Lecture 2:The International

Monetary System
A Discussion of Foreign Exchange
Regimes (i.e., The Arrangement
by which a Country’s Exchange
Rate is Determined)
Where is this International
Financial Center?
What is the International Monetary
System?
 It is the overall financial environment in which global
businesses and global investors operate.
 It is represented by the following 3 sub-sectors:
 International Money and Capital Markets
 Banking markets
 Bond markets
 Equity markets
 Foreign Exchange Markets
 Currency markets (and foreign exchange regimes)
 Derivatives Markets
 Forwards, futures, options…
 This lecture will focus on the foreign exchange
market
Concept of an Exchange Rate Regime
 The exchange rate regime refers to the arrangement
by which the price of country’s currency is determined
within foreign exchange markets.
 This arrangement is determined by individual
governments (essentially how much control if any
they wish to exert on the actual exchange rate).
 Foreign currency price is:
 The foreign exchange rate (referred to as the “spot rate”).
 Expresses the value of a county’s currency as a ratio of
some other country.
 Since the 1940’s that other currency has been the U.S. dollar.
 Century before (and under the “Classical Gold Standard) it was
the British pound.
Foreign Exchange Rate Quotations
 There are two generally accepted ways of
quoting a currency’s foreign exchange rate
(i.e., the ratio of one currency to the U.S.
dollar).
 American terms and European Terms quotes
 American terms quotes: Expresses the
exchange rate as the amount of U.S. dollars
per 1 unit of a foreign currency.
 For Example: $1.65 per 1 British pound
 Or $1.45 per 1 European euro
 Or $1.06 per 1 Australian dollar
Foreign Exchange Rate Quotations
 European terms quote: Expresses the
exchange rate as the amount of foreign currency
per 1 U.S. dollar
 For Example: 76.67 yen per 1 U.S. dollar
 Or 7.80 Hong Kong dollars per 1 U.S. dollar
 Or 6.38 Chinese yuan per 1 U.S. dollar
 For reporting and trading purposes, most of the
world’s major currencies are quoted on the basis
of American terms (Pound and Euro); however,
the majority of the world’s currencies are quoted
on the basis of European terms.
 http://www.bloomberg.com/markets/currencies/
Why are Exchange Rate Regimes Important
for Global Firms and Investors?
 As we will see in the next lecture, exchange rate
regimes will affect the potential volatility of a
country’s exchange rate.
 For global firms, changes in exchange rates can
affect the home currency equivalent
of the foreign currency cash flow
and thus the value of the firm.
 For global investors, changes in exchange rates:
 Affect the home currency returns associated with
investments in foreign financial assets.
A Model for Illustrating Exchange
Rate Regimes
 We can think of current exchange rate regimes as
falling along a spectrum as represented by a
national government’s involvement in affecting
(managing) their country’s exchange rate.
No Very Active
Involvement by Involvement by
Government Government

Market forces Government is

are Determining or
Determining Managing the
Exchange rate Exchange rate
Exchange Rate Regimes Today
Minimal (if any) Active
Involvement by Involvement by
Government Government

Market forces Government is

are Determining or
Determining Managing the
Exchange rate Exchange rate

Managed Pegged
Floating Rate
Rate Rate
(“Dirty Float”) Regime
Regime Regime
Classification of Exchange Rate
Regimes: Floating Rate Regimes
 Floating Currency Regime:
 No (or at best occasional) government involvement
(i.e., intervention) in foreign exchange markets.
 Market forces, i.e., demand and supply, are the
primary determinate of foreign exchange rates
(prices).
 Financial institutions (global banks, investment firms),
multinational firms, speculators (hedge funds),
exporters, importers, etc.
 Central banks may intervene occasionally to offset what
they regard as “inappropriate” or “disorderly” exchange
rate levels.
Classification of Exchange Rate
Regimes: Managed Rate Regimes
 Managed Currency (“Dirty Float”) Regime:
 High degree of intervention of government in foreign
exchange market (perhaps on a daily basis).
 Purpose: to offset moderate market forces and produce an
“desirable” exchange rate level or path.
 Usually done because exchange rate is seen as
important to the national economy (e.g., export sector
or the price of critical imports).
 Currency’s exchange rate will be managed in relation
to another currency (or a market basket of currencies)
 Preferred currencies are the US dollar and Euro.
Classification of Exchange Rate Regimes:
Pegged (Fixed) Rate Regimes
 Pegged Currency Regime
 Governments directly link (i.e., peg) their currency’s
rate to another currency.
 Government sets the exchange rate with a certain band (e.g.,
+ or – 1%) of a fixed rate or within a narrow margin,
sometimes called a crawling peg (e.g., + or – 2%) of a trend.
 Occurs when governments are reluctant to let market
forces determine rate.
 Exchange rate seen as essential to country’s
economic development and or trade relationships.
 Governments are also concerned about the potential
negative impacts of a open capital market (i.e.,
disruptive flows of short term funds – “hot money.”)
Examples of Currencies by Regime
 Floating Rate Currencies:
 Canadian dollar (1970), U.S. dollar (1973), Japanese yen (1973), British
pound (1973), yen (1973), Australian dollar (1985), New Zealand dollar
(1985), South Korean Won (1997), Thailand baht (1997), Euro (1999),
Brazilian real (1999), Chile peso (1999), Argentina Peso (2002).
 Managed Rate Currencies:
 Singapore dollar, 1981 (Euro), Costa Rica colon (U.S. dollar), Malaysia
ringgit (2005, Market Basket), Vietnam dong (11/08 U.S. dollar).
 Pegged Rate Currencies – to a fixed rate (against the U.S.
dollar or market basket):
 Hong Kong dollar, since 1983 (7.8KGD = 1USD), Saudi Arabia riyal
(3.75SAR = 1USD), Oman rial (0.385OMR = 1USD)
 Pegged Rate Currencies (Crawling Peg) – to a trend (against
the U.S. dollar or market basket):
 China yuan (7/05 Market Basket), Bolivia boliviano (U.S. dollar)
 Note: The IMF notes that 66 out of 192 countries they classify use
the U.S. dollar as a “anchor.” Data above as of 2009.
Changing Exchange Rate Regimes:
1970 -2010 (IMF Classifications)
% by Number of Countries % by GDP of Countries
Simplified Model of Floating Exchange
Rates (Market Determined Rates)
 The market “equilibrium” exchange rate at any point
in time can be represented by the point at which the
demand for and supply of a particular foreign
currency produces a market clearing price, or:

