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ASSIGNMENT On the Following Questions I. What Is The Balance Of Payments (BOP)? II. What is Balance Of Trade (BOT)? III. Difference between Balance of Trade and Balance of Payment. IV. What are the Significance of V. VI. VII. VIII. IX. X. Write down the Causes of disequilibrium in BOP. What are the functions of IMF & WB? What are the International Trade Barriers? Factors that affect currency rates. How to predict exchange rate fluctuations? Describe Foreign Exchange Derivatives. Submitted to::.. Course Teacher : Mr. Ashraf Ali Name of course : International Finance & Financial Institutions Program : BBA Department : Business administration, The Millennium University Submitted by::.. Name (in full) ID No. : Muhammad Ibrahim Sohel : 112 BBA 00 21 Batch : 21st (class with 15th) Program : BBA Department : Business administration, The Millennium University DATE OF SUBMISSION Pages Words Paragraph 1|Page 10 3510 153 28 June 2013 I. What Is The Balance Of Payments (BOP)? The balance of payments (BOP) is the method countries use to monitor all international monetary transactions at a specific period of time. Usually, the BOP is calculated every quarter and every calendar year. All trades conducted by both the private and public sectors are accounted for in the BOP in order to determine how much money is going in and out of a country. If a country has received money, this is known as a credit, and if a country has paid or given money, the transaction is counted as a debit. Theoretically, the BOP should be zero, meaning that assets (credits) and liabilities (debits) should balance, but in practice this is rarely the case. www.investopedia.com The Balance of Payments records financial transactions between a country and the international economy. The accounts are split into two sections with the current account measuring trade in goods and services and the capital account tracking capital flows in and out of the country. This includes portfolio capital flows (e.g. share transactions and the buying and selling of Government debt) and direct capital flows arising from foreign direct investment. II. What is Balance Of Trade (BOT)? The difference between a country's imports and its exports. Balance of trade is the largest component of a country's balance of payments. Debit items include imports, foreign aid, domestic spending abroad and domestic investments abroad. Credit items include exports, foreign spending in the domestic economy and foreign investments in the domestic economy. A country has a trade deficit if it imports more than it exports; the opposite scenario is a trade surplus. III. Difference between Balance of Trade and Balance of Payment Following is the list which is showing difference between balance of trade and balance of payment. It has been made on some basis. BASIS OF BALANCE OF TRADE (BOT) BALANCE OF PAYMENT (BOP) DIFFERENCE 1. Definition Balance of trade may be defined as difference between Balance of payment is flow of cash between domestic country and all other export and import of goods and services. foreign countries. It includes not only import and export of goods and services but also includes financial capital transfer. 2. Formula BOT = Net Earning on Export - Net payment for BOP = BOT + (Net Earning on foreign investment - payment made to imports foreign investors) + Cash Transfer + Capital Account +or - Balancing Item or BOP = Current Account + Capital 2|Page Account + or - Balancing item ( Errors and omissions) 3. Favourable If export is more than import, at that time, BOT will be Balance of Payment will be favourable, if you have surplus in current or Unfavourable favourable. If import is more than export, at that time, BOT account for paying your all past loans in your capital account. will be unfavourable. Balance of payment will be unfavourable, if you have current account deficit and you took more loan from foreigners. After this, you have to pay high interest on extra loan and this will make your BOP unfavourable. 4. Solution of Unfavourable To Buy goods and services from domestic country. To stop taking of loan from foreign countries. Following are main factors which affect BOT Following are main factors which affect BOP a) cost of production a) Conditions of foreign lenders. b) availability of raw materials, c) Exchange rate b) Economic policy of Govt. c) all the factors of BOT d) Prices of goods manufactured at home If you see RBI' Overall balance of payment report, it shows debit and credit of current account. Credit means total export of different goods and services and debit means total import of goods and services in current account. Credit means to receipt and earning both current and capital account and debit means total outflow of cash both current and capital account and difference between debit and credit will be net balance of payment. Problem 5. Factors 6. Meaning of Debit and Credit IV. Significance of BALANCE OF PAYMENT BOP statistics are regularly compiled, published and are continuously monitored by companies, banks and government agencies. A set of BOP accounts is useful in the same way as a motion picture camera. The accounts do not tell us what is good or bad, nor do they tell us what is causing what. But they do let us see what is happening so that we can reach our own conclusions. Below are 3 instances where the information provided by BOP accounting is very necessary: 1. Judging the stability of a floating exchange rate system is easier with BOP as the record of exchanges that take place between nations help track the accumulation of currencies in the hands of those individuals more willing to hold on to them. 3|Page 2. Judging the stability of a fixed exchange rate system is also easier with the same record of international exchange. These exchanges again show the extent to which a currency is accumulating in foreign hands, raising questions about the ease of defending the fixed exchange rate in a future crisis. 