INTERNATIONAL MARKETS

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CHAPTER 12

• INTERNATIONAL MARKETS

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International Transactions

• When potential suppliers are not located in the
  United States, there are several problems
• The U.S. buyer may have to exchange funds into
  another currency
• No single country or supranational organization
  has total authority
• Countries may have different legal traditions
• Financing goods and services from foreign sources
• Difficulty in obtaining reliable information
  about the supplier

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Foreign Exchange Rates

• Foreign trade and funds flow must involve a
  conversion from one currency to another
• Foreign exchange rate -- the price of a unit of
  one currency in terms of another.
• Foreign exchange rates are market determined (for
  convertible currencies).
• The increased (decreased) cost of a unit of
  foreign currency in terms of the U.S. dollar
  refers to the depreciation (appreciation) of the
  dollar.

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Terms

• Sovereignty Risk or political risk is the right
  of a country to do what it wants within its own
  borders.
• Spot Exchange Rate - Immediate delivery of
  foreign exchange
• Forward Exchange Rate - Delivery to take place in
  the future, such as 30, 90 or 180 days.

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Dumping

• Suppose a foreign chipmaker has excess capacity.
  A particular chip has a variable cost of 25, and
  its fully allocated cost is 25 plus total fixed
  cost per unit of output, is 40.
• Suppose that the foreign firm sells chips in the
  U.S. at 35 per unit and U.S. firms sell at
  35.50.
• The foreign firm covers its variable costs and
  makes a contribution to its fixed overhead.
• U.S. firms are excluded from the foreign market
  by import duties or other barriers. The foreign
  firm can sell at a high price in its market.

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Foreign Corrupt Practices Act of 1988

• The Act prohibits U.S. firms from making bribes
  or grease payments abroad to facilitate a
  transaction.
• In many countries, the receipt of bribes is not
  only permitted, it is expected.
• Bribes are common in capital-intensive industries
  such as aerospace, construction and energy, which
  deal with large projects.

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The Equilibrium Exchange Rate
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Supply and Demand

• The supply of a currency comes from domestic
  importers, domestic investors who want to invest
  abroad, and speculators.
• The demand for a currency comes from foreign
  buyers who pay for purchases, foreign investors,
  and speculators.

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Foreign Exchange Rates

• Supply and demand for currencies depends on the
  underlying demand and supply for goods and
  services between countries caused by
• Relative costs of the factors of production in
  each country.
• Productivity
• Relative supply of factors between nations.
• Resource Endowment
• Consumer tastes for certain goods and services.
• The ability of a country to supply its needs
  domestically.
• Barriers to trade such as import tariffs which
  affect the flow of goods and services

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Foreign Exchange Rates

• Also, supply and demand for currencies depends on
  the underlying demand and supply for goods and
  services between countries caused by
• The rate of growth of national income of a
  country.
• Trade flows will continue, with corresponding
  purchase and sale of foreign exchange, until
  (relative) purchasing power parity is achieved,
  or the cost of an item in one country's currency
  is the same cost as in another country's currency
• Absolute PPP does not exist.

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Relative Purchasing Power Parity (RPPP)
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S 1 1 h S 0 1 f

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(From the Moyer text)
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Financial Determinants of Exchange Rates

• Relative real interest rates between countries
  and inflation rates affect international capital
  flows.
• Small, real interest rate differentials between
  countries causes capital (and the demand/supply
  of foreign exchange) to move very quickly.

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Financial Determinants of Exchange Rates, cont.

• Relative inflation rates between countries affect
  foreign exchange rates.
• If country A has a lower rate of inflation
  relative to Country B, A's goods are relatively
  cheaper than B's.
• Country A's currency will appreciate as Country B
  acquires more of country A's goods and services.

