2. INTRODUCTION
As we learned in Chapter 9, an exchange rate represents the
number of units of one currency needed to acquire one unit of
another. Although this definition seems simple, managers must
understand how governments set an exchange rate and what
causes it to change. Such understanding can help them anticipate
exchange-rate changes and make decisions about business
factors that are sensitive to those changes, such as the sourcing of
raw mate- rials and components, the placement of manufacturing
and assembly, and the choice of final markets
3. THE
INTERNATIONAL
MONETARY
FUND
In 1944, toward the close of World
War II, the major Allied
governments met in Bretton
Woods, New Hampshire, to
determine what was needed to
bring economic stability and
growth to the postwar world. As a
result of those meetings, the
International Monetary Fund (IMF)
came into official existence on
December 27, 1945, with the goal
of promot- ing exchange-rate
stability and facilitating the
international flow of currencies.
The IMF began financial operations
on March 1, 1947.2
5. THE IMF TODAY
THE GLOBAL FINANCIAL CRISIS
AND THE IMF
The Quota System When a country
joins the IMF, it contributes a
certain sum of money, called a
quota, broadly based on its relative
size in the global economy. The IMF
can draw on this pool of money to
lend to countries, and it uses the
quota as the basis of how much a
country can borrow from the Fund.
It is also the basis on which the IMF
allocates special drawing rights
(SDRs), discussed later.
One fallout of the global crisis that
began in 2008–09 was the concern
over global liquidity, especially in the
emerging markets. The G8 countries
injected hundreds of billions of dollars
into their financial systems and
implemented large stimulus packages
to get their economies moving.
6. EVOLUTION TO FLOATING
EXCHANGE RATES
EXCHANGE-RATE
ARRANGEMENTS
The IMF’s system was initially one
of fixed exchange rates. Because
the U.S. dollar was the cornerstone
of the international monetary
system, its value remained constant
with respect to the value of gold.
Other countries could change the
value of their currency against gold
and the dollar, but the value of the
dollar remained fixed.
The Jamaica Agreement formalized the
break from fixed exchange rates. As
part of this move, the IMF began to
permit countries to select and maintain
an exchange-rate arrangement of their
choice, provided they communicated
their decision to the IMF. The formal
decision of a country to adopt a
particular exchange-rate mechanism is
called a de jure system. In addition, the
IMF surveillance program determines
the de facto exchange-rate system that
a country uses.
7. HARD PEG
There are two possibilities for countries that adopt a hard peg.
The first is like the example of El Salvador, which, as described
in the opening case, has no separate legal tender but instead
has adopted the U.S. dollar as its currency.
SOFT PEG
There are several different types of soft pegs, but most
countries in this category have adopted a conventional fixed-
peg arrangement, whereby a country pegs its currency to
another currency or basket of currencies and allows the
exchange rate to vary plus or minus 1 percent from that value.
FLOATING ARRANGEMENT
Currencies considered to be in a floating arrangement are
either floating (35 countries) or free floating (31 countries).
Floating currencies are those that generally change according
to market forces but may be subject to market intervention.
THREE CHOICES: HARD PEG, SOFT
PEG, OR FLOATING
ARRANGEMENT
The IMF classifies currencies
into one of three broad
categories, moving from the
least to the most flexible. If
they have adopted a hard
peg (13.2 percent of the
total), they lock their value
onto something and don’t
change.
8. NONINTERVENT
ION: CURRENCY
IN A FLOATING-
RATE WORLD
Currencies that float freely respond
to supply and demand conditions
uncontrolled by gov- ernment
intervention. This concept can be
illustrated using a two-country
model involving the United States
and Japan. Figure 9.2 shows the
equilibrium exchange rate in the
market and then a movement to a
new equilibrium level as the market
changes. The demand for yen in
this example is a function of U.S.
demand for Japanese goods and
services, such as auto- mobiles, and
yen-denominated financial assets,
such as securities.
