Summary of Chapter 6: Currency and Foreign Exchange
Introduction
This chapter discusses the role of money in global trade and the impact of fluctuating currency
values on international business. While electronic banking has facilitated currency transfers,
exchange rate fluctuations create complexities. The valuation of a currency affects trade; an
undervalued currency makes imports expensive, while an overvalued currency makes domestic
exports costlier
.
Key Topics and Important Terms
1. What Is Money?
Money has three primary functions:
Medium of Exchange – It eliminates the need for a barter system by allowing easy trade.
Unit of Account – It provides a standard measure of value for goods and services.
Store of Value – It retains value over time, enabling savings
.
Historically, money was backed by commodities like gold (gold standard), but most modern
currencies are fiat money, meaning their value is based on government decree rather than
intrinsic worth.
GOLD STANDARD a currency where the value is determined by the ability to
trade it for a specified amount of gold (i.e., $1 for 1/35 of an ounce) at a
government-approved bank
FIAT CURRENCY a currency that the government has declared to be legal
tender but is not backed by any physical commodity
2. Foreign Exchange and Exchange Rate Fluctuations
Exchange rates are influenced by:
Supply and Demand – High demand increases a currency’s value.
Political Stability – Stable countries attract investors, strengthening their currency.
Economic Policies – Monetary and fiscal policies can impact exchange rates
.
Exchange rate valuation concepts:
Purchasing Power Parity (PPP) – A theory suggesting identical goods should have the same
price across borders.
EXCHANGE RATE the value of one currency when being converted to another
currency
FLOAT an exchange rate system where the price of the currency is
determined by the supply and demand of the currency in the foreign
exchange market
CURRENCY EXCHANGE the process by which entities swap one nation’s
currency for that of another
MANAGED FLOAT an exchange rate system where the price of the currency is
largely determined by the supply and demand in the foreign exchange
market but where central banks attempt to influence the rate by actively
buying and selling currencies
PEG an exchange rate system where the price of the currency is fixed
against another currency or against a basket of other currencies
DOLLARIZATION the process of a country abandoning their currency and
using U.S. dollars or another currency instead
Law of One Price – Assumes that currency-adjusted prices should equalize globally.
3. Under- or Overvaluation of Currency
Undervalued Currency: Encourages exports, makes domestic products cheaper for foreigners.
Overvalued Currency: Increases import affordability but harms domestic exporters.
Governments sometimes manipulate currency values to favor their economic interests
.
BIG MAC INDEX a tool developed by the Economist magazine that
demonstrates the over- or undervaluation of a currency as compared to the
U.S. dollar using the price of the McDonalds’ Big Mac.
TRANSACTION EXPOSURE the extent to which income from foreign
transactions are exposed to currency fluctuations before payment is made.
TRANSLATION EXPOSURE the impact of currency exchange rate changes on
the financial statements of a company
ECONOMIC EXPOSURE a company’s exposure to unexpected change in
foreign exchange rates
4. Managing Exchange Rate Risk
Businesses face three types of exchange rate risk:
APPRECIATION an increase in the value of one currency relative to another
currency
DEPRECIATION a decrease in the value of one currency relative to another
currency
Tools for managing risk:
Spot Exchanges – Immediate currency conversion at the current rate.
Forward Contracts – Agreements to exchange currency at a future date at a predetermined
rate.
Currency Swaps – Exchanging currency flows between two parties.
Forward Exchange Rate Transactions a transaction involving two parties
that agree to exchange currency at some future date at a specific rate they
agree to at the time of the deal
Fx Swaps the simultaneous purchase and sale of a given amount of
currency at two different rates
5. Global Foreign Exchange Market
The Bank for International Settlements (BIS), headquartered in Switzerland, oversees central
banks and reports on global currency trading. The foreign exchange (Forex) market handles
$6.2 trillion daily, making it the world's largest financial market.
Key Players In The Market:
REPORTING DEALERS – Large banks (e.g., JPMorgan Chase, HSBC).
NON-FINANCIAL CUSTOMERS – Governments, corporations, and individuals.
OTHER FINANCIAL INSTITUTIONS – Investment banks, hedge funds, and money transfer
companies
.
The U.S. dollar dominates currency transactions, appearing in 88% of global trades. Major
Forex centers include London (37%) and New York (19%)
.
6. Case Study: Libra – The Next Bitcoin?
Facebook’s proposed Libra aimed to be a stable cryptocurrency that could bridge various
currencies worldwide. It promised lower fees and improved accessibility, particularly for the
unbanked. However, the challenge was maintaining stability amid fluctuating government
currencies
.
Conclusion
Understanding foreign exchange is crucial for businesses operating internationally. Managing
currency risk, monitoring exchange rate fluctuations, and utilizing financial instruments like
forward contracts and swaps can help mitigate potential losses.
This chapter highlights how businesses can navigate the complexities of foreign exchange while
leveraging opportunities in the global marketplace
.
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