Chapter 7

Foreign Exchange

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 Learning Objectives
By the end of this chapter, you should be able to:
7-1 Describe the determinants of foreign exchange rates.
7-2 Track the evolution of the international monetary system.
7-3 Identify firms’ strategic responses to deal with foreign exchange
movements.
7-4 Participate in three leading debates concerning foreign exchange
movements.
7-5 Draw implications for action.

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 7-1
What Determines Foreign Exchange Rates?

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 7-1 What Determines
Foreign Exchange Rates? (1 of 3)
• Foreign exchange rate: The price of one currency in terms of another
• Appreciation: An increase in the value of the currency
• Depreciation: A loss in the value of the currency

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 Table 7.1 Example of Key Currency Exchange Rates
Currency US dollar Euro (€) UK pound Swiss Australian Japanese Canadian Chinese
(US$) (£) franc dollar (A$) yen (¥) dollar (C$) yuan (CNY)
(CHF)
Chinese yuan
6.4687 7.8573 8.8166 7.2880 5.0143 0.0622 5.0975 —
(CNY)
Canadian
1.2692 1.5421 1.7303 1.4298 0.9835 0.012206 — 0.1962
dollar (C$)
Japanese
103.97 126.33 141.76 117.14 80.6739 — 81.91 16.0817
yen (¥)
Australian
1.2898 1.5671 1.7578 1.4535 — 0.0124 1.0166 0.1994
dollar (A$)
Swiss franc
0.8875 1.0783 1.2102 — 0.6882 0.008537 0.6994 0.1372
(CHF)
UK pound (£) 0.7335 0.8912 — 0.8263 0.5687 0.007054 0.5778 0.1134
Euro (€) 0.8230 — 1.1223 0.9273 0.6381 0.007916 0.6485 0.1273
US dollar
— 1.2150 1.3635 1.1268 0.7757 0.009618 0.7880 0.1546
(US$)
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 Figure 7.1 What Determines
Foreign Exchange Rates?
Long-run direction

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 Figure 7.1 What Determines
Foreign Exchange Rates?
PPP: Law of one price

- In the absence of trade barriers such as Tariffs, the price for identical
products sold in the different countries must be the same.

- The Purchasing Power Parity (PPP) theory convincingly asserts that

over time, exchange rates will adjust to align with the relative prices
of identical baskets of goods between two countries. This principle
highlights the natural tendency of markets to balance, making it a
crucial concept for understanding currency valuation in the long run.

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 Figure 7.1 What Determines
Foreign Exchange Rates?
Interest rate & Monetary supply

- High Interest rate attract foreign funds. ( More value when

converting to home currency)

- Inflation not attract foreign fund. ( devalued of money-too much

money chasing too few goods)

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 Figure 7.1 What Determines
Foreign Exchange Rates?
Balance of payments ( BOP)

- Productivity & Country’s performance.

- Competitive positioning
- Free trade, competitive advantage for FDI
- Trade surplus. ( Technically, the current account balance consists of
exports minus imports of merchandise and services-income on a
country’s assets minus on foreign assets in the focal country)

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 Table 7.2 The US Balance of Payments:
Current Account (Billion US Dollars)
• Balance of payments (BOP): A country’s international transaction statement, which includes
merchandise trade, service trade, and capital movement

Transaction Amount Balance

1. Exports of merchandise 1,429
2. Imports of merchandise –2,351
3. Balance on merchandise trade (lines 1 + 2) –922
4. Exports of services 706
5. Imports of services –460
6. Balance on service trade (lines 4 + 5) 246
7. Balance on merchandise and service trade (trade deficit/surplus—lines 3 + 6) –676
8. Income receipts on US-owned assets abroad 1,124
9. Income payments on foreign-owned assets in the US –1,063
10. Balance on current account (current account deficit/surplus—lines 7 + 8 + 9) –616
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 7-1 What Determines
Foreign Exchange Rates? (2 of 3)
• Floating (flexible) exchange rate policy: A government policy to let
supply-and-demand conditions determine exchange rates
• Clean (free) float: A pure market solution to determine exchange rates
• Dirty (managed) float: Using selective government intervention to determine
exchange rates
• Fixed exchange rate policy: A government policy to set the exchange rate of a
currency relative to other currencies
• Target exchange rate (crawling band): Specified upper or lower bounds within
which an exchange rate is allowed to fluctuate
• Peg: A stabilizing policy of linking a developing country’s currency to a key
currency ( National inflation could devalued money, secure import& export price)
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 7-1 What Determines
Foreign Exchange Rates? (3 of 3)
Investor Psychology

• Bandwagon effect: The effect of investors moving in the same direction at the
same time, like a herd
• Capital flight: A phenomenon in which a large number of individuals and
companies exchange domestic currency for a foreign currency

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 Discussion Activity

Can you recall a recent example of a bandwagon effect?

