1. Chapter 11 An Introduction to International Finance

2. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-2 Topics to be Covered Balance of payments Exchange rates Prices and exchange rates Interest and exchange rates Other topics

3. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-3 Balance of Payments (BOP) BOP—a record of a country’s economic transactions with the rest of the world.

4. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-4 Trade Surplus vs. Trade Deficit Trade surplus—occurs when a country’s merchandise exports exceed its imports. Trade deficit—occurs when a country’s merchandise imports exceed its exports. The U.S. has consistently run trade deficits, with 1975 as the last surplus year, while Japan, Germany, and Canada have had trade surpluses (refer to Figure 11.1).

6. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-6 Exchange Rates Foreign Exchange Market (FEM)— the market where monies of different countries are traded. Exchange rate—price of one country’s money in terms of another.

7. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-7 Features of Foreign Exchange Market Refer to Table 11.1 FEM Trading Volume The total volume of trade in the foreign exchange market was over $2.4 trillion in 2004. The largest markets are the United Kingdom, accounting for 31% of the market, and the U.S. with a 19% share.

9. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-9 Features of FEM (cont.) Refer to Table 11.2 The most traded currency is the U.S. dollar, accounting for 90% of the total amount traded. The dollar is followed by the euro, Japanese yen, and the British pound.

10. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-10

11. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-11 Prices and Exchange Rates Purchasing Power Parity (PPP) holds when two currencies have the same purchasing power in the two countries. Chapter 14 will analyze the prices–exchange rate relationship in more detail.

12. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-12 Big Mac PPP Refer to Table 11.3 Big Mac PPP If the price of a Big Mac hamburger was $1 in the U.S. and ¥100 in Japan and the ¥/$ exchange rate was 100, then the Big Mac PPP holds. PPP appears to hold more for Canada. China’s yuan is undervalued by 55% against the dollar, thus dollars will buy a lot in China. The reverse is true for Switzerland.

13. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-13

14. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-14 Interest Rates and Exchange Rates Figure 11.2 shows that even countries with close and extensive economic ties can have independent movements in their interest rates. Interest differentials among countries may reflect expected exchange rate changes as well as risk premiums. Chapter 15 will discuss interest rates in more detail.

15. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-15

16. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-16 Additional Major Topics to be Covered Later Foreign exchange risk—the risk of an unexpected change in the exchange rate. International investment—portfolio investment and direct investment. International monetary systems— history of international financial systems.

17. Copyright © 2007 Pearson Addison-Wesley. All rights reserved. 11-17 Additional Topics (cont.) International banking—offshore banking and country risk analysis International macroeconomics— determination of equilibrium income, interest rates, and exchange rates in a global setting.