Chapter 6 International Trade and Finance © 2000 John Wiley & Sons, Inc.

2 Chapter Outcomes n Explain the importance of finance to the effective conduct of international commerce and investment n Describe how international payments are made n Describe the nature of foreign exchange markets

3 Chapter Outcomes (Continued) n Discuss the effect of exchange rates on international trade and explain arbitrage and exchange quotations n Explain the role of financial managers of businesses in reducing foreign exchange risks n Describe how world banking systems facilitate financing sales by exporters and purchases by importers

4 Chapter Outcomes (Concluded) n Show how the Export-Import Bank aids in financing international trade n Describe the components of the U.S. balance of payments n Discuss characteristics of the international financial system

5 Development of International Finance n Began about 5,000 years ago when Babylonian cities rose to importance as centers of trading n Centers of international finance shifted to the Greek city of Athens around 500 B.C. n Centers shifted to the Roman Empire and Rome around 100 B.C.

6 Development of International Finance (Continued) n Financial centers shifted to the northern European Cities during the 1500s n In more recent years, London, New York, and Tokyo became the leading financial centers n Today, physical centers are no longer necessary for carrying out international transactions

7 International Currency Transactions n FOREIGN EXCHANGE MARKETS: n FOREIGN EXCHANGE MARKETS: Electronic network that connects the major financial centers of the world n CURRENCY EXCHANGE RATE: n CURRENCY EXCHANGE RATE: Value of one currency relative to another currency

8 European Monetary Union (EMU) n A possible monetary union was first discussed in December, 1969 n Treaty on European Union (known as the Maastricht treaty) was signed in February, 1992 n Decision to call the future common currency the “Euro” was made in December, 1995

9 European Monetary Union (EMU) (Continued) n 11 founding members in May, 1998 (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, & Spain) n Official currency of the EMU became the Euro in January, 1999 n National currencies of founding members to be exchanged for the Euro beginning in January, 2002

10 Exchange Rate Determination in the Foreign Exchange Market Dollar price of one British pound Quantity of Pounds $1.60 $1.61 $1.60 $1.62 S1S1 D1D1 D1D1 S1S1 D2D2 AB C D S1S1 D1D1 D2D2 D3D3 D2D2 S1S1 S2S2

11 Two Methods for Explaining Currency Exchange Rates n PURCHASING POWER PARITY: Currency of country with relatively higher inflation rate will depreciate relative to currency of country with relatively lower inflation rate n INTEREST RATE PARITY: Currency of a country with relatively higher interest rate will depreciate relative to currency of country with relatively lower interest rate

12 Purchasing Power Parity (PPP) Model n FR 1 = SR 0 [(1+InfR hc )/(1+InfR fc )] Where: FR 1 = forward rate in one year SR 0 = spot rate now in year zero InfR hc = inflation rate expected for home country next year InfR fc = inflation rate expected for foreign country next year

13 Purchasing Power Parity (PPP) Example n Basic Information: spot rate for one British pound is $1.600; inflation is expected to be 6% in U.S. and 3% in Britain next year. What is the one- year forward rate in $U.S.? n FR 1 = SR 0 [(1+InfR hc )/(1+InfR fc )] n FR 1 = $1.600[(1.06)/(1.03)] = $1.600(1.0291) = $1.647

14 Interest Rate Parity (IRP) Model n FR 1 = SR 0 [(1+IntR hc )/(1+IntR fc )] Where: FR 1 =forward rate in one year SR 0 =spot rate now in year zero IntR hc =inflation rate expected for home country next year IntR fc = inflation rate expected for foreign country next year

15 Interest Rate Parity (IRP) Example n Basic Information: spot rate for one British pound is $1.600; one-year government interest rates are 9% in the U.S. and 6% in Britain. What is the one-year forward rate in $U.S.? n FR 1 = SR 0 [(1+IntR hc )/(1+IntR fc )] n FR 1 = $1.600[(1.09)/1.06)] = $1.600(1.0283) = $1.645

16 Other Factors Affecting Currency Exchange Rates n POLITICAL RISK: Risk associated with the possibility that a national government might confiscate or expropriate assets held by foreigners n ECONOMIC RISK: Risk associated with possible slow or negative economic growth and/or the variability of economic growth

17 International Currency Arbitrage n ARBITRAGE: Buying commodities, securities, or bills of exchange in one market and immediately selling them in another market to make a profit from price differences in the two markets

18 Instruments Used in Financing International Trade n DRAFT (BILL OF EXCHANGE): An unconditional order for the payment of money from one person to another n SIGHT DRAFT: Draft requiring immediate payment n TIME DRAFT: Draft that is payable at a specified future date

19 Instruments Used in Financing International Trade (Continued) n ORDER BILL OF LADING: Document given by a transportation company that lists goods to be transported and terms of the shipping agreement n DOCUMENTARY DRAFT: Draft that is accompanied by an order bill of lading and other documents

20 Instruments Used in Financing International Trade (Concluded) n COMMERCIAL LETTER OF CREDIT: Statement by a bank guaranteeing acceptance and payment of a draft up to a stated amount n TRUST RECEIPT: Instrument through which a bank retains title to goods until paid for n BANKERS’ ACCEPTANCE: Promise of future payment issued by a firm and guaranteed by a bank

21 Other Aids to International Trade n EXPORT-IMPORT BANK: n EXPORT-IMPORT BANK: Bank established to aid in financing and facilitating trade between the U.S. and other countries n TRAVELER’S LETTER OF CREDIT: n TRAVELER’S LETTER OF CREDIT: Issued by a bank to banks in other countries authorizing them to cash checks or purchase drafts presented by the bearer

22 Exchange Rate Operations n FLEXIBLE EXCHANGE RATES: A system in which international exchange rates are determined by supply and demand n DIRTY FLOAT: Intervention by central banks to control exchange rates in the foreign exchange market’s flexible exchange system

23 U.S. Balance-of-Payments Accounts n BALANCE OF PAYMENTS: Summary of economic transactions between one country and the world n BALANCE OF TRADE: Net value of a country’s exports of goods and services versus imports n MERCHANDISE TRADE BALANCE: Net difference between a country’s import and export of goods

24 U.S. Balance-of-Payments Accounts (Continued) n CURRENT ACCOUNT BALANCE : Flow of income into and out of the U.S. during a specified time period n CAPITAL ACCOUNT BALANCE: Foreign government and private investments in the U.S. netted against similar U.S. investment in foreign countries

25 Exchange Rate Developments for the U.S. Dollar n First-Half of 1980s: Appreciation of $U.S. due to inflation reduction & U.S. economic growth (after ) n Last-Half of 1980s: Depreciation of $U.S. due to shift to holding more foreign assets and fewer U.S. assets n Decade of 1990s: Continued $U.S. fluctuations but within a relatively narrow trading range