Chapter 23
International Transactions
And Currency Values
23 - 2
 Learning Objectives 
• To explore the functions and roles performed by the
international markets within the global financial system.
• To see how international payments for goods and services are
made, and how international borrowing and lending can be
tracked through a nation’s balance-of-payments accounts.
• To understand how the values of national currencies are
determined.
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Introduction
• Facilitated by dramatic improvements in communication and
transportation, world trade and the international financial
markets have experienced enormous growth.
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The Balance of Payments Accounts
• One of the most widely used sources of information concerning
flows of funds, goods, and services between nations is each
country’s balance of payments (BOP) accounts.
• This statistical report summarizes all the economic and
financial transactions between residents of one nation and the
rest of the world during a specified period of time.
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The U.S. Balance of International Payments
• The transactions recorded in the balance of payments fall into
three broad groups:
- Transactions on current account, e.g. imports and exports of
goods and services, unilateral transfers (gifts)
- Transactions on capital account, e.g.long- and short-term
investment at home and abroad
- Official reserve transactions to settle BOP deficits
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The U.S. Balance of International Payments
Principal Credit and Debit Items
Recorded in a Nation’s Balance of Payments
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The U.S. Balance of International Payments
• U.S. international transactions are subdivided into categories –
the current account, the capital account, and residual items
(including a sizeable statistical discrepancy due to unreported
transactions) – that help us to understand how the BOP
bookkeeping system works.
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The U.S. Balance of International Payments
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The Current Account
• The most important components of the current account include:
-
The merchandise trade balance
The service balance
Net investment income
Compensation of employees (wages for domestic workers
employed overseas relative to wages for foreigners working in
the domestic economy)
- Unilateral transfers
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The Current Account
• A current account deficit generates net borrowing from abroad.
• In 2003, the U.S. balance on current account was a debit (–)
item balance, estimated at just over $530 billion – a record
number both in dollar terms and relative to the nation’s total
output of goods and services (the GDP).
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The Capital Account
• The capital accounts in a nation’s BOP are often divided into
two major subcategories:
- net private capital flows between private individuals and
institutions; and
- net official capital flows, involving governments, central banks,
and various government agencies.
• Capital investment activity abroad also may be divided into
short-term capital flows, direct investments, and portfolio
investments.
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The Capital Account
• In 2003, there was a net private capital inflow into the U.S.
from abroad of $295 billion.
• America’s net investment position went from positive to
negative about two decades ago and has continued to head
downward.
• This has enabled the U.S. to finance a substantial portion of its
merchandise trade deficit and has supported the creation of new
U.S. businesses and additional jobs.
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Official Transactions
• When a nation has a BOP deficit, it must settle up with other
nations by surrendering assets or claims to foreign accounts.
• Official capital flows usually consist of the movement of assets
that are readily transferable in order to make international
payments – e.g. transferring the ownership of gold, convertible
foreign currencies, deposits held in the IMF, SDRs.
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Disequilibrium in the Balance of Payments
• The U.S. has relied on foreign credit, foreign capital inflows,
and its stock of gold, foreign currencies, and other official
assets to settle its BOP deficits.
• However, the amount of these financial devices is limited.
• Relying on foreign capital inflows can be dangerous too.
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The Problem of Different Monetary Units
In International Trade and Finance
• Different monetary units are used as the standard of value in
different countries.
• When goods and services are sold or when capital flows across
national boundaries, currency exchange is often necessary.
• Currency exchange is risky. Speculative currency flows may
also complicate government policies aimed at curbing inflation
and ensuring economic growth.
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The Problem of Different Monetary Units
In International Trade and Finance
• The gold standard – During the 17th and 18th centuries, major
trading nations in Western Europe made their currencies freely
convertible into gold at predetermined prices.
• The gold exchange standard – Each currency was freely
convertible into gold at a fixed rate, and also free convertible
into other currencies at relatively stable prices.
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The Problem of Different Monetary Units
In International Trade and Finance
• The modified exchange standard (Bretton Woods System) –
Foreign currency prices were linked to the U.S. dollar and to
gold.
• The managed floating currency standard – Each nation chooses
its own exchange rate policy, consistent with the structure of its
economy and its goals. Examples of policies used include
pegging, managed float, and free floating.
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Determining Foreign Currency Values
In Today’s Markets
• The foreign exchange market is an over-the-counter market,
with no central trading location, no set hours of trading, and no
formal code of rules.
• There are three major sections:  the spot market,  the
forward market, and  the currency futures and options market.
• Foreign exchange rates are quoted as bid (buy) and ask (sell)
prices by dealers.
