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CHAPTER 7
DEALING WITH FOREIGN EXCHANGE
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1. understand the determinants of foreign exchange rates.
2. track the evolution of the international monetary system.
3. identify firms’ strategic responses to deal with foreign exchange movements.
4. participate in three leading debates concerning foreign exchange movements.
5. draw implications for action.
GENERAL TEACHING SUGGESTIONS
One way to help students understand the foreign exchange market is to relate it to an auction
market. This might help to develop a simulated experience and relate that experience to the
currency market. Pick a charity that most students would likely support if they could. Inform the
students that the charity is auctioning a valuable item to earn operating funds. Offer a small unit
of extra credit to the successful bidder. It is possible that not all will bid and the amounts that are
bid will vary – ask why. Students may indicate lack of funds or lack of need. Then, ask them if
the timing of the bidding might have an effect; after getting the results from an exam, their need
might have increased or decreased, making them more or less willing to bid. Some students may
acknowledge that it was their anticipation of a need caused by an upcoming exam (they were
confident or they were scared) that caused the level of the bid and they were trying to protect
themselves (insure or hedge) against that risk.
Go on to show the application to the currency market and apply it to the dollar. Discuss the
various forces that create a need for the dollar (such as other countries buying U.S. goods and
services or expansion of their firms’ operations into the U.S.), the supply of the dollar (our
purchases of goods and services from other nations and expansion of business operations
overseas), and the resulting value of the dollar in terms of other countries. Point out that the
exchange rate is affected not just by current transactions but also by anticipation of future needs
and risks – no one will accept a given value for a currency today if upcoming events are likely to
make the currency worth less and thus cause a loss. As a result, people needing currencies will
need to guard against that risk through some means of hedging or risk avoidance. With that as a
basis for discussion, you can then go on to cover the entire chapter.
OPENING CASE DISCUSSION GUIDE
Opening Case: Toyota’s Yen Advantage
When the value of the yen fell 16% against the dollar in 2012, Japanese companies, including
Toyota, gained funds that they could use to benefit their businesses. Toyota used the change to
stage a comeback by showing an increase in profit. The shift in currency values is a threat to U.S.
companies because it gives Japanese companies money to grow and compete successfully.
CHAPTER OUTLINE: KEY CONCEPTS AND TERMS
Sections I through V of Chapter 7
I. WHAT DETERMINES FOREIGN EXCHANGE RATES
1. Key Concept
A foreign exchange rate is the price of one currency expressed in another. Basic
determinants of foreign exchange rates include (1) relative price differences, (2) interest
rates and monetary supply, (3) productivity and balance of payments, (4) exchange rate
policies, and (5) investor psychology.
2. Key Terms
Appreciation is an increase in the price of one currency in terms of another.
Balance of payments (BOP) is a country’s international transaction statement,
which includes merchandise trade, service trade, and capital movement.
Bandwagon effect is the effect of investors moving in the same direction at the same
time, like a herd.
Capital flight is a phenomenon in which a large number of individuals and
companies exchange domestic currency for a foreign currency.
Clean (or free) float is a pure market solution to determine exchange rates.
Depreciation is a loss in the value of the currency.
Dirty (or managed) float is using selective government intervention to determine
exchange rates.
Fixed exchange rate policy is a government policy to set the exchange rate of a
currency relative to other currencies.
Foreign exchange rate is the price of one currency in terms of another.
Floating (or flexible) exchange rate policy is a government policy to let
supply-and-demand conditions determine exchange rates.
Peg is a stabilizing policy of linking a developing country’s currency to a key
currency.
Target exchange rate (or crawling band) is the specified upper or lower bounds
within which an exchange rate is allowed to fluctuate.
II. EVOLUTION OF THE INTERNATIONAL MONETARY SYSTEM
1. Key Concept
The international monetary system evolved from the gold standard (1870–1914), to the
Bretton Woods system (1944–1973), and eventually to the current post-Bretton Woods
system (1973–present). The IMF serves as a lender of last resort to help member
countries out of financial difficulty.
Key Terms
Bretton Woods system is a system in which all currencies were pegged at a fixed
rate to the U.S. dollar.
Common denominator is a currency or commodity to which the values of all
currencies are pegged.
Gold standard is a system in which the value of most major currencies was
maintained by fixing their prices in terms of gold.
International Monetary Fund (IMF) is an international organization that was
established to promote international monetary cooperation, exchange stability, and
orderly exchange arrangements.
Post–Bretton Woods system is a system of flexible exchange rate regimes with no
official common denominator.
Quota is the weight a member country carries within the IMF, which determines the
amount of its financial contribution (technically known as its “subscription”), its
capacity to borrow from the IMF, and its voting power.
III. STRATEGIC RESPONSES TO FOREIGN EXCHANGE MOVEMENTS
1. Key Concept
Three foreign exchange transactions are (1) spot transactions, (2) forward transactions,
and (3) swaps. Three strategic responses include (1) invoicing in their own currencies,
(2) currency hedging, and (3) strategic hedging.
2. Key Terms
Bid rate is the price to buy a currency.
Currency hedging is a transaction that protects traders and investors from exposure
to the fluctuations of the spot rate.
Currency risk is the potential for loss associated with fluctuations in the foreign
exchange market.
Currency swap is a foreign exchange transaction between two firms in which one
currency is converted into another at Time 1, with an agreement to revert it to the
original currency at a specific Time 2 in the future.
Foreign exchange market is the market where individuals, firms, governments, and
banks buy and sell foreign currencies.
Forward discount is a condition under which the forward rate of one currency
relative to another currency is higher than the spot rate.
Forward premium is a condition under which the forward rate of one currency
relative to another currency is lower than the spot rate.
Forward transaction is a foreign exchange transaction in which participants buy
and sell currencies now for future delivery.
Offer rate is the price to sell a currency.
Spot transaction is the classic single-shot exchange of one currency for another.
Spread is the difference between the offer rate and the bid rate.
Strategic hedging is spreading out activities in a number of countries in different
currency zones to offset any currency losses in one region through gains in other
regions.
IV. DEBATES AND EXTENSIONS
1. Key Concepts
The debates are (1) fixed versus floating exchange rates, (2) a strong dollar versus a
weak dollar, and (3) currency hedging versus not hedging.
2. Key Terms
Currency board is a monetary authority that issues notes and coins convertible into
a key foreign currency at a fixed exchange rate.
V. MANAGEMENT SAVVY
1. Key Concept
Fostering foreign exchange literacy is a must. Risk analysis of any country must include
an analysis of its currency risks. A currency risk management strategy is necessary via
currency hedging, strategic hedging, or both.
2. Key Terms
None
