International Finance and the Foreign Exchange Market

1
International Finance and the Foreign Exchange
Market
2
Exchange Rates-
Number of 1 countrys currency that is equal to 1
unit of another countrys
1 0.8338 1 0.5622
1 1.199 1 1.779
3
Foreign Exchange Market

• Market where different currencies are traded, one
  for another.
• The exchange rate enables people in one country
  to translate the prices of foreign goods into
  units of their own currency.
• An appreciation of a nations currency will make
  foreign goods cheaper.
• A depreciation of a nations currency will make
  foreign goods more expensive.

4
International Rates
CurrencyLast Trade U.S. en12/04 Euro 12/04 Can 12/04 U.K. 12/04 Aust 12/04 SFranc 12/04
U.S. 1 0.009328 1.222 0.7705 1.733 0.7403 0.7894
en 107.2 1 131 82.59 185.8 79.36 84.62
Euro 0.8181 0.007632 1 0.6303 1.418 0.6057 0.6458
Can 1.298 0.01211 1.586 1 2.249 0.9608 1.025
U.K. 0.577 0.005382 0.7053 0.4446 1 0.4272 0.4555
Aust 1.351 0.0126 1.651 1.041 2.341 1 1.066
SFranc 1.267 0.01182 1.548 0.976 2.195 0.9378 1
5
International Rates
U.S. 3/04
1
105.6
0.8237
1.31
0.5506
1.337
1.287
CurrencyLast Trade U.S. 5/04
U.S. 1
en 110.2
Euro 0.8368
Can 1.377
U.K. 0.5638
Aust 1.389
SFranc 1.299
U.S. 4/04
1
110.1
0.8338
1.374
0.5622
1.383
1.294
U.S. 12/04
1
107.2
0.8181
1.298
0.577
1.351
1.267
6
Appreciation
or
Depreciation
Currency Appreciate/ Depreciate Yahoo April 2005 Yahoo Mar 2004 Yahoo Dec 2003 Text Oct 2002
U.S. 1 1 1 1
en 107.293 105.6 107.2 123.3
Euro 0. 7689 0.8237 0.8181 1.01
Can 1.244 1.31 1.298 1.5987
U.K. 0.5232 0.5506 0.577 0.6391
Aust 1.2943 1.337 1.351 1.84
SFranc 1.1879 1.287 1.267 1.49
7
Another View
CurrencyLast Trade U.S. 1 en 109pm 1 Euro109pm 1 Can 109pm 1 U.K. 109pm 1 Aust 109pm 1 SFranc109pm
U.S. 5/3 1 0.009077 1.195 0.7262 1.774 0.72 0.7696
U.S. 12/04 1 0.009328 1.222 0.7705 1.733 0.7403 0.7894
U.S. 10/02 1 0.00811 0.9901 0.6255 1.5648 0.545 0.74
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Exchange Rate Regimes

• Three major types of exchange rate regimes
• flexible (floating) rates,
• fixed-rate (unified currency), and,
• pegged exchange rates.
• Examples of a fixed rate (unified) system
• Nations of the European Union have recent adopted
  a unified currency system.
• A country can also use a currency board to unify
  its currency with another.
• The currencies of Hong Kong, El Salvador, and
  Panama are unified with the U.S. dollar.

9
Pegged Exchange Rate Regimes

• Pegged exchange rate systema country commits to
  using monetary and fiscal policy to maintain the
  exchange-rate value.

10
Venezuela
flexible to fixed

11
Venezuela
12
Lebanon
pegged
13
Labatts beer is produced in Canada. In 1990,
in Ontario, a six-pack of Labatts beer sold for
6.60 Canadian.
Across the border in Michigan, a six pack of the
same beer was on sale for 2.75 U.S. At the
time, the exchange rate was 0.75 U.S. 1.00
Canadian.
14
In Ontario, 6.60 Canadian.
In Michigan, 2.75 U.S. 0.75 U.S. 1.00
Canadian.
1. How much would it cost in U.S. currency to
buy the beer in Ontario?
2. How much would it cost in Canadian currency
to buy the beer in Michigan?
3. Is there an arbitrage opportunity?
4. Where would you buy and where would you sell?
5. How much profit could you expect on a
six-pack?
6.60 x .75 4.95 US
4.95 - 2.75 2.20 US (2.93 Canadian)
2.75 / .75 3.67 Can
Buy in Michigan, sell in Ontario
15
Determinants of the Exchange Rate

• flexible rate system - the exchange rate is
  determined by supply and demand.
• The dollar demand for foreign exchange originates
  from American demand for foreign goods, services,
  assets (real or financial).
• The supply of foreign exchange originates from
  sales of goods, services, assets from Americans
  to foreigners.

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Foreign Exchange Market Equilibrium

• The vertical axis dollar price for 1 British
  pound
• . The horizontal axis - pounds exchanged

Dollar price of foreign exchange(for pounds)

• Equilibrium exchange rate of 1.50 1 English
  pound.

• A price of 1.80 1 pound would lead to an
  excess supply of pounds ...

1.80
1.50
causing the dollar price of the pound to fall
(depreciate).
1.20

• A price of 1.20 1 pound would lead to an
  excess demand for pounds

Quantity of foreign exchange (pounds)
Q
causing the dollar price of the pound to rise
(appreciate).
17
Changes in the Exchange Rate

• Determinants
• A change in national income (relative to trading
  partners) people buy more, or less of everything.
  
