International Business (International Monetary System & Capital Market) Erasmus programme V Lecturer Dr Pavlos Dimitratos International Business (International Monetary System & Capital Market) Erasmus programme V Lecturer Dr Pavlos Dimitratos

2 Foreign exchange market Foreign exchange riskForeign exchange risk Spot & forward exchange rateSpot & forward exchange rate The law of one price: in efficient markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same priceThe law of one price: in efficient markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price Three factors significantly affect future exchange rate of a currency: Three factors significantly affect future exchange rate of a currency: Country’s price inflation & money supplyCountry’s price inflation & money supply Country’s interest rateCountry’s interest rate Market psychologyMarket psychology

3 Inflation and money supply If a basket of goods costs $100 in the US and £66.67 in the UK, the purchasing power parity theory predicts that the $/£ exchange rate will be (100/66.67=) 1.5 ($/£)If a basket of goods costs $100 in the US and £66.67 in the UK, the purchasing power parity theory predicts that the $/£ exchange rate will be (100/66.67=) 1.5 ($/£) PPP theory stipulates that changes in relative prices (e.g. inflation) will result in changes (e.g. depreciation against countries with lower inflation) in exchange ratesPPP theory stipulates that changes in relative prices (e.g. inflation) will result in changes (e.g. depreciation against countries with lower inflation) in exchange rates Inflation rate is determined by money supplyInflation rate is determined by money supply The PPP theory appears to be accurate in the long-run but not necessarily in the short-runThe PPP theory appears to be accurate in the long-run but not necessarily in the short-run

4 Interest rates Interest rates reflect expectations about future inflation ratesInterest rates reflect expectations about future inflation rates For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest ratesFor any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates As before, this seems to be the case mainly in the longer-runAs before, this seems to be the case mainly in the longer-run Market psychology Expectations are very important, especially in the short-run and tend to become self-filling prophecies (bandwagon effects)Expectations are very important, especially in the short-run and tend to become self-filling prophecies (bandwagon effects)

5 Monetary system Floating exchange rate regime: when the market determines the relative value of a currencyFloating exchange rate regime: when the market determines the relative value of a currency Fixed exchange rate regime: the values of currencies are set against each other at mutually agreed exchange ratesFixed exchange rate regime: the values of currencies are set against each other at mutually agreed exchange rates Intermediate cases Pegged exchange rate: the value of the currency is fixed relative to a reference currency (which determines other exchange rates)Pegged exchange rate: the value of the currency is fixed relative to a reference currency (which determines other exchange rates) Dirty float: the value of the currency is hold within some range against a reference currencyDirty float: the value of the currency is hold within some range against a reference currency

6 Monetary system (con’d) The international monetary system has passed from the period of the gold standard (pegging currencies to gold)…The international monetary system has passed from the period of the gold standard (pegging currencies to gold)… to a system of fixed exchange rates (Bretton Woods – whereby only the dollar was convertible into gold)…to a system of fixed exchange rates (Bretton Woods – whereby only the dollar was convertible into gold)… IMF andIMF and World Bank were establishedWorld Bank were established to the floating exchange rate system (Jamaica agreement)to the floating exchange rate system (Jamaica agreement)

7 Floating vs. fixed exchange rates FloatingFloating Monetary policy autonomy for a countryMonetary policy autonomy for a country Smooth trade balance adjustmentsSmooth trade balance adjustments FixedFixed Monetary disciplineMonetary discipline Combats speculationCombats speculation Reduces uncertainty re currency movementsReduces uncertainty re currency movements A different (than the B-W) fixed rate system might work and foster stabilityA different (than the B-W) fixed rate system might work and foster stability

8 The international capital market Mini-case discussionMini-case discussion  Firms may use the international capital market in order to get access to wide liquidity of the international capital market and obtain lower cost of capital  Investors may use the international capital market in order to diversify efficiently their portfolio and reduce the level of risk

9  Stock markets in different countries show low correlation because  Countries pursue different policies in different contexts  Capital controls occur  Eurocurrency is a currency backed outside its country of origin  No/little government regulation in this market  Depositors may earn more than deposits in home currency

10  Foreign bonds are sold outside the borrower’s country and are denominated in the currency of the country in which they are issued (e.g. Siemens issues bonds in USA and sells them in the US -Yankee bonds)  Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated (e.g. Siemens issues bonds denominated in US dollars and sold to investors outside the US)

11  Eurobonds are …  Absent of regulatory interference  Less stringent on disclosure requirements than domestic bond markets  Usually offer a more favorable tax status  … but foreign exchange risk may always be a problem

12 Readings  Hill, chapters 9, 10 & 11 Recommended:  International Economics: Theory and Policy (6th Edition), Krugman P. R. and Obstfeld, 2004, Addison Wesley