CHAPTER SUMMARY

This chapter explained how the foreign exchange market works, examined the forces that determine
exchange rates, and then discussed the implications of these factors for international business. Given
that changes in exchange rates can dramatically alter the profitability of foreign trade and investment
deals, this is an area of major interest to international business. The chapter made the following
points:
1. One function of the foreign exchange market is to convert the currency of one country into the
currency of another. A second function of the foreign exchange market is to provide insurance against
foreign exchange risk.
2. The spot exchange rate is the exchange rate at which a dealer converts one currency into another
currency on a particular day.
3. Foreign exchange risk can be reduced by using forward exchange rates. A forward exchange rate is
an exchange rate governing future transactions. Foreign exchange risk can also be reduced by
engaging in currency swaps. A swap is the simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
4. The law of one price holds that in competitive markets that are free of transportation costs and
barriers to trade, identical products sold in different countries must sell for the same price when their
price is expressed in the same currency.
5. Purchasing power parity (PPP) theory states the price of a basket of particular goods should be
roughly equivalent in each country. PPP theory predicts that the exchange rate will change if relative
prices change.
6. The rate of change in countries relative prices depends on their relative inflation rates. A countrys
inflation rate seems to be a function of the growth in its money supply.
7. The PPP theory of exchange rate changes yields relatively accurate predictions of long-term trends
in exchange rates, but not of short-term movements. The failure of PPP theory to predict exchange
rate changes more accurately may be due to transportation costs, barriers to trade and investment, and
the impact of psychological factors such as bandwagon effects on market movements and short-run
exchange rates.
8. Interest rates reflect expectations about inflation. In countries where inflation is expected to be
high, interest rates also will be high.
9. The International Fisher Effect states that for any two countries, the spot exchange rate should
change in an equal amount but in the opposite direction to the difference in nominal interest rates.
10. The most common approach to exchange rate forecasting is fundamental analysis. This relies on
variables such as money supply growth, inflation rates, nominal interest rates, and balance
ofpayments positions to predict future changes in exchange rates.
11. In many countries, the ability of residents and nonresidents to convert local currency into a foreign
currency is restricted by government policy. A government restricts the convertibility of its currency
to protect the countrys foreign exchange reserves and to halt any capital flight.

12. Problematic for international business is a policy of nonconvertibility, which prohibits residents
and nonresidents from exchanging local currency for foreign currency. Nonconvertibility makes it
very difficult to engage in international trade and investment in the country. One way of coping with
the nonconvertibility problem is to engage in countertradeto trade goods and services for other
goods and services.
13. The three types of exposure to foreign exchange risk are transaction exposure, translation
exposure, and economic exposure.
14. Tactics that insure against transaction and translation exposure include buying forward, using
currency swaps, leading and lagging payables and receivables, manipulating transfer prices, using
local debt financing, accelerating dividend payments, and adjusting capital budgeting to reflect
foreign exchange exposure.
15. Reducing a firms economic exposure requires strategic choices about how the firms productive
assets are distributed around the globe.
16. To manage foreign exchange exposure effectively, the firm must exercise centralized oversight
over its foreign exchange hedging activities, recognize the difference between transaction exposure
and economic exposure, forecast future exchange rate movements, establish good reporting systems
within the firm to monitor exposure positions, and produce regular foreign exchange exposure reports
that can be used as a basis for action.

CHAPTER SUMMARY
This chapter explained the workings of the international monetary system and pointed out its
implications for international business. The chapter made the following points:
1. The gold standard is a monetary standard that pegs currencies to gold and guarantees convertibility
to gold. It was thought that the gold standard contained an automatic mechanism that contributed to
the simultaneous achievement of a balance-of-payments equilibrium by all countries. The gold
standard broke down during the 1930s as countries engaged in competitive devaluations.
2. The Bretton Woods system of fixed exchange rates was established in 1944. The U.S. dollar was
the central currency of this system; the value of every other currency was pegged to its value.
Significant exchange rate devaluations were allowed only with the permission of the IMF. The role of
the IMF was to maintain order in the international monetary system (a) to avoid a repetition of the
competitive devaluations of the 1930s and (b) to control price inflation by imposing monetary
discipline on countries.
3. The fixed exchange rate system collapsed in 1973, primarily due to speculative pressure on the
dollar following a rise in U.S. inflation and a growing U.S. balance-of-trade deficit.
4. Since 1973 the world has operated with a floating exchange rate regime, and exchange rates have
become more volatile and far less predictable. Volatile exchange rate movements have helped reopen
the debate over the merits of fixed and floating systems.

