Madura: International Financial Management Chapter 6

Madura: International Financial Management Chapter 6 Part II Exchange Rate Behavior Existing spot exchange rate Existing spot exchange rates at oth...
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Madura: International Financial Management

Chapter 6

Part II Exchange Rate Behavior Existing spot exchange rate

Existing spot exchange rates at other locations

locational arbitrage

covered interest arbitrage

Existing forward exchange rate

6 Government Influence On Exchange Rates

Existing cross exchange rates of currencies

triangular arbitrage

Chapter

Existing inflation rate differential Fisher effect purchasing power parity

covered interest arbitrage

Existing interest rate differential

international Fisher effect

Future exchange rate movements South-Western/Thomson Learning © 2003

Chapter Objectives

Exchange Rate Systems

• To describe the exchange rate

• Exchange rate systems can be classified

systems used by various governments;

according to the degree to which the rates are controlled by the government.

• To explain how governments can use

• Exchange rate systems normally fall into

direct and indirect intervention to influence exchange rates; and

one of the following categories: ¤ fixed ¤ freely floating ¤ managed float ¤ pegged

• To explain how government intervention in the foreign exchange market can affect economic conditions. B6 - 3

Fixed Exchange Rate System

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Fixed Exchange Rate System

• In a fixed exchange rate system, exchange

• Pros: Work becomes easier for the MNCs. • Cons: Governments may revalue their

rates are either held constant or allowed to fluctuate only within very narrow bands.

currencies. In fact, the dollar was devalued more than once after the U.S. experienced balance of trade deficits.

• The Bretton Woods era (1944-1971) fixed each currency’s value in terms of gold.

• The 1971 Smithsonian Agreement which

• Cons: Each country may become more

followed merely adjusted the exchange rates and expanded the fluctuation boundaries. The system was still fixed.

vulnerable to the economic conditions in other countries. B6 - 5

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Madura: International Financial Management

Freely Floating Exchange Rate System

Chapter 6

Freely Floating Exchange Rate System

• In a freely floating exchange rate system,

• Pros: Governments are not restricted by

exchange rates are determined solely by market forces.

exchange rate boundaries when setting new policies.

• Pros: Each country may become more

• Pros: Less capital flow restrictions are

insulated against the economic problems in other countries.

needed, thus enhancing the efficiency of the financial market.

• Pros: Central bank interventions that may affect the economy unfavorably are no longer needed. B6 - 7

Freely Floating Exchange Rate System

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Managed Float Exchange Rate System

• Cons: MNCs may need to devote

• In a managed (or “dirty”) float exchange

substantial resources to managing their exposure to exchange rate fluctuations.

rate system, exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction.

• Cons: The country that initially experienced economic problems (such as high inflation, increasing unemployment rate) may have its problems compounded.

• Cons: A government may manipulate its exchange rates such that its own country benefits at the expense of others. B6 - 9

Pegged Exchange Rate System

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Pegged Exchange Rate System

• In a pegged exchange rate system, the

• The European Monetary System which

home currency’s value is pegged to a foreign currency or to some unit of account, and moves in line with that currency or unit against other currencies.

followed in 1979 held the exchange rates of member countries together within specified limits and also pegged them to a European Currency Unit (ECU) through the exchange rate mechanism (ERM). ¤ The ERM experienced severe problems in 1992, as economic conditions and goals varied among member countries.

• The European Economic Community’s snake arrangement (1972-1979) pegged the currencies of member countries within established limits of each other. B6 - 11

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Pegged Exchange Rate System

Chapter 6

Currency Boards

• In 1994, Mexico’s central bank pegged the

• A currency board is a system for

peso to the U.S. dollar, but allowed a band within which the peso’s value could fluctuate against the dollar. ¤ By the end of the year, there was substantial downward pressure on the peso, and the central bank allowed the peso to float freely. The Mexican peso crisis had just began ...

maintaining the value of the local currency with respect to some other specified currency.

