Financial management

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Financial management

  1. 1. TITLE: PRINCIPLES OF INTERNATIONAL FINANCE PART I1.0 INTRODUCTION TO INTERNATIONAL FINANCIAL MANAGEMENTWhat is International Financial Management?This is concerned with financial management in an international setting.Financial management in general terms is mainly concerned with how to optimally makevarious corporate financial decisions, such as those pertaining to:-• Investment;• Capital structures;• Dividend policy; and• Working capital management.All the above decisions are with the view to achieving a set of given corporateobjectives.We need international financial management because we are now turning in a highlyglobalize and integrated world. Continued liberalization of international trade is certainto further internationalize consumption patterns around the world. Like consumption,production of goods and services has become highly globalize. To a large extent, thishas happened as a result of multinational corporations (MNCs) …. Efforts to sourceinputs and locate production anywhere in the world where costs are lower and profitsare higher.Recently, financial markets have also become highly integrated. This developmentallows investors to diversify their portfolios internationally. In the words of a wall streetjournal article, “Over the past decade, its investors have framed buckets of money intooverseas markets, in the form of mutual funds. At the same time, Japanese investorsare investing heavily in U.S and other foreign financial markets an effort to recycleenormous trade surpluses.In addition, many major corporations of the world, such as IBM, Sony, etc, have theshares cross-listed on foreign stock exchange, thereby rendering their sharesinternationally tradable and gaining access to foreign capital as well.Undoubtedly, we are now living in a world where all the major economic functions.Consumption, production and investment are highly globalised. It is thus essential for 1
  2. 2. financial managers to fully understand vital international dimensions of financialmanagement.Dimensions about International FinanceThis deals with: “How is international finance different from domestic finance”.There are three major dimensions set for international finance a part from domesticfinance. They are:-1. Foreign exchange and political risk.2. Market imperfection.3. Expanded opportunity set.These major dimensions of international finance largely stem from the fact thatsovereign nations have the right and power to issue currencies, formulate their owneconomic policies, impose taxes and regulate movement of people, goods and capitalacross their borders.1. Foreign Exchange and Political RiskWhen firms and individuals are engaged in cross border transactions, they arepotentially exposed to “foreign exchange risk” that they would not normally encounterin purely domestic transactions.Currently, the exchange rates among such major currencies fluctuate continuously in anunpredictable manner. This has been the case since the early 1970s when fixedexchange rates were abandoned, exchange rate utility has exploded since 1973 and willhave a persuasive influence in all major economic functions, that is, consumption,production and investment.On the other hand, one of the major risks that face firms and individuals an internationalsetting is “political risk”; and this ranges from unexpected changes in tax rules tooutright expropriation of assets held by foreigners. Political risk arises from the fact thata sovereign country can change the “rules of the game” and the affected parties maynot have effective recourse.For example, in 1992, the Enron Development Corporation, a subsidiary of a Huston-based energy-based company, signed a contract to build India’s longest power plant.After Euron had spent nearly $300 million, the project was cancelled in 1995 bynationalist politicians in the Maharashtra State, who argued India did not need thepower plant. This episode illustrates the difficulty of enforcing contracts with foreigncommittees. 2
  3. 3. 2. Market ImperfectionsAlthough the world economy is much more integrated today than was the case 20 yearsago, a variety of barriers still hamper free movement of people, goods, services, andcapital across national boundaries. These barriers include legal restrictions, excessivetransaction and transportation costs, and discriminatory taxation. The world markets arethus highly imperfect. Market imperfections, which of present various functions andimpediments preventing markets from functioning perfectly, play an important role inmotivating MNCs to locate production overseas. For example, Honda, a Japaneseautomobile company, decided to establish production facilities in Ohio, Munich tocircumvent trade barriers i.e. MNCs are always referred to be a gift of marketimperfections.Imperfections in the world financial market tend to restrict the extent to which investorscan diversify their portfolio. For example, Nestle Company, a Swiss MNC, used to issuetwo different classes of common stock, bearer shares and registered shares andforeigners were allowed to hold only bearer shares. Bearer shares used to trade forabout twice the price of registered shares, which were exclusively presented for Swissresidents. This kind of price disparity is a uniquely international phenomenon that isattributable to market imperfections.3. Expanded Opportunity SetWhen firms venture into the arena of global markets, they can benefit from “anExpanded Opportunity Set”. Firms can locate production in any country or region ofthe world to maximize their performance and raise funds in any capital market wherethe cost of capital is lowest. In addition, firms can gain from greater economies of scalewhen their tangible and intangible assets are deployed on a global basis.Individual investors can also benefit greatly if they invest internationally rather thandomestically. If you diversify internationally, the resulting international portfolio mayhave a lower risk or higher return (or both) than a purely domestic portfolio.This can happen mainly because stock returns tend to carry much less across countriesthan within a given country. Once you are aware of overseas investment opportunitiesand are willing to diversify internationally, you face a much expanded opportunity setand you can benefit from it.Goals for International Financial ManagementInternational Financial Management is designed to provide today’s financial managerswith an understanding of the fundamental concepts and tools necessary to be effectiveglobal managers. International financial management is geared to the realization of thegoal of “shareholder wealth maximization”, which means that the firm makes all 3
  4. 4. business decisions and investment with an eye towards making the owners of the firm –the shareholders better off financially, or more wealthy, than they were before.GLOBALISATION OF THE WORLD ECONOMY: RECENT TRENDS(i) Key Trends of the World EconomyThe emergence of globalised financial markets. The 1990s saw the rapid integration ofinternational capital and financial markets. The impetus for globalized financial marketsinitially came from the government of major countries that began to deregulate theforeign exchange and capital markets.For example, in 1980, Japan deregulated its foreign exchange market; 1986, the BigBang occurred when the London Stock Exchange eliminated brokerage commissions,etc.Deregulated financial markets and heightened competition in financial services provideda national environment for financial innovation that resulted in the introduction of variousinstruments; e.g. currency futures and options, multi currency frauds, internationalmutual funds, country funds and foreign stock index futures and options.Communications played an active role in integrating the world financial market listingtheir shares across boarders, and this allow investors to buy and sell foreign shares asif they were domestic shares, facilitating international investments.Lastly, advances in computer and telecommunication technology contributed to theemergence of global financial markets. These technological advancements, especiallyinternet based information technologies gave the investors around the world immediateaccess to the most recent news and information affecting their investments sharplyreducing information costs. Also computerized order processing and settlementprocedures have reduced the cost of international transactions. As a result of thesetechnological developments and the liberalization of financial markets, cross boarderfinancial transactions have exploded in recent years.(ii) Advent of the EuroThis has caused a massive change in the history of the financial world system. Thecommon monetary policy for the euro zone is now formulated by the European CentralBank (ECB) that is located in Frankfurt.ECB is legally mandated to achieve price stability for the euro zone. Considering thesheer size of the euro zone in terms of population, economic output and world tradeshare and the prospect of monetary stability in Europe, the euro has a strong potential 4
  5. 5. in becoming another global currency rivaling the US dollar for dominance ininternational trade and finance. The creation of the euro area will eventually butinevitably lead to competition with the dollar area both from the stand point ofexcellence in monetary policy, and in the enlistment of other currencies. Thus the worldfaces a prospect of bifrolen international monetary system.Since its inception, the euro has already brought about revolutionary changes inEuropean finance. For example, by redenominating corporate and government bondsand stocks from 12 different currencies into the common currency, the euro haspredicated the emergence of contaminated capital markets in Europe that arecomparable to the US market in depth and liquidity. Countries from all over the worldcan benefit as they can raise capital more easily on favourable terms in Europe.In addition, the recent surge in Europe M&A activities, cross boarder alliances amongfinancial exchanges, and lessening dependence on banking sector for capital rainingare all manifestation of the profound efforts of the euro.(iii) Trade liberalization and Economic LitigationInternational trade, which has been the traditional link between national economiescontinued to expand. Currently, international trade is becoming further liberalized atboth the regional and the global levels.At the global level, the GATT, which is a multilateral agreement among membercountries has played a key role in dismantling barriers to international trade. GATTsince its formation has been successful in gradually eliminating and reducing tariffs,subsidies, quotas and other barriers to trade.On the regional level, formal arrangement among countries have been instituted topromote integration. All these have helped to ease the movement of goods and servicesacross the globe and among countries.(iv) PrivatizationThrough this, a country divest itself of the ownership and operation of a businessventure by turning it over to the free market system. The major benefit is that the sale ofstate owned businesses brings to the national treasury local currency foreign reserves.The sale proceeds are often used to pay down sovereign debts that has weighedheavily on the economy.Multinational CorporationsIn addition to international trade, foreign direct investment by MNCs is a majorpredominating force in globalization of the world economy. 5
