TOPIC 4: GLOBAL MONETARY SYSTEMS & FINANCIAL VIABILITY

OVERVIEW AND TEACHING SUGGESTIONS

UNIT OF CHAPTER 9
FOREIGN EXCHANGE LOSSES AT JAL
INTRODUCTION
THE FUNCTIONS OF THE FOREIGN EXCHANGE MARKET
Currency Conversion
Insuring Against Foreign Exchange Risk
THE NATURE OF THE FOREIGN EXCHANGE MARKET
ECONOMIC THEORIES OF EXCHANGE RATE DETERMINATION
Prices and Exchange Rates
Interest Rates and Exchange Rates
Investor Psychology and Bandwagon Effects
Summary
EXCHANGE RATE FORECASTING
The Efficient Market School
The Inefficient Market School
Approaches to Forecasting
CURRENCY CONVERTIBILITY
Convertibility and Government Policy
Countertrade
IMPLICATIONS FOR BUSINESS
CHAPTER SUMMARY
CRITICAL DISCUSSION QUESTIONS
THE COLLAPSE OF THE THAI BAHT IN 1997

OBJECTIVES OF UNIT 9

1.

Explain how the foreign exchange market works.

2.

Explore the forces that determine exchange rates.

3.

Discuss the degree to which future exchange rates can be

predicted.

4.

Map out the implications for international businesses of

exchange rate movements and the foreign exchange market.

LECTURE OUTLINE FOR UNIT 9

A.

Introduction

Traditionally, different countries have different currencies

(although the appearance of the EU and the euro have
dramatically decreased the number of international currencies
that most people will use). If you have examples of different
currencies, these can be shown or passed around. Students are
particularly intrigued by the pictures of foreign rulers on foreign
currency, many of whom they have never heard of.

2.

Tourists clearly need to change money when they travel between

countries, although in some border towns merchants may accept
currency from both countries.

3.

Exchange rates determine the value of one currency in terms of

another. It can be illustrative at this point to show some
exchange rates by writing them down .Actually going through
several currency conversions provides a basis for many of the
following discussions. When I teach this chapter, I imagine the
class strolling down the Via Venito (Rome) and coming upon a
display window with a Lamborghini listed at 1 million lira. Is this
expensive? Students quickly convert lira into dollars to get the
answer. (No! Its about $454.10 when 1 lira equals 0.0004541
dollars, which is the conversion rate as I write this.)

9-5

Definitions
Foreign Exchange Market :
A market for converting the currency of one
country into the currency of another.

Exchange Rate:
The rate at which one currency is converted into
another.

Foreign Exchange Risk:

The risk that arises from changes in exchange
rates.
McGraw-Hill/Irwin

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4.

While dealing in multiple currencies is a requirement of doing

business internationally, it also creates risks and significantly
alters the attractiveness of different investments and deals over
time. Firms can use the foreign exchange market to minimize
the risk of adverse changes, but this can prevent them for
benefiting from favorable changes.

5.

Depending upon the student group, the need to go into many

details will vary considerably. When teaching this topic to a
group of international MBA students in Europe, it was
unnecessary to cover the basics - they knew from everyday life
as they converted the price of food into their own currencies to
assess value. However, a group of US students were surprised
that a McDonalds they visited on a road trip to Canada for a
hockey game didnt take US dollars.

6.

One thing that may be helpful is to bring into class paper bills of
$100, 100 NOK, 100, and 100 Pakistani rupees, and offer to buy
a students calculator. First you may start with the rupees, and
try to convince him or her that you have a great deal. If you
experience some reluctance, you might next offer the Norwegian
Kroner. Depending upon the calculator, you might offer the 100
but ask for $70 back in change. Regardless you can usually
cause a little confusion and get some people flustered, thinking
that they might be passing up a really good deal and just dont
know it.

B.

The Functions of the Foreign Exchange Market

9-6

Functions of the Foreign Exchange

Market
Currency Conversion
Companies receiving
payment in foreign
currencies need to convert
to their home currency.
Companies paying foreign
businesses for goods or
services.
Companies invest spare
cash for short terms in
money market accounts .
Speculation: taking
advantage changing
exchange rates.
McGraw-Hill/Irwin

Insuring Against FX Risk

Spot exchange rate :
rate of currency
exchange on a particular
day.
Forward exchange rate :
two parties agree to
exchange currencies on a
specific future date .
Currency
swap :simultaneous
purchase and sale of a
given amount of FX for
two different value
2003 The McGraw-Hill Companies, Inc., All Rights Reserved.
dates.

