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Calculating par values against the dollar and gold. In 1958, the French franc (FF) was defined as worth 1/175 ounce of gold. What was the FF’s par value against the dollar? What were the floor and ceiling exchange rates within which the French franc was allowed to fluctuate? I have added multiple images from the textbook for your reference to see if you can find the solution. Please check the images.

Calculating par values against the dollar and gold. In 1958, the French franc (FF) was defined as worth 1/175 ounce of gold. What was the FF’s par value against the dollar? What were the floor and ceiling exchange rates within which the French franc was allowed to fluctuate? I have added multiple images from the textbook for your reference to see if you can find the solution. Please check the images.

Essentials Of Investments
Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
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Calculating par values against the dollar and gold. In 1958, the French franc (FF) was defined as worth 1/175 ounce of gold. What was the FF’s par value against the dollar? What were the floor and ceiling exchange rates within which the French franc was allowed to fluctuate?

I have added multiple images from the textbook for your reference to see if you can find the solution. Please check the images. 

CHAPTER 3: Yesterday and Yesteryear 1929–1938: The Great Depression plays havoc with the world economy, pushing most coun- tries to protectionism and competitive devaluations. 1944: The Bretton Woods Accord establishes "pegged yet adjustable" exchange rates anchored around publicly defined par values, which are defined in terms of gold. The U.S. dollar is convertible into gold at the par value of $35 = 1 ounce. A modicum of flexibility, howev- er, is allowed as exchange rates are permitted to fluctuate within a narrow band of +/ -0.75 percent around their par values. Central banks closely monitor exchange rate fluc- tuations and intervene when necessary to maintain exchange rates within these narrow bands. 1958: First-world countries start to dismantle exchange controls on current account transac- tions but continue to restrict capital account transactions. The foreign exchange market for the currencies of major industrialized nations takes off. 1971: The Smithsonian Agreement suspends the unconditional convertibility of U.S. dollars into gold. The U.S. dollar is devalued against most Organisation for Economic Co-opera- tion and Development (OECD) currencies, and the permitted bands of exchange rate fluctuations are widened to +/-2.25 percent from +/-0.75 percent under Bretton Woods. 1973: The Bretton Woods system collapses and many countries abandon pegged exchange rates. Most of the first world's currencies trade within floating exchange rate regimes. The U.S. Federal Reserve Bank adopts a passive policy, letting other central banks inter- vene in the foreign exchange market as they see fit. 1979: The European Community's 12 member countries launch the European Monetary Sys- tem (EMS), anchored to a newly created European currency unit (ECU). De facto, a Eu- rope-wide system of pegged exchange rates à la Bretton Woods is reenacted.
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear 1929–1938: The Great Depression plays havoc with the world economy, pushing most coun- tries to protectionism and competitive devaluations. 1944: The Bretton Woods Accord establishes "pegged yet adjustable" exchange rates anchored around publicly defined par values, which are defined in terms of gold. The U.S. dollar is convertible into gold at the par value of $35 = 1 ounce. A modicum of flexibility, howev- er, is allowed as exchange rates are permitted to fluctuate within a narrow band of +/ -0.75 percent around their par values. Central banks closely monitor exchange rate fluc- tuations and intervene when necessary to maintain exchange rates within these narrow bands. 1958: First-world countries start to dismantle exchange controls on current account transac- tions but continue to restrict capital account transactions. The foreign exchange market for the currencies of major industrialized nations takes off. 1971: The Smithsonian Agreement suspends the unconditional convertibility of U.S. dollars into gold. The U.S. dollar is devalued against most Organisation for Economic Co-opera- tion and Development (OECD) currencies, and the permitted bands of exchange rate fluctuations are widened to +/-2.25 percent from +/-0.75 percent under Bretton Woods. 1973: The Bretton Woods system collapses and many countries abandon pegged exchange rates. Most of the first world's currencies trade within floating exchange rate regimes. The U.S. Federal Reserve Bank adopts a passive policy, letting other central banks inter- vene in the foreign exchange market as they see fit. 1979: The European Community's 12 member countries launch the European Monetary Sys- tem (EMS), anchored to a newly created European currency unit (ECU). De facto, a Eu- rope-wide system of pegged exchange rates à la Bretton Woods is reenacted.
