1. Explain the balance of payments for a country.
2. Describe the foreign exchange market and its
components.
3. Discuss the development of international
monetary systems.
4. Explain exchange rate changes over time.
5. Forecast exchange rates using different
methodologies.
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4–2
EXHIBIT 4.1
THE DOLLAR TO EURO EXCHANGE RATE:
JANUARY 2007–JUNE 2009
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4–3
The Balance of International Payments
• Balance of Payments (BOP)
– Shows all transactions between one country and the
rest of the world for a given period of time.
• Current Account
– Shows the activities of consumers and businesses in
the economy with respect to the trade balance,
services balance, income balance, and net transfers.
• Financial Account
– Consists of domestic-country-owned assets abroad,
foreign-owned assets in the domestic country, and net
financial derivatives.
Balance of Payments (BOP)
Current Account
Trade
balance
Services
balance
Income
balance
Net
transfers
Financial Account
U.S. assets
abroad
Foreign assets
in the U.S.
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Net financial
derivatives
4–5
The Financial Account of the BOP
• Risk Premium
– The added return required by investors for risk
associated with a security or asset
• Foreign Direct Investment (FDI)
– The purchases of fixed assets (such as factories and
equipment) abroad used in the manufacture and sales
of goods and services abroad
• Statistical Discrepancy
– Reconciles imbalances between the current account
and financial account to ensure that debit and credit
entries in the BOP statement sum to zero
EXHIBIT 4.2
U.S. BALANCE OF PAYMENTS (IN BILLIONS OF DOLLARS)
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4–7
EXHIBIT 4.3
TOP TEN COUNTRIES TRADING WITH THE UNITED STATES
Dollar values of imports plus exports (year-to-date total; December 2011).
These countries accounted for 62.8 percent of total trade with the United States
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4–8
EXHIBIT 4.4
U.S. FINANCIAL ACCOUNT (IN BILLIONS OF DOLLARS)
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4–9
EXHIBIT 4.5
GROWTH IN WORLD MERCHANDISE TRADE BY SELECTED REGION
AND ECONOMY, 2000–2008 (ANNUAL PERCENTAGE CHANGE)
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4–10
Foreign Exchange Markets
Setting Exchange Rates
Independent floating
exchange rate system
Managed floating
exchange rate system
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Fixed exchange
rate system
4–11
Components of the Foreign
Exchange Market
Forex Markets
Spot market
Forward market
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Futures market
4–12
Forex Trading Terms
• Bid-Ask Spread
– The difference between bid and ask prices of a
currency; the transaction fee earned by the bank
• Direct Quotes
– Prices of a foreign currency in dollars, or the number
of dollars per one unit of foreign currency)
• Indirect Quotes
– The reciprocal of the direct quote, or the prices of a
dollar (for example) in foreign currency terms
Forex Market Trading Terms (cont’d)
• Forward Rate
– The price at an earlier time of a currency in terms of another
currency established for future delivery in the forward market
• Discount
– The selling of a currency at a spot rate that is less than the
forward rate
• Premium
– The selling of a currency at a spot rate that is more than the
forward rate
• Hedge
– Insurance that reduces future risk
International Monetary Systems
• Gold Standard
– A monetary system that pegs currency values to the
market value of gold
• Bretton Woods Agreement
– The 1944 decision to establish a global currency
system with the U.S. dollar pegged at a fixed rate of
exchange to gold, and the currencies of 43 other
countries fixed to the dollar
• International Monetary Fund (IMF)
– The financial authority established under the Bretton
Woods Agreement to help ensure the stability of the
international monetary and financial system
Development of the Flexible
Exchange Rate System
• Smithsonian Agreement
– The 1971 decision allowing the United States to
devalue the dollar against other countries’ currencies
• Jamaica Agreement
– The 1976 international monetary order that allowed
countries to adopt different exchange rate systems
including floating their currencies in world markets
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4–16
Valuing (or Devaluing) Currencies
• Special Drawing Right (SDR)
– A basket of currencies (dollars, euros, pounds, and
yen) created by the IMF for use as a benchmark to
value the currencies of different countries
• Clean Float
– Currency monetary system with minimal government
intervention; largely market determined
• Dirty Float
– Currency monetary system with varying degrees of
government intervention to maintain a range of
acceptable values against other currencies
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4–17
What’s In Your Wallet?
