Chapter 23 International Transactions And Currency Values

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved.  Learning Objectives  To explore the functions and roles performed by the international markets within the global financial system. To see how international payments for goods and services are made, and how international borrowing and lending can be tracked through a nation’s balance-of-payments accounts. To understand how the values of national currencies are determined.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Introduction Facilitated by dramatic improvements in communication and transportation, world trade and the international financial markets have experienced enormous growth.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Balance of Payments Accounts One of the most widely used sources of information concerning flows of funds, goods, and services between nations is each country’s balance of payments (BOP) accounts. This statistical report summarizes all the economic and financial transactions between residents of one nation and the rest of the world during a specified period of time.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The U.S. Balance of International Payments The transactions recorded in the balance of payments fall into three broad groups: -Transactions on current account, e.g. imports and exports of goods and services, unilateral transfers (gifts) -Transactions on capital account, e.g.long- and short-term investment at home and abroad -Official reserve transactions to settle BOP deficits

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The U.S. Balance of International Payments Principal Credit and Debit Items Recorded in a Nation’s Balance of Payments

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The U.S. Balance of International Payments U.S. international transactions are subdivided into categories – the current account, the capital account, and residual items (including a sizeable statistical discrepancy due to unreported transactions) – that help us to understand how the BOP bookkeeping system works.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The U.S. Balance of International Payments

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Current Account The most important components of the current account include: -The merchandise trade balance -The service balance -Net investment income -Compensation of employees (wages for domestic workers employed overseas relative to wages for foreigners working in the domestic economy) -Unilateral transfers

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Current Account A current account deficit generates net borrowing from abroad. In 2003, the U.S. balance on current account was a debit (–) item balance, estimated at just over $530 billion – a record number both in dollar terms and relative to the nation’s total output of goods and services (the GDP).

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Capital Account The capital accounts in a nation’s BOP are often divided into two major subcategories: -net private capital flows between private individuals and institutions; and -net official capital flows, involving governments, central banks, and various government agencies. Capital investment activity abroad also may be divided into short-term capital flows, direct investments, and portfolio investments.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Capital Account In 2003, there was a net private capital inflow into the U.S. from abroad of $295 billion. America’s net investment position went from positive to negative about two decades ago and has continued to head downward. This has enabled the U.S. to finance a substantial portion of its merchandise trade deficit and has supported the creation of new U.S. businesses and additional jobs.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Official Transactions When a nation has a BOP deficit, it must settle up with other nations by surrendering assets or claims to foreign accounts. Official capital flows usually consist of the movement of assets that are readily transferable in order to make international payments – e.g. transferring the ownership of gold, convertible foreign currencies, deposits held in the IMF, SDRs.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Disequilibrium in the Balance of Payments The U.S. has relied on foreign credit, foreign capital inflows, and its stock of gold, foreign currencies, and other official assets to settle its BOP deficits. However, the amount of these financial devices is limited. Relying on foreign capital inflows can be dangerous too.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Problem of Different Monetary Units In International Trade and Finance Different monetary units are used as the standard of value in different countries. When goods and services are sold or when capital flows across national boundaries, currency exchange is often necessary. Currency exchange is risky. Speculative currency flows may also complicate government policies aimed at curbing inflation and ensuring economic growth.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Problem of Different Monetary Units In International Trade and Finance The gold standard – During the 17th and 18th centuries, major trading nations in Western Europe made their currencies freely convertible into gold at predetermined prices. The gold exchange standard – Each currency was freely convertible into gold at a fixed rate, and also free convertible into other currencies at relatively stable prices.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Problem of Different Monetary Units In International Trade and Finance The modified exchange standard (Bretton Woods System) – Foreign currency prices were linked to the U.S. dollar and to gold. The managed floating currency standard – Each nation chooses its own exchange rate policy, consistent with the structure of its economy and its goals. Examples of policies used include pegging, managed float, and free floating.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets The foreign exchange market is an over-the-counter market, with no central trading location, no set hours of trading, and no formal code of rules. There are three major sections:  the spot market,  the forward market, and  the currency futures and options market. Foreign exchange rates are quoted as bid (buy) and ask (sell) prices by dealers.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets Recent Foreign Exchange Rates: The U.S. Dollar vs. Other Key Currencies (Figures Are Currency Units per U.S. Dollar Except as Noted)