  6. 6. A MNC is a business firm incorporated in one country that has a production and salesoperations in several countries. It involves a firm obtaining raw materials from onenational market and financial capital from another, producing goods with labour andcapital equipment in a third country and selling the finished product in yet other nationalmarkets.MNCs obtain financing from major money centres around the world in many differentcurrencies to finance their operations.Global operations force the treasurer’s office to establish international bankingrelationships, place short-term funds in several currency denominations, and effectivelymanage foreign exchange risk.MNCs may gain from their global preserve in a variety of ways:(a) MNCs can benefit from the economy of scale by: • Spreading R & D expenditures and advertising costs over their global sales. • Pooling global purchasing power over suppliers. • Utilizing their technological and managerial know how globally with minimum additional costs, etc.(b) MNC can use their global preserve to take advantage of under prices, labour services available in certain developing countries, and gain access to special R & D capabilities residing in advanced foreign countries. MNCs can indeed leverage their global presence to boost their profit margins and create shareholder value.2.0 INTERNATIONAL MONETARY SYSTEMIntroductionThis defines the overall financial environment in which multinational corporationsoperate. The international monetary system can be defined as the institutionalframework within which international payments are made, movements of capital areaccommodated, and exchange rates among currencies are determined.It is a complex whole of agreements, rules, institutions, mechanizations, and policiesregarding exchange rates, international payments, and the flow of capital.Evolution of the International Monetary SystemThe international monetary system went through several distinct stages of evolution asfollows:1. Bimetallism, Begue 1875.2. Classical Gold Standard: 1875-1914. 6
  7. 7. 3. Inter war period 1915-1944.4. BreHon Woods System: 1945-1972.5. Flexible exchange rate regime: since 1973.1. Bimetallism: Before 1875Prior to the 1870s, many countries had “bimetallism”, that is, a double standard in thatfree coverage was maintained for both gold and silver. For example, in Great Britain,bimetallism was maintained until 1816 when Parliament passed a law maintaining freecoverage of sliver.While in the USA, bimetallism was adopted by the Coverage Act of 1792 and remaineda legal standard until 1873, when congress dropped the silver dollar from the list ofcoins to be invited.However, the international monetary system before 1870s can be characterized as“bimetallism” in the sense that both gold and silver were used as international meansof payment and that the exchange rates among currencies were determined by eithergold or silver contents. For example, Ground 1870, the exchange rate between theBritish pound, which was fully on a gold standard, and the French firm, which wasofficially in a bimetallic standard, was determined by the gold content of the twocurrencies.On the other hand, the exchange rate between the pound and the mark was determinedby their exchange rates against the franc.Countries that were on the bimetallic standard often experienced the well knownphenomenon referred to as “Gresham’s Law”. Since the exchange ratio between thetwo metals was fixed officially, only the abundant metal was used as money, drivingmore scarce metal out of circulation. This is what is termed as “Gresham’s Law”,according to which “bad” (abundant) money drives out “good” (scarce) money.2. Classical Gold Standard: 1875-1914Gold has been widely praised as a store for health and a means of exchange.Christopher Columbus once said “Gold constitutes treasure and he who preserves ithas all he needs in this world”.The first full fledged “gold standard”, however, was not established until 1801 in GreatBritain, when notes from the Bank of England were made fully redeemable for gold.France was effectively on the gold standard beginning in the 1850s and finally adoptedthe standard in 1878; while the USA adopted the gold standard in 1879, Russia andJapan in 1897. 7
  8. 8. However, the majority of countries got off gold in 1914 when world war I broke out.Among the classical gold, standard system, London became the centre of internationalfinancial system, reflecting Britain’s advanced economy and its pre-eminent position ininternational trade.In international gold standard can be said to exist when, in most major countries:(i) gold alone is assured of unrestricted coinage;(ii) there is two way convertibility between gold and national currencies at a stable ratio; and(iii) gold may be freely exported or imported. In order to support unrestricted convertibility into gold, bank notes need to be backed by a gold reserve of a minimum stated ratio. In addition, the domestic money stock shall rise and full as gold flows in and out of the country.Under the gold standard, the exchange rate between two currencies were determinedby their gold content. For example, suppose that the pound is pegged to gold at sixpounds per ounce, whereas one ounce of gold is worth 12 francs. The exchange ratebetween the pound and the franc would then be two francs per pound. To the extentthat the pound and the franc remain pegged to gold at given prices, the exchange ratebetween the two currencies will remain stable.Highly stable exchange rates under the classical gold standard, provided anenvironment that was conducive to international trade and investment.Under the gold standard, misalignment of the exchange rate was automaticallyconverted by cross border flows of gold. Likewise, international imbalances of paymentwas also converted automatically. This adjustment mechanism is referred to as the“price-spew-flow mechanism”. Gold standard is still viewed to-date as an ultimatehedge against price inflation. Gold has a national scarcity and no one can increase itsquantity at will. Likewise gold is used as the sole international means of payment, thenthe countries’ balance of payments will be regulated automatically via the movements ofgold.The Gold Standard, however, has few short comings:-(i) The supply of newly minted gold is so restricted that the growth of world trade and investment can be seriously hampered for the lack of sufficient monetary reserves. The world economy can fare deflationary pressures.(ii) Whenever the government finds it politically necessary to pursue national objectives that are inconsistent with maintaining the gold standard, it can abandon the gold standard. In other words, the international gold standard per se 8
  9. 9. has no mechanism to compel each major country to abide by the rules of the game. And there were the reasons for the collapse of the system.3. The Inter war Period: 1915-1944World war I ended the classical gold standard in August 1914, as major countries suchas major countries such as Great Britain, France, Germany and Russia suspendedredemption of bank notes in gold and imposed embargoes on gold exports.After the war, many countries suffered buffer inflation. Freed from war time pegging,exchange rates among currencies were fluctuating in the early 1920s. During thisperiod, countries widely used “predatory” depreciations of their currencies are a meansof gaining advantages in the world export market.As major countries began to recover from the war and stabilize their economies, theyattempted to restrict the gold standard; and the USA spearheaded this effort. With onlymild inflation, the USA was able to lift restrictions on gold exports and return to a goldstandard in 1919. In Britain, the Chancellor of the Exchequer, played a key role inrestricting the gold stand in 1925. Other countries in Europe also restored the goldstandard by 1928.During this period, most major countries gave priority to the “sterilization of gold” byhatching inflows and outflows of gold respectively with reductions and increases indomestic money and credit. For example, the Federal Reserve of the USA, kept somegold outside the credit base by circulating it as gold certificates. The Bank of Englandalso kept the amount of available domestic credit stable by neutralizing the efforts ofgold flows. In short, countries lacked the political will to abide by the “rules of thegame” and so the automatic adjustment mechanism of the gold standard was unable towork.The Great Depression and the accompanying financial crisis also contributed to thecollapse of the gold standard. During this period, many banks, especially in Austria,Germany, and the USA, suffered sharp declines in their portfolio values, touching offruins on the banks. Against this backdrop, Britain experienced a massive outflow ofgold, which resulted from chronic balance of payment diffracts and lack of confidence inthe pound sterling; their gold reserves continued to fall to the point where it wasimpossible to maintain the gold system. In the end the British Government suspendedgold payment and let the funds float. Other countries also followed suit to abandon thegold standard. 9
  10. 10. In summary, the inter war period was characterized by economic nationalism, halfhearted attempts and failures to restore the gold standard, economic and politicalinstabilities, bank failures and panicky flights of capital across boarders.4. Brettons Woods System: 1945-1972In July 1994, representatives of 44 nations gathered at BreHon Wooods, NewHansphire, to discuss and design the postwar international monetary system.These representatives crafted and signed the Articles of Agreement of the InternationalMonetary Fund (IMF) that constituted the core of the BreHon Woods System.This agreement was then ratified to launch the IMF in 1945; that embodied an explicitset of rules about the conduct of international monetary policies and responsible forenforcing them.Delegates also created a sister institution, the International Bank for Reconstruction andDevelopment (IBRD), commonly known as the World Bank, that was chiefly responsiblefor financing individual development projects.In designing the BreHon Woods system, representatives were coached with how toprevent the reassurance of economic nationalism with destructive “beggar-thy-neighbor” policies and how to adhere the lack of then rules of the game plaguing theinter war years.The delegates desired exchange rate stability without restoring an international goldstandard. They proposed a currency pool to which member countries would makecontributions and from which they might borrow to fide themselves over during short-term balance of payment deficits.Under this system, each country established a “far value” in relation to the US dollar,which was pegged to gold at $35 per ounce. Each country was responsible formaintaining its exchange rate within -1 or +1 percent of the adopted per value by buyingor selling foreign exchange as necessary.However, a member country with a “fundamental disequilibrium” may be allowed tomake a change in the per value of its currency. Under this system, the US dollar wasthe only currency that was fully convertible to gold; other currencies were not directlyconvertible to gold.Countries held US dollar, as well as gold, for use as an international means of payment.Because of this arrangements, the BreHon Woods system was described as dollar-based “gold exchange standard”. A country on the gold-exchange standard holdsmost of its reserves in the form of currency of a country that is really on the goldstandard. 10
