International Finance Management Midterm

Joseph E. Seagram & Sons imports a year's supply of French champagne. Payment in euros is due immediately.

The euro should appreciate relative to the dollar since demand for euros is rising.

Suppose that Brazil starts welcoming foreign investment with open arms. How is this likely to affect the value of the Brazilian real? The Brazilian current-account balance?

The increased demand for Brazilian assets brought about by the new Brazilian investment policy will cause the real to appreciate. This will reduce the Brazilian current-account balance => the capital inflow must be matched by a reduced Brazilian current-account balance

Korean Airlines buys five Boeing 747s. As part of the deal, Boeing arranges a loan to KAL for the purchase amount from the U.S. Export-Import Bank. The loan is to be paid back over the next seven years with a two-year grace period.

The spot price of the dollar should be unaffected. The future price of the dollar should increase as KAL repays the loan

relative income levels

US income level increases: US demand for British goods and hence the pound increase, no expected change for the supply of the pound

relative inflation rates

US inflation increases: US demand for British goods and hence the pound increase, British desire for US goods and hence the supply of pounds decrease; depreciation of the dollar relative to the pound

relative interest rates

US interest rates increase: US demand for British bank deposits and hence the pound decrease, British desire for US bank deposits and hence the supply of pounds increase; depreciation fo the pound relative to the dollar; a relatively high interest rate may actually reflect expectations of relatively high inflation, which may discourage foreign investment

a market maker in corporate bonds is constantly trading bonds when clients want to buy or sell. this can create substantial bond positions. the largest risk is that interest rates overall move. the trader can hedge this risk by:

selling government bonds short against his long positions in corporate bonds. this this way, the risk that remains is credit risk of the corporate bonds

short position

selling securities or other financial instruments that aren't currently owned, and subsequently repurchasing them; traders may hedge a long position or a portfolio through one or more short positions

BigMac Index

similar ingredients, similar process of making them, made in more than 100 different countries

the relationship between forward and future spot

spot and forward rate are influenced by currency expectations of future events and move in tandem linked by the interest rate differentials. then: the forward rate should reflect the expected future spot rate on the date of settlement of the forward contract

size

3.2 trillion a day; 50 more times than NYSE a day; biggest market is London

spot market

60% of trades involve $; american and european terms (american is # of american dollars per unit of foreign currency --> $/euro); dealing with non bank customers; no commission but spread

A current-account surplus is not always a sign of health; a current- account deficit is not always a sign of weakness. Why?

A current-account surplus = domestic savings > domestic investment. This excess savings could reflect a lack of domestic investment opportunities. For example, Japan's current-account surplus reflects a prolonged economic slump and relatively poor domestic growth opportunities. Countries growing rapidly are likely to face current-account deficits, as economic growth generates domestic investment opportunities that can't all be financed through domestic savings. In other words, the faster a nation grows relative to other nations, the more likely it is to have a current-account deficit; conversely, slow economic growth is more likely to lead to a current-account surplus

What happens to Mexico's ability to repay its foreign loans if the United States restricts imports of Mexican agricultural produce?

A repayment of Mexico's foreign loans is equivalent to an export of capital from Mexico. To run a capital- account deficit, it must run a current-account surplus. Anything that reduces Mexico's ability to export also reduces its ability to repay its debts. In effect, keeping out Mexican goods while demanding repayment is equivalent to firing a worker and then demanding that he repay the money.

As the value of the U.S. dollar rises, what is likely to happen to the U.S. balance on current account?

As the dollar rises in value, other things being equal, U.S. goods and services become relatively more expensive, while foreign G&S become relatively less, leading to a smaller surplus or larger deficit on the current account. This conclusion could be reversed if the reason for the rise in the real value of the dollar was a significant increase in U.S. Productivity. But other things do not remain equal. In fact, there is no simple relation between the exchange rate and the current-account balance. Trade deficits do not cause currency depreciation, nor does currency depreciation by itself helpreduce a trade deficit

Herstatt Risk

Cross-currency settlement risk that arises where the working hours of inter-bank fund transfer systems do not overlap due to time zone differences. In this situation, failure by one counterparty to settle its side of the deal starts a chain reaction of cross-defaults. It is named after a small German bank (Bankhaus Herstatt) which failed in June 1974 during the period it was supposed to settle a contract after having received the payment from the counterparty. That failure caused a string of cascading defaults in a rapid sequence, totaling a loss of $620 million to the international banking sector.

settlement date

D+2= usually 2 business days after execution date; exchange risk and herstatt risk

Seat buys a $400 million worth of GE machinery in 2010, financed by the U.S. Merchbank with a five-year loan with no payments due until 2011. What is the net impact on the U.S. current account, capital account, and overall balance of payments for 2010?

In 2010, the sale is recorded on the U.S. balance of payments as a $400 million merchandise export matched by a capital outflow of $400 million to finance the it. This appears as a $400 million plus on the U.S. current account, a $400 million minus on the U.S. capital account, and a zero impact on the overall balance of payments for 2010. Loan's repayments show up as inflows on the services account and principal repayments will appear as inflows on the capital account.

