Presentasi Kuliah Keuangan Internasional

Foreign Exchange Markets& The Balance Of Payments And International Linkages

Multinational FinanceDipresentasikan oleh Kelompok 1Fiona – Fitriyanto – Tassya Andini

Agenda

The foreign exchange (FX) market

Basic questions and definitions

Four theories Purchasing Power Parity

Interest Rate Parity

Fisher condition for capital market equilibrium

Expectations theory of forward rates2

1. The Foreign Exchange Market

Some currency rates as of November 29, 2012:Per IDR:

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Currency Value Sell Buy

AUD 1.00 10,104.20 10,002.81

EUR 1.00 12,511.94 12,385.66

GBP 1.00 15,469.22 15,310.67

HKD 1.00 1,246.24 1,233.77

JPY 100.00 11,765.14 11,645.35

SGD 1.00 7,903.44 7,823.60

THB 1.00 314.59 311.06

USD 1.00 9,658.00 9,562.00

The Foreign Exchange Market...

Some forward currency rates as of May 24, 2004:

U.S. dollars per Euro (bid prices):

Spot rate 1.2017

One-month forward1.20062

3 months forward 1.19898




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2. Some basic questions

Why aren’t FX rates all equal to one?

Why do FX rates change over time?

Why don’t all FX rates change in the same direction?

What drives forward rates – the rates at which you can trade currencies at some future date?

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3. Four theories

.

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Difference ininterest rates

1 + r€

1 + r$

Exp. difference ininflation rates

1 + iSFr

1 + i$

Difference betweenforward & spot rates

F€/$

s€/$

Expected changein spot rate

E(s€/$)S€/$

FisherTheory

Relative PPPInterest

Rateparity

Exp. Theory of forward

rates

Theory #1: Purchasing power parity

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Versions ofPURCHASING

POWERPARITY

Versions ofPURCHASING

POWERPARITY

Law of One Price

Absolute PPP

Relative PPP

The Law of One Price

A commodity will have the same price in terms of common currency in every country In the absence of frictions (e.g.

shipping costs, tariffs,..)

ExamplePrice of wheat in France (per bushel): P€

Price of wheat in U.S. (per bushel): P$

S€/$ = spot exchange rate 8

P€ = s€/$ P$

The Law of One Price, continued

Example: Price of wheat in France per bushel (p€) = 3.45 €

Price of wheat in U.S. per bushel (p$) = $4.15

S€/$ = 0.83215 (s$/€ = 1.2017)

Dollar equivalent priceof wheat in France = s$/€ x p€

= 1.2017 $/€ x 3.45 € = $4.15

Þ When law of one price does not hold, supply and demand forces help restore the equality

Þ As the supply of product A increases relative to others, the price of product A must decrease relative to others

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Absolute PPP

Extension of law of one price to a basket of goods:

States that equilibrium exchange rate between the domestic and the foreign currencies equals the ratio between the domestic and foreign price levels.

Absolute PPP examines price levels

Apply the law of one price to a basket of goods with price P€ and PUS (use upper-case P for the price of the basket):

where P€ = i (wFR,i p€,i )

PUS = i (wUS,i pUS,i )

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S€/$ = P€ / PUS

Absolute PPP

If the price of the basket in the U.S. rises relative to the price in Euros, the U.S. dollar depreciates:

May 21 : s€/$ = P€ / PUS

= 1235.75 € / $1482.07 = 0.8338 €/$

May 24: s€/$ = 1235.75 € / $1485.01 = 0.83215 €/$

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The Big Max Index

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Britain, Big Mac: 1.99 pound/3.41 USD , Implies a PPP exchange rate of: 0.58 pound

The actual exchange rate is 0.50

Pound was 16% overvalued.

Big Mac is not objective because its price containing local tax, location, local service, etc.

Starbuck Index

Using Tall Latte index, the purchasing power of each individual national currency can be reflected in the U.S.-dollar cost of a latte in that country.

In theory, if currency markets function with proper efficiency, the price of an identical product, such as a Starbucks latte, should have an identical U.S.-dollar cost in any country.