5. The case for a floating exchange rate regime claims (a) such a system gives countries autonomy
regarding their monetary policy and (b) floating exchange rates facilitate smooth adjustment of trade
imbalances.
6. The case for a fixed exchange rate regime claims that (a) the need to maintain a fixed exchange rate
imposes monetary discipline on a country, (b) floating exchange rate regimes are vulnerable to
speculative pressure, (c) the uncertainty that accompanies floating exchange rates dampens the growth
of international trade and investment, and (d) far from correcting trade imbalances, depreciating a
currency on the foreign exchange market tends to cause price inflation.
7. In todays international monetary system, some countries have adopted floating exchange rates,
some have pegged their currency to another currency such as the U.S. dollar, and some have pegged
their currency to a basket of other currencies, allowing their currency to fluctuate within a zone
around the basket.
8. In the postBretton Woods era, the IMF has continued to play an important role in helping
countries navigate their way through financial crises by lending significant capital to embattled
governments and by requiring them to adopt certain macroeconomic policies.
9. An important debate is occurring over the appropriateness of IMF-mandated macroeconomic
policies. Critics charge that the IMF often imposes inappropriate conditions on developing nations
that are the recipients of its loans.
10. The present managed-float system of exchange rate determination has increased the importance of
currency management in international businesses.
11. The volatility of exchange rates under the present managed-float system creates both opportunities
and threats. One way of responding to this volatility is for companies to build strategic flexibility and
limit their economic exposure by dispersing production to different locations around the globe by
contracting out manufacturing (in the case of low-value-added manufacturing) and other means.

CHAPTER SUMMARY
This chapter explained the functions and form of the global capital market and defined the
implications of these for international business practice. This chapter made the following points:
1. The function of a capital market is to bring those who want to invest money together with those
who want to borrow money.
2. Relative to a domestic capital market, the global capital market has a greater supply of funds
available for borrowing, and this makes for a lower cost of capital for borrowers.
3. Relative to a domestic capital market, the global capital market allows investors to diversify
portfolios of holdings internationally, thereby reducing risk.
4. The growth of the global capital market during recent decades can be attributed to advances in
information technology, the widespread deregulation of financial services, and the relaxation of
regulations governing cross-border capital flows.

5. A eurocurrency is any currency banked outside its country of origin. The lack of government
regulations makes the eurocurrency market attractive to both depositors and borrowers. Due to the
absence of regulation, the spread between the eurocurrency deposit and lending rates is less than the
spread between the domestic deposit and lending rates. This gives eurobanks a competitive advantage.
6. The global bond market has two classifications: the foreign bond market and the eurobond market.
Foreign bonds are sold outside of the borrowers country and are denominated in the currency of the
country in which they are issued. A eurobond issue is normally underwritten by an international
syndicate of banks and placed in countries other than the one in whose currency the bond is
denominated. Eurobonds account for the lions share of international bond issues.
7. The eurobond market is an attractive way for companies to raise funds due to the absence of
regulatory interference, less stringent disclosure requirements, and eurobonds favorable tax status.
8. Foreign investors are investing in other countries equity markets to reduce risk by diversifying
their stock holdings among nations.
9. Many companies are now listing their stock in the equity markets of other nations, primarily as a
prelude to issuing stock in those markets to raise additional capital. Other reasons for listing stock in
another countrys exchange are to facilitate future stock swaps; to enable the company to use its stock
and stock options for compensating local management and employees; to satisfy local ownership
desires; and to increase the companys visibility among its local employees, customers, suppliers, and
bankers.
10. When borrowing funds from the global capital market, companies must weigh the benefits of a
lower interest rate against the risks of greater real costs of capital due to adverse exchange rate
movements.
11. One major implication of the global capital market for international business is that companies can
often borrow funds at a lower cost of capital in the international capital market than they can in the
domestic capital market.
12. The global capital market provides greater opportunities for businesses and individuals to build a
truly diversified portfolio of international investments in financial assets, which lowers risk.