International Transactions And Currency Values

1. 25 International Transactions And Currency Values C h a p t e r Money and Capital Markets Financial Institutions and Instruments in a Global Marketplace Eighth Edition Peter S. Rose McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

2.  Learning Objectives  • To explore the functions and roles performed by the international markets within the global financial system. • To see how international payments for goods and services are made, and how international borrowing and lending can be tracked through a nation’s balance-of-payments accounts. • To understand how the values of national currencies are determined.

3. Introduction • Facilitated by dramatic improvements in communication and transportation, world trade and the international financial markets have experienced enormous growth.

4. The Balance of Payments • One of the most widely used sources of information concerning flows of funds, goods, and services between nations is each country’s balance of payments (BOP) accounts. • This statistical report summarizes all the economic and financial transactions between residents of one nation and the rest of the world during a specified period of time.

5. 25 - 5 The U.S. Balance of Payments The U.S. BOP Source: Bureau of Economic Analysis

6. 25 - 6 The U.S. Balance of Payments The U.S. BOP Source: Bureau of Economic Analysis

7. $ Millions Net Financial Flows Net Capital Account Transactions Balance of Current Account Data Source: Bureau of Economic Analysis The U.S. Balance of Payments

8. The Problem of Different Monetary UnitsIn International Trade and Finance • Different monetary units are used as the standard of value in different countries. • When goods and services are sold or when capital flows across national boundaries, currency exchange is often necessary. • Currency exchange is risky. Speculative currency flows may also complicate government policies aimed at curbing inflation and ensuring economic growth.

9. The Problem of Different Monetary UnitsIn International Trade and Finance • The gold standard – During the 17th and 18th centuries, major trading nations in Western Europe made their currencies freely convertible into gold at predetermined prices. • The gold exchange standard – Each currency was freely convertible into gold at a fixed rate, and also free convertible into other currencies at relatively stable prices.

10. The Problem of Different Monetary UnitsIn International Trade and Finance • The modified exchange standard (Bretton Woods System) – Foreign currency prices were linked to the U.S. dollar and to gold. • The managed floating currency standard – Each nation chooses its own exchange rate policy, consistent with the structure of its economy and its goals. Examples of policies used include pegging, managed float, and free floating.

11. Determining Foreign Currency ValuesIn Today’s Markets • The foreign exchange market is an over-the-counter market, with no central trading location, no set hours of trading, and no formal code of rules. • There are three major sections:  the spot market,  the forward market, and  the currency futures and options market. • Foreign exchange rates are quoted as bid (buy) and ask (sell) prices by dealers.

12. Determining Foreign Currency ValuesIn Today’s Markets • Foreign exchange rates are affected by a number of factors, including: • balance of payments positions • speculation over future currency values • domestic political and economic conditions • central bank interventions • These factors may be expressed in terms of the market forces of demand and supply.

13. Price of $ in terms of £ (£/$) D2 Supply of $ (demand for £) D • • S Demand for $ (supply of £) S2 Quantity of $ Determining Foreign Currency ValuesIn Today’s Markets

14. The Forward Market for Currencies • A forward contract is an agreement to deliver a specified amount of foreign currency at a set price on some future date. • There are several ways of measuring and quoting forward exchange rates: • outright rate, e.g. $1.14/€ for delivery in 6 months • swap rate, e.g. 2¢ discount from spot ($1.16/€) • annualized percentage rate, e.g. 3.45% discount

15. The Forward Market for Currencies • The functions of forward contracts can be grouped into four categories: • commercial covering by exporters and importers of goods and services • hedging an investment position in a foreign currency • speculation on future currency prices • covered interest arbitrage

16. The Forward Market for Currencies • A condition known as interest rate parity exists when the interest rate differential between two nations is exactly equal to the forward discount or premium on their two currencies. • When parity exists, the currency markets are in equilibrium and capital funds do not flow from one country to another.

17. The Market for Foreign Currency Futures • Foreign currency futures are contracts calling for the future delivery of a specific currency at a price agreed today, although there is usually no intent to actually deliver the currencies. • They are attractive to both foreign exchange hedgers and foreign exchange speculators. • Importers of goods typically use the buying hedge, while those expecting foreign currency earnings usually use the selling hedge.

18. Other Innovative Methods forDealing with Currency Risk • The recent volatility of foreign exchange rates has given rise to an ever-widening circle of devices to deal with currency risk. • Currency options • Options on currency futures • Currency swaps • Local loans and Dual-currency bonds • Prepayments, barter, or selective currency pricing • Risk-adjusted pricing

19. Government InterventionIn the Foreign Exchange Markets • A strong and stable currency encourages investment in the home country, stimulating its economic development. The US$ is also a vehicle currency that facilitates trade and investment between many nations. • Hence, the United States, as well as foreign governments, have intervened in the foreign exchange market to stabilize currency values and insulate domestic economic conditions from developments abroad.

20. Money and Capital Markets in Cyberspace • For more information about international transactions and currency values, visit: • http://www.encyclopedia.com/html/b1/balancp1ay.asp • http://www.bea.gov/ • http://www.stls.frb.org/ • http://www.forex-trc.com/ • http://www.oanda.com/ • http://quote.yahoo.com/ • http://www.forexnews.com/

21. Chapter Review • Introduction • The Balance of Payments • The U.S. Balance of International Payments • The Current Account • The Capital Account • The Financial Account • Disequilibrium in the Balance of Payments

22. Chapter Review • The Problem of Different Monetary Units in International Trade and Finance • The Gold Standard • The Gold Exchange Standard • The Modified Exchange Standard • Adoption of the Managed Floating Currency Standard

23. Chapter Review • Determining Foreign Currency Values in Today’s Markets • Essential Features of the Foreign Exchange Market • Exchange Rate Quotations • Factors Affecting Foreign Exchange Rates • Supply and Demand for Foreign Exchange

24. Chapter Review • The Forward Market for Currencies • Methods of Quoting Forward Exchange Rates • Functions of the Forward Exchange Market • The Principle of Interest Rate Parity • The Market for Foreign Currency Futures • Other Innovative Methods for Dealing with Currency Risk • Government Intervention in the Foreign Exchange Markets