|Home Page EC 340, International Trade and Finance Files EC 340 Lecture Notes Lecture 8: Foreign Exchange||| Search|
The balance of payments is a record of a country's trade in goods, services, and financial assets with the rest of the world.
Any international transaction involves two opposite flows of equal value:
The balance of payments consists of two parts: (1) the current account, which measures the country's trade in currently produced goods and services, and (2) the capital account, which records trade between countries in existing assets.
The current account balance = exports of goods, services, and investment income - imports of goods, services, and investment income + net unilateral transfersServices include transportation, tourism, insurance, education, and financial services. Investment income includes interest payments and dividends people receive from assets owned outside of their own country. A unilateral transfer occurs when one party gives something but receives nothing in return, e.g. foreign aid.
A capital outflow occurs when the home country buys an asset from abroad, e.g. an American obtains a Swiss bank account.
The capital account balance = capital inflows - capital outflows
A country has a capital account surplus when its residents sell more assets to foreigners than they buy from foreigners.
Current Account balance + Capital Account balance = Zero
When a country runs a current account deficit, it means that it received fewer funds from its exports than the funds paid for imports. To finance this deficit, it must sell its assets to the foreigners. So, a current account deficit must be accompanied by a capital account surplus. The balance of payments must balance.
Included in the capital account is the official settlements balance. The official settlements balance records transactions conducted by central banks. It measures the net increase in a country's official reserve assets, assets that can be used in making international payments. The official settlements balance is called the balance of payments.
|system||dollar rises in value||dollar falls in value|
Foreign exchange markets allow people to end up holding the national currency they need to purchase goods and services.
foreigners demand dollars to
Americans sell dollars to
Hedging refers to trying to reduce the risk from exchange rate fluctuations. You are fully hedged when you have neither a net asset nor a net liability position in an asset.
Suppose you receive 1 million lira. You now have an asset position in lira. You want to hold onto this money for 6 months but you would be exposed to exchange rate risk. You can convert the lira into dollars and remove that risk. Hedgers avoid gambling on the future of exchange rates.
You can use the forward market to remove risk also. You can hedge your lira risk by entering into a forward contract to sell 1 million lira in 6 months at an exchange rate agreed to today. The obligation to sell the lira gives you a liability position to offset your asset position. Now, you are fully hedged.
Speculation is gambling on the future of exchange rates. It refers to the act of taking a net asset or net liability position in a foreign currency. Speculators attempt to profit from price changes and therefore provide liquidity for hedgers.
Speculators can use derivatives to outguess the market. Suppose you believe that the Dutch guilder will sell for 25 cents in 90 days while the 90-day forward rate is 51 cents. You can sign a forward contract giving you the right to sell, say, 10 million guilders at 51 cents per guilders. If you are right you have a contract requiring a trader to give you $5,100,000 in exchange for 10 milli on guilders. On the spot market you will be able to purchase 10 million guilders for $2,500,000. You'll earn a profit of $2.6 million.
2 ways of dealing with risk:
Suppose at the time of investment, you could have contracted to sell DM in the forward market at rf = $0.52/DM to get an assured number of dollars next year. 21,200 DM in one year converted back into $ at the rf is $11,024.
Overall, every dollar invested yields (1 + ifor)(rf/rs in one year.
If you invest in the U.S. bond, you will have $10,800 after one year.
In general, the choice depends on the sign of the difference between the two returns. Let CD equal the covered interest differential.
CD = (1 + ifor)(rf/rs) - (1 + i)
Assets which have identical risk, taxation, and liquidity characteristics ought to have the same return. The U.S. bond and the German bond should have the same return. Covered interest parity says that CD = 0.
For the bond example, covered interest parity would exist if the percentage change in the value of the DM equaled the difference in interest rates, 2%. The forward exchange rate would need to appreciate 2% to $0.51/DM.
return on U.S. bond = return on German bond
U.S. interest rate = foreign interest rate + percentage change in the exchange rate value of the foreign currency
rf/rs = (1 + i)/(1 + ifor)
EUD = (1 + ifor)(res/rs) - (1 + i)
percentage change in the exchange rate = U.S. interest rate - foreign interest rate
|David A. Latzko
Department of Business and Economics
Wilkes-Barre, PA 18766
phone: (717) 408-4718
fax: (717) 408-4917