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Interest Rate Parity (IRP)

• The theory of IRP is that the annual percentage
  forward premium for a currency is equal to the
  approximate difference in interest rates
  prevailing in the two countries.
• When IRP exists, differences in interest rates
  between two countries will be offset by the
  difference in forward and spot exchange rates.
• Exchange rates are materially affected by a
  countrys rate of inflation.

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Exchange rates provide interest parity (IRP)
between countries

• Arbitragers establish interest parity.
• A higher interest rate in another country
  (security denominated in a foreign currency)
  would be nullified by a lower forward rate.

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Interest Rate Parity
F 1 i h S 0 1 i f

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Expectations Theory of Forward Exchange Rates
The forward rate should be an unbiased estimate
of expected future spot rates.
F S 1
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Exchange Rates and Inflation

• Fisher Effect embodies expected inflation in
  interest rates.
• Expected inflation differences between countries
  explain much of the interest rate differences
  between countries.
• Interest rate differentials are reflected in
  forward/spot differentials.

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International Fisher Effect
Differences in interest rates between two
countries should be offset by equal but opposite
changes in the future spot exchange rate.
S 1 1 i h S 0 1 i f

Use the IFE relationship when making longer term
exchange forecasts.
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Three types of capital flows which affect
exchange rates

• Speculative capital flows - buying/selling of
  foreign exchange based on future exchange rate
  expectations.
• Investment capital flows - investment in real or
  financial assets (money or capital market) based
  on prospects of real returns. Covered (forward
  contract hedge) interest rate parity conditions
  are achieved by arbitragers, eliminating the spot
  conversion, interest rate, and forward exchange
  differences between countries.

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Three types of capital flows which affect
exchange rates (concluded)

• Political capital flows - transfer of wealth from
  one country to another, also called capital
  flight.

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Government Intervention in the Foreign Exchange
Markets
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Government Intervention in the Foreign Exchange
Markets

• Support of currency value by selling foreign
  assets.
• Depression of currency value by buying foreign
  assets.
• Governments may fix exchange rates (decree or by
  market intervention) or the currency may float,
  determined by the market.
• There are no over- or under valuations with
  market determined (floating) exchange rates.

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Balance of Payments Terminology

• Double-entry bookkeeping -- debits equal credits.
• Surplus/deficit term relates to a subsection of
  the balance of payments report. The entire
  balance of payments report balances.
• Goods and services imports greater than exports
  for a period is called a trade deficit and
  typically decreases the currency exchange rate.
• Goods and services exports greater than imports
  is called a trade surplus and normally increases
  the currency exchange rate.

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The Current Account

• The current account records the trade balance of
  a country.
• Includes flow of imports and exports in the
  current period.
• Trade flows do not give rise to expectations of
  future flows.
• If services, investment income, and transfers are
  included, the net is the balance on current
  accounts.

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The Capital Account

• The balance-of payments capital accounts measure
  capital flows into or out of the country.
• Capital flows can be used to finance private
  long-term investments or they may be short-term
  flows invested in bank deposits or short-term
  securities.

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The Capital Account - Continued

• Surpluses (deficits) in the capital accounts
  offset deficits (surpluses) in the current
  account.
• Pressure on exchange rates from the current
  account is reversed with capital account flows.

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Negative Balance of Payments

• I believe that the United States cannot continue
  to run a negative balance of payments
  indefinitely.
• However, the dollar does not always fall when the
  U.S. runs a current account balance-of-payments
  deficit. The reason for this is that foreigners
  can buy U.S. capital assets, as well as U.S.
  manufactured goods and services.

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Foreign Exchange Appreciation Will Occur When

• A country's goods are cheaper than foreign goods
  based on purchasing power parity.
• A country has a large current accounts surplus.
• A country has higher real interest rates,
  attracting real and financial investment.
• A country's interest rates are high relative to
  other countries, attracting financial investment.
• A country's government may reduce the growth in
  the money supply, raising interest rates, and
  encouraging demand for its currency.

