8-chapter 8Foreign Exchange and International Fin.docx

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chapter 8
Foreign Exchange
and International
Financial
Markets
International Business, 6th Edition
Griffin & Pustay
fffffff
Copyright 2010 Pearson Education, Inc. publishing as Prentice
Hall
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Chapter Objectives Describe how demand and supply determine
the price of foreign exchangeDiscuss the role of international
banks in the foreign-exchange marketAssess the different ways
firms can use the spot and forward markets to settle

international transactions
Hall
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*
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Chapter Objectives (continued) Summarize the role of arbitrage
in the foreign-exchange marketDiscuss the important aspects of
the international capital market
Hall
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*
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Foreign Exchange
Foreign exchange is a commodity that consists of currencies
issued by countries other than one’s own.
Hall
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*
One factor that obviously distinguishes international business
from domestic business is the use of more than one currency in
commercial transactions. The foreign-exchange market exists to
facilitate this conversion of currencies, thereby allowing firms

to conduct trade more efficiently across national boundaries.
The foreign-exchange market also facilitates international
investment and capital flows. Firms can shop for low-cost
financing in capital markets around the world and then use the
foreign-exchange market to convert the foreign funds they
obtain into whatever currency they require.
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Figure 8.1 Demand for Yen
Demand for Japanese yen is derived from foreigners’
demand for Japanese products
Hall
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Figure 8.1 presents the demand curve for Japanese yen.
Economists call this demand curve a derived demand curve
because the demand for yen is derived from foreigners’ desire
to acquire Japanese goods, services, and assets. To buy
Japanese goods, foreigners first need to buy Japanese yen. Like
other demand curves, it is downward sloping, so as the price of
the yen falls, the quantity of yen demanded increases. This is
shown as a movement from point A to point B on the demand
curve.
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Figure 8.2 Supply of Yen
Supply for Japanese yen is derived from Japanese demand
for foreign products
Hall

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Figure 8.2 presents the supply curve for yen. Underlying the
supply curve for yen is the desire by the Japanese to acquire
foreign goods, services, and assets. To buy foreign products,
Japanese need to obtain foreign currencies, which they do by
selling yen and using the proceeds to buy the foreign currencies.
Selling yen has the effect of supplying yen to the foreign-
exchange market. As with other goods, as the price of the yen
rises, the quantity supplied also rises; you can see this when
you move from point A to point B along the supply curve in
Figure 8.2. The supply curve for the yen thus behaves like most
other supply curves: People offer more yen for sale as the price
of the yen rises.
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Figure 8.3 The Market for Yen
Hall
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Figure 8.3 depicts the determination of equilibrium price of yen.
Points along the vertical axis show the price of the yen in
dollars—how many dollars one must pay for each yen
purchased. Points along the horizontal axis show the quantity of
yen. As in other markets, the intersection of the supply curve
(S) and the demand curve (D) yields the market-clearing,
equilibrium price ($.009/yen in this case) and the equilibrium
quantity demanded and supplied (200 million yen). This
equilibrium price is called the exchange rate, the price of one
country’s currency in terms of another country’s currency.

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Foreign-Exchange RatesDirect exchange rateDirect quotePrice
of the foreign currency in terms of home currencyIndirect
exchange rateIndirect quotePrice of the home country in terms
of the foreign currency
Hall
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Foreign-exchange rates are quoted in two ways. A direct
exchange rate (or direct quote) is the price of the foreign
currency in terms of the home currency. An indirect exchange
rate (or indirect quote) is the price of the home currency in
terms of the foreign currency. Mathematically, the direct
exchange rate and the indirect exchange rate are reciprocals of
one another.
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Figure 8.4 Direct and Indirect
Exchange Rates
Hall
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Foreign-exchange rates are published daily in most major
newspapers worldwide. Figure 8.4 presents rates for July 19,
2006, published in the Wall Street Journal. From the perspective
of a U.S. resident, the direct exchange rate between the U.S.
dollar and the yen (¥) on Wednesday, July 19, was $.008579/¥1.

From the U.S. resident’s perspective, the indirect exchange rate
on Wednesday, July 19, was ¥116.57/$1.
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Structure of the Foreign-Exchange Markets
The foreign-exchange market
comprises buyers and sellers of
currencies issued by the world’s
countries.
Hall
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Foreign-Exchange Trading
The largest center for foreign
exchange trading is London, followed
by New York and Tokyo.
Hall
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Figure 8.5 Currencies Involved in Foreign-Exchange Market
Transactions
Hall
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*

As Figure 8.5 indicates, approximately 89 percent of the
transactions involve the U.S. dollar, a dominance stemming
from the dollar’s role in the Bretton Woods system. Because the
dollar is used to facilitate most currency exchange, it is known
as the primary transaction currency for the foreign-exchange
market.
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The Role of BanksBuy or sell major traded
currenciesMarketsWholesale market Retail market
Hall
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The foreign-exchange departments of large international banks
such as JPMorgan Chase, Barclays, and Deutsche Bank in major
financial centers like New York, London, and Frankfurt play a
dominant role in the foreign-exchange market. These banks
stand ready to buy or sell the major traded currencies. They
profit from the foreign-exchange market in several ways. Much
of their profits come from the spread between the bid and ask
prices for foreign exchange. International banks are key players
in the wholesale market for foreign exchange, dealing for their
own accounts or on behalf of large commercial customers.
Interbank transactions, typically involving at least $1 million
(or the foreign currency equivalent), account for a majority of
foreign-exchange transactions. Corporate treasurers, pension
funds, hedge funds, and insurance companies are also major
players in the foreign exchange market. International banks also
play a key role in the retail market for foreign exchange,
dealing with individual customers who want to buy or sell
foreign currencies in large or small amounts. Typically, the
price paid by retail customers for foreign exchange is the

prevailing wholesale exchange rate plus a premium. The size of
the premium is in turn a function of the size of the transaction
and the importance of the customer to the bank.
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Map 8.1 A Day of
Hall
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The foreign-exchange market comprises buyers and sellers of
currencies issued by the world’s countries. Anyone who owns
money denominated in one currency and wants to convert that
money to a second currency participates in the foreign-exchange
market. The worldwide volume of foreign-exchange trading is
estimated at $1.9 trillion per day. Foreign exchange is being
traded somewhere in the world every minute of the day (see
Map 8.1). The largest foreign-exchange market is in London,
followed by New York, Tokyo, and Singapore.
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Bank Foreign Exchange Clients
Commercial customers
Speculators
Arbitrageurs
Hall
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*
The clients of the foreign-exchange departments of banks fall
into several categories:
• Commercial customers engage in foreign-exchange
transactions as part of their normal commercial activities, such
as exporting or importing goods and services, paying or
receiving dividends and interest from foreign sources, and
purchasing or selling foreign assets and investments. Some
commercial customers may also use the market to hedge, or
reduce, their risks due to potential unfavorable changes in
foreign-exchange rates for moneys to be paid or received in the
future.
• Speculators deliberately assume exchange rate risks by
acquiring positions in a currency, hoping that they can correctly
predict changes in the currency’s market value. Foreign-
exchange speculation can be very lucrative if one guesses
correctly, but it is also extremely risky.
• Arbitrageurs attempt to exploit small differences in the price
of a currency between markets. They seek to obtain riskless
profits by simultaneously buying the currency in the lower-
priced market and selling it in the higher-priced market.
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The Tel Aviv foreign-exchange trader is an important link in the
$3.2 trillion-per-day global exchange market.
Hall
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*

