Currency, Economics and Financial Markets Trevor Hunter King’s University College

Currency, Economics and Financial Markets

Trevor HunterKing’s University College

King's University College 2

Foreign Exchange

• Foreign Exchange Market:– The market for converting the currency of one

country into that of another

• Exchange Rate:– The rate at which one currency is exchanged into

that of another country


Foreign Exchange

• Functions of the Foreign Exchange Market:– Convert currency of one country into another– Provide insurance against foreign exchange risk

• Foreign Exchange Risk:– Adverse consequences of unpredictable changes

in exchange rates.


Foreign Exchange

• What would happen if your business buys its raw materials in US dollars but earns sales in Canadian dollars and the Canadian dollar drops against the US?

• How can you guard against this?


Foreign Exchange

• Main uses of foreign exchange markets for international businesses:– Convert export payments, foreign investment

income or licensing income from host to home currency

– Payment of to suppliers of products or services to host country companies


Foreign Exchange

• Main uses of foreign exchange markets for international businesses:– Short term investments of spare cash in host

countries– Currency speculation (arbitrage) – short-term

movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates


Foreign Exchange

• Insurance against exchange risk:– Spot Exchange Rate: the rate at which a foreign

exchange dealer converts one currency into another

– Forward Exchange Rate: occurs when two parties agree to exchange currency and execute a deal at a future time

– Forward Exchange: rates for currency are typically quoted for 30, 90 or 180 days in the future


Economic Theories of Exchange Rate Determination

• Economic perspective:– Basically determined by supply and demand for

different currencies• The Law of One Price:– In a competitive market free of non-production

related costs or trade barriers, identical products sold in different countries must sell for the same price when expressed in the same currency


Prices and Exchange Rates• Purchasing Power Parity (PPP):– Used to examine what exchange rates “should” be– Given relatively efficient markets (markets with

few impediments to international trade and investment) the price of a “basket of goods” should be roughly equivalent in each country

– If a basket of goods costs $200 in the US and Y20 000 in Japan, the exchange rate should be $US 1 = Y100


Prices and Exchange Rates

• The Economist’s Big Mac Index:– Examines the cost of Big Macs in about 120

countries to examine what the exchange rate between those countries’ currencies and the US dollar “should” be.

– For numerous reasons, currencies can be over or under valued. The difference between the PPP and the actual exchange rates suggests by how much a currency is valued incorrectly.


The Big Mac Index Example

• Price in US: $4.80*

• Equivalent Price in China: Yuan 16.90• Implied PPP exchange rate: $US1 = Yuan 3.52• Actual exchange rate: $US1 = Yuan 6.20• Yuan is undervalued by 43.1% and should

appreciate against the dollar in the future*Source: July 2014 http://www.economist.com/content/big-mac-index,


Prices and Exchange Rates

• If prices increase in one country but not in the other, the currency in the country where prices increase devalues by the same amount as the price increase, against the first country.

• PPP is a powerful tool for predicting exchange rate fluctuations for businesses if they study the market in which they are operating well.


Convertibility and Government Policy

• Governments often restrict the convertibility of their currencies.– Government policies– Inflation control– Economic stabilization– Restrict external FDI– Restrict MNE profit repatriation



• Freely Convertible Currency:– Government allows residents and non-residents to

purchase unlimited amounts of foreign currency with its domestic currency

• Externally Convertible Currency:– Government allows non-residents to convert their

domestic currency into foreign currency, but residents can’t

• Non-convertible Currency:– Both residents and non-residents are prohibited from

converting their domestic currency into foreign currency



• Capital Flight:– Residents convert domestic currency into foreign

currency– Most likely to happen during periods of

hyperinflation or shaky economic prospects– Governments want to stop the loss of foreign

reserves to maintain or boost the domestic currency



• What happens if your business cannot convert the money it makes in a foreign country into your home country’s currency or transfer it out of the country? (profit repatriation)

• Countertrade:– Trade of goods and services for other goods and services

• Transfer pricing:– Charges to subsidiaries for services or products supplied

by the parent MNE or other subsidiaries


Foreign Exchange

• Dealing in multiple currencies is a requirement of doing business internationally, but it also creates risks and significantly alters the attractiveness of different investment locations (i.e. FDI) over time

• Firms can use foreign exchange markets to minimize the risks, but can also prevent them from benefiting from favourable changes


The Role of the IMF

• Frequent national and international financial crises have required the IMF to step in to save struggling economies burdened with debt.

