International FinanceFINA 5331

Lecture 2: Foreign Currency Markets Continued: Introduction to

Balance of Payments

Read: Chapters 3&5Aaron Smallwood Ph.D.

The Bid-Ask Spread

• The bid price is the price a dealer is willing to pay you for something.

• The ask price is the amount the dealer wants you to pay for the thing.

• The bid-ask spread is the difference between the bid and ask prices.

Cross Rates• Suppose that S($/€) = 2

– i.e. $1 = 0.50 €

• and that S(¥/€) = 50

– i.e. €1 = ¥50

• What must the $/ ¥ cross rate be?

2/50= ¥0.04.

$ $ €since ,

¥ € ¥

Example:

• If the bid ask spread for RMB is:– $0.1600 -$0.1610:– How many RMB do we receive if we sell

$10,000?

$10,000/0.1610 = 62,111.80.– What is we wanted to sell RMB 10,000?

RMB10,000 * .1600 = $1,600.

Review

• The spot market is an exchange market for delivery of currencies on the “spot.”

• Direct quotations for currency x from currency’s y perspective: S(y/x).

• Banks buy currencies at the bid price and sell at the ask price:– Ex. In the market for ¥ relative to €, suppose we get

the quote: €0.00770-75. How much to purchase ¥ 1,000,000?=

– ¥ 1,000,000*0.00775= €7,750.

Triangular Arbitrage

$

£¥

Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

Barclays

S(¥/$)=120

Suppose we observe these banks posting these exchange rates.

First calculate the implied cross rates to see if an arbitrage exists.

Triangular Arbitrage

Barclays

S(¥/$)=120

The implied S(¥/£) cross rate is S(¥/£) = 80

Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity.

So, how can we make money?

Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars.

$Credit Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85¥ £

Triangular Arbitrage

Barclays

S(¥/$)=120

As easy as 1 – 2 – 3:

1. Sell $ for £,

2. Sell £ for ¥,

3. Sell ¥ for $.

$Credit

Lyonnais

S(£/$)=1.50

Credit Agricole

S(¥/£)=85

¥ £

1

2

3

$

Triangular Arbitrage

Sell $100,000 for £ at S(£/$) = 1.50

receive £150,000

Sell our £ 150,000 for ¥ at S(¥/£) = 85

receive ¥12,750,000

Sell ¥ 12,750,000 for $ at S(¥/$) = 120

receive $106,250

profit per round trip = $ 106,250- $100,000 = $6,250

Cross Currency Exchange Rates with Bid-Ask Spreads

• Consider the example on page 122– Suppose, relative to the US $, we are given the bid

ask spread in the market for pounds (e.g. $/£). What then is the bid ask spread in the market for $?

• Bid price is the inverse of the ask price.• If bid-ask spread in the market for pounds is: $1.9712-17,

the bid price in the market for $=

– Can show that the ask price is 0.5073

5072.09717.1/1£/$ tS

Triangular Arbitrage

• Previous triangular arbitrage is unrealistic since traders face no transactions costs.

• We want to consider examples with bid-ask spreads.

• See example on pages 122-123, with the following quotes:– Market for pounds: $1.9712-17– Market for euros: $1.4739-44– Market for pounds: €1.3305-10

• Implied price in the third market is 1.3370-77. POUND UNDERVALED!

Exploit the arbitrage opportunity

• Suppose we start with $1,000,000• First, we need to get euros so we can buy

pounds in the 3rd market.– Start by selling dollars for euros:

• We receive: $1,000,000/1.4744 = €678,242.00

– Sell euros for pounds:• We receive: €678,242.00/1.3310 = £509,573.25

– Finally, sell pounds for dollars• We receive: £509,573.25*1.9712 = $1,004,470.79

• PROFIT: $4,470.79.

Balance of Payments Accounting

• The Balance of Payments is the statistical record of a country’s international transactions over a certain period of time presented in the form of double-entry bookkeeping.

credit “positive” entries

debit “negative entries”

Balance of Payments Example

• Suppose that Maplewood Bicycle in Maplewood, Missouri, USA imports $100,000 worth of bicycle frames from Mercian Bicycles in Darby England.

