rates
• Risk that government will alter value of currency.
• Country and MNC may be more vulnerable to economic
conditions in other countries.
Freely Floating Exchange Rate System

• Exchange rates are determined by market forces without
government intervention.
• Advantages of a freely floating system:
• Country is more insulated from inflation of other countries.
• Country is more insulated from unemployment of other
countries.
• Does not require central bank to maintain exchange rates
within specified boundaries.
• Disadvantages of a freely floating exchange rate system:
• Can adversely affect a country that has high unemployment.
• Can adversely affect a country with high inflation.
Managed Float Exchange Rate System

• Governments sometimes intervene to prevent their
currencies from moving too far in a certain direction.
• Countries with floating exchange rates: Currencies
of most large developed countries are allowed to float,
although they may be periodically managed by their
respective central banks. (Exhibit 6.1)
• Criticisms of the managed float system: Critics
suggest that managed float allows a government to
manipulate exchange rates to benefit its own country
at the expense of others.
Exhibit 6.1 Countries with Floating Exchange
Rates and Their Currencies
Pegged Exchange Rate System

• Home currency value is pegged to one foreign
currency or to an index of currencies.
• Limitations of pegged exchange rate
• May attract foreign investment because exchange rate is
expected to remain stable.
• Weak economic or political conditions can cause firms
and investors to question whether the peg will be broken.
Pegged Exchange Rate System (cont.)

Examples:
• Europe’s Snake Arrangement 1972 - 1979
• European Monetary System (EMS) 1979 - 1992
• Mexico’s Pegged System 1994
• China’s Pegged Exchange Rate 1996 - 2005
• Venezuela’s Pegged Exchange Rate 2010
Pegged Exchange Rate System (cont.)

• Currency Boards Used to Peg Currency Values
• A system for pegging the value of the local currency to some
other specified currency. The board must maintain currency
reserves for all the currency that it has printed.
• Interest Rates of Pegged Currencies
• Interest rate will move in tandem with the interest rate of the
currency to which it is tied.
• Exchange Rate Risk of a Pegged Currency
• Provides examples of countries that have pegged the
exchange rate of their currency to a specific currency.
Currencies are commonly pegged to the U.S. dollar or to the
euro.
• Classification of Pegged Exchange Rates (Exhibit 6.2)
Exhibit 6.2 Countries with Pegged Exchange Rates and
the Currencies to Which They Are Pegged
Dollarization
• Replacement of a foreign currency with U.S. dollars.
• This process is a step beyond a currency board
because it forces the local currency to be replaced by
the U.S. dollar. Although dollarization and a currency
board both attempt to peg the local currency’s value,
the currency board does not replace the local currency
with dollars.
A Single European Currency (1 of 5)
Monetary Policy in the Eurozone

• European Central Bank — Based in Frankfurt and is
responsible for setting monetary policy for all participating
European countries
• Objective is to control inflation in the participating countries and
to stabilize (within reasonable boundaries) the value of the euro
with respect to other major currencies.
Impact on Firms in the Eurozone — Prices of products are now
more comparable among European countries.
Impact on Financial Flows in the Eurozone — Bond investors who
reside in the eurozone can now invest in bonds issued by
governments and corporations in these countries without concern
about exchange rate risk, as long as the bonds are denominated in
euros.
Exposure of Countries within the Eurozone

• A single European monetary policy prevents any
individual European country from solving local economic
problems with its own unique monetary policy.
• Any given monetary policy used in the eurozone during a
particular period may enhance conditions in some
countries and adversely affect others.
Impact of Crises within the Eurozone — may affect the
economic conditions of the other participating countries
because they all rely on the same currency and same
monetary policy.
Impact of Crises within the Eurozone (cont.)

• Lessons from Eurozone crisis
• Financial problems of one bank can easily spread to other
banks.
• Banks in Eurozone frequently engage in loan
participations. If companies have trouble repaying, all
banks may be affected.
• News about concerns in one area of Eurozone can trigger
actions in other areas.
• Eurozone country governments must rely on fiscal policy
when they experience serious financial problems.
• Banks lend heavily to governments. Performance is
related to whether that government can repay its debts.
Impact of Crises within the Eurozone (cont.)

