Understanding Exchange Rates and International Finance

Posted on Aug 26, 2024 in Economy

Floating Exchange Rate System

Used by most advanced economies, governments refrain from intervention. Each nation’s currency floats independently according to market forces. Exchange rates are determined by the forces of demand and supply. Examples include the US dollar, Euro, Yen, Pound, and Canadian dollar.

Fixed Exchange Rate System (Pegged Exchange Rate System)

The value of a currency is set relative to the value of another (or the value of a basket of currencies) at a specified rate. As the reference value rises and falls, so does the currency pegged to it. This is the opposite of a floating exchange rate system. To maintain the peg, governments need to intervene in currency markets to buy and sell dollars and other currencies to maintain the exchange rate at a fixed preset level. Examples include China pegging to a basket of currencies and Belize to the U.S. dollar.

Floating vs. Fixed

Floating:

Economists believe the floating system is better because floating rates more naturally respond to and represent market forces. However, it can cause more harm during inflation.

Fixed:

Promotes greater stability and predictability of exchange rate movements, bringing stability to a nation’s economy. For example, China’s fixed exchange rate system helped contain the Asian financial crisis of the late 1990s.

Dirty Float

An exchange system where the value of the currency is determined by market forces, but the central bank intervenes occasionally in the foreign exchange market to maintain the value of its currency within acceptable limits relative to a major reference currency. Many Western countries resort to a dirty float from time to time.

Converting Currency

• US dollars = foreign currency / exchange rate
• Foreign currency = US dollar x exchange rate

Types of Currency Exchange Rates

• Spot rates
• Forward rates

Spot Rates

The rate for an immediate transaction. Market forces affecting spot rates include:

• The price of any currency (its rate of exchange) is determined by supply and demand.
• Greater the supply of a currency, lower its price.
• Lower supply of a currency, higher its price.
• Lower the demand of a currency, lower its price.
• Greater the demand of a currency, higher its price.

Forward Rates

3 month, 6 month, 9 month, or 12 month rates.

Hedging

Using financial instruments to reduce or eliminate exposure to currency risk. It protects firms from adverse currency rate fluctuations by locking in a guaranteed exchange rate position. Banks offer hedging to companies through three financial instruments:

• Forward contract
• Futures contract
• Currency options

Forward Contracts

A financial instrument to buy or sell a currency at an agreed-upon exchange rate at the initiation of the contract for future delivery and settlement. Example:

• GAP buys jeans from a supplier in India on January 2 for INR 1 million.
• INR 1 million is payable to the supplier on April 31.
• On January 2, the exchange rate (spot rate) is INR 50/$.
• On January 2, GAP enters into a forward contract with Bank of America to buy INR 1 million for delivery on April 31 at a forward rate of INR 50.30/$.

Futures Contract

An agreement to buy or sell a currency in exchange for another at a pre-specified price and on a pre-specified date. Similar to a forward contract, but unlike a forward contract, a futures contract gets traded on organized exchanges (CME – Chicago Mercantile Exchange).

Forward vs. Futures Contracts

Similarities:

• Both guarantee a fixed exchange rate.
• Both specify an exchange rate in advance of the actual exchange of currency.

Differences:

• Forwards are bank instruments, futures are private contracts traded on the exchange (CME).
• Sometimes future contracts are cheaper than forward contracts (the exchange rate is better).

Impact of Exchange Rate Change

Example: Strong dollar vs. weak yen. The US dollar is weakening against a foreign currency when the exchange rate goes down. It will cost an American buyer more than before. The impact of a weaker dollar on buyers is that imported goods get more expensive.

Effect of Currency Conditions on International Trade

When the US dollar is weak (under-valued):

• Demand for US goods increases because fewer units of local currency are needed to buy a US dollar.
• It would increase exports, reducing imports from other countries.

When the US dollar is strong (over-valued):

• Demand for US goods decreases.
• It would decrease exports, increasing imports from other countries.

Functions of the Foreign Exchange Market

• Spot exchange rate: The rate at which a foreign exchange dealer converts one currency into another currency on a particular day.
• Forward exchange rate: Exchange rate governing a transaction in which two parties agree to exchange currency and execute the deal at some specific date in the future.
• Currency swap: Simultaneous purchase and sale of a given amount of foreign exchange for two different value dates.

