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INTRODUCTION TO THE GLOBAL MONETARY SYSTEM
THE GLOBAL MONETARY SYSTEM
➢ The global monetary system refers to a system that forms rules and standards for
facilitating international trade among the nations and helps in relocating the capital and
investment from one nation to another
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➢ Hence, as companies engage in global trade, they rely on the ability to exchange one
currency for another, making the foreign exchange market crucial for smooth
international transactions
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➢ It is the lubricant that enables companies based in countries that use different currencies
to trade with each other
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How does the exchange work?
➢ It all revolves around something called the exchange rate
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For example:
❖ If a company in the U
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S
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TWO MAIN FUNCTIONS OF THE FOREIGN EXCHANGE MARKET:
1
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2
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CURRENCY CONVERSION
The exchange rate is the rate at which the market converts one currency into another
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Tourists are minor participants in the foreign exchange market; companies engaged in
international trade and investment are major ones
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1
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2
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3
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4
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➢ However, in general, companies should beware, for speculation by definition is a
very risky business
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While a speculator may profit handsomely if his speculation about
future currency movements turns out to be correct, he can also lose vast amounts
of money if it turns out to be wrong
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➢ The carry trade involves borrowing in one currency where interest rates are low and then
using the proceeds to invest in another currency where interest rates are high
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2
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To manage this risk,
firms utilize various financial strategies, including spot exchange rates, forward exchange rates,
and currency swaps
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➢ Forward exchange rates, on the other hand, allow businesses to lock in an exchange rate
for a future transaction, providing a hedge against potential adverse currency movements
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➢ Currency swaps are another effective tool for managing foreign exchange risk
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This enables companies to manage their currency
exposure while facilitating international transactions
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● Major secondary trading centers include Frankfurt, Paris, Hong Kong, and Sydney
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Today, London’s central position between
Tokyo and Singapore to the east and New York to the west has made it the critical link
between the East Asian and New York markets
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● The market is the integration of the various trading centers
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The integration of financial centers implies there can be no significant difference in
exchange rates quoted in the trading centers
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● The important role played by the U
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dollar
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Due to
its central role in so many foreign exchange deals, the dollar is a vehicle currency
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3 FACTORS OF EXCHANGE RATE MOVEMENTS
1
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Interest rate
3
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Specifically, a country experiencing high inflation is expected to
see its currency depreciate against those of countries with lower inflation rates
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Inflation - Is a monetary phenomenon
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Example, if everyone in the country was suddenly given 100,000 by the government
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There would be a surge in demand for goods and
services
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With that, price inflation is observed
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It includes various forms of money, such as cash, coins, and balances held in
checking and savings accounts
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An increase in the money supply makes it easier for banks to borrow
from the government and for individuals and companies to borrow from banks
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Unless the output of goods
and services are growing at a rate similar to that of the money supply, the result will be inflation
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Note: when the growth in a country’s money supply is faster than the growth in its output, price
inflation is fueled
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PRICE AND EXCHANGE RATES
The Law of One Price
-In competitive markets free of transportation costs and barriers to trade (such as tariffs),
identical products sold in different countries must sell for the same price when their price is
expressed in terms of the
same currency
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It involves buying a product or security in one market at a
lower price and simultaneously selling it in another market at a higher price, thereby profiting
from the price
discrepancy
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Impact of Inflation on PPP - PPP adjustments with inflation: If prices rise due to
inflation, currencies depreciate to maintain PPP
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● Long-Term Success - works best over long time horizons
● Short-Term Issues - performs poorly in the short run (periods shorter than 5 years)
Purchasing Power Parity Puzzle
● The Purchasing Power Parity Puzzle is when the disparity in results across different
economic environments
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Factors Limiting PPP Theory’s Accuracy
1
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2
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3
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Example:
Microsoft Office being sold in the United States and China
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S
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According to PPP theory, arbitrage
should drive prices to equalize
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Few
American consumers would want or be able to use a version that is not in English
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FIXED VS
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Floating interest rates, also known as adjustable or variable rates,
change periodically based on a benchmark index like LIBOR or the prime rate
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INTEREST RATES & EXCHANGE RATES
Interest rates - represent the cost of borrowing money or the return earned on savings
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Nominal interest rate: The stated rate, which includes both the real rate of return and
expected inflation
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Real interest rate: The return on investment or the cost of borrowing, adjusted for
inflation, which reflects the true purchasing power of money
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This economic theory is the Fisher Effect which was proposed by Irving Fisher
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It states that the nominal interest rate
is the sum of the real interest rate and the expected inflation rate
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Exchange rate refers to the value of one country’s currency in relation to another country's
currency
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International Fisher Effect (IFE) - For any two countries, the spot exchange rate should
change in an equal amount but in the opposite direction to the difference in nominal interest rates
between countries
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According
to the International Fisher Effect (IFE), the difference in nominal interest rates (4% in this
case) indicates that the U
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dollar is expected to depreciate by approximately 4% relative to the
Japanese yen over time
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S
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So, if the initial exchange rate was 1 USD = 100 JPY, the IFE predicts that the future exchange
rate will adjust by the interest rate differential, leading to the U
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dollar losing value by 4%
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This example illustrates how the International Fisher Effect suggests that a country with higher
nominal interest rates will see its currency depreciate relative to a country with lower interest
rates
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Examples:
1
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This can be amplified during market
downturns or periods of uncertainty
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Greed - greed can drive investors to chase high returns, leading them to take on excessive
risk or invest in overvalued assets
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3
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Bandwagon effect is a specific example of how investor psychology can lead to irrational
behavior
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Social Proof- People are more likely to do something if they see others doing it
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2
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Investors fear being left behind if they don't jump on the bandwagon,
even if they don't fully understand the underlying reasons for the trend
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Momentum- When an asset price rises, it attracts more buyers, further increasing the
price
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EXCHANGE RATE FORECASTING
A company’s need to predict future exchange rate variation raises the issue of whether it
is worthwhile for the company to invest in exchange services to aid decision making
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First, the Efficient Market School argues that
forward exchange rates already provide the best prediction of future spot exchange rates
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Efficient Market School in exchange rate forecasting
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In an efficient market, these rates are considered the best predictors as they

