International Financial Management

The International Monetary System Balance of Payments –A statement of all transactions between residents f the home country and the outside world during a specified period of time. –These transactions are grouped under two key headings: current items and capital items. –The balance of payments statement is compiled using double entry bookkeeping.

The International Monetary System The Current Account –Record of all cross-border transactions in goods, services, factor income and transfers within a certain period of time. –Transactions involving a positive inflow of foreign currency are entered with a positive sign, outflows with a negative sign.

The International Monetary System The Current Account –The current account has four major components: 1.Goods Trade: balance of visible trade, sometimes just the trade balance. Difference between the value of current exports and imports of merchandise goods. 2.Services Trade: tourism, transport, cross border banking and insurance. 3.Trading and Investment Income, also known as factor income. Includes interest payments on foreign debt, dividends and royalties. 4.Unilateral Transfers, unrequited payments such as foreign aid or remittances by family members abroad.

The International Monetary System The Capital Account. –Current account transactions account for only a small proportion of the total value of international transactions. As capital has become more mobile and investment more globailsed, the capital side of the balance of payments has grown in importance.

The International Monetary System The Capital Account has four major components: –Direct investment: transactions where the investor acquires a significant degree of influence on the management of a foreign enterprise –Portfolio Investment: transactions in instruments with more than one year to maturity. Example a Japanese firm buying US government bonds. –Short Term Capital: investment in instruments maturing in less than a year. Reason for the distinction is that short dated capital is more mobile. Tends to be the most sensitive part of the account to changes in interest rates. –Official Reserves: held by authorities, usually the central bank. They take the form of foreign exchange, balances with the IMF and gold.

The International Monetary System Balance of Payments = Current Account + Capital Account Balance of Payments always equals zero. Deficit in Current Account means a surplus in the Capital Account People tend to worry about Current Account Deficits.

The International Monetary System Balance of Payments = Current Account + Capital Account Balance of Payments always equals zero. Deficit in Current Account means a surplus in the Capital Account People tend to worry about Current Account Deficits.

Exchange Rates There are two ways of expressing exchange rates. Direct method of quotation: Number of units of home currency per unit of foreign currency. GBP-USD in New York is a direct quotation. One pound is worth USD.

Exchange Rates There are two ways of expressing exchange rates. Indirect method of quotation: Number of units of foreign currency per unit of domestic currency. USD-JPY in New York is an indirect quotation. One dollar is worth JPY.

Exchange Rate Equilibrium Let’s look at the demand curve for the British pound in US dollars.

Exchange Rate Equilibrium Now let’s look at the supply curve

Exchange Rate Equilibrium And equilibrium:

Exchange Rate Equilibrium We’re going to look at how exchange rates will change as a result of factors altering the supply and demand curves. –Relative Inflation Rates –Relative Interest Rates –Relative Income Levels

Exchange Rate Equilibrium Relative Inflation Rates: What would happen to the GBP-USD exchange rate if US inflation suddenly increased, while British inflation remained the same? Assume that both British and US firms sell goods that can serve as substitutes for each other. The sudden increase in US prices should lead to an increase in demand for British pounds as US consumers seek to buy British goods. Demand curve shifts to the right. It should also lead to an decrease in the supply of British pounds as British consumers switch to domestically produced goods and buy fewer US dollars. Supply curve shifts to the left.

Exchange Rate Equilibrium S  S’ and D  D’ A new equilibrium point is established, the value of the British Pound increases.

Exchange Rate Equilibrium Exercise: assume there is a sudden and substantial increase in British inflation, while US inflation remains low. Answer the following questions: –How is the demand schedule of British pounds affected –How is the supply schedule of British pounds affected. –Will the new equilibrium value of the British Pound be higher or lower than its current value.

Exchange Rate Equilibrium Relative Interest Rates What would happen to the GBP-USD exchange rate if US interest rates suddenly increased, while British interest rates remained the same? British rates will look less attractive to US investors so the demand for British pounds will decrease. Demand curve shifts to the left. Because US interest rates look more attractive to British investors with excess cash, the supply of British pounds for sale should increase. Supply curve shifts to the right.

Exchange Rate Equilibrium S  S’ and D  D’ A new equilibrium point is established, the value of the British Pound decreases.

Exchange Rate Equilibrium Relative Income Levels What would happen to the GBP-USD exchange rate if US income levels suddenly increased, while British income levels remained the same? US incomes are higher therefore the demand for imported goods should increase. Demand curve shifts to the right. There is no immediate affect on the supply of British pounds because British consumers will be indifferent to the income level in the US when it comes to making their buying decisions. This would not be true if US inflation increased. Supply curve does not move.

Exchange Rate Equilibrium S  S and D  D’ A new equilibrium point is established, the value of the British Pound increases.

Purchasing Power Parity Remember we said that if the inflation rate in a country increases the value of that country’s currency will decrease. We just looked at the relationship from a qualitative point of view. Purchasing Power Parity is theory in international finance that attempts to quantify the relationship between inflation rates and exchange rates.