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Spot and Forward MarketsSpot Market: foreign exchange
transactions that are consummated immediatelyForward Market:
foreign exchange transactions that are to occur sometime in the
future
Hall
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Spot and Forward Markets
Hall
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Many international business transactions involve payments to be
made in the future. Such transactions include lending activities
and purchases on credit. Because changes in currency values are
common, such international transactions would appear to be
risky in the post-Bretton Woods era. How can a firm know for
sure the future value of a foreign currency? Currencies can be
bought and sold for immediate delivery or for delivery at some
point in the future. The spot market consists of foreign-
exchange transactions that are to be consummated immediately.
(Immediately is normally defined as two days after the trade
date because of the time historically needed for payment to
clear the international banking system.) Spot transactions
account for 33 percent of all foreign-exchange transactions. The
forward market consists of foreign-exchange transactions that
are to occur sometime in the future. Prices are often published
for foreign exchange that will be delivered 30 days, 90 days,
and 180 days in the future. Many users of the forward market

engage in swap transactions. A swap transaction is a transaction
in which the same currency is bought and sold simultaneously,
but delivery is made at two different points in time.
For example, the Wall Street Journal excerpt shown in the slide
indicates that on Wednesday, July 19, 2006, the spot price of
the British pound was $1.4429, while the forward price for
pounds for delivery in 30 days was $1.4428 and for delivery in
180 days was $1.4404.
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Mechanisms for Future Foreign ExchangesCurrency
futureCurrency optionCall optionPut option
Hall
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The foreign-exchange market has developed two other
mechanisms to allow firms to obtain foreign exchange in the
future. Neither, however, provides the flexibility in amount and
in timing that international banks offer. The first mechanism is
the currency future. Publicly traded on many exchanges
worldwide, a currency future is a contract that resembles a
forward contract. However, unlike the forward contract, the
currency future is for a standard amount (for example, ¥12.5
million or SwFr 125,000) on a standard delivery date (for
example, the third Wednesday of the contract’s maturity
month). As with a forward contract, a firm signing a currency-
future contract must complete the transaction by buying or
selling the specified amount of foreign currency at the specified
price and time. This obligation is usually not troublesome,
however; a firm wanting to be released from a currency-future
obligation can simply make an offsetting transaction. In
practice, 98 percent of currency futures are settled in this

manner. Currency futures represent only 1 percent of the
foreign-exchange market.
The second mechanism, the currency option, allows, but does
not require, a firm to buy or sell a specified amount of a foreign
currency at a specified price at any time up to a specified date.
A call option grants the right to buy the foreign currency in
question; a put option grants the right to sell the foreign
currency. Currency options are publicly traded on organized
exchanges worldwide. Because of the inflexibility of publicly
traded options, international bankers often are willing to write
currency options customized as to amount and time for their
commercial clients. Currency options account for 5 percent of
foreign-exchange market activity.
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Arbitrage
Arbitrage is the riskless purchase of a product in one market for
immediate resale in a second market in order to profit from a
price discrepancy. There are two types of arbitrage activities
that affect the foreign-exchange market: arbitrage of goods and
arbitrage of money.
Hall
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Arbitrage
Arbitrage
of Goods

Arbitrage
of Money
Hall
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Arbitrage of Goods—Purchasing Power Parity. Underlying the
arbitrage of goods is a very simple notion: If the price of a good
differs between two markets, people will tend to buy the good
in the market offering the lower price, the “cheap” market, and
resell it in the market offering the higher price, the “expensive”
market. Under the law of one price such arbitrage activities will
continue until the price of the good is identical in both markets
(excluding transactions costs, transportation costs, taxes, and so
on). The arbitrage of goods across national boundaries is
represented by the theory of purchasing power parity (PPP).
This theory states that the prices of tradable goods, when
expressed in a common currency, will tend to equalize across
countries as a result of exchange rate changes. PPP occurs
because the process of buying goods in the cheap market and
reselling them in the expensive market affects the demand for,
and thus the price of, the foreign currency, as well as the market
price of the good itself in the two product markets in question.
Arbitrage of Money. Professional traders employed by money
market banks and other financial organizations seek to profit
from small differences in the price of foreign exchange in
different markets. Whenever the foreign-exchange market is not
in equilibrium, professional traders can profit through
arbitraging money. Numerous forms of foreign-exchange
arbitrage are possible, but three forms are common: two-point,
three-point, and covered interest.
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Arbitrage of Money
Two-point
Covered-interest
Three-point
Hall
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Two-point arbitrage involves profiting from price differences in
two geographically distinct markets. Suppose £1 is trading for
$2.00 in New York City and $1.80 in London. A foreign-
exchange trader at JPMorgan Chase could take $1.80 and use it
to buy £1 in London’s foreign-exchange market. The trader
could then take the pound she just bought and resell it for $2.00
in New York’s foreign-exchange market. Professional currency
traders can make profits through three-point arbitrage whenever
the cost of buying a currency directly (such as using pounds to
buy yen) differs from the cross rate of exchange. The cross rate
is an exchange rate between two currencies calculated through
the use of a third currency (such as using pounds to buy dollars
and then using the dollars to buy yen). The U.S. dollar is the
primary third currency used in calculating cross rates. The
difference between these two rates offers arbitrage profits to
foreign-exchange market professionals. The market for the three
currencies will be in equilibrium only when arbitrage profits do
not exist, which occurs when the direct quote and the cross rate
for each possible pair of the three currencies are equal.
Covered-interest arbitrage is arbitrage that occurs when the
difference between two countries’ interest rates is not equal to
the forward discount/premium on their currencies. In practice, it
is the most important form of arbitrage in the foreign-exchange
market. It occurs because international bankers, insurance
companies, and corporate treasurers are continually scanning
money markets worldwide to obtain the best returns on their
short-term excess cash balances and the lowest rates on short-

term loans.
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Figure 8.6
Three-Point Arbitrage
Hall
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Suppose that £1 can buy $2 in New York, Tokyo, and London,
$1 can buy ¥120 in those three markets, and £1 can buy ¥200 in
all three. Because the exchange rate between each pair of
currencies is the same in each country, no possibility of
profitable two-point arbitrage exists. However, profitable three-
point arbitrage opportunities exist. Three-point arbitrage is the
buying and selling of three different currencies to make a
riskless profit.
Figure 8.6 shows how this can work:
Step 1: Convert £1 into $2.
Step 2: Convert the $2 into ¥240.
Step 3: Convert the ¥240 into £1.2.
Through these three steps, £1 has been converted into £1.2, for
a riskless profit of £0.2.
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International Capital MarketMajor International
BanksInternational Bond MarketGlobal Equity MarketsOffshore
Financial Centers

Hall
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Table 8.1 The World’s Largest BanksING
GroupFortisCitigroupDexia GroupHSBC HoldingBNP
ParibasCredit AgricoleDeutsche BankBank of America
Corp.HBOS
Hall
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Not only are international banks important in the functioning of
the foreign-exchange market and arbitrage transactions, but they
also play a critical role in financing the operations of
international businesses, acting as both commercial bankers and
investment bankers. As commercial bankers, they finance
exports and imports, accept deposits, provide working capital
loans, and offer sophisticated cash management services for
their clients. As investment bankers, they may underwrite or
syndicate local, foreign, or multinational loans and broker,
facilitate, or even finance mergers and joint ventures between
foreign and domestic firms. The international banking system is
centered in large money market banks headquartered in the
world’s financial centers—Japan, the United States, and the
European Union.
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Establishment of Overseas Banking Operations
Subsidiary bank
Affiliated bank

Branch bank
Hall
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An overseas banking operation can be established in several
ways. If it is separately incorporated from the parent, it is
called a subsidiary bank; if it is not separately incorporated, it
is called a branch bank. Sometimes an international bank may
choose to create an affiliated bank, an overseas operation in
which it takes part ownership in conjunction with a local or
foreign partner.
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The Eurocurrency MarketOriginated in the early
1950sEurodollars – U.S. dollars deposited in European bank
accountsEuroyenEuropoundsEurocurrency – currency on deposit
outside in banks worldwide Euroloans quoted on basis of
LIBOR
Hall
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Another important facet of the international financial system is
the Eurocurrency market. Originally called the Eurodollar
market, the Eurocurrency market originated in the early 1950s
when the communist-controlled governments of Central Europe
and Eastern Europe needed dollars to finance their international
trade but feared that the U.S. government would confiscate or
block their holdings of dollars in U.S. banks for political
reasons. The communist governments solved this problem by
using European banks that were willing to maintain dollar

accounts for them. Thus Eurodollars—U.S. dollars deposited in
European bank accounts—were born.
As other banks worldwide, particularly in Canada and Japan,
began offering dollar-denominated deposit accounts, the term
Eurodollar evolved to mean U.S. dollars deposited in any bank
account outside the United States. As other currencies became
stronger in the post-World War II era—particularly the yen, the
pound, and the German mark—the Eurocurrency market
broadened to include Euroyen, Europounds, and other
currencies. Today a Eurocurrency is defined as a currency on
deposit outside its country of issue.
The Euroloan market is extremely competitive, and lenders
operate on razor-thin margins. Euroloans are often quoted on
the basis of the London Interbank Offer Rate (LIBOR), the
interest rate that London banks charge each other for short-term
Eurocurrency loans.
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The International Bond MarketMajor source of debt financing
for:World’s governmentsInternational organizationsLarger
firmsTwo types of bondsForeign bondsEurobonds
Hall
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The international bond market represents a major source of debt
financing for the world’s governments, international
organizations, and larger firms. This market has traditionally
consisted of two types of bonds: foreign bonds and Eurobonds.
Foreign bonds are bonds issued by a resident of country A but
sold to residents of country B and denominated in the currency
of country B. For example, the Nestlé Corporation, a Swiss
resident, might issue a foreign bond denominated in yen and

