PDF International Monetary and Financial System

MBA- H4030

UNIT ? I

International Business Finance

INTERNATIONAL MONETARY AND FINANCIAL SYSTEM

Objectives:

After studying this unit, you should be able to understand the: * Concept of International Monetary and Financial System: * Importance of international finance; * Bretton woods conference and afterwards developments; * Role of IMF and the World Bank in International business; * Meaning and scope of European monetary system.

Structure:

Introduction Currency terminology History of International Monetary System Inter-war years and world war II Bretton Woods and the International Monetary Fund, 1944-73. Exchange Rate Regime, 1973-85 1985 to date : The era of the managed float Current International Financial System International Monetary Fund (IMF) The IMF's Exchange Rate Regime classifications Fixed vs. Flexible Exchange Rates Determination of Exchange Rate World Bank European Monetary System European Bank of Investment (EBI) European Monetary Union (EMU) Foreign Exchange Markets International Financial Markets Summary Further Readings

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MBA- H4030

INTRODUCTION

International Business Finance

The international monetary system is the framework within which countries borrow, lend, buy, sell and make payments across political frontiers. The framework determines how balance of payments disequilibriam is resolved. Numerous frameworks are possible and most have been tried in one form or another. Today's system is a combination of several different frameworks. The increased volatility of exchange rate is one of the main economic developments of the past 40 years. Under the current system of partly floating and partly fixed undergo real and paper fluctuations as a result of changes in exchange rates. Policies for forecasting and reacting to exchange rate fluctuations are still evolving as we improve our understanding of the international monetary system, accounting and tax rules for foreign exchange gains and losses, and the economic effect of exchange rate changes on future cash flows and market values.

Although volatile exchange rate increase risk, they also create profit opportunities for firms and investors, given a proper understanding of exchange risk management. In order to manage foreign exchange risk, however, management must first understand how the international monetary system functions. The international monetary system is the structure within which foreign exchange rates are determined, international trade and capital flows are accommodated, and balance-of-payments (BoP) adjustments made. All of the instruments, institutions, and agreements that link together the world's currency, money markets, securities, real estate, and commodity markets are also encompassed within that term.

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MBA- H4030

CURRENCY TERMINOLOGY

International Business Finance

Let us begin with some terms in order to prevent confusion in reading this unit:

A foreign currency exchange rate or simply exchange rate, is the price of one country's currency in units of another currency or commodity (typically gold or silver). If the government of a country- for example, Argentina- regulates the rate at which its currency- the peso- is exchanged for other currencies, the system or regime is classified as a fixed or managed exchange rate regime. The rate at which the currency is fixed, or pegged, is frequently referred to as its par value. if the government does not interfere in the valuation of its currency in any way, we classify the currency as floating or flexible.

Spot exchange rate is the quoted price for foreign exchange to be delivered at once, or in two days for inter-bank transactions. For example, ?114/$ is a quote for the exchange rate between the Japanese yen and the U.S. dollar. We would need 114 yen to buy one U.S. dollar for immediate delivery.

Forward rate is the quoted price for foreign exchange to be delivered at a specified date in future. For example, assume the 90-day forward rate for the Japanese yen is quoted as ?112/$. No currency is exchanged today, but in 90 days it will take 112 yen to buy one U.S. dollar. This can be guaranteed by a forward exchange contract.

Forward premium or discount is the percentage difference between the spot and forward exchange rate. To calculate this, using quotes from the previous two examples, one formula is:

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MBA- H4030

International Business Finance

S ? F 360

?114/$ - ?112/$

360

-------- X ------- X 100 = -------------------- X ------ X100 = 7.14%

F

n

?112/$

90

Where S is the spot exchange rate, F is the forward rate, and n is the number of

days until the forward contract becomes due.

Devaluation of a currency refers to a drop in foreign exchange value of a currency that is pegged to gold or to another currency. In other words, the par value is reduced. The opposite of devaluation is revaluation. To calculate devaluation as a percentage, one formula is:

Beginning rate ? ending rate Percentage change = ------------------------------------------

Ending rate Weakening, deterioration, or depreciation of a currency refers to a drop in the foreign exchange value of a floating currency. The opposite of weakening is strengthening or appreciating, which refers to a gain in the exchange value of a floating currency.

Soft or weak describes a currency that is expected to devalue or depreciate relative to major currencies. It also refers to currencies whose values are being artificially sustained by their governments. A currency is considered hard or strong if it is expected to revalue or appreciate relative to major trading currencies.

The next section presents a brief history of the international monetary system form the days of the classical gold standard to the present time.

INTERNATIONAL MONETARY SYSTEM

Over the ages, currencies have been defined in terms of gold and other items of value, and the international monetary system has been the subject of a

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MBA- H4030

International Business Finance

variety of international agreements. A review of these systems provides a useful

perspective from which to understand today's system and to evaluate weakness

and proposed changes in the present system.

The Gold Standard, 1876-1913

Since the days of the Pharaohs (about 3000 B.C.), gold has served as a medium of exchange and a store of value. the Greeks and Romans used gold coins and passed on this through the mercantile era to the nineteenth century. The great increase in trade during the free-trade period of the late nineteenth century led to a need for a more formalized system for settling international trade balances. One country after another set a par value for its currency in terms f gold and then tried to adhere to the so-called "rules of the game". This later came to be known as the classical gold standard. The gold standard as an international monetary system gained acceptance in Western Europe in the 1870s. the United States was something of a latecomer to the system, not officially adopting the standard until 1879.

The "rules of the game" under the gold standard were clear and simple. Each country set the rate at which its currency unit could be converted to a weight of gold. The United States, for example, declared the dollar to be convertible to gold at a rate of $20.67 per ounce of gold (a rate in effect until the beginning of World War I). The British pound was pegged at ?4.2474 per ounce of gold. As long as both currencies were freely convertible into gold, the dollar/pound exchange was:

$20.67/ounce of gold ----------------------------- = $4.8665 / ? ?4.2474/ounce of gold

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