• For example, Hong Kong has tied the value of the Hong Kong dollar to the U.S. dollar (HK$7.8 = $1) since 1983, while Argentina has tied the value of its peso to the U.S. dollar (1 peso = $1) since 1991. B6 - 13

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Exposure of a Pegged Currency to Interest Rate Movements

Currency Boards • For a currency board to be successful, it

• A country that uses a currency board does

must have credibility in its promise to maintain the exchange rate.

not have complete control over its local interest rates, as the rates must be aligned with the interest rates of the currency to which the local currency is tied.

• It has to intervene to defend its position against the pressures exerted by economic conditions, as well as by speculators who are betting that the board will not be able to support the specified exchange rate.

• Note that the two interest rates may not be exactly the same because of different risks.

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Exposure of a Pegged Currency to Exchange Rate Movements

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Dollarization

• A currency that is pegged to another

• Dollarization refers to the replacement of a

currency will have to move in tandem with that currency against all other currencies.

local currency with U.S. dollars.

• Dollarization goes beyond a currency

• So, the value of a pegged currency does

board, as the country no longer has a local currency.

not necessarily reflect the demand and supply conditions in the foreign exchange market, and may result in uneven trade or capital flows.

• For example, Ecuador implemented dollarization in 2000.

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Madura: International Financial Management

A Single European Currency



Chapter 6

A Single European Currency

• In 1991, the Maastricht treaty called for a



• Within the euro-zone, cross-border trade

single European currency. On Jan 1, 1999, the euro was adopted by Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, and Spain. Greece joined the system in 2001.

and capital flows will occur without the need to convert to another currency.

• European monetary policy is also consolidated because of the single money supply. The Frankfurt-based European Central Bank (ECB) is responsible for setting the common monetary policy.

• By 2002, the national currencies of the 12 participating countries will be withdrawn and completely replaced with the euro. B6 - 19

A Single European Currency



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A Single European Currency

• The ECB aims to control inflation in the



• As currency movements among the

participating countries and to stabilize the euro within reasonable boundaries.

European countries will be eliminated, there should be an increase in all types of business arrangements, more comparable product pricing, and more trade flows.

• The common monetary policy may eventually lead to more political harmony.

• It will also be easier to compare and

• Note that each participating country may

conduct valuations of firms across the participating European countries.

have to rely on its own fiscal policy (tax and government expenditure decisions) to help solve local economic problems. B6 - 21

A Single European Currency



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A Single European Currency



• Stock and bond prices will also be more

• Since its introduction in 1999, the euro

comparable and there should be more cross-border investing. However, nonEuropean investors may not achieve as much diversification as in the past.

has declined against many currencies.

• This weakness was partially attributed to capital outflows from Europe, which was in turn partially attributed to a lack of confidence in the euro.

• Exchange rate risk and foreign exchange transaction costs within the euro-zone will be eliminated, while interest rates will have to be similar.

• Some countries had ignored restraint in favor of resolving domestic problems, resulting in a lack of solidarity. B6 - 23

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← strengthens € weakens →

A Single European Currency

Government Intervention

1.80 1.60

• Each country has a government agency

€/£

(called the central bank) that may intervene in the foreign exchange market to control the value of the country’s currency.

1.40 1.20 1.00

€/$ €/100¥

0.80 0.60 0.40 Jan-99

Chapter 6

• In the United States, the Federal Reserve System (Fed) is the central bank.

€/SwF (Swiss Franc) Jul-99

Jan-00

Jul-00

Jan-01

Jul-01 B6 - 25

Government Intervention

Government Intervention

• Central banks manage exchange rates ¤ ¤ ¤

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• Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market.

to smooth exchange rate movements, to establish implicit exchange rate boundaries, and/or to respond to temporary disturbances.

• Direct intervention is usually most effective when there is a coordinated effort among central banks.

• Often, intervention is overwhelmed by market forces. However, currency movements may be even more volatile in the absence of intervention. B6 - 27

Government Intervention Fed exchanges $ for £ to strengthen the £ Value of £ V2 V1

S1

D2

D1

Quantity of £

Government Intervention • When a central bank intervenes in the

Fed exchanges £ for $ to weaken the £ Value of £ V1 V2

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foreign exchange market without adjusting for the change in money supply, it is said to engaged in nonsterilized intervention.