CHAPTER 3: Yesterday and Yesteryear Pegged Exchange Rates Not surprisingly, the Bretton Woods Accord called for pegged or fixed exchange rates, with each national currency value defined in terms of gold, also known as par value. The U.S. dollar was, in turn, the only currency convertible into gold at a fixed price of $35 per ounce. In effect, by defining its currency in terms of gold, each country was also defining the value of its national currency in terms of the U.S. dollar. For example, West Germany defined the Deutsche mark as 1/140 ounce of gold, which amounted to $35 × 1/140 = $0.25. The Bretton Woods order %3D became known as the gold exchange standard. As illustrated in Exhibit 3.2, the Bretton Woods system architecture was anchored to the dollar-gold convertible par value while allowing a modicum of flexibility, as all signatory countries would maintain their exchange rates within a ¾ of 1 percent margin on either side of their currency's par value against the U.S. dollar. In theory, this provided the in- ternational economy with lasting stability. Nondollar currencies, of course, could always devalue their par values against the U.S. dollar to restore their national economic competitiveness and resolve fundamental balance-of-payments disequi- librium (which could not otherwise be dealt with by domestic fiscal and monetary policy). Gold ($35/oz)
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear Pegged Exchange Rates Not surprisingly, the Bretton Woods Accord called for pegged or fixed exchange rates, with each national currency value defined in terms of gold, also known as par value. The U.S. dollar was, in turn, the only currency convertible into gold at a fixed price of $35 per ounce. In effect, by defining its currency in terms of gold, each country was also defining the value of its national currency in terms of the U.S. dollar. For example, West Germany defined the Deutsche mark as 1/140 ounce of gold, which amounted to $35 × 1/140 = $0.25. The Bretton Woods order %3D became known as the gold exchange standard. As illustrated in Exhibit 3.2, the Bretton Woods system architecture was anchored to the dollar-gold convertible par value while allowing a modicum of flexibility, as all signatory countries would maintain their exchange rates within a ¾ of 1 percent margin on either side of their currency's par value against the U.S. dollar. In theory, this provided the in- ternational economy with lasting stability. Nondollar currencies, of course, could always devalue their par values against the U.S. dollar to restore their national economic competitiveness and resolve fundamental balance-of-payments disequi- librium (which could not otherwise be dealt with by domestic fiscal and monetary policy). Gold ($35/oz)
gimes CHAPTER 3: Yesterday and Yesteryear EXHIBIT 3.1 Map of Exchange Rate Regimes: Time × Flexibility 1878–1914: Most industrial countries' currencies are on the gold standard-a de facto in- ternational monetary system of fixed exchange rates. The world economy experiences a period of unbridled prosperity-the first era of globalization. 1914: With the outbreak of World War I, belligerent countries suspend the gold standard. Governments print money to finance their war efforts. 1925–1931: Major industrial powers attempt to reenact the gold standard by repegging their currencies to gold. 1929–1938: The Great Depression plays havoc with the world economy, pushing most coun- tries to protectionism and competitive devaluations. 1944: The Bretton Woods Accord establishes “pegged yet adjustable" exchange rates anchored around publicly defined par values, which are defined in terms of gold. The U.S. dollar is convertible into gold at the par value of $35 = 1 ounce. A modicum of flexibility, howev- er, is allowed as exchange rates are permitted to fluctuate within a narrow band of +/ -0.75 percent around their par values. Central banks closely monitor exchange rate fluc- tuations and intervene when necessary to maintain exchange rates within these narrow bands. 1958: First-world countries start to dismantle exchange controls on current account transac- tions but continue to restrict capital account transactions. The foreign exchange market for the currencies of major industrialized nations takes off. 1971: The Smithsonian Agreement suspends the unconditional convertibility of U.S. dollars
Transcribed Image Text:gimes CHAPTER 3: Yesterday and Yesteryear EXHIBIT 3.1 Map of Exchange Rate Regimes: Time × Flexibility 1878–1914: Most industrial countries' currencies are on the gold standard-a de facto in- ternational monetary system of fixed exchange rates. The world economy experiences a period of unbridled prosperity-the first era of globalization. 1914: With the outbreak of World War I, belligerent countries suspend the gold standard. Governments print money to finance their war efforts. 1925–1931: Major industrial powers attempt to reenact the gold standard by repegging their currencies to gold. 1929–1938: The Great Depression plays havoc with the world economy, pushing most coun- tries to protectionism and competitive devaluations. 1944: The Bretton Woods Accord establishes “pegged yet adjustable" exchange rates anchored around publicly defined par values, which are defined in terms of gold. The U.S. dollar is convertible into gold at the par value of $35 = 1 ounce. A modicum of flexibility, howev- er, is allowed as exchange rates are permitted to fluctuate within a narrow band of +/ -0.75 percent around their par values. Central banks closely monitor exchange rate fluc- tuations and intervene when necessary to maintain exchange rates within these narrow bands. 1958: First-world countries start to dismantle exchange controls on current account transac- tions but continue to restrict capital account transactions. The foreign exchange market for the currencies of major industrialized nations takes off. 1971: The Smithsonian Agreement suspends the unconditional convertibility of U.S. dollars
