Exchange Rates and the

International Monetary System

WN–BMGC–L6

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Contents
 Factors that influence a currency’s exchange
rate
 Types of foreign exchange risk
 Ways to manage foreign exchange risks
 International monetary system & its three stages
 International Monetary Fund (IMF) and its role
 Recent financial crisis and IMF performance
 Cryptocurrencies
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Foreign Exchange Market and Foreign
Exchange Rate
 Foreign exchange market
 A market for converting the currency of
one country into that of another country.
 Foreign exchange rate
 A rate (price) at which one currency is
converted into another.
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Factors that Influence a Currency’s
Exchange Rate
 Exchange rates are determined by
demand and supply. But demand and
supply of a currency are influenced by
the following factors:
1. Relative price differences
 In real life, we have differences in the
prices of an identical basket of goods
across countries. 4
Factors that Influence a Currency’s
Exchange Rate
 Some countries are expensive, and
others are less costly.
 E.g. the prices of a Big Mac burger in
McDonald’s restaurants differ in different
countries (the Big Mac Index).
 Hence, relative price differences help to
determine the relative value of different
currencies.
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Factors that Influence a Currency’s
Exchange Rate
2. Inflation and money supply
 When UK has a higher inflation than
abroad, UK exports will become less
competitive and reduce. The demand
for pound will fall.
 When UK has a lower inflation than
abroad, UK exports will become more
competitive and increase. The demand
for pound will rise. 6
Factors that Influence a Currency’s
Exchange Rate
 Inflation is also closely associated with
a country’s money supply. High
inflation can also be caused by an
increase of a country’s money supply.
 During budgetary shortfalls, a
government may choose to print more
currency to increase the money supply,
which tends to increase inflation. This
in turn would cause its currency to
depreciate. 7
Factors that Influence a Currency’s
Exchange Rate
3. Changes in interest rates
 A rise in interest rates in UK encourages
other countries to invest in UK. The demand
for pounds rises, increasing the value of the
pound.
 When interest rates in UK fall, investors
move away from UK. The demand for
pounds falls, reducing the value of the
pound. 8
Factors that Influence a Currency’s
Exchange Rate
4. Productivity and balance of payments
 An increase in a country’s productivity,
relative to other countries, improves
its exports, which in turn increases the
demand for and value of its currency.
 Changes in productivity will change a
country’s balance of trade. High
productivity generates trade surplus,
whereas low productivity results in
trade deficit. 9
Factors that Influence a Currency’s
Exchange Rate

A country with total balance of payment

surplus will see its currency appreciate
relative to other currencies, e.g.
Singapore.
 A country with total balance of payment
deficit will see its currency depreciate
relative to other currencies, e.g. UK.
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Factors that Influence a Currency’s
Exchange Rate
5. Investor psychology
a. Speculation
 Influence short-term movement of exchange rate.
 If buyers of currency feel that the value of the
pound is going to go down in the future, they will
not buy pounds now. So the value of the pound
will fall.
 On the other hand, if they believe that the value
of the pound is going to rise, they will buy pounds
now and try to make a profit out of a rising pound.
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Factors that Influence a Currency’s
Exchange Rate
 These speculators are people, companies, and
banks, whose aim is to make money by simply
buying and selling currencies.
b. Bandwagon effect
 In extreme cases, can result in bandwagon effect,
i.e. investors moving as a herd in the same
direction at the same time.

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Factors that Influence a Currency’s
Exchange Rate
6. Buying and selling of currency by central
banks
 E.g. Bank of England wants to see the
value of the pound go up, it will buy
pounds. If it wants to see the pound fall,
it will sell pounds.

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Types of Foreign Exchange Risks
 Foreign exchange risks (exposures)
 International managers are bound to
expose to exchange rate movements,
hence facing exchange rate risk (i.e. the
risk of financial losses of unexpected
changes in exchange rates).

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Types of Foreign Exchange Risks
 Types of foreign exchange risks
1. Translation exposure
 Also known as accounting exposure.
 It arises from the need, for purposes of reporting
and consolidation, to convert the results of foreign
operations from the local currency to the home
currency.
 Paper exchange gains or losses.
 Retrospective.
 Short-term in nature.