S1 S2

• In a sterilized intervention, Treasury D1

securities are purchased or sold at the same time to maintain the money supply.

Quantity of £

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Madura: International Financial Management

Nonsterilized Intervention

Chapter 6

Sterilized Intervention

Federal Reserve To Strengthen the C$:

$

Banks participating in the foreign exchange market Federal Reserve

To Weaken the C$:

$

T- securities

Federal Reserve To Strengthen the C$:

C$

$

C$

$

Banks participating in the foreign exchange market $

Federal Reserve To Weaken the C$:

C$

Banks participating in the foreign exchange market

$

C$

Financial institutions that invest in Treasury securities

T- securities

Banks participating in the foreign exchange market

Financial institutions that invest in Treasury securities

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Government Intervention

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Government Intervention

• Some speculators attempt to determine

• Central banks can also engage in indirect

when the central bank is intervening, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort.

intervention by influencing the factors that determine the value of a currency.

• For example, the Fed may attempt to increase interest rates (and hence boost the dollar’s value) by reducing the U.S. money supply. ¤ Note that high interest rates adversely affects local borrowers. B6 - 33

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Government Intervention

Exchange Rate Target Zones

• Governments may also use foreign

• Many economists have criticized the

exchange controls (such as restrictions on currency exchange) as a form of indirect intervention.

present exchange rate system because of the wide swings in the exchange rates of major currencies.

• Some have suggested that target zones be used, whereby an initial exchange rate will be established with specific boundaries (that are wider than the bands used in fixed exchange rate systems). B6 - 35

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Madura: International Financial Management

Chapter 6

Exchange Rate Target Zones

Intervention as a Policy Tool

• The ideal target zone should allow rates to

• Like tax laws and money supply, the

adjust to economic factors without causing wide swings in international trade and fear in the financial markets.

exchange rate is a tool which a government can use to achieve its desired economic objectives.

• However, the actual result may be a

• A weak home currency can stimulate

system no different from what exists today.

foreign demand for products, and hence local jobs. However, it may also lead to higher inflation.

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Impact of Government Actions on Exchange Rates

Intervention as a Policy Tool

Government Monetary and Fiscal Policies

• A strong currency may cure high inflation, since the intensified foreign competition should cause domestic producers to refrain from increasing prices. However, it may also lead to higher unemployment.

Relative Interest Rates

Relative Inflation Rates

Relative National Income Levels

International Capital Flows

Exchange Rates

International Trade

Government Purchases & Sales of Currencies

B6 - 39

Tax Laws, etc.

Impact of Central Bank Intervention on an MNC’s Value

Government Intervention in Foreign Exchange Market

Quotas, Tariffs, etc.

B6 - 40

Chapter Review

Direct Intervention Indirect Intervention

• Exchange Rate Systems ¤

⎧m [E (CFj , t )× E (ER j , t )]⎫⎪ n ⎪∑ ⎪ j =1 ⎪ Value = ∑ ⎨ ⎬ (1 + k )t t =1 ⎪ ⎪ ⎪⎩ ⎪⎭

¤ ¤ ¤ ¤ ¤

E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent

¤ B6 - 41

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Fixed Exchange Rate System Freely Floating Exchange Rate System Managed Float Exchange Rate System Pegged Exchange Rate System Currency Boards Exposure of a Pegged Currency to Interest Rate and Exchange Rate Movements Dollarization B6 - 42

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Chapter 6

Chapter Review

Chapter Review

• A Single European Currency ¤ ¤ ¤ ¤ ¤ ¤ ¤ ¤

• Government Intervention

Membership Euro Transactions Impact on European Monetary Policy Impact on Business Within Europe Impact on the Valuation of Businesses in Europe Impact on Financial Flows Impact on Exchange Rate Risk Status Report on the Euro

¤ ¤ ¤

Reasons for Government Intervention Direct Intervention Indirect Intervention

• Exchange Rate Target Zones

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Chapter Review • Intervention as a Policy Tool ¤ ¤

Influence of a Weak Home Currency on the Economy Influence of a Strong Home Currency on the Economy

• How Central Bank Intervention Can Affect an MNC’s Value

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