incorporate all available information, making additional forecasting services potentially
unnecessary
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Although early studies support their reliability, recent research suggests they
may not always be perfect predictors and that more accurate forecasts might be possible with
additional data
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Inefficient market school
• is one in which prices do not reflect all available information
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Example 1: The 1997 Southeast Asian Currency Crisis
• Prior to the Asian financial crisis, exchange rates in Southeast Asia did not reflect the looming
economic and financial problems in the region
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Example 2: The 2008 Financial Crisis and the U
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Dollar
• During the U
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financial crisis, many expected the U
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dollar to weaken
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Forecasting
services did not predict this rise in value, further showing the inefficiency in predicting currency
movements
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Fundamental Analysis and
Technical Analysis
1
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2
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CURRENCY CONVERTIBILITY
Freely convertible- when the country’s government allows both resident and nonresident to
purchase unlimited amounts of a foreign currency with it
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Nonconvertible- When neither residents nor nonresidents are allowed to convert it into foreign
currency
- Companies can deal with the non convertibility problem by engaging in countertrade
-Countertrade refers to a range of a barter like agreements by which goods and
services can be traded by other goods and services

FOREIGN EXCHANGE RATE RISK
The risk introduced into international business transactions by changes in exchange rates is
referred to as foreign exchange risk
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TRANSACTION EXPOSURE is the extent to which the income from individual transactions is
affected by fluctuations in foreign exchange values
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Example:
Si KUKUnOts Inc
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S
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Sa
time sa agreement, ang value sa 1 USD is equal to 55 pesos
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expects to
receive 8, 250,000 pesos
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Translation exposure is concerned with the present
measurement of past events
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This company has a subsidiary in the USA that earns 20
million USD every year
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At the beginning of the year, ang value sa
1 USD is equal to 55 pesos ang ibutang nila na profit is 1
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But, by the end of the year, ang value sa 1 USD is equal to 50 pesos na and ang mareport
na profit is 1 billion pesos nalang
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ECONOMIC EXPOSURE is the extent to which a firm’s future international earning power is
affected by changes in exchange rates
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REDUCING TRANSLATION AND TRANSACTION EXPOSURE
A lead strategy involves attempting to collect foreign currency receivables (payments from
customers) early when a foreign currency is expected to depreciate and paying foreign currency
payables (to suppliers) before they are due when a currency is expected to appreciate
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Because lead and lag strategies can put pressure on a weak currency, many governments limit
leads and lags
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REDUCING ECONOMIC EXPOSURE
The key to reducing economic exposure is to distribute the firm’s productive assets to various
locations so the firm’s long-term financial well-being is not severely affected by adverse changes
in exchange rate
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Central control of exposure - is needed to protect resources efficiently and ensure that
each sub-unit adopts the correct mix of tactics and strategies that set guidelines for the firm’s
subsidiaries to follow
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Distinguish between different types of exposure – firms need to distinguish between
transaction exposure, translation exposure, and economic exposure, they must develop strategies
on how to deal with each kind of the exposure
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Forecasting future exchange rate movements – means predicting future movements in
foreign exchange rates
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4
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Such reporting systems should enable the firm to identify any exposed accounts, the
exposed position by currency of each account, and the time periods covered
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(n
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In International business competing in the global market
(13th

ed
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294–348)
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urbeuniversity
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