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Types of Foreign Exchange Risks
 Example - converting profit from US subsidiary to
Japanese HQ for reporting and consolidation
purposes. (a reduction of profit in Yen from Year 1 to
Year 2, but not the case in US currency)
Year 1 Year 2

 Profit made (US$) US$100 million US$100 million

 Dollar/Yen exchange US$1:Yen110 US$1:Yen 100

 Profit of US subsidiary Yen 11 billion Yen 10 billion

in Yen (100x110) (100x100) 16
Types of Foreign Exchange Risks
2. Transaction exposure
It arises from the possibility of incurring exchange gains
or losses on business transactions already entered into
between two countries of different currencies.
Can apply to both costs (payment to suppliers) and
revenues (payment collected from customers).
Real exchange gains or losses.
Retrospective and prospective.
Short-term in nature (can be just one time transaction).

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Types of Foreign Exchange Risks
 Example - a UK company sells goods to a US
customer. Selling price is US$120,000. When
the price is determined, the exchange rate is 1
pound to US$1.20.
 But the UK company allows a 30 days A/R. In
the course of the 30 days, the US dollar has
fallen in value against the pound. Now the
exchange rate is 1 pound to US$1.25. Hence,
after 30 days by the time the UK company
collects the US$120,000, the money value is
only 96,000 pounds (1x120,000/1.25), instead of
the original 100,000 pounds (1x120,000/1.20).
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Types of Foreign Exchange Risks
3. Economic exposure
Also known as operating exposure.
It arises because unexpected currency fluctuations
alter the amounts and riskiness of a company’s future
costs and revenues.
The impact can be substantial due to
unanticipation.
Real exchange gains or losses.
Prospective.
Long-term in nature.

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Types of Foreign Exchange Risks
 Example - a large U.S. company has 50% of
its annual revenues from two export markets
of Japan and Europe.
 In planning, management had expected the
US$ to decline by 3% against Yen and Euro.
 But in reality, the US$ had gained 5% versus
these two currencies, i.e. a variance of 8%
point.
 This has a negative impact on the company’s
sales and profits.
 Investors reacted by dumping the stock.
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Types of Foreign Exchange Risks
 Illustration
 Japanese Yen
 Sales: 10,000,000 Yen US$
Last year actual 100 to US$1 100,000
This year budgeted 97 to US$1 103,093
This year actual 105 to US$1 95,238

 Euros
 Sales 87,000 Euros
Last year actual 0.87 to US$1 100,000
This year budgeted 0.84 to US$1 103,571
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This year actual 0.92 to US$1 94,565
Ways to Manage Foreign Exchange Risks

Ways to manage the translation

exposure
companies break down ‘translation
exposure’ to record in the financial
statements as an exchange rate gain
(or loss) with full disclosure of the
exchange rate movements.
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Ways to Manage Foreign Exchange Risks
 Ways to manage the foreign exchange risks in
transaction and economic exposures.
1.Strategic responses
 Use strategies to manage foreign exchange risks.
a. Invoicing in own currency
 The most basic way is to invoice customers in own
currency, and only accept payment in own currency.
Need good negotiation.
A powerful way to protect exchange risk.
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Ways to Manage Foreign Exchange Risks
b. Strategic hedging
 Organize activities in such a way that
currencies of revenues and expenditures
match.
 E.g. a British firm receiving an export
order from France will in turn order some
components in France, so that it can use the
euro received from its export order to pay
for its own imports.
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Ways to Manage Foreign Exchange Risks
c. Risk diversification
 Reduce overall risk exposure by working with a
number of different currencies, such that it
reduces exposure to unfavourable exchange
movements from any one currency.
 E.g. a European firm selling to a number of
countries (and invoicing in respective foreign
currency) would make losses from one country,
but gains from another.