  11. 11. Advantages of the system are that:-(i) It economizes on gold because countries can use not only gold but also foreign exchange as international means of payment; that always offsets the deflationary effects of limited addition to the world’s monetary gold stock;(ii) Individual countries can earn interest on their foreign exchange holdings, whereas gold holdings yield no returns;(iii) Countries can save transaction costs associated with transporting gold across countries under the gold exchange system.However, in the 1970s, this system also collapsed creating a phenomenon known asthe “Triffin Paradox”. This means that under the gold exchange system, the reserve-currency country should run balance of payments deficits to supply reserves but if suchdeficits are large and persistent, they can lead to a crisis of confidence in the reservecurrency itself.The IMF then created an artificial international reserve called the SAR in 1970. TheSAR which is a basket currency comprising major individual currencies, was allotted tothe embers of the IMF, who could then use it for transactions among themselves or withthe IMF. In addition to gold and foreign exchanges, countries could use the SAR tomake international payments.(e) The Flexible Exchange Rate Regime: 1973 to PresentThis followed the demise of the BreHon Woods system, and the key elements are asfollows:(i) Flexible exchange rates were declared acceptable to the IMF members, and central banks were allowed to intervene in the exchange markets to iron out unwarranted volatilities;(ii) Gold was officially abandoned (i.e. demonetized) as an international reserve asset. Half of the IMF’s gold holdings were returned to the members and the other half were sold with the proceeds to be used to help poor nations;(iii) Non-oil exporting countries and less developed countries were given greater access to IMF funds.The IMF cautioned to provide assistance to countries facing balance-of-payments andexchange rate difficulties; on the condition that these countries follow the IMF macroeconomic policy presentation. This conditionality, which often involves deflationarymacro economic policies and the elimination of various subsidy programs providedresentment among the people of developing countries receiving the IMFs balance-of-payments loans. 11
  12. 12. As can be expected, exchange rates have become substantially more volatile than theywere under the BreHon Woods System. The value of the dollar has been on as of itspeak. In lieu of this, as the dollar continued its decline, the governments of the majorindustrial counties began to worry that the dollar may fall too far.To address the problem of exchange rate volatility and other related issues, the G.7economic summit meeting was convened in Paris in 1987. The meeting produced the“Louvre Accord; according to which:• G.7 countries would cooperate to achieve greater exchange rate stability;• The G.7 countries agreed to move closely consult and coordinate their macro economic policies.The Louvre Accord marked the inception of the ‘managed flat system’ under which theG.7 countries would jointly intervene in the exchange market to correct over orundervaluation of currencies. Since this accord, exchange rates became relatively morestable for a while.(f) The current Exchange Rate ArrangementAlthough the most traded currencies of the world such as the dollar, yen, pound are theeuro may be fluctuating against each other, a significant number of the world’scurrencies are pegged to single currencies, particularly the US dollar and the euro, orbaskets of currencies such as the SAR.The IMF currently classifies exchange rate arrangements into eight special regimes.(i) Exchange arrangements with no separate legal tenderThe currency of another country circulates as the sole legal tender or the countrybelongs to monetary or currency union in which the same legal tender is shared by themembers of the union e.g. the Euro Zone.(ii) Currency board arrangementsA monetary regime based on an explicit legislative commitment to exchange domesticcurrency for a specified foreign currency at a fixed exchange rate, combined withrestrictions in the issuing authority to ensure the fulfillment of its obligations. Forexample, Hongkong fixed to the US Dollar.(iii) Other conventional fixed peg managementThe country pegs its currency(formally or defacto) at a fixed rate to a major currency ora basket of currencies where the exchange rate fluctuates within a narrow margin ofless than 1%, plus or minus, a round a central rate. For example, China, Malaysia andSaudi Arabia. 12
  13. 13. (iv) Pegged exchange rates within horizontal banksThe value of the currency is maintained within the margins of fluctuations around aformal or defacto fixed peg that are wider than at least 1%, plus or minus, around acentral rate. For example, Denmark, Egypt and Hungary.(v) Crawling pegThe currency is adjusted periodically in small amounts at a fixed, pre-announced rate orin response to changes in selective quantitative indicators e.g. Bolivia and Costa Rica.(vi) Exchange rates within Crawling banksThe currency is maintained within certain fluctuation margins around a central rate thatis adjusted periodically at a fixed pre-annoused rate or in response to changes inselective quantitative indicators. For example, Israel, Romania and Venezuela.(vii) Managed floating with no preannounced path for the exchange rateThe monetary authority influences the movement of the exchange rate through activeintervention in the foreign exchange market without specifying or pre-committing to apreannounced path for the exchange rate. For example, Algeria, Singapore andThailand.(viii) Independent floatingThe exchange rate is market determined with any foreign exchange intervention aimedat moderating the rate of change and preventing undue fluctuations in the exchangerate than at establishing a level for it. For example, Australia, Brazil, Canada, Korea,Mexico, the UK, Japan, Switzerland, and the USA.THE EUROPEAN MONETARY SYSTEMSAccording to the Savithsanian Agreement, which was signed in December, 1971, theband of exchange rate movement was expanded from the original plus or minus 1% toplus or minus 2.25%.BALANCE OF PAYMENTSThis provides detailed information concerning the demand and supply of a country’scurrency. For example, if the USA imports more than it exports, then this means that thesupply of dollars is likely to exceed the demand in the foreign exchange market, ceterisbaribus. 13
  14. 14. One would infer that the US dollar would be under pressure to depreciate against othercurrencies. On the other hand, if the USA exports more than it exports, then the dollarwould be likely to appreciate.Secondly, a country’s balance of payments data may signal its potential as a businesspartner for the rest of the world. If a country is grappling with a major balance ofpayment difficulties, it may be able to expand imports from outside world. Instead, thecountry may be tempted to impose resources to restrict imports and discourage capitaloutflows in order to improve the balance of payments situation.On the other hand, a country experiencing a significant balance of payment surpluswould be more likely to expand imports, offering marketing opportunities for foreignenterprises, and less likely to impose foreign exchange restrictions.Thirdly, balance of payments data can be used to evaluate the performance of thecountry in international economic competition. For example, if a country is experiencingtrade deficit year after year. This trade data may then signal that the country’s domesticindustries lack international competitiveness.Balance of Payments AccountingThe balance of payments can be formally defined as “the statistical record of acountry’s international transactions over a certain period of time presented in theform of double entry book-keeping”. For example, if international transactionsinclude imports and exports of goods and services and cross-boarder investments inbusinesses, bank accounts, bonds, stocks and real estates. Since the balance ofpayment is recorded over a certain period of time i.e. a quarter or a year, it has thesame time dimension as national income accounting.Generally speaking, any transaction that results in a receipt from foreigners will berecorded as a credit, with a positive sign, in the country’s balance of payments, whereasany transaction that gives rise to a payment to foreigners will be recorded as a debitwith a negative sign. Credit entries in the Government balance of payments results fromforeign sales of the Government goods and services, goodwill, financial claims, and realassets.Debit entries on the other hand, arise from Government purchases of foreign goods andservices, goodwill, financial claims, and real assets.Further, credit entries gives rise to the demand for the country’s currency, whereas debitentries gives rise to the supply of the country’s currencies. Note that the demand(supply) for the country’s currency is associated with the supply (demands) of foreignexchange. 14
  15. 15. Since the balance of payments is presented as a system of double entry bookkeeping,every credit in the account is balanced by matching debt and vice versa.Example I: Suppose that Boeing Corporation exported a Boeing 747 aircraft to JapanAirlines for $50 million, and that Japan Airlines pays from its dollar account kept withChase Mashattan Bank in New York City. Then the receipt of $50 million by Boeing willbe recorded as a credit (+), which will be matched by a debit (-) of the same amountrepresenting a reduction of the US bank’s liabilities.Example II: Suppose that Boeing imports jet engines produced by Rolls-Royce for $30million, and that Boeing makes payment by transferring the funds to a New York bankaccount kept by Rolls-Royce. In this case, payment by Boeing will be recorded as adebit (-) whereas the deposit of the funds by Rolls-Royce will be recorded as a credit(+).As shown by the preceding examples, every credit in the balance of payments ismatched by a debit somewhere to conform to the principle of double-entry bookkeeping.Not only international trade, that is, exports and imports, but also cross boarderinvestments are recorded in the balance of payments.Example III: Suppose that Ford acquires Jaguar a British car manufacturer, for $750million and that Jaguar deposits the money in Barclays Bank in London, which in turnuses the sum to purchase US treasury notes. In this case, the payment of $750 millionby Ford will be recorded as a debit (-), whereas Barclay’s purchase of the US treasurynotes will be recorded as a credit (+).The above samples, therefore, can be summarized as follows:Transactions Credit DebitBoeing’s export +$50 millionWithdrawal from US Bank -$50 millionBoeing’s import -$30 millionDeposits at US bank +30 millionFord’s acquisition of Jaguar -$750 millionBarclay’s purchase of US securitiesBalance of Payments AccountsSince the balance of payments records all types of international transactions, a countryconsummates over a certain period of time, it contains a wide variety of accounts.However, a country’s international transactions can be grouped into the following threemain types:-(i) The current account.(ii) The capital account. 15
