Chapter 2

International Flow of Funds

 Balance of Payments

• A summary of transactions between domestic and

foreign residents for a specific country over a
specified period of time.
• Represents an accounting of a country’s international
transactions for a period, usually a quarter or a year.
• Accounts for transactions by businesses, individuals,
and the government.
 Balance of Payments

• Current account: represents a summary of the flow of

funds between one specified country and all other
countries due to purchases of goods and services or to
the cash flows generated by income-producing financial
assets.
– Payments for goods and services
– Factor income payments
– Transfer payments
• Capital account: a summary of the flow of funds resulting
from the sale of assets between one specified country
and all other countries over a specified period of time.
Balance of Payments
Balance of Payments
 Balance of Payments

• Financial account: refers to special types of

investment.
– Direct foreign investment
– Portfolio investment
– Other capital investment
• Errors and omissions
 Growth in International Trade

• Events that increased trade volume

• Impact of outsourcing on trade
• Trade volume among countries
 Factors Affecting
International Trade Flows

• Cost of labor
• Inflation
• National income
• Credit conditions
• Government policies
• Exchange rates
 Factors Affecting
International Trade Flows
 International Capital Flows

• Factors affecting direct foreign investment:

– Change in restrictions
– Privatization
– Potential economic growth
– Tax rates
– Exchange rates
 International Capital Flows

• Factors affecting international portfolio investment:

– Tax rates on interest or dividends
– Interest rates
– Exchange rates
• Impact of international capital flows
International Capital Flows
 Agencies That Facilitate
International Flows

• International Monetary Fund (IMF)

• World Bank (WB)
• World Trade Organization (WTO)
• International Financial Corporation (IFC)
• International Development Association (IDA)
• Bank for International Settlements (BIS)
• Organisation for Economic Co-operation and
Development (OECD)
• Regional development agencies
 Chapter 3

International Financial Markets

 Foreign Exchange Market

• The foreign exchange market allows for the exchange

of one currency for another in order to facilitate
international trade or financial transactions.
• Large commercial banks serve this market by holding
inventories of each currency so that they can
accommodate requests by individuals or MNCs.
• For one currency to be exchanged for another
currency, an exchange rate is needed that specifies
the rate at which one currency can be exchanged for
another.
 Foreign Exchange Market

• History of foreign exchange:

– Gold standard
– Agreements on fixed exchange rates
– Floating exchange rate system
 Foreign Exchange Market

• Foreign Exchange Transactions:

– Foreign exchange dealers serve as intermediaries in the
foreign exchange market by exchanging currencies desired
by MNCs or individuals.
– The most common type of foreign exchange transaction is
for immediate exchange. The market where these
transactions occur is known as the spot market.
– The exchange rate at which one currency is traded for
another in the spot market is known as the spot rate.
– If a bank begins to experience a shortage of a particular
foreign currency, it can purchase that currency from other
banks. This trading between banks occurs in what is often
referred to as the interbank market.
 Foreign Exchange Market

– The spot market for each currency is characterized

by its liquidity, which reflects the level of trading
activity.
– Attributes of banks that provide foreign exchange:
§ Competitiveness of quote
§ Special relationship with the bank
§ Speed of execution
§ Advice about current market conditions
§ Forecasting advice
 Foreign Exchange Market

• Foreign Exchange Quotations:

– Bid/ask spread: the difference between the bid
and ask prices (buy and sell quotes respectively)
– This spread is meant to cover the costs associated
with fulfilling requests to exchange currencies.
– Normally expressed as a percentage of the ask
quote:

– Factors that affect the spread:

 Foreign Exchange Market

• Interpreting Foreign Exchange Quotations:

– Direct quotation: the number of domestic
currency’s units per unit of foreign currency
– Indirect quotation: the number of foreign
currency’s units per unit of domestic currency
– Cross exchange rate: between two foreign
currencies
 International Money Market

• Composed of several large banks that accept

deposits and provide short-term loans in various
currencies.
• Used primarily by governments and large
corporations.
• Origins and development
– Eurodollars
– London Interbank Offer Rate (LIBOR)
• Money market interest rates among currencies
 International Credit Market

• Composed of the same commercial banks that serve

the international money market.
• These banks convert some of the deposits received
into loans (for medium-term periods) to
governments and large corporations.
• Syndicated loans in the credit market
• Regulations in the credit market
• Impact of the credit crisis
 International Bond Market

• The international bond markets facilitate

international transfers of long-term credit, thereby
enabling governments and large corporations to
borrow funds from various countries.
• Facilitated by multinational syndicates of investment
banks.
• A foreign bond is issued by a borrower foreign to the
country where the bond is placed.
• Eurobonds are bonds that are sold in countries other
than the country whose currency is used to
denominate the bonds.
 International Bond Market

• Eurobond market
• Development of other bond markets
• Risk of international bonds
– Interest rate risk
– Exchange rate risk
– Liquidity risk
– Credit risk
– International integration of credit risk
• Impact of the Greek Crisis
 International Stock Markets