CHAPTER 3: Yesterday and Yesteryear THE BRETTON WOODS SYSTEM (1944–1971) As World War II was drawing to a close, the Allied powers met at Bretton Woods, New Hampshire (United States), in the summer of 1944 (July 1-22) to lay the groundwork for the reconstruction of the world economy. The overarching goal of the conference was to establish a global monetary and financial system that would guarantee the stability and ensure the orderly functioning of the world economy. The economic devastation of the Great Depression, which had played havoc with international trade and investment through competitive "beggar thy neighbor" devaluations and protectionism, was to be avoided at all costs. The Bretton Woods conference established two new supranational agencies- the International Monetary Fund and the International Bank for Reconstruction and Development (also known as the World Bank)–to implement its blueprint for the world economy. The International Monetary Fund was charged with ensuring international monetary stability by overseeing its member countries' exchange rate policies. Today it advises its members on sound monetary and fiscal policies and often acts as a lender of last resort for members experiencing severe balance- of-payments difficulties. It is funded by taxpayers' money from each member country. The World Bank was to provide major funding to countries devastated by the war so that they could rebuild their infrastructures. It now focuses primarily on less developed countries. Like any bank, it funds itself by issuing bonds on ma- jor capital markets. Pegged Exchange Rates
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear THE BRETTON WOODS SYSTEM (1944–1971) As World War II was drawing to a close, the Allied powers met at Bretton Woods, New Hampshire (United States), in the summer of 1944 (July 1-22) to lay the groundwork for the reconstruction of the world economy. The overarching goal of the conference was to establish a global monetary and financial system that would guarantee the stability and ensure the orderly functioning of the world economy. The economic devastation of the Great Depression, which had played havoc with international trade and investment through competitive "beggar thy neighbor" devaluations and protectionism, was to be avoided at all costs. The Bretton Woods conference established two new supranational agencies- the International Monetary Fund and the International Bank for Reconstruction and Development (also known as the World Bank)–to implement its blueprint for the world economy. The International Monetary Fund was charged with ensuring international monetary stability by overseeing its member countries' exchange rate policies. Today it advises its members on sound monetary and fiscal policies and often acts as a lender of last resort for members experiencing severe balance- of-payments difficulties. It is funded by taxpayers' money from each member country. The World Bank was to provide major funding to countries devastated by the war so that they could rebuild their infrastructures. It now focuses primarily on less developed countries. Like any bank, it funds itself by issuing bonds on ma- jor capital markets. Pegged Exchange Rates
mes CHAPTER 3: Yesterday and Yesteryear Napoleon I n May 2, 2010, the euro-zone governments and the International Monetary OFund (IMF) announced a €110 billion rescue plan for beleaguered Greece. The country was mired in sluggish growth, a budget deficit at 13 percent of gross do- mestic product (GDP), and public debt-to-GDP ratio approaching 150 percent. The Greek government was forced to commit to drastic budget reductions in order to avoid bankruptcy. Would and could the Greek government impose so much pain on its citizens in order to remain in the euro-zone and keep the European Mone- tary Union intact? Would the austerity package only makes matters worse and condemn Greece to endless recession? Theoretically, devaluation is not an option since Greece has been an integral part of the European Monetary Union since 2002! Or should Greece simply exit the euro and resurrect a devalued drachma in order to revive economic growth–ultimately perhaps the only (but painful) rem- edy to balance its budget by stimulating revenues? Crises such as the 2010 Greek near default are rooted in a long history of trial and error as countries attempt to adopt the optimal exchange rate regime. This chapter, by presenting a brief histo- ry of the international monetary system, will allow the reader to better under- stand the genesis of ongoing currency crises and therefore better anticipate changes in the rules of currency trading that are themselves so central to sound international financial management. After reading this chapter you will understand: • How the gold standard (1878–1914) was the first system of fixed exchange rates.
Transcribed Image Text:mes CHAPTER 3: Yesterday and Yesteryear Napoleon I n May 2, 2010, the euro-zone governments and the International Monetary OFund (IMF) announced a €110 billion rescue plan for beleaguered Greece. The country was mired in sluggish growth, a budget deficit at 13 percent of gross do- mestic product (GDP), and public debt-to-GDP ratio approaching 150 percent. The Greek government was forced to commit to drastic budget reductions in order to avoid bankruptcy. Would and could the Greek government impose so much pain on its citizens in order to remain in the euro-zone and keep the European Mone- tary Union intact? Would the austerity package only makes matters worse and condemn Greece to endless recession? Theoretically, devaluation is not an option since Greece has been an integral part of the European Monetary Union since 2002! Or should Greece simply exit the euro and resurrect a devalued drachma in order to revive economic growth–ultimately perhaps the only (but painful) rem- edy to balance its budget by stimulating revenues? Crises such as the 2010 Greek near default are rooted in a long history of trial and error as countries attempt to adopt the optimal exchange rate regime. This chapter, by presenting a brief histo- ry of the international monetary system, will allow the reader to better under- stand the genesis of ongoing currency crises and therefore better anticipate changes in the rules of currency trading that are themselves so central to sound international financial management. After reading this chapter you will understand: • How the gold standard (1878–1914) was the first system of fixed exchange rates.
