Value of U.S. Dollar Term Paper

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Down? The Value of the Dollar

International Currency Exchanges

Current Trends and Initiatives

Impact of the Euro on Dollar Valuation

Analysis of Current Trends and Initiatives on Dollar Valuation in the Future

Up or Down? The Value of the Dollar: A Historical Analysis of the Valuation of the U.S. Dollar

According to Michael Artis, Elizabeth Hennessy, and Axel Weber (2000), capital losses can be caused by differential changes in the value of assets and liabilities, primarily exchange rate changes; these changes affect the value of a central bank's foreign exchange reserves. To date, exchange rate changes have only been a major problem for national central banks with very large foreign exchange reserves (i.e., Portugal); however, it might also become a problem for the European Central Bank in the future, whose balance sheet on the asset side will be dominated by the approximately 40 billion euro in foreign exchange reserves it has called up from the national central banks as of the end of 1999 (Artis et al. 208). The strength of the euro compared to the U.S. dollar has been growing in recent months, and economists are of mixed opinions about the impact on the valuation of the dollar as the European Union continues to gain economic momentum as it streamlines it trading practices.

Purpose of Study

The purpose of this study will be to examine the historical basis for the valuation of the U.S. dollar, the impact of recent trends and initiatives including but not limited to the euro, and an analysis of how these factors will serve to affect the dollar's valuation in the future.

Importance of Study

A country's nominal exchange rate is defined as the actual foreign exchange quotation in contrast to the real exchange rate, which has been adjusted for changes in purchasing power (Harvey 2004). Artis et al. (2000) suggest that it is reasonable to assume that the nominal exchange rate will be a key element in determining the level of competitiveness of a country, which in turn will be an increasingly important factor in stock market valuations in the future.

Scope of Study

This study will examine a wide range of international currencies, with an emphasis on the world's leading economies besides the U.S. And EU such as China, Japan, Korea, and others, with a particular emphasis on how these currencies have tended to interact with the U.S. dollar over the years. Current theories concerning currency valuation techniques will be provided, and statistical analyses will be carried out where appropriate.

Overview of the Study

According to Mike Luck, Rob Pocock, and Mike Tricker (2000), "In its crudest form, exploratory research produces endless series of descriptive statistics, correlation analyses and multi-way cross-tabulations that encompass every conceivable permutation and combination of variables in the hope of finding something significant" (153). Therefore, this study will use an exploratory approach to review the relevant and peer-reviewed literature to develop fresh insights and theories concerning what can be expected as these increasingly powerful international valuation forces come to bear on the U.S. dollar in the future.

Chapter 2: Review of Related Literature

Background and Overview: International Currency Exchanges. While it may not be hard to believe that people are making money in the international currency exchange market, it is difficult to understand how they are doing it. After all, if there was a magic formula whereby accurate predictions could be consistently made concerning an individual currency's likely behavior against another currency, that formula would eventually become known and it would be boom times for everyone. Alas, such a magic formula does not exist but that has not stopped analysts from trying for the past 400 years. In fact, much of the existing mechanisms of transnational trade were introduced during the last four centuries; international currency exchanges, the joint stock company, marine insurance, international arbitration, bills of lading, and the stock market all fueled international trade and therefore interest in international currency exchanges (Arthurs 1996:132).

More recently, the increasing globalization of the world's economy has compelled analysts to redouble their efforts at understanding how market forces and world events all affect the rise and fall of a nation's currency. In fact, the same pressures that served to hasten the development of international trade over the past 400 years are the same ones taking place today: "At the core of it all, globalization - then as now - was about wealth and dreams of wealth" (Arthurs 133). In this regard, foreign exchange represents both an opportunity and a potential liability if handled inappropriately.

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According to Laux, Pantzalis and Simkins (2001), "Investors are concerned with the impact of unexpected changes in the exchange rate on their portfolio values, while managers who typically are over-invested in their own firms are primarily concerned with the exposure of their firms. Risk aversion provides an incentive to manage foreign exchange risk" (793). The authors define foreign exchange exposure as the effect of unexpected changes in the real exchange rate on firms, and distinguish between two types of economic exposure:

1) Transaction exposure (this is the effect of unexpected changes in the nominal exchange rate on cash flows associated with monetary assets and liabilities such as contractually fixed cash flows); and

2) Transaction exposure (this is usually a short-term exposure that can be easily hedged using currency derivatives) (Laux et al. 794).

By contrast, operating exposure is the effect of unexpected changes in the exchange rate on the cash flows that are associated with a company's non-monetary (real) assets and liabilities. According to these authors, "Operating exposure results from unexpected changes in the exchange rate on the firm's input costs (e.g., raw materials, labor costs, etc.) and output prices (e.g., product prices)" (794). Further, because the correlation of prices with exchange rates is determined by the extent of segmentation within their respective markets, operating exposure will depend on whether input costs and output prices are influenced on a local or global level (Laux et al. 795). Taken together, these risks and opportunities are all based on how the U.S. dollar has been historically valued; these issues are discussed further below.

Current Trends and Initiatives. According to Richard N. Cooper, the U.S. current account deficit reached $450 billion in 2001, or 4.4% of the nation's GDP; this was a 3.6% from 1999. In fact, current account balance was last achieved in 1991 (actually, in 1981 if the First Persian Gulf War-related expenses are excluded for 1991). "One has to go back to the two decades before 1914," Cooper says, "a period of mass immigration and extensive infrastructure construction, to find deficits even approximately as large, relative to GDP, as those of recent years" (217). By global standards, the U.S. is regarded to be relatively rich in capital; the questions emerge then, as to why the U.S. has been importing more capital than ever before?

There are two clear trends in thinking evident in the growing body of literature on the impact of foreign debt on the U.S. dollar in this regard. In their essay, "The Looming U.S. External Debt. How Serious is It?," Susan Charrette and Juann Hung (1997) report that, "When the United States first became a net debtor in the mid-1980s, some analysts worried that the prospect of an escalating U.S. foreign debt would cause foreigners to become unwilling to hold dollar assets, precipitating a sudden depreciation of the dollar. Such a scenario was thought to be plausible since a continued rise in the U.S. external deficit would lead to rapid accumulation of external debt" (32). Having receded for a number of years, though, this lingering doubt about the U.S. external debt has reemerged in the public forum. According to Charrette and Hung, as a result of the United States becoming the world's largest net international debtor, some observers have blamed the net international debt for depressing the dollar: "They argue that the weak dollar should signal policymakers to act now in order to redress the continuing buildup of U.S. international debt" (32). By contrast, other financial analysts suggest that this concern about external deficits and debt accumulation is unwarranted; provided that a significant share of the net borrowing from abroad is directed toward investment, the accumulation of external debt should not be a reason for worry. "As long as foreign debt is incurred for productive investment and its cost is lower than the rate of return on its investment," the authors point out, "the United States should profit from foreign borrowing" (Charrette & Hung 33). Beyond these two schools of thought, though, there is a new major player in the international currency exchange marketplace that is having profound effects on the valuation of the U.S. dollar in some unpredictable ways; these issues are discussed further below.

Impact of the Euro on Dollar Valuation. According to Cooper (2001), the increasing purchase of euros places some amount of downward pressure on the dollar, thereby reducing some of the exchange rate pressures on U.S. producers; these pressures are taking place during a period.....

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