Download International finance and the foreign exchange market

International Finance
and the Foreign
Exchange Market
Foreign Exchange Market
• Market where different currencies are
traded, one for another.
• The exchange rate enables people in one
country to translate the prices of foreign
goods into units of their own currency.
• An appreciation of a nation’s currency will
make foreign goods cheaper.
• A depreciation of a nation’s currency will
make foreign goods more expensive.
Foreign Exchange Market
$5.3 trillion per day.
Currency
% of Daily Share
US dollar
Euro
Japanese yen
87.0%
33.4%
23.0%
British pound
Australian dollar
Swiss franc
11.8%
8.6%
5.2%
Canadian dollar
Mexican peso
Chinese yuan
4.6%
2.5%
2.2%
Number of 1 country’s currency that
is equal to 1 unit of another country’s
$1 = 0.6292 €
$1 = 0.755 €
1€ = 1.5892 $
1€ = 1.3245 $
$1 = 0.5051 £
$1 = 0.6787 £
1£ = 1.9797 $
1£ = 1.4734 $
Currency
Last Trade
U.S. $
¥en
Euro
U.S. $
¥en
12/04
Euro
12/04
1 0.009328
Can $
12/04
U.K. £
12/04
Aust $
12/04
SFranc
12/04
1.222
0.7705
1.733
0.7403
0.7894
1
131
82.59
185.8
79.36
84.62
0.8181 0.007632
1
0.6303
1.418
0.6057
0.6458
107.2
Can $
1.298
0.01211
1.586
1
2.249
0.9608
1.025
U.K. £
0.577 0.005382
0.7053
0.4446
1
0.4272
0.4555
Aust $
1.351
0.0126
1.651
1.041
2.341
1
1.066
SFranc
1.267
0.01182
1.548
0.976
2.195
0.9378
1
Currency
$
Appreciate
/
Depreciate
Yahoo
April 2008
Yahoo April 2005
U.S. $
1
1
¥en
Euro
Can $
U.K. £
103.21
0. 6292
1.0197
0.5051
107.293
0. 7689
1.244
0.5232
Aust $
SFranc
1.0561
1.0125
1.2943
1.1879
Yahoo
Mar 2004
Yahoo
Dec 2003
1
1
105.6 107.2
0.8237 0.8181
1.31 1.298
0.5506 0.577
1.337
1.287
1.351
1.267
Text
Oct 2002
1
123.3
1.01
1.5987
0.6391
1.84
1.49
Currency U.S. $ 1 ¥en
Last Trade
1:09pm
1 Euro 1 Can $ 1 U.K. £ 1 Aust $ 1 SFranc
1:09pm 1:09pm 1:09pm 1:09pm 1:09pm
U.S. $
4/08
1
0.009689 1.5892 0.9708 1.9797 0.9468
U.S. $
5/3
1
0.009077 1.195
U.S. $
12/04
1
0.009328
U.S. $
10/02
1
0.7262 1.774
1.222 0.7705
0.72
1.733 0.7403
0.00811 0.9901 0.6255 1.5648
0.545
0.9877
0.7696
0.7894
0.74
Currencies
1. Everyone has their own.
dollar, peso, pound, …
2. Use someone else’s – Dollarize
Ecuador, El Salvador, and Panama
3. Use a common currency - European Union
euro
Exchange Rate Regimes
1. Three major types of exchange rate regimes:
a. flexible (floating) rates (US and 40% of all),
b. Merged currency (unified currency), and,
c. pegged exchange rates
1) hard peg – government sets a fixed rate
2) soft peg – market determines rate, but
government may intervene.
2. Examples of a merged currency (unified):
The
• Nations of the European Union have recent
adopted a unified currency system.
Standard
•Gold
A country
can also use a currency board to
unify its currency with another.
• The currencies of Hong Kong, El Salvador, and
Panama are unified with the U.S. dollar.
The Gold Standard
a. $1 = 1/35 oz of Gold
b. 4 German marks = 1/35
oz of Gold
c. $1 = 4 German marks
d. Devaluation – change rate
flexible to fixed
pegged
strange?
Determinants of the Exchange Rate
• flexible rate system - the exchange rate is
determined by supply and demand.
• The dollar demand for foreign exchange
originates from American demand for foreign
goods, services, & assets (real or financial).
• The supply of foreign exchange originates from
sales of goods, services, & assets from
Americans to foreigners.
