International Monetary System

Question 1

What is the IMS?

Answer 1

System of exchange rates and international payments that facilitates trade and investment

Question 2

What is a pegged exchange rate system?

Answer 2

value fixed to a reference country or to basket of currencies

Question 3

What is a dirty float?

Answer 3

rying to hold the value of currency in some range without pegging - China

Question 4

What is true of the distribution of exchange rate regimes around the world?

Answer 4

Minority of countries have a floating currency

Question 5

What is a currency board and how does it work?

Answer 5

• Commitment to converting domestic currency on demand into another at a fixed rate
• Must hold reserved of foreign currency equal to at least 100% of the domestic currency issued e.g. Hong Kong holding US dollars
• Not truly fixed as US dollar still floats and therefore Hong Kong does too
• Interest rates automatically adjust by market forces - no ability for Hong Kong government to set them, effectively set by the Fed
• Inflation kept at bay because of reserve requirement

Question 6

What is the case for a floating exchange rate?

Answer 6

• Monetary policy autonomy
• Help with trade balance adjustment
• Can help deal with economic crisis
  
  • Currency becomes so cheap that exports start to be stimulated
  • Counter argument that it won’t, and will only increase inflation through higher import prices

Question 7

What is the case for a fixed exchange rate?

Answer 7

• Monetary discipline - low inflation (or same as peg country)
• Speculation limited
  
  • Uncertainty reduced

Question 8

What kids of IMS crises are there and what is true of all of them?

Answer 8

• Currency Crisis
• Banking crisis
• Foreign Debt crisis
• Tend to all involve high relative inflation, widening current account deficit, excessive expansion of domestic borrowing, high government deficit and asset price inflation

Question 9

What is a currency crisis?

Answer 9

When a speculative attack on the exchange rate results in a sharp depreciation or forces authorities to expend large volumes of international currency reserves and sharply increase interest rates to defend prevailing rates

Question 10

What is a banking crisis?

Answer 10

A loss of confidence in the banking system that leads to a run on banks

Question 11

What is a foreign debt crisis?

Answer 11

Situation in which a country cannot service its foreign debt obligations

Question 12

What are the objectives of the IMF?

Answer 12

• Ensure stability of the IMS
• Promote international monetary cooperation and exchange rate stability
• Facilitate the balanced growth on international trade
• Provide resources to help members in BoP difficulties or to assist with poverty reduction

Question 13

What are the criticisms of the IMF?

Answer 13

• One size fits all approach to policies are inapporproate for many countries
• IMF is exacerbating moral hazard - when people behave recklessly because they know they will be saved if things go wrong
• Has become to powerful for an institution without any real mechanism for accountability
• In recent years, has started to change its policies and be more flexible

Question 14

What is the world banks mission and main departments?

Answer 14

• Mission: global poverty reduction and improvement of living standards
• International Bank for Reconstruction and Development
  
  • Middle income and credit worth poor countries
• International Development Association
  
  • Poorest countries in the world

Question 15

What is the international capital market, what does it do and what kind of loans are extended?

Answer 15

• International network of individuals, companies, financial institutions, governments investing/borrowing across national boundaries
• Capital markets bring together investors and borrowers
• Capital markets loans can be equity or debt

Question 16

What is the difference between commercial and investment banks?

Answer 16

• Commercial banks perform an indirect connection function by taking cash deposits, paying them a rate of interest and lending their deposits at higher rate
• Investment banks performa a direct connection function by bringing investors and borrowers together and charging commission for doing so

Question 17

What is the difference between equity and debt loans?

Answer 17

• Equity loans are made when a corporation sells stocks and a claim to the firms profit stream to investors
• Debt loans require the corporation to repay a predetermined portion of the loan amount at regular intervals regardless of profit levels

Question 18

What are the important factors of portfolio diversification?

Answer 18

• Portfolio risk decreases with greater diversification but with decreasing marginal benefit as it approaches the level of systematic risk - the movements in a portfolio’s value that are attributable to macroeconomic forces, i.e. nondiversifiable risk
• By diversifying internationally, the overall exposure to systematic risk can be reduced
• However exchange rate volatily becomes more of a risk

Question 19

Why does diversifying internationally reduce overall exposure to systematic risk?