  16. 16. (iii) The official reserve account.(i) The Current AccountThis includes the export and imports of goods and services. It is defined as exportsminus imports plus unilateral transfer that is (1) + (2) + (3) in the exhibit below, wasnegative -$444.69 billion. The US thus had a balance of payments deficit on the currentaccount in 2000. The current account deficit implies that the USA used more outputthan it produced. Since a country must finance its current account deficit either byborrowing from foreigners or drawing down on its previously accumulative foreignwealth, a current account deficit represents a reduction in the country’s net foreignwealth.On the other hand, a country with a current account surplus acquires 104 fromforeigners, there by increasing its net foreign wealth.The current account is divided into four categories:-• Merchandise trade.• Services.• Factor income.• Unilateral transfers.A summary of the US Balance of Payments for 2000 (in $ billion) Credits DebitsCurrent Account1. Exports 1,418.64 1.1 Merchandise 774.86 1.2 Services 290.88 1.3 Factor income 352.902 Imports -1809.18 1.1 Merchandise -1204.42 1.2 Services -217.07 1.3 Factor income -367.683. Unilateral transfer 10.24 -64.39 Balance on current account -444.69 (1)+(2)+(3)Capital Account4. Direct investment 287.68 -152.445. Portfolio investment 474.59 -124.94 5.1 Equity Securities 193.85 -99.74 5.2 Debt Securities 280.74 -25.706. Other investments 262.64 -303.27 Balance on capital account 444.26 (4)+(5)+(6) 16
  17. 17. 7. Statistical discrepancies 0.73 Overall balance 0.30 Official Reserve Account -30The current account balance, especially trade balance, tends to be sensitive toexchange rate charges when a country’s currency depreciates against the currencies ofmajor trading partners, the country’s exports and to rise and imports fall, improving thetrade balance.The effect of currency depreciation on a country’s trade balance can be morecomplicated than the case described above. Indeed, following a depreciation, the tradebalance may at first deteriorate for a while. Eventually, however, the trade balance willtend to improve over time. This particular reaction pattern of the trade balance to adepreciation is referred to as J – Curve effect.A depreciation will begin to improve the trade balance immediately if imports andexports are responsive to the exchange rate changes. On the other hand, if imports andexports are inelastic, the trade balance will worsen following a depreciation. Following adepreciation of the domestic currency and the resultant rise in import prices, domesticresidents may still continue to purchase imports because it is difficult to change theirconsumption habits in a short period of time. Even if domestic residents are willing toswitch to less expensive domestic substitutes for foreign imports, it may take time fordomestic producers to supply import substitutes. Likewise, foreigners demand fordomestic products, which become less expensive with a depreciation of the domesticcurrency, can be inelastic essentially for the same reasons. In the long run, however,both imports and exports tend to be responsive to exchange rate changes, exertingpositive influences in the trade balance.(ii) The Capital Account 17
  18. 18. The capital account balance measures the effectiveness between the Government’ssales of assets to foreigners and the Government’s purchase of foreign assets.Government sales or exports of assets are recorded as credits, as they result in capitalinflow. On the other hand, the country’s purchases (imports) of foreign assets arerecorded as debits, as they lead to capital outflow.Unlike trades in goods and services, trade in financial assets affect future payments andreceipt of factor income.As the previous exhibit shows, the US had a capital account surplus of $444.26 billion in2000, implying that the capital inflow to the USA far extended capital outflow.Clearly, the current account deficit was almost entirely offset by the capital accountsurplus. A country’s current account deficit must be paid for either by borrowing fromforeigners or selling off post foreign investments.In the absence of the government’s reserve transactions, the current account balancemust equal to the capital account balance but with the opposite sign. When nothing isexcluded, a country’s balance of payments must balance.The capital account can be divided into three categories:• Direct investment;• Portfolio investments; and• Other investments.Direct investment occurs when the investor acquires a measure of control of the foreignbusiness. In the US balance of payments, acquisition of 10% or more of the votingshares of a business is considered giving a measure of control to the investor.Portfolio investments mostly represents sale and purchases of foreign financial assetssuch as stock and bonds that do not involve a transfer of control international portfolioinvestments have booked due to the relaxation of capital controls and regulations inmany countries, and partly due to investors’ desires to diversify risks globally. Portfolioinvestments comprises equity securities and debt securities that include corporateshares, bonds and notes respectively, and money market instruments and financialderivatives like options.Other investments include transactions in currency bank deposits, trade credits, etc.these investments are quite sensitive to both changes in relative interest rates betweencountries and the anticipated change in exchange rate.(iii) Statistical Discrepancy 18
  19. 19. Imperfections arising out of recording, where certain invisible services are likely notgoing to be captured and always escape detention, e.g. cross boarder financialtransactions conducted electronically as well as consulting.(iv) Official Reserve AccountWhen a country must make payment to foreigners because of a balance of paymentsdeposit, the central bank of the country should either run down its official reserveassets, such as gold, foreign exchanges and SARs, or borrow a new from foreigncentral banks.On the other hand, if a country has a balance of payments surplus its central bank willeither retire some of its foreign debts or acquire additional reserve assets fromforeigners.The official reserve account includes transactions undertaken by authorities to financethe overall balance and intervene in foreign exchange markets.International reserve assets comprise:-• Gold.• Foreign exchange.• Special drawing rights (SARs).• Reserve positions in the IMF.The Balance of Payments IdentityWhen the balance of payments accounts are recorded correctly, the combined balanceof the current account, the capital account, and the reserve account must be zero, thatis,BCA + BKA + BRA = 0Where; BCA = balance on the current account. BKA = balance on the capital account. BRA = balance on the reserve account.Hence, the balance on the reserve account, BRA represent the change in the officialreserves. BOP indicates that a country can run a balance of payments surplus ordeficits by increasing or decreasing its official reserves. Under the fixed exchange rateregime, countries maintain official reserves that allow them to have a balance ofpayments disequilibrium, that is, BCA + BKA is non zero, without adjusting theexchange rate. Under this exchange rate playing, the combined balance on the currentand capital accounts will be equal in size, but opposite in sign, to the change in theofficial reserves.BCA + BKA = -BRA 19
  20. 20. For example, if a country runs a deficit on the overall balance that is, BCA + BKA isnegative, the Central Bank of the country can supply foreign exchange out of its reserveholdings. But if the deficit persists, the central bank will eventually run out of its reserve,and the country may be forced to devalue its currency.Under the pure flexible exchange rate regime, the Central Bank will not intervene in theforeign exchange market. In fact, Central Banks do not need to maintain officialreserves than this regime, the overall balance this must necessarily balance, that is,BCA = -BKA. In other words, a current account surplus or deficit or surplus and vice-versa.In a duty float, the exchange rate system under which the central bank discreetly buyand sale foreign exchange.Functions and Structure of the Forex MarketThe structure of the foreign exchange market is an outgrowth of one of the primaryfunctions of commercial banker to assist clients in the conduct of internationalcommerce. For example, a corporate client desiring to import merchandize from abroadwould need a source for foreign exchange if the import was invoiced and received in theimporter’s home currency. Assisting in foreign exchange transactions of this type is oneof the services that commercial banks provide for their clients, and one of the servicesthat bank customers expect from their bank.The spot and forward foreign exchange market is an “over-the-counter (OTC) market”;that is, trading does not take place in a central place of the market where buyers andsellers congregate; Rather, the foreign exchange market is a world wide linkage of bankcurrency traders, non dealers, and FX bookers who assist in trades connected to oneanother via a network of telephones telex machines, computer terminals, andautomated dealing systems.The communications systems of the foreign exchange market is highly modern,including industry, governments, the military and national security and intelligenceoperations.Twenty-for-how-a-day among trading follows the sum around the globe. And threemajor market segments are Australia, Europe and North America. Most trading normsoperate over a 9 to 12 hour working days although some banks have experimented withoperating three eight-hour shift in order to trade around the clock.The FX Market ParticipantsThe market for foreign exchange can be viewed as a two tier market. One tier is the“wholesale” or “retail or client market”. FX market participants can be categorized intofive groups:- 20