Foreign Exchange
Market Equilibrium
• If incomes increase in the
foreign exchange
United States, U.S. imports of (for pounds)
foreign goods and services will
grow.
• The increase in imports will
increase the demand for
pounds in the foreign exchange $1.80
market causing the dollar
price of the pound to rise from $1.50
$1.50 to $1.80.
Dollar price of
S(sales to
foreigners)
b
a
D2
D1
Q1 Q2
Quantity of
foreign exchange
(pounds)
Demand for Foreign Currencies
1. Foreign Direct Investment.
buying a foreign firm (InBev)
2. Portfolio Investment
a. purely financial by individual investors
b. taking advantage of changing
exchange rates
c. Taking advantage of higher interest
rates.
Demand for Foreign Currencies
Demand for the US dollar Supply of the US dollar
comes from…
comes from…
A U.S. exporting firm that
earned foreign currency and is
trying to pay U.S.-based
expenses
Foreign tourists visiting the
United States
Foreign investors who wish to
make direct investments in the
U.S. economy
Foreign investors who wish to
make portfolio investments in
the U.S. economy
A foreign firm that has sold
imported goods in the United
States, earned U.S. dollars, and
is trying to pay expenses
incurred in its home country
U.S. tourists leaving to visit
other countries
U.S. investors who want to make
foreign direct investments in
other countries
U.S. investors who want to make
portfolio investments in other
countries
A Strong Dollar Favors,
or
A Weak Dollar Favors:
1.
2.
3.
4.
5.
6.
A US exporting firm?
A foreign firm exporting to the US?
A US tourist abroad?
A foreign tourist in the US?
A US investor abroad?
A foreign investor in the US?
•
Changes in the Exchange Rate
Determinants:
1. A change in interest rates, or an expected
change in interest rates (relative to rates
abroad).
a. High rates attract money
b. Currency appreciates
2. A change in the inflation rate in one country.
a. Higher rate decreases demand
b. Lower demand - depreciation
3. Purchasing Power Parity.
a. Exchange rates make it cheaper to buy
the same product in a particular country at
lower cost.
b. Causes a demand for that currency
4. Changes in incomes and tastes
Inflation With
Flexible Exchange Rates
S
• If the price level in the U.S.
increased by 50 % …
the U.S. demand for British
goods (and pounds) would
increase (relatively cheap).
Since U.S. exports to Britain
would decline and thereby
cause the supply of pounds to
fall.
• These forces would cause the
dollar to depreciate relative
to the pound.
2
Dollar price of
foreign exchange
(for pounds)
S1
$2.25
b
$1.50
a
D2
D1
Q1
Quantity of
foreign exchange
(pounds)
Labatt’s beer is produced in Canada.
In 1990, in Ontario, a six-pack of Labatt’s beer sold
for $6.60 Canadian.
Across the border in
Michigan, a six pack of the
same beer was on sale for
$2.75 U.S.
At the time, the exchange
rate was
$0.75 U.S. = $1.00 Canadian.
In Ontario, $6.60 Canadian.
In Michigan, $2.75 U.S.
$0.75 U.S. = $1.00 Canadian.
1. How much would it cost in U.S.
currency to buy the beer in Ontario?
2. How much would it cost in Canadian
currency to buy the beer in Michigan?
3. Is there an arbitrage opportunity?
4. Where would you buy and where would you sell?
5. How much profit could you expect on a six-pack?
$6.60
x ($2.93
.75 = $4.95
US
$4.95
$2.75
= $2.20
Canadian)
$2.75
.75
= $3.67
Can
Buy in/-Michigan,
sell
inUS
Ontario
Peso – Appreciation or Depreciation?
1. The US reduces tariffs on Mexican products.
2. Mexico encounters severe inflation.
3. Deteriorating political relations reduce American
tourism in Mexico.
4. The US economy moves into a severe recession
5. A bartender puts a lime in a Corona and beer
sales jump
6. The Mexican government encourages American
firms to invest in Mexican oil fields
7. A large federal government budget deficit raises
interest rates in the US
Euro – Appreciation or Depreciation?
1. An American importer purchases a shipload of
Bordeaux wine.
2. BMW decides to build an assembly plant in LA
3. A CVCC student decides to spend a year studying
at the Sorbonne.
4. A Spanish manufacturer exports machinery to
Morocco on an American freighter.
