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Lecture 9

International Financial Markets & Institutions

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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 currency’s 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-à-vis the dollar or gold.

• Post–Bretton 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.

• 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.

Types of Exchange Rate

Exchange Rate Arrangements

Pegged Rate System:Bahamas Bermuda Hong KongBarbados China Saudi Arabia

Pegged to U.S. dollar

Floating Rate System:Afghanistan Hungary Paraguay SwedenArgentina India Peru SwitzerlandAustralia Indonesia Poland TaiwanBolivia Israel Romania ThailandBrazil Jamaica Russia United Kingdom

Canada Japan Singapore VenezuelaChile Mexico South Africa

Euro countries Norway South Korea

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.

• 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.

Government Direct 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

Indirect Intervention

Impact of Government Actions on Exchange Rates

Government Intervention inForeign Exchange Market

Government Monetaryand Fiscal Policies

Relative InterestRates

Relative InflationRates

Relative NationalIncome Levels

InternationalCapital Flows Exchange Rates International

Trade

Tax Laws, etc.

Quotas, Tariffs, etc.

Government Purchases & Sales of Currencies

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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.

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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.