sold primarily to residents of Japan.
A Eurobond is a bond issued in the currency of country A but
sold to residents of other countries. For example, American
Airlines could borrow $500 million to finance new aircraft
purchases by selling Eurobonds denominated in dollars to
residents of Denmark and Germany. The euro and the U.S.
dollar are the dominant currencies in the international bond
market.
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Figure 8.7 International Bond Issues
2007, by Currency (in billions of U.S. dollars)
Hall
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*
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Global Equity MarketsStart-up companies are no longer
restricted to raising new equity only from domestic
sourcesDevelopment of country fundsMutual fund specializing
in a given country’s funds
Hall
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*
The growing importance of multinational operations and
improvements in telecommunications technology have also

made equity markets more global. Start-up companies are no
longer restricted to raising new equity solely from domestic
sources. For example, Swiss pharmaceutical firms are a major
source of equity capital for new U.S. biotechnology firms.
Established firms also tap into the global equity market. When
expanding into a foreign market, a firm may choose to raise
capital for its foreign subsidiary in the foreign market.
Numerous MNCs also cross-list their common stocks on
multiple stock exchanges. British Airways, for instance, is
listed on both the London Stock Exchange and the New York
Stock Exchange, thereby enabling both European and American
investors to purchase its shares conveniently. Another
innovation is the development of country funds. A country fund
is a mutual fund that specializes in investing in a given
country’s firms.
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Offshore Financial CentersFocus on offering banking and other
financial services to nonresident customersLocationsBahamas,
Bahrain, the Cayman Islands, Bermuda, the Netherlands
Antilles, Singapore, Luxembourg, Switzerland
Hall
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*
Offshore financial centers focus on offering banking and other
financial services to nonresident customers. Many of these
centers are located on island states, such as the Bahamas,
Antilles, and Singapore. Luxembourg and Switzerland, although
not islands, are also important “offshore” financial centers.
MNCs often use offshore financial centers to obtain low-cost
Eurocurrency loans. Many MNCs locate financing subsidiaries

in these centers to take advantage of the benefits they offer:
political stability, a regulatory climate that facilitates
international capital transactions, excellent communications
links to other major financial centers, and availability of legal,
accounting, financial, and other expertise needed to package
large loans. The efficiency of offshore financial centers in
attracting deposits and then lending these funds to customers
worldwide is an important factor in the growing globalization of
the capital market.
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any
form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of
the publisher. Printed in the United States of America.
Copyright © 2010 Pearson Education, Inc. publishing as
Prentice Hall
*
*
*
*
One factor that obviously distinguishes international business
from domestic business is the use of more than one currency in
commercial transactions. The foreign-exchange market exists to
facilitate this conversion of currencies, thereby allowing firms
to conduct trade more efficiently across national boundaries.
The foreign-exchange market also facilitates international
investment and capital flows. Firms can shop for low-cost

financing in capital markets around the world and then use the
foreign-exchange market to convert the foreign funds they
obtain into whatever currency they require.
*
Figure 8.1 presents the demand curve for Japanese yen.
Economists call this demand curve a derived demand curve
because the demand for yen is derived from foreigners’ desire
to acquire Japanese goods, services, and assets. To buy
Japanese goods, foreigners first need to buy Japanese yen. Like
other demand curves, it is downward sloping, so as the price of
the yen falls, the quantity of yen demanded increases. This is
shown as a movement from point A to point B on the demand
curve.
*
Figure 8.2 presents the supply curve for yen. Underlying the
supply curve for yen is the desire by the Japanese to acquire
foreign goods, services, and assets. To buy foreign products,
Japanese need to obtain foreign currencies, which they do by
selling yen and using the proceeds to buy the foreign currencies.
Selling yen has the effect of supplying yen to the foreign-
exchange market. As with other goods, as the price of the yen
rises, the quantity supplied also rises; you can see this when
you move from point A to point B along the supply curve in
Figure 8.2. The supply curve for the yen thus behaves like most
other supply curves: People offer more yen for sale as the price
of the yen rises.
*
Figure 8.3 depicts the determination of equilibrium price of yen.
Points along the vertical axis show the price of the yen in
dollars—how many dollars one must pay for each yen
purchased. Points along the horizontal axis show the quantity of
yen. As in other markets, the intersection of the supply curve
(S) and the demand curve (D) yields the market-clearing,
equilibrium price ($.009/yen in this case) and the equilibrium
quantity demanded and supplied (200 million yen). This
equilibrium price is called the exchange rate, the price of one

country’s currency in terms of another country’s currency.
*
Foreign-exchange rates are quoted in two ways. A direct
exchange rate (or direct quote) is the price of the foreign
currency in terms of the home currency. An indirect exchange
rate (or indirect quote) is the price of the home currency in
terms of the foreign currency. Mathematically, the direct
exchange rate and the indirect exchange rate are reciprocals of
one another.
*
Foreign-exchange rates are published daily in most major
newspapers worldwide. Figure 8.4 presents rates for July 19,
2006, published in the Wall Street Journal. From the perspective
of a U.S. resident, the direct exchange rate between the U.S.
dollar and the yen (¥) on Wednesday, July 19, was $.008579/¥1.
From the U.S. resident’s perspective, the indirect exchange rate
on Wednesday, July 19, was ¥116.57/$1.
*
As Figure 8.5 indicates, approximately 89 percent of the
transactions involve the U.S. dollar, a dominance stemming
from the dollar’s role in the Bretton Woods system. Because the
dollar is used to facilitate most currency exchange, it is known
as the primary transaction currency for the foreign-exchange
market.
*
The foreign-exchange departments of large international banks
such as JPMorgan Chase, Barclays, and Deutsche Bank in major
financial centers like New York, London, and Frankfurt play a
dominant role in the foreign-exchange market. These banks
stand ready to buy or sell the major traded currencies. They
profit from the foreign-exchange market in several ways. Much
of their profits come from the spread between the bid and ask
prices for foreign exchange. International banks are key players
in the wholesale market for foreign exchange, dealing for their
own accounts or on behalf of large commercial customers.
Interbank transactions, typically involving at least $1 million

(or the foreign currency equivalent), account for a majority of
foreign-exchange transactions. Corporate treasurers, pension
funds, hedge funds, and insurance companies are also major
players in the foreign exchange market. International banks also
play a key role in the retail market for foreign exchange,
dealing with individual customers who want to buy or sell
foreign currencies in large or small amounts. Typically, the
price paid by retail customers for foreign exchange is the
prevailing wholesale exchange rate plus a premium. The size of
the premium is in turn a function of the size of the transaction
and the importance of the customer to the bank.
*
The foreign-exchange market comprises buyers and sellers of
currencies issued by the world’s countries. Anyone who owns
money denominated in one currency and wants to convert that
money to a second currency participates in the foreign-exchange
market. The worldwide volume of foreign-exchange trading is
estimated at $1.9 trillion per day. Foreign exchange is being
traded somewhere in the world every minute of the day (see
Map 8.1). The largest foreign-exchange market is in London,
followed by New York, Tokyo, and Singapore.
*
The clients of the foreign-exchange departments of banks fall
into several categories:
• Commercial customers engage in foreign-exchange
transactions as part of their normal commercial activities, such
as exporting or importing goods and services, paying or
receiving dividends and interest from foreign sources, and
purchasing or selling foreign assets and investments. Some
commercial customers may also use the market to hedge, or
reduce, their risks due to potential unfavorable changes in
foreign-exchange rates for moneys to be paid or received in the
future.
• Speculators deliberately assume exchange rate risks by
acquiring positions in a currency, hoping that they can correctly
predict changes in the currency’s market value. Foreign-

