International Corporate Finance

This textbook is an invalueable resource on a wide range of issues regarding currencies.  This brief summary barely scratches the surface of the deep pools of knowledge contained inside.  We will focus this summary on exchange rate policy and the concept of Purchasing Power Parity.

Exchange Rate Policy

After World War 2, 44 allied nations met at Mount Washington Hotel in Bretton-Woods New Hampshire to discuss the future of monetary policy.

This agreement (known as Bretton-Woods) would establish an exchange rate policy where every country was pegged to the US dollar, and the US dollar was pegged to gold.

The goal was to have the exchange rates fluctuate very little by having a controlled and tightly managed band by which the countries’ Central banks could buy and sell their currencies to keep the exchange rate within the band.

In addition, the Bretton-Woods agreement formed the International Monetary Fund (IMF) to help countries manage this trading peg band and any balance of payments crises.

The goal of a gold standard is to control inflation by having a limited supply of money.  Unfortunately, the United States did not honor its commitment to trade US dollars for gold because it printed so many US dollars to fund the Vietnam War and social programs.

France’s president Charles de Gaulle was outraged by the United States forcing the rest of the world to eat its inflation.

President Richard Nixon in 1971 officially took the US dollar off the gold standard.  This created a lot of volatility in the markets referred to as the ‘Nixon Shock’.

Now different countries currencies float, meaning the market decides what their exchange rates will be.  This can lead to significant changes in the values of currencies.

The European countries decided that they wanted to stabilize their exchange rates against each other and began to form the European Monetary System’s Snake in a Tunnel.  We discussed this situation in greater depth with a summary article of the book the Euro by David Marsh.

In 1997, there was a crisis with Asian countries currencies suffering rapid depreciation.  Some commentators believe this crisis was due to the companies and governments in Southeast Asia borrowing US dollars for the lower interest rate and then using or lending their local currencies to get the appreciation during good times.  Once the exchange rate reversed, the debt became un-payable.

Exchange Rate Freedom

Different countries allowed greater degrees of freedom in their exchange rate as time passed.  The expression a “clean float” is used to refer to a currency whose value is freely allowed to be decided by market forces, this textbook uses the example the US dollar.  A “dirty float” is when the Central bank sometimes allows market forces to determine the value but often intervenes in the market to influence it, for example the Japanese yen.  A controlled currency or low convertibility is when the Central bank dictates the rate.  This chart shows the changes in currencies’ regimes through time.

Purchase Power Parity

Purchasing Power Parity refers to the theory that 2 currencies should be able to buy the same amount of goods and services in their respective nations. 

The Economist magazine publishes the Big Mac Index, which compares the cost of a McDonalds Big Mac in different countries.

According to the theory of Purchasing Power Parity, countries with a more expensive bundle of goods should have their currencies depreciate, and countries with a cheaper burger should have their currencies appreciate.

This textbook computes the Purchasing Power Parity (PPP) of Japan through the 80s financial bubble.  Here you can see from a chart comparing the PPP to the USD/JPY. Please ignore their mislabeling JPY/USD, when it’s actually USD/JPY.

This textbook says the PPP is a better predictor of overvaluation than undervaluation. They gave the example of Brazil’s Big Mac Index spiking before its July 2012 depreciation.  I downloaded the Big Mac Index values from Quandl.com and compared them to the exchange rate. This chart below is not in the textbook; I made it.