1.

The foreign exchange market serves two functions: converting

currencies and reducing risk. There are four major reasons firms
need to convert currencies.

2.

First, the payments firms receive from exports, foreign

investments, foreign profits, or licensing agreements may all be
in a foreign currency. In order to use these funds in its home
country, an international firm has to convert funds from foreign
to domestic currencies.

3.

Second, a firm may purchase supplies from firms in foreign

countries, and pay these suppliers in their domestic currency.

4.

Third, a firm may want to invest in a different country from that

in which it currently holds under-used funds.

5.

Fourth, a firm may want to speculate on exchange rate

movements, and earn profits on the changes it expects. If it
expects a foreign currency to appreciate relative to its domestic
currency, it will convert its domestic funds into the foreign
currency. Alternately stated, it expects its domestic currency to
depreciate relative to the foreign currency. An example similar
to the one in the book can help illustrate how money can be
made (or lost) on exchange rate speculation. The management

focus on George Soros shows how one fund has benefited from
currency speculation.
6.

Exchange rates change on a daily basis. The price at any given

time is called the spot rate, and is the rate for currency
exchanges at that particular time. One can obtain the current
exchange rates from a newspaper or online (e.g., ww.wsj.com).
Comparing these with the rates listed in Table 9.1 can show
which currencies have undergone the most significant changes
since the time of publication.

7.

The fact that exchange rates can change on a daily basis

depending upon the relative supply and demand for different
currencies increases the risks for firms entering into contracts
where they must be paid or pay in a foreign currency at some
time in the future.

8.

Forward exchange rates allow a firm to lock in a future exchange

rate for the time when it needs to convert currencies. Forward
exchange occurs when two parties agree to exchange currency
and execute a deal at some specific date in the future. The book
presents an example of a laptop computer purchase where using
the forward market helps assure the firm that will won't lose
money on what it feels is a good deal. It can be good to point
out that from a firms perspective, while it can set prices and
agree to pay certain costs, and can reasonably plan to earn a
profit, it has virtually no control over the exchange rate. When
spot exchange rate changes entirely wipe out the profits on what
appear to be profitable deals, the firm has no recourse.

9.

When a currency is worth less with the forward rate than it is

with the spot rate, it is selling at forward discount. Likewise,
when a currency is worth more in the future than it is on the spot
market, it is said to be selling at a forward premium, and is
hence expected to appreciate.

10.

A currency swap is the simultaneous purchase and sale of a

given amount of currency at two different dates and values.
Figure 9.1 shows an indication of the relative importance of the
different types of currency exchanges.

C.

The Nature of the Foreign Exchange Market

9-9

The Foreign Exchange Market

It is a 24/7 market.
The markets are integrated. Connected by highspeed computers, it creates one virtual market.
Londons dominance is explained by:
History (capital of the first major industrialized
nation).
Geography (between Tokyo/Singapore and New
York).

McGraw-Hill/Irwin

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1.

The foreign exchange market is not a place, but a whole network

of banks, brokers, and dealers that exchange currencies 24
hours/day.

2.

The exchange rates quoted worldwide are basically the same. If

different US dollar/French Franc rates were being offered in New
York and Paris, there would be an opportunity for arbitrage and
the gap would close. An illustrative example can be done,
showing how someone could make money in arbitrage, and how
this would affect the supply and demand for the currencies in
both markets to close the gap.

3.

The US dollar frequently serves as a vehicle currency to ease the

exchange of two other currencies.

4.

The actual mechanics of currency exchange are fairly simple, but

some students seem to have difficulty with the basic algebra, not
knowing when to multiply or divide by exchange rates. It is
important to spend some time and make sure that they
understand this. One technique is to use the analogy of
measurement, and say that currencies are just a matter of
measuring the value of a good by different rulers or yardsticks.
Hence converting US dollars to British Pounds is not any different
from converting yards to meters, pounds to kilograms, or inches
to feet. The questions in the test bank have a number of

examples that can be used directly or slightly modified to show

how currency conversion works.
D.

Economic Theories of Exchange Rate Determination

9-14

Economic Theories of Exchange Rate

Determination
Base level: rates are determined by the demand/supply
of one currency relative to the demand/supply of
another.
Price and Exchange Rates:

Law of One Price

Purchasing Power Parity (PPP)
Interest Rates and Exchange Rates.
Investor Psychology and Bandwagon Effects.
McGraw-Hill/Irwin

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1.