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Ways to Manage Foreign Exchange Risks
2. Financial management responses
 Use financial markets to manage foreign exchange risks.
a. Spot transactions
 The classic single-shot exchange of one currency for
another.
 E.g. a Russian firm expects an invoice in euro in a
year’s time can buy euros on the spot market, and then
invest them in say German government bonds until the
invoice arrives, then cash the bonds to receive euros to
make payment.
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Ways to Manage Foreign Exchange Risks

b. Forward transactions
 Use forward markets, by buying or selling
currencies now for future delivery,
typically in 30, 90 or 180 days, after the
date of the transaction, known as currency
hedging (a transaction that protects
investors from exposure to the fluctuations
of the spot rate).

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Ways to Manage Foreign Exchange Risks
 A forward discount
e.g. spot rate US$1.15= 1 pound; forward rate (say 6
months) US$1.10= 1 pound.
 Forward rate for 1 pound is lower than the spot rate for
1 pound (against US$), i.e. Pound is trading at a
forward discount against US$.
 A forward premium
e.g. spot rate US$1.15= 1 pound; forward rate (say 6
months) US$1.20= 1 pound.
 Forward rate for 1 pound is higher than the spot rate for
1 pound (against US$), i.e. Pound is trading at a
forward premium against US$. 28
Ways to Manage Foreign Exchange Risks
c. Currency swaps
A currency swap is a currency exchange
between two firms in which one currency is
converted into another at Time 1, with an
agreement to revert it back to the original
currency at a specific Time 2 in the future.

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Ways to Manage Foreign Exchange Risks
 E.g.Deutsche Bank has an excess balance of
pounds but needs US dollars. At the same time,
Union Bank of Switzerland (UBS) has an excess
balance of US dollars but needs pounds. The two
banks negotiate a swap agreement.
 Thisswap agreement involves that Deutsche Bank
agrees to exchange with UBS pounds for US dollars
today, and then revert US dollars for pounds at a
specified time in the future (say in one year’s
time).
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Ways to Manage Foreign Exchange Risks
3. Administrative responses
Use administrative measures to manage foreign
exchange risks.
a. Lead/lag payables and receivables
Pay suppliers or collect payments early or late
depending on anticipated exchange rate movements.
b. Monthly foreign exchange exposure reports
Produce exchange exposure reports on monthly basis as
basis for hedging strategies.
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Ways to Manage Foreign Exchange Risks

c. Reporting systems to HQ
Set up good reporting systems to the central finance
function at HQ so that the entire company’s exposure
position can be regularly monitored.

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International Monetary System
 International monetary system is a system
by which countries value and exchange their
currencies.
 History: three stages over the last 200 years
1. The gold standard (1821-1914)
 Ancient reliance on gold coins as an
international medium of exchange led to
the adoption of an international monetary
system known as the gold standard.
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International Monetary System
 In1821, UK was the first country to
adopt the gold standard.
 During 19th century, many other
countries did the same.
Countries agreed to buy or sell their
currencies under a fixed exchange
rate system for gold and allowed the
free movement of gold.
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International Monetary System
 E.g. UK agreed to buy or sell an ounce of gold for
4.247 pounds sterling.
 E.g. US agreed to buy or sell an ounce of gold for
US$20.67.
 This implied a fixed exchange rate between the
pound and the dollar at 1 pound = US$4.867
(20.67/4.247)
 The gold standard period represented a global
financial order.

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International Monetary System
 But this system collapsed with the First World
War, when governments printed large amounts
of currency to purchase military supplies, and
restricted movements in the gold market, thus
undermining the gold standard.
 After WWI, efforts to re-adopt the gold
standard were not successful.

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International Monetary System
 Due to the worldwide Great Depression,
countries devalued their currencies to stimulate
exports and raised tariffs to protect domestic
jobs.
 International trade contracted, leading to high
unemployment.
 Countries continued to allow their currencies to
float, and then the Second World War started in
1939.