• Dollarization
– The practice of using the dollar or some other foreign
currency together with, or instead of, a domestic
currency in a country
• Hard Currencies
– Leading world currencies of developed industrialized
countries, including the dollar, euro, yen, and pound
• Soft Currencies
– Emerging market countries’ currencies that are less
stable in value than hard currencies and are
sometimes pegged to hard currency values
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4–18
International Flows of Goods and Capital
• Law of One Price
– Principle stating that identical goods should sell for
the same price in different countries according to
local currencies
• Arbitrage
– Buying goods in a lower priced market and selling
them in a higher priced market to make profits
• Purchasing Power Parity (PPP)
– Theory stating that a basket of goods should have
approximately the same prices across different
countries
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4–19
Do You Want PPP Fries With That?
The Big Mac Index
• The Big Mac Index
– A calculation using the cost of a Big Mac sandwich to
assess the relative values of currencies
– Click on the following link to view the Big Mac index
cited in the textbook and its associated chart :
• Big Mac Index
– What could cause the index to provide inaccurate
estimates of PPP among its comparison countries?
• Click Here
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4–20
Inflation and Purchasing Power Parity
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4–21
Problems with PPP
• Empirical tests of PPP have found mixed results:
– PPP appears to hold in the long run for periods
exceeding five years, but not hold in shorter periods.
– For countries with little difference in inflation rates,
PPP does not reliably explain exchange rate changes.
• PPP predictions are affected by:
–
–
–
–
–
Transportation costs and trade barriers
Government intervention in trade and exchange rates
Multinational firms with pricing power
Market expectations about economic factors
Goods not traded but that affect internal prices
Interest Rate Parity
• Interest Rate Parity (IRP) Theory
– States that the bond interest rate in different
countries will become the same as investors buy
and sell bonds to make arbitrage profits.
• Covered Interest Rate Parity Principle
– Implies that forward exchange rates and spot
exchange rates set interest rates on bonds in
different countries equal to one another.
• Uncovered Interest Rate Parity Principle
– Implies that expected future spot exchange rates
and spot exchange rates set interest rates on bonds
in different countries equal to one another.
Calculating Interest Rate Parity
This equation says that a dollar invested in a U.S. bond earns the same dollar return as
a dollar converted to euros and invested in European bonds with euro returns later
repatriated to dollars. If S is fairly stable over time, this IRP can be approximated
with the following well-known formula:
Problems with IRP
• Empirical evidence on IRP theories is mixed:
– Transactions cost is one impediment to achieving IRP.
– Political risk, legal restrictions, tax effects, managedfloat rate regimes can disrupt traders’ ability to
arbitrage away profit differentials.
– Market psychology (herd behavior) can play a role in
rate movements as traders speculate in currencies.
– Central bank intervention may cause IRP not to hold at
all points in time.
Forecasting Exchange Rates
• F = S(1 + p)
– where F = forward rate, S = spot rate,
and p = forward premium.
• Multiple Regression Model:
KEY TERMS
balance of payments (BOP)
current account
trade balance
trade deficit
services balance
income balance
balance of transfers
financial account
risk premium
foreign direct investment (FDI)
statistical discrepancy
foreign exchange markets
exchange rate
independent floating exchange rate
system
managed floating exchange rate
system
fixed exchange rate system
spot market
bid-ask spread
direct quotes
indirect quotes
forward market
forward rate
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4–27
KEY TERMS
discount
premium
hedge
inflation
gold standard
Bretton Woods Agreement
International Monetary Fund (IMF)
Smithsonian Agreement
Jamaica Agreement
special drawing right (SDR)
clean float currency
dirty float currency
dollarization
hard currencies
soft currencies
law of one price
arbitrage
purchasing power parity (PPP)
Big Mac index
interest rate parity (IRP)
covered interest rate parity
uncovered interest rate parity
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
4–28