International Business (Intl Biz) 101: International Finance - Exchange Rate Systems, Floating Fixed Managed Float Pegged Currency Board Dollarization Crawling Peg

What This Is

Exchange rate systems determine how a country's currency value is set in relation to other currencies. This matters for international business as it affects trade, investment, and profit margins. For instance, IKEA's Swedish krona is pegged to the euro, which helps the company maintain stable prices and supply chains across Europe.

Key Theories & Frameworks

• Floating Exchange Rate: A currency's value is determined by market forces, with no government intervention. This system is used by countries like the US and UK, and it allows for flexibility in monetary policy. Practical implication: Companies like Apple and Toyota can adjust their prices and production costs in response to changes in exchange rates.
• Fixed Exchange Rate: A currency's value is fixed to another currency or a basket of currencies. This system is used by countries like China and Hong Kong, and it provides stability for trade and investment. Practical implication: Companies like HSBC and Walmart can benefit from stable exchange rates when trading with countries that have fixed exchange rates.
• Managed Float: A currency's value is allowed to float, but the government intervenes to influence the exchange rate. This system is used by countries like Japan and Australia, and it allows for some flexibility in monetary policy. Practical implication: Companies like Toyota and McDonald's can benefit from a managed float when trading with countries that have a similar economic profile.
• Pegged Exchange Rate (Currency Board): A currency's value is fixed to another currency, with a currency board that issues and manages the currency. This system is used by countries like Hong Kong and Singapore, and it provides stability for trade and investment. Practical implication: Companies like HSBC and DBS can benefit from stable exchange rates when trading with countries that have a currency board.
• Pegged Exchange Rate (Dollarization): A country adopts another country's currency as its own, with no exchange rate risk. This system is used by countries like Ecuador and El Salvador, and it provides stability for trade and investment. Practical implication: Companies like Walmart and McDonald's can benefit from stable exchange rates when trading with countries that have dollarized their currency.
• Crawling Peg: A currency's value is allowed to float, but the government intervenes to influence the exchange rate, with a gradual adjustment to the peg. This system is used by countries like Brazil and Mexico, and it allows for some flexibility in monetary policy. Practical implication: Companies like Toyota and Volkswagen can benefit from a crawling peg when trading with countries that have a similar economic profile.
• Monetary Policy: A country's central bank uses interest rates and money supply to influence the exchange rate. This system is used by countries like the US and UK, and it allows for flexibility in monetary policy. Practical implication: Companies like Apple and Toyota can benefit from a country's monetary policy when trading with countries that have a similar economic profile.
• Exchange Rate Risk: The risk that changes in exchange rates will affect a company's profits and cash flows. This risk is managed through hedging and other risk management techniques. Practical implication: Companies like HSBC and DBS can benefit from managing exchange rate risk when trading with countries that have volatile exchange rates.
• Balance of Payments: A country's balance of trade, investment, and other economic transactions with the rest of the world. This system is used by countries like the US and UK, and it provides information on a country's economic performance. Practical implication: Companies like Toyota and Volkswagen can benefit from understanding a country's balance of payments when trading with countries that have a similar economic profile.

Step-by-Step Application

1. Analyze a country's exchange rate system: Determine the type of exchange rate system used by a country and its implications for trade and investment.
2. Assess exchange rate risk: Evaluate the risk that changes in exchange rates will affect a company's profits and cash flows.
3. Choose an entry mode: Select an entry mode (e.g., export, FDI, licensing) based on a country's exchange rate system and other factors.
4. Evaluate a potential FDI location: Assess the attractiveness of a country for FDI based on its exchange rate system, economic stability, and other factors.
5. Develop a currency risk management strategy: Manage exchange rate risk through hedging and other risk management techniques.

Common Mistakes

• Mistake: Assuming that a country's exchange rate system is fixed or floating, without considering other factors.
• Correction: Analyze a country's exchange rate system and its implications for trade and investment.
• Mistake: Failing to consider exchange rate risk when trading with countries that have volatile exchange rates.
• Correction: Assess exchange rate risk and develop a currency risk management strategy.
• Mistake: Assuming that a country's balance of payments is a reliable indicator of its economic performance.
• Correction: Evaluate a country's balance of payments in conjunction with other economic indicators.

Exam / Case Interview Tips

• Be prepared to analyze a country's exchange rate system: Understand the implications of different exchange rate systems for trade and investment.
• Assess exchange rate risk: Evaluate the risk that changes in exchange rates will affect a company's profits and cash flows.
• Choose the right entry mode: Select an entry mode based on a country's exchange rate system and other factors.
• Develop a currency risk management strategy: Manage exchange rate risk through hedging and other risk management techniques.

Quick Practice Scenario

Scenario: A Brazilian firm wants to enter Germany – what entry mode is lowest risk?

Answer: Exporting or licensing would be the lowest risk entry mode, as it would allow the firm to maintain control over its operations and minimize exposure to exchange rate risk.

Last-Minute Cram Sheet

• Floating exchange rate: A currency's value is determined by market forces, with no government intervention.
• Fixed exchange rate: A currency's value is fixed to another currency or a basket of currencies.
• Managed float: A currency's value is allowed to float, but the government intervenes to influence the exchange rate.
• Pegged exchange rate (currency board): A currency's value is fixed to another currency, with a currency board that issues and manages the currency.
• Pegged exchange rate (dollarization): A country adopts another country's currency as its own, with no exchange rate risk.
• Crawling peg: A currency's value is allowed to float, but the government intervenes to influence the exchange rate, with a gradual adjustment to the peg.
• Monetary policy: A country's central bank uses interest rates and money supply to influence the exchange rate.
• Exchange rate risk: The risk that changes in exchange rates will affect a company's profits and cash flows.
• Balance of payments: A country's balance of trade, investment, and other economic transactions with the rest of the world.
• Absolute advantage is different from comparative advantage – absolute means lower cost of production; comparative means lower opportunity cost, which always exists even if one country is better at everything.