Global Chapter 6, Foreign Exchange and International Accounting
V I The Balance of Payments
* A It is double-entry. For every transaction there are two, offsetting entries.
* B It balances.
* C Debit entry: negative, money out, domestic person making a payment abroad.
* D Credit entry: positive, money in, foreign person paying the domestic person
V E All transactions fall into one of three accounts
V 1 Current Account
V a Merchandise imports and exports
* i Tangible
* ii Includes machinery
V b Services
* i A large and growing item for the US
* ii Travel & tourism, insurance, banking, accounting, military, royalties, RIAA fees?
* iii Intangible (invisibles)
* c Income - payments (earnings) from assets held US in foreign countries (credit); from assets held by foreigners in the US
V d Unilateral transfers
* i Gifts - between individuals or governments
* ii Purchasing goodwill?
V 2 Capital Account - purchase and sale of of assets either financial or physical
* a Not governmental
* b Purchases of foreign securities
* c Lending and borrowing
* d Investment (purchasing assets)
* e Net capital outflow if: net purchase of foreign assets by domestic person exceeds net purchase of domestic assets by foreigners
* f Net capital inflow if: ...
V 3 Official Settlements Balance - official reserve transactions
* a Transactions between central banks and finance ministries
* b Central banks keep deposits with other central banks
* c SDR's, gold, foreign currencies included
V 4 Balance of...
* a The sum of the debits and credits must equal zero
* b A current accounts deficit must be offset by a capital (financial) accounts surplus
* c Statistical discrepancy
V d Balance-of-payments equilibrium: debits & credits in the current accounts and capital accounts add to zero
* i If there is a balance of payments surplus, (more in than out) the sum of debits & credits is positive, the official settlements balance must be negative.
* ii If there is a balance of payments deficit, (more out than in) the sum of debits & credits is negative; the official settlements balance must be positive.
V e Other measures:
* i Balance on merchandise trade
* ii Balance on goods, services, and income
* iii Balance on the current accounts
* iv Balance on the capital account
* 5
Krugman and the issue of balance:
Space Aliens Steal American Jobs!
Paul Krugman, Professor of Economics, MIT. "The MIT Economics Department has now solved the riddle of world economic crisis. It turns out that if you adcd up last year's reported imports and exports for all of the countries in the world, world imports exceeded world exports by more than one hundred billion dollars. You know what that means. It means that we are running a huge global deficit in our interplanetary trade. So Ross Perot has it wrong. That great sucking sound isn't coming from Mexico -- it's coming from outer space. Space aliens are stealing American jobs."
V 6 Is $775b deficit in the balance trade a lot?
* a www.census.gov—c0004.html
* b % of GDP
* c A result of high asset sales (borrowing?) to foreigners
* d The US has grown faster than Europe and Japan thus
* e Uncertainty in other parts of the world account for some of the US asset sales to foreigners
* f If this continues, the terms of trade will change (exchange rates will become less favorable)
* 7 The official books: BofPData
V II The Foreign Exchange Markets
V A Basic Matters - the issue is that different countries have different currencies
* 1 Foreign Exchange www.imf.org—rms_rep.aspx
V 2 Foreign exchange market -
* a a system of banks, foreign exchange brokers and central banks that exchange currencies
* b Banks-60%, brokers -20%, online-more and more
* c The oldest and largest of the financial markets
* d More than $1 trillion per day - no other market is close
* e 24 hours a day, worldwide
* 3 Foreign exchange rate
* B Spot market (vs. forward markets) - for immediate delivery
V C Rates are expressed as:
* 1 $ per SOC and as SOCs per $
* 2 One is the reciprocal of the other
V D Determining Foreign Exchange Rates
V 1 Supply and demand for a currency
* a The demand for a currency in the foreign exchange markets is derived from...
* b The supply of a currency is derived from...
* c To demand one currency is the act of supplying the other in the foreign exchange market
* d Why demand curves slope downward.
* e Change in quantity demanded vs. a change in demand.
V f Shift factors (anything that affects trade besides the exchange rate):
* i Relative income changes
* ii Relative inflation
* iii Tastes and preferences
* iv Relative interest rates
* v Trade policies
* vi Political risk
* g Why supply curves slope upward
* h Change in quantity supplied vs. a change in supply
* i Equilibrium
* j Diagrams and examples
Exchange Market
Exchange Market

* k Some event:
* l Is is a credit or debit transaction?
* m In which account?
* n Does this affect the supply or demand for dollars?
* o Does it increase or decrease?
* p Which appreciates, which depreciates?