  21. 21. • International banks;• Bank customers;• Non-bank dealers; and• Central banks.International banks provide the core of the FX market and actively “make a market” inforeign exchange, that is, they stand willing to buy or sell foreign currency for their ownaccount. These international banks service their retail clients, the bank customers, inconducting foreign commerce or making international investments in financial assetsthat require foreign exchange. Bank customers include, MNCs, money managers, andprivate speculators.Non-bank dealers are large non-bank financial institutions such as investment banks,while size and frequency of trades make it cost effective to establish their own dealingnorms to trade directly in the interbank market for their foreign exchange needs.Part of the interbank trading among international banks involve adjusting the inventorypositions they hold in various foreign currencies. However, most interbank trades arespeculative or arbitrage transactions, where market participants attempt to correctlyjudge the future direction of price movement in one currency versus another or attemptto profit from temporary price discrepancies in currencies between competing dealers.Market psychology is a key ingredient in currency today and a dealer can often inferanother’s trading intention from the currency position being accumulated.FX brokers match dealer orders to buy and sell currencies for a fee, but do not take aposition themselves. Brokers have knowledge of the quotes of many dealers in themarket. Consequently, interbank traders will use a broker primarily to disseminate asquickly as possible a currency quote to many other dealers. However, in recent years,since the introduction and increased usage of electronic dealing systems, the use ofbrokers has declined because the computerized systems duplicate many of the sameservices at much lower fees.Central banks of particular countries always intervene in the foreign exchange market inan attempt to influence the price of its currency against that of major trading partner, ora security that it “fixes” or “pegs” its currency against. Intervention is the process ofusing foreign currency reserves to buy one’s own curry in order to decrease its supplyand thus increase its value in the foreign exchange market, or alternatively, sellingone’s own currency for foreign currency in order to increase its supply and lower itsprice. However, intervention that successfully increases the value of one’s currencyagainst a trading partner may reduce exports and increase imports, thus alleviatingpersistent trade deficits of the trading partner likewise central bank intervention incurrency markets lose bank reserves attempting to accomplish their goals.Correspondent Banking Relationships 21
  22. 22. The interbank market is a network of correspondent banking relationships, with largecommercial banks maintaining demand deposit accounts with one another calledcorrespondent banking accounts. The correspondents bank accounts network allows forthe efficient functioning of the foreign exchange market.The Society for World wide Interbank Financial Telecommunications (SWIFT) allowsinternational commercial banks to communicate instructions to one another. SWIFT is aprivate non-profit message transfer system, headquarters in Brussels, withintercontinental switching centres in the Netherlands and Virginia.The Clearing House Ltd (ECHO), the first global clearing house for settling interbankFOREX transactions, allows multilateral netting system that on each settlement datenetted a client’s payments and receipts in each currency, regardless of whether they aredue to or from multiple counter parties. Multilateral netting eliminates the risk andinefficiency of individual settlement.The Spot MarketThis involves almost the immediate purchase or sale of foreign exchange. Typicallycash settlement is made two business days (excluding holidays of either the buyer orthe seller) after the transactions of trades between the US dollar and non-NorthAmerican currency for example.(a) Spot Rate QuotationsSpot rate currency quotations can be stated in direct or indirect terms. Direct quotationsis the price of one unit of the foreign currency priced in US dollars. Indirect quotations isthe price of the US dollar in the foreign currency.It is common practice among currency trades world wide to both price and tradecurrencies against the US dollar.Most currencies in the interbank market are quoted in “European terms”, i.e. the USdollar is priced in terms of the foreign currency (an indirect quote from the US,perspective). By convention, it is standard practice to price certain currencies in terms ofthe US dollar or in what is referred to as “American terms”. (a direct quote from the USperspective).In general, S(j/k) refers to the price of one unit of currency K in terms of currency j. itshould thus be intuitive that the American and European term quotes are reciprocals ofone another; i.e.S($/£) = 1/S(£/$)1.5272 = 1/.6548 22
  23. 23. andS(£/$) = 1/S($/£).6548 = 1/1.5272(b) The Bid-Ash SpreadInterbank FX traders buy currency for inventory at the “bid price” and sell from theinventory at the higher “offer” or “ask price”.The recognition of the bid-ask spread implies:S($/£a) = 1/$(£/$b)(c) Spot FX TradingMost currencies quotations are carried out to four decimal places in both American andEuropean terms. However, for some currencies e.g. the Japanese yen, SlovalcianKoruna, South Korean wou), quotations in European terms are carried out only to two orthree decimal places, but in American terms the quotations may be carried out to asmany as eight decimals.The establishment of the bid-ask spread always facilitate acquiring or disposing ofinventions. For example, a trader believing the pound will soon appreciate substantiallyagainst the dollar will desire to acquire a larger inventory of British pounds. The retailbid-ask spread is wider than the interbank spread; i.e. lower bid and higher ask pricesapply to the smaller sums traded at the retail level. This is necessary to cover the fixedcosts of a transaction that exists regardless of which tier the trade is made in.Interbank trading rooms are typically organized with individual traders dealing in aparticular currency. The dealing rooms of large banks are set up with traders dealingagainst the US dollars in all the major currencies: the Japanese yen, euro, Canadiandollar, Swiss Franc and British pound plus the local currency if it is not one of themajors.Individual banks may also specialize by making a market in regional currencies or in thecurrencies of less developed countries, again all versus the US dollar. Additionally,banks will normally have a cross rate desk where trades between two currencies notinvolving the US dollar are handled. In smaller European Banks accustomed to moreregional tradings, dealers will frequently quote and trade versus the euro.(d) Cross-Exchange Rate QuotationsCross-exchange rate is an exchange rate between a currency pair where neithercurrency as the US dollar. The cross-exchange rate can be calculated from the US 23
  24. 24. dollar exchange rates for the two currencies, using either European or American termquotation. For example, є/£ cross rate can be calculated from American term quotationsas follows:-S(ŧ/£) = S($/£)/S($/ŧ)(e) Triangular ArbitrageCertain banks specialize in making direct market between non-dollar currencies, pricingat a narrower bid-ask spread than the cross rate spread. If their direct quotes are notconsistent with cross-exchange rates, a triangular arbitrage profit is possible. Triangulararbitrage is the process of trading out of the US dollar into a second currency thentrading it for a third currency, which is in turn traded for US dollars.The purpose is to earn an arbitrage profit via trading from the second to the thirdcurrency when the direct exchange rate between the two is not in alignment with thecross-exchange rate.The Forward MarketThis involves contracting today for the future purchase or sale of foreign exchange. Theforward price may be the same as the spot price, but usually it is higher (at a premiumor lower (at a discount) then spot price. Forward exchange rates are quoted on mostmajor currencies for a variety of maturities. Bank quotes for maturities of 1, 3, 6, 9 & 12months are readily available. Maturities extending beyond one yen are being morefrequent and for good bank customers a maturity extending out to 5, and even as longas 10 years is possible.(a) Forward Rate QuotationsForward quotes are either direct or indirect, one being the reciprocal of the other. Forexample, European term forward quotations are the reciprocals of the American termquotes. One can buy (take a long position) or sell (take a short position) foreignexchange forward. Bank customers can contract with their international bank to buy orsell a specific sum of FX for delivering on a certain date. Likewise, interbank traders canestablish a long or short position by dealing with a trader from a competing bank.Forward contracts can also be used for speculative purpose. If one uses the forwardcontract, he has “locked in” the forward price for forward purchase or sale of foreignexchange.(b) Forward Cross Exchange RatesThese quotations are calculated in an analogous manner to spot cross rates. In generalterms, 24
  25. 25. FN(j/k) = FN($/k)/FN($/j)orFN(j/k) = FN(j/$)/FN(k/$)andFN(k/j) = FN($/j)/FN($/k)orFN(k/j) = FN(k/$)/FN(j/$)(c) Swap TransactionsForward traders can be classified as outright or swap transactions. In conducting theirtrading, bank dealers do take speculative position in the currencies they trade but moreoften traders offset the currency exposure inherent in the trade.Swap transactions provide a means for the bank to mitigate the currency exposure in aforward trade.A swap transaction as the simultaneous sale or purchase of spot foreign exchangeagainst a forward purchase or sale of approximately an equal amount of the foreigncurrency. Because interbank forward transactions are most frequently made as part of aswap transaction, bank dealers in conversation among themselves use a shorthandnotation to quote bid and ask forward prices in terms of forward points that are eitheradded or subtracted from the spot bid and ask quotations.(d) Forward PremiumsThe forward premium or discount is useful for comparing against the interest ratedifferentials between two countries.The forward premium or discount can be expressed in American or European terms, itwill be at a discount (premium) in European terms. The formula for calculating theforward premium or discount in American terms for currency j is:ƒNjv$ = FN($/j) – S($/j)/S($/j) x 360 daysFor example, ƒ3v$ = .008471 - .008433 x 360 = 0.176 .008433 92 25
  26. 26. We see that the three months forward premium is 0.176 or 1.76 percent. In other words,we see that the Japanese yen is trading versus the US dollar is trading versus the yenat a 1.75 percent discounts for delivery in 92 days.INTERNATIONAL PARITY RELATIONSHIPS AND FORECASTING FOREIGNEXCHANGE RATESThese are the manifestations of the lieu of one price that must hold in arbitrageequilibriums. An understanding of these parity relationships provides insights into:1. how foreign exchange rates are determined;2. how to forecast foreign exchange rates.Arbitrage can be defined as the act of simultaneously buying and selling the same orequivalent assets or commodities for the purpose of making certain guaranteed profits.As long as there are profitable arbitrage opportunities, the market cannot be inequilibrium when no profitable opportunities exist. Such well known parity relationshipsas interest rate parity and purchasing power parity, in fact, present arbitrage equilibriumconditions.Interest Rate ParityIRP is an arbitrage condition that must hold when international financial markets are inequilibrium.IRP is a manifestation of the law of one price (LOP) applied to international moneymarket instruments.IRP can as well be derived by constructing an arbitrage portfolio, which involves:-(a) not net investment, as well as(b) no risk, and then requiring that such a portfolio should not generate any net cash flow in equilibrium.Consider an arbitrage portfolio consisting of three separate positions:-1. Borrowing $S in the US, which is just enough to buy £1 at the prevailing spot exchange rate (S);2. Lending £1 in the UK at the UK interest rate.3. Selling the maturity value of UK investment forward.Exhibit below summarizes the present and future (maturity date) cash flows, CFO andCFI, from investing in the arbitrage portfolio. Transactions CF0 CF1 26