• Enable firms to obtain equity financing in foreign

countries, thus help MNCs finance their international
expansion.
• Issuance of stock in foreign markets
• Issuance of foreign stock in the U.S.
• Non-U.S. firms listing on U.S. exchanges
• Investing in foreign stock markets
• How market characteristics vary among countries
• Integration of stock markets
• Integration of international stock markets and credit
markets
International Stock Markets
How Financial Markets
Serve MNCs
 Chapter 4

Exchange Rate Determination

 Measuring Exchange Rate
Movements

• A decline in a currency’s value is known as

depreciation.
• An increase in currency value is known as
appreciation.
• The percentage change in the value of the foreign
currency is then computed as follows:
 Exchange Rate Equilibrium

• An exchange rate (at a given time) represents the

price of a currency, or the rate at which one currency
can be exchanged for another.
• The price of a currency is determined by the demand
for that currency relative to its supply.
Exchange Rate Equilibrium
 Factors That Influence
Exchange Rates

• Relative inflation rates

• Relative interest rates
• Relative income levels
• Government controls
• Expectations
• Interaction of factors
• Influence of factors across multiple currency markets
• Impact of liquidity on exchange rate adjustment
Factors That Influence
Exchange Rates
Factors That Influence
Exchange Rates
Factors That Influence
Exchange Rates
Factors That Influence
Exchange Rates
 Movements In Cross
Exchange Rates

• A change in the equilibrium cross exchange rate over

time is due to the same types of forces identified
earlier in the chapter that affect the demand and
supply conditions between the two currencies.
 Capitalizing On
Expected Exchange Rate
Movements
• Institutional speculation based on expected
appreciation/depreciation
• Speculation by individuals
• The “carry trade”
– Impact of appreciation in the investment currency
– Risk of the carry trade
 Chapter 6

Government Influence
on Exchange Rates
 Exchange Rate Systems

• Fixed
• Freely floating
• Managed float
• Pegged
 Fixed Exchange Rate System

• In a fixed exchange rate system, exchange rates are

either held constant or allowed to fluctuate only
within very narrow boundaries.
• In general, the central bank must offset any
imbalance between demand and supply conditions
for its currency in order to prevent its value from
changing.
• The central bank may devalue (reduce the value of)
or revalue (increase the value of) the currency.
 Fixed Exchange Rate System

• Bretton Woods Agreement, 1944–1971

• Smithsonian Agreement, 1971–1973
• Advantages of fixed exchange rates
• Disadvantages of fixed exchange rates
 Freely Floating
Exchange Rate System

• In a freely floating exchange rate system, exchange

rate values are determined by market forces without
intervention by governments.
• A freely floating exchange rate adjusts on a continual
basis in response to the demand and supply
conditions for that currency.
• Advantages of a freely floating system
• Disadvantages of a freely floating system
 Managed Float
Exchange Rate System

• Exchange rates are allowed to fluctuate on a daily

basis and there are no official boundaries.
• Governments can and sometimes do intervene to
prevent their currencies from moving too far in a
certain direction.
• Criticisms of the managed float system
 Pegged Exchange Rate
System
• The home currency’s value is pegged to one foreign
currency or to an index of currencies.
• Although the home currency’s value is fixed in terms
of the foreign currency to which it is pegged, it
moves in line with that currency against other
currencies.
• Limitations of a pegged exchange rate
• Currency boards used to peg currency values
• Interest rates of pegged currencies
• Exchange rate risk of a pegged currency
 Dollarization

• Replacement of a foreign currency with U.S. dollars

• The decision to use U.S. dollars as the local currency
cannot be easily reversed because in that case the
country no longer has a local currency.
 A Single European Currency

• Monetary policy in the Eurozone

• Impact on firms in the Eurozone
• Impact on financial flows in the Eurozone
• Exposure of countries within the Eurozone
• Impact of crises within the Eurozone
• Impact on a country that abandons the euro
• Impact of abandoning the euro on Eurozone
conditions
 Government Intervention

• Reasons for government intervention:

– To smooth exchange rate movements
– To establish implicit exchange rate boundaries
– To respond to temporary disturbances
 Government Intervention

• Direct intervention: the central bank can purchase or

sell currencies in the foreign exchange market,
thereby altering demand and supply conditions and
hence the currencies’ equilibrium values.
• The potential effectiveness of a central bank’s direct
intervention is influenced by the amount of reserves
it can use.
Government Intervention
 Government Intervention

• Nonsterilized intervention: the central bank

intervenes in the foreign exchange market without
adjusting for the change in the money supply.
• Sterilized intervention: the central bank intervenes in
the foreign exchange market and simultaneously
engages in offsetting transactions in the government
securities markets.
Government Intervention
 Government Intervention

• Indirect intervention: the central bank can influence

the economic factors that affect equilibrium
exchange rates.
• Government control of interest rates
• Government use of foreign exchange controls
• Intervention warnings
 Intervention as a Policy Tool

