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International Business
Dealing with Currencies (Foreign Exchange)
with summary of international organizations and basic introduction to the International Monetary System
9-1
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The international economy so far…
Huge cultural differences between countries
Big differences in political economic systems Getting narrower
Reduction in restrictions accelerates growth in trade
Technology ties world together WTO addresses disputes
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Enormous increase in wealth Effects for businesses not in
international trade: huge increase in competition
Not everyone benefits Median incomes in developed world not
increasing Benefits in poorer countries are
unevenly spread
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Today’s tasks…
Understand the use of currencies in international trade
Get a basic sense of the international monetary system
Summarize international organizations
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Discuss the midterm
Maybe … watch a video that captures what this is doing in the fastest changing countries
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Foreign Exchange Terms
Foreign exchange: money denominated in the currency of another nation or group of nations Cash Credit Bank deposits Other short-term claims (e.g., bonds)
Exchange rate: the price of a particular currency relative to another
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Basic questions … What is money? How should you convert money from one
currency into another? How are the values of currencies set? How can you limit foreign exchange risk
(the possibility that unpredicted changes in exchange
rates will have adverse consequences for the firm)? Can you predict when currency values will
change? If so, how?
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What is money? The “medium of exchange”
that is, something widely accepted as means of payment
Usually, governments declare certain pieces of paper to be money But people must accept them Alternatives are inconvenient, but
possible Tobacco in early American colonies U.S. dollar in Russia when ruble collapsed
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Sell abroad, and you may receive payment in foreign currency
Buy abroad, and you may have to pay in foreign currency
Travel abroad, you must spend foreign currency
A foreign direct investment will have to pay expenses in foreign currency
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How should you convert money from one currency into another?
Current values of major foreign currencies are available on the Web
Most businesspeople normally buy from or sell to a bank The bank takes a bigger ‘spread’ than
the rates offered on the Web, but handles all details
Banks may vary a lot in how good a deal they give
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A business with significant foreign activity creates a stable relationship with one or a few banks
Nowadays, you can do your own currency trading
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How are the values of currencies set?
There are two basic ways “Fixed” or “Pegged” exchange rates
Governments decide the value of currency Example: Hong Kong’s government keeps
the value of its dollar at roughly US$0.129 (US$1=HK$7.75)
With a ‘fixed rate’, there is absolutely no variability.
A ‘pegged’ rate implies small variability
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Most key world currencies float against each other
Supply and demand sets values This is how exchange rates are set for the
US dollar vs. Euro, Japanese yen, British pound, Swiss franc, etc.
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Insuring Against Foreign Exchange Risk
Businesses use the foreign exchange market to provide insurance against foreign exchange risk
Protecting yourself against foreign exchange risk is called hedging
You can buy or sell using1. spot exchange rates2. forward exchange rates3. currency swaps
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Insuring Against Foreign Exchange Risk
1. Spot Exchange Rates The spot exchange rate is the rate at
which a foreign exchange dealer converts one currency into another currency on a particular day Spot rates are determined by the
interaction between supply and demand, and so change continually
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Insuring Against Foreign Exchange Risk
2. Forward Exchange Rates A forward exchange occurs when two
parties agree to exchange currency at some specific future date Forward rates are typically quoted for 30,
90, or 180 days into the future Forward rates are typically the same as
the spot rate plus or minus an adjustment for the interest the parties will pay/receive
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Insuring Against Foreign Exchange Risk
3. Currency Swaps A currency swap is the simultaneous
purchase and sale of an amount of foreign exchange on two different dates Swaps are used when it is desirable to
move out of one currency into another for a limited period without incurring foreign exchange rate risk
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Fixed exchange rates have important benefits
They make business predictable In some very prosperous periods,
most major exchange rates have been fixed The late 19th century 1945-1971
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The gold standard made the benefits of fixed rates clear Before WW I, all major currencies
were convertible into gold UK £1=113 grains gold (.2354 oz) US $1= 23.22 grains (.0484 oz) So £1=4.87
Everyone knew what everything was and would be worth