Theories of Exchange Rate Determination

Three factors that have an important impact on future exchange rate movements are:

• Country’s price inflation
• Country’s interest rate
• Market psychology

To understand how prices and exchange rates are linked, we need to understand:

• Law of one price
• Theory of purchasing power parity

Fisher Effect

A country’s nominal interest rate (i) is the sum of the required real rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (l) i = r + l

International Fisher Effect

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 between the two countries.

Bandwagon Effect

Expectations turn into self-fulfilling prophecies.

Exchange Rate Forecasting

• Efficient market school
• Inefficient market school

Efficient Market School

Forward exchange rates are the best predictors of future spot exchange rates. Investing in forecasting services would be a waste of money.

Inefficient Market School

Companies should invest in forecasting services. Forward rates are not the best predictor of future spot rates.

Currency Convertibility

• Freely convertible
• Externally convertible
• Nonconvertible

Freely Convertible

Both residents and non-residents can purchase unlimited amounts of foreign currency with the domestic currency.

Externally Convertible

Only non-residents can convert their holdings of domestic currency into a foreign currency.

Nonconvertible

Both residents and non-residents are prohibited from converting their holdings of domestic currency into a foreign currency.

Implications for Managers

Firms must understand the influence of exchange rates on the profitability of trade and investment deals. Exchange rate risk can be divided into:

• Transaction exposure – the amount you buy
• Translation exposure – how it affects your books
• Economic exposure – where you buy it

Minimize Translation and Transaction Exposure

• Buy forward
• Use swaps
• Lead and lag payables and receivables – paying suppliers and collecting payment from customers early or late depending on expected exchange rate movements

Reduce Economic Exposure

Distribute productive assets to various locations so the firm’s long-term financial well-being is not severely affected by changes in exchange rates. Requires that the firm’s assets are not overly concentrated in countries where likely rises in currency values will lead to damaging increases in the foreign prices of the goods and services they produce.

Countertrade

Refers to an international business transaction where all or partial payments are made in kind rather than cash. Also known as “two-way” or “reciprocal” trade. Operates on the principle of “I’ll buy your products if you buy mine.” Barter is a form of countertrade.

Countertrade Transactions

• Goodyear traded tires for minerals, textiles, and agricultural products.
• Coca-Cola sourced tomato paste from Turkey, oranges from Egypt, and beer from Poland to contribute to national exports in the countries it conducts business.
• Control Data Corporation accepted Christmas cards from the Russians in a countertrade deal.

Nature of Countertrade

Countertrade occurs in response to two primary factors:

• The chronic shortage of hard currency in developing economies.
• The lack of marketing expertise, adequate quality standards, and knowledge of western markets by developing-economy enterprises. Countertrade enables them to access markets that may otherwise be inaccessible and generate hard currency.

Risks in Countertrade

• The goods that the customer offers may be inferior in quality.
• It is very difficult to put a market value on goods the customer offers because these goods are typically commodities or low-quality manufactured products.
• Countertrade deals are inefficient because both parties tend to pad prices.
• Reciprocal trade amounts to highly complex, cumbersome, and time-consuming transactions.
• Countertrade rules imposed by governments make them highly bureaucratic.

FDI: Product Life Cycle

Firms undertake FDI at particular stages in the life cycle.

Eclectic Paradigm

• Location-specific advantages
• Externalities

Location-Specific Advantages

Arise from using resource endowments or assets that are tied to a particular location and that a firm finds valuable to combine with its own unique assets.

Externalities

Knowledge spillovers that occur when companies in the same industry locate in the same area.

Eclectic Theory

• Ownership
• Internalization
• Location

Ownership Advantages

• Asset-based: something tangible
• Transaction-based: knowing how to do something
• Tacit information: learning by doing

Microcredit/Lending

Loans to the poor, primarily women. Based on social and ethical principles. Informal credit – if I lend it to you, you’ll pay me back (regardless of income & credit score).

Timing of Entry

Firms entering a market early can gain first-mover advantages, including choice of location, less competition, etc.

• Second-mover advantages
• First-mover disadvantages

Second Mover Advantages

Learning from others.