Purchasing Power Parity Absolute form of Purchasing Power Parity, also called the law of one price suggests that prices of similar products of two different countries should be equal when measured in a common currency. Realistically the existence of transportation costs, tariffs and quotas prevent the absolute form of PPP.

Purchasing Power Parity Relative form of Purchasing Power Parity accounts for the possibility of market imperfections such as transportation costs, tariffs and quotas. The version acknowledges that because of these market imperfections, prices of similar products in different countries will not be the same when measured in a common currency. It does state however that the rate of change of prices of products should be somewhat similar when measured in a common currency so long as the transportation costs etc. are unchanged.

Purchasing Power Parity

Assume that the home currency inflation rate is 5% while the foreign currency inflation rate is 10%. Currently one unit of foreign currency is worth units of domestic currency. Calculate the expected change in the value of the foreign currency over the next year and also the expected value of the foreign currency.

Purchasing Power Parity

Exercise: The USD-MXN exchange rate is currently ( MXN per USD) Mexican inflation is running at 12% per anum while US inflation is 4% per anum. Calculate the expected value of the MXN in six months time from PPP.

International Financial Management We need to derive the equation for the Forward Rate. Covered Interest Rate Parity We have used the base currency and counter currency notation previously. Let’s say that a spot rate S is given in terms of units of counter currency per unit of base currency. The relevant interest rates are r b and r c and we’re looking over a time horizon of t years.

International Financial Management

We have derived two similar looking formulas linking future exchange rates to spot exchange rates. One uses inflation while the other uses interest rates. Is there a link between the two?

International Financial Management In general economies with high inflation will have high nominal interest rates. The nominal rate of interest tends to incorporate inflation expectations. The expected effect of inflation on the nominal interest rate is called the Fischer effect. The Fischer Equation:

International Financial Management If assume that real rates of return are the same in all countries ( questionable assumption) then our PPP formula looks like:

International Financial Management We’ve demonstrated the consistency of the PPP equation with our formula for forward rates. So we expect that countries with high inflation and high interest rates will see the value of their currencies decline over time.

International Financial Management Foreign Exchange Risk While we’ve seen some good qualitative and quantitative methods for predicting the direction of FX rates the fact remains that future FX rates are inherently random and impossible to predict satisfactorily.

International Financial Management

Foreign Exchange Risk Is there anything predictable about FX rat movements? If we plot a histogram of daily EUR-USD shifts then we get the following:

International Financial Management Foreign Exchange Risk Is there anything predictable about FX rat movements? If we plot a histogram of daily EUR-USD shifts then we get the following:

International Financial Management We see that the distribution of the changes in the FX rate can be well approximated by a normal distribution.

International Financial Management If we assume that the FX rate will change according to a normal distribution we can put upper an lower bounds, to a certain degree of confidence, on where the exchange rate will be in a certain period of time.

International Financial Management

68.3% of the area lies within +/- one standard deviation of the mean.

International Financial Management 5% of the area under the normal distribution lies less than 1.65 standard deviations below the mean. This means that we can be 95% certain that a random variable chosen from a normal distribution will be greater than the mean minus 1.65 standard deviations.

International Financial Management Let’s put some numbers with these concepts. Say you expect to receive USD 1,000,000 in 1- year’s time. The EUR-USD exchange rate is The mean change in the exchange rate is zero and the standard deviation is 10.75% Calculate the amount of EUR that you will get from conversion equivalent to a 95% confidence interval.

International Financial Management We need to sell USD and buy EUR. What direction spot move are we worried about? We are concerned about an increase in the exchange rate. 95% confidence is equivalent to 1.65 standard deviations. This is equivalent to USD per EUR.

International Financial Management We expect to receive € 787,402. The standard deviation of the FX rate is 10.75% 1.65 Standard Deviations = 17.74% We can be 95% confident that we will lose no more than €139,665 over the next 12 months by leaving the $1,000,000 unhedged. We have seen this idea before. It’s called the Value At Risk (VAR)

International Financial Management What if you had a double exposure? You expect to receive USD 1,000,000 and GBP 1,000,000 in 12 months time. The exchange rates are and for EUR-USD and EUR-GBP respectively. The standard deviations are 10.75% and 8.35% for EUR-USD and EUR-GBP respectively. Calculate the VAR to a 95% degree of confidence.

International Financial Management The VAR of the dollars is €139,665 What about the sterling? We expect to receive €1,470,558 in one year’s time. The standard deviation of the exchange rate is 8.40% Standard Deviations = 13.86% We can be 95% confident that we will lose no more than €203,824 over the next 12 months by leaving the £1,000,000 unhedged. Our USD VAR is €139,665. Our GBP VAR is €203,824. Does this mean that our total VAR is €343,849?

International Financial Management How likely is it that we will experience a simultaneous worst case in both EUR- USD and EUR-GBP? Intuitively we feel that the VAR of the USD and GBP exposures should be less than the simple sum of the two VAR figures. Unless there is 100% correlation between EUR-USD and EUR-GBP the VAR will be less than the simple sum.

International Financial Management

So VAR provides us with a way of measuring the likely worst case scenarios for a FX hedging problem. VAR numbers are usually higher than most people would be intuitively comfortable with. Correlation effects reduce VAR values.