9. INTERVENTION:
CURRENCY IN A
FIXED-RATE OR
MANAGED
FLOATING-
RATE WORLD
In the preceding example,
Japanese and U.S. authorities
allowed supply and demand to
determine the values of the yen
and dollar. That doesn’t happen for
currencies that fix their exchange
rates and then don’t allow them to
move according to market forces.
There can be times when one or
both countries might not want
exchange rates to change.
10. BLACK
MARKETS
In many of the countries that do not
allow their currencies to float
according to market forces, a black
market can parallel the official
market and yet be aligned more
closely with the forces of supply and
demand. The less flexible a country’s
exchange-rate arrangement, the
more likely there will be a thriving
black (or parallel) market, which
exists when peo- ple are willing to
pay more for dollars than the official
rate. In order for such a market to
work, the government must control
access to foreign exchange so it can
control the price of its currency.
11. FOREIGN-
EXCHANGE
CONVERTIB
ILITY AND
CONTROLS
Some countries with fixed
exchange rates control access
to their currencies. Fully
convertible currencies are those
that the government allows both
residents and nonresidents to
purchase in unlimited amounts.
12. EXCHANGE
RATES AND
PURCHASIN
G POWER
PARITY
The next three sections examine
three interconnected issues: the
relationship between infla- tion
and exchange rates, the
relationship between interest
rates and exchange rates, and
the factors you can use to
forecast (or at least attempt to
forecast) future exchange rates.
13. EXCHANGE
RATES AND
INTEREST
RATES
Although inflation is the most
important medium-term
influence on exchange rates,
interest rates are also important.
Interest rate differentials,
however, have both short-term
and long- term components to
them. In the short term,
exchange rates are strongly
influenced by inter- est rates.
14. OTHER
FACTORS IN
EXCHANGE-
RATE
DETERMINATION
Confidence: Flight to Risk vs. Flight to
Safety Various other factors can
affect cur- rency values. One not to
be dismissed lightly is confidence: In
times of turmoil, people prefer to hold
currencies that are considered safe.
Information It is interesting how the
release of information can influence
currency values. Services such as
Bloomberg are so important because
they carry up-to-date financial news
that traders can follow as they try to
figure out what will happen to
exchange rates.
15. FUNDAMENTAL
AND
TECHNICAL
FORECASTING
Managers can forecast exchange
rates by using either of two
approaches: fundamental or
technical. Fundamental forecasting
uses trends in economic variables to
predict future
rates. The data can be plugged into an
econometric model or evaluated on a
more subjective basis. Technical
forecasting uses past trends in
exchange rates themselves to spot
future rate trends.
16. 1.FUNDAMENTAL
FACTORS TO
MONITOR
For freely fluctuating currencies,
the law of supply and demand
determines market value.Your
ability to forecast exchange
rates depends on your time
horizon.
17. MARKETING
DECISIONS
Marketing managers watch
exchange rates because they can
affect demand for a company’s
products at home and abroad. In
2013, as the Indian rupee plunged in
value against the U.S. dollar, Indian
small importers were in trouble
because they didn’t have the financial
strength to deal with the currency
fluctuations. In most cases, they had
to pay their suppliers in U.S. dollars,
and when the rupee fell, they had to
come up with more rupees to
convert into dollars to pay the
suppliers, and they were struggling to
do so.
18. PRODUCTION
DECISIONS
Exchange-rate changes can also
affect production decisions. A
manufacturer in a country where
wages and operating expenses
are high might be tempted to
relocate production to a country
with a currency that is rapidly
losing value. The company’s
home currency would buy lots of
the weak currency, making the
company’s initial investment
cheap.
19. FINANCIAL
DECISIONS
Exchange rates can affect
financial decisions primarily in
sourcing financial resources,
remitting funds across national
borders, and reporting financial
results. In the first area, a
company might be tempted to
borrow money in places where
interest rates are lowest.
However, recall that interest-
rate differentials often are
compensated for in money
markets through exchange-rate
changes.