Therefore, if a latte costs significantly less in one country than another, this suggests that the country with the cheaper latte price has an undervalued currency.

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Relative PPP

Main idea – The difference between (expected) inflation rates equals the (expected) rate of change in exchange rates:

The currency with the higher inflation rate isexpected to depreciate relative to the currency with the lower rate of inflation adjustment of various rates and prices to inflations

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1 + i€ = E(s€/$)1 + i$ s€/$

Example

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The German

hyperinflation (1920-23) and the lessons thereof. Inflation peaked at 200 billion percent in 1923.

In 1922, Germany’s highest currency denomination was 50,000 mark.

By 1923, the highest denomination was 100,000,000,000,000 mark.

In December of 1923 one US dollar was equal to 4,000,000,000,000 marks!.

Example

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Yugoslavia, 1993 (500 billion dinar for a gallon of milk!)

Yugoslavia’s Central Bank introduced a 500 billion dinar bank note around Christmas 1993.

It marked another milestone in the country’s descent into economic chaos.

In November 1993, inflation topped 600,000 %.

In 1992, the U.S dollar was worth 1,000 dinar.

By Christmas 1993, it took 180 trillion of the same 1,000 dinar notes to equal one dollar!

What is the evidence?

The Law of One Price frequently does not hold.

Absolute PPP does not hold, at least in the short run.

See The Economist’s Big McCurrencies

The data largely are consistent with Relative PPP, at least over longer periods.

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Deviations from PPP

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Why doesPPPnot

hold?

Why doesPPPnot

hold?

Simplistic model

Imperfect Markets

Statistical difficulties

Deviations from PPP

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Simplistic model

Imperfect Markets

Statistical difficulties

Transportation costsTariffs and taxesConsumption patterns differNon-traded goods & services

Sticky pricesMarkets don’t work well

Construction of price indexes- Different goods- Goods of different qualities

Summary of theory #1:

.

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1 + i€

1 + i$


E(s€/$)S€/$

Relative PPP

Theory #2: Interest rate parity Main idea: There is no fundamental

advantage to borrowing or lending in one currency over another

This establishes a relation between interest rates, spot exchange rates, and forward exchange rates

Forward market: Transaction occurs at some point in future BUY: Agree to purchase the underlying currency at a predetermined

exchange rate at a specific time in the future SELL: Agree to deliver the underlying currency at a predetermined

exchange rate at a specific time in the future

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Example of a forward market transaction

Suppose you will need 100,000€ in one year

Through a forward contract, you can commit to lock in the exchange rate

f$/€ : forward rate of exchangeCurrently, f$/€ = 1.19854 1 € buys $1.19854

1 $ buys 0.83435 €

At this forward rate, you need to provide $119,854 in 12 months.

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Interest Rate Parity

START (today) END (in one year)

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$117,228 $117,228 1.0224 = $119,854

r$=2.24%

$117,228 0.83215 = 97,551€

s€/$=0.83215

r€=2.51%

97,551€ 1.0251 = 100,000€

f€/$=0.83435One year

(Invest in $)

(Invest in €)

Interest rate parity

Main idea: Either strategy gets you the 100,000€ when you need it.

This implies that the difference in interest rates must reflect the difference between forward and spot exchange rates

Interest Rate Parity:

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1 + r€ = f€/$

1 + r$ s€/$

Evidence on interest rate parity

Generally, it holds

Why would interest rate parity hold better than PPP?

Lower transactions costs in moving currencies than real goods

Financial markets are more efficient that real goods markets

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Summary of theories #1 and #2:

.

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1 + r€

1 + r$


1 + i€

1 + i$


f€r/$

s€/$


E(s€/$)s€/$


Rateparity

Theory #3: The Fisher condition Main idea: Market forces tend to allocate

resources to their most productive uses So all countries should have equal real rates of

interest The difference in interest rates is equal to the

expected difference in inflation rates.

Nominal interest rates (r) are a function of the real interest rate (a) and a premium (i) for inflation expectations.

