Money and Capital Markets 25 C h a p t e r Eighth Edition Financial Institutions and Instruments in a Global Marketplace Peter S. Rose McGraw Hill / IrwinSlides by Yee-Tien (Ted) Fu International Transactions And Currency Values

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin  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 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 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 Payments The U.S. BOP Source: Bureau of Economic Analysis

The U.S. Balance of Payments The U.S. BOP Source: Bureau of Economic Analysis

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin The U.S. Balance of Payments 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 The Problem of Different Monetary Units In 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 The Problem of Different Monetary Units In International Trade and Finance  The gold standard – During the 17 th and 18 th 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 The Problem of Different Monetary Units In 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 Determining Foreign Currency Values In 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 Determining Foreign Currency Values In 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 Determining Foreign Currency Values In Today’s Markets Price of $ in terms of £ (£/$) Quantity of $ Supply of $ (demand for £) S Demand for $ (supply of £) D D2D2 S2S2

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

 2003 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw Hill / Irwin 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 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 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 Other Innovative Methods for Dealing 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 Government Intervention In 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 Money and Capital Markets in Cyberspace  For more information about international transactions and currency values, visit:  asp asp      

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