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UNIT THREE International Finance: Enduring Issues CHAPTER SIX Balance of Payments and Foreign Exchange Markets I. Fundamental Issues 1. 2. 3. 4. 5. 6. 7. What is a country’s balance of payments, and what does this measure? What is the role of foreign exchange markets in the global marketplace? What is the spot foreign exchange market? What is foreign exchange risk, and what is the role of forward foreign exchange markets? What determines the value of a currency? How are the spot and forward exchange markets related? What other foreign exchange instruments are commonly traded? II. Chapter Outline 1. Balance of Payments a. Balance of Payments as a Double-Entry Bookkeeping System b. Balance of Payments Accounts c. Deficits and Surpluses in the Balance of Payments d. Other Deficit and Surplus Measures 2. The Role of Foreign Exchange Markets in the Global Marketplace a. How Foreign Exchange Rates and Foreign Exchange Markets Facilitate Global Transactions b. How a Foreign Exchange Transaction is Conducted c. What is the Foreign Exchange Market? d. Online Globalization: Online Foreign Exchange Services 3. The Spot Market for Foreign Exchange a. Exchange Rates as Relative Prices b. Real Exchange Rates c. Measuring the Overall Strength or Weakness of a Currency: Effective Exchange Rates 4. Foreign Exchange Risk and the Forward Market for Foreign Exchange a. Foreign Exchange Risk b. The Forward Market for Foreign Exchange c. Covering a Transaction With a Forward Contract 51 52 Chapter 6 5. Demand for and Supply of Currencies a. Demand for a Currency b. Visualizing Global Economic Issues: The Demand for the Euro c. Supply of a Currency d. Visualizing Global Economic Issues: The Dollar Demand-Euro Supply Relationship e. The Equilibrium Exchange Rate f. Visualizing Global Economic Issues:: The Equilibrium Exchange Rate 6. Relationship between the Spot Market and the Forward Market a. The Forward Premium and Discount b. The Standard Forward Premium c. The Forward Rate and the Expected Future Spot Rate 7. Other Foreign Exchange Instruments a. Foreign Exchange Derivatives b. Common Foreign Exchange Derivatives c. Management Notebook: Just How Widespread is the Use of Derivatives by U.S. Businesses? 8. Questions and Problems III. Chapter in Perspective The chapter introduces balance of payments accounts, and then covers the purpose of the foreign exchange markets. The calculation of real and effective exchange rates is presented, and the determination of the equilibrium exchange rate is introduced. The terms forward discount and premium are introduced, and the uses of currency derivatives such as currency forward and futures contracts are discussed. IV. Teaching Notes 1. Balance of Payments a. Balance of Payments as a Double-Entry Bookkeeping System The balance of payments (BOP) accounts attempt to measure the value of flows in and out of a country during a given time period. Every international transaction results in two entries (i.e., standard double-entry bookkeeping is employed). For example if a private resident of the U.S. imports a computer assembled in Taiwan the value of the computer coming into the U.S. results in one entry and the value of the payment for the computer going to Taiwan generates an offsetting entry. Text Table 6-1 presents summary BOP data for the U.S. for 2001. Teaching Tip: Any transaction that results in money leaving the country (such as an import) will be entered as a negative, or debt, in the appropriate balance of payments account. Similarly, any transaction that results in money entering the country (such as an export) will be entered as a positive, or credit, in the appropriate account. Balance of Payments and Foreign Exchange Markets 53 b. Balance of Payments Accounts • • • • • Current Account: The current account measures the flow of goods, services, income and transfers between domestic residents, businesses, and governments and the rest of the world. This is the “headline” account that is often mentioned in the media. It has the following subcomponents: – Merchandise balance (imports and exports of goods): –$426,615 million The minus sign indicates the U.S. imported $426,615 more than it exported. – Services balance (imports and exports of services): +$78,805 million Notice that this component of the Current Account is in surplus, implying that the U.S. exported more services than it imported. – Balance on income (income received and income paid including dividends and interest payments on assets): –$19,118 million · Balance on goods, services and income = –$366,928 million – Unilateral transfers: –$50,501 million · Current account balance = Balance on goods, services and income + unilateral transfers = –$417,429 Capital Account: The capital account measures the flows of financial assets between domestic private residents and businesses and foreign private residents and businesses. – U.S. private investments overseas: –$434,079 million – Foreign private investment in the U.S. +$889,367 million – Other: +$726 millions · Capital account balance = +$456,014 million Official Settlement Balance: measures transactions of official holdings of gold, foreign currencies and other reserve assets by official government agencies. – U.S. official reserves assets and other U.S. govt. assets held abroad: –$5484 million – Foreign official assets in the U.S.: +$6,092 million · Official Settlement Balance = +$608 million Statistical Discrepancy: an account reflecting measurement error in all other accounts. The statistical discrepancy is set to equal the negative of the sum of the current, capital and official settlement balance and is assumed to be measurement error: – Statistical discrepancy = –(–$417,429 + $456,014 + $608) = –$39,193 The Overall Balance of Payments: The overall balance is always zero and is equal to the sum of the debt and credits in the current, capital, official settlement and statistical discrepancy accounts. c. Deficits and Surpluses in the Balance of Payments If an individual account is in surplus, then the sum of the credit entries exceeds the sum of debit entries in that account. If an account is in the deficit then this implies that transactions in that category net the sum of the debit entries exceeds the sum of the credit entries. When the media refers to a balance of payments deficit (surplus) they are probably indicating that the sum of the current and capital accounts is in deficit (surplus). 54 Chapter 6 d. Other Deficit and Surplus Measures Individual BOP accounts may be in surplus (net money moving into the country), or in deficit (net money leaving the country) due to transactions in that account. A current account deficit implies that a country is importing more than it is exporting, or similarly its demand for funds for consumption and investment is greater than its supply of funds. The excess funds demanded are provided through the large capital account surplus. Because of the high current account deficit, and the resulting capital account surplus, the U.S. has become a net debtor nation, one that owes far more to foreigners on net than foreigners owe to the U.S. Teaching Tip: In recent years in the U.S., the current account has experienced very high deficits. Part of this is due to the size of the U.S. economy. The account balances are normally standardized by dividing the deficit or surplus by GDP. Recently the current account deficit has been over 4 percent of GDP Nonetheless, analysis concludes that a deficit of this size is sustainable in the near term. [See for instance, “Is the Large U.S. Current Account Deficit Sustainable?” J. Holman, Federal Reserve Bank of Kansas City Economic Review, First Quarter 2001, pp. 5-23.] High current account deficit levels imply a high level of borrowing from foreigners (or high asset sales to foreigners). Eventually the terms of trade will likely deteriorate if the high deficit levels continue resulting in either higher U.S. inflation, a lower value of the dollar and/or higher U.S. interest rates. Better growth prospects in the U.S. than elsewhere, uncertainty over the Euro and weaknesses in Japan and Asia have probably helped the U.S. maintain its large deficits with favorable terms of trade so far. The logical conclusion is that the U.S. will not be able to continue to consume more than it produces unless it can continue to generate more favorable growth opportunities than other countries. Hence our standard of living has become very dependent on relative growth of the U.S. and the rest of the world. 2. The Role of Foreign Exchange Markets in the Global Marketplace a. How Foreign Exchange Rates and Foreign Exchange Markets Facilitate Global Transactions The major participants in the foreign exchange market are commercial banks, central banks, foreign exchange brokers and multinational corporations. Foreign exchange trading supports global trade in goods and services and financial assets, but the growth in foreign exchange (hereafter FX) has been much more rapid than the growth in trade, primarily because FX markets are also used extensively for speculation, capital raising and for hedging various international risks. Most wholesale trades involve banks and financial earning assets denominated in a foreign currency. Balance of Payments and Foreign Exchange Markets 55 b. How a Foreign Exchange Transaction is Conducted A U.S. importer may contract to pay for an import in say Canadian dollars (C$) after delivery of the goods is made. The U.S. firm may inform its bank of its desire to purchase Canadian dollars or the firm may call a foreign exchange broker and have the broker search for the best rate at various banks. Different banks may offer better rates because trading costs vary inversely with dealer volume. For example, a buyer may find a better rate for the Swiss franc from UBS than from Citicorp. Most international banks make a market in the major currencies. Dealers maintain a bid and ask quote with a typical spread of 0.1 percent on active currencies. Brokers charge a small commission as well. Note that using a broker will normally impose an additional cost on the currency buyer or seller above the