17: International Investment DecisionsThis chapter focuses on the problems and
opportunities companies face as a result of
globalisation, with special emphasis on currency-
related issues. We explain the rudimentary
features of currency markets, including howand why currencies are traded and the rules
governments impose on trading in their
currencies. We conclude by illustrating how
operating across national borders affects capital
budgeting analysis.17-1 EXCHANGE RATE FUNDAMENTALS
We begin our coverage of exchange rate fundamentals by describing the ‘rules of the game’ as dictated
by national governments.17-1a FIXED VERSUS FLOATING EXCHANGE RATES
Since the mid-1970s, most of the world’s major currencies have had a floating exchange rate relationship
with respect to the US dollar and to one another, which means that forces of supply and demand
continuously move currency values up and down (the yuan being a major exception). The opposite of a
floating exchange rate regime is a fixed exchange rate system. Under a fixed-rate system, governments fix (or peg)
their currency’s value, usually in terms of another currency, such as the US dollar. Once a government
pegs the currency at a particular value, it must stand ready to pursue economic and financial policies
necessary to maintain that value. For example, if demand for the currency increases, the government
must be ready to sell currency so that the increase in demand does not cause the currency to appreciate.
If demand for the currency falls, the government must buy its own currency to prevent the currency from
depreciating. In many countries with fixed exchange rates, governments impose restrictions on the free
flow of currencies into and out of the country. Even so, maintaining a currency peg can be quite difficult.
For example, in response to mounting economic problems, the government of Argentina allowed the
peso, which had been linked to the US dollar, to float freely for the first time in a decade on 11 January- After one day, the peso lost more than 40% of its value relative to the dollar.
Some countries have adopted hybrid currency systems in which the currency is neither pegged nor
allowed to float freely. A managed floating rate system is a hybrid in which a nation’s government loosely
‘fixes’ the value of the national currency in relation to that of another currency, but does not expend
the effort and resources that would be required to maintain a completely fixed exchange rate regime.
Other countries simply choose to use another nation’s currency as their own, and a handful of nations
have adopted a currency board arrangement. In such an arrangement, the national currency continues to
circulate, but every unit of the currency is fully backed by government holdings of another currency –
usually the US dollar.
The International Monetary Fund, in its Annual Report on Exchange Arrangements 2014, details the
exchange rate systems in place for 188 countries and three territories. As can be seen from Table 17.1,
in October 2014, only 15.2% (29 countries) had independently floating exchange rates. In contrast, 6.8%
(13 IMF members) used another currency as their country’s legal tender.
LO 17.1
floating exchange rate
An exchange rate system
in which a currency’s value
is allowed to fluctuate in
response to market forces
fixed exchange rate
An exchange rate system
in which the price of one
currency is fixed relative
to another currency by
government authoritiesmanaged floating rate
system
A hybrid currency system in
which a government loosely
fixes the value of the national
currency relative to one or
more other currencies
currency board
arrangement
An exchange rate system
in which each unit of the
domestic currency is backed
by a unit of some foreign
currency