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The gold standard system had broken down after WW I
The Bretton Woods conference in 1944 created a new system of fixed rates
The International Monetary Fund (IMF) managed the system It can lend to countries in fiscal crisis
But it usually demands dramatic cuts in government spending, etc., in return
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However, fixed exchange rates require discipline in the government – and a willingness to create pain Example: Suppose your nation’s economy is
very prosperous Your people will have money to buy imports Their demand for foreign currencies will put
upward pressure on their exchange rates Government has to slow the domestic economy
to prevent change in exchange rate Higher taxes, higher interest rates, lower spending
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Many economists say if a country is having
difficulty maintaining a fixed exchange rate, the economy is ‘overheated’ They say higher interest rates or higher taxes
might be better for the economy in the long run in those circumstances
But politicians don’t like to take pain
U.S. abandoned fixed exchange rates when the Vietnam War created strong inflation
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It seems that the more complicated an economy, the more difficult it is to maintain fixed/pegged rates Many small countries succeed
Hong Kong, Bangladesh, Fiji Few propose them for the largest
developed countries today
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But China maintains a pegged exchange rate Its government buys all surplus dollars
in the country In June 2012 China had $3,240 billion
US dollars
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Most international business involves currencies with floating rates
Buyers and sellers establish prices in markets like those for tea and wheat
$5,000,000,000,000 in foreign exchange is traded every day
US dollar is most widely traded involved in 90% of all transactions
London is the main foreign-exchange market
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Key Foreign-Exchange Terms
Bid: the rate at which a trader will buy foreign currency from you
Offer: the rate at which a trader will sell foreign currency to you
Spread: the difference between bid and offer rates; The spread is the profit margin for the
trader
9-6
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Market Rhythms
9-13
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How can you predict when currency values will change?
Business decisions demand you look far ahead If exchange rates will change and you
don’t hedge adequately, your whole calculation will be off
Some foreign currencies have lost 90% or more of their value in a year Argentine peso went from $1=1 peso to
$1=3.5 pesos in one jump
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‘Fundamental analysis’ involves examining basic economic data
These forces can drive changes in exchange rates: How fast are prices rising in the
country? If prices are rising the currency may fall
Is there a trade surplus or deficit? Is the government running budget
deficits? How much? If the government or its people are
borrowing too much the currency may fall
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How do interest rates in the countries compare? If a country’s interest rates are high, its
currency may rise How has the government been
managing the currency? Is it buying or selling foreign currency? Is it running out of resources for pursuit of a
strategy it has been following?
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Technical analysis involves examining trends in exchange rates
One principle: Trends once established often tend to continue ‘The trend is your friend’
But if “everyone” agrees something will happen, it may not happen When ‘everyone’ thinks the dollar will go
down, ‘everyone’ has already sold dollars If the news changes, many may quickly
change their minds and want to buy
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Foreign exchange can be the difference between profit and loss
HSBC Bank in Argentina They entered Argentina at a time when it
appeared the government was starting to manage the economy effectively
But they continued investing as government became more irresponsible
They lost big
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International organizations: a summary
Biggest driver of free trade has been the treaty created from the 1944 Bretton Woods conference: the General Agreement on Tariffs and Trade
To strengthen it, countries created the World Trade Organization in 1995 WTO judges trade disputes
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International Monetary Fund was also created at Bretton Woods to keep the world’s currency system reasonably stable
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These won’t be on the test, but are good to know… World Bank – founded at Bretton Woods to
lend to needy countries United Nations – a basically political
organization founded just after WW II principally as a forum for discussions to prevent war
Organization for Economic Cooperation and Development – set up by North American and European nations after WW II, it is now a cooperation group of almost all the rich countries
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Material below here is not required
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Foreign-Exchange Convertibility
Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts “Hard currencies” are fully convertible “Soft currencies” (or weak currencies) are not
fully convertible Typically from developing countries Known as “exotic currencies”
9-10