Chapter Outline
LO1: List the factors that determine foreign exchange rates.
1. Key Concepts
A foreign exchange rate is the price of one currency in terms of another. This section
identifies six factors that determine foreign exchange rates: (1) basic supply and demand, (2)
relative price differences and purchasing power parity, (3) interest rates and money supply,
(4) productivity and balance of payments, (5) exchange rate policies, and (6) investor
psychology.
2. Key Terms
3. Discussion Exercise
While individuals often attribute movements in the exchange rate to purely economic
reasons, investor psychology can produce dramatic swings as well. To illustrate this point,
lead the students through a game. The game begins with the instructor handing out different
amounts of money in various currencies (these can be copied or could even be pieces of
paper with a denomination written on it) to the students. The instructor should then present a
At the game’s conclusion, have students consider and discuss how changes to the exchange
rate affected their attitude toward the currencies that they held, and the currencies that they
wanted. How does the psychological factor bring about changes to the supply and demand of
currencies? How did their mindset influence the actions that they took in the class’ currency
exchange market?
LO2: Articulate and explain the steps in the evolution of the international monetary
system.
1. Key Concepts
2. Key Terms
LO3: Identify strategic responses firms can take to deal with foreign exchange movements.
1. Key Concepts
2. Key Terms
3. Discussion Exercise
Ask each student to imagine that he or she is an executive of a manufacturing firm that
receives supplies from 18 different countries and sells products to 24 countries. The
student’s/executive’s success or failure is determined by the exchange rates, which cause
frequent fluctuations in the price of supplies and the sale price of manufactured goods.
Considering both the pros and cons of currency hedging and strategic hedging, which
strategy would students opt for? How would they justify this decision to other executives
and to shareholders?
LO4: Identify three things you need to know about currency when doing business
internationally.
1. Key Concepts
Debate: Ethical Dilemma/Emerging Markets
International Monetary Fund versus New Development Bank and Asian Infrastructure
Investment Bank
1. Key Concepts
Critics argue that the IMF’s lending may facilitate moral hazard, which means recklessness
when people and organizations (including governments) do not have to face the full
consequences of their actions. A second criticism centers on the IMF’s lack of
accountability. A third and perhaps most challenging criticism is that the IMF’s “one-size-
fits-all” strategy—otherwise known as the “bitter medicine”—may be inappropriate.
However, the momentum of the criticisms, the severity of the global crisis, and the desire to
Closing Case Discussion Guide
Bellini Do Brasil’s Foreign Exchange Challenges
Danilo Bellini, owner and CEO of Bellini do Brasil, and his export manager, Carlo di Toni both
set on complaining about the political and economic situation. After more than a decade of high
inflation, low growth, and debt default, the Brazilian government introduced a new currency, the
real (R$), in 1994. José Ignácio Lula da Silva’s government gained the confidence of the
international financial markets.
During the 2003 crisis, the Central Bank’s reference nominal interest rates topped 26%. Even at
the beginning of 2017, nominal interest rates were around 13% and real interest rates close to
8%, one of the highest worldwide. After paying back its last IMF loan in 2005, the country
obtained the investment grade rating in 2008. Billions of U.S. dollars poured into the country
since then. Things markedly changed since 2013 when the commodity price boom came to an
end. Brazil, being the third largest iron ore producer worldwide after China and Australia,
seriously suffered from the collapse of the iron ore price thanks to the Chinese slowdown.
After Rousseff was reelected in October 2014 by a narrow margin, she quickly fell into disgrace
with approval ratings falling to as low as 13% in 2016. In parallel, Brazilian prosecutors and
judges uncovered a hitherto unseen corruption scheme, which dragged the national oil company
Petrobras and major construction companies, such as Odebrecht, Camargo Correa, and Andrade
Gutierrez, into the abyss.
As if the economic and political crisis and the ensuing foreign exchange pressures were not
enough, other problems, colloquially summarized as “Custo Brasil” (“Brazil cost”), gave Carlo
and Danilo headaches. The government increased minimum wages from R$ 200 in 2002 to R$
880 in 2016. Worse, taxes levied on interstate business transactions within Brazil make it often
cheaper to import than to buy from suppliers located in another state.
Bellini do Brasil was founded by descendants of Italian immigrants who populated the Gaucho
Highlands region in South Brazil in the second half of the 19th century. Bellini recognized that
the more lucrative export markets would only be reachable by focusing on upscale furniture.
However, things changed unexpectedly. Not only did the commodity price boom come to an end,
but Brazil also suffered from a deep domestic political and economic crisis, which led to one of
the worst economic performances among emerging economies. Although exports would
generally benefit from currency devaluations, noted Carlo, recent data from the Brazilian
furniture industry showed rather a mixed picture (Exhibit 7.8). Firmly believing that there must
be a way to save their company, Danilo and Carlo discussed possible coping strategies to get out
of this trap.
Video Case
Watch “Interpret Numbers with Care” by Sir Peter Middleton of Camelot.
1. Sir Peter Middleton quoted an instructor who wanted everyone to be above average. What
is the problem with everyone being above average? Middleton then indicated that actually
everyone was above average except for one person. How was that possible?
2. Middleton argues that almost everything you do is affected by numbers. Show how
numbers are related to each major heading of this chapter.
3. According to Middleton, one could produce six versions of a balance sheet or a profit-and-
loss statement. If you have had an accounting class, show how one could produce two
versions of either of those financial statements. If you have never had an accounting class,
use what you learned about currency exchange rates to show how those changes could
affect what is reported as profit.
4. Middleton recommended that one ask how a number would look if things were different.
One way to do that is to not simply compare performance in Period B to Period A but to
compare actual performance in Period B to what was forecast for Period B. For example,
suppose your firm’s exports drop by 10%, which would appear to be bad. How might that
be good?
5. Numbers can be misleading according to Middleton. That could be true in the currency
market. For example, when the value of the dollar increases, many people would feel that
is a good thing. How might it be bad?
Additional Discussion Questions
(From Prep Cards)
Critical Discussion Questions
1. Suppose that one U.S. dollar equals 0.7778 euro in New York and one dollar equals 0.7775
euro in Paris. How can foreign exchange traders in New York and Paris profit from these
exchange rates?
2. Should China revalue the yuan against the dollar? If so, what impact might this have on:
(1) U.S. balance of payments, (2) Chinese balance of payments, (3) relative
competitiveness of Mexico and Thailand, (4) firms such as Walmart, and (5) U.S. and
Chinese retail consumers?
Review Questions
1. What are the five major factors that influence foreign exchange rates?
2. What are the differences between a floating exchange rate policy and a fixed exchange rate
policy?
3. Describe the IMF’s roles, responsibilities, and challenges.
4. Describe the three primary types of foreign exchange transactions made by financial
companies.
5. Why is the strength of the U.S. dollar important to the rest of the world?
6. How would you describe the theory of purchasing power parity (PPP)?
7. What is the relationship between a country’s current account balance and its currency?
8. How is the phenomenon of capital flight an example of the bandwagon effect or herd
mentality?
9. Why did the gold standard evolve to the Bretton Woods system? Then, why did the Bretton
Woods system evolve to the present post-Bretton Woods system?
10. Name and describe three ways nonfinancial companies can cope with currency risks.
11. Which do you think is a better policy to adopt: a floating exchange rate or a fixed rate?
12. Devise your own example of a way a firm might engage in currency hedging.
13. What concepts must a savvy manager understand about currencies to do international
business successfully?
14. What skills might a manager need to devise strategies for managing currency risk?