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets How to Calculate Foreign Exchange Rates Source: Based on a similar exhibit developed originally by the Public Information Center of the Federal Reserve Bank of Chicago.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets Foreign exchange rates are affected by a number of factors, including: -balance of payments positions -speculation over future currency values -domestic political and economic conditions -central bank interventions These factors may be expressed in terms of the market forces of demand and supply.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets Price of $ in terms of £ (£/$) Quantity of $ Supply of $ (demand for £) S Demand for $ (supply of £) D D2D2 S2S2

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Determining Foreign Currency Values In Today’s Markets

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Forward Market for Currencies A forward contract is an agreement to deliver a specified amount of foreign currency at a set price on some future date. There are several ways of measuring and quoting forward exchange rates: -outright rate, e.g. $1.14/€ for delivery in 6 months -swap rate, e.g. 2¢ discount from spot ($1.16/€) -annualized percentage rate, e.g. 3.45% discount

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions of the Forward Exchange Market The functions of forward contracts can be grouped into four categories: -commercial covering by exporters and importers of goods and services -hedging an investment position in a foreign currency -speculation on future currency prices -covered interest arbitrage

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Functions of the Forward Exchange Market A condition known as interest rate parity exists when the interest rate differential between two nations is exactly equal to the forward discount or premium on their two currencies. When parity exists, the currency markets are in equilibrium and capital funds do not flow from one country to another.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Market for Foreign Currency Futures Foreign currency futures are contracts calling for the future delivery of a specific currency at a price agreed today, although there is usually no intent to actually deliver the currencies. They are attractive to both foreign exchange hedgers and foreign exchange speculators. Importers of goods typically use the buying hedge, while those expecting foreign currency earnings usually use the selling hedge.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Innovative Methods for Dealing with Currency Risk The recent volatility of foreign exchange rates has given rise to an ever-widening circle of devices to deal with currency risk. -Currency options -Options on currency futures -Currency swaps -Local loans and dual-currency bonds -Prepayments, barter, or selective currency pricing -Risk-adjusted pricing

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Innovative Methods for Dealing with Currency Risk

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Intervention In the Foreign Exchange Markets A strong and stable currency encourages investment in the home country, stimulating its economic development. The US$ is also a vehicle currency that facilitates trade and investment between many nations. Hence, the United States, as well as foreign governments, have intervened in the foreign exchange market to stabilize currency values and insulate domestic economic conditions from developments abroad.

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net Chicago Mercantile Exchange at European Central Bank at European Community Activities at FOREX News at International Monetary Fund at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Markets on the Net The Euro at World Bank at World Trade Organization at

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Introduction to International Transactions and Currency Values The Balance of Payments (BOP) Accounts -The U.S. Balance of International Payments -The Current Account -The Capital Account -Official Transactions -Disequilibrium in the Balance of Payments

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Problem of Different Monetary Units in International Trade and Finance -The Gold Standard -The Gold Exchange Standard -The Modified Exchange Standard -The Managed Floating Currency Standard

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review Determining Foreign Currency Values in Today’s Markets -Essential Features of the Foreign Exchange Market -Exchange Rate Quotations -Factors Affecting Foreign Exchange Rates -Supply and Demand for Foreign Exchange

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Forward Market for Currencies -Methods of Quoting Forward Exchange Rates Functions of the Forward Exchange Market -Commercial Covering -Hedging an Investment Position -Speculation on Future Currency Prices -Covered Interest Arbitrage -The Principle of Interest Rate Parity

McGraw-Hill/Irwin Money and Capital Markets, 9/e © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Review The Market for Foreign Currency Futures Other Innovative Methods for Dealing with Currency Risk Government Intervention in the Foreign Exchange Markets