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Instructor Manual
Chapter 7: Exchange Rates
(Prepared by Klaus E. Meyer, March 2019)
Introduction to the Topic
Learning Objectives
1. Understand the determinants of exchange rates
2. Track the evolution of the international monetary system
3. Identify firms’ strategic responses to deal with exchange movements
4. Participate in two leading debates on exchange movements
5. Draw implications for action
General Teaching Suggestions
Many students (at least in Europe) underestimate the volatility of exchange rates. They seem
to be very stable, and unless students have personal experiences of winning or losing money
through exchange rate moves, they may not appreciate the extent of exchange rate risk. My
suggestion thus is to start the class with the two Figures on page 187 – or a similar graph for
currencies relevant to your students (which can be generated on the FT website, for example).
From there, move the question of taking out a foreign currency mortgage (opening case) and
then into the substance of concepts and theories surrounding exchange rates.
If you like a historical introduction, you could start your class with the following
contributions in the BBC’s “History of the World in 100 Objects”. The first is about paper
currency introduced in China around 1000 AD. While it was initially highly successful,
inflation in 1400s eventually made the money valueless...
http://www.bbc.co.uk/ahistoryoftheworld/objects/F3oFoFDuTx-rzhCkCL9_BA. The first
global currency was the silver coins of ‘pieces of eight’, which were coined by the Spanish in
their Silvermines in modern day Bolivia and used around the world. In the US, for example,
they were legal tender until 1957
http://www.bbc.co.uk/ahistoryoftheworld/objects/JO391t6cRtGxstjbE4EEmg.
Opening Case Discussion Guide
The opening case links issues of exchange rate dynamics to a sphere of life that students may
be familiar with. While they are unlikely to have mortgages themselves, their parents often
would. The case shows that different East European countries – despite many similarities –
experienced the 2008 crisis very differently. To motivate the case, the instructor may ask,
‘would you take out a mortgage in euro (pounds) when the interest rates in euro (pounds) are
lower than in your own currency?’ This will lead students to recognize the importance of
exchange rate regime, and lead into the key issues of the chapter.
Chapter Outline, Section by Section
Section 1: Markets for Currencies
Key Ideas
This section introduces lot of concepts and theoretical explanations of exchange rates
movements that are very important to anyone engaging even in simple transactions abroad –
such as a tourist trip. Students who have taken an international economics or finance course
may be familiar with the concepts and theories. If this is not the case, instructors should go
through this material very carefully.
A foreign exchange rate is the price of one currency expressed in another. Basic determinants
of foreign exchange rates include (1) relative price differences and PPP, (2) interest rates, (3)
productivity and balance of payments, (4) exchange rate policies, and (5) investor
psychology.
Key Concepts
exchange rate
The price of one currency in another currency.
appreciation (of a currency)
An increase in the value of a currency
depreciation (of a currency)
A decrease in the value of a currency
currency exchange market
A market where individuals, firms, governments, and banks buy and sell foreign currencies.
purchasing power parity (PPP) hypothesis
Hypothesis suggesting that, in the long run, baskets of goods would cost the same in all currencies
(“law of one price”)
relative PPP hypothesis
Hypothesis suggesting that changes in exchange rates will be proportional to differences in inflation
rates
inflation
The (average) change of prices over time
interest rate parity
Hypothesis suggesting that the interest rate in two currencies should be the same after accounting for
spot and forward in exchange rates.
spot market rate
The exchange rate for immediate payment
forward transaction
A currency exchange transaction in which participants buy and sell currencies now for future delivery,
typically in 30, 90, or 180 days, after the date of the transaction.
forward exchange rate
The exchange rate for forward transactions
balance of payments (BoP)
A country’s international transaction statement, including merchandise trade, service trade, and capital
movement.
current account (of the BoP)
exports and imports of goods and services
financial account (of the BoP)
sales and purchases of financial assets
bandwagon effect
The result of investors moving as a herd in the same direction at the same time.
capital flight
A phenomenon in which a large number of individuals and companies exchange domestic currencies
for a foreign currency.
Section 2: Institutions of the International Monetary System
Key Ideas
Exchange rate regimes – or the institutions governing exchange rate markets – are essential to
understand the actual movements of exchange rates, and of the nature of exchange rate risks.
We take a historical perspectives (as found in textbooks in international monetary economics)
to move from simple arrangements such as the gold standard to more complex systems of the
present day. We end the section with a reference to common currency, which will be
discussed further in Chapter 8 based on the example of the euro.
Key Concepts
gold standard
A system in which the value of most major currencies was maintained by fixing their prices in terms of
gold, which served as the common denominator.
Bretton Woods system
A system in which all currencies were pegged at a fixed rate to the US dollar.
international Monetary Fund (IMF)
International organization that provides financial assistance to countries experiencing temporary imbalances in
their balance of payment, and helps securing macroeconomic stability.