• There will exist a $100,000 credit recorded by Mercian that offsets a $100,000 debit at Maplewood’s bank account.

• This will lead to a rise in the supply of dollars and the demand for British pounds.

• The balance of payments accounts are those that record all transactions between the residents of a country and residents of all foreign nations.

• They are composed of the following:– The Current Account– The Capital Account– The Financial Account– The Official Reserves Account– Statistical Discrepancy

Balance of Payments Accounts

The Current Account

• Includes all imports and exports of goods and services (invisible trade).

• Includes unilateral transfers of foreign aid.• If the debits exceed the credits, then a

country is running a trade deficit.• If the credits exceed the debits, then a

country is running a trade surplus.• It is thought that the CA responds to changes

in income and the exchange rate.

The Current Account

• A credit on the current account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the current account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Current Account

• When a domestic company sells goods or services to a foreign resident, there will be a credit recorded on the current account.

• When a domestic resident buys goods or services from a foreign firm, there will be a debit recorded on the current account.

• When a foreign asset pays interest to a domestic resident, or a domestic resident earns income in the foreign economy, there will be a credit recorded on the current account.

• When a domestic asset pays interest to a foreign resident, or a foreign resident earns income in the domestic economy, there will be a debit recorded on the current account.

J-curve Effect

What conditions are necessary for J-curve effect?

εIM is the import demand elasticity = %Δimports divided by %ΔSt.

When εIM is greater than one (in absolute value), a domestic depreciation will lead to a fall in the dollar value of imports. Import demand is said to be elastic.

When εIM is equal to one (in absolute value), a domestic depreciation will not change the dollar value of imports.

When εIM is less than one (in absolute value), a domestic depreciation will lead to a rise in the dollar value of imports. Import demand is inelastic.

The J-curve can only occur when import demand elasticities are inelastic.

Algebra of Import Demand Elasticities

$ value of imports t importsS Q

% $ value of imports % %t importsS Q

%% $ value of imports % 1

% % %imports IMt

t t t

QS

S S S

Since 0 and % 0,

0 if unit elasticity% $ value of imports

0 if elastic%

0 if inelastic

IMt

t

S

S

The Financial Account

• The financial account measures the difference between U.S. sales of assets to foreigners and U.S. purchases of foreign assets.

• The financial account is composed of Foreign Direct Investment (FDI), portfolio investments and other investments.

The Financial Account

• A credit on the financial account results in foreign reserves flowing in (fixed exchange rate) or an increase in the demand for domestic currency in the FOREX market (flexible exchange rate).

• A debit on the financial account results in foreign reserves flowing out of the domestic economy (fixed exchange rate) or an increase in the supply of domestic currency in the FOREX market (flexible exchange rate).

The Financial Account

• When a domestic entity (firm or individual) sells an asset to a foreign resident, there will be a credit recorded on the financial account.

• When a domestic resident buys an asset from a foreign entity, there will be a debit recorded on the financial account.

• Note – income earned on these assets is recorded on the current account, not the financial account.

The Balance of Payments Identity

BCA + BFA + BRA = 0whereBCA = balance on current accountBFA = balance on financial accountBRA = balance on the reserves account

• Note: When a country experiences a currency crisis, we typically see BRA>0 (and HUGE)

Under a pure flexible exchange rate regime, BCA + BFA = 0

Because BRA = 0

Balance of Payments Trends

• Since 1982 the U.S. has experienced continuous deficits on the current account and continuous surpluses on the financial account.

• During the same period, China has experienced the opposite.

China BOP

Japan BOP

USA BOP

Balances on the Current (BCA) and Financial (BKA) Accounts of United Kingdom

1981 1986 1991 1996 2001 2006 2011-100

-80

-60

-40

-20

0

20

40

60

80United Kingdom

Bala

nces

in B

illion

s of

US

dolla

rs

Current Account Balance

Financial Account Balance

Balance of Payments and National Income Accounting

• GNP = Y = C + I + G + X – M• Y = C + S + T• X – M = (S- I) + (T- G)• If a developing economy experiences large

trade deficits (X-M <0), the remedies are:1. Savings must increase, S↑2. Investment must fall, I↓3. Government spending must fall, G↓4. Taxes must rise, T↑