978-1473758438 Chapter 7

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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

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-

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