International Finance Balance of Payments Foreign Exchange Markets Foreign Exchange Rates Spot rates and forward rates Foreign Exchange Systems Risk Management in International Business Other internationally traded financial instruments

Balance of Payments The balance of payments is an accounting listing (tabulation) of the values of economic (trade and financial) transactions between the resident of a (home) country and residents of other countries. Balance of payments entries are recorded based on the double-entry bookkeeping principle. The balance of payments entries are always balanced; the entries add up to zero.

Balance of Payments Account Categories Current Accounts Merchandise Trade Service Trade Services of Capital: Interest Incomes, Dividends Unilateral Current Transfers Capital Accounts US private investments abroad Foreign private investments in the US Other investments/capital transactions Official Accounts (Changes in) US official reserve assets abraod: gold, SDRs, foreign currencies (Changes in) foreign official assets in the US

Double-Entry Principle Each transaction affects at least two account Debit entries balance credit entries Imports are debit entries The balancing (credit) entry(ies) for an import take(s) place in one (or more) of the sections of capital the accounts Exports are credit entries The balancing (debit) entry(ies) for an export take(s) place in one (or more) of the sections of the capital accounts Capital inflows (increases in foreign assents) are credit entries Capital outflows (increases in US residents-owned assets abroad) are debit entries Increases in US claims against residents of other countries are debit entries Increases in foreign residents’ claims against US are credit entries

Balance of Payments Balances Balance of Merchandise Trade Balance Merchandise and Services Current Account Balance »Capital Account Balance Official Settlement Balance »Statistical errors Overall Balance = 0

How is the BOP balances? Debit(-)Credit (+) Export 100 Import 120 Current Account Balance -20 Reduction in US bank Deposit claims abroad 10 Official Settlement Balance -10 Reduction in official reserves 10 Balance of Payments 00

Foreign Exchange Markets Given that each nation state has its own currency (with which domestic transactions are carried out), all international transactions potentially generate either supply or demand for foreign exchange. Generally, transactions resulting in debit entries in the BOP generate demand for FX(e.g., imports, investments abroad); transaction resulting in credit entries generate demand(e.g., exports, foreign investments in the US) Foreign exchange markets are places, systems, or mechanisms through which currencies are exchanged or traded. Today, most currency exchange rates are largely determined by the forces of supply and demand

Foreign Exchange Markets Yen $ o D S D` eo e1e1 Qo Q 1

Prices and Exchange Rates Exchange rate quotes: The value of FX in domestic currency ($) $1.5/pound $.0089/Y $1.20/Euro The value domestic currency ($) in terms of a foreign currency pound/$ Y112.36/$ E0.8333/$ $ P = e. YP $ P =.0089 X = $ 178

Foreign (FX)Exchange Rates and Inflation Changes in FX rate and domestic prices »Appreciation of a currency »Depreciation of a currency Nominal FX rate vs. real FX rate The effect of a currency depreciation (on price) could be partly of totally off set by inflation in the prices denominated in that currency

FX Cross Rates and Arbitrage Suppose Y/$ rate = Y128/$ Y/E rate = Y150/E Cross $/E rate = (150/128) = $ If the market $ spot rate for euro is quoted as $1.20/E, there is an arbitrage opportunity: Buy 128 yen with a dollar, convert it to euro at Y150/E. You’ll get euro. Then sell your euro at $1.20/E. You’ll receive $ You have made $.024 on each dollar.

Foreign Exchange Risk Transaction Exposure Accounting/Translation Exposure Economic Exposure

FX Risk Management FX Spot Markets Buying or selling FX for immediate delivery (on the spot) FX Forward Markets Buying or selling FX at a predetermined (agreed upon) rate for future delivery FX Futures Buying or selling standardized blocks of FX at (market determined) preset rates for future delivery FX Options Buying or selling options to buy (call) or options to sell (put) standardized blocks of FX at preset prices in the future for future delivery Currency Swaps

A Forward Transaction An American company is expecting to receive 2.5 million euro from a German company in the first week of March. Today’s euro spot rate is $1.17/euro.To avoid a loss from possible depreciation of the euro, through it bank, the company sells its expected euro receipt in the forward market at $1.16 per euro for March delivery. According to this forward contract on March 3 the company will receive: 2,500,000 x 1.16 = $2,900,000

A Call Option Transaction An American auto importer has purchased 1000 automobiles from Japan. On March 3, the importer is expected to pay for these cars in yen: 1,320,000,000 yen The importer purchases 105 blocks of yen (call) options for March settlement at 92.5* cents per 100 yen at 1.25 per 100 yen. Today the importer pays: 105x(12,500,000/100)x.0125 = $164,062.5 That is equivalent to yen per dollar