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 7-2
Evolution of the International Monetary System

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 7-2 Evolution of the
International Monetary System (1 of 2)
• Common denominator: A currency or commodity to which the value of all
currencies are pegged
• Gold standard: A system in which the value of most major currencies was
maintained by fixing their prices in terms of gold (1870–1914)
• Bretton Woods system: A system in which all currencies were pegged at a
fixed rate to the US dollar (1944–1973), High productivities of US, only US dollar
will be gold convertible.
• Post–Bretton Woods system: A system of flexible exchange rate regimes with
no official common denominator (1973–Present)

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 7-2 Evolution of the
International Monetary System (2 of 2)

• International Monetary Fund (IMF): An international organization that was

established to promote international monetary cooperation, exchange stability,
and orderly exchange arrangements
− The IMF provides loans to countries suffering from balance-of-payments problems.
− Each member country is assigned a quota, which is the weight a member country carries
within the IMF, which determines the amount of its financial contribution (technically known
as its “subscription”), its capacity to borrow from the IMF, and its voting power.

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 Polling Activity

You are an IMF official going to a country whose export earnings are not able to
pay for imports. The government has requested a loan. Which area would you
recommend the government to cut?
🔲 Education
🔲 Salaries for officials
🔲 Food subsidies
🔲 Tax rebates for exporters

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 7-3
Managing Currency Risk

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 Table 7.3 Managing Currency Risk
• Currency risk: The potential for loss associated with fluctuations in the foreign
exchange market

Strategies for Strategies for

Financial Companies Nonfinancial Companies
• Spot transactions • Invoicing in your own currency
• Forward transactions • Currency hedging
• Swaps • Strategic hedging

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 7-3 Managing Currency Risk (1 of 4)

• Foreign exchange market: The market where individuals, firms, governments,

and banks buy and sell foreign currencies
− Services the needs of trade and FDI
− Trades in its own commodity—namely, foreign exchange
• Spot transaction: The classic single-shot exchange of one currency for another
( on spot)

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 7-3 Managing Currency Risk (2 of 4)

• Forward transaction: A foreign exchange transaction in which participants buy

and sell currencies now for future delivery
• Currency hedging: A transaction that protects traders and investors from
exposure to the fluctuations of the spot rate
• Forward discount: A condition under which the forward rate of one currency
relative to another currency is higher than the spot rate
− EX. Euro 1 = 1 US$ , Forward rate Euro 1.1 : US1, forward discount, you
need 1.1 Euro for a dollar.
• Forward premium: A condition under which the forward rate of one currency
relative to another currency is lower than the spot rate ( Euro 0.9 : US 1)
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 7-3 Managing Currency Risk (3 of 4)

• Currency swap: A foreign exchange transaction between two firms in which

one currency is converted into another at Time 1, with an agreement to revert it
to the original currency at a specified Time 2 in the future
• Offer rate: The price to sell a currency
• Bid rate: The price to buy a currency
• Spread: The difference between the offer rate and the bid

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 7-3 Managing Currency Risk (4 of 4)

• Nonfinancial companies cope with currency risk using three primary strategies:
− Invoicing in their own currencies
▪ US firm enjoys in US, China enjoys in Yuan.
− Currency hedging ( Forward discount & Forward premium)
− Strategic hedging: Spreading out activities in a number of countries in different currency
zones to offset any currency losses in one region through gains in other regions

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 7-4
Debates and Extensions

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 7-4 Debates and Extensions (1 of 3)

Debate 1: Fixed versus Floating Exchange Rates

• Proponents of fixed exchange rates argue that fixed exchange rates impose
monetary discipline by preventing governments from engaging in inflationary
monetary policies and that fixed exchange rates encourage trade and FDI.
• Proponents of floating exchange rates believe that market forces should take
care of supply, demand, and the price of any currency.
• Currency board: A monetary authority that issues notes and coins convertible
into a key foreign currency at a fixed exchange rate

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 7-4 Debates and Extensions (2 of 3)
Debate 2: Usual versus Unusual (Post-COVID) Turbulence
• Specific turbulence in the foreign exchange market due to changing investor
moods—coupled with sudden geopolitical crises and long-term economic
adjustments—recently made the foreign exchange market more volatile.
− To currency traders, such heightened turbulence became “business as usual” prior to the
COVID pandemic.

• The unprecedented nature of COVID triggered the global pandemic depression,

and COVID’s shadow will be long and dark—perhaps as long as a decade.
− Debt burdens will become more crushing as future incomes decrease. At the same time,
with bankruptcies rising and unemployment spiking, populist nationalism is rising in many
parts of the world.
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 7-4 Debates and Extensions (3 of 3)

Debate 3: Currency Hedging versus Not Hedging

• The standard argument for currency hedging is increased stability of cash flows
and earnings.
• Many managers of large firms argue that currency hedging eats into profits.

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 7-5
Management Savvy

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 Table 7.4 Implications for Action

Implications for Action

• Fostering foreign exchange literacy is a must.
• Risk analysis of any country must include an analysis of its
currency risks.
• A currency risk management strategy is necessary—via currency
hedging, strategic hedging, or both.

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 Knowledge Check
Which international monetary system is currently in place?
1. Post–Bretton Woods system
2. Gold standard
3. Bretton Woods system
4. A common denominator system

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 Summary
At the end of this chapter, you should be able to:
7-1 Describe the determinants of foreign exchange rates.
7-2 Track the evolution of the international monetary system.
7-3 Identify firms’ strategic responses to deal with foreign exchange
movements.
7-4 Participate in three leading debates concerning foreign exchange
movements.
7-5 Draw implications for action.

Peng, Global Business, 5th Edition. © 2023 Cengage. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly
accessible website, in whole or in part. 31