First Mover Disadvantages

The disadvantages associated with entering a foreign market before other international businesses. May result in pioneering costs.

Pioneering Costs

Costs that an early entrant has to bear that a later entrant can avoid, such as:

• Costs of business failure if the firm, due to its ignorance of the foreign environment, makes some major mistakes.
• The costs of promoting and establishing a product offering, including the cost of educating the customers.

Exporting

Often the first method firms use to enter the foreign market.

Advantages:

• Relatively low cost
• Firms may achieve experience curve economies

Disadvantages:

• Lower-cost manufacturing locations may exist
• Transport costs may be high
• Tariff barriers may be high
• Foreign agents fail to act in the exporter’s best interest
• Soft services do not have an export alternative

Retail Internationalization

Quest for growth, or to colonize a concept (laying claim to an idea).

Four Types:

• Global – strategic: highly centralized decision-making, can open very rapidly, has the option to franchise.
• Multinational – strategic: alters what they do when they go into different countries, no blueprint to follow, differs by location.
• Acquisition – opportunistic
• Pure Franchising – opportunistic

Strategic

Thought out and made decisions about what you’re going to do based on objectives. The retailer purposely considers internationalization options in expansion.

Opportunistic

Something came along, something happened and was put in front of you, and you decided to follow it.

Global Retailers

• Standard retail format
• Centralized management – headquarters makes decisions
• Often vertically integrated backward – moving to raw materials
• Extensive use of private label
• Franchise alternative
• Generally small-medium size
• Examples: Aldi, Zara, Mango, H&M

Multinational (Localized) Retailers

• Decentralized
• Concentrate expansion within a geographic area
• Change retail offering based on customer and cultural differences
• Generally large-sized retailers such as hypermarkets, cash and carry
• No franchise option
• Examples: Walmart, Carrefour

Asset-Based

Global retailers with significant asset-based ownership advantages will franchise to colonize a concept. Multinational retailers will find that PL works against them when they internationalize.

Transaction-Based

Global retailers with significant transaction-based ownership advantages will not franchise to protect their secrets. Multinational retailers generally have greater transaction-based ownership advantages.

Locational Advantages

1. Cultural proximity
2. Market size
3. Competitors’ moves
4. Geographic proximity
5. Low-cost land and labor

Global: Not important, expand to world-class cities. Multinational: Very important, adapt to cultural differences.

Push factors, Pull factors

Internalization Advantages

Keeping company secrets. Licensing — franchising — joint venture — wholly owned = Giving away secrets.

Stages Theory

Risk Theory

Handling Risk – Resource vs. Agency Theory

Agency: If resource-based, they would not franchise if they have adequate capital. Risk-Resource: Or would acquire franchised property once they have adequate capital.

Importing

Refers to the buying of products and services from foreign sources and bringing them into the home market. Also known as Global sourcing, global procurement, or global purchasing.

Examples:

• In the U.S., Walmart, Target, and Home Depot are the biggest importers of foreign products.
• Retailers secure a substantial portion of their merchandise from foreign suppliers.

Documentation

Refers to the official forms and other paperwork required for export sales to transport goods and clear customs. Typically documentation from the supplier (exporter) consists of:

• Quotation/Pro Forma invoice
• Commercial invoice
• Packing list
• Bill of Lading
• Export declaration (ex dec)
• Certificate of Origin
• Insurance certificate

Quotation/Pro Forma Invoice

The foreign exporter initially issues a quotation or a pro forma invoice upon request by potential buyers. The quotation is structured as a standard form (hence pro “forma” invoice) and informs the potential buyer about the price and description of the foreign exporter’s product or service.

Commercial Invoice

The actual demand for payment issued by the exporter when a sale is concluded. Includes a description of the goods, exporter’s address, delivery address, and payment terms.

Packing List

Itemizes the material in each individual package and indicates the type of package, such as a box, crate, drum, or carton. Becomes necessary for shipments that involve numerous goods.

Bill of Lading

Basic contract between exporter (foreign supplier) and shipper (shipping company). Authorizes a shipping company to transport the goods to the buyer’s destination. Also serves as the importer’s receipt and proof of title for the purchase of the goods.

