International Business
Lola2230
Gaspar2eChapter04.pptxChapter 4 The International Flow of Funds and Exchange Rates
Introduction to Global Business
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Explain the balance of payments for a country.
Describe the foreign exchange market and its components.
Discuss the development of international monetary systems.
Explain exchange rate changes over time.
Forecast exchange rates using different methodologies.
After studying this chapter, you should be able to:
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EXHIBIT 4.1 THE DOLLAR TO EURO EXCHANGE RATE: JANUARY 2007 – JUNE 2009
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The Balance of International Payments
Balance of payments (BOP)
Shows all transactions between one country and the rest of the world for a given period of time
Current account
Shows the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers
Financial account
Consists of domestic-country-owned assets abroad, foreign-owned assets in the domestic country, and net financial derivatives
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Balance of Payments (BOP)
Trade balance
Services balance
Income balance
Net transfers
Current Account
U.S. assets abroad
Foreign assets in the U.S.
Net financial derivatives
Financial Account
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The Financial Account of the BOP
Risk premium
The added return required by investors for risk associated with a security or asset
Foreign direct investment (FDI)
The purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services abroad
Statistical discrepancy
Reconciles imbalances between the current account and financial account to ensure that debit and credit entries in the BOP statement sum to zero
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EXHIBIT 4.2 U.S. BALANCE OF PAYMENTS (IN BILLIONS OF DOLLARS)
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EXHIBIT 4.3 TOP TEN COUNTRIES TRADING WITH THE UNITED STATES
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EXHIBIT 4.4 U.S. FINANCIAL ACCOUNT (IN BILLIONS OF DOLLARS)
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EXHIBIT 4.5 GROWTH IN WORLD MERCHANDISE TRADE BY SELECTED REGION AND ECONOMY, 2005–2013
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Foreign Exchange Markets
Independent floating exchange rate system
Managed floating exchange rate system
Fixed exchange rate system
Setting Exchange Rates
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Components of the Foreign Exchange Market
Spot market
Forward market
Futures market
Forex Markets
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Forex Trading Terms
Bid-ask spread
The difference between bid and ask prices of a currency; the transaction fee earned by the bank
Direct quotes
Prices of a foreign currency in dollars, or the number of dollars per one unit of foreign currency)
Indirect quotes
The reciprocal of the direct quote, or the prices of a dollar (for example) in foreign currency terms
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Forex Trading Terms (continued)
Forward rate
The price at an earlier time of a currency in terms of another currency established for future delivery in the forward market
Discount
The selling of a currency at a spot rate that is less than the forward rate
Premium
The selling of a currency at a spot rate that is more than the forward rate
Hedge
Insurance that reduces future risk
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International Monetary Systems
Gold standard
Monetary system that pegs currency values to the market value of gold
Bretton Woods Agreement
The 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar
International Monetary Fund (IMF)
The financial authority established under the Bretton Woods Agreement to help ensure the stability of the international monetary and financial system
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Development of the Flexible Exchange Rate System
Smithsonian Agreement
The 1971 decision allowing the United States to devalue the dollar against other countries’ currencies
Jamaica Agreement
The 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets
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Valuing (or Devaluing) Currencies
Special drawing right (SDR)
A basket of currencies (dollars, euros, pounds, and yen) created by the IMF for use as a benchmark to value the currencies of different countries
Clean float currency
Monetary system with minimal government intervention; largely market determined
Dirty float currency
Monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies
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What’s in Your Wallet?
Dollarization
The practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country
Hard currencies
Leading world currencies of developed industrialized countries, including the dollar, euro, yen, and pound
Soft currencies
Emerging market countries’ currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values
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International Flows of Goods and Capital
Law of one price
Principle stating that identical goods should sell for the same price in different countries according to local currencies
Arbitrage
Buying goods in a lower priced market and selling them in a higher priced market to make profits
Purchasing power parity (PPP)
Theory stating that a basket of goods should have approximately the same prices across different countries
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Do You Want PPP Fries with That? The Big Mac Index
The Big Mac Index
A calculation using the cost of a Big Mac sandwich to assess the relative values of currencies
Click on the following link to view the Big Mac index cited in the textbook and its associated chart:
What could cause the index to provide inaccurate estimates of PPP among its comparison countries?