bid-ask spread. The typical currency transaction is now in the range of $3,000,000 (or equivalent) per trade. c. What is the Foreign Exchange Market? Traditionally, trades have been conducted by telephone and telex, with banks comprising about 66 percent of trading and brokers accounting for about 20 percent. Foreign exchange trading is increasingly being conducted online, and a few websites now offer trades to the public. The company Opulent FX at http://www.forexmarketonline.com/site.htm offers accounts to the public with minimums as low as $300. However, banks and brokers still dominate trading, only the mechanism of trade execution has changed. The largest centers for FX trading are London, followed by New York and Tokyo respectively. The FX market is basically a global, 24-hour market. d. Online Globalization: Online Foreign Exchange Services For Critical Analysis: Do you think that online foreign exchange services like those described above will have any impact on exchange rate prices and their volatility? Why or why not? The growth of online services may increase competition among dealers and result in lower trading costs for customers. Generally, these services allow customers to more easily compare rates, leading to a convergence of prices among dealers. As trading costs fall, trading tends to increase and some economists believe that trading generates increased volatility. In deep markets this is not necessarily true. Trading can also improve efficiency, because it is the actions of traders that results in new information being incorporated into current prices. 3. The Spot Market for Foreign Exchange The spot market is normally for delivery of a currency within two business days. Trades between the Canadian dollar and the U.S. dollar may settle within one day. The bulk of foreign exchange trading involves the dollar, followed by the euro and the yen. The volume of spot market trading is much larger than forward trading. 56 Chapter 6 a. Exchange Rates as Relative Prices There are two prices involved in purchasing a foreign good or service: the price of the good and the price of the currency. The nominal (quoted) exchange rate considers only one of those two prices. An exchange rate may be thought of as an entry price to acquire a country’s goods, services and financial assets. Foreign exchange rates may be quoted in two methods, the foreign currency per domestic currency, say the U.S. dollar (e.g. ¥124 / $), or the domestic currency per unit of foreign currency ($0.008065 / ¥). The two quotes are inverses of one another. Teaching Tip: It is very important to keep track of the quote method and keep the quote method correct when dealing with parity equations, real exchange rates and supply/demand curves. It is also important to put the currency quote in the correct form when dealing with currency appreciations and depreciations. Because most transactions involve the dollar, one may have to calculate cross rates if a firm is interested in converting two currencies, neither of which is the dollar. For instance, if the Danish Krone is trading at 7.5 Krone to the dollar and the British pound is trading at $1.58 to the pound, what is the exchange rate between the Krone and the pound? Set up the problem to cancel out the dollar: Kr 7.5 / $1 * $1.58 / £ = Kr 11.85 / £ or inverting, £0.084 / Kr. b. Real Exchange Rates The quoted exchange rate is the nominal exchange rate and it accounts for only one of the two prices involved in purchasing foreign goods, services or financial assets. The real exchange rate is a bilateral exchange rate that has been adjusted for price changes that occurred in the two nations. Hence, real exchange rates are relative price measures that measure relative purchasing power in two different countries. Teaching Tip: Suppose that the exchange rate between the yen and the dollar is ¥125 / $. Also, the price of a market basket of goods and services purchased in one year in the U.S. is $30,000 and the price of the same market basket purchased in Japan is ¥4 million. Though the exchange rate between dollars and yen is ¥125, the relative value of the market baskets purchased in the two countries is not ¥125 per dollar. At the nominal exchange rate the Japanese market basket has an equivalent dollar cost of ¥4 million / ¥125 / $ = $32,000, or $2,000 more than the similar market basket in the U.S. Balance of Payments and Foreign Exchange Markets 57 c. Measuring the Overall Strength or Weakness of a Currency: Effective Exchange Rates It is sometimes useful to calculate an “overall” value of a currency. Firms often calculate effective exchange rates for their home currency against the value of the currencies of their major trading partners. Effective exchange rates (EERs) are a weighted average measure of the value of a currency relative to two or more other currencies. The currencies selected are called the currency basket, and the weights are selected to reflect the relative importance of the currency in the basket. EERs are index numbers that are calculated relative to a base year. Teaching Tip: Probably