CHAPTER 12 & 13

INTERNATIONAL EXCHANGE

AND

CREDIT MARKETS

Exchange Rates: Foreign trade involves 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.

The Equilibrium Exchange Rate

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.

Supply and demand for currencies depends on the underlying demand and supply for goods and

services between countries caused by: (concluded)

• 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.

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.

• 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.

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.

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.

Government Intervention in the Foreign Exchange Markets

Government Intervention in the Foreign Exchange Markets (concluded)

• 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.

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.

Balance of Payments Terminology (concluded)

• Initiating transaction– Buying an import.

– Called an autonomous flow.

– Listed first in the balance of payments -- above the line.

• Offsetting entry– Payment for the import.

– Accommodating flow.

– Listed below the line.

The Current Account

• The current account records the trade balance of a country.

• Includes flow of imports and exports in the current period.

• Transactions are nonreversible.• Trade flows do not give rise to expectations of

future flows.• If services, investment income, and transfers

are included, the net is the balance on current accounts.

The Capital Account

• The capital account measures capital flows into or out of a country.

• Surpluses (deficits) in the capital accounts offset deficits (surpluses) in the current account.

• Pressure on exchange rates from the current account is reversed with capital account flows.

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.

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.

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.

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.

Three InternationalTrade 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.

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 to the exporter by the shipping company.

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..

Eurocurrency markets

• Highly liquid assets that can be used to conduct international transactions.

• LIBOR - the rate international banks charge other banks.

The Euro

• The Euro is a common currency unit for the 15 members of the European Currency Union.

• The currencies of these countries were permanently fixed to the Euro.

• Purpose is to encourage trade and economic efficiency.