exchange speculation can be very lucrative if one guesses
correctly, but it is also extremely risky.
• Arbitrageurs attempt to exploit small differences in the price
of a currency between markets. They seek to obtain riskless
profits by simultaneously buying the currency in the lower-
priced market and selling it in the higher-priced market.
*
*
Many international business transactions involve payments to be
made in the future. Such transactions include lending activities
and purchases on credit. Because changes in currency values are
common, such international transactions would appear to be
risky in the post-Bretton Woods era. How can a firm know for
sure the future value of a foreign currency? Currencies can be
bought and sold for immediate delivery or for delivery at some
point in the future. The spot market consists of foreign-
exchange transactions that are to be consummated immediately.
(Immediately is normally defined as two days after the trade
date because of the time historically needed for payment to
clear the international banking system.) Spot transactions
account for 33 percent of all foreign-exchange transactions. The
forward market consists of foreign-exchange transactions that
are to occur sometime in the future. Prices are often published
for foreign exchange that will be delivered 30 days, 90 days,
and 180 days in the future. Many users of the forward market
engage in swap transactions. A swap transaction is a transaction
in which the same currency is bought and sold simultaneously,
but delivery is made at two different points in time.
For example, the Wall Street Journal excerpt shown in the slide
indicates that on Wednesday, July 19, 2006, the spot price of
the British pound was $1.4429, while the forward price for
pounds for delivery in 30 days was $1.4428 and for delivery in
180 days was $1.4404.
*
The foreign-exchange market has developed two other

mechanisms to allow firms to obtain foreign exchange in the
future. Neither, however, provides the flexibility in amount and
in timing that international banks offer. The first mechanism is
the currency future. Publicly traded on many exchanges
worldwide, a currency future is a contract that resembles a
forward contract. However, unlike the forward contract, the
currency future is for a standard amount (for example, ¥12.5
million or SwFr 125,000) on a standard delivery date (for
example, the third Wednesday of the contract’s maturity
month). As with a forward contract, a firm signing a currency-
future contract must complete the transaction by buying or
selling the specified amount of foreign currency at the specified
price and time. This obligation is usually not troublesome,
however; a firm wanting to be released from a currency-future
obligation can simply make an offsetting transaction. In
practice, 98 percent of currency futures are settled in this
manner. Currency futures represent only 1 percent of the
foreign-exchange market.
The second mechanism, the currency option, allows, but does
not require, a firm to buy or sell a specified amount of a foreign
currency at a specified price at any time up to a specified date.
A call option grants the right to buy the foreign currency in
question; a put option grants the right to sell the foreign
currency. Currency options are publicly traded on organized
exchanges worldwide. Because of the inflexibility of publicly
traded options, international bankers often are willing to write
currency options customized as to amount and time for their
commercial clients. Currency options account for 5 percent of
foreign-exchange market activity.
*
*
Arbitrage of Goods—Purchasing Power Parity. Underlying the
arbitrage of goods is a very simple notion: If the price of a good
differs between two markets, people will tend to buy the good
in the market offering the lower price, the “cheap” market, and

resell it in the market offering the higher price, the “expensive”
market. Under the law of one price such arbitrage activities will
continue until the price of the good is identical in both markets
(excluding transactions costs, transportation costs, taxes, and so
on). The arbitrage of goods across national boundaries is
represented by the theory of purchasing power parity (PPP).
This theory states that the prices of tradable goods, when
expressed in a common currency, will tend to equalize across
countries as a result of exchange rate changes. PPP occurs
because the process of buying goods in the cheap market and
reselling them in the expensive market affects the demand for,
and thus the price of, the foreign currency, as well as the market
price of the good itself in the two product markets in question.
Arbitrage of Money. Professional traders employed by money
market banks and other financial organizations seek to profit
from small differences in the price of foreign exchange in
different markets. Whenever the foreign-exchange market is not
in equilibrium, professional traders can profit through
arbitraging money. Numerous forms of foreign-exchange
arbitrage are possible, but three forms are common: two-point,
three-point, and covered interest.
*
Two-point arbitrage involves profiting from price differences in
two geographically distinct markets. Suppose £1 is trading for
$2.00 in New York City and $1.80 in London. A foreign-
exchange trader at JPMorgan Chase could take $1.80 and use it
to buy £1 in London’s foreign-exchange market. The trader
could then take the pound she just bought and resell it for $2.00
in New York’s foreign-exchange market. Professional currency
traders can make profits through three-point arbitrage whenever
the cost of buying a currency directly (such as using pounds to
buy yen) differs from the cross rate of exchange. The cross rate
is an exchange rate between two currencies calculated through
the use of a third currency (such as using pounds to buy dollars
and then using the dollars to buy yen). The U.S. dollar is the
primary third currency used in calculating cross rates. The

difference between these two rates offers arbitrage profits to
foreign-exchange market professionals. The market for the three
currencies will be in equilibrium only when arbitrage profits do
not exist, which occurs when the direct quote and the cross rate
for each possible pair of the three currencies are equal.
Covered-interest arbitrage is arbitrage that occurs when the
difference between two countries’ interest rates is not equal to
the forward discount/premium on their currencies. In practice, it
is the most important form of arbitrage in the foreign-exchange
market. It occurs because international bankers, insurance
companies, and corporate treasurers are continually scanning
money markets worldwide to obtain the best returns on their
short-term excess cash balances and the lowest rates on short-
term loans.
*
Suppose that £1 can buy $2 in New York, Tokyo, and London,
$1 can buy ¥120 in those three markets, and £1 can buy ¥200 in
all three. Because the exchange rate between each pair of
currencies is the same in each country, no possibility of
profitable two-point arbitrage exists. However, profitable three-
point arbitrage opportunities exist. Three-point arbitrage is the
buying and selling of three different currencies to make a
riskless profit.
Figure 8.6 shows how this can work:
Step 1: Convert £1 into $2.
Step 2: Convert the $2 into ¥240.
Step 3: Convert the ¥240 into £1.2.
Through these three steps, £1 has been converted into £1.2, for
a riskless profit of £0.2.
*
Not only are international banks important in the functioning of
the foreign-exchange market and arbitrage transactions, but they
also play a critical role in financing the operations of
international businesses, acting as both commercial bankers and
investment bankers. As commercial bankers, they finance
exports and imports, accept deposits, provide working capital

loans, and offer sophisticated cash management services for
their clients. As investment bankers, they may underwrite or
syndicate local, foreign, or multinational loans and broker,
facilitate, or even finance mergers and joint ventures between
foreign and domestic firms. The international banking system is
centered in large money market banks headquartered in the
world’s financial centers—Japan, the United States, and the
European Union.
*
An overseas banking operation can be established in several
ways. If it is separately incorporated from the parent, it is
called a subsidiary bank; if it is not separately incorporated, it
is called a branch bank. Sometimes an international bank may
choose to create an affiliated bank, an overseas operation in
which it takes part ownership in conjunction with a local or
foreign partner.
*
Another important facet of the international financial system is
the Eurocurrency market. Originally called the Eurodollar
market, the Eurocurrency market originated in the early 1950s
when the communist-controlled governments of Central Europe
and Eastern Europe needed dollars to finance their international
trade but feared that the U.S. government would confiscate or
block their holdings of dollars in U.S. banks for political
reasons. The communist governments solved this problem by
using European banks that were willing to maintain dollar
accounts for them. Thus Eurodollars—U.S. dollars deposited in
European bank accounts—were born.
As other banks worldwide, particularly in Canada and Japan,
began offering dollar-denominated deposit accounts, the term
Eurodollar evolved to mean U.S. dollars deposited in any bank
account outside the United States. As other currencies became
stronger in the post-World War II era—particularly the yen, the
pound, and the German mark—the Eurocurrency market
broadened to include Euroyen, Europounds, and other
currencies. Today a Eurocurrency is defined as a currency on