the most widely used EER in the U.S. is the trade-weighted value of the dollar. Monthly values for this index are available from http://woodrow.mpls.frb.fed.us/Research/data/us/charts/exc1.cfm. 4. Foreign Exchange Risk and the Forward Market for Foreign Exchange a. Foreign Exchange Risk Foreign exchange risk is the risk that arises when a firm’s economic value is affected by an exchange rate change. There are three main types of FX exposure. • Transaction Exposure: Transaction exposure is the risk that arises from a specific transaction involving a foreign currency payment or receipt. Suppose an importer agrees to purchase manufactured goods made in Singapore priced in the Singapore dollar (S$). The importer does not wish to pay until the goods are received in the U.S. in about 90 days. The importer may agree to obtain a letter of credit signifying that they have the funds available to purchase the goods. Based upon the letter of credit, the Singaporean exporter agrees to ship the goods. Once the contract is signed, the importer has a transaction exposure in the S$. The importer is at risk from the U.S. dollar depreciating against the S$. Transaction exposures are generally the easiest to hedge. • Translation exposure: Translation is an accounting term that refers to the need to translate foreign currency denominated assets and liabilities into the domestic currency. Translation exposure refers to the risk that foreign currency denominated assets and liabilities (and revenues and expenses) may have to be reported at different values on the balance sheet (or income statement) if currency values change. If a firm has a net asset exposure (i.e., more foreign currency denominated assets than liabilities), the translated value can be hurt by falling foreign currency values. If the firm has a net liability exposure instead, rising foreign currency exchange rates would hurt the value of the firm’s foreign position. • Operating Exposure: Operating exposure refers to the changes in competitive conditions that can occur when exchange rates change. Firms’ comparative advantages can be altered by changing exchange rates. A foreign firm that incurs revenues in dollars and has its costs in euros may enjoy a rising profit margin on U.S. sales if the dollar strengthens against the euro. Competing U.S. based firms (who may have no foreign currency transaction exposure (and thus think themselves insulated from currency changes) may then find themselves losing market share to foreign firms. 58 Chapter 6 • Economic Exposure: Economic exposure is the broadest measure of exposure and this term refers to changes in the present value of a firm’s future income stream as currency values change. Note that the income stream itself may change as currency values fluctuate. b. The Forward Market for Foreign Exchange The forward market is the wholesale market for delivery of a currency beyond two working days, although the price of the currency is set at the time the contract is enacted. Forward contracts are negotiated with FX market participants, usually banks. Currencies are typically bought or sold for delivery in one month, three months, six months and one year. Deals for delivery of a currency beyond one year are unusual and will normally be more expensive. No cash changes hands initially in a forward contract, although the bank may require collateral. c. Covering a Transaction With a Forward Contract Forward contracts are often used to hedge transaction exposures, such as the one discussed above for the U.S. firm that had contracted to pay Singapore dollars in 90 days. The U.S. importer could easily hedge this risk by buying the Singapore dollar forward. Whether the U.S. dollar depreciates will then not matter to the importer since their firm has already locked in the U.S.$ value of the Singapore dollar. 5. Demand for and Supply of Currencies a. Demand for a Currency The demand for a currency is derived from the international demand for that country’s goods, services and financial assets. The exchange rate follows the basic law of demand. Teaching Tip: Be careful how you quote the exchange rate when depicting supply and demand curves. The quote should be per unit of currency depicted on the horizontal (quantity) axis of the supply and demand curves. Balance of Payments and Foreign Exchange Markets 59 b. Visualizing Global Economics Issues: The Demand for the Euro For Critical Analysis: Would an appreciation of the dollar relative to the euro always result in a greater quantity demanded of euros? What role does the slope of the demand curve play in determining the answer to this question? An appreciation of the dollar relative to the euro would not result in a greater quantity demanded of euros if the demand curve for the euro was perfectly inelastic or vertical. The more inelastic (elastic) demand is, the smaller (greater) the change in quantity of euros demanded as the price of the euro changes. Recall that the demand for the currency is a derived demand so the shape of the curve is dependent upon the extent to which U.S. consumers’ desire