Chapter Nine Copyright, John Wiley and Sons, Inc. Chapter Nine three Learning Concepts – Chapter 9 1. Know the types of exchange systems that are available

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Copyright, John Wiley and Sons, Inc.

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Learning Concepts – Chapter 9

1. Know the types of exchange systems that are available today.

2. Understand that all nations do not use the same exchange systems, and that adds complexity to the foreign exchange markets.

3. Understand why some currencies fluctuate more than others as a function of economic, political, or social stability. …/…

The International Monetary System and Financial

Markets.

The International Monetary System and Financial

Markets.

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Learning Concepts – Chapter 9 (cont)

4. Understand that currencies appreciate and depreciate against others.

5. Understand the complexity of world financial markets and institutions.

6. Know something about how Multinational Enterprises finance global operations via international capital markets.

The International Monetary Systems and Financial

Markets.

The International Monetary Systems and Financial

Markets.

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Mexican Financial Crisis, 1994 - 1995

Initially pegged to United States

dollar, 1988 – 1992. Objective: Price Stabilization. Overvalued peso depreciated dramatically in order

to control inflation. Depreciated peso inhibited business purchasing of

foreign goods.

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Mexican Financial Crisis, 1994 - 1995

Mexican economy stalled, deficits rose, politics became unstable, politicians assassinated.

Government issues peso obligations, pesobonos, to cover obligations.

Nuevo Peso issued in 1994-1995 to create new valuation schemes.

2000, PRI lost government control to PAN party, effectively ending 72 years of political control.

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History of the International Monetary System

Gold Standard Period (1876-1914), exchange rates determined as ratio of nations’ own valuation of gold. Economic uncertainty and government obligations changed nations’ willingness to pay more or less for gold reserves. F(x) rates changed accordingly.

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WWI/WWII created stronger demand for gold as mechanism for war debt payment. Currencies devalued against gold to make debts easier to pay. United States dollar depreciated from $20.67/troy ounce to $35.00. Currencies without gold reserves lost value in the market. United States dollar became the ONLY trading currency as other countries had traded or lost their gold reserves.

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The Bretton Woods Agreement (1944; Bretton-Woods, New Hampshire) created a system where currencies could be pegged to gold, or the United States dollar. This made it easier for Allied powers to pay war debts and created mechanism for controlling Axis powers after the war. Currency devaluation could approach 10% - after which participating countries had to help control the devaluation. This ensured that all members paid fairly on war obligations. This created a floating system so “true valuations” could be determined.

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After B-W, floating exchange rates controlled the system. OPEC crises devalued the United States dollar, so the Group of Seven (G-7) was created (1987) to manage dollar valuation through the Louvre Accords, which tied international economic policy with valuation. This helped stabilize western currencies.

1997, the Asian economic crisis forcefully devalued Asian currencies. 1998, Russia and Latin America came under pressure. Brazil, Argentina, Russia all experience GDP shrinkage and political instability.

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1999, the Euro is launched and the new currency starts circulation in 2002.

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Contemporary Exchange Rate Systems

The Fixed Rate System has governments buying and selling currency reserves when exchange rates differ from stated par values. Pure fixed systems are rare. Current examples: Cuba, North Korea, Malaysia.

The Crawling Peg System has governments managing exchange rates within a percentage range from par. A peg can be made to other currencies (like a dollar) or to market baskets of currencies.

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The Target Zone Arrangement, is a managed multilateral float system arranged by nations (like the G7) who have common interests and goals. The European Monetary System is an example of this. This is managed by the European Central Bank.

The Managed Float System, known as the dirty float, is managed by governments to preserve orderly exchange and eliminate excess volatility. Central banks manage currency valuations by buying and selling currencies, and altering balances of payments, exchange reserves, and black market rates. …/…

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Independent Float Systems, allow clean floating and full flexibility.

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The United States

uses independent floating,

Canada uses managed floats,

the EU uses target zones,

Panama uses the crawling peg, and

Cuba uses the fixed system.

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Determination of Foreign Exchange Rates

The determination of exchange rates should address two questions:

How base rates between currencies are determined.

How exchange rates change over time. The gold standard did this, and each exchange

system does that for countries that uses respective systems. How well they do this predicts exchange volatility and future policy on f(x).

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PPP and IRP

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP) are approaches to F(x) that tie exchange rates to baskets of goods, or baskets of borrowed money.

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PPP

Absolute PPP states that the exchange rate is determined by the relative prices of similar baskets of goods and/or services. Relative PPP considers inflation and the change of F(x) rate over time.

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IRP

Interest Rate Parity provides an understanding of the way in which interest rates are linked between countries through capital flows. IRP suggests that the differences in interest rates for securities of similar beta should be similar, but opposite, the forward rate discount for a currency. The Forward Rate is the rate at which a bank will exchange currencies at some future date.

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The Balance of Payments

The balance of payments is an accounting statement that summarizes all the economic transactions between residents of a home country and those of all other countries. An Account Deficit means more money is going out of a country to purchase goods than is coming in. An Account Surplus, is just the opposite.

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Interpretation of Deficit and Surplus

This is a difficult issue. Ever wonder why economics is called a “dismal science”? An account deficit theoretically means that foreign goods are more competitive and that perhaps national industries aren’t making competitive products, which could then signal recession, depression, or closure of economies or business firms . A surplus, could theoretically mean there is excess demand, that could trigger inflation and eventual economic slowdown.

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Interpretation: Does it matter?

Another group of people believe the interpretations of deficit and surplus are only good for politicians. They believe that with globalization, the older interpretations of deficit and surplus are becoming meaningless.

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International Foreign Exchange Market

International financial markets play a crucial role in global business. Business firms face many opportunities and threats from monetary systems and financial/capital markets.

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International Foreign Exchange Market: Terms

Foreign Exchange Market/Transaction Direct Quotes/Indirect Quotes Bids and Offers Spot and Forward Swaps and Barters Arbitrage, Black, and Parallel Markets

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International Foreign Exchange Market

International Money Markets are the markets in which foreign monies are financed or invested. International firms use international markets to finance global operations at lower costs than are available domestically. Firms assume the risk of currency devaluation (which can lower the cost of borrowing) or currency appreciation (which raises the cost). Available to businesses are the currency markets, like the Eurocurrency market, international bond markets, international stock and equity markets, and international loan or commercial paper markets.

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The Asian Financial Crisis

Crises can occur in international financial markets. These impact business operations dramatically because they impact the availability and cost of financial instruments, while introducing political risk, and making it more difficult to plan, organize, lead, and control business operations globally.

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Asian Crisis Perspectives: Financial

This point of view suggests that the crisis came from financial sector weakness and market failure. Specifically, the maintenance of pegged exchange rates became too expensive and forced rising deficits in Asian countries. Loan defaults increased and governments were left with no recourse but to float their currencies, causing massive devaluation.

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Asian Crisis Perspectives: Political

This perspective asserts that the causes of the crisis extended deeper than financial. Market and financial sector failures were symptoms of corruption, cronyism, irresponsible governance, weak institutions, poor regulatory environments and institutions, and bad political systems.

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Asian Crisis Perspectives: Managerial

This perspective maintains that micro-management was at the heart of the problem. Companies pursued risky diversification. When faced with the reality of performance, the banks and networks couldn’t provide returns. As a result, the financial markets collapsed.

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Chapter Nine Copyright, John Wiley and Sons, Inc. Chapter Nine three Learning Concepts – Chapter 9 1. Know the types of exchange systems that are available