While at the most basic level exchange rates are determined by

the supply and demand for different currencies. What affects the
supply and demand is the focus of this section.

2.

The Law of One Price states that in competitive markets free of

transportation costs and trade barriers, identical products sold in
different countries must sell for the same price when their price
is expressed in terms of the same currency. An example can be
illustrative, like the one on jackets in the book. The Purchasing
Power Parity (PPP) exchange rate shows what the exchange rate
would be if the law of one price held. Every April the Economist
magazine prints the implied PPP and real exchange rate based
on McDonalds Big Mac - a product that is virtually identical
across a number of locations worldwide but priced in local
currencies. The covers of some magazines, particularly The
Economist, print their prices in multiple currencies.

9-15

Price and Exchange Rates

Law of One Price:
In competitive markets free of transportation costs and trade
barriers, identical products sold in different countries must
sell for the same price when their price is expressed in terms
of the same currency.
Example: US/French exchange rate: $1 = FFr 5. A jacket selling
for $50 in New York should retail for FFr 250 in Paris (50x5).

Purchasing Power Parity

By comparing the prices of identical products in different
currencies, it should be possible to determine the real or PPP
exchange rate - if markets were efficient.
In relatively efficient markets (few impediments to trade and
investment) then a basket of goods should be roughly
equivalent in each country.

McGraw-Hill/Irwin

3.

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To express the PPP theory in symbols, let P$ be the US dollar

price of a basket of goods and PDM be the price of the same
basket of goods in German marks. The PPP theory predicts that
the dollar/DM exchange rate should be equivalent to:
$/DM Exchange Rate = P$/PDM
Thus if a basket of goods costs $200 in the United States, and
the same basket costs DM600 in Germany, PPP theory predicts
that the dollar/DM exchange rate should be $0.33 per DM (i.e.
$1=DM3).

4.

The exchange rate will change if relative prices change. For

example, assume there is no price inflation in the US, while
prices in Germany are increasing by 20% a year. At the
beginning of the year a basket of goods costs $200 in the US and
DM600 in Germany, so the dollar/DM exchange rate according to
PPP theory should be $0.33=DM1. At the end of the year the
basket of goods still costs $200 in the US, but now it costs
DM720 in Germany. PPP theory predicts that the exchange rate
should then be $0.27=DM1 (i.e. $1=DM3.6). Due to price
inflation the DM has depreciated against the dollar, and the
dollar is relatively stronger (it takes less of a dollar to equal one
DM).

5.

There is a positive relationship between the inflation rate and the

level of the money supply. When the growth in the money supply
is greater than the growth in output, inflation will occur.

9-16

Money Supply and Inflation

PPP theory predicts that changes in relative
prices will result in a change in exchange
rates.
A country with high inflation should expect its
currency to depreciate against the currency of
a country with a lower inflation rate.
Inflation occurs when the money supply
increases faster than output increases .

Purchasing Power Parity Puzzle.

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6.

Simply put, PPP suggests that changes in relative prices between

countries will lead to exchange rate changes. The empirical tests
suggest that this relationship does hold in the long run, but not in
the short run. While PPP assumes no transportation costs or
barriers to trade and investment, it also assumes that
governments do not intervene to affect their exchange rates - a
topic for the next chapter.

7.

Interest rates also affect exchange rates. The Fisher effect says
that the real interest rates should be the same in each, while the
nominal rate will include both this real rate and expected
inflation. The International Fisher effect states that for any two
countries the spot exchange rate should change in an equal
amount but in the opposite direction to the difference in nominal
interest rates between two countries. Stated more formally:
(S - S )/S x 100 = i$ - iDM
1
2 2
where i$ and iDM are the respective nominal interest rates in two
countries (in this case the US and Germany), S1 is the spot
exchange rate at the beginning of the period and S2 is the spot
exchange rate at the end of the period.

9-19

Interest Rates and Exchange Rates

Theory says that interest rates reflect
expectations about future exchange rates.
Fisher Effect (I = r+l).
International Fisher Effect:
For any two countries, the spot exchange rate
should change in an equal amount but in the
opposite direction to the difference in nominal
interest rates between the two countries.
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8.

While interest rate differentials suggest future exchange rate

changes, this appears to hold in the long run but not necessarily
in the short run.