• A change in the inflation rate in one country.
• a. Higher rate decreases demand
• b. Lower demand - depreciation
• A change in interest rates (relative to rates
  abroad).
• a. High rates attract money
• b. Currency appreciates
• 4. Changes in tastes

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Foreign Exchange Market Equilibrium
Dollar price of foreign exchange(for pounds)

• If incomes increase in the United States, U.S.
  imports of foreign goods and services will grow.

S(sales to foreigners)

• The increase in imports will increase the
  demand for pounds in the foreign exchange market

1.80
causing the dollar price of the
pound to rise from 1.50 to 1.80.
1.50
a
D1
Quantity of foreign exchange (pounds)
Q1
Q2
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Inflation With Flexible Exchange Rates

• If the price level in the U.S. increased by 50
  

Dollar price of foreign exchange(for pounds)
the U.S. demand for British goods (and pounds)
would increase (relatively cheap).
S1
2.25
Since U.S. exports to Britain would decline and
thereby cause the supply of pounds to fall.
1.50
a

• These forces would cause the dollar to
  depreciate relative to the pound.

D1
Quantity of foreign exchange (pounds)
Q1
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Peso Appreciation or Depreciation?

• The US reduces tariffs on Mexican products.
• Mexico encounters severe inflation.
• Deteriorating political relations reduce American
  tourism in Mexico.
• The US economy moves into a severe recession
• A bartender puts a lime in a Corona and beer
  sales jump
• The Mexican government encourages American firms
  to invest in Mexican oil fields
• A large federal government budget deficit raises
  interest rates in the US

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Euro Appreciation or Depreciation?

• An American importer purchases a shipload of
  Bordeaux wine.
• BMW decides to build an assembly plant in LA
• A CVCC student decides to spend a year studying
  at the Sorbonne.
• A Spanish manufacturer exports machinery to
  Morocco on an American freighter.
• The US incurs a balance of payments deficit in
  its transactions with Belgium.
• A US government bond held by an Italian citizen
  matures.
• It is widely believed that the international
  value of the Euro will fall in the near future.

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Balance of Payments

• Balance of payments accounts that summarize the
  transactions of a countrys citizens,
  businesses, and governments with foreigners

• Imports create a demand for foreign currency (and
  a supply of the domestic currency) and are
  recorded as a debit item.

• Exports create a supply of foreign currency (and
  demand for the domestic currency) and are
  recorded as a credit item.

23
Balance of Payments

• Under a pure flexible rate system, the foreign
  exchange market will bring the quantity demanded
  and the quantity supplied into balance, and as a
  result, it will also bring the total debits into
  balance with the total credits.

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Balance of Payments

• Current account transactionsall payments (and
  gifts) related to the purchase or sale of goods
  and services and income flows during the current
  period
• Four categories of current account transactions
• Merchandise trade(import and export of goods)
• Service trade(import and export of services)
• Income from investments
• Unilateral transfers(gifts to and from
  foreigners)

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Balance of Payments

• Capital account transactionstransactions that
  involve changes in the ownership of real and
  financial assets
• The capital account includes both
• direct investments by foreigners in the U.S. and
  by Americans abroad, and,
• loans to and from foreigners.
• Under a pure flexible-rate system, official
  reserve transactions are zero therefore
• a current-account deficit implies a
  capital-account surplus.
• a current-account surplus implies a
  capital-account deficit.

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U.S. Balance of Payments, 2003
Balance
Debits
Credits
deficit (-) / surplus ()
Current account
713.1
1. U.S. merchandise exports
2. U.S. merchandise imports
- 1260.7

3. Balance of merchandise trade (1 2)
- 547.6
307.4
4. U.S. service exports
5. U.S. service imports
- 256.3
6. Balance on service trade (4 5)
51.1
7. Balance on goods and services (3 6)
- 496.5
8. Income receipts of Americans from abroad
294.4
9. Income receipts of foreigners in the U.S.
- 261.1
33.3
10. Net income receipts (8 9)
- 67.4
11. Net unilateral transfers
12. Balance on current account (7 10 11)
- 530.6
Source http//www.economagic.com/. Figures
are in Billions of Dollars
27
U.S. Balance of Payments, 2003
Balance
Debits
Credits
deficit (-) / surplus ()
Current account
12. Balance on current account (7 10 11)
- 530.6
Capital account
580.6
13. Foreign investment in the U.S. (capital
inflow)
-297.1
14. U.S. investment abroad (capital outflow)
15. Balance on capital account (13 14)
283.5
Official Reserve Transactions
16. U.S. official reserve assets
-1.5
17. Foreign official assets in the U.S.
248.6
247.1
18. Balance, Official Reserve Account (16 17)
17. Total (12 15 18)
0.0
Source http//www.economagic.com/. Figures
are in Billions of Dollars
28

• Capital Flows and
• the Current Account

29
Leading Trading Partners of the U.S.
2
0
- 2
- 4
1973
1978
1983
1988
1993
2003
1998
4
2
0
- 2
1973
1978
1983
1988
1993
2003
1998

• Under a flexible exchange rate system the inflow
  and outflow of capital will exert a major impact
  on the current account and trade balances.
• The figures for the U.S. (above) illustrate this
  linkage.

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Monetary Policy the Exchange Rate

• An unanticipated shift to a more restrictive
  monetary policy will
• raise the real interest rate,
• reduce the rate of inflation, and,
• at least temporarily, reduce aggregate demand
  and the growth of income
• causing an appreciation in domestic currency.
• the currency appreciation (with shift the current
  account toward a deficit).
• An unanticipated shift to more expansionary
  monetary policy will cause the opposite
• lower interest rates, and,
• an outflow of capital
• leading to a currency depreciation, and,
• a shift toward a current account surplus.