  27. 27. 1. Borrow in the US $S -S(1+i$)2. Lead in the UK -$S S1(1+i£)3. Sell the £ receivable forward 0 (1+i£)(F-S1) Nit cash flow 0 (1+i£)F, (1+i$)STwo things are worth noting in the above exhibit.(i) the net cash flow at the time of investment is zero, which implies that eh arbitrage portfolio is indeed fully self financing; it does not cost any money to hold this portfolio;(ii) the net cash flow on the maturity date is known with certainty because non of the variables involved in the net cash flow, that is, S, F, 2$ and 2£ is uncertain. Since no one should be able to make certain profits by holding this arbitrage portfolio. Market equilibrium requires that the net cash flow on the maturity date be zero for this portfolio: (1+i£)F-(1+i$)S = 0The IRP relationship is often approximated as follows:-(i$-i£) = (F-S)/SAs can be seen from this equation, IRP provides a linkage between interest rates in twodifferent countries. Specifically, the interest rate will be higher in the US than in the UKwhen the dollar is at a forward discount i.e. F75. This implies that, the dollar is expectedto depreciate against the pound. If so, the US interest rate to compensate for theexpected depreciation of the dollar. Otherwise, nobody would hold dollar denominatedsecurities.On the other hand, the US interest rate will be lower than the UK interest rate when thedollar is at a forward premium, that is, FLS.Equation above also indicates that the forward exchange rate will deviate from the spotrate as long as the interest rates of the two countries are not the same.When IRP holds, you will be indifferent between investing your money in the US andinvesting in the UK with forward hedging. However, if IRP is violated, you will major oneto another. When IRP does not hold, the situation also gives rise to “covered interest”arbitrage opportunities, as illustrated in the example below:Example 2: Suppose that the annual interest rate is 5 percent in the USA and 8 percentin the UK and that the spot exchange rate is $1.50/£ and the forward exchange rate,with one year maturity is $1.48/£. In terms of our notation, i$ = 5%, i£ = 8%, S = $1.50and F = $1.48. 27
  28. 28. Assume that the arbitrager can borrow up to $1,000,000 on £666,667, which isequivalent to $1,000,000 at the current spot exchange rate. Let me first check if IRP isholding under current market conditions. Subtracting the given data we find,(F/S)(1+i£) = (1.48/1.50)(1.08) = 1.0656which is not exactly equal to (1+2$) = 1.05. Specifically, we find that the current marketcondition is characterized by:(1+i$)<(F/S)(1+i£)Clearly, IRP is not holding, implying that arbitrage opportunity exists since the interestrate is lower in the US, an arbitrage transaction should involve borrowing in the USAand lending in the UK.The arbitrager can carry out the following transactions:-1. In the USA, borrow $1,000,000. Repayment in one year will be $1,050,000 = $1,000,000 x 1.05.2. Buy £666,667 spot using $1,000,000.3. Invest £666,667 in the UK. The maturity value will be £720,000 = £666,667 x 1.08.4. Sell £720,000 forward in exchange for $1,065,600 = (£720,000)($1.48/£).Hence, in one year when everything matures, the arbitrager will receive the full maturityvalue of his UK investment, that is, £720,000. The arbitrager then will deliver this poundamount to the counterparty if the forward contract and receive $1,065,600 in return. Outof this dollar amount, the maturity value of the dollar loan, $1,050,000 will be paid. Thearbitrager still has $15,000 ($1,065,600-$1,050,000) left in his account, which is hisarbitrage profit.In making this certain profit, the arbitrager neither invested any money out of his pocketnor bore any risk. He indeed carried out “lowered interest arbitrage”, which meansthat he borrowed at one interest rate and simultaneously lent at another interest rate,with exchange risk fully covered via forward hedging.The exhibit below provides a summary of C/A transactions Transaction CF0 CF11. Borrow $1,000,000 $1,000,000 -$1,050,0002. Buy spot -$1,000,000 £666,6673. Land £666,667 -£666,667 £720,000 28
  29. 29. 4. Sell 720,000 forward -£720,000 $1,065,000 Net cash flow 0 $15,000This arbitrage opportunity will last only for a short while. As soon as deviations from IRPare detected, informed traders will immediately carry out C/A transactions. As a result ofthese arbitrage activities IRP will be resolved quite quickly.Interest Rate Parity and Exchange Rate DeterminationBeing an arbitrage equilibrium condition involving the (spot) exchange rate, IRP has animmediate implication for exchange rate determination.S = {1+i£/1+i$}FThis indicates that given the forward exchange rate, the spot exchange rate depends onrelative interest rates. All else equal, an increase in US interest rate will lead to a higherforeign exchange value of the dollar. This is so because a higher US interest rate willattract capital to the US, increasing the demand for dollar. In contrast, a decrease in theUS interest rate will lower the foreign exchange value of the dollar.In addition to relative interest rates, the forward exchange rate is an important factor inspot exchange rate determination. Under certain conditions the forward exchange ratecan be viewed as the expected future spot exchange rate conditional on all relevantinformation being available now, that is,F = E(St+1/1t)Where st+1 is the future spot rate when the forward contract matures, and 1t denotesthe set of information currently achievable. Two things are important to note:-(i) Expectations plays a key role in exchange rate determination; the expected future exchange rate is shown to be a major determinant of the current exchange rate; when people expect the exchange rate to go up in the future, it goes up now. People’s expectations thus become self-fulfilling.(ii) The exchange rate behavior will be driven by news events. People from their expectation based on the set of information (1t) they possess. As they receive news continuously, they are going to update their expectations continuously. As a result, the exchange rate will tend to exhibit a dynamic and volatile short-term behavior, responding to various news events, which are unpredictable, making forecasting future exchange rate an arduous task.Reasons for deviation from IRP are:-(a) Transaction costs. 29
  30. 30. (b) Capital controls imposed by governments, etc.Purchasing Power ParityWhen the law of one price is applied internationally to a standard basket of commoditiesobtain the theory of “Purchasing Power Parity” (PPP). This theory states that theexchange rate between currencies of two countries equal to the ratio of the countries’price levels.Formally, PPP states that the exchange rate between the dollar and the pound shouldbe:S=P$/PtWhere S is the dollar price of one pound. PPP implies that if the standard commoditybasket costs $225 in the US, and £150 in the UK, then the exchange rate should be$1.50 per pound: $1.50/£ = $225/£150.If the price of the commodity basket is higher in the US, say $300, then PPP indicatesthat the exchange rate should be higher, i.e. $2000/£. PPP1 is written as follows: P$ = S x P£This equation states that the dollar price of the commodity basket in the USA, P$ mustbe the same as the dollar price of the basket in the UK, that is, P£ multiplied by S. inother words, PPP requires that the price of the standard commodity basket be the sameacross countries when measured in a common currency. PPP is a way of defining theequilibrium exchange rate.PPP has important implications for international trade. If PPP holds and thus thedifferential inflation rates between countries are exactly offset by exchange ratechanges, countries’ competitive positions in world export market will not besystematically affected by exchange rate changes. However, if there are deviations fromPPP1 charges in nominal exchange rate cause changes in the “real exchange rates”,affecting the international competitive positions of countries. This in turn, would affectcountries’ trade balances.The real exchange rate, q, which measures deviation from PPP1 can be defined asfollows:-Q = 1+ /(1+e)(1+ ) 30
  31. 31. If PPP holds, i.e. (1+e) = (1+ )/(+ the real exchange rate will be unity, q=1. WhenPPP is violated, however, the real exchange rate will deviate from unity.Suppose for example, the annual inflation rate is 5 percent in the US and 3.5 percent inthe UK, and the dollar depreciated against the pound by 4.5 percent. Then the realexchange rate is .97.Q = (1.05)/(1.045)(1.035) = .97In the above example, the dollar depreciated by more than warranted by PPP1strengthening the competitiveness of US industries in the world market. If the dollardepreciates by less than the inflation rate differential, the real exchange rate will begreater than unity, weakening the competitiveness of US industries. To summarize:-q=1 : competitiveness of the domestic country unaltered.q<1 : competitiveness of the domestic country improves.q>1 : competitiveness of the domestic country deteriorates.Fisher EffectsThis holds that an increase (decrease) in the expected inflation rate in a country willcause a proportionate increase (decrease) in the interest rate in the country.Formally the Fisher effect can be written for the US as follows:-i$=p$+E( ≅ +E(Where p$ denotes the equilibrium expected “real” interest rates in the US.The fisher effect implies that expected inflation rate is the difference between thenominal and real interest rates in each country, that is,E( = (i$-p$)/(1+p$) ≅ i$-p$E( =(i£-p£)/(1+p£) ≅ i£-p£The International Fisher Effect (IFE) suggests that the nominal interest rate differentialreflects the expected change in exchange rate. For example, if the interest rate is 5 31
