Study Unit 7 Part 2 – Currency Exchange Rates & International Trade What is this graph? Exchange Rates Overview • The Market for Foreign Currency: basic concepts • 4 Systems for setting exchange rate: • • • • Fixed rates = fix or narrow range (Govt intervention) Freely floating rates = correct disequilibrium + vulnerability Managed float rates = mix between free and Govt intervention Pegged rates = Govt fixes the rate of exchange for its currency • Spot Rate = TODAY! • Forward Rate = definite future date • forward premium and forward discount • Calculation = [FR – SR / SR] x [365 / Days Forward Period] • Cross Rate = 2 currencies are not stated in terms of each other • Calculation = Domestic currency USD / Foreign currency USD Foreign Exchange Cross Rates Exchange Rate & Purchasing Power • Demand Curve downward sloping • Currency becomes cheaper • Goods in that currency become more affordable • Domestic consumers need more of it • Supply Curve upward sloping • Currency becomes expensive • Goods and services become more affordable to users of the foreign currency leading them to inject more of their currency into the domestic market Foreign Trade / Balance of Payments • Balance of Payments = Domestic transactions – Foreign ones • 2 major categories of activities: • Currency Account • Exchange of goods, services, interest and dividends • Goods = Balance of Trade • Capital Account • Exchange of Capital Assets and Financial Instruments • Unfavorable Balance of Payments Need for Reserves • The necessity of holding such reserves depletes the country’s reserves of foreign currencies and ties up domestic funds that could be used for other purposes Balance of Trade = net exports • Weak country’s currency = goods & services are more affordable to foreign consumers Balance of Trade > 0 • Strong country’s currency = goods & services are more expensive to foreigners Balance of Trade < 0 • Short-term measure for a country = devaluing its currency USA Top 15 countries: Trade Effective Interest Rate: Currency Loan • Example page 284 • Effective rate = Difference (conversion rate) / amount borrowed • Factors affecting Exchange Rates: • Trade-related factors (3) • Relative inflation rates • Relative income levels • Government intervention • Financial factors (2) • Relative interest rates • Ease of capital flow Trade-related factors 1. Relative inflation rates - When rate of inflation goes up, demand of that country’s currency goes down (less attractive) = falling purchasing power - Investors unload this currency = more available = outward shift of the supply curve see graph page 285 - An investor’s domestic currency has gained purchasing power in the country where inflation is worse 2. Relative income levels - Citizens with higher incomes look for new consumption opportunities in other countries driving up the demand - Incomes rise = prices of foreign currency rise = local currency will depreciate 3. Government intervention - Actions by national governments (Trade Barriers, currency restriction, quotas) complicate the process of exchange rate determination Financial factors 1. Relative interest rates - Same concept than inflation = when interest rates rise, demand for that country’s currency rises - Outward shift of the demand curve results from the influx of other currencies seeking the higher returns available in that country - More and more investors buy up the high-interest country’s currency = less available = inward shift of the supply curve 2. Ease of capital flow - Country with high real interest rates loosing restrictions against cross-border movement of capital = demand for the currency rises as investors seek higher returns - Example page 287 in Asia Graphical Depiction Calculating simultaneous effects • Differential interest rates • Interest rate parity (IRP) theory = equilibrium point • Differential inflation rates • Purchasing power parity (PPP) theory = differing inflation rates • International Fisher Effect (IFE) Theory • Spot rate will change over time: interplay between real and nominal interest rates Exchange Rate fluctuations over Time • Long-term PPP theorem • Relative price levels determine exchange rates • Medium-term economic activity • Exports and imports affecting equilibrium • Short-term interest rates • Reserves of cash invested in high-rate countries • Interplay between interest rate and inflation Risks of exchange rate fluctuation: - A/R denominated in customer’s currency depreciation - Same with A/P from a foreign supplier appreciation Hedging and Mitigating Risk • Hedging a foreign-denominated receivable = depreciation • Hedging a foreign-denominated payable = appreciation • Managing Net A/R and A/P positions • A Firm can reduce its exchange rate risk by maintaining a position in each foreign currency of A/R and A/P that net to near ZERO • Foreign currency Future Contracts when necessary to achieve balance - Money market hedges = least complex hedging tool - Future Contracts = essentially commodities traded on an exchange + only available for generic amounts with specific settlements dates - Less flexible than forward contracts because they are not customized for the parties - Currency Swaps = swapping cash flows in each other’s currency International Trade • Purchase the stock of a foreign corporation or make a direct foreign investment • Advantages of direct investment: a. b. c. Lower taxes in the foreign nation Annual depreciation allowances for the amount invested Access to foreign capital sources • Cost of capital should be higher than “domestic” because of exchange rate risk, political risk and other constraints • Multinational corporations: a. b. Benefits/adverse effects to the home country Benefits/adverse effects to the host country International Trade • Methods of Financing • • • • • Cross-border factoring Letters of credit Banker’s acceptances Forfaiting Countertrade • International Tax considerations • Treaties = avoid double taxation • Transfer Pricing • Tariffs Problems • Page 305 # 22 – Premium or Discount? • Page 307 # 29 – Depreciation or Appreciation?