Money and Capital Markets

2525C h a p t e r

Eighth Edition

Financial Institutions and Instruments in a Global Marketplace

Peter S. Rose

McGraw Hill / Irwin Slides by Yee-Tien (Ted) Fu

International Transactions And Currency ValuesInternational Transactions And Currency Values

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Introduction

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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

The U.S. Balance of PaymentsThe U.S. BOP

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Source: Bureau of Economic Analysis

The U.S. Balance of PaymentsThe U.S. BOP

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Source: Bureau of Economic Analysis

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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The U.S. Balance of Payments

-500,000

-400,000

-300,000

-200,000

-100,000

0

100,000

200,000

300,000

400,000

500,000

1961 1966 1971 1976 1981 1986 1991 1996 2001

Data Source: Bureau of Economic Analysis

$ Millions

Net Financial Flows

Balance of Current Account

Net Capital Account Transactions

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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Determining Foreign Currency ValuesIn Today’s Markets

Price of $ in terms of £

(£/$)

Quantity of $

Supply of $(demand for £)

S Demand for $(supply of £)

D

•

D2

S2

•

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

%45.31006

12

16.1

16.114.1

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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.

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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/

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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

2003 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw Hill / Irwin

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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