deposit outside its country of issue.
The Euroloan market is extremely competitive, and lenders
operate on razor-thin margins. Euroloans are often quoted on
the basis of the London Interbank Offer Rate (LIBOR), the
interest rate that London banks charge each other for short-term
Eurocurrency loans.
*
The international bond market represents a major source of debt
financing for the world’s governments, international
organizations, and larger firms. This market has traditionally
consisted of two types of bonds: foreign bonds and Eurobonds.
Foreign bonds are bonds issued by a resident of country A but
sold to residents of country B and denominated in the currency
of country B. For example, the Nestlé Corporation, a Swiss
resident, might issue a foreign bond denominated in yen and
sold primarily to residents of Japan.
A Eurobond is a bond issued in the currency of country A but
sold to residents of other countries. For example, American
Airlines could borrow $500 million to finance new aircraft
purchases by selling Eurobonds denominated in dollars to
residents of Denmark and Germany. The euro and the U.S.
dollar are the dominant currencies in the international bond
market.
*
*
The growing importance of multinational operations and
improvements in telecommunications technology have also
made equity markets more global. Start-up companies are no
longer restricted to raising new equity solely from domestic
sources. For example, Swiss pharmaceutical firms are a major
source of equity capital for new U.S. biotechnology firms.
Established firms also tap into the global equity market. When
expanding into a foreign market, a firm may choose to raise
capital for its foreign subsidiary in the foreign market.
Numerous MNCs also cross-list their common stocks on

multiple stock exchanges. British Airways, for instance, is
listed on both the London Stock Exchange and the New York
Stock Exchange, thereby enabling both European and American
investors to purchase its shares conveniently. Another
innovation is the development of country funds. A country fund
is a mutual fund that specializes in investing in a given
country’s firms.
*
Offshore financial centers focus on offering banking and other
financial services to nonresident customers. Many of these
centers are located on island states, such as the Bahamas,
Antilles, and Singapore. Luxembourg and Switzerland, although
not islands, are also important “offshore” financial centers.
MNCs often use offshore financial centers to obtain low-cost
Eurocurrency loans. Many MNCs locate financing subsidiaries
in these centers to take advantage of the benefits they offer:
political stability, a regulatory climate that facilitates
international capital transactions, excellent communications
links to other major financial centers, and availability of legal,
accounting, financial, and other expertise needed to package
large loans. The efficiency of offshore financial centers in
attracting deposits and then lending these funds to customers
worldwide is an important factor in the growing globalization of
the capital market.
*
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chapter 7
The International
Monetary System

and the Balance
of Payments
International Business, 6th Edition
Griffin & Pustay
Hall
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7-*
Chapter Objectives Discuss the role of the international
monetary system in promoting international trade and
investmentExplain the evolution and functioning of the gold
standardSummarize the role of the World Bank Group and the
International Monetary Fund in the post-World War II
international monetary system established at Bretton Woods
Hall
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*
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Chapter Objectives (continued) Explain the evolution of the
flexible exchange rate systemDescribe the function and
structure of the balance of payments accounting
systemDifferentiate among the various definitions of a balance
of payments surplus and deficit

Hall
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*
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International Monetary System
The international monetary system
establishes the rules by which
countries value and exchange their
currencies and provides a mechanism for
correcting imbalances between a
country’s international payments and
receipts.
Hall
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*
The international monetary system exists because most
countries have their own currencies. A means of exchanging
these currencies is needed if business is to be conducted across
national boundaries. The cost of converting foreign money into
a firm’s home currency—a variable critical to the profitability
of international operations—depends on the smooth functioning
of the international monetary system.
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Balance of Payments

The Balance of Payments (BOP)
Accounting System records
international transactions and
supplies vital information about the
health of a national economy and
likely changes in its fiscal and
monetary policies.
Hall
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*
International businesspeople also monitor the international
monetary system’s accounting system, the balance of payments.
BOP statistics can be used to detect signs of trouble that could
eventually lead to governmental trade restrictions, higher
interest rates, accelerated inflation, reduced aggregate demand,
or general changes in the cost of doing business in any given
country.
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History of the International Monetary SystemThe Gold
StandardThe Sterling-Gold StandardThe Collapse of the Gold
StandardThe Bretton Woods EraThe End of the Bretton Woods
Era
Hall
7-*
*
The international monetary system can trace its roots to the
allure of gold and silver, both of which served as media of

exchange in early trade between tribes and in later trade
between city-states. The coming slides will present the
evolution of the IMS from the gold standard to the modern day.
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The Gold Standard
Countries agree to buy or sell their
paper currencies in exchange for gold
on the request of any individual or firm
and to allow the free export of gold
bullion and coins.
Hall
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*
In 1821 the United Kingdom became the first country to adopt
the gold standard. During the nineteenth century, most other
important trading countries—including Russia, Austria-
Hungary, France, Germany, and the United States—did the
same.
As long as firms had faith in a country’s pledge to exchange its
currency for gold at the promised rate when requested to do so,
many actually preferred to be paid in currency. Transacting in
gold was expensive.
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Fixed Exchange Rate System
Hall
7-*

*
The gold standard effectively created a fixed exchange rate
system. An exchange rate is the price of one currency in terms
of a second currency. Under a fixed exchange rate system the
price of a given currency does not change relative to each other
currency. The gold standard created a fixed exchange rate
system because each country tied, or pegged, the value of its
currency to gold. The United Kingdom, for example, pledged to
buy or sell an ounce of gold for 4.247 pounds sterling, thereby
establishing the pound’s par value, or official price in terms of
gold. The United States agreed to buy or sell an ounce of gold
for a par value of $20.67. The two currencies could be freely
exchanged for the stated amount of gold, making £4.247 = 1
ounce of gold = $20.67. This implied a fixed exchange rate
between the pound and the dollar of £1 = $4.867, or
$20.67/£4.247.
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Sterling-Based Gold StandardBritish pound sterling was the
most important currency from 1821 to 1918.Most firms would
accept either gold or British pounds.
Hall
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*
The international monetary system during this period is often
called a sterling-based gold standard. The pound’s role in world
commerce was reinforced by the expansion of the British
Empire, including present-day Canada, Australia, New Zealand,
Hong Kong, Singapore, India, Pakistan, Bangladesh, Kenya,

Zimbabwe, South Africa, Gibraltar, Bermuda, and Belize. In
each colony, British banks established branches and used the
pound sterling to settle international transactions among
themselves. Because of the international trust in British
currency, London became a dominant international financial
center in the nineteenth century, a position it still holds. The
international reputations and competitive strengths of such
British firms as Barclays Bank, Thomas Cook, and Lloyd’s of
London stem from the role of the pound sterling in the
nineteenth-century gold standard.
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Map 7.1 The British Empire, 1913
Hall
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*
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The Collapse of the Gold StandardEconomic pressures of
WWICountries suspended pledges to buy or sell gold at
currencies’ par valuesGold standard readopted in 1920sDropped
during Great DepressionBritish pound allowed to float in
1931Float: value determined by supply and demand
Hall
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*
During World War I, the sterling-based gold standard unraveled.
With the outbreak of war, normal commercial transactions
between the Allies (France, Russia, and the United Kingdom)
and the Central Powers (Austria-Hungary, Germany, and the
Ottoman Empire) ceased. The economic pressures of war caused
country after country to suspend their pledges to buy or sell
gold at their currencies’ par values. After the war, conferences
at Brussels (1920) and Genoa (1922) yielded general agreements
among the major economic powers to return to the prewar gold
standard. Most countries readopted the gold standard in the
1920s despite the high levels of inflation, unemployment, and
political instability that were wracking Europe. The
resuscitation of the gold standard proved to be short lived,
however, due to the economic stresses triggered by the
worldwide Great Depression. The Bank of England was unable
to honor its pledge to maintain the value of the pound. On
September 21, 1931, it allowed the pound to float, meaning that
the pound’s value would be determined by the forces of supply
and demand and the Bank of England would no longer redeem
British paper currency for gold at par value. After the UK
abandoned the gold standard, a “sterling area” emerged as some
pegged their currencies to the pound. Other countries tied the
value of their currencies to the U.S. dollar or the French franc.
The harmony of the international monetary system degenerated
further as some engaged in a series of competitive devaluations
of their currencies. By deliberately and artificially lowering
(devaluing) the official value of its currency, each nation hoped
to make its own goods cheaper in world markets, thereby
stimulating its exports and reducing its imports.
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Figure 7.1 The Contraction of World Trade, 1929-1933

Hall
7-*
*
Figure 7.1 illustrates how international trade contracted as
countries devalued their currencies and raised tariffs.
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The Bretton Woods Era44 countries met in Bretton Woods, New
Hampshire, in 1944Goal: to create a postwar economic
environment to promote worldwide peace and
prosperityRenewed gold standard on modified basis (dollar-
based)Created International Bank for Reconstruction and
Development and International Monetary Fund
Hall
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*
Determined not to repeat the mistakes that had caused World
War II, Western diplomats desired to create a postwar economic
environment that would promote worldwide peace and
prosperity. In 1944 the representatives of 44 countries met at a
resort in Bretton Woods, New Hampshire, with that objective in
mind. The Bretton Woods conferees agreed to renew the gold
standard on a greatly modified basis. They also agreed to the
creation of two new international organizations that would
assist in rebuilding the world economy and the international
monetary system: the International Bank for Reconstruction and
Development and the International Monetary Fund. These
organizations are discussed further on the following slides.