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International Monetary System
2. The Bretton Woods system (1944-1973)
 At the end of World War II, 44 countries joined a
conference in 1944 in Bretton Woods, New
Hampshire, USA, and agreed a new system known as
‘the Bretton Woods system’, in which all currencies
were pegged at a fixed exchange rate to the US
dollar.
 The dollar was given an important role in the global
economy. It was appropriate at that time, because
the US economy contributed 70% of the world’s GDP
in the late 1940s, and it had a large US trade
surplus against the rest of the world. 38
International Monetary System
 The Bretton Woods system was built on two
conditions:
a. US inflation rate had to be low, and
b. US could not run a substantial trade deficit.
 In the late 1960s and early 1970s, both the
above two conditions were violated. Hence,
the Bretton Woods system broke down during
the oil crises in 1973 when the US dollar came
under pressure, and US lost credibility as a
sound currency country.

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International Monetary System
3. The post-Bretton Woods system (1974-present)
Since 1974, we live in the post-Bretton Wood
system, in which both types of fixed and flexible
exchange rate systems are used.
Countries choose between FOUR major exchange
rate policies:
a. Floating exchange rate policy
A country allows demand and supply to determine
exchange rate, e.g. US dollar.

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International Monetary System
b. Pegged exchange rate policy (‘soft’ peg)
A country attaches its exchange rate to that of another
country’s currency, to limit fluctuations within a
narrow band relative to the other currency.
 e.g. in Denmark, Danish krone is pegged to the euro.
 The ‘pegged’ policy seeks to stabilize import and
export prices.
 Many developing countries with high inflation see
advantages in pegging their currencies with US dollars
or euro, which traditionally have low inflation.
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International Monetary System
c. Fixed exchange rate policy (‘hard’ peg)
A country uses a currency board to fix the exchange rate.
 Currency board is a monetary authority that issues notes
and coins convertible into a key foreign currency at a
fixed exchange rate, usually fixed by law.
 E.g. Hong Kong’s currency board (Hong Kong Monetary
Authority) has ensured that every 7.8 HK dollars is backed
by 1 US dollar.
 Hong Kong has been successful with this fixed exchange
rate policy during a number of financial crises, backing
the domestic currency with 100% of equivalent foreign
currencies. 42
International Monetary System

d. Common currency policy

A country gives up its monetary policy and
relies on another country or common central
bank to manage exchange rate.
 E.g.euro is a common currency shared by 19
countries of the 27 member countries of the
EU and controlled by the European Central
Bank in Frankfurt.

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International Monetary Fund (IMF)
 Founded in 1944
 Major role of IMF
1. Surveillance
- Monitor economic and financial developments and provide
policy advice to member countries.
2. Lending
- Provide financial resources under specified conditions to
assist a developing country experiencing financial
difficulties.
3. Technical assistance
- Help on designing or improving the quality and effectiveness
of a country’s policy-making.
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Recent Financial Crisis and IMF Performance
Global financial crisis 2007-2008
 Background:
 Very different from the previous financial crisis
that was started by a developing country. The
global financial crisis was started by a developed
country – USA.

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Recent Financial Crisis and IMF Performance

 Itis the worst financial crisis since the Great

Depression of the 1930s.
 The immediate crisis was the bursting of US
housing bubble.
 Lax lending standards in ‘subprime’ mortgages
lead to easy availability of credit in US. Together
with housing construction boom, housing prices in
US greatly increased.

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Recent Financial Crisis and IMF Performance

 Many financial institutions made loans without

verification of the borrower’s income or assets, and to
borrowers with poor credit histories.
 As housing bubble bursted, housing prices declined,
which resulted in homes worth less than the mortgage
loan.
 Financial institutions that had invested heavily in
subprime mortgages encountered significant losses.
 E.g. Bankruptcy of Lehman Brothers, and rescue of AIG
by US government.
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Recent Financial Crisis and IMF Performance
 The US stock market peaked the Dow Jones Industrial
Average Index at 14,000 points in Oct 2007.
 But over a period of 17 months, it fell more than 50%
to 6,600 points in Mar 2009 (compared to a 55% drop
in the Great Depression over a similar period).
 The crisis in US affected Europe, resulting in a
number of European bank failures, and large declines
in various stock indexes.
 The crisis continued and spread into a global
economic shock. The crisis spillovered to the
emerging and less-developed countries.
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Recent Financial Crisis and IMF Performance

 IMF’s performance:
1. Initially IMF had limited role in dealing with the crisis
 IMF’s role has always been to help developing
countries. (note: US and European countries are the
main contributors to IMF resources, and the purpose
is to help developing economies. Hence, it is
unlikely that these developed countries would seek
IMF assistance for loans.)

