Tutorial Questions- International finance
Banks find it necessary to accommodate their clients' needs to buy or sell FX forward, in many instances for hedging purposes. How can the bank eliminate the currency exposure it has created for itself by accommodating a client's forward transaction? Use an example to illustrate your answer.
: Swap transactions provide a means for the bank to mitigate the currency exposure in a forward trade. A swap transaction is the simultaneous sale (or purchase) of spot foreign exchange against a forward purchase (or sale) of an approximately equal amount of the foreign currency. To illustrate, suppose a bank customer wants to buy dollars three months forward against British pound sterling. The bank can handle this trade for its customer and simultaneously neutralize the exchange rate risk in the trade by selling (borrowed) British pound sterling spot against dollars. The bank will lend the dollars for three months until they are needed to deliver against the dollars it has sold forward. The British pounds received will be used to liquidate the sterling loan.
Explain how a country can run an overall balance-of-payments deficit or surplus.
A country can run an overall BOP deficit or surplus by engaging in the official reserve transactions. For example, an overall BOP deficit can be supported by drawing down the central bank's reserve holdings. Likewise, an overall BOP surplus can be absorbed by adding to the central bank's reserve holdings.
Briefly discuss the criteria for a 'good' international monetary system.
A good international monetary system should provide (i) sufficient liquidity to the world economy. In other words it should be able to provide the world economy with sufficient monetary reserves to support the growth of international trade and investment. (ii) smooth adjustments to BOP disequilibrium as it arises by way of an effective mechanism that restores the balance-of-payments equilibrium whenever it is disturbed, and (iii) safeguard against the crisis of confidence in the system that results in panicked flights from one asset to another.
What are multinational corporations (MNCs) and what economic roles do they play?
A multinational corporation (MNC) can be defined as a business firm incorporated in one country that has production and sales operations in many other countries. Indeed, some MNCs have operations in dozens of different countries. MNCs obtain financing from major money centers around the world in many different currencies to finance their operations. Global operations force the treasurer's office to establish international banking relationships, to place short-term funds in several currency denominations, and to effectively manage foreign exchange risk. By circumventing and also taking advantage of various market imperfections, MNCs contribute to greater integration of world economy.
How is a country's economic well-being enhanced through free international trade in goods and services?
According to David Ricardo, with free international trade, it is mutually beneficial for two countries to each specialize in the production of the goods that it can produce relatively most efficiently and then trade those goods. By doing so, the two countries can increase their combined production, which allows both countries to consume more of both goods. This argument remains valid even if a country can produce both goods more efficiently in absolute terms than the other country. International trade is not a 'zero-sum' game in which one country benefits at the expense of another country. Rather, international trade could be an 'increasing-sum' game from which all players become winners.
Give a full definition of the market for foreign exchange
Broadly defined, the foreign exchange (FX) market encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, and trading in foreign currency options and futures contracts.
In an integrated world financial market, a financial crisis in a country can be quickly transmitted to other countries, causing a global crisis. What kind of measures would you propose to prevent the recurrence of an Asia-type crisis.
First, there should be a multinational safety net to safeguard the world financial system from the Asia-type crisis. Second, international institutions like IMF and the World Bank should monitor problematic countries more closely and provide timely advice to those countries. Countries should be required to fully disclose economic and financial information so that devaluation surprises can be prevented. Third, countries should depend more on domestic savings and long-term foreign investments, rather than short-term portfolio capital. There can be other suggestions.
Explain official reserve assets and its major components.
Official reserve assets are those financial assets that can be used as international means of payments. Currently, official reserve assets comprise: (i) gold, (ii) foreign exchanges, (iii) special drawing rights (SDRs), and (iv) reserve positions with the IMF. Foreign exchanges are by far the most important official reserves.
Why would it be useful to examine a country's balance-of-payments data?
It would be useful to examine a country's BOP for at least two reasons. First, BOP provides detailed information about the supply and demand of the country's currency. Second, BOP data can be used to evaluate the performance of the country in international economic competition. For example, if a country is experiencing perennial BOP deficits, it may signal that the country's industries lack competitiveness.
Once capital markets are integrated, it is difficult for a country to maintain a fixed exchange rate. Explain why this may be so.
Once capital markets are integrated internationally (Capital can flow freely across national borders where investors can respond to new global information and exploit arbitrage opportunities), vast amounts of money may flow in and out of a country in a short time period. Market forces may be stronger than the exchange rate intervention that the government can muster. This will make it very difficult for the country to maintain a fixed exchange rate.
Explain how special drawing rights (SDR) are constructed. Also, discuss the circumstances under which the SDR was created.
SDR was created by the IMF in 1970 as a new reserve asset, partially to alleviate the pressure on the U.S. dollar as the key reserve currency. The SDR was a basket currency that consisted of 4 currencies, but since October 2016 the Chinese renminbi was added. Currently it comprises five major currencies, i.e: • U.S. dollar 41.73 percent (compared with 41.9 percent at the 2010 Review) • Euro 30.93 percent (compared with 37.4 percent at the 2010 Review) • Chinese renminbi 10.92 percent • Japanese yen 8.33 percent (compared with 9.4 percent at the 2010 Review) • Pound sterling 8.09 percent (compared with 11.3 percent at the 2010 Review)
How are foreign exchange transactions between international banks settled? Use an example to illustrate your answer
The interbank market is a network of correspondent banking relationships, with large commercial banks maintaining demand deposit accounts with one another, called correspondent bank accounts. The correspondent bank account network allows for the efficient functioning of the foreign exchange market. As an example of how the network of correspondent bank accounts facilities international foreign exchange transactions, consider a U.S. importer desiring to purchase merchandise invoiced in guilders from a Dutch exporter. The U.S. importer will contact his bank and inquire about the exchange rate. If the U.S. importer accepts the offered exchange rate, the bank will debit the U.S. importer's account for the purchase of the Dutch guilders. The bank will instruct its correspondent bank in the Netherlands to debit its correspondent bank account with the appropriate amount of guilders and to credit the Dutch exporter's bank account. The importer's bank will then credit its books to offset the debit of the U.S. importer's account, reflecting the decrease in its correspondent bank account balance.