• Clear Bill of Lading: shipment is fine
• Foul Bill of Lading: shipment was damaged or inaccurate

Export Declaration

Shipper’s export declaration lists:

• Contact information of the exporter and the buyer (or importer)
• Full description, declared value, and destination of the products being shipped

Customs officials and port authorities use the ex-dec to determine the content of shipments, to control exports and to compile statistics for which goods are entering or leaving the country.

Certificate of Origin

Birth certificate of the goods being shipped and indicates the country where the product originates.

Insurance Certificate

Exporters usually purchase an insurance certificate to protect the exported goods against damage, loss, pilferage (theft), and, in some cases, delay.

Incoterms (International Commerce Terms)

Refers to a system of universal, standard terms of sale and delivery, developed by the International Chamber of Commerce. Commonly used in international sales contracts to eliminate disputes between the buyer and supplier over the cost of freight and insurance exports and imports. Incoterms specify how the buyer and the seller share the cost of freight and insurance, and at which point the buyer takes title to the goods.

Incoterms – EXW (Point of Origin)

Ex works or ex factory. Buyer takes title when he/she picks up the goods at the supplier’s factory and is totally responsible for the shipment and duties.

Incoterms – F.A.S. (Free Alongside Ship)

Foreign seller quotes a price for the goods, including the cost of delivery of the goods to the port alongside a vessel designated by the buyer. Seller handles the cost of unloading. Buyer takes possession at the dock at the port of export. Loading, ocean transport, and insurance are the buyer’s responsibility.

Incoterms – F.O.B. (Free on Board Named Port of Shipment)

Seller pays for the transportation of the goods to the port of shipment and the cost of loading the goods onto the cargo ship. Buyer pays for all costs beyond that point (including unloading). Responsibility for the goods lies with the seller until the goods pass the ship’s rail. Once loaded onto the ship, the buyer assumes risk. Buyer arranges the shipping.

Incoterms – CIF (Cost, Insurance, and Freight – Port of Entry)

Delivery takes place when goods pass the ship’s rail in the port of shipment. Seller pays for the insurance and freight necessary to bring the goods to the named port of destination. At that point, the risk of loss or damage gets transferred from the seller to the buyer.

Selection of an Incoterm

Depends on whether your company is handling its own freight and customs work. It is recommended that you not use any term that allows the seller to buy insurance for you. It is a good idea to handle the import details and duty payment yourself.

Methods of Payment

Cash in Advance

Most favorable to the seller because it relieves the exporter of all risk and allows for immediate use of the money. For the buyer, it is risky and may cause cash flow problems. The buyer may hesitate to pay cash in advance for fear the exporter will not follow through with shipment, particularly if the buyer does not know the exporter well. Used in smaller, first-time transactions or situations in which the exporter has reason to doubt the importer’s ability to pay. Unpopular with importers and discourages sales.

Letters of Credit (LC)

What most people do. A contract between the banks of the buyer and the seller that ensures payment from the buyer to the seller upon receiving an export shipment. LC guarantees payment to a supplier if the supplier presents appropriate export documents to a bank in its country. LC offers complete protection to the supplier. Shipment of goods is guaranteed for the buyer. LC provides advantages to both the exporter and the importers, which explains its wide use.

Revocable Letter of Credit

Can be amended or canceled at any time by the opening bank at the request of the buyer or account party.

Irrevocable Letter of Credit

Cannot be changed without the permission of both seller and buyer.

Drafts and Types of Drafts

Similar to a check, the draft is a financial instrument that instructs a bank to pay a specific amount of a specific currency to the bearer on demand or at a future date. For both letters of credit and drafts, the buyer must make payment upon presentation of documents that convey title to the purchased goods. Letters of credit and drafts can be paid immediately (sight drafts) or at a later date, often after the buyer receives the goods (time drafts or date drafts).

Open Account

Exporter simply bills the buyer who is expected to pay under agreed terms at some future time. Buyer pays the exporter at some future time following receipt of the goods. Open accounts are risky to exporters. Exporters use this approach only with buyers of long-standing or with excellent creditworthiness.

Consignment

Pay after you sell it. Allows the importer to defer payment until the goods are actually sold. This approach places all the burden on the exporter (seller). Therefore, it is the most favorable term to the importer (buyer). If the exporter wants entry into a specific market, consignment may be the only method of gaining acceptance. However, due to its burdensome characteristics, it is not widely used. In case the goods are not sold, returning them will be costly and time-consuming.