Supply (of a certain FX)

Price
Demand (for a certain FX)

Quantity of FX
Simplified Model: Strengthening FX
 Any situation that increases the demand (d to d’) for a
given currency will exert upward pressure on that
currency’s exchange rate (price).
 Any situation that decreases the supply (s to s’) of a given
currency will exert upward pressure on that currency’s
exchange rate (price).

s s’ s
p p

d d’ d

q q
Simplified Model: Weakening FX
 Any situation that decreases the demand (d to d’) for a
given currency will exert downward pressure on that
currency’s exchange rate (price).
 Any situation that increases the supply (s to s’) of a given
currency will exert downward pressure on that currency’s
exchange rate (price).

s s s’
p p

d’ d d

q q
Factors That Affect the Equilibrium
Exchange Rate: Changes in Demand
 Relative (short-term) interest rates.
 Affects the demand for financial assets (increase demand for
high interest rate currencies).
 Relative rates of inflation.
 Affects the demand for real (goods) and financial assets; hence
the demand for currencies
 Low inflation results in increase global demand for a country’s goods.
 Low inflation results in high real returns on financial assets.
 Relative economic growth rates.
 Affects longer term investment flows in real capital assets (FDI)
and financial assets (stocks and bonds).
 Changes in global and regional risk.
 Safe Haven Effects: Foreign exchange markets seek out safe
haven countries during periods of uncertainty.
Safe Haven Effect: September 11, 2001
Factors That Affect the Equilibrium
Exchange Rate: Government Intervention
 Foreign exchange intervention policy if a
government feels its currency is “too weak”
 Government will buy their currency in foreign
exchange markets
 Create demand and push price up.
 Foreign exchange intervention policy if
government feels its currency is “too strong”
 Government will sell their currency in foreign
exchange markets
 Increase supply to bring price down.
Factors That Affect the Equilibrium
Exchange Rate: Government Interest Rate
Adjustments
 Some governments may also use interest rate
adjustments to influence their currencies.
 When a currency become “too weak:”
 Governments might raise short term interest rates to
encourage short term foreign capital inflows.
 Higher interest rates make investments more attractive and
increase demand for the currency.
 When a currency becomes “too strong:”
 Governments might lower short term interest rates to
discourage short term foreign capital inflows.
 Lower interest rates will make investments less attractive and
reduce the demand for the currency.
Factors That Affect the Equilibrium
Exchange Rate: Carry Trade Strategies
 Carry trade strategy: A foreign exchange trading strategy in which a
trader sells a currency with a relatively low interest rate and uses
the funds to purchase a different currency yielding a higher interest
rate. This strategy offers profit not only from the interest rate
difference (overnight interest rate) but additionally from the currency
pair’s fluctuation.

 An example of a "yen carry trade": A trader borrows Japanese yen

from a Japanese bank, converts the funds into Australian dollars
and buys an Australian bond for the equivalent amount. If we
assume that the bond pays 4.5% and the Japanese borrowing rate
is 1.0%, the trader stands to make a profit of 3.5% as long as the
exchange rate between the countries does not change.
 In this example, the trader is short on yen and long on Australian dollars.
Impact of Carry Trades on
Exchange Rates
 Carry trades can result in a huge amount of capital flows in and
out of currencies.
 High interest rate currency will experience increase demand.
 Low interest rate currency will experience increase in supply.
 Combined this will result in a strengthening of the high interest rate
currency against the low interest rate currency.
 However, when traders reverse their positions, the opposite
exchange rate effects will occur.
 When do they reverse: During periods of increasing global
uncertainty about interest rates and exchange rates.
 For a case which combines carry trade and government
intervention, please see: Case Study: New Zealand Central Bank
Intervention in the Foreign Exchange Market, June 11, 2007
(posted on course web site).