CHAPTER 3: Yesterday and Yesteryear 1982: During the Latin American sovereign debt crisis, Mexico, Brazil, and Argentina default on their sovereign debt obligations in excess of $100 billion. 1985–1987: The Plaza and Louvre Accords call for greater coordination among G-5 countries in intervening in the foreign exchange market. Responsibility for such intervention should be shared among the United States and other countries. Gross overvaluation of the U.S. dollar is corrected. 1989: Collapse of the Soviet Union. Newly emancipated East European satellite countries scrap government-controlled inconvertible currency regimes and adopt market-based systems to trade their currencies. 1992: EMS crisis. The pound sterling and Italian lira are forced to devalue and exit the EMS. Remaining EMS currencies now float within a +/-15 percent band around their respec- tive cross-par values (instead of +/-2.25 percent). EMS is shipwrecked! 1997: Asian financial crisis. East and Southeast Asian currencies are engulfed in a domino- like currency crisis. Thailand, Malaysia, Indonesia, the Philippines, and South Korea are forced to abandon overvalued exchange rates pegged to the U.S. dollar and adopt a tightly managed float. 1999: Launch of the euro-the European Union single currency. Eleven countries join the euro-zone, adopting the euro as their official currency (and therefore burying their na- tional currencies). Britain, Denmark, and Sweden opt out of the euro-zone and decide to retain their own currencies. 2002: Argentina abandons its currency board. Facing a deep economic recession on January 8, 2002, Argentina unpegged its currency from the U.S. dollar; the peso, free to float, promptly lost more than 50 percent of its value.
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear 1982: During the Latin American sovereign debt crisis, Mexico, Brazil, and Argentina default on their sovereign debt obligations in excess of $100 billion. 1985–1987: The Plaza and Louvre Accords call for greater coordination among G-5 countries in intervening in the foreign exchange market. Responsibility for such intervention should be shared among the United States and other countries. Gross overvaluation of the U.S. dollar is corrected. 1989: Collapse of the Soviet Union. Newly emancipated East European satellite countries scrap government-controlled inconvertible currency regimes and adopt market-based systems to trade their currencies. 1992: EMS crisis. The pound sterling and Italian lira are forced to devalue and exit the EMS. Remaining EMS currencies now float within a +/-15 percent band around their respec- tive cross-par values (instead of +/-2.25 percent). EMS is shipwrecked! 1997: Asian financial crisis. East and Southeast Asian currencies are engulfed in a domino- like currency crisis. Thailand, Malaysia, Indonesia, the Philippines, and South Korea are forced to abandon overvalued exchange rates pegged to the U.S. dollar and adopt a tightly managed float. 1999: Launch of the euro-the European Union single currency. Eleven countries join the euro-zone, adopting the euro as their official currency (and therefore burying their na- tional currencies). Britain, Denmark, and Sweden opt out of the euro-zone and decide to retain their own currencies. 2002: Argentina abandons its currency board. Facing a deep economic recession on January 8, 2002, Argentina unpegged its currency from the U.S. dollar; the peso, free to float, promptly lost more than 50 percent of its value.
nes 1821: Great Britain is the first nation to formally declare full convertibility of its banknotes CHAPTER 3: Yesterday and Yesteryear into gold at the “mint" parity of £4.2474 per troy ounce of gold. 1834: The United States formally defines the dollar as 480 fine grains per troy ounce, or US$20.67 per troy ounce, and preserves it until 1933. It formally adopts the gold stan- dard in 1878. Вreakdown of Bretton Woods Collap se of Soviet Empire European Asian Financial Crisis Clean Monetary System Subprime Crisis 2008 FLOATING FX Launch of € 2000 Dirty High Convertibility STABILIZED FX Ruble Low ¥-. Convertibility CONTROLLED FX Yuan Ruble Yuan EXHIBIT 3.1 Map of Exchange Rate Regimes: Time × Flexibility 1878–1914: Most industrial countries' currencies are on the gold standard-a de facto in- ternational monetary system of fixed exchange rates. The world economy experiences a period of unbridled prosperity–the first era of globalization.
