EC 340

Lecture 8 - Foreign Exchange

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

Balance of Payments Accounts

An open economy engages in international trade and international borrowing and lending. A country's spending need not equal its production in every period. By importing more than it exports and borrowing from abroad to make up the difference, a nation can temporarily spend more than it produces.

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

Each transaction is recorded twice in the balance of payments: once as a credit and once as a debit. This is called double-entry bookkeeping. As a result, the balance of payments must balance.

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
Services 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.

capital account

A capital inflow occurs when the home country sells an asset to another country, e.g. Rockefeller Center is sold to a Japanese company.

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

Foreign exchange is the money of another country. The exchange rate is the price of one country's currency in terms of another country's money. For example, say, $1 = 5.6415 French francs.

Click here for the 10AM foreign exchange rates

Flexible exchange rates are determined by supply and demand in the foreign exchange market; fixed exchange rates are officially determined.

systemdollar rises in value dollar falls in value

Uses of Foreign Exchange 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

    Americans sell dollars to

  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

Suppose you have $10,000 to invest and you've narrowed your investment options to (1) a U.S. government bond with an 8% interest rate or (2) a German government bond with a 6% interest rate. Which bond is the better investment? It all depends on what you expect to happen to the exchange rate between dollars and German marks. You are exposed to exchange rate risk if you purchase the German bond.

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)
If you invest in the German bond you must turn your dollars into marks now and back again in one year. Suppose the exchange rate is now $1 = DM 2 or rs = $0.50/DM.

Every $ invested yields (1 + ifor/rs DM in 1 year.

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)

So, the German bond is the better investment. This is because the German bond provides two sources of return:
  1. interest rate
  2. appreciation in the value of the DM
The return on the foreign bond equals the foreign interest rate plus the percentage change in the exchange rate value of the foreign currency (called the forward premium).

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)

Let res = expected future spot exchange rate and EUD = expected uncovered interest differential.

EUD = (1 + ifor)(res/rs) - (1 + i)

Uncovered interest parity says that EUD equals 0. A currency is expected to appreciate by as much as its interest is lower than the interest rate in the other country.

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

For countries with no capital controls and for comparable short-term financial assets, covered interest parity holds almost perfectly. It is hard to directly measure res, but uncovered interest parity appears to roughly hold.

Currency Options

An options contract give the rights to buy or sell an asset at a pre-determined price by a predetermined time.

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