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International Bank for Reconstruction and Development (the
World Bank)Goal 1: to help finance reconstruction of European
economiesAccomplished in mid-1950sGoal 2: to build
economies of the world’s developing countries
Hall
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*
The International Bank for Reconstruction and Development
(IBRD) is the official name of the World Bank. Established in
1945, the World Bank’s initial goal was to help finance
reconstruction of the war-torn European economies. With the
assistance of the Marshall Plan, the World Bank accomplished
this task by the mid-1950s. It then adopted a new mission—to
build the economies of the world’s developing countries.
As its mission has expanded over time, the World Bank has
created three affiliated organizations: 1) The International
Development Association, 2) The International Finance
Corporation, and 3) The Multilateral Investment Guarantee
Agency.
Together with the World Bank, these constitute the World Bank
Group (see next slide). The World Bank is owned by its 184
member countries. To reach decisions, the World Bank uses a
weighted voting system that reflects the economic power and
contributions of its members. The United States currently
controls the largest bloc of votes (16 percent), followed by
Japan (8 percent), Germany (4 percent), the United Kingdom (4
percent), France (4 percent), and six countries with 3 percent
each: Canada, China, India, Italy, Russia, and Saudi Arabia. To
finance its lending operations, the World Bank borrows money
in its own name from international capital markets. Interest

earned on existing loans it has made provides it with additional
lending power. New lending by the World Bank averaged $11
billion per year from 2001 to 2005.
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Figure 7.2 Organization of the World Bank Group
Hall
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*
According to its charter, the World Bank may lend only for
“productive purposes” that will stimulate economic growth
within the recipient country. The World Bank cannot finance a
trade deficit, but it can finance an infrastructure project, such as
a new railroad or harbor facility, that will bolster a country’s
economy. It may lend only to national governments or for
projects that are guaranteed by a national government, and its
loans may not be tied to the purchase of goods or services from
any country. Most important, the World Bank must follow a
hard loan policy; that is, it may make a loan only if there is a
reasonable expectation that the loan will be repaid. In response
to criticism from poor countries, the World Bank established the
International Development Association (IDA) in 1960. The IDA
offers soft loans, loans that bear some significant risk of not
being repaid. IDA loans carry no interest rate, although the IDA
collects a small service charge (currently 0.75 percent) from
borrowers. The loans also have long maturities (normally 35 to
40 years). The two other affiliates of the World Bank Group
have narrower missions. The International Finance Corporation
(IFC), created in 1956, is charged with promoting the
development of the private sector in developing countries.
Acting like an investment banker, the IFC, in collaboration with

private investors, provides debt and equity capital for promising
commercial activities. The other World Bank affiliate, the
Multilateral Investment Guarantee Agency (MIGA), was set up
in 1988 to overcome private-sector reluctance to invest in
developing countries because of perceived political riskiness.
MIGA encourages direct investment in developing countries by
offering private investors insurance against noncommercial
risks.
7-*
Objectives of the
International Monetary Fund To promote international monetary
cooperationTo facilitate the expansion and balanced growth of
international tradeTo promote exchange stability, to maintain
orderly exchange arrangements among members, and to avoid
competitive exchange depreciationTo assist in the establishment
of a multilateral system of payments
Hall
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*
The Bretton Woods attendees believed that the deterioration of
international trade during the years after World War I was
attributable in part to the competitive exchange rate
devaluations that plagued international commerce. To ensure
that the post-World War II monetary system would promote
international commerce, the Bretton Woods Agreement called
for the creation of the International Monetary Fund (IMF) to
oversee the functioning of the international monetary system.
Article I of the IMF’s Articles of Agreement lays out the
organization’s objectives.

7-*
Objectives of the
International Monetary Fund (continued)To give confidence to
members by making the general resources of the IMF
temporarily available to them and to correct maladjustments in
their balances of paymentsTo shorten the duration and lessen
the degree of disequilibrium in the international balances of
payments of members
Hall
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*
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Membership in the IMFOpen to any country willing to agree to
rules and regulations185 member countries as of
2008Membership requires payment of a quota
Hall
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*
Membership in the IMF is available to any country willing to
agree to its rules and regulations. As of April 2006, 184
countries were members. To join, a country must pay a deposit,
called a quota, partly in gold and partly in the country’s own

currency. The quota’s size primarily reflects the global
importance of the country’s economy, although political
considerations may also have some effect.
The size of a quota is important for several reasons: A country’s
quota determines its voting power within the IMF. A country’s
quota serves as part of its official reserves. The quota
determines the country’s borrowing power from the IMF. Each
IMF member has an unconditional right to borrow up to 25
percent of its quota from the IMF. IMF policy allows additional
borrowings contingent on the member country’s agreeing to
IMF-imposed restrictions—called IMF conditionality—on its
economic policies.
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A Dollar-Based Gold StandardCountries agreed to peg the value
of currencies to goldU.S. $ keystone of systemFixed exchange
rate systemAdjustable peg Functioned well in times of economic
prosperity
Hall
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*
The Breton Woods system worked well as long as countries
were experiencing economic prosperity. However, beginning in
the late 1960s, British productivity decreased relative to that of
its major international competitors, and the pound’s value
weakened. The Bank of England had to intervene continually in
the foreign currency market, selling gold and foreign currencies
to support the pound. In so doing, however, the Bank’s holdings
of official reserves, which were needed to back up the country’s
Bretton Woods pledge, began to dwindle. International currency
traders began to fear the Bank would run out of reserves. As

that fear mounted, international banks, currency traders, and
other market participants became unwilling to hold British
pounds in their inventory of foreign currencies. They began
dumping pounds on the market as soon as they received them. A
vicious cycle developed: As the Bank of England continued to
drain its official reserves to support the pound, the fears of the
currency-market participants that the Bank would run out of
reserves were worsened.
7-*
The End of the Bretton Woods SystemSusceptible to speculative
“runs on the bank”U.S. $ became only source of liquidity
necessary to expand international tradePeople questioned the
ability of U.S. to meet obligations (Triffin Paradox)IMF created
special drawing rights (SDRs) – paper goldBretton Woods
system ended August 15, 1971
Hall
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*
These runs on the British and French central banks were a
precursor to a run on the most important bank in the Bretton
Woods system—the U.S. Federal Reserve Bank. Because the
supply of gold did not expand in the short run, the only source
of the liquidity needed to expand international trade was the
U.S. dollar. Under the Bretton Woods system, the expansion of
international liquidity depended on foreigners’ willingness to
continually increase their holdings of dollars. Foreigners were
perfectly happy to hold dollars as long as they trusted the
integrity of the U.S. currency, and during the 1950s and 1960s
the number of dollars held by foreigners rose steadily. As
foreign dollar holdings increased, however, people began to

question the ability of the United States to live up to its Bretton
Woods obligation. This led to the Triffin paradox: foreigners
needed to increase their holdings of dollars to finance expansion
of international trade, but the more dollars they owned, the less
faith they had in the ability of the United States to redeem those
dollars for gold. The less faith foreigners had in the United
States, the more they wanted to rid themselves of dollars and
get gold in return. If they did this, however, international trade
and the international monetary system might collapse because
the United States did not have enough gold to redeem all the
dollars held by foreigners.
As a means of injecting more liquidity into the international
monetary system while reducing the demands placed on the
dollar as a reserve currency, IMF members agreed in 1967 to
create special drawing rights (SDRs). IMF members can use
SDRs to settle official transactions at the IMF. Thus, SDRs are
sometimes called “paper gold.”
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Performance of the International Monetary System since
1971Most currencies began to floatValue of U.S. $ fell relative
to most major currenciesGroup of Ten agreed to restore fixed
exchange rate system with restructured rates of exchange
Hall
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*
In a dramatic address on August 15, 1971, President Richard M.
Nixon announced that the United States would no longer redeem
gold at $35 per ounce. The Bretton Woods system was ended. In
effect, the bank was closing its doors. After Nixon’s speech,
most currencies began to float, their values being determined by

