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
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
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
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
- 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
- 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:
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:
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
• International Tax considerations
• Treaties = avoid double taxation
• Transfer Pricing
• Tariffs
• Page 305 # 22 – Premium or Discount?
• Page 307 # 29 – Depreciation or Appreciation?

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