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Determining Foreign Currency Values
In Today’s Markets
Recent Foreign Exchange Rates:
The U.S. Dollar vs. Other Key Currencies
(Figures Are Currency Units per U.S. Dollar Except as Noted)
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Determining Foreign Currency Values
In Today’s Markets
How to Calculate Foreign Exchange Rates
Source: Based on a similar exhibit developed originally by the
Center of the Federal
Reserve
BankCompanies,
of Chicago.
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Determining Foreign Currency Values
In Today’s Markets
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Determining Foreign Currency Values
In Today’s Markets
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Determining Foreign Currency Values
In Today’s Markets
• Foreign exchange rates are affected by a number of factors,
including:
-
balance of payments positions
speculation over future currency values
domestic political and economic conditions
central bank interventions
• These factors may be expressed in terms of the market forces of
demand and supply.
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Determining Foreign Currency Values
In Today’s Markets
Price of $ in
terms of £
(£/$)
D2
Supply of $
(demand for £)
D
•
S
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•
Demand for $
(supply of £)
Quantity of $
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Determining Foreign Currency Values
In Today’s Markets
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The Forward Market for Currencies
• A forward contract is an agreement to deliver a specified
amount of foreign currency at a set price on some future date.
• There are several ways of measuring and quoting forward
exchange rates:
- outright rate, e.g. $1.14/€ for delivery in 6 months
- swap rate, e.g. 2¢ discount from spot ($1.16/€)
- annualized percentage rate, e.g. 3.45% discount
1.14  1.16 12
  100  3.45%
1.16
6
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Functions of the Forward Exchange Market
• The functions of forward contracts can be grouped into four
categories:
- commercial covering by exporters and importers of goods and
services
- hedging an investment position in a foreign currency
- speculation on future currency prices
- covered interest arbitrage
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Functions of the Forward Exchange Market
• A condition known as interest rate parity exists when the
interest rate differential between two nations is exactly equal to
the forward discount or premium on their two currencies.
• When parity exists, the currency markets are in equilibrium and
capital funds do not flow from one country to another.
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The Market for Foreign Currency
Futures
• Foreign currency futures are contracts calling for the future
delivery of a specific currency at a price agreed today, although
there is usually no intent to actually deliver the currencies.
• They are attractive to both foreign exchange hedgers and
foreign exchange speculators.
• Importers of goods typically use the buying hedge, while those
expecting foreign currency earnings usually use the selling
hedge.
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Other Innovative Methods for
Dealing with Currency Risk
• The recent volatility of foreign exchange rates has given rise to
an ever-widening circle of devices to deal with currency risk.
-
Currency options
Options on currency futures
Currency swaps
Local loans and dual-currency bonds
Prepayments, barter, or selective currency pricing
Risk-adjusted pricing
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Other Innovative Methods for
Dealing with Currency Risk
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Government Intervention
In the Foreign Exchange Markets
• A strong and stable currency encourages investment in the
home country, stimulating its economic development. The US$
is also a vehicle currency that facilitates trade and investment
between many nations.
• Hence, the United States, as well as foreign governments, have
intervened in the foreign exchange market to stabilize currency
values and insulate domestic economic conditions from
developments abroad.
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Markets on the Net
•
•
•
•
•
Chicago Mercantile Exchange at www.cme.com
European Central Bank at www.ecb.int
European Community Activities at www.ecuactivities.be/
FOREX News at www.forexnews.com
International Monetary Fund at www.imf.org
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Markets on the Net
• The Euro at www.euro.gov.uk/
• World Bank at www.worldbank.org
• World Trade Organization at www.wto.org
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Chapter Review
• Introduction to International Transactions and Currency Values
• The Balance of Payments (BOP) Accounts
-
The U.S. Balance of International Payments
The Current Account
The Capital Account
Official Transactions
Disequilibrium in the Balance of Payments
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Chapter Review
• The Problem of Different Monetary Units in International Trade
and Finance
-
The Gold Standard
The Gold Exchange Standard
The Modified Exchange Standard
The Managed Floating Currency Standard
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Chapter Review
• Determining Foreign Currency Values in Today’s Markets
-
Essential Features of the Foreign Exchange Market
Exchange Rate Quotations
Factors Affecting Foreign Exchange Rates
Supply and Demand for Foreign Exchange
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Chapter Review
• The Forward Market for Currencies
- Methods of Quoting Forward Exchange Rates
• Functions of the Forward Exchange Market
-
Commercial Covering
Hedging an Investment Position
Speculation on Future Currency Prices
Covered Interest Arbitrage
The Principle of Interest Rate Parity
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Chapter Review
• The Market for Foreign Currency Futures
• Other Innovative Methods for Dealing with Currency Risk
• Government Intervention in the Foreign Exchange Markets
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