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Chapter Eight

International Monetary
System and Financial
Forces

McGrawHill/Irwin

Copyright2010byTheMcGrawHillCompanies,Inc.Allrightsreserved.
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Learning Objectives
1. Describe the evolution of monetary arrangements
of the international monetary system
2. Discuss the purpose of the Bank of International
Settlements
3. Explain the impact of fluctuating currency values
4. Describe currency exchange controls
5. Summarize the influence of differences in
taxation an d inflations rates on international
business
6. Explain the role of the balance of payments

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Gold Standard
Gold Standard
The use of gold at an established number of
units per currency
Discontinued after WWII
Continues to have ardent supporters who like
the fiscal policy discipline it poses on
governments
Economists do not agree because discipline
sacrifices flexibility and limits the
governments ability to respond to crises

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Bretton Woods System


The Bretton Woods system was a gold
exchange standard with the U.S. dollar fixed
to $35 to the ounce

Other currencies par values fixed to


the dollar
System agreed to in 1945 and abandoned in
1971 when the U.S. eliminated the
convertibility of the U.S. dollar to gold

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Special Drawing Rights


Special Drawing Rights (SDR) are an
international reserve asset established by the
IMF

SDRs are the unit of account for the


IMF and other international
organizations
Based on a basket of four currencies:
euro, Japanese yen, UK pound
sterling, and the U.S. dollar

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Floating Currency Exchange


Rates
Freely floating currencies fluctuate against
each other
Values determined by market forces
Fluctuations may be quite large
Financial managers must understand how to
protect against losses or optimize gains

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IMFs Current Exchange


Rate Arrangements
Exchange arrangements with no separate
legal tender
Currency board arrangements
Other conventional fixed peg arrangements
Pegged exchange rates within horizontal
bands

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IMFs Current Exchange


Rate Arrangements
Crawling pegs

Exchange rates within crawling


bands
Managed float with no preannounced path for
the exchange rate

Independently floating exchange


rates
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Summary of
Currency Arrangements

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Bank of International
Settlements
The Bank of International Settlements is based
in Basel, Switzerland

an international organization of central


banks: the banker for central banks
fosters cooperation among central
banks and other agencies in pursuit of
monetary and financial stability

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Foreign Exchange
Terminology
Foreign Exchange Quotation
The price of one currency expressed in terms of another
Reported in the worlds currency exchange markets
Central reserve asset
Asset, usually currency, held by a governments central
bank
Vehicle currency
A currency used as a vehicle for international trade or
investment
Intervention currency
A currency used by a country to intervene in the foreign
currency exchange markets, often to buy (strengthen) its
own currency
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Euro to U.S. Dollar


Exchange Rate

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Foreign Exchange Quotations


Exchange Rates
Foreign currency Xs per U.S.$ rate can be
computed from the reciprocal of the U.S. $
equivalent rate of currency X (and vice versa)

1/(U.S. $ equivalent rate of currency X) =


(Currency X per U.S. $ rate)
1/(Currency X per U.S. $ rate) = (U.S. $ equivalent rate
of currency X)
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Exchange Rates
Spot rates

The exchange rate between two


currencies for delivery within two
business days

Forward currency market

Trading market for currency


contracts deliverable 30, 60, 90, or
180 days in the future

Forward rate

The exchange rate between two


currencies for delivery in the future,
usually 30, 60, 90, or 180 days

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Exchange Rates
Trading at a premium

A currencys forward rate quote is


stronger than the spot rate
Trading at a discount

A currencys forward rate quote is


weaker than the spot rate
Premium or a discount depends on the
expectations of the world financial community,
businesses, individuals, and governments about
what the future will bring

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Exchange Rates
Cross Rates

Currency exchange rates for


trading directly between nonU.S. dollar currencies
Bid price

Price offered to buy


Ask price

Sales price
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Influences of
Exchange Rate Fluctuation
Supply and demand of the currency
Interest rates
Inflation
Expectations

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Exchange Rate
Fluctuation
Monetary policies

Government policies that control the


amount of money in circulation and its
growth rate

Fiscal policies

Policies that address the collecting and


spending of money by the government

Law of one price

Concept that in an efficient market, like


products will have like prices

Arbitrage

The process of buying and selling


instantaneously to make profit with no risk
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Exchange Rate Fluctuation


Fisher effect
The relationship between real and nominal interest
rates: the real interest rate will be the nominal
interest rate minus the expected rate of inflation

International Fisher effect


Concept that the interest rate differentials for any
two currencies will reflect the expected change in
their exchange rates

Purchasing Power Parity (PPP)


Theory that predicts that currency exchange rates
between two countries should equal the ratio of the
price levels of a commodity basket in each country
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Exchange Rate Forecasting


Efficient market approach

Assumption that current market prices


fully reflect all available relevant
information
Random walk hypothesis

Assumption that the unpredictability of


factors suggests that the best predictor
of tomorrows prices is todays prices

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Exchange Rate Forecasting


Fundamental approach

Exchange rate prediction based on


econometric models that attempt to
capture the variables and their correct
relationships
Technical analysis

An approach that analyzes data for trends


and then projects these trends forward

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Currency Exchange Controls


Currency exchange controls are

government controls that limit the legal


uses of a currency in international
transactions
the value of the currency is arbitrarily
fixed at a rate higher than its market value
If you see official rate next to a currency rate
quotation, that country has currency exchange
controls in place

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Currency Exchange
Controls
A black market typically surfaces as a result of
currency exchange controls

However, this type of currency


exchange transaction is illegal
The black market is rarely able to
accommodate transactions of the size
involved in international business

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Taxation
Income tax

Direct tax on personal and corporate


income
Value-added tax (VAT)

A tax charged on the value added to a


good as it moves through production
from raw materials to final purchaser
Withholding tax

Indirect tax levied on passive income that


the corporation would pay out to non
residents
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Corporate Tax Rates

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Inflation and Interest


Rates
A trend of rising prices

may be caused by demand


exceeding supply
may be caused by an increase in
the money supply
Measured by consumer price index (CPI)

Basket of consumer goods


Gross domestic product deflator--OECD

Takes into account the prices of


intermediate goods and services
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Inflation Map

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GDP Deflator

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Inflation and the


International Company
High inflation rates

make capital expenditure planning


more difficult
cause the cost of goods and services to
rise
tend to cause bop deficits
could lead to more restrictive fiscal or
monetary policies, currency controls,
export incentives, and import obstacles

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Inflation and the


International Company
High inflation rates

encourage borrowing because the loan


will be repaid with cheaper money
bring high interest rates
discourage lending
make capital expenditure planning
more difficult

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Balance of Payments
The state of a nations balance of payments (BOP)
reveals the state of that countrys economy
If the BOP is slipping into deficit the government
is probably considering one or more market or
nonmarket measures to correct or suppress that
deficit
Currency devaluation or restrictive monetary
or fiscal policies to induce deflation are likely
Currency or trade controls may be near

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Balance of Payments
Major Accounts

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A Nations Balance of
Payments
Current account: records exports and imports in
goods and services

Goods or merchandise account


Services account
Unilateral transfers

Capital account: records the net changes in


international financial assets and liabilities

Direct investments
Portfolio Investments
Short-term capital flows

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Balance of Payments
Current Account

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A Nations Balance of
Payment
Official Reserves account: records the assets
held by the government

Gold, foreign currencies


Accounts in foreign banks: A balance
of the countrys foreign currency

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