Transcribed Image Text:nes 1821: Great Britain is the first nation to formally declare full convertibility of its banknotes CHAPTER 3: Yesterday and Yesteryear into gold at the “mint" parity of £4.2474 per troy ounce of gold. 1834: The United States formally defines the dollar as 480 fine grains per troy ounce, or US$20.67 per troy ounce, and preserves it until 1933. It formally adopts the gold stan- dard in 1878. Вreakdown of Bretton Woods Collap se of Soviet Empire European Asian Financial Crisis Clean Monetary System Subprime Crisis 2008 FLOATING FX Launch of € 2000 Dirty High Convertibility STABILIZED FX Ruble Low ¥-. Convertibility CONTROLLED FX Yuan Ruble Yuan EXHIBIT 3.1 Map of Exchange Rate Regimes: Time × Flexibility 1878–1914: Most industrial countries' currencies are on the gold standard-a de facto in- ternational monetary system of fixed exchange rates. The world economy experiences a period of unbridled prosperity–the first era of globalization.
CHAPTER 3: Yesterday and Yesteryear Maximum divergence = 0.0225 × [1 – w;(0)] %3D A good warning indicator should sound a warning signal before a currency reaches its maximum divergence: By setting arbitrary threshold divergence at 75 percent of maximum divergence, we can define the threshold divergence indica- tor effectively used by the EMS: Threshold divergence = 0.075 × 0.0225 × [1 – w;(0)] Q: If, for example, the French franc (FF) accounts for 15 percent of the value of one ECU, what is its threshold divergence indicator? A: Based on the threshold divergence equation, it will be less than the +/-2.25 percent mandat- ed by the EMS grid of par values. It will also be less than the 75 percent of 2.25 percent. It will reflect the weight of the FF in the ECU of w;(0) = 0.15 and is readily computed as: (0.075) x (0.0225) × (1 – 0.15) = 0.0143 or 1.43% which is considerably less than the +/-2.25 percent margin. The EMS Straitjacket Comes Unglued In spite of the EMS's lofty ambition of providing a zone of monetary stability to the European Community, most member nations currencies' (with the exception of the Dutch guilder) devalued by at least 20 percent against the Deutsche mark between 1979 and 1987. The French franc alone devalued by more than 50 per- cent against the Deutsche mark, and the Italian lira did not fare any better. The severe currency crisis in the summer of 1992 hastened the demise of the EMS. The
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear Maximum divergence = 0.0225 × [1 – w;(0)] %3D A good warning indicator should sound a warning signal before a currency reaches its maximum divergence: By setting arbitrary threshold divergence at 75 percent of maximum divergence, we can define the threshold divergence indica- tor effectively used by the EMS: Threshold divergence = 0.075 × 0.0225 × [1 – w;(0)] Q: If, for example, the French franc (FF) accounts for 15 percent of the value of one ECU, what is its threshold divergence indicator? A: Based on the threshold divergence equation, it will be less than the +/-2.25 percent mandat- ed by the EMS grid of par values. It will also be less than the 75 percent of 2.25 percent. It will reflect the weight of the FF in the ECU of w;(0) = 0.15 and is readily computed as: (0.075) x (0.0225) × (1 – 0.15) = 0.0143 or 1.43% which is considerably less than the +/-2.25 percent margin. The EMS Straitjacket Comes Unglued In spite of the EMS's lofty ambition of providing a zone of monetary stability to the European Community, most member nations currencies' (with the exception of the Dutch guilder) devalued by at least 20 percent against the Deutsche mark between 1979 and 1987. The French franc alone devalued by more than 50 per- cent against the Deutsche mark, and the Italian lira did not fare any better. The severe currency crisis in the summer of 1992 hastened the demise of the EMS. The
CHAPTER 3: Yesterday and Yesteryear Ule ECU was useu by private-sector IIITIS IOI IIVOICIng trade Conracts UI uenoImaung boNUS issues. EXHIBIT 3.4 What Is an ECU, and How Much Is It Worth in Dollars as of January 10, 1991? Exchange Rate of the Currency i's ECU Each Currency Currency in Dollars (2) $ (3) = (1) × (2) Amount Value of the Weight of of Each Currency in One ECU (1) Component in in the ECU Currency (4) German mark (DM) 0.6242 0.6607 0.4127 30.8 French franc (FF) 1.332 0.1942 0.2587 19.3 British pound (£) Italian lira (IL) 0.08784 1.90250 0.1671 12.5 151.8 0.000877 0.1331 9.9 Dutch guilder (DG) Belgian franc (BF) Luxembourg franc (LF) Spanish peseta (Pta) Danish krone (DK) Irish pound (I£) 0.2198 0.5848 0.1285 9.6 3.301 0.032 0.1056 7.9 0.130 0.0167 0.0021 0.2 6.885 0.0104 0.0716 5.4 0.1976 0.1711 0.0338 2.5 0.008552 1.7415 0.0148 1.1 Greek drachma (GD) 1.440 0.00328 0.0047 0.4 Portuguese escudo (Esc) 1.393 0.00384 0.0053 0.4 1.3380 100.0 The currency composition of the ECU was valid from September 21, 1989, until the launch of the euro on January 1, 1999. This system of divergence indicators acts as an early warning signal. Once a cur- rency ECU rate diverges by three-quarters of its allowable band, there is a pre- sumption that its government will take remedial action, such as raising interest rates and/or tightening fiscal policy if the currency is weak. Thus, divergence indi-