• Influence of a weak home currency:

 Intervention as a Policy Tool

• Influence of a strong home currency:

 Chapter 7

International Arbitrage
and Interest Rate Parity
 International Arbitrage

• Arbitrage can be loosely defined as capitalizing on a

discrepancy in quoted prices by making a riskless profit.
• Locational arbitrage:
– Buying a currency at a location where it is priced
cheap and then immediately selling it at some other
location where it is priced higher.
– Gain is based on two factors:
§ The amount of money used to capitalize on the exchange
rate discrepancy
§ The size of discrepancy
– Quoted prices will react to the locational arbitrage
strategy used by you and other foreign exchange
market participants (realignment).
International Arbitrage
 International Arbitrage

• Triangular arbitrage:
– Currency transactions are conducted in the spot
market to capitalize on a discrepancy in the cross
exchange rate between two currencies.
International Arbitrage
 International Arbitrage

– Accounting for the bid/ask spread:

International Arbitrage
 International Arbitrage

– Realignment:
 International Arbitrage

• Covered interest arbitrage:

– Capitalizing on the difference in interest rates
between two countries while covering your
exchange rate risk with a forward contract.
– Realignment is focused on forward rate.
International Arbitrage
 International Arbitrage

– Accounting for spreads:

International Arbitrage
• Comparison of arbitrage effects:
 Interest Rate Parity

• When market forces cause interest rates and

exchange rates to adjust such that covered interest
arbitrage is no longer feasible, the result is an
equilibrium state known as interest rate parity (IRP).
• In equilibrium, the forward rate differs from the spot
rate by a sufficient amount to offset the interest rate
differential between two currencies.
 Interest Rate Parity

• An investor’s return from using covered interest

arbitrage can be determined using the following
information:
– Ah: amount of initial investment in home currency
– S: spot rate when the foreign currency is
purchased
– if: interest rate on the foreign deposit
– F: forward rate at which the foreign currency will
be converted back to home currency
 Interest Rate Parity

• Amount of home currency received at the end of

deposit period (An):

• Substitute F = S(1 + p):

 Interest Rate Parity

• Return from covered interest rate arbitrage:

• If IRP holds, R = ih (home interest rate)

 Interest Rate Parity

• Forward premium:

• Approximation:
Interest Rate Parity
 Interest Rate Parity

• Considerations when assessing interest rate parity:

– Transaction costs
– Political risk
– Differential tax laws
Interest Rate Parity
 Variation in
Forward Premiums

• Forward premiums across maturities:

Variation in Forward Premiums
• Changes in forward premiums over time
 Variation in
Forward Premiums

– Recall that F = S(1 + p)

– Interest rate movements can affect the forward
rate by affecting both the spot rate (indirectly) and
the forward premium.
 Chapter 8

Relationships among Inflation,

Interest Rates, and Exchange Rates
 Purchasing Power Parity

• The Purchasing Power Parity (PPP) theory attempts

to quantify the relationship between inflation and
exchange rate.
• Comes in two forms:
§ Absolute form: prices of the same basket of goods
in two different countries should be equal when
measured in a common currency
§ Relative form: the rate of change in price of those
baskets should be equal when measured in a
common currency (assuming that transportation
costs and trade barriers are unchanged)
 Purchasing Power Parity

• The relative PPP theory is based on the notion that

exchange rate adjustment is necessary for the
relative purchasing power to be the same whether
buying products locally or from another country.
• If that purchasing power is not equal, then
consumers will shift purchases to wherever products
are cheaper until purchasing power equalizes.
 Purchasing Power Parity

• Percentage change in foreign currency’s value under

PPP can be calculated as follows:

• Approximation:
Purchasing Power Parity
Purchasing Power Parity
Purchasing Power Parity
 Purchasing Power Parity

• Why Purchasing Power Parity Does Not Hold:

§ Confounding effects
§ No substitutes for traded goods
 International Fisher Effect

• The International Fisher Effect (IFE) theory uses the

difference in interest rates (instead of inflation) to
explain why exchange rates shift over time.
• Fisher effect:
§ Nominal interest rate = Real interest rate +
Expected inflation rate
§ If the real rate of interest in a country is constant
over time, then the nominal rate of interest there
must adjust to changes in the expected rate of
inflation.
 International Fisher Effect

• Using the IFE to predict exchange rate movements:

§ Apply the Fisher effect to derive expected inflation
per country
§ Rely on PPP to estimate the exchange rate
movement
• Implications of the IFE
 International Fisher Effect

• Percentage change in foreign currency’s value under

IFE can be calculated as follows:

• Approximation:
International Fisher Effect
International Fisher Effect
 International Fisher Effect

• Limitations of the IFE

§ Limitation of the Fisher Effect
§ Limitation of PPP
• IFE Theory versus Reality
Comparison of the IRP, PPP, and IFE