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Inflation and Purchasing Power Parity
PUS(1 + IUS) = (1 + p)PE(1 + IE),
where PUS = price index of U.S. goods in dollars
PE = price index of European goods in dollars
IUS = inflation rate in the United States in dollar terms
IE = inflation rate in Europe in euro terms
p = percentage change in the euro, which equals the forward premium [(F – S)/S] 100 with F the forward dollar/euro exchange rate and S the spot dollar/euro exchange rate.
Given an exchange rate of $1.40 per euro, an initial PPP with PUS = $140 and PE = €100 or $140, and 10 percent U.S. inflation and 0 percent European inflation, we have
$140(1.10) = (1+ p) $140(1),
such that the forward premium p = [($154 – $140)/$140] 100 = 10 percent.
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Problems with PPP
Empirical tests of PPP have found mixed results:
PPP appears to hold in the long run for periods exceeding five years, but may not hold in shorter periods.
For countries with little difference in inflation rates, PPP does not reliably explain exchange rate changes.
PPP predictions are affected by:
Transportation costs and trade barriers
Government intervention in trade and exchange rates
Multinational firms with pricing power
Market expectations about economic factors
Goods not traded but that affect internal prices
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Interest Rate Parity
Interest rate parity (IRP)
Theory stating that the bond interest rate in different countries will become the same as investors buy and sell bonds to make arbitrage profits
Covered interest rate parity
Principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
Uncovered interest rate parity
Principle implying that expected forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
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Calculating Interest Rate Parity
(1 + iUS) = (F/S)(1 + iE),
where iUS = interest rate on U.S. bond paid in euros
iE = interest rate on European bond paid in euros
F = forward dollar to euro exchange rate
S = spot dollar to euro exchange rate.
This equation says that a dollar invested in a U.S. bond earns the same dollar return as a dollar converted to euros and invested in European bonds with euro returns later repatriated to dollars. If S is fairly stable over time, this IRP can be approximated with the following well-known formula:
(iUS – iE) = (F – S)/S = p
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Problems with IRP
Empirical evidence on IRP theories is mixed:
Transactions cost is one impediment to achieving IRP.
Political risk, legal restrictions, tax effects, managed-float rate regimes can disrupt traders’ ability to arbitrage away profit differentials.
Market psychology (herd behavior) can play a role in rate movements as traders speculate in currencies.
Central bank intervention may cause IRP not to hold at all points in time.
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Forecasting Exchange Rates
Using the forward rate in the covered IRP to forecast future spot rates:
F = S(1 + p),
where F = forward rate, S = spot rate, and p = forward premium.
Using a multiple regression model:
X = b0 + b1(IUS – IE) + b2(iUS – iE) + b3(YUS – YE),
where (IUS – IE) = difference in inflation rates
(iUS – iE) = difference in interest rates
(YUS – YE) = difference in GDP growth rates.
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balance of payments (BOP)
current account
trade balance
trade deficit
services balance
income balance
balance of transfers
financial account
risk premium
foreign direct investment (FDI)
statistical discrepancy
foreign exchange markets
exchange rate
independent floating exchange rate system
managed floating exchange rate system
fixed exchange rate system
spot market
bid-ask spread
direct quotes
indirect quotes
forward market
forward rate
Key Terms
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discount
premium
hedge
inflation
gold standard
Bretton Woods Agreement
International Monetary Fund (IMF)
Smithsonian Agreement
Jamaica Agreement
special drawing right (SDR)
clean float currency
dirty float currency
dollarization
hard currencies
soft currencies
law of one price
arbitrage
purchasing power parity (PPP)
Big Mac index
interest rate parity (IRP)
covered interest rate parity
uncovered interest rate parity
Key Terms (continued)
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