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear Ule ECU was useu by private-sector IIITIS IOI IIVOICIng trade Conracts UI uenoImaung boNUS issues. EXHIBIT 3.4 What Is an ECU, and How Much Is It Worth in Dollars as of January 10, 1991? Exchange Rate of the Currency i's ECU Each Currency Currency in Dollars (2) $ (3) = (1) × (2) Amount Value of the Weight of of Each Currency in One ECU (1) Component in in the ECU Currency (4) German mark (DM) 0.6242 0.6607 0.4127 30.8 French franc (FF) 1.332 0.1942 0.2587 19.3 British pound (£) Italian lira (IL) 0.08784 1.90250 0.1671 12.5 151.8 0.000877 0.1331 9.9 Dutch guilder (DG) Belgian franc (BF) Luxembourg franc (LF) Spanish peseta (Pta) Danish krone (DK) Irish pound (I£) 0.2198 0.5848 0.1285 9.6 3.301 0.032 0.1056 7.9 0.130 0.0167 0.0021 0.2 6.885 0.0104 0.0716 5.4 0.1976 0.1711 0.0338 2.5 0.008552 1.7415 0.0148 1.1 Greek drachma (GD) 1.440 0.00328 0.0047 0.4 Portuguese escudo (Esc) 1.393 0.00384 0.0053 0.4 1.3380 100.0 The currency composition of the ECU was valid from September 21, 1989, until the launch of the euro on January 1, 1999. This system of divergence indicators acts as an early warning signal. Once a cur- rency ECU rate diverges by three-quarters of its allowable band, there is a pre- sumption that its government will take remedial action, such as raising interest rates and/or tightening fiscal policy if the currency is weak. Thus, divergence indi-
CHAPTER 3: Yesterday and Yesteryear um excnange rate woula be close to the official par value. That is wnen central banks started to play a critical role in stabilizing exchange rates at their pre- scribed par values through intervention in the foreign exchange market. INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.1 HOW DID CENTRAL BANKS PEG THE EXCHANGE RATE? The Bretton Woods system was squarely associated with fixed exchange rates, but it did allow for a modicum of foreign exchange rate flexibility around each currency's par value. Referring to the dollar-sterling exchange rate relationship, this is how it worked: The Bank of England would set a floor for the price of its currency at -0.75 percent of the par value-that is, $2.80 × (1 - 0.0075) = $2.78. Whenever the spot price determined by the interplay between supply and demand forces would fall below 2.78, the Bank of England would immediately step into the market and buy as many pounds as necessary to bring it back above the floor rate; this is also known as central bank intervention, and it can be carried out as long as the central bank has sufficient foreign exchange reserves available. Conversely, the Bank of England would set a ceiling at +0.75 percent above the par value-or $2.80 ×x (1 + 0.0075) = $2.82–at which it would sell sterling to bring its price back below the ceiling of $2.82 should market forces push the spot price above it. Both floor and ceiling exchange rates were publicly defined, as was the par value of the cur- rency: In effect the central bank would act as a guarantor of exchange rate stability. For all practical purposes, spot (currency purchase or sale for immediate delivery) forex transactions would be carried out between $2.78 and $2.82–the Bank of England would make sure of it; in a way the Bank of England provided all participants in the foreign exchange market with in- surance against price risk that was free of charge (Exhibit 3.3 illustrates the tunnel within which the exchange rate fluctuated over the period 1964–1965). Pegged Exchange Rate ($,£) with Band of Allowable Fluctuations
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear um excnange rate woula be close to the official par value. That is wnen central banks started to play a critical role in stabilizing exchange rates at their pre- scribed par values through intervention in the foreign exchange market. INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.1 HOW DID CENTRAL BANKS PEG THE EXCHANGE RATE? The Bretton Woods system was squarely associated with fixed exchange rates, but it did allow for a modicum of foreign exchange rate flexibility around each currency's par value. Referring to the dollar-sterling exchange rate relationship, this is how it worked: The Bank of England would set a floor for the price of its currency at -0.75 percent of the par value-that is, $2.80 × (1 - 0.0075) = $2.78. Whenever the spot price determined by the interplay between supply and demand forces would fall below 2.78, the Bank of England would immediately step into the market and buy as many pounds as necessary to bring it back above the floor rate; this is also known as central bank intervention, and it can be carried out as long as the central bank has sufficient foreign exchange reserves