Study Unit 7 Part 2 – Currency Exchange Rates & International Trade

What is this graph?

Exchange Rates Overview The Market for Foreign Currency: basic concepts 4 Systems for setting exchange rate: Fixed rates = fix or narrow range (Govt intervention) Freely floating rates = correct disequilibrium + vulnerability Managed float rates = mix between free and Govt intervention Pegged rates = Govt fixes the rate of exchange for its currency Spot Rate = TODAY! Forward Rate = definite future date forward premium and forward discount Calculation = [FR – SR / SR] x [365 / Days Forward Period] Cross Rate = 2 currencies are not stated in terms of each other Calculation = Domestic currency USD / Foreign currency USD

Foreign Exchange Cross Rates

Exchange Rate & Purchasing Power Demand Curve downward sloping Currency becomes cheaper Goods in that currency become more affordable Domestic consumers need more of it Supply Curve upward sloping Currency becomes expensive Goods and services become more affordable to users of the foreign currency leading them to inject more of their currency into the domestic market

Foreign Trade / Balance of Payments Balance of Payments = Domestic transactions – Foreign ones 2 major categories of activities: Currency Account Exchange of goods, services, interest and dividends Goods = Balance of Trade Capital Account Exchange of Capital Assets and Financial Instruments Unfavorable Balance of Payments  Need for Reserves The necessity of holding such reserves depletes the country’s reserves of foreign currencies and ties up domestic funds that could be used for other purposes

Balance of Trade = net exports Weak country’s currency = goods & services are more affordable to foreign consumers  Balance of Trade > 0 Strong country’s currency = goods & services are more expensive to foreigners  Balance of Trade < 0 Short-term measure for a country = devaluing its currency

USA Top 15 countries: Trade

Effective Interest Rate: Currency Loan Example page 284 Effective rate = Difference (conversion rate) / amount borrowed Factors affecting Exchange Rates: Trade-related factors (3) Relative inflation rates Relative income levels Government intervention Financial factors (2) Relative interest rates Ease of capital flow

Trade-related factors 1.Relative inflation rates -When rate of inflation goes up, demand of that country’s currency goes down (less attractive) = falling purchasing power -Investors unload this currency = more available = outward shift of the supply curve  see graph page 285 -An investor’s domestic currency has gained purchasing power in the country where inflation is worse 2.Relative income levels -Citizens with higher incomes look for new consumption opportunities in other countries driving up the demand -Incomes rise = prices of foreign currency rise = local currency will depreciate 3.Government intervention - Actions by national governments (Trade Barriers, currency restriction, quotas) complicate the process of exchange rate determination

Financial factors 1.Relative interest rates -Same concept than inflation = when interest rates rise, demand for that country’s currency rises -Outward shift of the demand curve results from the influx of other currencies seeking the higher returns available in that country -More and more investors buy up the high-interest country’s currency = less available = inward shift of the supply curve 2.Ease of capital flow -Country with high real interest rates loosing restrictions against cross-border movement of capital = demand for the currency rises as investors seek higher returns -Example page 287 in Asia

Graphical Depiction

Calculating simultaneous effects Differential interest rates Interest rate parity (IRP) theory = equilibrium point Differential inflation rates Purchasing power parity (PPP) theory = differing inflation rates International Fisher Effect (IFE) Theory Spot rate will change over time: interplay between real and nominal interest rates

Exchange Rate fluctuations over Time Long-term  PPP theorem Relative price levels determine exchange rates Medium-term  economic activity Exports and imports affecting equilibrium Short-term  interest rates Reserves of cash invested in high-rate countries Interplay between interest rate and inflation Risks of exchange rate fluctuation: -A/R denominated in customer’s currency  depreciation -Same with A/P from a foreign supplier  appreciation

Hedging and Mitigating Risk Hedging a foreign-denominated receivable = depreciation Hedging a foreign-denominated payable = appreciation Managing Net A/R and A/P positions A Firm can reduce its exchange rate risk by maintaining a position in each foreign currency of A/R and A/P that net to near ZERO Foreign currency Future Contracts when necessary to achieve balance -Money market hedges = least complex hedging tool -Future Contracts = essentially commodities traded on an exchange + only available for generic amounts with specific settlements dates -Less flexible than forward contracts because they are not customized for the parties -Currency Swaps = swapping cash flows in each other’s currency

International Trade Purchase the stock of a foreign corporation or make a direct foreign investment Advantages of direct investment: a.Lower taxes in the foreign nation b.Annual depreciation allowances for the amount invested c.Access to foreign capital sources Cost of capital should be higher than “domestic” because of exchange rate risk, political risk and other constraints Multinational corporations: a.Benefits/adverse effects to the home country b.Benefits/adverse effects to the host country

International Trade Methods of Financing Cross-border factoring Letters of credit Banker’s acceptances Forfaiting Countertrade International Tax considerations Treaties = avoid double taxation Transfer Pricing Tariffs

Problems Page 305 # 22 – Premium or Discount? Page 307 # 29 – Depreciation or Appreciation?