World Bank
International organization that provides loans for specific projects in developing countries
post–Bretton Woods system
A system of flexible exchange rate regimes with no official common denominator.
floating (or flexible) exchange rate policy
The willingness of a government to let the demand and supply conditions determine exchange rates.
free float
A pure market solution to determine exchange rates.
managed float
The common practice of influencing exchange rates through selective government intervention.
pegged exchange rate
an exchange rate of a currency attached to that of another currency
crawling bands
A limited policy of keeping the exchange rate within a specified range, which may be changing over
time.
fixed exchange rate
an exchange rate of a currency relative to other currencies.
currency board
A monetary authority that issues notes and coins convertible into a key foreign currency at a fixed
exchange rate.
common currency
Currency shared by a number of countries
Section 3: Managing Exchange Risks
Key Ideas
This section takes a managerial perspective on exchange rate management. What can
companies do to handle exchange rates? We distinguish financial and strategic approaches: It
may not be necessary to engage in complex financial transactions to reduce exchange risk
exposure!
I especially recommend In Focus 7.2 which highlights the risk of naively trying to save
money by investing in foreign currency bonds. Even municipal administrations make these
mistakes, but I wish our students not to make these mistakes (at least not without
understanding the risks)!
Key Concepts
exchange rate risk (or currency risk)
The risk of financial losses because of unexpected changes in exchange rates
strategic hedging
organizing activities in such a way that currencies of revenues and expenditures match
currency risk diversification
reducing overall risk exposure by work with a number of different currencies
currency hedging
A transaction that protects traders and investors from exposure to the fluctuations of the spot rate.
forward discount
A condition under which the forward rate of one currency relative to another currency is higher than
the spot rate.
forward premium
A condition under which the forward rate of one currency relative to another currency is lower than the
spot rate.
currency swap
A currency exchange transaction between two firms in which one currency is converted into another in
Time 1, with an agreement to revert it back to the original currency at a specific Time 2 in the future.
offer rate
The price offered to sell a currency.
bid rate
The price offered to buy a currency.
spread
The difference between the offered price and the bid price.
Section 4: Debates and Extensions
Key Ideas
The first debate concerns the macro-economic discussion regarding the US$/Yuan exchange
rate that keeps re-emerging in various disguises.
The second debate focuses on corporate issues and ask why many big companies do not use
financial hedges that we earlier have introduced.
Key Concepts
counter party risk
the risk of a business partner not being able to fulfil a contract
Section 5: Implications for Practice
Key Ideas
The main message here is that exchange rate risks affect most businesses, and there for the
workings of exchange rates and the causes of risks thus emerging are important to understand
for any manager.
Key Concepts
No new concepts.
Review Questions
Review questions are provided to students on the website accompanying the book. They
directly ask to summarize the material provided in the text. Instructors may also use the
questions to structure their lectures or review sessions.
Review Questions
(as provided to students on the website)
Material in the Book
For use with Peng and Meyer, International Business 3e, 9781473758438, © Cengage Learning
EMEA 2019
1. Why did Polish, Hungarian, Latvian and Slovakian
homeowners with mortgages have very different
experiences during the currency turmoil in the
currency markets in 2008?
2. Explain the concepts of appreciation and
depreciation in the context of exchange rates!
3. How does purchasing power parity inform foreign
exchange rate movements?
4. How do interest rates influence movements in
exchange rates?
5. Why do interest rates and current exchange rates
together allow you to predict the forward rate?
6. How do different items in the balance of payment
affect the demand for a country’s currency?
7. How did the ‘Bretton Woods’ system of exchange
rates work after 1945?
8. Why did the ‘Bretton Woods’ system of exchange
rates brake down in the 1970s?
9. What is the function of the International Monetary
Fund (IMF) in the global system of exchange rates?
10. What are the differences between free float,
exchange rates?
11. How can companies organize their operations in
ways that minimize the exchange rate risk they
face?
12. How can firms financial market instruments to
minimize the exchange rate risk they face?
13. Is the large balance of payments deficit of the USA
a problem for the world economy?
14. Should companies always hedge their foreign
currency exposure?
Page 182-184
Page 184-185 – use Fig 7.1
as examples
Page 187-188
Page 188-189
Page 187-188
Page 188-190
Page 192-193
Page 193-194
Page 193
Page 193-194
Page 196-197
Page 198-200
Page 200-201
Page 200-201
Critical Discussion Questions
At the end the chapter, we provide discussion questions that aim to stimulate students
thinking beyond memorizing the material learned in the chapter. They are designed to be
used at a basis for in-class discussions, group work, or individual assignments. Below,
provide some indicative answers of issues that may be raised in response to these questions.
1. Identify the currencies of the top-three
trading partners of your country in the
last ten years. Find the exchange rates
of these currencies, relative to your
country’s currency, ten years ago and
now. Explain the changes. Then predict
the movement of these exchange rates
ten years from now.
from China, and (5) European retail
consumers?
3. As a finance manager in a European
company (accounting in euro), one of
you react?
4. The English Premier league earns £250
million annually arises from
As manager of a television company in
South East Asia, you want a share of
payment in British pound spread over
the three year period. How do you
manage the associated exchange rate
1. This is a question in which the answer is
not as important as the thought process
and the ability to clearly articulate.