3. To spot whether it is becoming more difficult for debtor counties to repay foreign creditors, one needs a set of accounts that shows the accumulation of debts, the repayment of interest and principal and the country’s ability to earn foreign exchange for future repayment. A set of BOP accounts supplies this information. This point is further elaborated below. V. Causes of disequilibrium in BOP These forms of disequilibrium may be caused by the following factors; 1. Population growth: Most countries experience rapid population growth which lead to a high quantity of import that exceeds the quantity of export. This leads to a disequilibrium of deficit. 2. Development Programs: Developing countries which have embarked upon planned development programs require to import capital goods, some raw materials which are not available at home and highly skilled and specialized manpower. Since development is a continuous process, imports of these items continue for the long time landing these countries in a balance of payment deficit. 3. Demonstration Effect: When the people in the less developed countries imitate the consumption pattern of the people in the developed countries, their import will increase. Their export may remain constant or decline causing disequilibrium in the balance of payments. 4. Natural Factors: Natural calamities such as the failure of rains or the coming floods may easily cause disequilibrium in the balance of payments by adversely affecting agriculture and industrial production in the country. The exports may decline while the imports may go up causing a discrepancy in the country's balance of payments. 5. Cyclical Fluctuations: Business fluctuations introduced by the operations of the trade cycles may also cause disequilibrium in the country's balance of payments. For example, if there occurs a business recession in foreign countries, it may easily cause a fall in the exports and exchange earning of the country concerned, resulting in a disequilibrium in the balance of payments. 6. Inflation: An increase in income and price level owing to rapid economic development in developing countries, will increase imports and reduce exports causing a deficit in balance of payments. 7. Poor Marketing Strategies: The superior marketing of the developed countries have increased their surplus. The poor marketing facilities of the developing countries have pushed them into huge deficits. 8. Flight Of Capital: Due to speculative reasons, countries may lose foreign exchange or gold stocks People in developing countries may also shift their capital to developed countries to safeguard against political uncertainties. These capital movements adversely affect the balance of payments position. 4|Page 9. Globalisation: Due to globalisation there has been more liberal and open atmosphere for international movement of goods, services and capital. Competition has beer increased due to the globalisation of international economic relations. The emerging new global economic order has brought in certain problems for some countries which have resulted in the balance of payments disequilibrium. 10. Price-Cost Structure: Changes in price-cost structure of export industries affect the volume of exports and create disequilibrium in the balance of payments. Increase in prices due to higher wages, higher cost of raw materials, etc. reduces exports and makes the balance of payments unfavorable. 11. Changes in Foreign Exchange Rates: Changes in the rate of exchange is another cause of disequilibrium in the balance of payments. An increase in the external value of money makes imports cheaper and exports dearer; thus, imports increase and exports fall and balance of payments become unfavourable. Similarly, a reduction in the external value of money leads to a reduction in imports and an increase in exports. 12. Fall in Export Demand: There has been a considerable decline in (he export demand for the primary goods of the underdeveloped countries as a result of the large increase in the domestic production of foodstuffs raw materials and substitutes in the rich countries. Similarly, the advanced countries also find a fall in their export demand because of loss of colonial markets. However, the deficit in the balance of payment due to the fall in export demand is more persistent in the underdeveloped countries than in the advanced countries. VI. What are the Functions of IMF & WB? Key IMF activities The IMF supports its membership by providing policy advice to governments and central banks based on analysis of economic trends and crosscountry experiences; research, statistics, forecasts, and analysis based on tracking of global, regional, and individual economies and markets; loans to help countries overcome economic difficulties; concessional loans to help fight poverty in developing countries; and Technical assistance and training to help countries improve the management of their economies. The World Bank seeks to promote the economic development of the world's poorer countries assists developing countries through long-term financing of development projects and programs 5|Page provides to the poorest developing countries whose per capita GNP is less than $865 a year special financial assistance through the International Development Association (IDA) encourages private enterprises in developing countries through its affiliate, the International Finance Corporation (IFC) VII. What are the International Trade Barriers? Trade barriers are government-induced restrictions on international trade. Man-made trade barriers come in several forms, including: Tariffs Non-tariff barriers to trade Import licenses Export licenses Import quotas Subsidies Voluntary Export Restraints Local content requirements Embargo Currency devaluation Trade restriction Most trade barriers work on the same principle–the imposition of some sort of cost on