What is the difference between the retail or client market and the wholesale or interbank market for foreign exchange
The market for foreign exchange can be viewed as a two-tier market. One tier is the wholesale or interbank market and the other tier is the retail or client market. International banks provide the core of the FX market. They stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, corporations or individuals, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Retail transactions account for only about 14 percent of FX trades. The other 86 percent is interbank trades between international banks, or non-bank dealers large enough to transact in the interbank market.
Who are the market participants in the foreign exchange market and what are their roles?
The market participants that comprise the FX market can be categorized into five groups: international banks, bank customers, non-bank dealers, FX brokers, and central banks. International banks provide the core of the FX market. Approximately 100 to 200 banks worldwide make a market in foreign exchange, i.e., they stand willing to buy or sell foreign currency for their own account. These international banks serve their retail clients, the bank customers, in conducting foreign commerce or making international investment in financial assets that requires foreign exchange. Non-bank dealers are large non-bank financial institutions, such as investment banks, mutual funds, pension funds, and hedge funds, whose size and frequency of trades make it cost- effective to establish their own dealing rooms to trade directly in the interbank market for their foreign exchange needs. Most interbank trades are speculative or arbitrage transactions where market participants attempt to correctly judge the future direction of price movements in one currency versus another or attempt to profit from temporary price discrepancies in currencies between competing dealers. FX brokers match dealer orders to buy and sell currencies for a fee, but do not take a position themselves. Interbank traders use a broker primarily to disseminate as quickly as possible a currency quote to many other dealers. Central banks sometimes intervene in the foreign exchange market in an attempt to influence the price of its currency against that of a major trading partner, or a country that it "fixes" or "pegs" its currency against. Intervention is the process of using foreign currency reserves to buy one's own currency in order to decrease its supply and thus increase its value in the foreign exchange market, or alternatively, selling one's own currency for foreign currency in order to increase its supply and lower its price.
2. How is international financial management different from domestic financial management? Name the risks and explain them.
There are four major dimensions that set apart international finance from domestic finance. They are: 1. foreign exchange • This is risk that foreign currency profits may evaporate due to unanticipated unfavourable exchange rate movements. • Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000 per share. One year later the investment is worth ten percent more in yen: ¥110,000. • But, if the yen has depreciated to $1 = ¥120, your investment has actually lost money in dollar terms. 2. and political risks, • Sovereign governments have the right to regulate the movement of goods, capital, and people across their borders. These laws sometimes change in unexpected ways 3. market imperfections, • Legal restrictions on the movement of goods, people, and money • Transactions costs • Shipping costs • Tax arbitrage 4. expanded opportunity set. • It doesn't make sense to play in only one corner of the sandbox. • True for corporations as well as individual investors
Explain how to compute the overall balance and discuss its significance.
The overall balance is determined by computing the cumulative balance of payments including the current account, capital account, and the statistical discrepancies. The overall balance is significant because it indicates a country's international payment gap that must be financed by the government's official reserve transactions.
What considerations might limit the extent to which the theory of comparative advantage is realistic?
The theory of comparative advantage was originally advanced by the nineteenth century economist David Ricardo as an explanation for why nations trade with one another. The theory claims that economic well-being is enhanced if each country's citizens produce what they have a comparative advantage in producing relative to the citizens of other countries, and then trade products. Underlying the theory are the assumptions of free trade between nations and that the factors of production (land, buildings, labor, technology, and capital) are relatively immobile. To the extent that these assumptions do not hold, the theory of comparative advantage may not realistically describe international trade.
Over the past five years, the exchange rate between British pound and U.S. dollar, $/£, has changed from about 1.90 to about 1.45. Would you agree that over this five-year period that British goods have become cheaper for buyers in the United States?
The value of the British pound in U.S. dollars has gone up from about 1.90 to about 1.45. Therefore, the dollar has appreciated relative to the British pound, and the dollars needed by Americans to purchase British goods have decreased. Thus, the statement is correct.
What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?
Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange between the two is not in alignment with the cross exchange rate. Most, but not all, currency transactions go through the dollar. Certain banks specialize in making a direct market between non-dollar currencies, pricing at a narrower bid-ask spread than the cross-rate spread. Nevertheless, the implied cross-rate bid-ask quotations impose a discipline on the non-dollar market makers. If their direct quotes are not consistent with the cross exchange rates, a triangular arbitrage profit is possible.
There are arguments for and against the alternative exchange rate regimes. a. List the advantages of the flexible exchange rate regime. b. Criticize the flexible exchange rate regime from the viewpoint of the proponents of the fixed exchange rate regime. c. Rebut the above criticism from the viewpoint of the proponents of the flexible exchange rate regime.
a. The advantages of the flexible exchange rate system include: (I) automatic achievement of balance of payments equilibrium and (ii) maintenance of national policy autonomy. b. If exchange rates are fluctuating randomly, that may discourage international trade and encourage market segmentation. This, in turn, may lead to suboptimal allocation of resources. c. Economic agents can hedge exchange risk by means of forward contracts and other techniques. They don't have to bear it if they choose not to. In addition, under a fixed exchange rate regime, governments often restrict international trade in order to maintain the exchange rate. This is a self-defeating measure. What's good about the fixed exchange rate if international trade need to be restricted?
