Chapter 7 Foreign exchange and the international monetary system

Lecture overview

Introduction The role of foreign exchange in international marketing Foreign exchange rates The forward exchange market Exchange rate systems (regimes) Models of exchange rate behaviour Exchange controls

Learning outcomes
Define the term exchange rate and briefly explain how it is determined and its importance in international marketing Distinguish between hedging and speculation as they applies to transactions in the forward exchange market Explain the different exchange rate systems and highlight their importance for the exporter. Identify the main factors underpinning exchange rate movements Briefly explain what is meant by the balance of payments (BOP) and show how a trade transaction is recorded in the BOP List the advantages and disadvantages of exchange controls.

Introduction
With the advent of globalisation the world has become one global village. Domestic producers are increasingly forced to compete with foreign producers. With trade liberalisation, producers are increasingly being forced to compete, irrespective of whether they export or not. In this chapter we explore the concept of foreign exchange and the issues related to foreign exchange which have a bearing on a firms profitability.

The role of foreign exchange in international marketing

Foreign exchange is defined as a financial instrument that gives the bearer a claim on the currency of another country. What is the relevance of foreign exchange in international marketing? Figure 7.1 illustrates the important role of foreign exchange transactions in modern business practice.

Role of foreign exchange in international trade

Foreign exchange rates

The rate of conversion at which one currency is converted into another currency is known as the foreign exchange rate. The foreign exchange rate (usually termed the exchange rate) is the price of one currency expressed in terms of another currency. The spot exchange rate is the rate that applies to transactions that are for immediate delivery.

How is the exchange rate determined?

The exchange rate of the rand is determined by the demand and supply of Rands in the foreign exchange market.

The supply of dollars (= demand for Rands) in the Forex markets is due to the following:
South African exports foreigners convert their currencies into Rands to pay for goods purchased from South Africa. Foreign investment flows into South Africa. When foreigners invest in South Africa these investments are done in Rands.

How is the exchange rate determined?

The supply of dollars (= demand for Rands) in the Forex market is due to the following: Speculators who buy Rands in the hope of making a profit. South African Reserve Bank (SARB) activities. - The SARB sells dollars (and buys Rands) in the foreign exchange market. - This could be to control inflation. - They may want to reduce the money supply to dampen the demand for goods and prevent prices from rising rapidly.

How is the exchange rate determined?

The demand for dollars (= supply of Rands) is influenced by the following: South African imports South African companies convert their Rands into foreign currencies in order to pay for imports Speculators sell Rands for another currency. Capital outflows from South Africa investors may choose to redirect their investments from South Africa to other investment destinations.

How is the exchange rate determined?

The purchase of foreign currencies by the central bank. - This is done in order to influence the exchange rate and/or build up foreign exchange reserves. - In the former case, the central bank is primarily interested in maintaining a particular exchange rate. - The South African Reserve Bank does not target the exchange rate. - Their activity in the foreign exchange market is motivated by the sole intention of building up foreign exchange reserves.

The concepts of appreciation and depreciation

Appreciation: when fewer units of domestic currency (Rands) are required to purchase one unit of foreign currency ($US). Depreciation: when a larger quantity/units of domestic currency (Rands) are required to purchase one unit of foreign currency ($US).

The exchange rate determines the number of Rands that are received (or paid) for each US dollar, and therefore changes in the exchange rate have a direct impact on the profits of a firm.

The concepts of appreciation and depreciation (continued)

The net impact on profitability depends on how reliant the company is on exports for its revenue.

If a firm is totally or heavily reliant on the export market for its revenue, and appreciation of the currency is likely to lead to a decline in demand for its product, there is hence a decline in export revenue.
If on the other hand, the domestic market is the major source of its revenue, an appreciation of the exchange rate could increase the profitability of the firm (since input costs decline).

The forward exchange market

Participants agree to trade some commodity, security, or foreign exchange at a predetermined price for delivery at a specified future date.

The forward exchange market involves the delivery of currency at some date in the future.
Exchange rate changes can have an adverse impact on a firm's profitability. A large and sustained appreciation of the exchange rate can threaten the survival of export firms. .../

The forward exchange market (continued)

To prevent this from happening, the firm can hedge against unfavourable movements in the exchange rate. Hedging is a form of insurance against adverse or unfavourable exchange rate changes. Exchange rate changes also provide opportunities for speculation; that is, opportunities to make a profit from exchange rate movements.

