1. International Trade and Finance
PPTs series 6
April 2014

2. List of Contents Part II Finance The Balance of Payments Introduction
2. Foreign exchange
3. Exchange Regimes
4. Agents and their Activities
a) Spot and Forward Markets
b) Export and Import
c) Spot Speculation
d) Forward Speculation
e) Interest arbitrage
5. Selected Exchange Rate Theories
Introduction
Part I Trade
1. Theories of Trade
a) Motives for Trade
b) Absolute Ádvantage
c) Comparative Advantage
d) Extensions
2. Barriers to Trade
a) Non.tariffary Barriers
b)Tariffs
c) Quotas
d) Subsidies
April 2014

3. Spot and Forward markets
Spot market:
agreement on price and quantity of foreign exchange and transaction trake place simultaneously
Forward market:
agreement on price and quantity of foreign exchange takes place today, but transaction at a specified later date
April 2014
© Dr. Helmut Less

4. Abbreviations Exchange Rate e Spot Exchange Rate es
Forward Exchange Rate ef
Swap Rate s = (ef – es)/es
Expected Spot Exchange Rate e*
Foreign Interest Rate if
Domestic Interest Rate i
Gross interest differential dg= if – i
Net interest differential d = if – i + s
© Dr. Helmut Less
April 2013

5. Activities on foreign exchange markets
Export and import
Speculation in spot exchange
Speculation in forward exchange
Covered interest arbitrage
Uncovered interest arbitrage
© Dr. Helmut Less
April 2014

6. Export and Import: Rules
Payment immediate: Spot market
Payment delayed:
Exporter: if es* > ef  spot market at date of payment
if es* < ef  forward market today
Importer: if es* < ef  spot market at date of payment
if es* > ef  forward market today
(Hint: Risk preference or aversion will play a roll)
© Dr. Helmut Less
April 2014

7. Export and Import: Example
Export of merchandise worth 20 Million $
es = 2,00 es* = 1,92 ef = 1,91 (both for 3 months)
Payment immediate  sale of $ spot today
Payment in three months
- Risk lover: wait and sell spot in three months
- risk averter: sell forward today
Summer 2013
© Dr. Helmut Less

8. Speculation in Spot Exchange: Rules
If es* > es  buy spot today, sell spot later
If es* < es  sell spot today, buy spot later
April 2014
© Dr. Helmut Less

9. Speculation in Forward Exchange: Chance
ef = 0,84
es* = 0,81
Sell 3-months forward today, wait until three months elapse.
Assuming a correct guess, buy spot and collect a profit of
0,03 EUR per $ commitment.
Or, if the guess was wrong and the spot rate hits i.e.
es = 0,85 lose 0,01 EUR per $ commitment
April 2014
© Dr. Helmut Less

10. Speculation in Forward Exchange: Rules
If ef > es*  sell forward today, buy spot at time of maturity and fulfill forward contract
If ef < es*  buy forward today, sell spot at time of maturity and fulfill forward contract
April 2014
© Dr. Helmut Less

11. Covered Interest Arbitrage: Problem
From the domestic perspective:
if = 6% and i = 4% could be a motive to invest into US securities.
What if at time of maturity $ depreciates from
es1 = to es2 = 0,72?
Investers would incurr a loss.
Solution: swap = simultaneous spot a forward transaction.
April 2014
© Dr. Helmut Less

12. Covered Interest Arbitrage: RulesIf
d = if – i + (ef – es)/es > 0  buy spot today, sell forward today
d = if – i + (ef – es)/es < 0  sell spot today, buy forward today
April 2014
© Dr. Helmut Less

13. Uncovered Interest Arbitrage: Rules
If if – i + (es* – es)/es > 0  buy spot today, sell spot later
If if – i + (es* – es)/es < 0  sell spot today, buy spot later
April 2014
© Dr. Helmut Less