FROREIGN EXCHANGE REGIME final

The foreign exchange marketForeign Exchange rate regime∙Cross-border business transactions + increased international flows of capital result in the rise of markets for FX and capital, the interdependence of country’s monetary & financial policies and the International Monetary System as an institutional arrangements that govern exchange rates.The Bretton Woods System∙The Bretton Woods system could work only as long as the US inflation rate remained low and the US did not run a balance-of-payment deficit.The contemporary System∙The pegged exchange ratePegged to a currency or a basket of main currencies, allowing their currency to fluctuate within a zone around the basket.Fixed pegged: pegged at a fixed rate. E.g. pegged to US dollarPegged but manage float within a pre-defined band. E.g. HongkongCrawling peg: pegged and allows appreciate/depreciate gradually (frequently but in small increments).- Is a fixed exchange rate tied or pegged to the value of another currency with provisions to prevent it from falling sharply in value in too short a time.- E.g. ChinaTYPES OF EXCHANGE RATE REGIMES∙Three distinct types of exchange rate regimes: floating, fixed and pegged∙In Friedman’s sense, strictly fixed and floating rates are regimes in which the monetary authority is aiming for only one target at a time and they are members of same free-market family (Friedman&Mundell, 2000).Fixed exchange regime1.Currency board sets exchange rate, no monetary policy2.Or country is ‘dollarized’ and uses a foreign currency as its own→Monetary base is determined by the balance of payments, moving in a one-to-one correspondence with changes in its foreign reserves∙no conflicts between monetary and exchange rate policies, balance-of-payments crises cannot rear their ugly heads→Conclusion: Floating- and Fixed-rate regimes are inherently equilibrium systems in which market forces act to automatically rebalance financial flows and avert balance-of-payments crisisFloating exchange rates (Benefit)∙Monetary policy autonomyRemoval of the obligation to maintain exchange rate parity would restore monetary control to a government.E.g. government faced with unemployment could increase its money supply tostimulate domestic demand and reduce unemployment regardless of maintainingexchange rate.Money expansion→ inflation→ currency depreciation. If PPP holds→ reduces exchange rate against the other currency→ depreciation on the foreign exchange markets should offset the effects of inflation.Domestic inflation under the floating exchange rates system should have no impact on businesses international cost competitiveness due to exchange rate depreciation.∙Trade balance adjustmentsUnder the Bretton Woods system, if a country developed a permanent deficit in its balance of trade, it would require the IMF to agree to a currency devaluation →criticism argues that the adjustment mechanism works much more smoothly under a floating exchange rate regimeUnderlying logistic: the imbalance between the supply and demand of country’s currency in the foreign market (supply > demand) will lead to depreciation of exchange rate→ making exports cheaper and imports more expensive→ correct trade deficit∙问题：speculation + uncertainty (在fixed exchange rates这里会解释)Fixed exchange rates∙Monetary disciplineThe need to maintain fixed exchange rate parity ensures that governments do not expand their money supplies in inflationary rates.Advocates argue that governments all too often give in to political pressures and expand the monetary supply far too rapidly, causing unacceptably high price inflation.Opponents: see it as a lost of monetary policy control—countries are limited their ability to use monetary policy to expand or contract their economies.- Monetary expansion can lead to inflation→ puts downward pressure on a fixed exchange rate;- Higher interest (to reduce money demands) leads to an inflow of money from abroad → puts upward pressure on a fixed exchange rate.∙Discourage speculation (floating 会出现的情况)Speculation is a main trigger of fluctuation and currency crisisAvoids the bandwagon effect (羊群效应): irrational selling- When foreign exchange dealers see a currency depreciating, they tend to sell the currency in the expectation of future depreciation.- As more traders jump on the bandwagon, the expectations of depreciation are realized→it can damage a country’s economy by distorting export and importprices.∙Reducing uncertainty （floating会出现的情况）The unpredictability of exchange rate movements adds risk to exporting, importing and foreign investment activities → distorts and defers business decisions and dampens the growth of international trade and investmentAdvocates of fixed exchange rate: insures against the risks associated with exchange rate fluctuations→ low uncertainty adds more confidence to invest→ growth IT∙Trade balance adjustments 是对floating的反对Criticize the closeness of the link between the exchange rate and the trade balance.Claim trade deficits are determined by the balance between savings and investment ina country not by the external value of its currencyArgues that depreciation of currency will lead to inflation that wipes out any apparent gains in cost competitiveness that arise from currency depreciation.