Home Page EC 340, International Trade and Finance Files EC 340 Lecture Notes Lecture 8: Foreign Exchange

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from last time
balance of payments accounts
exchange rates
uses of foreign exchange markets
relationship between spot and forward exchange rates
currency options

From Last time

• Are there any cases where the external costs can be good?
  
• How much do all tariffs together cost us a year? I haven't seen any figures for all tariffs put together. One study estimated that trade restrictions on only 3 goods - clothing, sugar, and automobiles - caused increased consumer expenditures of $14 billion in 1984. That's about $140 a household.
• Economists make a distinction between private costs and external costs. Private costs are borne by someone involved in the transaction that created the externality. External costs are borne by someone not involved in the transaction. Marginal external costs are the additional external costs resulting from producing one more unit of output.
• Does India produce a lot of CFC's that it matters globally? Yes, because of it large population. India is the only major CFC-producing country outside the Montreal Protocol.
• What is an example of a distribution keiretsu? This type is found in the distribution of automobiles, consumer electronics, cosmetics, pharmaceuticals, cameras, and newspapers.

Balance of Payments Accounts

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:

1. credit - flow for which the country is paid, e.g. exports, sale of assets
2. debit - flow for which the country must pay, e.g. imports, purchase of assets

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.

Click here to go to the balance of payments accounts for the U.S.

current account

The current account balance =  exports of goods, services, and investment income
                             - imports of goods, services, and investment income
                             + net unilateral transfers

capital account

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.

Exchange Rates

Click here for the 10AM foreign exchange rates

system	dollar rises in value	dollar falls in value
flexible	appreciation	depreciation
fixed	revaluation	devaluation

Uses of Foreign Exchange Markets

• spot vs. forward markets

1. clearing

   Foreign exchange markets allow people to end up holding the national currency they need to purchase goods and services.

   foreigners demand dollars to

   • buy U.S. goods and services
   • buy U.S. assets

   Americans sell dollars to

   • buy foreign goods and services
   • buy foreign assets

   
   

2. hedging

   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.

3. speculation

   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.

Relationship Between Spot and Forward Exchange Rates

2 ways of dealing with risk:

1. contract now to convert DM back into $ at the 1 year forward exchange rate - covered (hedged)
2. wait and convert DM into $ at the future spot exchange rate in 1 year - uncovered (speculation)

• $10,000 today = DM 20,000
• DM 20,000 + 6% = DM 21,200 after one year

Suppose at the time of investment, you could have contracted to sell DM in the forward market at r_f = $0.52/DM to get an assured number of dollars next year. 21,200 DM in one year converted back into $ at the r_f is $11,024.

Overall, every dollar invested yields (1 + i_for)(r_f/r_s 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 + i_for)(r_f/r_s) - (1 + i)

• if CD > 0, invest abroad
• if CD < 0, invest in U.S.

1. interest rate
2. appreciation in the value of the DM

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

r_f/r_s = (1 + i)/(1 + i_for)

• a rise in i causes r_f to rise (dollar falls in value in forward market)
• a rise in i_for causes r_f to fall (dollar rises in value in forward market)

EUD = (1 + i_for)(r^e_s/r_s) - (1 + i)

• if EUD > 0, invest abroad

percentage change in the exchange rate = U.S. interest rate - foreign interest rate

• if the U.S. interest rate is greater than the foreign interest rate, the dollar is expected to depreciate against the foreign currency
• if the U.S. interest rate is less than the foreign interest rate, the dollar is expected to appreciate

Currency Options

buy a call option

you have a right to purchase an asset at a specified price

buy a put option

you have the right to sell an asset at a specified price

write (sell) a call option

you have an obligation to sell an asset at a specified price

write (sell) a put option

you have an obligation to buy an asset at a specified price

strike price

the predetermined, specified price

experiration date

when the option expires

option premium

fee charged by the option writer

David A. Latzko 318 COB Department of Business and Economics Wilkes University Wilkes-Barre, PA 18766 phone: (717) 408-4718 fax: (717) 408-4917 dlatzko@wilkes.edu wilkes1.wilkes.edu/~dlatzko