trade that raises the price of the traded products. If two or more nations repeatedly use trade barriers against each other, then a trade war results. Technological Barriers Standards-related trade measures, known in WTO parlance as technical barriers to trade play a critical role in shaping global trade. KEY POINTS Governments, market participants, and other entities can use standards-related measures as an effective and efficient means of achieving legitimate commercial and policy objectives. Significant foreign trade barriers in the form of product standards, technical regulations and testing, certification, and other procedures are involved in determining whether or not products conform to standards and technical regulations. Significant foreign trade barriers in the form of product standards, technical regulations and testing, certification, and other procedures are involved in determining whether or not products conform to standards and technical regulations. 6|Page Cultural Barriers It is typically more difficult to do business in a foreign country than in one’s home country due to cultural barriers. KEY POINTS With the process of globalization and increasing global trade, it is unavoidable that different cultures will meet, conflict, and blend together. People from different cultures find it is hard to communicate not only due to language barriers but also cultural differences. It is typically more difficult to do business in a foreign country than in one’s home country, especially in the early stages when a firm is considering either physical investment in or product expansion to another country. Expansion planning requires an in-depth knowledge of existing market channels and suppliers, of consumer preferences and current purchase behavior, and of domestic and foreign rules and regulations. The Argument Against Barriers Economists generally agree that trade barriers are detrimental and decrease overall economic efficiency. KEY POINTS Trade barriers are often criticized for the effect they have on the developingworld. Even countries promoting free trade heavily subsidize certain industries, such as agriculture and steel. Most trade barriers work on the same principle: the imposition of some sort of cost on trade that raises the price of the traded products. If two or more nations repeatedly use trade barriers against each other, then a trade war results. The Argument for Barriers Some argue that imports from countries with low wages has put downward pressure on the wages of Americans and therefore we should have trade barriers. KEY POINTS Economy-wide trade creates jobs in industries that have a comparative advantage and destroys jobs in industries that have a comparative disadvantage. Trade barriers protect domestic industry and jobs. Workers in export industries benefit from trade. Moreover, all workers are consumers and benefit from the expanded market choices and lower prices that trade brings. Economics Trade barriers are government-induced restrictions on international trade, which generally decrease overall economic efficiency. KEY POINTS Trade barriers cause a limited choice of products and, therefore, would force customers to pay higher prices and accept inferior quality. Trade barriers generally favor rich countries because these countries tend to set international trade policies and standards. 7|Page Economists generally agree that trade barriers are detrimental and decrease overall economic efficiency, which can be explained by the theory of comparative advantage. Ethical Barriers Despite international trading laws and declarations, countries continue to face challenges around ethical trading and business practices. International trade is the exchange of goods and services across national borders. In most countries, it represents a significant part of gross domestic product (GDP). The rise of industrialization, globalization, and technological innovation has increased the importance of international trade, as well as its economic, social, and political effects on the countries involved. KEY POINTS Although some argue that the increasing integration of financial markets between countries leads to more consistent and seamless trading practices, others point out that capital flows tend to favor the capital owners more than any other group. With increased international trade and global capital flows, critics argue that income disparities between the rich and poor are exacerbated, and industrialized nations grow in power at the expense of under-capitalized countries. Anti-globalization groups continue to protest what they view as the unethical trading practices of multinational businesses and capitalist nations, often targeting groups such as the WTO and IMF. VIII. What are the Factors that affect currency rates? Exchange rates continuously fluctuate, there are several factors such as interest rate expectations, inflation, macro economic risks and events. Short-term factors Interest rates: a government may decide to lower interest rates in an attempt to stimulate growth in the economy. Generally, this means that investment funds will flow out of one currency into another currency that has higher interest rates. So when looked at in isolation, lower interest rates could weaken the currency. Trade flows: a trade surplus is where there is a greater demand for goods and services from a country, which means its currency (needed to pay for those goods) will be stronger. Conversely, a trade deficit will usually weaken the currency. Natural disasters: think about the earthquakes in Japan and New Zealand and the effect this has had on their currencies. The currencies initially weakened on the events due to the unknown damage made to the economy. They then strengthened as insurance funds and other sources of funding flowed back to these countries from overseas to fund the repairs. Then the currencies weakened due to action taken by their central banks to aid economic recovery, such as injecting additional funding into the financial market and reducing interest rates, had a negative impact on the currency. Economic growth: an investor may choose to hold one currency over another simply because that country is growing at a faster pace than the other or is perceived to do so in the future. 