∙Often being criticized of masking the true value of the currencyAttracts speculation attack: if a country cannot defend the fixed rate, ultimately will force devaluation.Summary∙Whether a fixed exchange rate or floating depends on countries’ degree of development and policyFavoured both fixed and floating rates, rejected pegged rate as ‘worse than either extreme’ (Friedman 2000)But fixed exchange rate administrated by central bank is dangerous- Potential for a central bank to engage in discretionary monetary policy and to break the one-to-one link between foreign reserves and money supply changese.g. Argentina’s central bank simultaneously attempted to maintain a rigidexchange rate and engaged in an active monetary policy→BOP crisis, exch.g.restrictions and a peso devaluation in January 2002For developing countries with high inflation and pervasive exchange control, a fixed exchange rate with the currency of a large, relatively stable developed country withwhich it has close economic relations is favourable.- Reason: tie those countries’ monetary policy to the kite of the monetary policy of other country—preferably a more developed, larger and relatively stable country.∙Peg regimePegged-rate systems are those where monetary authority is aiming for more than one target at timePegged to a currency or a basket of main currencies, allowing their currency to fluctuate within a zone around the basket.Employ exchange controls & no free-market mechanisms for international balance-of-payments adjustmentsInherently disequilibrium systems, lack automatic mechanism to produce BOY adjustmentsRequire central bank to manage both exchange rate and monetary policyMonetary base contains both domestic and foreign componentsResult in conflicts between monetary and exchange rate policiese.g. when capital inflows become ‘excessive’→central bank sterilize the ensuringincrease in the foreign component of monetary base by selling bonds, reducing thedomestic component of the base; vice verse →keep balanceBOP crises occur as central bank begins to offset more and more of the reduction in foreign component of the monetary base with domestically created base money→Currency speculators spot contradictions between exchange rate and monetarypolicies→force devaluation or imposition of exchange controlsTopic II: Economic Theory of Exchange Rate DeterminationPrice and inflation rate; interest rate; investor psychology and bandwagon effects; confidence: ‘safe’ currencies are considered attractive in terms of turmoil; seasonal demands for a currency; technical adjustment: slight strengthening of a currency following a prolonged weakness (谷底反弹).Price and exchange rates∙The Law of One PriceIn competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price isexpresses in terms of the same currency.Market (demand and supply of the product in the two countries) will equalize any difference in prices.∙The Purchasing power parity (PPP)PPP is an extension of LOOP→ instead of a single good; it looks at the prices of a bundle of goods.PPP exchange rate can be predicted by comparing the weighted average prices of a basket of goods.Relative PPP: exchange rate changes when relative price (inflation) between two countries over a period of time determines the change in the exchange rate over thatperiod.- ∆S= - ∆I- The projected inflation rate becomes a predictor of exchange rate: when the growth in a country’s money supply is faster than the growth in its output, price inflation ishigher, the currency weakens against other currencies with lower inflation rate.∙Empirical Tests of PPP theory（老师PPT没说，其实如果考了就变成IF了，纠的太深了，所以我觉得不会考)While PPP seems to yield relatively accurate prediction in the long run, it does not appear to be a strong predictor of short-term movements in exchange rates coveringtime spans of five years or less.Assume away transportation costs and barriers to trade- In practice, these factors are significant and create significant price differentials between countries- Trade and non-trade barriers limit the ability of traders to use arbitrage to equalize prices for the same product in different countries;- Government intervention weakens the link between relative price changes and changes in exchange rate.PPP may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercisesome influence over prices, control distribution channels, and differentiate theirproduct offerings between nations.- E.g. in the detergent industry, Unilever and P&G dominate the market in nation after nation.Government intervenes in the foreign exchange market in attempting to influence the value of their currencies.Interest rates and exchange rates∙Fisher effectThe nominal interest rates in each country are equal to the required real rate of return plus compensation for expected inflation. i = r + IWhen investors are free to transfer capital between countries, real interest rates will be the same in every country→ any difference in interest rates between countriesreflects differing expectation about inflation rates—country with higher nominalinterest rate indicates expectation of higher inflation∙International fisher effect (IFE): links interest rates and exchange ratesAny two countries, the spot exchange rate should change in an equal amount but in the direction to the difference in nominal interest rates between the two countries.