available. Conversely, the Bank of England would set a ceiling at +0.75 percent above the par value-or $2.80 ×x (1 + 0.0075) = $2.82–at which it would sell sterling to bring its price back below the ceiling of $2.82 should market forces push the spot price above it. Both floor and ceiling exchange rates were publicly defined, as was the par value of the cur- rency: In effect the central bank would act as a guarantor of exchange rate stability. For all practical purposes, spot (currency purchase or sale for immediate delivery) forex transactions would be carried out between $2.78 and $2.82–the Bank of England would make sure of it; in a way the Bank of England provided all participants in the foreign exchange market with in- surance against price risk that was free of charge (Exhibit 3.3 illustrates the tunnel within which the exchange rate fluctuated over the period 1964–1965). Pegged Exchange Rate ($,£) with Band of Allowable Fluctuations
CHAPTER 3: Yesterday and Yesteryear r ----, - Gold ($35/oz) United States Dollar All Other Currencies Pound Sterling French Franc Japanese Yen German Mark Par Value of National Currency against Gold Par Value of National Currency against U.S. Dollar USS = 1 Ounce of Gold EXHIBIT 3.2 Gold Exchange Standard Such adjustments were not as few and far between as originally envisioned: Over the period 1946–1971 only the United States and Japan did not change the par value of their currencies. Out of the leading 21 industrialized countries, 12 of them experienced devaluations in excess of 30 percent, while four countries revalued their currencies and another four abandoned fixed par values to allow their currencies to float indenendently (cee International Cornorate Finance in
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear r ----, - Gold ($35/oz) United States Dollar All Other Currencies Pound Sterling French Franc Japanese Yen German Mark Par Value of National Currency against Gold Par Value of National Currency against U.S. Dollar USS = 1 Ounce of Gold EXHIBIT 3.2 Gold Exchange Standard Such adjustments were not as few and far between as originally envisioned: Over the period 1946–1971 only the United States and Japan did not change the par value of their currencies. Out of the leading 21 industrialized countries, 12 of them experienced devaluations in excess of 30 percent, while four countries revalued their currencies and another four abandoned fixed par values to allow their currencies to float indenendently (cee International Cornorate Finance in
CHAPTER 3: Yesterday and Yesteryear Pegged Exchange Rate ($,£) with Band of Allowable Fluctuations Spot exchange rate at time t ($ price of one £) 2.82 ,Ceiling 2.80 Par value 2.78 Floor Time EXHIBIT 3.3 The Gold Exchange Standard under the Bretton Woods System, 1944–1971 INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.2 WHAT ARE FOREIGN EXCHANGE CONTROLS? After World War II most countries' economies were devastated and needed to import food, ma- chinery, and fuel to revive their fortunes. Most imports had to be paid in U.S. dollars-the hard currency that every country needed and did not have. All countries enacted tight restrictions in order to allocate scarce dollars to the best of their ability. Under such circumstances, firms and individuals cannot buy (or sell) foreign currencies freely. They are forced to apply formally to the central bank for whatever amount of foreign exchange they need. Proper justification has to accompany the request-for example, a factory's assembly operation needs to import a con- veyor belt to keep assembling irrigation pumps. A special department within the central bank Twill review the annlication and denending on its merits. will authorize all or some of the re.
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear Pegged Exchange Rate ($,£) with Band of Allowable Fluctuations Spot exchange rate at time t ($ price of one £) 2.82 ,Ceiling 2.80 Par value 2.78 Floor Time EXHIBIT 3.3 The Gold Exchange Standard under the Bretton Woods System, 1944–1971 INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.2 WHAT ARE FOREIGN EXCHANGE CONTROLS? After World War II most countries' economies were devastated and needed to import food, ma- chinery, and fuel to revive their fortunes. Most imports had to be paid in U.S. dollars-the hard currency that every country needed and did not have. All countries enacted tight restrictions in order to allocate scarce dollars to the best of their ability. Under such circumstances, firms and individuals cannot buy (or sell) foreign currencies freely. They are forced to apply formally to the central bank for whatever amount of foreign exchange they need. Proper justification has to accompany the request-for example, a factory's assembly operation needs to import a con- veyor belt to keep assembling irrigation pumps. A special department within the central bank Twill review the annlication and denending on its merits. will authorize all or some of the re.