R = a + I

Relation between real and nominal interest rates:(1 + rNominal) = (1 + rReal)(1 + i )(1 + rReal) = (1 + rNominal) / (1 + i )

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Example of capital market equilibrium

Fisher condition in U.S. and France:(1 + r$(Real)) = (1 + r$) / (1 + i$)(1 + r€(Real)) = (1 + r€) / (1 + i€)

If real rates are equal, then the Fisher condition implies:

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1 + r€ = 1 + i€1 + r$ 1 + i$

Summary of theories 1-3:

.

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1 + r€

1 + r$


1 + i€

1 + i$


f€/$

s€/$


E(s€/$)s€/$

FisherTheory


Rateparity

Theory #4: Expectations theory of forward rates

Main idea: States that if the forward rate is

unbiased, then it should reflect the expected future spot rate.

The forward rate equals expected spot exchange rate

Expectations theory of forward rates:

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f€/$ = E(s€/$)

f€/$ = E(s€/$ ) s€/$ s€/$

Expectations theory of forward rates

With risk, the forward rate may not equal the spot rate

If Group 1 predominates, then E(s€/$) < f€/$ If Group 2 predominates, then E(s€/$) > f€/$ 31

Group 1: Receive € in six months, want $

• Wait six months and convert € to $

or• Sell € forward

Group 1: Receive € in six months, want $

• Wait six months and convert € to $

or• Sell € forward

Group 2: Contracted to pay out € in six months

• Wait six months and convert $ to €

or• Buy € forward

Group 2: Contracted to pay out € in six months

• Wait six months and convert $ to €

or• Buy € forward

Takeaway: Summary of all four theories

.

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1 + r€

1 + r$


1 + i€

1 + i$


f€/$

s€/$


E(s€/$)s€/$

FisherTheory


Rateparity

Exp. Theory of forward

rates

Summary

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When a parity condition fails to hold, the structure of international financial markets may influence investor’s strategy of borrowing, investing, hedging, speculating, or making investment location decisions.

If absolute PPP does not hold, sellers have the power to price discriminate across countries and buyers have incentives to overcome barriers to access lower cost goods.

If IRP does not hold, the cost of borrowing or return on investment (with forward cover) differs depending on which currency is used … therefore it is possible to find superior investment or lower cost funds without incurring foreign exchange risk.

If IFE does not hold, investments with higher expected returns and funds with lower expected costs are possible but these contain exposure to currency risk.

Rational for the IFE is that a country with a higher interest rate will tend to have a higher inflation rate. This increased level of inflation should cause the currency in the country with the high interest rate to depreciate against that of a country with lower interest rate.

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The Balance Of Payments And International Linkages

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Agenda

I. Balance-Of-Payment Categories

II. The International Flow Of Goods, Services, And Capital

II. Coping With Current Account Deficits

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Balance-Of-Payment Categories

DefinitionAn accounting statement that summarizes all the economic transactions between residents of the home country and residents of all other countries.

PurposeMeasures all financial and economic transactions over a specified period of time.

BoP is Double-entry bookkeepingi.e. a source of funds => credits

a use of funds => debits

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Three Major Accounts (a/c):1. Current a/c2. Capital a/c3. Financial a/c

Total amount of Debit should equals to Credit; or

Current a/c balance + Finance a/c balance + Financial a/c balance

= BoP = “0”



1. Current Account

To records net flow of goods, services, and unilateral transfers (Gifts, grants, both private and government.) . Export and Import is included.

Often called “The balance on current spending.”

It tells whether we are spending more abroad than foreigners are spending in our country (ignoring investment flows and accommodating flows).

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2. Capital Account (minor a/c)

Record transactions that are undertaken, without exchange, in fixed assets or in their financing (such as: development aid).I.e. Migrant’s funds represent the shift of the migrant’s networth to or from US.

3. Financial Account

Records public and private investment and lending.

Capital Inflows = credit; Outflows = debit


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3. Financial Account (cont.)

Classified as: Portfolio Investments

Purchases of financial assets with maturity more than 1 year; and short-term investments involve securities with maturity less than one year.