△%(S)= -△%(i).Here the nominal interest-rate differential as a predictor- Currency of a country with lower interest rate will strengthen in the future- Currency of a country with higher interest rate will weaken in the future.Like PPP, works well in the long-run.Investor psychology and bandwagon effects (short-term predictor)∙Investor psychology and bandwagon effects play a major role in determining short-run exchange rate movements, but hard to predict.Bandwagon effect: traders moving as a herd in the same direction (either selling or buying a currency) at the same time→ their expectations become a self-fulfilling prophecyTopic III: Impact of Fluctuation of Exchange Rate on Firm Conducting“Is there a currency war?”∙The idea that currencies can be used as a policy weapon.∙Facing economic downturn, countries compete to weaken their currencies to boost exports and speed up economic recovery.The Bank of Japan began a massive sale of yen and bought dollars to weaken the yen’s value against the dollar and so make goods exported cheaper + boost companies’profits when they convert dollar back to yen.A series of governments intervention in the currency market around the world—the US,UK, Japan, Korea and Brazil.∙Emerging economies (China) are urged to appreciate their currencies. In particular the value of Chinese yuan continues to initiate debate.The foreign exchange rate market can have a fundamental impact on the sales, profits and strategy of an enterprise- Firms pay foreign company for its products/services, if pay less under exchange rate changes→reduce costs→increase competitiveness/profitsRisk of international business and investment exists because future exchange rates cannot be perfectly predicted.∙Allow us to compare the relative prices of goods and services in different countries Function of the foreign exchange market∙Converts the currency of one country into the currency of another∙Provides some insurance against foreign exchange risk (adverse consequences of unpredictable changes in exchange rates.Exchange Rate and IB∙Selling products abroad (Exporting)e.g. D omestic currency depreciates and export destinations’ currencies appreciates: you are earning more in the value of your currency (payments a company receive from export)∙Sourcing and Manufacturing Abroade.g. Currencies of the countries of your supplies and foreign operations depreciates: you are reducing costs (foreign investment)∙Financial Decisionse.g. Currency of your borrowings depreciates and currencies of your earnings appreciates: your debt becomes cheaper∙Currency speculationThe short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates.HINTS: be careful with appreciation/depreciation of whether home/host currency values against other countries.Foreign exchange exposures and risks∙In foreign exchange market, companies expose to foreign exchange risks because of fluctuation of exchange rates. Under an international purchasing contract, adverse foreign exchange exposure may jeopardize purchaser’s benefits.∙Transaction exposureShort-term fluctuations in FX values affect the income from individual transactions.It measures changes in the value of outstanding financial obligations incurred prior toa change in exchange rates but not due to be settled until after the exchange rateschange. Thus it deals with changes in cash flows that result from existing contractual obligations (payables and receivables).∙Translation exposureImpact on the reported financial statements of a company. Influence financial ratios that are of shareholders and oth er stakeholders’ interest.It concerned with the present measurement of past events.E.g. the translation of assets value and profits of a foreign subsidiary into homecountry currency. If exchange rate of host country depreciates adversely→ thetranslated value into the consolidated financial statement is substantially lower though the subsidiary performs well in the host country.Transfer local earning of US subsidiary to UK. Year 1 with $10m local earnings under exchange rate £0.6→£6m in UK; while Year 2 with $10m under exchange rate£0.55→£5.5m in UK.∙Economic exposureIs the extent to which a firm’s future international earning power is affected by changes in exchange rates.It impacts a firm’s long-term international earning power and profitability.E.g. the rapid rise in the value of the dollar on the foreign exchange market in the1990s hurt the price competitiveness of many US products in world markets.E.g. Intel invoices 65% of its chip in USD. If euro weakens against the dollar, whichforeign exchange risk are Intel and the European importers subject to?- Intel: Operating Exposure (because European importers are not willing to import from Intel since they will pay more Euros)Minimize transaction and translation exposure∙Lead / lag strategy; hedging strategiesA LEAD STRATEGY∙Collect foreign currency receivables (payment from customers) early when a foreign currency is expected to depreciate∙Pay foreign currency payables to suppliers before they are due when a foreign currency is expected to appreciate.A LAG STRATEGY∙ A firm that holds a hard currency and having debts denominated in a soft currency will lag by paying those debts late; hoping less of the hard currency will be needed.