es CHAPTER 3: Yesterday and Yesteryear IMIO one sIngie currency uiat joImned ne clUD OI Independent l1oaters; il Is Loday the second most widely traded currency. Clean Float ↑ Managed Float ↑ China (2007) Crawling Peg ↑ Stabilized ↑ China (1997) Controlled Low Convertibility High Controls on Current Limited Controls on and Capital Accounts Capital Account EXHIBIT 3.5 Flexibility x Convertibility Space with Clusters of Currencies Flexibility High MO7
Transcribed Image Text:es CHAPTER 3: Yesterday and Yesteryear IMIO one sIngie currency uiat joImned ne clUD OI Independent l1oaters; il Is Loday the second most widely traded currency. Clean Float ↑ Managed Float ↑ China (2007) Crawling Peg ↑ Stabilized ↑ China (1997) Controlled Low Convertibility High Controls on Current Limited Controls on and Capital Accounts Capital Account EXHIBIT 3.5 Flexibility x Convertibility Space with Clusters of Currencies Flexibility High MO7
CHAPTER 3: Yesterday and Yesteryear INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.5 FOOTLOOSE CAPITAL AND THE FEAR OF FLOATING Long considered a clean floater, the Swiss National Bank intervened aggressively in the first half of 2010 to stem the appreciation of the Swiss franc (SF) against the U.S. dollar and the euro. Repeated purchases of dollars caused the bank's foreign exchange reserves to balloon from SF 100 billion at the end of 2009 to SF 232 billion by mid-2010, which-as a proportion of GDP- puts Switzerland on par with China, which is known for its stubborn pegging of the yuan at an undervalued rate. The euro sovereign debt crisis of early 2010 on the back of the subprime cri- sis had footloose investors seeking refuge in a safe haven. Indeed, the Swiss economy has been marching to a different beat than its European Union neighbors with a resurgent economy fu- eled by exports, a significant budget surplus, and unemployment falling below 4 percent. Mas- sive intervention in the foreign exchange market slowed the Swiss franc appreciation against the euro to 7 percent during the first half of 2010, when the euro was falling against the U.S. dollar by 13 percent, thereby preserving its export competiveness. In a similar vein but using the quantity tool rather than the price tool, Thailand attempted to curb the massive inflow of footloose capital, which had strengthened the Thai baht against the U.S. dollar by 17 percent in 2006, undermining its export competitiveness. On December 19, 2006, the Bank of Thailand enacted a Tobin-style tax on all foreign investment (direct as well as portfolio investment), which required foreign investors to make a 30 percent interest-free de- posit with the Bank of Thailand for at least a year as collateral to any stock portfolio invest- ment. Investors were spooked, and the Stock Exchange of Thailand dropped by 15 percent, wip- ing out $22 billion of market capitalization. The tax applicable on stock investment was can- celed the next day! Controlled Exchange Rates
Transcribed Image Text:CHAPTER 3: Yesterday and Yesteryear INTERNATIONAL CORPORATE FINANCE IN PRACTICE 3.5 FOOTLOOSE CAPITAL AND THE FEAR OF FLOATING Long considered a clean floater, the Swiss National Bank intervened aggressively in the first half of 2010 to stem the appreciation of the Swiss franc (SF) against the U.S. dollar and the euro. Repeated purchases of dollars caused the bank's foreign exchange reserves to balloon from SF 100 billion at the end of 2009 to SF 232 billion by mid-2010, which-as a proportion of GDP- puts Switzerland on par with China, which is known for its stubborn pegging of the yuan at an undervalued rate. The euro sovereign debt crisis of early 2010 on the back of the subprime cri- sis had footloose investors seeking refuge in a safe haven. Indeed, the Swiss economy has been marching to a different beat than its European Union neighbors with a resurgent economy fu- eled by exports, a significant budget surplus, and unemployment falling below 4 percent. Mas- sive intervention in the foreign exchange market slowed the Swiss franc appreciation against the euro to 7 percent during the first half of 2010, when the euro was falling against the U.S. dollar by 13 percent, thereby preserving its export competiveness. In a similar vein but using the quantity tool rather than the price tool, Thailand attempted to curb the massive inflow of footloose capital, which had strengthened the Thai baht against the U.S. dollar by 17 percent in 2006, undermining its export competitiveness. On December 19, 2006, the Bank of Thailand enacted a Tobin-style tax on all foreign investment (direct as well as portfolio investment), which required foreign investors to make a 30 percent interest-free de- posit with the Bank of Thailand for at least a year as collateral to any stock portfolio invest- ment. Investors were spooked, and the Stock Exchange of Thailand dropped by 15 percent, wip- ing out $22 billion of market capitalization. The tax applicable on stock investment was can- celed the next day! Controlled Exchange Rates
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