However, it should be noted that there is
a risk in trying to predict the future
based on past trends in our rapidly
changing global environment. It is
much like driving down the road with
consideration which currencies are tied
to which other currencies. A related
question is the ability of the USA to
finance their budget deficit.
such exchange rate risks without
approval from top management. You
may want to give your students a more
diplomatic answer and suggest a two
4. This real-life situation challenges
students to assess the alternative ways to
risk can ve passed on to customers, for
example by denominating contracts with
advertisers (some of whom may be UK-
For use with Peng and Meyer, International Business 3e, 9781473758438, © Cengage Learning
strategies correctly is more important
than the conclusion offered.
Closing Case
The closing case provides further opportunities to apply ideas and concepts learned in this
chapter in a real world setting. The Closing Case for this Chapter is “Jobek do Brasil’s foreign
exchange challenges” and focuses on exchange risks faced by a small exporting company.
Below are some indicative responses to the case discussion questions.
Case Discussion Questions
(as provided in the book)
Indicative Responses
1. How do you evaluate Jobek’s
situation from the resource-
based and institution-based
views? Why have resources
and institutions hindered
Barney to cope with the
foreign exchange situation,
but simultaneously helped
him to turn his company
around?
2. How do you evaluate Jobek’s
strategic response to foreign
exchange risks?
3. What would you do if you
were Barny? Why?
1. First, students are encouraged to list
capabilities and challenges of resources-
based view and institution-based views and
explain how they influence company’s
financial strategy. It is important that
students correctly explain what financial
hedging can and cannot achieve.
2. For most exporting companies, it would be
cheaper to invoice in their own currency, or
at least keep both options open in their
negotiations.
3. For example, Barney may source
components from the countries in which
they are selling.
1. Based in the United States, your firm trades extensively in European countries that
have adopted the euro. You have been asked to evaluate the impact of currency
fluctuations on sales in this region over the past month. The first step in this process is
between the U.S. dollar and the euro. Once this has been accomplished, what general
trends do you notice? How could these trends impact your firm’s sales in countries
that use the euro?
One resource which can be used is “OANDA.com: The Currency Site”. This website
can be found by entering the search term “exchange rate table” at the globalEDGE™
Resource Desk search box located at http://globaledge.msu.edu/resourceDesk/. Once
at the OANDA website, click on FXHistory (located on the left side of the screen).
After accessing the exchange rate data between the United States Dollar (USD) and
the Euro, analysis can take place. Generally, as the USD reduces in value versus the
Euro, goods and services from the United States are less expensive. As a result, this
can encourage more sales in countries using the Euro. Likewise, as the USD increases
in value versus the Euro, goods and services from the United States become more
expensive – thus discouraging sales in countries using the Euro.
Search Term: “exchange rate table”
Resource Name: OANDA.com: The Currency Site
Website: http://www.oanda.com/
globalEDGE™ Tags: Reference, Standards and Conversions, Currency
2. Your company is examining possible market opportunities in the Asia Pacific region.
As a part of this possible strategic shift, the benchmark currencies of the region must be
identified to diversify currency risk for future operations. Using a resource that examines
foreign exchange, determine which predominant currencies are likely candidates for your
analysis.
One resource which can be used is “Bloomberg Online: Foreign Exchange”. This
website can be found by entering the search term “foreign exchange” at the
globalEDGE™ Resource Desk search box located at
http://globaledge.msu.edu/resourceDesk/. Once at the Bloomberg website, click on
Currencies and Benchmark Currency Rates (located on the left side of the screen).
After comparing the currencies listed, students may determine that the three most
likely currencies which could be used for regional currency diversification are: the
Hong Kong Dollar, the Australian Dollar, and/or the Japanese Yen.
Search Term: “foreign exchange”
Resource Name: Bloomberg Online: Foreign Exchange
Website: http://www.bloomberg.com/markets/currencies/fxc.html
globalEDGE™ Tags: Money, Finance
Further Readings
At the end the chapter, suggested further readings are provided. The primary aim is to
provide students a starting point for further work, for example when preparing a class
assignment or dissertation. These references also are recommended for instructors not
familiar with the topic and wishing to ‘get ahead of the students’ before lecturing on a topic.
S. Y. Cross, 1998, The Foreign Exchange Market in the United States, New York: Federal Reserve Bank of
New York – a clear exposition of the institutions and practice in currency markets.
J. Fox. 2009. The Myth of the Rational Market: The History of Risk, Reward, and Delusion on Wall Street,
New York: Harper – Explains how financial markets really work, how their interpretation has evolved
over the past 100 year, and what theory does or does not explain.
C. Henderson, 2006, Currency Strategy, 2nd ed., New York: Wiley – a comprehensive though somewhat
theoretical treatment of different aspects of currency exchange markets.
M. Taylor, 1995, The economics of exchange rates, JEL 33, 13-47 – a comprehensive review of the
economics underlying the formation of exchange rates. J. Williamson, 1998, Crawling Bands or
Monitoring Bands: How to Manage Exchange Rates in a World of Capital Mobility, Washington, DC,
Institute of International Economics (www.iie.com/publications/papers/paper.cfm?ResearchID=319) – a
review of the alternative ways for countries to manage their currencies.