Hedging
Hedging is primarily directed at managing risks. As far as foreign exchange is concerned, hedging involves limiting the risks that could arise from fluctuations in the exchange rate. Instruments that are available for hedging include the following:
- Forward contracts - Futures contract - Option contracts
/

Hedging Forward contracts

An agreement to exchange a specified amount and type of commodity or financial instrument (currency) at a fixed price at a specific date in the future. It eliminates some of the uncertainty in the sense that it enables an exporter to lock in an exchange rate that will apply to its future export earnings. /

Hedging Futures contracts

An agreement to transact a standard amount of a specified commodity or financial instrument at a fixed price at a specified date in the future.
For currency futures contract, the future exchange rate will be almost identical to that of a forward contract but the transaction is restricted between the specified parties on the contract, the futures contract can be traded on recognized futures exchanges by dealers who are members of the exchange. The currency futures contract is usually specific to a particular exchange. Currency futures contracts are for amounts that are usually smaller than forward foreign exchange contracts. .../

Hedging Option contracts

Gives the bearer the right, but not the obligation to buy or sell foreign currency at a fixed price at a specified future date or during a specified future period. Since this contract does not obligate the bearer to take up the option, a premium is charged for the right to exercise the option (irrespective of whether the option is actually going to be taken up or not). In this case, the main advantage to the bearer is that there is a possibility to make profits if exchange rate movements are in the exporters favour.

Advantages and disadvantages of hedging instruments

Management of foreign exchange risks

Hodge identifies three steps in the management of foreign exchange risks:
Step 1 Identification of the foreign exchange (FX) risk Step 2 Select the optimal financial risk profile for foreign exchange

Step 3 Putting in place processes to manage FX risks

Speculation
Speculation refers to the situation where foreign exchange is purchased or sold with the sole aim of making a profit. The profit is realised from transacting in foreign exchange rather than from a commercial transaction such as the export of goods.

Exchange rate regimes

Broadly categorised there are three exchange rate systems:

Fixed exchange rate system

Intermediate exchange rate system, and Flexible exchange rate system /

Exchange rate regimes (continued)

Under the fixed exchange rate system, the central bank determines the exchange rate and its foreign exchange activities in the Forex markets which are geared towards maintaining the predetermined exchange rate.
Under a flexible exchange rate system, the central bank allows the supply of foreign currency and the demand for foreign currency to freely determine the exchange rate. South Africas major trading partners have flexible exchange rate systems. /

Exchange rate regimes (continued)

Some of the major exporters on the world market do operate in countries that have fixed exchange rate systems.
There is a huge controversy surrounding the exchange rate policies of China. It is argued that the Chinese authorities deliberately intervene in the forex market to keep their currency at a depreciated level to give Chinese producers the competitive edge on the export market.

Models of exchange rate behaviour

Economic models have identified three factors, as important determinants of exchange movements:
- National price levels - Interest rates - Balance of payments

The purchasing power parity (PPP) hypothesis maintains that the exchange rate between the currencies of two countries should equal the ratio of the price levels of the two countries.

Models of exchange rate behaviour

It is argued that interest rate differentials between countries exert an influence on exchange movements. Economists also emphasise a strong interdependence between exchange rates and the balance of payments.
The exchange rate adjusts to international payments imbalances (currency outflows will cause the domestic currency to depreciate and vice versa).

Balance of payments
It reflects the economic transactions between a country and the rest of the world for a given. The balance of payments is a statistical reflection of the economic relations with the rest of the world, and is therefore an important indicator influencing domestic economic developments, particularly those in financial markets. Its role in policy formulation has increased over time, particularly with the intensification of globalisation over the last half century.

Exchange controls
Exchange controls refer to the laws that prohibit or restrict the flow of foreign currencies into or out of a country.
They entail the various forms of controls imposed by the authorities on the purchase and/or sale of foreign currencies by residents or on the purchase and/or sale of local currency by non-residents. Experience has shown that stringent exchange controls are not successful (they can lead to the creation of an informal market in foreign exchange a black market).

Summary
Exchange rate changes have a direct impact on profitability and hence are an important element underpinning a firm's production decisions. The forward exchange market in modern business practices Hedging and speculation are two practices common to the forward exchange market and its relevance in export decisions is without question. A thorough understanding of the operations of the foreign exchange market is an integral to effective decision making in businesses operating on the international market.