International Trade and Finance PPTs series 6 April 2014

List of Contents Part II Finance The Balance of Payments Introduction 2. Foreign exchange 3. Exchange Regimes 4. Agents and their Activities a) Spot and Forward Markets b) Export and Import c) Spot Speculation d) Forward Speculation e) Interest arbitrage 5. Selected Exchange Rate Theories Introduction Part I Trade 1. Theories of Trade a) Motives for Trade b) Absolute Ádvantage c) Comparative Advantage d) Extensions 2. Barriers to Trade a) Non.tariffary Barriers b)Tariffs c) Quotas d) Subsidies April 2014

Spot and Forward markets Spot market: agreement on price and quantity of foreign exchange and transaction trake place simultaneously Forward market: agreement on price and quantity of foreign exchange takes place today, but transaction at a specified later date April 2014 © Dr. Helmut Less

Abbreviations Exchange Rate e Spot Exchange Rate es Forward Exchange Rate ef Swap Rate s = (ef – es)/es Expected Spot Exchange Rate e* Foreign Interest Rate if Domestic Interest Rate i Gross interest differential dg= if – i Net interest differential d = if – i + s © Dr. Helmut Less April 2013

Activities on foreign exchange markets Export and import Speculation in spot exchange Speculation in forward exchange Covered interest arbitrage Uncovered interest arbitrage © Dr. Helmut Less April 2014

Export and Import: Rules Payment immediate: Spot market Payment delayed: Exporter: if es* > ef  spot market at date of payment if es* < ef  forward market today Importer: if es* < ef  spot market at date of payment if es* > ef  forward market today (Hint: Risk preference or aversion will play a roll) © Dr. Helmut Less April 2014

Export and Import: Example Export of merchandise worth 20 Million $ es = 2,00 es* = 1,92 ef = 1,91 (both for 3 months) Payment immediate  sale of $ spot today Payment in three months - Risk lover: wait and sell spot in three months - risk averter: sell forward today Summer 2013 © Dr. Helmut Less

Speculation in Spot Exchange: Rules If es* > es  buy spot today, sell spot later If es* < es  sell spot today, buy spot later April 2014 © Dr. Helmut Less

Speculation in Forward Exchange: Chance ef = 0,84 es* = 0,81 Sell 3-months forward today, wait until three months elapse. Assuming a correct guess, buy spot and collect a profit of 0,03 EUR per $ commitment. Or, if the guess was wrong and the spot rate hits i.e. es = 0,85 lose 0,01 EUR per $ commitment April 2014 © Dr. Helmut Less

Speculation in Forward Exchange: Rules If ef > es*  sell forward today, buy spot at time of maturity and fulfill forward contract If ef < es*  buy forward today, sell spot at time of maturity and fulfill forward contract April 2014 © Dr. Helmut Less

Covered Interest Arbitrage: Problem From the domestic perspective: if = 6% and i = 4% could be a motive to invest into US securities. What if at time of maturity $ depreciates from es1 = 0. 80 to es2 = 0,72? Investers would incurr a loss. Solution: swap = simultaneous spot a forward transaction. April 2014 © Dr. Helmut Less

Covered Interest Arbitrage: Rules If d = if – i + (ef – es)/es > 0  buy spot today, sell forward today d = if – i + (ef – es)/es < 0  sell spot today, buy forward today April 2014 © Dr. Helmut Less

Uncovered Interest Arbitrage: Rules If if – i + (es* – es)/es > 0  buy spot today, sell spot later If if – i + (es* – es)/es < 0  sell spot today, buy spot later April 2014 © Dr. Helmut Less