∙Delaying collection of foreign currency receivables if home currency is expected to appreciate∙Delaying payables if the home currency is expected to depreciate.Problem∙Both lead and lag strategy is difficult to implementPayment terms often set out clearly in the contract: difficult to change→ firms do not always have a position to exercise some control over payment terms.Requires compromise by the trading partners: they are neither fools nor puppets Because these strategies can put pressure on a weak currency, many governments limit them. E.g. some countries set 180 days as a limit for receiving payments forexports or making payments for importsHedging strategiesDO NOTHING∙Convert receivable (USD100m) and payable based on the spot exchange rate at the particular time it is received or paid.Spot exchange rateIs reported on a real-time basis.Set by the market situation: the interaction between the demand and supply of that currency relative to the demand and supply of other currencies.∙ProsSimple and no hedging costs involvedMay be a good choice if:1)This particular transaction is small comparing to the others2)You know the US dollars will either remain stable or will appreciate.∙ConsPassive and risky: may loss substantiallyFORWARD MARKET HEDGE∙Defined as an agreement to purchase or sell amounts of underlying asset at a negotiated price on a future date. Thus it involves a forward contract and a source of funds to fulfill that contract.In most cases, forward rates are quoted for 1-month, 3-month, 6-monthTransactions are taken place in Over-The-Counter.∙The forward rate is not a wild guess, but based on some mathematical calculations. It is an unbiased predictor of future spot rate.∙Here: engage in (buy) a 6-month forward exchange—convert the receivables at a forward exchange rate (the specified exchange rate agreed by two parties (e.g. with a bank or a Forex dealer), which is to be executed in 6 months time.∙ProsMinimize the risk any adverse at the time payment is due. By locking in a predetermined price, a buyer also is hedging or safeguarding against the possibility of volatility in the underlying asset’s priceIncreases control and planning of incomes and costs (plan budget accordingly)—the value of the transaction can be accurately calculated.∙ConsIncurs insuring costsNeeds to execute the pre-agreed binding rate even if the spot exchange rate at settlement day becomes benefit for the firmCounter-party risks: if funds to fulfill the contract are not already available or due to be received later→ must be purchased in the spot market at some future date (nohedging effect)OPTION MARKET HEDGE∙Option contract gives the option buyer the right, but not the obligation, to buy or sell a certain amount of foreign exchange at a fixed price per unit for a specified time period until the maturity date.∙Here: buying a 6-month put option contract on US dollars with a strike price of USD2=GBP1Exercise the option after 6 months if US dollars depreciatesNot to exercise the option if US dollars appreciate and convert US dollar to sterling based on the more favorable spot exchange rate∙Pay a non-refundable premium for the right∙ProsBuyers of option can choose exercise or expire→ the maximum loss is the option premium—flexible∙ConsPremium is higher than a forward contract and if not exercise option, the premium will be the sunk costs.CURRENCY SWAP∙Engage a counterparty to exchange one currency for another currency according to a specified schedule, and give back original swapped amounts (plus interest)∙ A firm and a swap dealer or bank agree to exchange an equivalent amount of two different currencies for a specified period of time∙Firms first required to borrow funds in the markets and currencies in which they are best known→participate in a cross-currency swap→one firm can have another country’s debt without actually borrowing that country’s currency∙Pros:1.Reduce costs of generating financial funds2.Satisfy both parties3.Reduce exchange exposure (settled exchange rate)∙Cons: counter-party risk if one party is unable to fulfill the contract.MONEY MARKET∙Includes a contract (a loan agreement) and a source of funds fulfilling that contract∙The basic operation is that firm borrows money denominated in one currency and exchanges the proceeds for another currency∙Here borrow US dollars and exchange immediately to ponds and invest the proceeds for six months. When receive the dollar payment, repay principle and interest.Compare Hedging Techniques∙They key is to distribute the firm’s productive assets to various locations so the firm’s long-term financial well-being is not severely affected by adverse changes in exchange rates.Other precautionary measures∙The firm needs to develop a mechanism for ensuring that it maintains an appropriate mix of tactics and strategies for minimizing its foreign exchange exposure1.Central control of exposure is needed to protect resources efficiently and ensure that eachsubunit adopts the correct mix of tactics and strategiesSet up in-house foreign exchange centers2.Firms should distinguish between transaction, translation and economic exposure.3.Emphasize flexibility in international operation—diversify risks through various locationsand networks.4.The need to forecast future exchange rate movements cannot be overstated→ a trickybusinessNo model comes close to perfectly predicting future movements in foreign exchange ratesShort-run: forward exchange rates (best predictor); long-run: inflation rate5.Firms need to establish good reporting systems so the central finance function canregularly monitor the firm’s exposure positions.6.The firm should produce monthly foreign exchange exposure reports。