International Business

Third Edition

Shad Morris and James Oldroyd

Chapter 6

Currency and Foreign Exchange

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Introduction
“Money makes it easier to buy and sell goods around the
world. In fact, thanks to electronic banking, paper money
and coins no longer need to exchange hands. However,
despite electronic advances in the ways we can transfer
currency, the value of money fluctuates across countries,
adding a layer of complexity to international business”.
Learning Objectives
1. Identify the three functions of money.
2. Explain why foreign exchange rates fluctuate.
3. Discuss the causes and consequences of under- or
overvaluation of currency.
4. Describe how companies settle international monetary
transactions and manage exchange rate risk.
What Is Money?
For thousands of years,
people have used physical
money in various forms to
facilitate exchange.
The three major functions
of money are:
• Medium of Exchange
• Unit of Account
• Store of Value
Cryptocurrency
• Cryptocurrencies: electronic currencies that are monitored by
distributed peer networks that simultaneously keep track of
currency ownership and trades.
• Bitcoin and other digital forms of money have recently
emerged.
• Advantageous because they are decentralized from
institutions and political risk and control; they cannot be
stolen nor seized; and they do not require the sharing of
private information like other modern methods of purchasing.
• Disadvantages because of the incredible volatility of their
value, and the risk of an electronic crash or systematic failure
that could completely decimate accumulated wealth.
Bitcoin

FIGURE 6.1 Bitcoin

Bitcoin's monetary value is historically very volatile and experienced major
changes in 2020 and 2021.
Bitcoin

FIGURE 6.1 Bitcoin

Bitcoin's monetary value is historically very volatile and experienced major
changes in 2020 and 2021.
Example of Hyperinflation
In the early 2000s, Zimbabwe experienced a period of such rapid
hyper-inflation that money printed there held almost no value (1
trillion Zimbabwean dollars could not even buy an apple).

FIGURE 6.2 Worthless

Zimbabwean dollars
Hyperinflation left the
Zimbabwean dollar worthless.
This man displays millions of
Zimbabwean dollars on his
hat; using the useless dollars
for decoration.
https://en.wikipedia.org/wiki/Hyperinflation
Understanding Exchange Rates
Key terms:
• 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
• 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
Exchange Rates
Imagine Apple Inc. wants to open stores in England (Figure 6.3). To finance the
stores’ rent and payroll and pay its taxes, Apple will need to sell U.S. dollars
and acquire British pounds (£). The actual cost for a U.S. company to rent a
store in the United Kingdom thus depends not only on the price of the store
space in British pounds but also on the price of the British pound in U.S.
dollars, because the company will first have to acquire the currency it needs to
do business in England.

FIGURE 6.3 Apple in England The actual

cost for a U.S. company to rent a store
in the United Kingdom depends not
only on the price of the space in British
pounds but also on the price of the
British pound in U.S. dollars.
Government Policy and Currency
Four main types of government policy that affect currency
valuations and foreign exchange rates:
• Float
• Managed Float
• Peg
• Dollarization

Gold Standard and Bretton Woods

Countries that peg their currency to
the U.S

FIGURE 6.4 Pegged currencies This map indicates countries that peg their
currencies to the U.S. dollar, the euro, or a basket of other currencies.
 What Institutions Make Foreign
Exchange Happen?

FIGURE 6.5 Institutions That Facilitate Foreign Exchange

The over six trillion average daily foreign exchange market if facilitated by both financial
and non-financial institutions.
 Facilitating Exchange through U.S.
Dollars
The use of U.S. dollars facilitates exchange. For instance, if a company wanted to
trade kip (the currency in Laos for pesos (the currency in Chile), it might have to
trade kip for U.S. dollars and then the dollars for pesos, because few companies,
governments, or individuals likely are seeking to trade kip for pesos in a given day.

FIGURE 6.6 A 10,000 kip

note (Laos), alongside a
2,000 peso note (Chile)
Most transactions move
through U.S. dollars
rather directly from
other currencies. A
move from kip to pesos
would most likely trade
to U.S. dollars first.
 Foreign Exchange Spread

FIGURE 6.7 How the Spread Operates in Foreign Exchange Transactions

Determining Exchange Rates
So how, exactly, do we determine an exchange rate?
The formula is simple:

where e is the exchange rate, P* represents the price of the

foreign currency, and P is the price of the domestic currency.
• The currency you are holding and want to trade is the
domestic currency.
• For instance, if you want to trade U.S. dollars for euros when
the exchange rate is €0.80 to US$1, the dollar is the domestic
currency, and the equation will look like this: 0.8=€x/US$1
Euro to U.S. Dollar Exchange Rate

FIGURE 6.8 Euro to U.S. Dollar Exchange Rate

The exchange rate between euros and dollars has ranged
between 0.83 to 1.59 dollars per euro over the past few years.
Undervalued Currency

Changes in the Example:

price of currency The Chinese government has made
can have huge a concerted attempt to keep its
implications for a currency valuation low. Because of
country’s foreign those efforts, Chinese goods are
trade and comparatively cheap on the world
investment market, fueling demand for them,
encouraging the development of
Chinese industry, and driving
employment in the country.
Big Mac Index
1. Popular scale for figuring out whether a currency is
over- or undervalued.
2. Tool is now standard and well-studied.
3. Compares Big Mac to the equivalent cost of a Big Mac in
other countries.
4. Compares Big Mac to the actual exchange rates.
Big Mac Index Illustration

FIGURE 6.9 Local Currency Value Relative to the U.S. Dollar

According to the Big Mac Index
In 2019, the Chinese yuan was undervalued against the U.S. dollar
by 45 percent.
Overvalued Currency

Changes in the price of Why would a country want an

currency can have huge overvalued currency?
implications for a 1. It makes imports cheaper. The
country’s foreign trade cost of buying foreign goods
and investment. or taking a foreign vacation
goes down with an overvalued
domestic currency.
2. An overvalued currency can
make foreign debt
comparatively cheaper to pay
off.
 Understanding and Managing
Exchange Rate Risk

FIGURE 6.10 Foreign Exchange Risk

Foreign exchange entails three types of risk: transaction exposure,
translation exposure, and economic exposure.
 Forward Rate for Exchange
The forward rate is a prediction of future spot rates. In this way,
the company again bypasses uncertainty in the currency market
and locks in an acceptable rate.

TABLE 6.1 Forward rate for British pound–to–U.S. dollar exchange,

2022
This table shows the spot and forward rates for exchanging British
pounds for U.S. dollars in August 2022 and June 2023. It suggests
that the pound will depreciate from the current rate of 1.227 to
1.219 per U.S. dollar in August 2022, and further to 1.216 per U.S.
dollar in June 2023.
Forward Rate for Exchange
Predicting Exchange Rate Shifts
Four key indicators may help predict future exchange
rates:
• Economic Growth
• Foreign Direct Investment
• Monetary and Fiscal Policies
• Political Stability

Black
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