  32. 32. percent per year in the USA and 7 percent in the UK, the dollar is expected toappreciate against the British pound by about 2 percent per year.Lastly, when the International Fisher Effect is combined with IRP, that is,(F-S)/S=(i$-i£)/(1+i£), we obtain:(F-S)/S=E(e),which is referred to as Forward Expectation Parity (PEP), which states that any forwardpremium a discount is equal to the expected change in the exchange rate.When investors are risk neutral, forward party will hold as long as the foreign exchangemarket is informationally efficient. Otherwise, it need not hold even if the market isefficient.Forecasting Exchange RatesSince the advent of the flexible exchange rate system in 1973, exchange rates havebecome increasingly more volatile and erratic. At the same time, the scope of businessactivities has become highly international. Consequently, many business decisions arenow made based on forecasts, implicit or explicit, of future exchange rates.Forecasting exchange rate as accurately as possible is a matter of vital importance forcurrency traders who are actively engaged in speculating, hedging, and arbitrage in theforeign exchange markets.It is also a vital concern for MNCs that are formulating international sourcing,production, financing and marketing strategies. The quality of these corporate decisionswill critically depend on the accuracy of exchange rate forecasts.Some corporations generate their own forecasts while others subscribe to outsideservices for a fee. Forecasters use the following approaches:-(i) Efficient market approach(ii) Fundamental approach(iii) Technical approach(i) Efficient Market ApproachFinancial markets are said to be efficient if the current asset prices reflect fully all theavailable and relevant information.Suppose that foreign exchange markets are efficient. This means that the currentexchange rate has already reflected all relevant information, such as money supplies,inflation rates, trade balances and output growth. The exchange rate will then changeonly when the market receives new information. Since news by definition isunpredictable, the exchange rate will change randomly over time. In a word, incremental 32
  33. 33. changes in the exchange rate will be independent of the past history of the exchangerate.If the exchange rate indeed follows a random walk, the future exchange rate isexpected to be the same as the current exchange rate, that is,St = E(St+1)In a sense the “random walk hypothesis” suggests that today’s exchange rate is thebest predictor of tomorrow’s exchange rate.Hence, predicting the exchange rates using the efficient market approach has toadvantages:-(a) since the efficient market approach is based on market determined process, it is costless to generate forecasts. Both the current spot and forward exchange rates are public information. As such, everyone has free access to it.(b) Given the efficiency of foreign exchange markets, it is difficult to out perform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.(ii) Fundamental ApproachThis approach uses various models e.g. the monetary approach to exchange ratedetermination suggests that the exchange rate is determined by three independent(explanatory) variables:-• relative money supplies;• relative velocity of monies;• relative national outputs.Money approach is computed as below:- 1 (m-m*)+β2)v-v*)+β3(y*-y)+ųWhere;S = National logarithm of the spot exchange rate.m-m* = National logarithm of domestic/foreign money supply.v-v* = National logarithm of drastic/foreign velocity of money.y*-y = National logarithm of foreign/domestic output.ų = Random term error with mean zero. 33
  34. 34. = Model parameters.Generating forecasts using the fundamental approach involves three steps:1. Estimation of the structural model to determine the numerical values of the parameters such as and βs.2. Estimation of future values of the independent variables like (m-m*)(v-v*), and (y*-y).3. Substituting the estimated values of the independent variables into the estimated structural model to generate the exchange rate forecasts.(iii) Technical ApproachThis approach first analyses the past behavior of exchange rates for the purpose ofidentifying “patterns” and their projects then into the future to generate forecasts.This approach is based on the premise that history repeats itself. It sometimesconsiders various transactions data like trading volume, outstanding interests, and bid-ask spreads to aid them analyses.Many technical analysts or chartists compute moving averages as a way of separatingshort and long term trends from the vicissitudes of daily exchange rates.Many traders depend on technical analysis for their trading strategies. If a trader knowsthat other traders use technical analysis, it can be rational for the trader to use technicalanalysis, the predictions based on it can become self-fulfilling to some extent, at least inthe short run.Performance of ForecastersBecause predicting exchange rates is difficult, many firms and investors subscribe toprofessional forecasting services for a fee.In evaluating performance, forecasters compute the following ratio especially for banks: R = MSF(B)/MSF(S)Where; MSE(B) = mean square forecast error of a bank; MSE(S) = mean square forecast error of the spot change rate. 34
  35. 35. If a bank provides more accurate forecasts rather than the spot exchange rate, that is,MSE(B)<MSE(S), the ratio R will be less than unity, i.e. R<1.PART TWO: WORLD FINANCIIAL MARKET AND INSTITUTIONS6.0 INTERNATIONAL BANKING AND MONEY MARKETInternational banks can be categorized by the types of services they provide thatdistinguish them from domestic banks.International banks facilitate the imports and exports of their clients by arranging tradefinancing. They also serve their clients by arranging for foreign exchange necessary toconduct cross border transactions and make foreign investments.In conducting foreign exchange transactions, banks often assist their clients in hedgingexchange rate risks in foreign currency receivables and payables through forward andoptions contacts.Some international banks have the facilities to trade foreign exchange, they generallyalso trade foreign exchange presents for their own account.Large international banks borrow and lend in Euro currency market. Likewise, they arefrequently members of international loan syndicates, participating with other banks tolend large sums to MNCs needing project financing and the foreign governmentsneeding funds for economic development.Depending on the regulations of the country in which it operates and its organizationaltype, an international bank may participate in the underwriting of Eurobonds and foreignbonds. International banks frequently provide consulting services and advice to their clients, inareas of foreign exchange hedging strategies, interest rate and currency swapfinancing, and international cash management services. Banks that do provide amajority of these services are commonly known as “Universal Banks” or “Full ServiceBanks”.Reasons for International BankingRugman and Kamath (1987) provides a more formal list as follows:-1. Low Marginal Costs – Management and marketing knowledge development at home can be used abroad with low marginal costs.2. Knowledge Advantage – The foreign bank subsidiary can draw on the parent bank’s knowledge of personal contacts and credit investigations for use in that foreign market. 35
  36. 36. 3. Home Nation Information Services – Local firms in a foreign market may be able to obtain more complete information on trade and financial market in the multinational bank’s home nation than is otherwise obtainable from foreign domestic banks.4. Prestige – Very large multinational banks have perceived prestige, liquidity, and deposit safety that can be used to attract clients abroad.5. Regulation advantage – Multinational banks are often not subject to the same regulations as domestic banks. There may be reduced need to publish adequate financial information, lack of required deposit insurance and reserve requirement on foreign currency deposit, and the absence of territorial restrictions (i.e. US banks may not be restricted to the state of origin).6. Wholesale defensive strategy – Banks follow their multinational customers abroad to prevent the erosion of their clientele to foreign banks seeking to service the multinational’s foreign subsidiaries.7. Retail defensive strategy – Multinational banks prevent erosion by foreign banks of the traveler’s check, tourists, and foreign business market.8. Transaction costs – By maintaining foreign branches and foreign currency balances, banks may reduce transaction costs and foreign exchange risks on currency conversion if government controls can be circumvented.9. Growth – Growth prospects in a home nation may be limited by a market largely saturated with the services offered by domestic banks.10. Risk Reduction – Greater stability of earnings is possible with international diversification. Offsetting business and monetary policy cycles across nations reduces the country specific risk of any one nation.Types of International Banking OfficesThe services and operations of international banks are a function of the regulatoryenvironment in which the bank operates and the type of banking facility established.1. Correspondent BankA correspondent bank relationship is established when two banks maintain acorrespondent bank account with one another. For example, a large New York bank willhave a correspondent bank account in a London Bank, and the London Bank willmaintain one with the New York Bank. 36
  37. 37. The correspondent banking relationship system enables a bank’s MNC client to conductbusiness world wide through his local bank or its contacts. The banking services centeraround foreign exchange conversions that arise through the international transactionsthe MNC makes; also include assistance with trade financing such as honoring letters ofcredit and attempting drafts drawn on the correspondent banks. Likewise, a MNCneeding foreign local financing for one of its subsidiaries may rely on its local bank toprovide it with a letter of introduction to the correspondent bank in the foreign country.This banking relationship is advantageous because a bank can service its MNC clientsat a very low cost and without the need of having bank personal physically located inmany countries.2. Representative OfficeA representative office is a finance service facility staffed by parent bank personnel thatis designed to assist MNC clients of the parent bank in dealings with the bank’scorrespondent. It is a way for the parent bank to provide its MNC clients with a level ofservice greater than that provided through merely a correspondent relationship.The parent bank may open a representative office in a country in which it has manyMNCs. Clients or at least an important client. This office also assists MNC clients withinformation about local business practices, economic information, and credit evaluationof the MNCs foreign customers.3. Foreign BranchesThis operates like a local bank, but legally it is a part of the parent bank. As such abranch bank is subject to both the banking regulations of its home country and thecountry in which it operates.The reasons why a parent bank might establish a branch bank are:-(a) the bank organization to provide a much fuller range of service for its MNC customers through a branch office then it can through a representative office. Thus, a branch bank system allows customers much faster check clearing than does a correspondent bank system because the debit and credit procedure is handled internationally within one organization.(b) to compete on a local level with the banks of the host country in terms of their cost structure in making loans;For instance, the most important piece of legislation affecting the operation of foreignbanks in the USA is the International Banking Act of 1978 which specifies that foreign 37