for European goods and services is sensitive to price. c. Supply of a Currency The supply of a currency is derived from domestic residents’ demand for the foreign country’s goods, services and financial assets. Notice that the supply of one currency is the demand for the other currency. To continue with the above example, in the critical analysis of the demand for the euro, the U.S. demand for the Euro is the supply of the dollar offered for exchange with the euro. d. Visualizing Global Economics Issues: The Dollar Demand-Euro Supply Relationship For Critical analysis: How would you derive the supply curve for the U.S. dollar? What factors would influence the demand for the U.S. dollar? The supply curve for the U.S. dollar is the demand curve for the Euro (with the exchange rate quote switched from €/$ to $/€. The European demand for the dollar will be influenced by the relative attractiveness of U.S. goods and services relative to European goods and services. Relative price, quality, tastes and income levels are all factors that will affect the demand. )See also the discussion in e. below.) e. The Equilibrium Exchange Rate As always in a market situation, the interaction of supply and demand sets the price absent government interference. The exchange rate is set where the quantity of currency demanded equals the quantity supplied. 60 Chapter 6 Teaching Tip: A brief discussion may be in order of some of the major determinants of exchange rates: Relative real interest rates: Higher real interest rates attract more capital and tend to raise FX rates. Relative inflation rates: Lower relative inflation rates promote higher FX rates. In line with this, strong, credible central banks that have a record of maintaining low inflation tend to be associated with stronger currency values. Countries with sound fiscal policies and low levels of foreign currency denominated debt tend to have stronger currencies. Relative economic strength: Countries with strong growth prospects tend to offer assets with relatively higher rates of return that attract capital and result in strong currency values. Relatively low political and economic risk implies that a country’s investments will be valued more highly in the global market and imply a higher currency value. f. Visualizing Global Economic Issues: The Equilibrium Exchange Rate For Critical Analysis: What would happen to the equilibrium exchange rate of the yen if the demand for the yen and the supply of the yen were to increase simultaneously? The answer is indeterminate, as it depends on the relative increases in supply and demand. If demand increased more (less) than supply, then the value of the yen would appreciate (depreciate). 6. Relationship between the Spot Market and the Forward Market a. The Forward Premium and Discount The forward premium or discount is the difference between the forward exchange rate and the spot exchange rate expressed as a percentage of the spot exchange rate. b. The Standard Forward Premium The standard forward premium is the forward premium or discount expressed on an annual basis. Balance of Payments and Foreign Exchange Markets 61 c. The Forward Rate and the Expected Future Spot Rate The forward exchange rate may contain information about the future spot rate. In other words, the forward rate for time T (call it FN) is related to the expected future spot rate at time T (call it S eN ). A currency is trading at a forward premium if the forward rate implies a higher value for the currency than the spot rate. Likewise, a currency is trading at a forward discount if the forward rate implies a lower value for the currency than the spot rate. Forward premiums and discounts may be standardized by annualizing without compounding the percentage change implied by the difference in the forward and spot rates: 100 where N is the number f the Standard forward premium or discount = (FN – S)/ S 12 N months forward. 7. Other Foreign Exchange Instruments a. Foreign Exchange Derivatives FX derivatives are contracts whose value is linked to or derived from other financial instruments. Forward contracts are a form of derivative that is particularly useful in hedging, because the terms are negotiated and can be tailored to offset the risk of specific spot positions that arise in the course of business. Forwards however are not liquid and have significant counterparty risk. Consequently, other instruments are often more useful for speculating in the major currencies. b. Common Foreign Exchange Derivatives Currency futures: Futures are a highly standardized, very liquid form of a forward contract. The world’s largest current futures market is the Chicago Mercantile Exchange (www.cme.com). If a party goes long (short) in a futures contract, he or she is committing to buy (deliver) the foreign currency at a preset price at contract maturity. Other differences between futures and forwards include: – Forwards are usually for much larger currency amounts than futures contracts. – Futures contracts recognize gains and losses daily as currency values change whereas gains or losses on forward contracts are recognized only at maturity. – Futures are highly liquid, and most futures participants never make or take delivery of a foreign currency, whereas most forwards do result in making or taking delivery. – Futures contracts are highly levered and there is no counterparty default risk so participants can remain anonymous. This makes futures very suitable contracts for speculation. 