9.

Investor psychology and can also affect exchange rate

movements. Expectations on the part of traders can turn into
self-fulfilling prophecies, and traders can join the bandwagon and
move exchange rates based on group expectations. While such
changes can be important in explaining some short-term
exchange rate movements, they are very difficult to predict. At
times governmental intervention can prevent the bandwagon
from starting, but at other times it is ineffective and only
encourages traders.

E.

Exchange Rate Forecasting

1.

The efficient market school argues that forward exchange rates

are the best possible predictors of future spot rates, as they are
impounding all information available in the market. Forward
rates present an unbiased, yet inaccurate prediction.

2.

The inefficient market school argues that companies can improve

upon the forward rate by investing in forecasting services.

3.

Forecasters that use fundamental analysis draw upon economic

theories to predict future exchange rates, including factors like
interest rates, monetary policy, inflation rates, or balance of
payments information.

4.

F.
1.

Forecasters that use technical analysis typically chart trends, and

they believe that past trends and waves are reasonable
predictors of future trends and waves.
Currency Convertibility
A currency is said to be freely convertible when the
government of a country allows both residents and non-residents
to purchase unlimited amounts of a foreign currency with the
domestic currency. A currency is said to be externally
convertible when non-residents can convert their holdings of
domestic currency into a foreign currency, but when the ability of
residents to convert currency is limited in some way. A currency
is not convertible when both residents and non-residents are
prohibited from converting their holdings of domestic currency
into a foreign currency. During the 1980s, American visitors to
the Soviet Union might have been surprised to discover that their
unused rubles would not be exchanged for US dollars at the
Moscow airport. Instead, if the exchange clerk was feeling
charitable, they might receive some worthless Stalin buttons.
When the currency is not convertible, foreign visitors must
calculate their currency usage closely and attempt to zero out
their foreign currency use.
9-21

Exchange Rate Forecasting

Efficient market: where prices reflect all available
public information.

Early studies seem to confirm the efficient market

theory, but recent studies have challenged it.
Inefficient market: where prices do not reflect all
available information.

Use fundamental (economic theory) or technical

(price/volume data) analysis to predict the
exchange rates.
Analysis suggest that professional forecasters are
no better than forward exchange rates in
McGraw-Hill/Irwin
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predicting future spot 2003
rates.

2.

Free convertibility is the norm in the world today, although many

countries impose some restrictions on the amount of money that

can be converted. The main reason to limit convertibility is to

preserve foreign exchange reserves and prevent capital flight.
9-22

Currency Convertibility
Freely convertible.
Externally convertible.
Not convertible.
Preserve foreign exchange reserves.
Service international debt.
Purchase imports.
Government afraid of capital flight.
Political decision.
Many countries have some kind of restrictions.
Countertrade.
Barter-like agreements where goods/services are traded for
goods/services.
Helps firms avoid convertibility issue.

McGraw-Hill/Irwin

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3 Countertrade, where goods are exchanged for other goods, is

one way firms can work around problems in currency
convertibility. A recent example of countertrade can help
illustrate the point.

G.

Implications for Business

1.

Adverse changes in exchange rates can make an otherwise

profitable deal unprofitable. Thus firms face risks anytime they
work in multiple currencies.

2.

Forward exchanges and swaps allow firms to hedge, or insure

themselves, against exchange rate changes. A currency swap is
an agreement between two parties in which one party promises
to make payments in one currency and the other promises to
make payments in another currency. Currency swaps are similar
yet notably different from interest rate swaps and are often
combined with interest rate swaps. Both parties benefit from the
swap because they end up borrowing at lower foreign interest
rates than they could have on their own. As an example of a
typical situation, American Firm Microsoft would like to borrow
British pounds, and British Firm Rolls Royce wants to borrow
dollars. Because it is better known in the US, Microsoft can
borrow dollars at a lower interest rate than Rolls Royce, while

Rolls Royce, because it is better known in the UK, can borrow

pounds at a lower interest rate than Microsoft. So if Microsoft
borrows dollars in the US and Rolls Royce borrows pounds in the
UK, but then they swap their obligations, each firm can benefit
from the other firms superior borrowing rate in its domestic
currency.
3.

It is important that international businesses understand the

forces that determine exchange rates. If a company wants to
know how the value of a particular currency will change over the
long-term on the foreign exchange market, it should take a close
look at those economic fundamentals that appear to predict
long-run exchange rate movements - i.e. the growth in a
country's money supply, its inflation rate, and nominal interest
rates.