  38. 38. branch bank operating in the USA must comply with USA banking regulation just likeUS banks.4. Subsidiary and Affiliate BanksA subsidiary bank is a locally incorporate bank that is either wholly owned or owned inmajor part by a foreign parent.An affiliate bank is one that is only partially owned but not controlled by its foreignparent. Both subsidiary and affiliate banks operate under the banking laws of thecountry in which they are incorporated.5. Edge Act BanksThese are federally characterized subsidiaries of US banks that are physically located inthe US and are allowed to engage in a full range of international banking activities.The Federal Reserve Regulation K, allows Edge Act banks to accept foreign deposits,extend trade credit, finance foreign projects abroad, trade foreign currencies, andengage in investment banking activities with the US citizens involving foreign securities.An Edge Act bank is typically located in a state different from that of its parent in orderto get around the prohibition on interstate branch banking.6. Offshore Banking CentersAn offshore banking center is a country whose banking system is organized to persistexternal accounts beyond the normal economic activity of the country. The IMFrecognizes the Bahamas, Bahavain, the Layman Island, Hongkong, the NetherlandsAntilles, Panama and Singapore as major offshore banking centers.These banks operate as branches or subsidiaries of the parent bank. The attractivefeature for offshore banks are critically total freedom from the host countrygovernmental banking regulations e.g. low reserve requirements, and no depositinsurance, low taxes, favourable time zone that facilitates international bankingtransactions and a strict banking secrecy laws.The primary activities of offshore banks are to seek deposits and grant loans incurrencies other than the currency of the host government.7. International Banking Facilities 38
  39. 39. An IBF is a separate set of asset and liability accounts that are segregated on theparent bank’s books; it is not a unique physical or legal entity. IBFs are not subject todomestic reserve requirements on deposits. IBF seeks deposits from non US citizensand can make loans only to foreigners. IBFs were established largely as a result of thesuccess of offshore banking and were able to capture a large part of the two dollarbusiness that was previously handled offshore.Capital Adequacy StandardsA concern of bank regulators world wide and of bank depositors is the safety of bankdeposits. Bank capital adequacy refers to the amount of equity capital and othersecurities a bank holds as reserves against risky assets to reduce the probability of abank failure.The Basle Accord was established to adopt this issue, which amongst other thingscalled for a minimum bank capital adequacy ratio of 8 percent of risk-weighted assetsfor banks that engage in cross-boarder transactions. This accord widens bank capitalinto two categories:-(i) Tier I core capital, which consists of shareholder equity and retained earnings; and(ii) Tier II supplemental capital, which consist of internationally recognized non- equity items such as preferred stock and subordinated bonds. This capital is allowed to count for no more than 50 percent of total bank capital, or as more than 4 percent of risk-weighted assets.In determining risk-weighted assets, four categories of risky assets are weighteddifferently. More risky assets receive a higher weight. Government obligations areweighted at zero percent, short term interbank assets are weighted at 20 percent,residential mortgages at 50 percent, and other assets at 100 percent.Due to some shortcomings of the 1988 accord, amendment was made in 1996 whichrequires commercial banks engaging in significant trading activity to set aside additionalcapital to cover the market risks inherent in their trading accounts. It allowssophisticated banks to use internally developed portfolio models to assess adequatecapital requirements, i.e., instead of using a “rules based” approach to determiningadequate bank capital, a “risk focused” approach that relies on modern portfolio maybe used. The bank’s portfolio is the monetary value of its own and off balance sheettrading account positions.Value at risk (VAR) technique is used and is a loss that will be exceeded with aspecified probability over a specified time horizon. 39
  40. 40. The amendment requires VAR to be calculated clearly according to the criterion thatthese will only be 1 percent chance that the maximum loss over a 10 day time periodwill exceed the bank’s capital. VAR = Portfolio Value X daily standard Deviation of Return X Confidence Interval Factor X Horizon.The confidence interval factor is the appropriate Z-Value from the standard normaldensity functions associated with the maximum level of loss that is tolerable.For example, the 1 percent VAR for a portfolio of $400 million with a daily portfoliostandard deviation of .75 percent for a 10 day planning horizon is $22.07 million = $400million X 0.0075 x 2.326 X √10 where 2.326 is the Z value associated with a one-tail 99percent confidence level. That there is only a 1 percent chance that the loss during a 10day period will exceed $22.07 million.Hence, in this example, the bank would be required to maintain an equivalent amount ofcapital as an explicit cushion against it price risk exposure.Therefore, the Basle II provides a capital adequacy framework incorporating threemutually reinforcing pillars that allow banks and supervisors to evaluate the risks thatbanks face. The three pillars are:-• minimum capital requirements;• a supervisory review process; and• effective use of market discipline.With respect to the first pillar, a bank’s minimum 8 percent capital ratio is calculated onthe sum of the bank’s credit, market and operational risks that include such matters ascomputer failure, poor documentation and fraud.The second pillar is designed to ensure that each bank has a sound internal process inplace to properly assess the adequacy of its capital based on a thorough evaluation ofits risks and encourage supervisory intervention at the national level with the authority torequire capital in excess of the minimum.Lastly, the third pillar seeks to enhance bank disclosures standards to holster the rolethat market participants have in encouraging banks to hold adequate capital.International Money Market(a) Euro Currency MarketThe core of the international money market is the Euro currency market. A Eurocurrency is a time deposit of money in an international bank located in a countrydifferent from the country that issued the currency. For example, Euro dollars aredeposits of US dollars in banks located outside the USA, Euro Sterling are deposits of 40
  41. 41. British pound sterling in banks outside of the UK, and Euro yen are deposits ofJapanese yen in banks outside the Japan.The Euro currency market is an external banking system that runs parallel to thedomestic banking system of the country that issued the currency. Both banking systemsseek deposits and make loans to customers from the deposited funds. Euro dollardeposits are not subject to arbitrary regulations such as reserve requirements or depositinsurance; hence, the cost of operations is less.The Euro currency market operates at the interbank and wholesale level. The majorityof Euro currency transactions are interbank transactions, representing sums of$1,000,000 or more Eurobanks with surplus funds and no retail customers to lend to willlend to Eurobanks that have borrowers but need loanable funds.The rate charged by banks with excess funds is referred to as the “interbank offeredrate”; they will accept interbank deposits at the “interbank bid rate”. The spread isgenerally 1/8 of 1 percent for most major Euro currencies.LIBOR refers to the reference rate in London for Euro currency deposits. There isLIBOR for Euro dollars, Euro Canadian dollars, Euro yen and even euros. Likewise inother financial centres, other reference rates are used e.g. SIBOR (Sing aproneInterbank Offer Rate), and BRIBOR (the Brussells at which interbank deposits of theeuro are offered by one prime bank to another in the euro zone.In the wholesale money market, Eurobanks accept Euro currency fixed time depositsand issue Negotiable Certificates of Deposits (NCDs). These are preferable ways forEurobanks to raise loanable funds as the deposits tend to be a lengthier period and theacquiring rate is often slightly less than the interbank rate. Rates on Eurocurrencydeposits are quoted for maturities ranging from one day to several years; however,more standard maturities are for 1, 2, 3, 6, 9 and 12 months.(b) Euro CreditsThese are short-to medium-term loans of Euro currency extended by eurobanks tocorporations, sovereign governments, non prime banks, or international organizations.The loans are denominated in currencies other than the home currency of theEurobank. Eurobanks always bond together to form a bank lending syndicate to sharerisks because of the large size of the loan.However, the credit risks in these loans is greater than on loans to other banks in theinterbank market. Thus, the interest rate on Euro credits must compensate the bank, orbanking syndicate for the added credit risk. Therefore, a Euro credit may be viewed as aseries of shorter term loans, where at the end of each time period (generally three to sixmonths), the loan is rolled over and the base lending rate is repriced to current LIBORover the next interval of the loan. 41
  42. 42. Example: Rollover pricing of Euro credit Telforex International can borrow $3,000,000at LIBOR plus a lending margin of .75 percent per annum on a three months rolloverbasis from Barclays in London. Suppose that three months LIBOR is currently 517/32percent. Further, suppose that over the second three months interval LIBOR fall to 51/8percent. How much will Telforex pay in interest to Barclays over the six months periodfor the Euro dollar loan.Solution: $3,000,000 x (0.0553125 + 0.0075)/4 + $3,000,000 x (.05125 + .0075)/4 =$47,109.38+$44,062.50 = $91,171.88.(c) Forward Rate AgreementA major risk Eurobanks face in accepting Euro deposits and in extending Euro Credits isinterest rate risk resulting from a mismatch in the maturities of the deposits and credits.For instance if deposit maturities are longer than credit maturities, and interest rates fall,the credit rates will be adjusted downwards while the bank is still paying a higher rateon deposits. Conversely, if deposit maturities are shorter than credit maturities andinterest rates risk deposit rates will be adjusted upwards while the bank is still receivinga lower rate on credits. Therefore, only when deposits and credit maturities are perfectlymatched will the rollover feature of Euro credits allow the bank to earn the deposit loanrate spread.A Forward Rate Agreement (FRA) is an interbank contract that allows the Eurobank tohedge the interest rate risk in mismatched deposits and credits. An FRA involves twoparties, a buyer and a seller where:(i) the buyer agrees to pay the seller the increased interest cost on a notional amount if the interest rates fall below an agreements rate, or(ii) the seller agrees to pay the buyer the increased interest cost if interest rates increased above the agreement rate.FRAs are structured to capture the maturity mismatched in standard length Eurodeposits and credits. For example, the FRA might be on a six months interest rate for asix months period beginning three months from today and ending nine months fromtoday; this would be a “three against nine” FRA.The following time line depicts this FRA example. 42

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