Direct InvestmentsInvestments where the management control is exerted. Government borrowing and lending are included.

Other Investmentsi.e. Gold, foreign currency by official monetary institutions, etc.


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The Balance-of-payment measures:

I. Basic Balance Focuses on transaction considered to be

fundamental to the economic health of currency.

It indicates the extent to which long-term investments are affecting the balance of payments.

Includes: Balance of current a/c and long-term capital.

Emphasizes long-term trends & Excludes short-term capital flows that heavily depend on temporary factors.


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II. Net Liquidity Balance Measures the change in private domestic

borrowing or lending require to keep payments equal without adjusting official reserves.

III. Official Reserve Transactions Balance Measures adjustments needed by official

reserves to achieve BoP equilibrium. Assume that official transaction are different from private transaction.


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The International Flow Of Goods, Services, And Capital

Set of basic macroeconomic identities which link domestic spending and production to current and capital accounts.

I. Domestic Savings and Investment and the Capital Account

NI – NS = S – I

*NI = National income NS = National Spending S = Saving I = Investments

*If NI >NS, S > I which implies that surplus capital spent overseas*

Background NI = Consumption + S NS = Consumption + I

Implications A nation which produces more than it spends will save

more than it invests domestically with a net capital outflow producing a capital account deficit.

A nation which spends more than it produces has a net capital inflow producing a capital account surplus.

A healthy economy will tend to run a current account deficit.

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NI – NS = S - I

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II. The Link Between The Current And Capital Accounts

NFI = E - I

*NFI = Net Foreign Investment E = Export I = Import

BackgroundNI - NS = E - IS - Investment = E - I


S – Investment = E - I

Implications

If Current a/c is in surplus, the nation must be a net exporter of capital.

If Current a/c is a deficit, the nation is a major capital importer.

When NS > NI, the excess must be acquired through foreign trade.

Solutions for Improving CA deficits:1. Raise national income (output) relative to domestic investment (I).2. Increase (S) relative to domestic investment (I).

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III. Government Budgets And Current Account Deficits

CA = Saving Surplus – Government budget deficit

CA Deficit The nation is not saving enough to finance (I) and the deficit.

CA SurplusThe nation is saving more than needed to finance its (I) and deficit.


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Coping With The Current Account Deficit

I. Currency Depreciation Many believes that devaluation can reduce the

trade deficit. Based on US experience in 1980’s, the trade

deficit kept worsening on the other hand of US depreciation.

I. i. Lagged Effects The simplest explanation that time is needed for an exchange rate.

I. ii. J-Curve TheoryA decline in currency value will initially worsen the deficit before improvement.

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TIME

Net changein trade balance

0

Currency depreciation

Trade balance initially deteriorates

Trade balanceimproves

“

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I. iii. Devaluation and Inflation Weaker currency tend to result in higher domestic inflation.

II. Protectionism The imposition of tariffs, quotas, or other forms of

restraint against foreign imports.

III. Ending Foreign Ownership of Domestic Assets

If foreigners can not hold claims on the nation, they will export an amount equal in value only to what they are willing to import.

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IV. Boosting the Saving Rate Stimulating saving behavior.

V. External Policy Better understanding of External Policy

Further Impact of Current a/c deficit⇒Increasing unemployment rate??

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Indonesia Balance of Payment

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Why are managers and investors interested in the BOP of countries?

Helps forecast a country's market potential, especially in the short-run. A country experiencing a serious BOP deficit is not likely to import as much as if it were running a surplus.

The BOP is an important indicator of pressure on a country's foreign exchange rate, unstable currency results in exchange gains or losses!

Continuing deficit in a country's BOP may signal weak controls on outgoing capital movements, such as payment of dividends, fees, interest on foreign investment.

Continuing surpluses in a country's BOP may indicate that country's strong international position, and therefore a potentially good location for an operating subsidiary, or portfolio investment.

Thank You

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Presentasi Kuliah Keuangan Internasional

Documents

interest rate parity

nominal interest rates

higher inflation rate

fx rates change

current account deficits

interest rates

exchange rate

fisher condition