Answer 19

International stock markets are relatively uncorrelated because of different macro policies and capital control segmentation

Question 20

What are the purposes of the international capital market?

Answer 20

• Expanding money supply for borrowers
• Reducing cost of money for borrowers
• Reducing risk for lenders

Question 21

What are the pros and cons of the international capital market?

Answer 21

• Today’s capital markets are highly interconnected and facilitate the free flow of money around the world
• Borrowers benefit from the additional supply of funds global capital markets provide
  
  • Lowers the cost of capital
• Investors benefit from the wider range of investment opportunities
  
  • Diversify portfolios and lower risk
• But, volatile exchange rates can make what would otherwise be profitable investment unprofitable

Question 22

What are the forces accelerating the expansion of the international capital market?

Answer 22

• Information technology
• Deregulation
• More financial instruments

Question 23

In regard to the international capital market how can money be divided and how does this occur

Answer 23

• Hot money - short term capital flows
• Patient money - long term capital flows
• Deregulation may be leading to individual nations becoming more vulnerable to speculative capital flows
• Lack of patient money is due to relative paucity of information that investors have about foreign investments - if they had better information about foreign assts, the global capital market would be less subject to short term speculative capital flows

Question 24

What is a eurocurrency?

Answer 24

Any currency banked outside its country of origin

Question 25

What is true of eurocurrencies?

Answer 25

- About 2/3 are of all eurocurrencies are Eurodollars - Dollars banked outside the US - Other important: euro-yen, euro-pound, euro-euro - Market is important source of low cost funds for international companies

Question 26

What are the pros and cons of the eurocurrency market?

Answer 26

- Pros - Not regulated so banks can offer higher deposit rates and lower lending rates - competitive advantatge over domestic banks - Cons - Higher risk of losing funds as not regulated - Companies borrowing eurocurrencies are exposed to foreign exchange risk

Question 27

What is the international bond market and what kinds of bonds are sold?

Answer 27

- All bonds sold by issuing companies, governments or their organisations outside their home countries - Foreign Bonds - Euro Bonds

Question 28

What has been the trend in the international bond market and what has been the effect?

Answer 28

- Rapid growth during 1990s due to low interest rates - Causing investors to look worldwide for bonds paying higher interest rates, such as junk bond - Problems - Higher returns = higher risk - Currency risk for borrowers

Question 29

What are the pros of the international bond market?

Answer 29

- Lacks regualtory interference - Cost of issuing bonds is lower - Less stringent disclosure requirements than domestic bond markets - Cheaper and less time consuming - It is more favourable from a tax perspective - Eurobonds can be sold directly to foreign investors

Question 30

What are foreign bonds (vs euro bonds)?

Answer 30

- Denominated in own currency | - Denominated in currency of country where they are sold

Question 31

What are euro bonds?

Answer 31

- Normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated - Routinely issues by MNCs, large domestic corporations, sovereign governments and international institutions. - Can be offered simultaneously in several national capital markets, but not in the capital market of the country, nor to residents of the country, in whose currency they are denominated

Question 32

What is the global equity market?

Answer 32

No global equity market in the sense that there are international currency and bond markets. Rather, may countries have their own domestic equity markets in which corporate stock is traded

Question 33

What does the global equity market allow firms to do?

Answer 33

- Attract capital from international investors - Many investors buy foreign equities to diversify their portfolios - List their stock on multiple exchanges - Internationalisation of corporate ownership - Raise funds by issuing debt or equity around the world - By issuing stock in other countries, firms open the door to raising capital in the foreign market - Gives the firms the options of compensating local managers and employees with stock - Provides for local ownership - Increases visibility with local stakeholders

Question 34

What are the exchange rate effects on the cost of capital?

Answer 34

- Adverse exchange rates can increase the cost of foreign currency loans - While it may initially seem attractive to borrow foreign currencies, when exchange rate risk is factored in, that can change - Firms can hedge their risk by entering into forward contracts, but this will also raise costs - Firms must weight the benefits of a lower interest rate against the risk of an increase in the real cost of capital