What is likely to happen to the value of the dollar as the U.S. current-account deficit increases?

It depends on what is driving the increase in the current-account deficit. If the deficit increases because the economy is growing strongly, then the dollar is likely to rise in value. On the other hand, if the current- account deficit rises because the government budget deficit is increasing, then the value of the dollar is likely to decline because of the adverse implications of a budget deficit for future economic growth

trade agreements

NAFTA, European Union

Which of these factors is likely to underlie the persistent U.S. trade deficits? 1) a lack of U.S. competitiveness owing to (1.a )low productivity or 1.b) low-quality products and/or 1.3) lower wages, 2) superior technology, 3) unfair trade practices by foreign countries

None of these factors underlie the persistent U.S. trade deficits. For example, Ireland is handicapped even more than the U.S. by these factors but nonetheless runs a trade surplus. Latin American nations ran trade surpluses during the 1980s. The U.S. trade deficits reflect the U.S. savings deficit, period.

What are the consequences for the balance on capital account and its overall balance of payments, if the current account is running a deficit? Condider we're in a freely floating exchange rate system.

Since the nation's balance of payments must always be zero, then, if the current account is running a deficit,the capital account must be running a surplus of the same size.

a farmer who has just planted his wheat wants to lock in the price at which he can sell after the harvest

he would take a short position in wheat futures

exchange risk

a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company

direct quotation

home currency price of a unit (or 100) of foreign currency

forward market

same credit risk as spot transactions but for longer; involves significant exchange risks; calls for delivery of foreign currency; at a fixed future date; of a specified amount of one currency; with a price in dollars fixed at contracting time

arbitrageurs

seek to earn risk free profits by taking advantage of differences in interest rates among countries

Many Asian governments have attempted to promote their export competitiveness by holding down the values of their currencies through foreign exchange market intervention. a. What is the likely impact of this policy on Asian foreign exchange reserves? on Asian inflation? on Asian export competitiveness? on Asian living standards? b. Some Asian countries have attempted to sterilize their foreign exchange market intervention by selling bonds. What are the likely consequences of sterilization on interest rates? on exchange rates in the longer term? on export competitiveness?

a. In order to hold down their currencies, Asian central banks must buy up foreign. The result is increased foreign reserves and an expanded domestic money supply, which has the potential to increase inflation. At the same time, the lower exchange rates boosts Asian export competitiveness, but at the expense of a lower living standards for their populations (who find foreign goods and services more expensive). b. In order to sterilize the expanded domestic money supply, the Asian central bank must sell government securities to the market. These sales would drive down the price of government bonds and drive up domestic interest rates. Higher interest rates, in turn, would attract more foreign capital, which would boost the value of the domestic currency. Thus, in the long run, sterilized intervention will not affect exchange rates and export competitiveness.

Japan had a C/A surplus of $98 billion and a F/A deficit, aside from the change in its foreign-exchange reserves, of $67 billion. a. what can you conclude about the change in Japan's foreign exchange reserves? b. What is the gap between Japan's national expenditure and its national income? c. What is the gap between Japan's savings and its domestic investment? d. What was Japan's net foreign investment for the year?

a. Japanese official reserves increased by $31 billion which is a déficit in the oficial reserves account b. The current-account balance equals the difference between national income and national expenditure. In Japan's case, this identity means the income-expenditure gap is $98 billion; that is, Japan's national income exceeds its spending by the equivalent of $98 billion c. Since national savings- domestic investment equals national income - national expenditure, the answer here is the same as the answer to part b d. Japan's net foreign investment equals national savings minus domestic investment, or $98 billion Net foreign investment = National Savings - Domestic Investment

speculators

actively expose themselves to currency risk by buying or selling currency forwards in order to profit form exchange fluctuations

balance of payments

an accounting statement that summarized all the economic transactions between home and foreign countries' residents

cross rates

an exchange rate between two currencies computed by reference to a third currency; used because most currencies are rated agains the dollar

unsterilized intervention

an increase/decrease in the supply of money; will sell dollars against euros to devaluate the dollar, will buy dollars against euros to appreciate the dollar

currency carry trades

between 2 currencies borrow int he weaker currency and invest in the stronger currency providing that the interest rate difference is not too advance

transaction costs

bid-ask spread: volatility increases, spread increases; liquidity increase, spread decreases; time to maturity increases, spread increases

long position

buying securities or other financial instruments

the international fisher effect

currencies with low interest rates are expected to appreciate relative to currencies with high interest rates; interest differential between two countries is an unbiased predictor of the future change in the spot rate of exchange; a rise in inflation rate (relative to other countries) will be associated with a fall in the value of the home currency; it will also be associated with an increase in the home interest rates; the interest rate is not an especially accurate predictor, but prediction errors tend to cancel over time

forward rate

delivery in a specified future date

Financial account (capital account)

deposits and bonds, stocks, derivatives, reserves

free floating exchange rate

depreciation and appreciation

current account

exports, imports, income, transfers

indirect quotation

foreign currency units to buy one unit of home currency

expectations

foreign exchange markets react to any news that may have a future effect (news of a potential surge in US inflation may cause currency traders to sell dollars); many institutional investors take currency position based on anticipated interest rate movements in various countries; economic signals that affect exchange rates can change quickly, such that speculators may overreact initially and then find that they have to make a correction; speculation on the currencies of emerging markets can have a substantial impact on their exchange rates

swap rate

forward>spot = premium; forward<spot = discount

China's overall saving rate is now nearly 50% of GDP, the highest in the world. China's domestic investment rate, at 43%, is also high, but not as high as its saving rate. What do these facts imply about China's current- account balance?

