Part II Exchange Rate Behavior

Existing spot
exchange rates
at other locations
Existing cross
exchange rates
of currencies
Existing inflation
rate differential
Future exchange
rate movements
Existing spot
exchange rate
Existing forward
exchange rate
Existing interest
rate differential
locational
arbitrage
triangular
arbitrage
purchasing power parity
international
Fisher effect
covered interest arbitrage
covered interest arbitrage
Fisher
effect
Government Influence
On Exchange Rates
6
Chapter
C6 - 3
Chapter Objectives
To describe the exchange rate
systems used by various
governments;
To explain how governments can use
direct and indirect intervention to
influence exchange rates; and
To explain how government intervention
in the foreign exchange market can affect
economic conditions.
C6 - 4
Exchange Rate Systems
Exchange rate systems can be classified
according to the degree to which the rates
are controlled by the government.
Exchange rate systems normally fall into
one of the following categories:
fixed
freely floating
managed float
pegged
C6 - 5
In a fixed exchange rate system, exchange
rates are either held constant or allowed
to fluctuate only within very narrow bands.
Fixed
Exchange Rate System
C6 - 6
Pros: Work becomes easier for the MNCs.
Cons: Governments may revalue their
currencies. In fact, the dollar was
devalued more than once after the U.S.
experienced balance of trade deficits.
Cons: Each country may become more
vulnerable to the economic conditions in
other countries.
Fixed
Exchange Rate System
C6 - 7
In a freely floating exchange rate system,
exchange rates are determined solely by
market forces.
Pros: Each country may become more
insulated against the economic problems
in other countries.
Pros: Central bank interventions that may
affect the economy unfavorably are no
longer needed.
Freely Floating
Exchange Rate System
C6 - 8
Pros: Governments are not restricted by
exchange rate boundaries when setting
new policies.
Pros: Less capital flow restrictions are
needed, thus enhancing the efficiency of
the financial market.
Freely Floating
Exchange Rate System
C6 - 9
Cons: MNCs may need to devote
substantial resources to managing their
exposure to exchange rate fluctuations.
Cons: The country that initially
experienced economic problems (such as
high inflation, increasing unemployment
rate) may have its problems compounded.
Freely Floating
Exchange Rate System
C6 - 10
In a managed (or dirty) float exchange
rate system, exchange rates are allowed to
move freely on a daily basis and no official
boundaries exist. However, governments
may intervene to prevent the rates from
moving too much in a certain direction.
Cons: A government may manipulate its
exchange rates such that its own country
benefits at the expense of others.
Managed Float
Exchange Rate System
C6 - 11
In a pegged exchange rate system, the
home currencys value is pegged to a
foreign currency or to some unit of
account, and moves in line with that
currency or unit against other currencies.
Pegged
Exchange Rate System
C6 - 12
Dollarization
Dollarization refers to the replacement of a
local currency with U.S. dollars.
Dollarization goes beyond a currency
board, as the country no longer has a
local currency.
For example, Ecuador implemented
dollarization in 2000.
C6 - 13
Government Intervention
Each country has a government agency
(called the central bank) that may
intervene in the foreign exchange market
to control the value of the countrys
currency.
In the United States, the Federal
Reserve System (Fed) is the
central bank.
C6 - 14
Government Intervention
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate
boundaries, and/or
to respond to temporary disturbances.
Often, intervention is overwhelmed by
market forces. However, currency
movements may be even more volatile in
the absence of intervention.
C6 - 15
Direct intervention refers to the exchange
of currencies that the central bank holds
as reserves for other currencies in the
foreign exchange market.
Direct intervention is usually most
effective when there is a coordinated
effort among central banks.
Government Intervention
C6 - 16
Government Intervention
Quantity of
S
1

D
1

D
2

Value
of
V
1

V
2

Fed exchanges $ for
to strengthen the
Quantity of
S
2

D
1

Value
of
V
2

V
1

Fed exchanges for $
to weaken the
S
1

C6 - 17
When a central bank intervenes in the
foreign exchange market without
adjusting for the change in money supply,
it is said to engaged in nonsterilized
intervention.
In a sterilized intervention, Treasury
securities are purchased or sold at the
same time to maintain the money supply.
Government Intervention
C6 - 18
Nonsterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To
Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken
the C$:
C6 - 19
Sterilized Intervention
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To
Strengthen
the C$:
Federal Reserve
Banks participating
in the foreign
exchange market
$ C$
To Weaken
the C$:
$
Financial
institutions
that invest
in Treasury
securities
T- securities
Financial
institutions
that invest
in Treasury
securities
$
T- securities
C6 - 20
Some speculators attempt to determine
when the central bank is intervening, and
the extent of the intervention, in order to
capitalize on the anticipated results of the
intervention effort.
Government Intervention
C6 - 21
Central banks can also engage in indirect
intervention by influencing the factors that
determine the value of a currency.
For example, the Fed may attempt to
increase interest rates (and hence boost
the dollars value) by reducing the U.S.
money supply.
Note that high interest rates adversely
affects local borrowers.
Government Intervention
C6 - 22
Governments may also use foreign
exchange controls (such as restrictions
on currency exchange) as a form of
indirect intervention.
Government Intervention
C6 - 23
Impact of Government Actions on Exchange Rates
Government Intervention
in
Foreign Exchange Market
Government
Monetary
and Fiscal Policies
Relative Interest
Rates
Relative Inflation
Rates
Relative National
Income Levels
International
Capital Flows
Exchange Rates
International
Trade
Tax Laws,
etc.
Quotas,
Tariffs, etc.
Government
Purchases & Sales
of Currencies
C6 - 24
Impact of Central Bank Intervention
on an MNCs Value
( ) ( ) | |
( )

=
n
t
t
m
j
t j t j
k
1 =
1
, ,
1
ER E CF E
= Value
E (CF
j,t
) = expected cash flows in currency j to be received
by the U.S. parent at the end of period t
E (ER
j,t
) = expected exchange rate at which currency j can
be converted to dollars at the end of period t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention
C6 - 25
Exchange Rate Systems
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
Currency Boards
Exposure of a Pegged Currency to Interest
Rate and Exchange Rate Movements
Dollarization
Chapter Review
C6 - 26
Chapter Review
A Single European Currency
Membership
Euro Transactions
Impact on European Monetary Policy
Impact on Business Within Europe
Impact on the Valuation of Businesses in
Europe
Impact on Financial Flows
Impact on Exchange Rate Risk
Status Report on the Euro
C6 - 27
Chapter Review
Government Intervention
Reasons for Government Intervention
Direct Intervention
Indirect Intervention
Exchange Rate Target Zones
C6 - 28
Chapter Review
Intervention as a Policy Tool
Influence of a Weak Home Currency on the
Economy
Influence of a Strong Home Currency on
the Economy
How Central Bank Intervention Can Affect
an MNCs Value