4.

When governments restrict currency convertibility, firms must

find ways to facilitate international trade and investment.
Addenda:
1

Ex.Rate facilitates international trade - debts cannot be

settled
2
Govt. needs to monitor ex. rates - improve trade balance
and to
take action e.g depreciation or appreciation
3
Firms have to monitor the exchange so that they enter into
contractual strategies to cover themselves against
fluctuation of exchange rates e.g Spot rate, forward rate
or SWAP
ANSWERS TO CRITICAL DISCUSSION QUESTIONS FOR CHAPTER 9
QUESTION 1: The interest rate on South Korean government securities
with one-year maturity is 4% and the expected inflation rate for the
coming year is 2%. The US interest rate on government securities with
one-year maturity is 7% and the expected rate of inflation is 5%. The
current spot exchange rate for Korea won is $1 = W1200. Forecast the
spot exchange rate one year from today. Explain the logic of your
answer.
ANSWER 1: From the Fisher effect, we know that the real interest rate
in both the US and South Korea is 2%. The international Fisher effect
suggests that the exchange rate will change in an equal amount but in
an opposite direction to the difference in nominal interest rates. Hence
since the nominal interest rate is 3% higher in the US than in South

Korea, the dollar should depreciate by 3% relative to the South Korean

Won. Using the formula from the book: (S1 - S2)/S2 x 100 = i$ - iWon
and substituting 7 for i$, 4 for iWon, and 1200 for S1, yields a value for
S2 of $1=W1165.
QUESTION 2: Two countries, Britain and the US produce just one good beef. Suppose that the price of beef in the US is $2.80 per pound, and
in Britain it is 3.70 per pound.
(a)
According to PPP theory, what should the $/ spot
exchange
rate be?
(b)
Suppose the price of beef is expected to rise to $3.10 in
the US, and to 4.65 in Britain. What should be the one year
forward $/ exchange rate?
(c)
Given your answers to parts (a) and (b), and given that the
current interest rate in the US is 10%, what would you
expect current interest rate to be in Britain?
ANSWER 2:
(a)
According to PPP, the $/ rate should be 2.80/3.70, or
.76$/.
(b)
According to PPP, the $/ one year forward exchange rate
should be 3.10/4.65, or .67$/.
(c)
Since the dollar is appreciating relative to the pound, and
given the relationship of the international fisher effect, the
British must have higher interest rates than the US. Using
the formula (S1 - S2)/S2 x 100 = i - i$ we can solve the
equation for i, with S1=.76, S2=.67, I$ = 10, yielding a
value
of 23.4% for the British interest rates.
QUESTION 3: You manufacture wine goblets. In mid June you receive
an order for 10,000 goblets from Japan. Payment of 400,000 is due in
mid December. You expect the yen to rise from its present rate of
$1=130 to $1=100 by December. You can borrow yen at 6% per
annum. What should you do?
ANSWER 3: The simplest solution would be to just wait until
December, take the 400,000 and convert it at the spot rate at that
time, which you assume will be $1=100. In this case you would have
$4,000 in mid-December. If the current 180-day forward rate is lower
than 100/$, then it would be preferable since it both locks in the rate
at a better level and reduces risk. If the rate is above 100/$, then
whether you choose to lock in the forward rate or wait and see what

the spot does will depend upon your risk aversion. There is a third
possibility also. You could borrow money from a bank that you will pay
back with the 400,000 you will receive (400,000/1.03 = 388,350
borrowed), convert this today to US$ (388,350/130 = $2,987), and
then invest these dollars in a US account. For this to be preferable to
the simplest solution, you would have to be able to make a lot of
interest (4,000 - 2,987 = $1,013), which would turn out to be an annual
rate of 51% ((1,013/4000) * 2). If, however, you could lock in these
interest rates, then this method would also reduce any exchange rate
risk. What you should do depends upon the interest rates available,
the forward rates available, how large a risk you are willing to take,
and how certain you feel that the spot rate in December will be 100 =
$1.
SUGGESTED READINGS FOR CHAPTER 4
The footnotes suggest some appropriate additional readings. The
following may be of particular interest:
Krugman, Paul and M. Obstfeld 1994. International economics: Theory
and Policy. New York: Harper Collins.
Weisweiller, R. 1990. How the foreign exchange market works. New
York: Institute of Finance.