62 Chapter 6 Currency options: Currency call (put) options provide the holder the right, but not the obligation, to purchase (sell) the foreign currency at a preset price for a preset time period. American style options can be exercised at anytime until the contract expires, and European style options can only be exercised on the date of expiration. Some buyers prefer European style options because they are cheaper. Currency swaps: Swaps are sometimes likened to a series of forward contracts, for which the forward rates are set according to some predetermined formula. Swaps are an exchange of cash flow streams denominated in different currencies. These are complex, negotiated contracts that can be tailored to meet a variety of purposes. They evolved from parallel loans and often serve a similar purpose. A U.S. firm may earn euro revenues, which it has to convert to dollars. Likewise, a French concern may be earning dollars from its American subsidiary that it needs to convert to euros on an ongoing basis. The two could negotiate a swap that avoids the exchange rate risk by swapping the U.S. firm’s euros for the French firm’s American subsidiary’s dollars. c. Management Notebook: Just How Widespread is the Use of Derivatives by U.S. Businesses? For Critical Analysis: Why would larger firms be more likely to use foreign exchange derivative instruments than smaller firms? Why would firms that use foreign exchange derivatives hedge less than 100 percent of their perceived foreign exchange exposure? Larger firms are more likely to have greater FX exposures. The bigger firms are also more likely to have the expertise needed to handle these complex instruments and can call on the large banks that deal in these instruments to assist them at fairly low cost because they are important customers of the bank. It is rare to find firms that hedge 100 percent of their FX exposure. Hedging involves the familiar risk-return tradeoff. The more a firm hedges the more likely it is to reduce its overall rate of return. If a firm’s managers hedged all of its risks, the shareholders could expect to earn the Treasury rate (and would assuredly fire the managers). Hedging is akin to buying insurance, and all insurance has a cost. There are both out of pocket and opportunity costs involved in hedging. Moreover, almost all managers are willing to take on some risks. More simply, hedging strategies allow firms to tailor their desired risk-return tradeoff patterns and there is no implication that 100 percent hedging strategy is optimal. Balance of Payments and Foreign Exchange Markets 63 8. Answers to End of Chapter Questions 1. The merchandise trade balance is $106 – $119 = –$13 (deficit). The balance on goods services and income is $106 – $119 + $34 – $28 = –$7 (deficit). The current account is –$7 + $8 = 1 (surplus). 2. The euro depreciated by 1.07 percent {[(0.9805 – 0.9701) / 0.9701] * 100}. 3. $ ₤ Can$ € — 0.7001 1.5433 1.0255 US$ 1.4284 — 2.2044 1.4648 UK₤ 0.6480 0.4536 — 0.6645 Can$ 0.9751 0.6827 1.5049 — euro 4. a. The euro depreciated 20 percent. b. U.S. inflation was 4.91 percent [113.3 – 108.0) / 108.0] and euro-area inflation was 3.32 percent [(108.8 – 105.3) / 105.3]. 5. The real rate for 2003 was (0.90)(108.0 / 105.3) = 0.9231. The real rate for 2004 is (1.08)(113.3 / 108.8) = 1.1247. This represents a real depreciation of 21.84 percent [(1.1247 – 0.9231) / 0.9231]. 6. The euro depreciated and the yen depreciated. 7. There is no way of knowing, based on this information alone, whether the euro appreciated or depreciated against the yen. One would assume that the yen is a currency represented in the effective exchange for the euro, and that the euro is represented in effective exchange rate for the yen. Without knowing the weight of each, it is impossible to deduce to tell how the value of the euro changed relative to the yen alone. 8. The baht is trading at a discount of 6.11 percent [(46.50 – 45.80) / 45.80 * (12/3) * 100]. 9. a. As European savers purchase more Canadian assets, the demand for the Canadian dollar increases, resulting in an appreciation of the Canadian dollar relative to the euro. b. As European firms shift their business from Canadian firms to Russian firms, the demand for the Canadian dollar decreases, resulting in a depreciation of the Canadian dollar relative to the euro. 10. Because one event results in an increase in demand while the other results in a decrease in demand, there is no way of knowing what happened to the exchange rate and quantity transacted. 11. Because the peso is trading at a discount, one would expect the peso to depreciate. The forward discount is equal to 7.69 percent [(57.29 – 53.20) / (53.20) * 100].