if a nation's saving exceeds its domestic investment, that nation will run a current-account surplus equal to its net saving surplus. Given the figures presented in this question, China should run a current-account surplus equal to 7% of GDP, the difference between its saving and domestic investment.

spot rate

immediate delivery

law of one price

in competitive markets, with low cost access to info, exchange adjusted prices of similar goods must be within transaction costs of equality worldwide

foreign exchange market intervention

it refers to official purchases and sales of foreign exchange that nations undertake through their central banks to influence their currencies

participants

large commercial banks, foreign exchange brokers, commercial customers, central banks; arbitrageurs, traders, hedgers, speculators

speculating on anticipated exchange rates

many commercial banks attempt to capitalize on their forecasts of anticipated exchange rate movements in the foreign exchange market; the potential returns from foreign currency speculation are high for banks that have large borrowing capacity; the simply strategy is to get out of the currency about to depreciate and into the currency that is going to appreciate against it. then reserve the positions after the event to end up with more than you started with; exchange rates are very volatile, and a poor forecast can result in a large loss

government controls

may influence the equilibrium exchange rate by: imposing foreign exchange barriers, imposing foreign trade barriers, intervening in the foreign exchange market, and affecting macro variables such as inflation, interest rates, and income levels

exchange rate

measures the value of one currency in units of another currency

hedgers

most MNCs engage in forward contracts to protect the home currency value of various currency denominated assets and liabilities in their balance sheets that are not realized over the life of the contracts

Interbank Market

most important foreign exchange market; accounts for 95% of foreign exchange transactions

currency boards

not a central bank; issues notes and coins convertible on demand and at a fixed rate into foreign currency (normally US dollar); provides an anchor to local currency (similar to previous gold standard); no printing of notes allowed; besides price stability, it also compels government to follow a responsible fiscal policy

sterilized intervention

open market operation is the sale or purchase of Treasury securities to neutralize the impact of the intervention

PPP absolute version

price levels should be equal worldwide when expressed in a common currency; the problem is that it isn't so easy to compare; need to check a product that is similar everywhere in the world -- resulted in the BigMac index

foreign exchange market

primary function is to facilitate international trade and investment (to permit transfers of purchasing power denominated in one currency to another)

the real interest rate

real returns are equalized across countries through arbitrage. with no government interference, interest rate differential should equal anticipated inflation differential between both currencies

factors that affect the equilibrium exchange rate

relative inflation rates, relative interest rates, relative economic growth rates, political and economic risks

currency arbitrage

taking advantage of exchange rate inconsistencies in different money centers; involve buying a currency in one market and selling it in another

trade restrictions

tariffs, quotas, legal requirements, subsidies

dollarization

the complete replacement of the local currency with the US dollar; Panama and Ecuador; disadvantages: the loss of seignorage

interest rate parity

the currency of the country with lower interest rate should be a forward premium (in terms of currency of the country with the higher rate); then when there are no covered arbitrage (covered interest differential is nonzero) opportunities

PPP relative version

the exchange rate between two currencies will adjust to reflect changes in the price levels of two countries; nominal exchange rate may be of little significance in determining the true effects of currency changes affecting competitiveness

currency arbitrage implications

the existence of currency arbitrage transactions explain why such profitable opportunities are fleeting. when taking advantage of an arbitrage opportunity, the buying and selling of currencies tend to move rates in a manner than eliminates the profit opportunity in the future; then we talk about no-arbitrage condition

Central Bank

the nation's official monetary authority; objectives are price stability, low interest rate, or a target currency value; central bank independence = price stability and low inflation rate; central bank lack of independence = monetize the deficit

interaction of factors

the various factors sometimes interact and simultaneously affect exchange rate movements; for example, an increase in income levels sometimes causes expectations of higher interest rates, thus placing opposing pressures on foreign currency values; the sensitivity of an exchange rate to the factors is dependent on the volume of international transactions between the two countries; large volume of international trade --> relative inflation rates may be more influential; large volume of capital flows --> interest rate fluctuations may be more influential

bid

to buy

ask

to sell

traders

use forward contracts to eliminate or cover the risk of loss on export or import orders in foreign currencies

"mixed in trading"

what a currency is said to be on the days when some currencies appreciate while others depreciate against a particular currency

depreciate

when a currency declines in value

appreciate

when a currency increases in value