V E Appreciation & depreciation
* 1 Rate of appreciation - the percentage change in the exchange rate
* 2 (New - Previous) / Previous x 100 (it's a %)
* 3 E.g., If the opening value is 3.758 SOCs per dollar and the close is 3.845 SOCs per dollar. What is the rate of change? Which is appreciating and which is depreciating?
V F Cross rates:
* 1 The Danish krone is 7.5 to the $ and $1.58 to the British pound. What is the exchange rate between the krone and the pound?
* 2 Set it up to cancel the dollars: Kr7.5/$1 * $1.58/ £. Result: Kr 11.85/£ or 1/11.85£/Kr
* 3 The real ones: www.bloomberg.com—fxc.html
V G Real Exchange Rates
* 1 Adjusts the exchange rates for changes in purchasing power
V 2 Must use a Price index to measure the price changes in each country
* a What is a price index?
* b How is it calculated (in general terms)?
* c If the rate of exchange between the Japanese Yen & US dollar is ¥125/$1 and a basket of goods costs $3,000 in the US but the same basket of goods in Japan costs ¥400,000, the relative value of the basket in dollars at the exchange rate is (400,000/125) = $3,200. The real purchasing power of the dollar is greater.
V H Effective Exchange Rate - A trade weighted index
* 1 A basket of currencies - weighted by their importance
* 2 It tells the overall change in the value of the dollar vs. other currencies
* 3 research.stlouisfed.org—TWEXM
* 4 They can be real also.
V III Foreign Exchange Risk and How to Deal with It
* A Foreign exchange risk exposure - commit now, pay in a different currency later
V B Types of risk
* 1 Transaction exposure - the risk that the profitability will decrease because of exchange rate changes
* 2 Translation exposure - the risk that exchange rate changes will alter the value of assets or liabilities on the books when they are translated into the home currency units.
* 3 Economic exposure - a change in exchange rates alters the value of future income streams.
V C Hedging risk
* 1 Offsetting risk exposure
* 2 Covered exposure - the risk is entirely eliminated through some hedging activity
V D Forward markets
* 1 Using the forward market to cover exposure
V 2 Example - a short position - obligation to pay in a foreign currency in the future
V a Example - a short position - obligation to pay in a foreign currency in the future
* i Need protection against dollar depreciation
* ii I owe €100,000 to be paid in 6 months. The Euro is €1.2/$1
* iii Uncovered, I will pay how many dollars if the value of the Euro is $1.20? If it is $1.30?
* iv I can buy the Euros now or
* v Go to the forward market
* vi Buy in the forward market for delivery in 6 months
V 3 Example - a long position - receive a future amount denominated in a foreign currency
* a
* b Need protection against dollar appreciation
* c I will be paid €100,000 in 3 months. The Euro is €1.2/$1.
V d Uncovered I will receive how many dollars if the exchange rate is €1.2? €1.1?
* i $120,000 vs. $110,000
* e I can go to the forward market and arrange to sell €100,000 at today's price in 3 months. The value is protected, I am covered.
* E The point - The ability to cover exposure reduces the risk of trading internationally and increases the amount of trading done.
V F The forward rate and the spot rate - a relationship
V 1 Forward premium - expressed as a %.
* a Forward(nmonths) - ForwardN / Spot * 12/N * 100'
* 2 Forward discount
V G The forward rate = the expected spot rate
* 1 Speculators see a profitable opportunity when the expected future rate is different from the spot rate.
* 2 Example: If the forward premium for the £ is 2% but I only expect a 1% increase, I sell £ for $ in the forward market, hold them for the period of time then buy back the ₤ at the lower rate and pocket the difference.
* 3 This speculative mechanism assures that the forward rate will equal the expected spot rate.
V IV Other Instruments
V A Derivatives
* 1 Hedging and speculating with derivatives
* 2 Risk issues?
V B Types
V 1 Currency futures - a forward contract
* a Standardized quantities of a currency
* b Value changes daily
* c They are highly liquid (MERC)
* d Futures are normally settled before maturity (whereas forwards normally end in delivery of the currency).
* e High leverage opportunities
V 2 Currency options - the right to buy or sell a quantity of a currency at a specific price for a specific period of time
* a Can exercise the option anytime the price gets to the exercise price (strike price)
V b Put - the right to sell an amount of currency at the exercise price
* i The BUYER of a put would buy it if they expected the price to decrease. The SELLER expects the price to not fall.
V c Call - the right to buy an amount of currency at the exercise price
* i The BUYER of a call would buy it if they expected the price to rise. The SELLER expects that the price will not increase.
* d The right but not the obligation. If the option finishes out of the money, it simply expires.
V 3 Currency swaps
* a Swapping streams of income over a period of time at some predetermined formula