supply and demand in the foreign-exchange market. The value
of the U.S. dollar fell relative to most of the world’s major
currencies. The nations of the world, however, were not yet
ready to abandon the fixed exchange rate system. At the
Smithsonian Conference, held in Washington, D.C. in December
1971, central bank representatives from the Group of Ten
agreed to restore the fixed exchange rate system but with
restructured rates of exchange between the major trading
currencies. The U.S. dollar was devalued to $38 per ounce but
remained inconvertible into gold, and the par values of strong
currencies such as the yen were revalued upward. Currencies
were allowed to fluctuate around their new par values by ±2.25
percent, which replaced the narrower ±1.00 percent range
authorized by the Bretton Woods Agreement.
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International Monetary System
since 1971Development of floating exchange rate systemSupply
and demand for a currency determine its price in the world
marketManaged float – central banks can affect supply and
demandLegitimized in 1976 with the Jamaica Agreement
Hall
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*
Free-market forces disputed the new set of par values
established by the Smithsonian conferees. Speculators,
believing the dollar and the pound were overvalued, sold both
and hoarded currencies they believed were undervalued, such as
the Swiss franc and the German mark. The Bank of England was
unable to maintain the pound’s value within the ±2.25 percent

band and in June 1972 had to allow the pound to float
downward. The United States devalued the dollar by 10 percent
in February 1973. By March 1973 the central banks conceded
they could not successfully resist free-market forces and so
established a flexible exchange rate system. Under a flexible (or
floating) exchange rate system, supply and demand for a
currency determine its price in the world market. Since 1973,
exchange rates among many currencies have been established
primarily by the interaction of supply and demand. The current
arrangements are often called a managed float (or, a dirty float)
because exchange rates are not determined purely by private-
sector market forces. The new flexible exchange rate system
was legitimized by an international conference held in Jamaica
in January 1976. According to the resulting Jamaica Agreement,
each country was free to adopt whatever exchange rate system
best met its own requirements. The United States adopted a
floating exchange rate. Other countries adopted a fixed
exchange rate by pegging their currencies to the dollar or some
other currency. Still others adopt crawling pegs, where the peg
was allowed to change gradually over time.
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Table 7.1 The Groups of
Five, Seven, and Ten
Hall
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*

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Table 7.2 Key Central Banks
HallCountryBankCanadaBank of CanadaEuropean
UnionEuropean Central BankJapanBank of JapanUnited
KingdomBank of EnglandUnited StatesFederal Reserve Bank
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*
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European UnionBelieved flexible system would hinder ability to
create integrated economyCreated European Monetary System
to manage currency relationships ERM participants maintained
fixed exchange rates among their currenciesFacilitated creation
and adoption of euro
Hall
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*
The strategy adopted by European Union (EU) members is based
in the belief that flexible exchange rates would hinder their
ability to create an integrated European economy. In 1979 EU
members created the European Monetary System (EMS) to
manage currency relationships among themselves. Most EMS
members chose to participate in the EU’s exchange rate
mechanism (ERM). ERM participants pledged to maintain fixed
exchange rates among their currencies within a narrow range of
±2.25 percent of par value and a floating rate against the U.S.
dollar and other currencies. The exchange rate mechanism
facilitated the creation of the EU’s single currency, the euro.
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Map 7.2 Exchange Rate Arrangements as of 2007
Hall
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Figure 7.3 Exchange Rates of Dollar vs. Yen, the Euro, and the
Deutsche Mark, 1970-2005
Hall
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International Debt CrisisOPEC quadrupled world oil
pricesResulted in inflationary pressures in oil-importing
countriesExchange rates adjustedTransfer of wealthCountries

borrowed more than they could repay
Hall
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*
The flexible exchange rate system instituted in 1973 was
immediately put to a severe test. In response to the Israeli
victory in the Arab-Israeli War of 1973, Arab nations imposed
an embargo on oil shipments to countries such as the United
States and the Netherlands, which had supported the Israeli
cause. As a result, the Organization of Petroleum Exporting
Countries (OPEC) succeeded in quadrupling world oil prices
from $3 a barrel in October 1973 to $12 a barrel by March 1974.
This rapid increase in oil prices caused inflationary pressures in
oil-importing countries. The new international monetary
arrangements absorbed some of the shock caused by this
upheaval in the oil market, as exchange rates adjusted to
account for changes in the value of each country’s oil exports or
imports. The higher oil prices acted as a tax on the economies
of the oil-importing countries. Many of the oil-exporting
countries went on spending sprees, using their new wealth to
improve their infrastructures or to invest in new facilities (such
as petroleum refineries) to produce wealth for future
generations. The unspent petrodollars were deposited in banks
in international money centers such as London and New York
City. The international banking community then recycled these
petrodollars through its international lending activities to help
revive the economies damaged by rising oil prices. The
international banks were too aggressive in recycling these
dollars. Many countries borrowed more than they could repay.
The financial positions of these borrowers became precarious
after the oil shock of 1978-1979 when the price of oil triggered
another round of worldwide inflation. Interest rates on these
loans rose, as most carried a floating interest rate, further

burdening the heavily indebted nations. The international debt
crisis formally began when Mexico requested a rescheduling of
its debts, a moratorium on repayment of principal, and a loan
from the IMF to help it through its debt crisis. In total, more
than 40 countries in Asia, Africa, and Latin America sought
relief from their external debts.
7-*
Approaches to Resolve the International Debt Crisis
The Baker Plan
The Brady Plan
Hall
7-*
*
The 1985 Baker Plan (named after then U.S. Treasury Secretary
James Baker) stressed the importance of debt rescheduling, tight
IMF-imposed controls over domestic monetary and fiscal
policies, and continued lending to debtor countries in hopes that
economic growth would allow them to repay their creditors. In
Mexico’s case, the IMF agreed to provide a loan package only if
private foreign banks holding Mexican debt agreed to
reschedule their loans and provide Mexico with additional
financing. However, the debtor nations made little progress in
repaying their loans. Debtors and creditors alike agreed that a
new approach was needed.
The 1989 Brady Plan (named after the first Bush
administration’s treasury secretary Nicholas Brady) focused on
the need to reduce the debts of the troubled countries by writing
off parts of the debts or by providing the countries with funds to
buy back their loan notes at below face value.

7-*
The Balance of Payments Accounting System
The BOP accounting system is a
double-entry bookkeeping system
designed to measure and record all
economic transactions between
residents of one country and residents of
all other countries during a particular
time period.
Hall
7-*
*
It helps policy makers understand the performance of each
country’s economy in international markets. It also signals
fundamental changes in the competitiveness of countries and
assists policy makers in designing appropriate public policies to
respond to these changes. International businesspeople need to
pay close attention to countries’ BOP statistics for several
reasons, including the following:
1. BOP statistics help identify emerging markets for goods and
services.
2. BOP statistics can warn of possible new policies that may
alter a country’s business climate, thereby affecting the
profitability of a firm’s operations in that country.
3. BOP statistics can indicate reductions in a country’s foreign-
exchange reserves, which may mean that the country’s currency
will depreciate in the future, as occurred in Thailand in 1997.
Exporters to such a country may find that domestic producers
will become more price competitive.
4. As was true in the international debt crisis, BOP statistics
can signal increased riskiness of lending to particular countries.

7-*
Figure 7.4
The Asian Contagion
Hall
7-*
*
The Asian currency crisis erupted in July 1997, when Thailand,
which had pegged its currency to a dollar-dominated basket of
currencies, was forced to unpeg its currency, the baht, after
investors began to distrust the abilities of Thai borrowers to
repay their foreign loans and of the Thai government to
maintain the baht’s value. Not wanting to hold a currency likely
to be devalued, foreign and domestic investors converted their
bahts to dollars and other currencies. The Thai central bank
spent much of its official reserves desperately trying to
maintain the pegged value of the baht. After Thailand was
forced to abandon the peg on July 2, the baht promptly fell 20
percent in value. As investors realized that other countries in
the region shared Thailand’s overdependence on foreign short-
term capital, their currencies also came under attack and their
stock markets were devastated. Indonesia was hit the worst by
the so-called Asian contagion (see Figure 7.4). Aftershocks of
the crisis spread to Latin America and Russia, and the Russian
government effectively defaulted on its foreign debts. All told,
the IMF and the Quad countries pledged over $100 billion in
loans to help restore these countries to economic health.