Countertrade

Refers to an international business transaction where all or partial payments are made in kind rather than cash. Also known as “two-way” or “reciprocal” trade, countertrade operates on the principle of “I’ll buy your products if you buy mine.” Barter is a form of countertrade.

Benefits of Multinational Markets

• Large mass market
• Improved channels of distribution, advertising, and transportation
• Increased trade with member nations
• Lower internal tariff barriers

Drawbacks of Multinational Markets

• Increased competition
• Looks like a single market, but it’s not
• Inflation
• Additional layer of government complexity

Stages in Multinational Cooperation

• Stage 1: Regional cooperation group: No substantive change
• Stage 2: Free trade area: Take away internal barriers
• Stage 3: Full customs union: Establish the same external barriers
• Stage 4: Common market: Free flow of capital and labor
• Stage 5: Political union: Unifying economic ideology

Good Regional Groups

Depend on different factors of production: Land, Labor, Capital, Entrepreneurship.

Sectoral Development

No differences.

Effects of NAFTA

Hard to quantify, Trade between partners grew 220%. Canada and Mexico are the U.S.’s first and third largest trading partners.

Mexico:

• Real wages have gone down, income inequality increased, immigration to the US increased.
• NAFTA buoyed the Mexican economy.
• Labor productivity increased 50%.

Euro Economic Requirements

• Inflation must not exceed the 3 best nations by more than 1.5%.
• Public sector budget deficit not to exceed 3% of GDP.
• Long-term interest rates not to exceed those of the 3 nations with the best inflation performance by 2%.
• The exchange rate has to be kept in normal bands of the European Exchange Rate Mechanism (ERM) for the previous two years.

Establishment of the Euro

Maastricht Treaty (1991) committed EU members to adopt a single currency, the euro. Used by 17 of 27 member states. The Eurozone is the second largest currency zone in the world after the U.S. dollar. Countries that participate have agreed to give up control of their monetary policy. Britain, Denmark, and Sweden have opted out of the eurozone.

Enlargement of the EU

Many countries, particularly from Eastern Europe, have applied for membership. 10 countries joined in 2004 to expand the EU to 25 states, a population of 450 million, and a continental GDP of 11 trillion. Bulgaria and Romania joined in 2007 to bring membership to 27 countries. Turkey has applied, but it is not clear whether it will be accepted.

Foreign Direct Investment (FDI)

Occurs when a firm invests directly in new facilities to produce or market in a foreign country. The firm engaged in FDI is a multinational enterprise.

Two Forms of FDI:

• Greenfield investment – the establishment of a wholly new operation in a foreign country.
• Acquisition or merging with an existing firm in the foreign country.

The Form of FDI

Most cross-border investment involves mergers and acquisitions rather than greenfield investments. Acquisitions are attractive because:

• Quicker to execute than greenfield investments.
• It is easier and less risky for a firm to acquire desired assets than build them from the ground up.
• Firms believe they can increase the efficiency of an acquired unit by transferring capital, technology, or management skills.

Advantages of FDI

Will be favored over exporting when:

• Transportation costs are high
• Trade barriers are high

Will be favored over licensing when:

• Firm wants control over its technological know-how
• Firm wants control over its operations and business strategy
• Firm’s capabilities are not amenable to licensing

Pattern of FDI – Strategic Behavior

Knickerbocker explored the relationship between FDI and rivalry in oligopolistic industries (industries composed of a limited number of large firms). FDI flows reflect strategic rivalry between firms. The theory can be extended to multipoint competition (when two or more enterprises encounter each other in different regional markets, national markets, or industries).

Oligopolistic Market Structure

4/50 + concentration. Avoid price competition, compete on service, etc. If there is a price reduction, it comes from the dominant firm.

Pattern of FDI – Product Life Cycle

Vernon – firms undertake FDI at particular stages in the life cycle of a product they have pioneered. Firms invest in other advanced countries when local demand in those countries grows large enough to support local production. Firms shift production to low-cost developing countries when product standardization and market saturation create price competition and cost pressures.