1. CHAPTER 12 INTERNATIONAL MARKETS

2. Copyright© 2003 John Wiley and Sons, Inc. Foreign Exchange Rates Foreign trade and funds flow must involve a conversion from one currency to another Foreign exchange rate -- the price of a unit of one currency in terms of another. Foreign exchange rates are market determined. The increased (decreased) cost of a unit of foreign currency in terms of the U.S. dollar refers to the depreciation (appreciation) of the dollar.

3. Copyright© 2003 John Wiley and Sons, Inc. The Equilibrium Exchange Rate

4. Copyright© 2003 John Wiley and Sons, Inc. Foreign Exchange Rates Supply and demand for currencies depends on the underlying demand and supply for goods and services between countries caused by: Relative costs of the factors of production in each country. Relative supply of factors between nations. Consumer tastes for certain goods and services. The ability of a country to supply its needs domestically. Barriers to trade such as import tariffs which affect the flow of goods and services.

5. Copyright© 2003 John Wiley and Sons, Inc. Foreign Exchange Rates Supply and demand for currencies depends on the underlying demand and supply for goods and services between countries caused by: The rate of growth of national income of a country. Trade flows will continue, with corresponding purchase and sale of foreign exchange, until purchasing power parity is achieved, or the cost of an item in one country's currency is the same cost as in another country's currency.

6. Copyright© 2003 John Wiley and Sons, Inc. Financial Determinants of Exchange Rates Relative real interest rates between countries and inflation rates affect international capital flows. Small, real interest rate differentials between countries causes capital (and the demand/supply of foreign exchange) to move very quickly.

7. Copyright© 2003 John Wiley and Sons, Inc. Financial Determinants of Exchange Rates, cont. Relative inflation rates between countries affect foreign exchange rates. If country A has a lower rate of inflation relative to Country B, A's goods are relatively cheaper than B's. Country A's currency will appreciate as Country B acquires more of country A's goods and services.

8. Copyright© 2003 John Wiley and Sons, Inc. Three types of capital flows which affect exchange rates: Speculative capital flows - buying/selling of foreign exchange based on future exchange rate expectations. Investment capital flows - investment in real or financial assets (money or capital market) based on prospects of real returns. Covered (forward contract hedge) interest rate parity conditions are achieved by arbitragers, eliminating the spot conversion, interest rate, and forward exchange differences between countries.

9. Copyright© 2003 John Wiley and Sons, Inc. Three types of capital flows which affect exchange rates: (concluded) Political capital flows - transfer of wealth from one country to another, also called capital flight.

10. Copyright© 2003 John Wiley and Sons, Inc. Government Intervention in the Foreign Exchange Markets Support of currency value by selling foreign assets. Depression of currency value by buying foreign assets. Governments may fix exchange rates (decree or by market intervention) or the currency may float, determined by the market. There are no over- or under valuations with market determined (floating) exchange rates.

11. Copyright© 2003 John Wiley and Sons, Inc. Balance of Payments Terminology Double-entry bookkeeping -- debits equal credits. Surplus/deficit term relates to a subsection of the balance of payments report. The entire balance of payments report balances. Goods and services imports greater than exports for a period is called a trade deficit and decreases the currency exchange rate. Goods and services exports greater than imports is called a trade surplus and increases the currency exchange rate.

12. Copyright© 2003 John Wiley and Sons, Inc. Foreign Exchange Appreciation Will Occur When: A country's goods are cheaper than foreign goods based on purchasing power parity. A country has a large current accounts surplus. A country has higher real interest rates, attracting real and financial investment. A country's interest rates are high relative to other countries, attracting financial investment. A country's government may reduce the growth in the money supply, raising interest rates, and encouraging demand for its currency.

13. Copyright© 2003 John Wiley and Sons, Inc. Nature of Foreign Exchange Market Efficient Large number of diverse buyers and sellers (breadth). Significant market activity (buy/sell) with any change in value (depth). Market returns to normal price quickly after any significant price swing (resiliency). Worldwide over-the-counter trading.

14. Copyright© 2003 John Wiley and Sons, Inc. Nature of Foreign Exchange Market (continued) Major participants large multinational banks. Central Banks. Transfer process is through interbank clearing systems. Spot vs. Forward Transactions Delivery in the spot market takes place within 2 business days. Forward contracts are typically written for delivery in 30, 60, 90, or 180 days.

15. Copyright© 2003 John Wiley and Sons, Inc. Exchange rates provide interest parity between countries Interest rate differentials between countries are reflected in the forward/spot exchange rate differentials. Arbitragers establish interest parity. A higher interest rate in another country (security denominated in a foreign currency) would be nullified by a lower forward rate.

16. Copyright© 2003 John Wiley and Sons, Inc. Three International Trade Problems Exporters lack information about importer's credit rating. Exact amounts of the trade and date of payment must be known before one party can hedge foreign exchange risk. Bank wants a clean deal without disputes and delay of funds flow.

17. Copyright© 2003 John Wiley and Sons, Inc. Specialized Financial Trade Instruments to Overcome International Trade Problems Letter of credit - guarantees payment upon submission of correct documents. Draft - a request for payment submitted to the guaranteeing bank by the exporter Site draft - payable on demand. Time draft - payable on a particular date. Bill of lading - a receipt issued by the exporter to the shipping company.

18. Copyright© 2003 John Wiley and Sons, Inc. Euromarkets Eurocurrency - any currency held in time-deposit outside its country of origin. Eurodollars - dollar denominated deposits held in a bank outside the U.S..

19. Copyright© 2003 John Wiley and Sons, Inc. Eurocurrency markets Highly liquid assets that can be used to conduct international transactions. LIBOR - the rate international banks charge other banks.

20. Copyright© 2003 John Wiley and Sons, Inc. The Euro The Euro is a common currency unit for the 11 members of the European Currency Union. The currencies of these countries are permanently fixed to the Euro. Purpose is to encourage trade and economic efficiency.