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Chapter Ten
The Determination of Exchange
Rates
Part Four
World Financial Environment
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Chapter Objectives
To describe the International Monetary Fund and its role
in the determination of exchange rates
To discuss the major exchange-rate arrangements that
countries use
To explain how the European Monetary System works
and how the euro came into being as the currency of the
euro zone
To identify the major determinants of exchange rates
To show how managers try to forecast exchange-rate
movements
To explain how exchange-rate movements influence
business decisions
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The International Monetary Fund
Originally organized in 1945
Objectives:
To promote international monetary
cooperation, exchange stability, and orderly
exchange arrangements
To foster economic growth and high levels of
employment
To provide temporary financial assistance to
countries to help ease balance-of-payments
adjustment
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IMF History
The Bretton Woods Agreement set a fixed
exchange rate against gold & the US
dollar
The Jamaica Agreement (1976) eliminated
par values against gold and the US dollar
and permitted greater flexibility.
Voting is through the Quota system
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Special Drawing Right
The Special Drawing Right (SDR) is a
special asset the IMF created to increase
international reserves
The value of the SDR is based upon the
weighted average of a basket of four
currencies: the U.S. dollar, the euro, the
Japanese yen, and the British pound.
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Exchange Rates
The world can be divided into:
Countries that basically let their currencies
float according to market forces with minimal
or no Central Bank intervention
Countries that do not but rely on heavy
Central Bank intervention and control
Anyone involved in international business
needs to understand how the exchange
rates of countries with which they do
business are determined
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The Euro
European Monetary System (EMS): established by the
EU (then the EC) in 1979 as a means of creating
exchange rate stability within the bloc
European Central Bank: established by the EU on July
1, 1998, to set monetary policy and to administer the
euro
Euro: the common European currency established on
Jan. 1, 1999 as part of the EUs move toward monetary
union as called for by the Treaty of Maastricht of 1992
European Monetary Union (EMU): a formal arrangement
linking many but not all of the currencies of the EU

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Africa
African countries are committed to
establishing a common currency by 2021,
but there are many obstacles to
accomplishing this objective
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The Determination Of Exchange
Rates
Currencies that float freely respond to supply
and demand conditions free from government
intervention
The demand for a countrys currency is a
function of the demand for its goods and
services and the demand for financial assets
denominated in its currency
Fixed exchange rates do not automatically
change in value due to supply and demand
conditions but are regulated by their Central
Banks
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Central Banks
Central banks are the key institutions in countries that
intervene in foreign-exchange markets to influence
currency values
The Bank for International Settlements (BIS) in
Switzerland acts as a central bankers bank.
It facilitates communication and transactions among the
worlds central banks
A central bank intervenes in money markets by
increasing a supply of its countrys currency when it
wants to push the value of the currency down and by
stimulating demand for the currency when it wants the
currencys value to rise
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Black Markets The Result of Fixed
Exchange Rates
Many countries that strictly control and
regulate the convertibility of their currency
have a black market that maintains an
exchange rate that is more indicative of
supply and demand than is the official rate
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Foreign-Exchange Convertibility
Fully convertible currencies, often called hard
currencies, are those that the government allows
both residents and nonresidents to purchase in
unlimited amounts
Currencies that are not fully convertible are often
called soft currencies, or weak currencies
They tend to be the currencies of developing
countries
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Exchange Controls
To conserve scarce foreign exchange,
some governments impose exchange
restrictions on companies or individuals
who want to exchange money, such as
import licensing
multiple exchange rates
import deposit requirements
quantity controls
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Factors that determine exchange
rates
purchasing-power parity
differences in real interest rates
confidence in the governments ability to
manage the political and economic
environment
certain technical factors that result from
trading
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Forecasting Exchange-Rate
Movements
Fundamental forecasting uses trends in
economic variables to predict future rates.
The data can be plugged into an
econometric model or evaluated on a
more subjective basis.
Technical forecasting uses past trends in
exchange rates themselves to spot future
trends in rates.
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Factors to Monitor
Major factors that managers should
monitor when trying to predict the timing,
magnitude, and direction of an exchange-
rate change include
the institutional setting
fundamental analysis
confidence factors
events
technical analysis
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Business Implications of Exchange-
Rate Changes
Exchange rates can affect business
decisions in three major areas:
Marketing
Production
Finance