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Recent Financial Crisis and IMF Performance

2. Since late 2008, a successful role.

 In late 2008, collapse of the financial system in US and
Europe led to an economic contraction outside of developed
countries. World trade fell and capital flows slowed. The world
economy was starting to show recession as a result of the global
financial crisis.
 As this now affected the developing countries, IMF stepped in
and played two important roles.
a. Immediate crisis management
Provided loans and lending facility (total US$1.7 trillion) to a
number of countries, e.g. Ukraine, Hungary, Iceland, Pakistan, S.
Korea, Brazil, Mexico, Colombia, Poland, etc.
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Recent Financial Crisis and IMF Performance

b. Increased surveillance of the global economy

 Expand its ability to conduct effective multilateral
surveillance through better coordination with the
international financial regulatory agencies such as the
Bank for International Settlements (BIS), the Basel
Committee on Banking Supervision, etc.

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Cryptocurrencies
A. What is cryptocurrency?
 Crypto means ‘hidden’ or ‘secret’.
 A cryptocurrency is a digital asset that can be used to
buy goods and services, but uses an online ledger with
strong cryptography to secure online transactions.

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Cryptocurrencies
 Difference between cryptocurrency and digital currency:
 Digital currency = the electronic form of fiat money
(money that the government guarantees as legal
tender), e.g. we electronically transfer an amount from
our bank account to someone else account.
 Cryptocurrency = a store of value secured by encryption,
often referred to as digital coins, e.g. Bitcoin, Dogecoin,
etc. All these crypto coins are privately owned or
created. To trade cryptocurrency, we need to first have
a bank account and digital currency in it. We’ll have to
exchange digital currency via an online exchange to get
cryptocurrency for the corresponding value.
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Cryptocurrencies
B. Background of cryptocurrencies
 The oldest and most popular cryptocurrency is Bitcoin,
which was released after the global financial crisis as a
decentralized payment instrument.
 The intention was to restore the credibility of the
payment system by removing intermediaries such as
banks and central banks and relying only on end users’
network.

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Cryptocurrencies

C. Pros of cryptocurrencies
1. Easier to transfer funds directly between two parties,
without the need for a third party like a bank or credit
card company.
2. Fund transfers are completed with minimal processing
fees, allowing users to avoid the higher fees charged by
banks and financial institutions for wire transfers.

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Cryptocurrencies
D. Limitations of cryptocurrencies
1. Lack the backing of value of cryptocurrencies by credible
issuing banks or central banks. The value of cryptocurrencies
is driven by market sentiment.
2. High volatility of the value of cryptocurrencies. E.g. Market
cap of all cryptocurrenices:
2009 US$17 billion
2017 US$579 billion
2018 (Feb) US$394 billion (due to crackdown of
cryptocurrencies by China and South Korea)
2021 (Aug) US$1.8 trillion
2022 (Oct) US$932 billion 56
Cryptocurrencies

3. Lack an effective mean of exchange. As of now, still very

few countries adopt cryptocurrencies as country-wide legal
tender.
Exception – El Salvador (Sept 7, 2021) was the world-first
country to adopt bitcoin as legal tender.
4. The anonymity of cryptocurrency transactions make them
potential for illegal activities, such as money laundering and
tax evasion.

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Cryptocurrencies
E. Will the time of cryptocurrencies come?
 According to Willcocks
As of 2022, cryptocurrencies have still not met the two
basic requisites of a currency.
 Cryptocurrencies are
(a) not an effective mean of exchange in most countries
as legal tender,
(b) nor are they backed by a centralised authority.

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Chapter 6 - Reading
 Lecture notes – L6
 Subject guide – chapter 6
 Willcocks
(2021), Global business:
management – chapter 6
 Peng& Meyer – chapter 7 & chapter 9
p.252-254
 Internet – Global financial crisis (Wikipedia)
 Internet – Cryptocurrency (Investopedia)
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