8|Page Links to commodity based currencies: currencies such as Norwegian Krone or Canadian dollar are commodity linked currencies and their exchange rates tend to increase in value when there is a rise in commodities such as oil. Conflict: there may be a period of time where there is no official government in place or when a person or organisation has taken power illegally. This will naturally have an effect on the currency and will be ongoing as the conflict continues. Short term inflation: if inflation is starting to rise then the natural response for the authorities will be to limit the rise of inflation by increasing interest rates, therefore clients may convert into that currency in anticipation of gaining a better return on their money. Long-term factors Long term inflation: this is a rise in the general level of the prices of goods and services in an economy over a period of time. When the price level rises, each unit of currency buys fewer goods and services. Consequently, inflation wears away the purchasing power of money in that country. So higher inflation in a country typically weakens its currency. Economic growth: it can take many years for an economy to recover i.e. the subprime crisis in the US took place over three years ago, and it has taken many years for the US economy to recover to the level it's currently at. IX. How to predict exchange rate fluctuations In order to correctly forecast future fluctuations in currency exchange rates, it is critical to keep abreast of political events, to monitor economic indicators, and to keep a ‘track record’ of previous changes in currency exchange rates. You will be able to significantly reduce your losses and increase your gains if you carefully analyze the current status of your Forex account and prepare detailed action plans to follow if exchange rates fluctuate dramatically. FUNDAMENTAL ANALYSIS It is postulated that price fluctuations in the securities, commodity, and currency markets are impossible to predict. Not surprisingly, very few people adhere to this view. The average member of society who watches the news on TV could not but notice that, over the past several years, starting from 2001, the state of the US economy has deteriorated significantly. Since then, the exchange rate of the euro against the US dollar has increased from approximately 85 cents per euro to 1 dollar 37 cents per euro (as of end 2004). Meanwhile, market pundits and active market participants constantly monitor a far greater number of economic indicators, which are calculated to gauge the health of the world’s leading economies. This means they are better informed about current events, which helps them respond more quickly and accurately to fluctuations in exchange rates and, therefore, earn hefty gains. As a rule, forecasts, based on the careful analysis of economic parameters, underlying indicators, and news flows, lay the groundwork for the so-called fundamental analysis. Fundamental analysis is a valuation method used to forecast future fluctuations of exchange rates, estimated on the basis of economic parameters, underlying indicators, and news flows. TECHNICAL ANALYSIS 9|Page Additionally, certain patterns in price movements have been detected through trial-and-error and consistent analysis of price charts. Some of these patterns were discovered and described hundreds of years ago. Moreover, today theoretical foundations have been identified for these patterns. Forecasts, issued on the basis of price charts, analyzed with the help of technical indicators, are collectively called technical analysis. Technical analysis is a valuation method, based on the analysis of price charts with the use of technical indicators and linear instruments. DECISION-MAKING After making his/her forecasts, a market participant needs to assess the current status of his/her Forex account, a possible number of open positions, as well as to develop an action plan if the market reverses against him/her. Then he/she opens all or a part of the trading positions, continuously monitors the current status of his/her account, and makes a decision either to close positions or to open additional positions. Strictly speaking, this process called Money Management is not a forecasting technique, but it does help ramp up gains and reduce possible losses. X. Describe Foreign Exchange Derivatives Definition: Any financial instrument that locks in a future foreign exchange rate. These can be used by currency or forex traders, as well as large multinational corporations. The latter often uses these products when they expect to receive large amounts of money in the future but want to hedge their exposure to currency exchange risk. Financial instruments that fall into this category include: currency options contracts, currency swaps, forward contracts and futures contracts. In international finance, derivative instruments imply contracts based on which you can purchase or sell currency at a future date. The three major types of foreign exchange (FX) derivatives: forward contracts, futures contracts, and options. They have important differences, which changes their attractiveness to a specific FX market participant. FX derivatives are contracts to buy or sell foreign currencies at a future date. The table summarizes the relevant characteristics of three types of FX derivatives: forward contracts, futures contracts, and options. Because the types of FX derivatives closely correspond to the identity of the FX market participant, the table is based on the derivative type-market participant relationship. -THE END- 10 | P a g e