The International Monetary System

"The 2007 survey shows an unprecedented rise in

activity in traditional foreign exchange markets compared to 2004. Average daily turnover rose to $3.2 trillion in April 200
- Bank for International Settlements (BIS)

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Objectives
How exchange rate markets work Examine the forces that determine exchange rates Implication to International business of exchange
rate movement and foreign exchange market

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The function of foreign exchange market

Convert currency of one country into another To provide insurance against forex risks

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I. Currency Conversion
Tourists a minor participants in currency conversions Companies engaged in international trade and
investments Payments for imports Currency speculation short term movement of funds from one currency into another in hopes of profiting from shifts in exchange rates

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II. Insuring against forex risks

To understand this we must first distinguish between spot exchange rate, forward exchange rates and currency swaps. Spot Exchange rates When two parties agree to exchange and execute the deal immediately, the transaction is referred to as a spot exchange. Exchange rates governing such on the spot trades are referred to as spot exchange rates. The spot exchange rate is the rate at which a foreign exchange dealer coverts one currency into another currency on a particular day. The value of the currency is determined by the demand and supply of that currency.
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Forward Exchange Rate

A forward exchange occurs when two parties agree to exchange currency and execute the deal at some specific date in future. Exchange rates governing such future transactions are referred to as forward exchange rates. For most major currencies, forward exchange rates are quoted for 30 days, 90 days, 120 days

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Example

An Indian company imports American computers and knows that it must pay $ to US when the shipment arrives. The company will pay US supplier $1000/- for each computers and the current dollar/Rs. Spot exchange rate is $1=Rs.45 Therefore it cost 45,000/- Rs. For each laptop. The importer knows that she can sell them for 50,000/- , yielding a gross profit of 5,000/- on each laptop. If on next 30 days Rs. Depreciates against dollar, say $1=Rs.51 , she still has to pay $1000 for each computer but it now costs her 51,000/- Rs. Which is more than the price in which she can sell, thus making the deal unprofitable. To avoid this risk Indian importer can engage in forward exchanges. Assume the 30 day forward rate for converting dollars to Rs. $1=Rs.47. The importer enters into a 30day forward and ensures she does not have to pay more than 47000/- per computer, this guarantees a profit of Rs.3000/per computer

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Currency Swaps

A swap that involves the exchange of principal and interest in one currency for the same in another currency. It is considered to be a foreign exchange transaction and is not required by law to be shown on the balance sheet. For example, suppose a U.S.-based company needs to acquire Swiss francs and a Swiss-based company needs to acquire U.S. dollars. These two companies could arrange to swap currencies by establishing an interest rate, an agreed upon amount and a common maturity date for the exchange. Currency swap maturities are negotiable for at least 10 years, making them a very flexible method of foreign exchange. Currency swaps were originally done to get around exchange controls. .

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Purchasing Power Parity Theory

Purchasing power parity is an economic technique
used when attempting to determine the relative values of two currencies. It is useful because often the amount of goods a currency can purchase within two nations varies drastically, based on availability of goods, demand for the goods, and a number of other, difficult to determine factors.

Purchasing-Power Parity Theory states that a unit of any given currency should be able to buy the same quantity of goods in all countries.
Based upon The Law of One Price
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The Law of One Price

A good must sell for the same price in all locations.

This law applies in the international market and is a

common sense notion.

If the law were not true, unexploited profit opportunities would exist, allowing someone to earn risk less profits by purchasing low in one market and selling high in another. Example: Buying coffee in India and selling in Japan

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Purchasing-Power Parity

A currency must have the same buying power (i.e.

parity) in all countries and it is the exchange rate that assures that this purchasing power is approximately equal across countries. The nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries.

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Limitations of The Purchasing-Power Parity

Two things may keep nominal exchange rates from exactly equalizing purchasing power:

1. Many goods are not easily traded or shipped from one country to another. 2. Traded goods are not always perfect substitutes. 3. Transportation Cost & Tariff Barriers

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Big Mac index

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Big Mac index

Perhaps the most famous example of purchasing
power parity was given by the Economist Magazine as the Big Mac index. Using the Big Mac index, we determine the cost of a Big Mac in a number of countries and can then conclude an exchange rate based on this index. For example, if a Big Mac costs $3 in the US, and 9,000 riel in Cambodia, we can determine that the exchange rate is $1 for 3,000 riel. We would then use this indexed exchange rate to determine relative value of other items.

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Inferences of PPP
The exchange rate will change if relative prices
change If rate of inflation is high in a country, its currency will depreciate against the country whose rate of inflation is low. Increase in money supply raises demand for goods/services resulting in increase in price level leading to inflation leading to currency depreciation

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Empirical Tests of PPP Theory

The connection between a countrys exchange rate
and PPP has yielded mixed results in empirical testing, specially in short run (span of 5yrs or less) Reasons: government intervention, trade barriers, transportation costs

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Interest Rates and Exchange Rates

Inflation leads to increase in interest rates, because
investors want compensation for the decline in the value of their money. This is referred to as fisher effect: It sates that a countrys nominal interest rate is the sum of the real rate of interest and the expected rate of inflation over the period for which funds are to be lent. Ex: if real int. rate 5%, inflation rate 10% then nominal interest rate 15%
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When investors are free to transfer capital between countries, real interest rates will be the same in every country. If differences in real interest rates did emerge between countries then arbitrage would soon equalize them. (In practice differences in real interest rates may persist due to government control on capital flow.) It follows that if real interest rate is same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates. Since PPP theory establishes a link between inflation and exchange rates and since interest rates and reflect expectations about inflation, it follows that there is a link between interest rates and exchange rates, This link is known as international fisher effect.

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International Fisher Effect

An economic theory that states that an expected change in the current exchange rate between any two currencies is approximately equivalent to the difference between the two countries' nominal interest rates for that time. Calculated as: E=i1 i2

Where: "E" represents the % change in the exchange rate "i1" represents country A's interest rate "i2" represents country B's interest rate

For example, if country A's interest rate is 10% and country B's interest rate is 5%, country B's currency should appreciate roughly 5% compared to country A's currency. The rational for the IFE is that a country with a higher interest rate will also tend to have a higher inflation rate. This increased amount of inflation should cause the currency in the country with the high interest rate to depreciate against a country with lower interest rates Slide 18-20

Do interest rate differentials help predict future currency movement?

Like PPP theory , IFE is not good predictor of short

run changes in exchange rates Reasons:

Investor psychology Bandwagon effect

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Summary

Relative monetary growth, relative inflation rates and nominal interest rates differentials are all moderately good predictor of long run changes in exchange rates and poor predictors in short run spot rates It is useful for international business:

Long term profitability of foreign investments Export opportunities Price competitiveness of foreign imports
Are influenced by long term movement in foreign exchange

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