Lecture 9 International Financial Markets & Institutions

Session Outline
International Monetary System Foreign Exchange Markets Exchange Rates Determination MNE Foreign Exchange Strategies Government Intervention IMF and the World Bank

The International Monetary System The arrangement between national governments/central banks that oversee the operation of official foreign exchange dealings between countries.

Relevance to Companies International financial markets are relevant to companies, whether or not they become directly involved in international business through exports, direct investment, etc
Purchases of imported products or services, borrowing and investment in other countries or currency, all involve exchange risk.

Exchange risk: The risk of financial loss or gain due to an unexpected change in a currencys value.

A Brief history of the Intl. Monetary System

Classical gold standard: 1821 1914 Desirable properties: durable, storable, portable, easily recognised, divisible and easily standardised. Exchange rate between two currencies is determined by their gold content. The Inter-War years and World War II, 1914 1944 Gold exchange standard broke down during WWI and WW2 New standard with only US and UK able to hold reserves in Gold others in USD and GBP The Bretton Woods System (1946 1971) Under the Bretton Woods Agreement, implemented in 1946, each government pledged to maintain a fixed, or pegged, exchange rate for its currency vis--vis the dollar or gold. PostBretton Woods System (1971-present) The Smithsonian Agreement, 1971 Flexible Exchange Rates officially adopted n 1973

The Foreign Exchange Markets

The foreign exchange market is a mechanism, through which financial instruments (cash, cheques or drafts, wire transfers telephone transfers and contracts to sell or buy currency in the future) that are denominated in different currencies can be transacted.

Exchange Rate systems Free floating

Managed float

Fixed-rate
Pegged

Dollarisation

Dollarization refers to the replacement of a foreign currency with U.S. dollars. For example, Ecuador implemented dollarization in 2000.

Types of Exchange Rate

Spot rate is the rate quoted for current foreign currency transactions.
Forward rate is the rate quoted for the delivery of foreign currency at a predetermined future date such as 90 days from now. Futures rates is very similar to the forward foreign exchange market except in that the amount of currency transacted is fixed to be transferred at a future date at a fixed exchange rate. Cross rate is an exchange rate that is computed from two other rates.

Exchange Rate Arrangements

Floating Rate System: Afghanistan Hungary Argentina India Australia Indonesia Bolivia Israel Brazil Jamaica Canada Japan Chile Mexico Euro countries Norway
Pegged Rate System: Bahamas Bermuda Barbados China Paraguay Sweden Peru Switzerland Poland Taiwan Romania Thailand Russia United Kingdom Singapore Venezuela South Africa South Korea

Hong Kong Saudi Arabia

Pegged to U.S. dollar

Activities of Various Actors

Traders work in commercial banks where they buy and sell foreign currency for their employer. Brokers work in brokerage firms where they often deal in both spot rate and forward rate transactions. A speculator is a participant who takes an open position. This means that the individual either has foreign currency on hand (called a long position) or has promised to deliver foreign currency in the future and does not have it on hand (called a short position). Hedgers limit their potential losses by locking in guaranteed foreign exchange positions. Arbitrageurs are individuals who simultaneously buy and sell currency in two or more foreign markets and profit from the exchange rate differences. Governments.

Foreign Exchange Market for Euros in New York

MNE Foreign Exchange Strategy

Through local borrowing, local deposits or Investments. Currency swaps

Protecting Against Exchange Risk Risk avoidance: avoid foreign currency transactions. Risk adaptation: this strategy includes all methods of hedging against exchange rate changes. Risk transfer: the use of an insurance contract or guarantee that transfers the exchange risk to the insurer or guarantor. Diversification: spreading assets and liabilities across several currencies.

Government Intervention

Central banks manage exchange rates to smooth exchange rate movements, to establish implicit exchange rate boundaries, and 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.

Government Direct Intervention

Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market.
This is usually most effective when there is a coordinated effort among central banks and when the central banks have high levels of reserves that they can use.

Indirect Intervention
Central banks can also engage in indirect intervention by influencing the factors that determine the value of a currency, such as Inflation, Interest rates,

Income level,
Government controls, Expectations Restriction

Impact of Government Actions on Exchange Rates

Government Monetary and Fiscal Policies

Relative Interest Rates

Relative Inflation Rates

Relative National Income Levels

International Capital Flows

Exchange Rates Government Purchases & Sales of Currencies

International Trade

Tax Laws, etc.