5. The US incurs a balance of payments deficit in
its transactions with Belgium.
6. A US government bond held by an Italian citizen
matures.
7. It is widely believed that the international value
of the Euro will fall in the near future.
Balance of Payments
• Balance of payments:
accounts that summarize the transactions
of a country’s citizens, businesses, and
governments with foreigners
• Imports create a demand for foreign currency
(and a supply of the domestic currency) and are
recorded as a debit item.
• Exports create a supply of foreign
currency (and demand for the domestic currency)
and are recorded as a credit item.
Balance of Payments
• Under a pure flexible rate system, the foreign
exchange market will bring the quantity
demanded and the quantity supplied into
balance, and as a result, it will also bring the
total debits into balance with the total
credits.
Balance of Payments
• Current account transactions:
all payments (and gifts) related to the purchase
or sale of goods and services and income flows
during the current period
• Four categories:
• Merchandise trade
(import and export of goods)
• Service trade
(import and export of services)
• Income from investments
• Unilateral transfers
(gifts to and from foreigners)
Balance of Payments
• Capital account transactions:
transactions that involve changes in the ownership
of real and financial assets
• The capital account includes both
• direct investments by foreigners in
the U.S. and by Americans abroad, and,
• loans to and from foreigners.
• Under a pure flexible-rate system, official
reserve transactions are zero; therefore:
• a current-account deficit implies
a capital-account surplus.
• a current-account surplus implies
a capital-account deficit.
Monetary Policy & the Exchange Rate
• An unanticipated shift to a more restrictive
monetary policy will:
• raise the real interest rate,
• reduce the rate of inflation, and,
• at least temporarily, reduce aggregate
demand and the growth of income;
• causing an appreciation in domestic currency.
• the currency appreciation (with shift the current
account toward a deficit).
• An unanticipated shift to more expansionary
monetary policy will cause the opposite:
•
•
•
•
lower interest rates, and,
an outflow of capital;
leading to a currency depreciation, and,
a shift toward a current account surplus.
1.
A depreciation in the value of the U.S. dollar would
a. encourage foreigners to travel on American owned airlines.
b. make U.S. goods more expensive to foreign consumers.
c. decrease the number of dollars it takes to buy a Swiss franc.
d. make it more expensive for U.S. citizens to travel abroad.
2.
a.
b.
c.
d.
A nation’s trade deficit will tend to expand when
its economy is expanding.
its economy is shrinking.
its investment environment is less attractive to foreigners.
both b and c above are true.
3. Under a system of flexible exchange rates, an increase in demand
for a nation’s currency in the foreign exchange market will
a. cause the nation’s currency to appreciate.
b. make it more expensive for the nation to import goods.
c. cause the nation’s balance on current account to shift toward a
surplus.
d. make it less expensive for foreigners to buy the nation’s goods.
4.
Under a system of flexible exchange rates, which of the
following will most likely cause a nation’s currency to appreciate on the
foreign exchange market?
a. a decrease in domestic interest rates
b. an increase in foreign interest rates
c. domestic inflation of 10 percent while the nation’s trading partners
are experiencing stable prices
d. stable domestic prices while the nation’s trading partners are
experiencing 10 percent inflation
5.
Suppose a German-produced car becomes very popular in the
United States. This would tend to
a. affect the U.S. balance of payments but not the balance of trade.
b. reduce any existing balance of trade deficit in the United States.
c. increase a balance of trade surplus in the United States.
d. increase a balance of trade deficit in the United States.
6.
If the dollar price of the euro goes from $1 to 90 cents, the
euro has
a. appreciated, and Europeans will find U.S. goods cheaper.
b. appreciated, and Europeans will find U.S. goods more expensive.
c. depreciated, and Europeans will find U.S. goods cheaper.
d. depreciated, and Europeans will find U.S. goods more expensive.
Which of the following would cause the
American demand for foreign exchange
(pounds) to shift from D1 to D2?
a. an increase in the U.S. real interest
rate
b. higher inflation in Britain than in
the United States
c. higher income growth in Britain than
in the United States
d. an increased level of vacation travel
to Britain by Americans
Which of the following would cause the demand for foreign exchange
(pounds) to shift from D1 to D2?
a. an increase in the real interest rate in Britain relative to the US
b. higher inflation in Britain than in the United States
c. higher income growth in Britain than in the United States
d. an increase in the number of British citizens vacationing in the US