• ECB Role in Resolving Economic Crises
• In recent years the bank’s role has expanded to include
providing credit for eurozone countries that are
experiencing a financial crisis.
• The ECB imposes restrictions intended to help resolve
the country’s budget deficit problems over time.
Impact on a Country that Abandons the Euro

• Would allow a country to set its own exchange rate to encourage
purchasers of exports.
• Would possibly be expelled from the European Union, which
would almost certainly reduce its trade with other European Union
countries.
Impact of Abandoning the Euro on Eurozone Conditions
• Investors may fear other countries abandoning the euro and
reduce investments in the eurozone.
• Critics agree that the threat of abandonment creates more
problems than actual abandonment.
Government Intervention (1 of 5)
Reasons for Government Intervention

• Smoothing exchange rate movements
• If a central bank is concerned that its economy will be
affected by abrupt movements in its home currency’s value, it
may attempt to smooth the currency movements over time.
• Establishing implicit exchange rate boundaries
• Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries.
• Responding to temporary disturbances
• A central bank may intervene to insulate a currency’s value
from a temporary disturbance.
Direct Intervention (Exhibit 6.3)

• To force the dollar to depreciate, the Fed can intervene
directly by exchanging dollars that it holds as reserves for
other foreign currencies in the foreign exchange market.
• By “flooding the market with dollars” in this manner, the Fed
puts downward pressure on the dollar.
• If the Fed desires to strengthen the dollar, it can exchange
foreign currencies for dollars in the foreign exchange
market, thereby putting upward pressure on the dollar.
Exhibit 6.3 Effects of Direct Central Bank Intervention in
the Foreign Exchange Market
Direct Intervention (cont.)

• Reliance on reserves
• The potential effectiveness of a central bank’s direct
intervention is the amount of reserves it can use.
• Frequency of Intervention
• Number of direct interventions has declined from 97 different
days in 1989 to no more than 20 days in a year
• Coordinated Intervention
• Intervention more likely to be effective when it is coordinated
by several central banks.
Direct Intervention (cont.)

• Nonsterilized versus sterilized intervention (See Exhibit
6.4)
• When the Fed intervenes in the foreign exchange market
without adjusting for the change in the money supply, it is
engaging in a nonsterilized intervention.
• In a sterilized intervention, the Fed intervenes in the
foreign exchange market and simultaneously engages in
offsetting transactions in the Treasury securities markets.
• Speculating on direct intervention
• Some traders in the foreign exchange market attempt to
determine when Federal Reserve intervention is occurring
and the extent of the intervention in order to capitalize on the
anticipated results of the intervention effort.
Exhibit 6.4 Forms of Central Bank Intervention in the
Foreign Exchange Market
Indirect Intervention
The Fed can affect the dollar’s value indirectly by influencing
the factors that determine it.
e  f (INF , INT , INC , GC, EXP)
where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
Indirect Intervention
Indirect Intervention (cont.)

• Government Control of Interest Rates by increasing or
reducing interest rates.
• Government Use of Foreign Exchange Controls such as
restrictions on the exchange of the currency.
• Intervention Warnings intended to warn speculators. The
announcements could discourage additional speculation and
might even encourage some speculators to unwind
(liquidate) their existing positions in the currency.
Intervention as a Policy Tool
A weak home currency can stimulate foreign demand for

products. (See Exhibit 6.5)
A strong home currency can encourage consumers and
corporations of that country to buy goods from other
countries. (See Exhibit 6.6)
Exhibit 6.5 How Central Bank Intervention Can
Stimulate the U.S. Economy
Exhibit 6.6 How Central Bank Intervention Can
Reduce Inflation
SUMMARY (1 of 4)
• Exchange rate systems can be classified as fixed rate,