Government Intervention in Foreign Exchange Market

Quotas, Tariffs, etc.

The IMF
IMF, is a global financial organisation whose members are countries worldwide. The IMF is an agency of the United Nations has played a role in the global economy since the end of World War II. The organization's main role is to ensure stability in the global financial system.
The IMF is involved in aspects such as dealing with the aftermath of the recession of 2007 through 2009, and the credit crisis.
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Task of the IMF

Watchdog and Surveillance Lending Activities Sharing of Expertise Support

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Watchdog Role
Through its surveillance activities.
Member countries of the IMF agree to follow certain rules, such as not manipulating their currencies for their own advantage.

Member countries also make their economic data available to the IMF. The agency monitors such data to ensure that members' economic policies are sound.
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Lending Activities
Provide loans to members to help stabilize their economies.
This provides stability to the global economy. Country in financial distress, the IMF could lend the country money.

The IMF provides funding to provide stability and is not engaged in development lending activities.
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Sharing of Expertise
The IMF shares its expertise with member countries in order to help them better develop their economic policies.
In the form of training in areas such as central banking and exchange rate policies. A number of developing countries in Asia and Africa make use of the IMF's technical expertise.

The agency's technical expertise helps to strengthen the international financial system.
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IMF Support
As many as 80 percent of IMF members have used funding from the agency at least once. In the early years of the IMF, most of the agency's lending went to industrial countries. After the 1970s' oil shock and the debt crisis of the 1980s more developing countries started to approach the agency. And as the Eastern European countries ran into difficulties in the 1990s, as they moved away from their socialistic economic systems, they too turned to the IMF.
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World Bank
Functions Lending Development Strategy Financial Services Data Collection

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World Bank
The World Bank is one of the Bretton Woods institutions, consists of the World Bank and the International Monetary Fund
Named for the city of Bretton Woods, New Hampshire, where they were created at a 1944 summit between representatives from the United States, the United Kingdom, Australia and India. The World Bank promotes the facilitation of the international economy.
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Lending
The Bank was created to help with reviving Europe's economy and repairing the damage of the war.
It did this by giving loans -- its first loan, in 1947, gave $250 million to France to rebuild. As of 2010, the bank loaned about $13 billion each year to developing countries in the form of interest-free credits.
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Development strategy
Loans from the World Bank have strings attached The Bank monitors how each country spends the funds that it receives. To ensure that World Bank funds are not spent inefficiently or lost to corruption. The Bank studies the economy and political atmosphere of each country to which it intends to lend funds. The loan comes with a development strategy
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Financial Services
The World Bank also helps developing countries to manage their money effectively.
As part of its development strategies, the World Bank counsels the borrowing countries on developing their financial strategies. It helps them to develop their investment portfolios and teaches them about financial practices like risk management through hedging and derivatives trading. It gives continuing financial advice to its borrowing countries, advising them on managing investments and risk in addition to protecting against disasters with catastrophe bonds. 29

Data Collection
The World Bank draws on the experiences of countries that it has supplied funds to in the past to decide how a new borrower may best use its loan.
It documents its experiences in data banks.
The World Bank collects information about each borrowing country and how it uses World Bank funds. While the Bank collects this information primarily for its own use, it also shares its knowledge.

The World Bank makes much of its data available to the public in online databases, and it also publishes its analysts reports on emerging global trends.

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Achievements and Criticisms of the World Bank

Following creation of the Millennium Development Goals Achievements WB points to progress toward achieving benchmarks. Evidence of gradual reduction in poverty, Measurable improvements with respect to health and disease.
Critics WB market-oriented strategies that at times have benefited global corporations more than the target population. Promotion of economic liberalization, deregulation and privatization undermines its stated goals with respect to poverty and environmental sustainability
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Affiliates of WB
International Development Association (IDA)
International Finance Corporation (IFC) Multilateral Investment Guarantee Agency (MIGA) International Centre for Settlement of Investment Disputes (ICSID)
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Seminar Question
Working in groups: Critically examine the various foreign exchange regimes and how they impact on activities of a selected MNE and how the challenges could be minimised.

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