INTB 4
Analyzing BOP statistics is based upon
"flow of funds"
BOP is generally split into two major components with major business implications:
(1) the current account (2) the financial account
In addition, if the bank sells euros for 1.40 EUR/USD (ask price) and buys euros for 1.35 EUR/USD (bid price), the bid/ask spread in percentage terms is
(1.40 2 1.35)/1.40 3 100 5 3.6 percent.
What are some important implications of FDI
-consumers gain through greater choice of product (or services) at competitive prices -businesses face increased competition as well as profit opportunities -governments reap additional tax revenues -society benefits through increased employment opportunities and corporate social responsibility
Reasons why currency values change
-different price levels in different countries for the same goods and services (due to mispricing or inflation) -varying interest rates across countries -economic prospects of countries
The function of the foreign exchange market is to
-facilitate international trade of goods and services -facilitate investment (FDI)
What else do large financial institutions do?
-finance international trade -manage cash for international corporations -make international loans to corporations and foreign governments
The Financial Account has 3 subaccounts:
1. U.S.- owned assets abroad 2. Foreign-owned assets in the U.S. 3. Net financial derivatives inflow = + outflow= -
BOP Current Account consists of 4 subaccounts:
1. trade or (goods) balance 2. services balance 3. income balance 4. net transfers *the sum of these 4 accounts= current account balance positive balance= Surplus negative balance= deficit important because it measures the financing needs of a country
There are almost _____ countries in the world, most of which are engaged in international trade, and about ____different countries that are used to make international payments for goods and services.
200, 150
Forward rates are regularly quoted for
30, 90, and 180 days in the future.
Together, the dollar, euro, and yen account for around
60 percent of the world economy
special drawing right (SDR)
a basket of currencies consisting of dollars, euros, pounds, and yen created by the Inter-national Monetary Fund (IMF) for use as a benchmark to value the currencies of different countries
foreign exchange markets
a global network of international banks and currency traders that trade different countries' currencies Also known as forex 24-HR market
balance of payments (BOP)
a statement of account that shows all transactions between the residents of one country and the rest of the world for a given period of time (usually one year) accounts document trade and finance interactions between countries; they show exports, imports, trade finance, foreign investment, and other important trends in international activities between countries. *based on a system of debits and credits *payments must always balance
The current account of the BOP is largely driven by
activities of consumers and business
inflation
an increase in the prices of goods and services caused by the supply of money exceeding the demand for goods and services
arbitrage
buying goods in a lower priced market and selling them in a higher priced market to make profits
The gold standard for benchmarking or pegging currencies was replaced in 1973
by a flexible exchange rate system with freely floating currency values determined by market supply and demand
big mac index
calculation using the cost of a McDonald's restaurant sandwich to assess the relative values of currencies
A country with a current account Surplus is called a
capital surplus country Ex: China, France, Japan, Singapore, and Switzerland surplus is used to invest abroad
financial account
consists of domestic-country-owned assets abroad, foreign-owned assets in the domestic country, and net financial derivatives the second half of a country's balance of payments, which shows how the country's current account balance is financed.
In flow of funds analysis, money moving into a country is _________, while money leaving the same country is a ________.
credit (+), debit (-)
Currency values can be affected by a variety of forces, including
current account balance, economic conditions, inflation and interest rates, and other factors.
The U.S. has large current account _______ each year, which implies that it will need to attract capital from abroad in order to finance.
deficits
To earn interest on their foreign exchange reserves, central banks
deposit some of their reserves with foreign central banks.
soft currencies
emerging market countries' currencies that are less stable in value than hard currencies and are sometimes pegged to hard currency values
foreign direct investment (FDI)
encompasses purchases of fixed assets (such as factories and equipment) abroad used in the manufacture and sales of goods and services
forward market
exchange that enables purchases and sales of currencies in the future with prices (or the forward rate) established at a previous time
spot market
exchange that trades currencies on a real-time basis for immediate delivery
The difference between forward and spot exchange rates reflects
expectations by inves-tors about future exchange rate movements.
Why would foreign investors be hesitant to invest in countries with current account deficits?
extended periods of investment are perceived risk of nonpayment of debt and will require a risk premium that increase interest rates for the borrowing country
International Monetary Fund (IMF)
financial authority established under the Bretton Woods Agreement in 1944 to help ensure the stability of the international monetary and financial system
premium
in the forward market, the sell-ing of a currency at a spot rate that is more than the forward rate
discount
in the forward market, the selling of a currency at a spot rate that is less than the forward rate
Printing more money could
increase eco-nomic activity
excess supplies of money could cause
inflation
hedge
insurance that reduces future risk
Some emerging market countries practice managed float due to
potential problems with liabilities denominated in foreign currencies and assets denominated in local currency
direct quotes
prices of a foreign currency in dollars or the number of dollars per one unit of foreign currency
uncovered interest rate parity
principle implying that expected future spot exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
covered interest rate parity
principle implying that forward exchange rates and spot exchange rates set interest rates on bonds in different countries equal to one another
law of one price
principle stating that identical goods should sell for the same price in different countries according to local currencies
Bretton Woods Agreement
the 1944 decision to establish a global currency system with the U.S. dollar pegged at a fixed rate of exchange to gold, and the currencies of 43 other countries fixed to the dollar
Smithsonian Agreement
the 1971 decision allowing the United States to devalue the dollar against other countries' currencies, thereby beginning the breakdown of the 1944 Bretton Woods Agreement
Jamaica Agreement
the 1976 international monetary order that allowed countries to adopt different exchange rate systems including floating their currencies in world markets
current account
the activities of consumers and businesses in the economy with respect to the trade balance, services balance, income balance, and net transfers
risk premium
the added return required by investors for risk associated with a security or asset
In a free-market-oriented foreign exchange market, major currency values are determined by
the demand for and sup-ply of currencies; this is called the independent floating exchange rate system
bid-ask spread
the difference between bid and ask prices of a currency; the transaction fee earned by the bank
What happens if the U.S. current account deficits cannot be financed?
the dollar will become weaker and interest rates will increase in order to attract foreign capital.