7-*
Balance of Payments (BOP)
Accounting SystemMeasures and records all economic
transactions between residents of one country and residents of
all other countries during specified time periodProvides
understanding of performance of each country’s economy in
international marketsSignals fundamental changes in country
competitiveness Assists policy makers in designing appropriate
public policies
Hall
7-*
*
7-*
Four Important Aspects of the BOP Accounting SystemRecords
international transactions made in some time periodRecords
only economic transactionsRecords transactions between
residents of one country and all other countriesResidents
include individuals, businesses, government agencies, nonprofit
organizationsUses a double-entry system
Hall
7-*
*
Four important aspects of the BOP accounting system need to be
highlighted:
1. The BOP accounting system records international

transactions made during some time period, for example, a year.
2. It records only economic transactions, those that involve
something of monetary value.
3. It records transactions between residents of one country and
residents of all other countries. Residents can be individuals,
businesses, government agencies, or nonprofit organizations,
but defining residency is sometimes tricky. Persons temporarily
located in a country—tourists, students, and military or
diplomatic personnel—are still considered residents of their
home country for BOP purposes. Businesses are considered
residents of the country in which they are incorporated.
4. The BOP accounting system is a double-entry system. Each
transaction produces a credit entry and a debit entry of equal
size. In most international business dealings, the first entry in a
BOP transaction involves the purchase or sale of something—a
good, a service, or an asset. The second entry records the
payment or receipt of payment for the thing bought or sold.
Debit entries reflect uses of funds; credit entries indicate
sources of funds. Under this framework, buying things creates
debits, and selling things produces credits.
7-*
Major Components of the BOP Accounting System
Current Account
Capital Account
Official Reserves
Errors and Omissions
Hall
7-*
*
The BOP accounting system can be divided conceptually into

four major accounts. The first two accounts—the current
account and the capital account—record purchases of goods,
services, and assets by the private and public sectors. The
official reserves account reflects the impact of central bank
intervention in the foreign-exchange market. The last account—
errors and omissions—captures mistakes made in recording BOP
transactions.
7-*
Types of Current Account TransactionsExports and imports of
goodsExports and imports of servicesInvestment incomeGifts
Hall
7-*
*
The goods account records sales and purchases of goods. The
difference between a country’s exports and imports of goods is
called the balance on merchandise trade. The services account
records sales and purchases of such services as transportation,
tourism, medical care, telecommunications, advertising,
financial services, and education. The difference between a
country’s exports of services and its imports of services is
called the balance on services trade. The third type of
transaction recorded in the current account is investment
income. The fourth type of transaction in the current account is
unilateral transfers, or gifts between residents of one country
and another. Unilateral transfers include private and public
gifts.
7-*

Capital Account
Foreign Direct
Investment
Portfolio
Investment
Hall
7-*
*
The second major account in the BOP accounting system is the
capital account, which records capital transactions—purchases
and sales of assets—between residents of one country and those
of other countries. Capital account transactions can be divided
into two categories: foreign direct investment (FDI) and
portfolio investment.
FDI is any investment made for the purpose of controlling the
organization in which the investment is made, typically through
ownership of significant blocks of common stock with voting
privileges. Under U.S. BOP accounting standards, control is
defined as ownership of at least 10 percent of a company’s
voting stock. A portfolio investment is any investment made for
purposes other than control. Portfolio investments are divided
into two subcategories: short-term investments and long-term
investments. Short-term portfolio investments are financial
instruments with maturities of one year or less. Included in this
category are commercial paper; checking accounts, time
deposits, and certificates of deposit held by residents of a
country in foreign banks or by foreigners in domestic banks;
trade receivables and deposits from international commercial
customers; and banks’ short-term international lending
activities, such as commercial loans. Long-term portfolio
investments are stocks, bonds, and other financial instruments
issued by private and public organizations that have maturities
greater than one year and that are held for purposes other than

control.
7-*
Table 7.4 Capital Account Transactions
Hall
7-*
*
Current account transactions invariably affect the short-term
component of the capital account. The first entry in the double-
entry BOP accounting system records the purchase or sale of
something—a good, a service, or an asset. The second entry
typically records the payment or receipt of payment for the
thing bought or sold. In most cases, this second entry reflects a
change in someone’s checking account balance, which in the
BOP accounting system is a short-term capital account
transaction.
7-*
Table 7.5 BOP Entries, Capital Account
HallDebt (Outflow)Credit (Inflow)Portfolio (short-
term)Receiving a payment from a foreigner Making a payment
to a foreignerBuying a short-term foreign assetSelling a
domestic short-term asset to a foreignerPortfolio (long-
term)Buying back a short-term domestic asset from its foreign
ownerSelling a short-term foreign asset acquired
previouslyBuying back a long-term domestic asset from its
foreign ownerSelling a domestic long-term asset to a
foreignerForeign direct investmentBuying a foreign asset for

purposes of controlSelling a long-term foreign asset previously
acquiredBuying back from its foreign owner a domestic
assetSelling a domestic asset to a foreigner
7-*
*
Capital inflows are credits in the BOP accounting system. They
can occur in two ways: Foreign ownership of assets in a country
increases. Ownership of foreign assets by a country’s residents
declines.
Capital outflows are debits in the BOP accounting system. They
also can occur in two ways: Ownership of foreign assets by a
country’s residents increases. Foreign ownership of assets in a
country declines.
7-*
Official Reserves AccountRecords level of official reservesFour
types of assetsGoldConvertible currenciesSDRsReserve
positions at the IMF

Hall
7-*
*
7-*
Official Reserves Account
Assets
Gold
Convertible
securities
SDRs
Reserve
positions
Hall
7-*
*
The third major account in the BOP accounting system, the
official reserves account, records the level of official reserves
held by a national government. These reserves are used to
intervene in the foreign-exchange market and in transactions
with other central banks. Official reserves comprise four types
of assets: 1) Gold, 2) Convertible currencies, 3) SDRs, and 4)
Reserve positions at the IMF. Official gold holdings are
measured using a par value established by a country’s treasury
or finance ministry. Convertible currencies are currencies that
are freely exchangeable in world currency markets.

7-*
Errors and OmissionsBOP must balanceCurrent Account +
Capital Account + Official Reserves Account = 0Current
Account + Capital Account + Official Reserves Account +
Errors and Omissions = 0
Hall
7-*
*
The last account in the BOP accounting system is the errors and
omissions account. One truism of the BOP accounting system is
that the BOP must balance. In theory, the following equality
should be observed:
Current Account + Capital Account + Official Reserves Account
= 0.
However, this equality is never achieved in practice because of
measurement errors. The errors and omissions account is used to
make the BOP balance in accordance with the following
equation:
Current Account + Capital Account + Official Reserves Account
+ Errors and Omissions = 0.
Sometimes, errors and omissions are due to deliberate actions
by individuals who are engaged in illegal activities such as drug
smuggling, money laundering, or evasion of currency and
investment controls imposed by their home governments.
Politically stable countries, such as the United States, are often
the destination of flight capital, money sent abroad by foreign
residents seeking a safe haven for their assets, hidden from the
sticky fingers of their home governments. Given the often
illegal nature of flight capital, persons sending it to the United
States often try to avoid any official recognition of their
transactions, making it difficult for government BOP
statisticians to record such transactions. Residents of other

countries who distrust the stability of their own currency may
also choose to use a stronger currency, such as the dollar or the
euro, to transact their business or keep their savings.
7-*
Table 7.6. U.S. Balance of Payments in 2007
Hall
7-*
7-*
Figure 7.5a. Leading U.S. Merchandise
Exports, 2007
Hall
7-*
7-*
Figure 7.5b. Leading U.S. Merchandise
Imports, 2007
Hall
7-*
7-*
Figure 7.6. Trade Between the U.S. and its Major Trading
Partners, 2007

Hall
7-*
7-*
Defining BOPs Surpluses and Deficits
Official Settlements Balance reflects changes in a country’s
official reserves; essentially, it records the net impact of the
Central Bank’s intervention in the foreign-exchange market in
support of the local currency
Hall
7-*
7-*
Figure 7.7 The U.S. BOP
According to Various Reporting Measures
Hall
7-*
*
All rights reserved. No part of this publication may be
reproduced, stored in a retrieval system, or transmitted, in any
form or by any means, electronic, mechanical, photocopying,
recording, or otherwise, without the prior written permission of
the publisher. Printed in the United States of America.

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