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Government Intervention and Sterilization

• Unsterilized interventions are interventions in
  the exchange markets that are allowed to change
  the money supply.
• Sterilized interventions offset the foreign
  exchange activities by adjusting the domestic
  money supply so that it remains unchanged.

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Countertrade

• If a corporation chartered in another country
  wants to do business with a country whose
  currency is nonconvertible, the corporation may
  be required to accept locally produced
  merchandise in lieu of money as payment for goods
  and services.
• This practice is known as countertrade.

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Nature of Foreign Exchange Market

• Efficient
• Large number of diverse buyers and sellers
  (breadth).
• Significant market activity (buy/sell) with any
  change in value (depth).
• Market returns to normal price quickly after any
  significant price swing (resiliency).
• Worldwide over-the-counter trading.

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Nature of Foreign Exchange Market (continued)

• Major participants
• large multinational banks.
• Central Banks.
• Transfer process is through interbank clearing
  systems.
• Foreign exchange transactions total over 1.5
  trillion per day
• Spot vs. Forward Transactions
• Delivery in the spot market takes place within 2
  business days.
• Forward contracts are typically written for
  delivery in 30, 60, 90, or 180 days.

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Three InternationalTrade Problems

• Exporters lack information about importer's
  credit rating.
• Exact amounts of the trade and date of payment
  must be known before one party can hedge foreign
  exchange risk.
• Bank wants a clean deal without disputes and
  delay of funds flow
• A clean deal means that the collection is made
  without accompanying or attached documentation.

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Specialized Financial TradeInstruments to
OvercomeInternational Trade Problems

• Letter of credit - guarantees payment upon
  submission of correct documents.
• Draft - a request for payment submitted to the
  guaranteeing bank by the exporter
• Sight draft - payable on demand.
• Time draft - payable on a particular date.
• Bankers Acceptance
• Bill of lading - a receipt issued to the exporter
  by the shipping company.

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Reduction of Risk for Exporters

• Export Credit Insurance
• Foreign Credit Insurance Association (FCIA)
• Provides export credit insurance
• Export-Import Bank (Eximbank)
• Seeks to stimulate U.S. exports through a
  discount loan program for foreign purchasers,
  direct loans, guarantee and insurance programs
• Forfaiting
• A specialized finance firm buys trade receivables
  or other medium term promissory notes arising out
  of export operations on a without-recourse basis
  from an exporter. Then repackages them for sale
  to investors..similar to Factoring

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Functions of the Eurocurrency Markets

• Attractive source of working capital for
  multinational corporations
• Low rates - no reserve requirements or insurance
• Wholesale market
• Storehouse for excess liquidity - less
  regulation, competitive rates of return, and
  anonymity
• Facilitates international trade
• Banks find it attractive to use Eurocurrency
  loans to make payments.

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Euromarkets

• Eurocurrency - any currency held in time-deposit
  outside its country of origin.
• Eurodollars - dollar denominated deposits held in
  a bank outside the U.S.
• Roughly two-thirds of all U.S. currency
  outstanding is held outside the United States.

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Eurocurrency markets

• Highly liquid assets that can be used to conduct
  international transactions.
• LIBOR - the rate international banks charge other
  banks for Eurodollars (in London)
• EURO LIBOR the rate international banks charge
  each other for EUROs (in London)
• Euribor is not a Eurocurrency since it is the
  rate charged in Frankfort, Germany, home of the
  European Central Bank

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Additional Terms

• Eurobond
• A long term bond that is sold in markets other
  than the domestic market of the country in whose
  currency the bond is denominated.

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The Euro

• The Euro is a common currency unit for the
  members of the European Currency Union and
  European Central Bank. Originally, there were 11
  countries involved.
• Purpose is to encourage trade and economic
  efficiency.

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Conclusion

• Exchange Rates
• Purchasing Power Parity
• Interest Rate Parity
• Balance of Payments
• Current Account
• Capital Account
• Trade Instruments
• Eurocurrency
• EURO