• 188 members (April 2012 – South Sudan joins), 117 of which had some kind of surveillance program:– “To maintain stability and prevent crises in the

international monetary system, the IMF reviews country policies, as well as national, regional, and global economic and financial developments through a formal system known as surveillance” http://www.imf.org/external/np/exr/facts/glance.htm


The Role of the IMFA member country's quota subscription determines the maximum amount of financial resources the country is obliged to provide to the IMF. A country must pay its subscription in full upon joining the IMF: up to 25 percent must be paid in the IMF's own currency, called Special Drawing Rights (SDRs) or widely accepted currencies (such as the dollar, the euro, the yen, or pound sterling), while the rest is paid in the member's own currency.Voting powerThe quota largely determines a member's voting power in IMF decisions. Each IMF member's votes are comprised of basic votes plus one additional vote for each SDR 100,000 of quota. The number of basic votes attributed to each member is calculated as 5.502 percent of total votes. Accordingly, the United States has 421,965 votes (16.76 percent of the total), and Tuvalu has 759 votes (0.03 percent of the total).Access to financingThe amount of financing a member country can obtain from the IMF is based on its quota. For instance, under Stand-By and Extended Arrangements, which are types of loans, a member country can borrow up to 200 percent of its quota annually and 600 percent cumulatively.

Source: https://www.imf.org/external/about/members.htm


Crises Facing the IMF

• Currency Crisis:– Occurs when a speculative attack on the exchange

value of a currency results in a sharp depreciation in the value of the currency or forces authorities to expend large amounts of international currency reserves and increase interest rates in order to defend the exchange rates.



• Currency Crisis:– If the domestic currency devalues:• Imported goods increase in price –

hyperinflation• Loss of reserves – no secure source of funding

vital operations• Citizens rush to exchange their currency for

others – further decreasing reserves• Lowers the revenues exporting companies earn



• Banking Crisis:– A situation in which a loss of confidence in the

banking system leads to a run on the banks as individuals and companies withdraw their deposits

– If banks do not have cash on hand to meet their short term obligations (such as customer savings – that’s why they are considered liabilities to banks) they go out of business



• Banking Crisis:– If banks go out of business there is:• Increased unemployment• No source of financing for businesses or

individuals meaning businesses close, people don’t buy things and the economy halts – fast.• No place to save money - no injection of

investment into economy• No way to exchange foreign currency



• Foreign Debt Crisis:– A situation in which a country cannot service its

foreign debt obligations, whether private sector or government debt

– Essentially, a government owes more than it earns and risks defaulting

– What happens when a government goes bankrupt?



• Foreign Debt Crisis:– If a country owes more than it earns:• Huge amounts of its GDP is earmarked for

interest and principle payments on loans rather than the education and health of its citizens• Government is not free to use its income to

stimulate its economy• National assets owned by foreigners



• Since the 1970s there have been six main crises:– Third World Debt – 1980s– The Russian economic crisis after 1991– 1995 Mexican currency crisis– the 1997 Asian financial crisis– Argentina foreign debt default in 2001– Great Recession 2008

• Generally all caused by excessive foreign borrowing, a weak or poorly regulated banking system and high inflation rates


Implications for Business

• In reality the currency markets don’t often work as they are planned or intended. Government intervention occurs often and can have disastrous results

• Speculative currency trading (which is a way that a lot of companies – including Canada’s banks – make a lot of money) can create currency volatility when such movement may not be economically warranted – Soros vs. Bank of England

Documents

Currency, Economics and Financial Markets Trevor Hunter King’s University College