freely floating, managed float, and pegged. In a fixed
exchange rate system, exchange rates are either held
constant or allowed to fluctuate only within very
narrow boundaries. In a freely floating exchange rate
system, exchange rate values are determined by
market forces without intervention. In a managed float
system, exchange rates are not restricted by
boundaries but are subject to government
intervention. In a pegged exchange rate system, a
currency’s value is pegged to a foreign currency or a
unit of account and moves in line with that currency
(or unit of account) against other currencies.
SUMMARY (2 of 4)
• Numerous European countries use the euro as their

home currency. The single currency allows
international trade among firms in the eurozone without
foreign exchange expenses and without concerns
about future exchange rate movements. However,
countries that participate in the euro do not have
complete control of their monetary policy because a
single policy is applied to all countries in the eurozone.
In addition, being part of the eurozone may render
some countries more susceptible to a crisis occurring
in some other eurozone country.
SUMMARY (3 of 4)
• Governments can use direct intervention by purchasing

or selling currencies in the foreign exchange market,
thereby altering demand and supply conditions and
hence the currencies’ equilibrium values. When a
government purchases a currency in the foreign
exchange market, it puts upward pressure on that
currency’s equilibrium value. When a government sells
a currency in the foreign exchange market, it puts
downward pressure on the currency’s equilibrium
value.
SUMMARY (4 of 4)
• Governments can use indirect intervention by

influencing the economic factors that affect equilibrium
exchange rates. A common form of indirect intervention
is to increase interest rates in order to attract more
international capital flows, which may cause the local
currency to appreciate. However, indirect intervention
is not always effective.

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International Financial Management

• Explain how exchange rate movements are measured.

Depreciation: decline in a currency’s value

Comparing foreign currency spot rates over two points

A positive percent change indicates that the currency

The exchange rate represents the price of a currency, or the

Change in the Equilibrium Exchange Rate

The equilibrium exchange rate will change over time as supply

Relative Inflation Rates: Increase in U.S. inflation leads to

Relative Income Levels: Increase in U.S. income

Interaction of Factors: Some factors place upward

If currencies A and B move in same direction, there is no

Explaining Movements in Cross Exchange Rate.

Institutional speculation based on expected

The “Carry Trade” — Where investors attempt to capitalize

• Exchange rate movements are commonly measured by the

• The key economic factors that can influence exchange rate

• There are distinct international trade and financial flows

A currency derivative is a contract whose price is

A forward contract is an agreement between a

How MNCs Use Forward Contracts

Premium or Discount on the Forward Rate

• Arbitrage — If the forward rate was the same as the

Movements in the Forward Rate over Time — The forward

Similar to forward contracts in terms of obligation to

Trading Currency Futures

Comparing Futures to Forward Contracts

How Firms Use Currency Futures

Speculation with Currency Futures (Exhibit 5.5)

Speculation with Currency Futures (cont.)

Currency options provide the right to purchase or sell

Grants the right to buy a specific currency at a

Factors Affecting Currency Call Option Premiums

The premium on a call option (C) is affected by three factors:

How Firms Use Currency Call Options

Speculating with Currency Call Options

Speculating with Currency Call Options (cont.)

Grants the right to sell a currency at a specified strike price or

The buyer of the options pays a premium.

Factors Affecting Put Option Premiums

Put option premiums are affected by three factors:

Hedging with Currency Put Options

Speculating with Currency Put Options

Speculating with Currency Put Options (cont.)

Contingency graph for the caller of a call option

Conditional Currency Options (Exhibit 5.8)

European Currency Options

• A forward contract specifies a standard volume of a

• Futures contracts on a particular currency can be

• Call options allow the right to purchase a specified

• Call options on a specific currency can be purchased

• Describe the exchange rate system used by various

• Describe the development and implications of a single

• Explain how governments can use direct intervention to

• Explain how governments can use indirect intervention to

Exchange rate systems can be classified

Fixed Exchange Rate System

Fixed Exchange Rate System (cont.)

Freely Floating Exchange Rate System

Managed Float Exchange Rate System

Pegged Exchange Rate System

Pegged Exchange Rate System (cont.)

Pegged Exchange Rate System (cont.)