Page 189 - DECO503_INTERNATIONAL_TRADE_AND_FINANCE_ENGLISH

Unit 16 : Theories of Determination of Exchange Rate (Portfolio and Balance of Payments)

be worth US dollars 35. After the establishment of the fixed rate of exchange, all other currencies Notes
were pegged to the US dollar at a fixed exchange rate.
As stated in the article7 'The End Of the "Fixed" Dollar', by the beginning of the 1960s, the US dollar
35 = 1 oz. gold ratio was becoming more and more difficult to sustain. Gold demand was rising and
the U.S. Gold reserves were declining.
On 15th August, 1971, President Nixon, repudiated the international obligation of the U.S. to redeem
its dollar in gold.
By the end of 1974, gold had soared from $35 to $195 an ounce.
Since the collapse of the Bretton Woods agreement (February 1973), the world's currencies have
"floated" with respect to the US dollar.
Thus, the foreign exchange rate regime changed from a 'fixed exchange rate' to a 'flexible or floating
exchange rate'. A system in which, exchange rates are determined by supply and demand that is
called 'clean float' or where governments through central banks intervene (buy and sell currencies) in
the markets, which is called 'dirty float'.

The demand for foreign exchange arises from the debit side of the balance of payments. it
is equal to the value of payments made to the foreign country for goods and services
purchased from it plus loans and investments made abroad.

16.2 Volatility and Risk

Undoubtedly, dramatic movements in the value of currencies can occur where the forces of supply
and demand freely determine the price. Consequently, such a system increases the exchange rate risk
associated with but not limited to international transactions.
The cross-border financial activity differs from the domestic activity in respect to related risk due to
the fact that when investing in a foreign country you have to consider many other factors, such as:
• Tax system: differences related to the specific country's system.
• Political risk: a democratic country is preferable to a non-democratic one.
• Government intervention: it is also preferable to deal with a country without government
intervention.
• Business risk: unforeseen changes in the general economic environment.
• In addition, the likely volatility in the exchange rate can drastically affect the cost, profits and
return on investments of international firms, thus, resulting in the following levels of risk:
• Economic exposure: Transaction exposure is related to those activities that trade internationally.
For example, a EU company imports bicycle components from the United States with 2 months'
credit. Possible US dollar depreciation will be for the benefit of the EU organization because it
will pay fewer euros. On the contrary, if the US dollar appreciates, the company will suffer a
loss, due to the fact that it will pay more euros. The transaction exposure (the risk of adverse
movements in the exchange rate) can be eliminated using hedging instruments. An example of
this would be forward rate contracts.
• Operational exposure. Although a company may not trade globally, due to competitiveness, it
may suffer the exchange rate risk. For example, a US bicycle producer will have a competitive
advantage compared to a EU producer of a similar type of bicycle if the euro depreciates against
the US dollar. The price of the US bicycle if converted into euros will fall, and consequently will
attract EU members to buy it.
• Translation exposure Assuming a company that has a subsidiary outside the EU and expects
profits in one year's time. Based on the current exchange rate between foreign and domestic

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