The largest decline in world trade was after
WWII
gold standard
monetary system that pegs currency values to the market value of gold
clean float currency
monetary system with minimal government intervention; largely market determined
dirty float currency
monetary system with varying degrees of government intervention to maintain a range of acceptable values against other currencies
Most European countries are ____ ____ except for Norway who is a ____ ____
net exporters, net importer
The U.S. has always been a _____ ______ of goods and services in the past
net importer
_______ and ______ make foreign loans to pursue foreign policy objectives (e.g., economic and military).
Certain government agencies (e.g., Export Import Bank and USAID, which are involved in international lending activities)
The largest forex traders are
Citibank, JP Morgan Chase (United States), and Deutsche Bank (Germany).
Which country holds the largest foreign exchange market?
London handling over 30% of of transactions
The three largest foreign exchange markets are in
London, New York, and Tokyo followed by Hong Kong, Singapore, and Bahrain
PPP equation
Pus (1+ius)=(1+p)Pe(1+iE) where PUS 5 price index of U.S. goods in dollars PE= price index of European goods in dollars IUS = inflation rate in the United States in dollar terms IE = inflation rate in Europe in euro terms p = percentage change in the euro, which equals the forward premium [(F 2 S)/S]3 100 with F the forward dollar/euro exchange rate and S the spot dollar/euro exchange rate
__________ and __________hold foreign exchange, or currencies, of major countries (U.S. dollar, euro, yen, etc.) as part of their reserves in addition to their local currency.
The U.S. Federal Reserve and Germany's Deutsche Bundesbank
Alternate term for foreign exchange markets
forex markets
hard currencies
leading world currencies of developed industrialized countries, including the U.S. dollar, European euro, Japanese yen, and British pound sterling
Capital flows generally represent investments for the
long term (more than one year).
Indonesian rupiah, Thai baht, Russian ruble, Indian rupee, and Singapore dollar) are determined by the
managed floating exchange rate system.
statistical discrepancy
reconciles any imbalance between the current account and financial account to ensure that all debit and credit entries in the balance of payments statement sum to zero This line captures statistical inconsistencies in the recording of the credit and debit entries as well as illegal trade.
A country's balance of payments is an objective standard that shows
shows how well the country's economy and government policies are performing.
The forex market consists of
spot, forward, and futures markets.
Countries with current account______ generally finance countries with current account ________
surpluses, deficits
fixed exchange rate system
system in which the country pegs its currency at a fixed rate to a major currency or basket of currencies, while the exchange rate fluctuates within a narrow margin around a central rate
managed floating exchange rate system
system that determines the value of some currencies partly by demand and supply in the foreign exchange market and partly by active government intervention in the foreign exchange market
independent floating exchange rate system
system that sets the values of major currencies based on their demand and supply in world currency markets
services balance
the net of exports of services and imports of services (shipping, airlines, consulting, insurance, banking, tourism, software development) is the net of exports of services (+ sign when they are sold overseas) and imports of services (- sign when they purchased from overseas).
income balance
the net of investment income from abroad and investment payments to foreigners net of investment income from abroad (+ sign reflects earnings from overseas investment) and investment income paid to foreigners (- sign indicates payments are sent overseas).
trade balance
the net of merchandise exports and merchandise imports net of merchandise exports (+ sign as incoming dollars when merchandise, such as a Dell computer, is exported) and merchandise imports (- sign as dollars leave the country to pay for imports, such as Toyota bra provides an indication of how competitive an economy is via its primary trade part
balance of transfers
the net of transfer payments going overseas and inflows from abroad flows (- sign means that a payment is going abroad as foreign aid, retirement benefits, etc.) and inflows (+ sign reflects repayment of foreign aid loans, etc.).
dollarization
the practice of using the dollar or some other foreign currency together with, or instead of, a domestic currency in a country
forward rate
the price at an earlier time of a currency in terms of another currency established for future delivery in the forward market
exchange rate
the price at which one currency can be converted to another currency
indirect quotes
the reciprocal of the direct quote or the prices of a dollar (for example) in foreign currency terms
purchasing power parity (PPP)
theory stating that a basket of goods should have approximately the same prices across different countries
interest rate parity (IRP)
theory stating that interest rates on bonds in different countries should be the same, as investors would buy and sell these bonds to make arbitrage profits until this condition holds
Resulting currency fluctuations led to a
variety of efforts by countries to manage currency values, including pegging, dollarization, and adoption of regional currencies, such as the Europe
trade deficit
when merchandise imports exceed merchandise exports for a country
As an example, the spot rate for the euro may be quoted at 1.40 EUR/USD, which is a direct quote indicating that
€1 5 $1.40 (i.e., one euro costs 1.40 dollars). The indirect quote would be 1/1.40 5 0.71 USD/EUR, or $1 5 €0.71 (i.e., one dollar costs 0.71 euros).
