1.3 ​Assets, Institutions, and Linkages.

​Which assets play the most critical role in

linking the major institutions that make up the global financial marketplace?

The debt securities issued by governments. These low risk or risk-free assets form the
foundation for the creation, trading, and pricing of other financial assets like bank loans,
corporate bonds, and equities (stock). In recent years, a number of additional securities
have been created from the existing securities—derivatives, whose value is based on
market value changes in the underlying securities. The health and security of the global
financial system relies on the quality of these assets.

1.13 ​Multinational Versus International.​What is the difference between an

international firm and a multinational firm?

A multinational firm goes beyond selling to or trading with firms in foreign countries
(international), by expanding its intellectual capital and acquiring a physical presence in
foreign countries. This allows the firm to expand and deepen its core competitiveness
and global reach to more markets, customers, suppliers and partners.

2.5 ​Fixed Versus Flexible.​What are the advantages and disadvantages of fixed
exchange rates?

Fixed rates provide stability in international prices for the conduct of trade. Stable prices
aid in the growth of international trade and lessen risks for all businesses.

Fixed exchange rates are inherently anti-inflationary, requiring the country to follow
restrictive monetary and fiscal policies. This restrictiveness, however, can often be a
burden to a country wishing to pursue policies that alleviate continuing internal
economic problems, such as high unemployment or slow economic growth.

Fixed exchange rate regimes necessitate that central banks maintain large quantities of
international reserves (hard currencies and gold) for use in the occasional defense of
the fixed rate. As international currency markets have grown rapidly in size and volume,
increasing reserve holdings has become a significant burden to many nations.

Fixed rates, once in play, may be maintained at rates that are inconsistent with
economic fundamentals. As the structure of a nation’s economy changes, and as its
trade relationships and balances evolve, the exchange rate itself should change.
Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates
must be changed administratively - usually too late, too highly publicized and too large a
one-time cost to the nation’s economic health.

2.7 ​Crawling Peg.​How does a crawling peg fundamentally differ from a pegged
exchange rate?
In a ​crawling peg​system, the government will make occasional small adjustments in its
fixed rate of change in response to changes in a variety of quantitative indications, such
as inflation rates of economic growth. In a truly ​pegged exchange rate regime​, no such
changes or adjustments are made to the official fixed rate of exchange.

2.11 ​Currency Board or Dollarization.​Fixed exchange rate regimes are sometimes

implemented through a currency board (Hong Kong) or dollarization (Ecuador). What is
the difference between the two approaches?

In a currency board arrangement, the country issues its own currency but that currency
is backed 100% by foreign exchange holdings of a hard foreign currency - usually the
US dollar. In dollarization, the country abolishes its own currency and uses a foreign
currency, such as the US dollar, for all domestic transactions.

3.12 ​The Financial Account.​What are the primary sub-components of the financial
account? Analytically, what would cause net deficits or surpluses in these individual
components?

The main components and possible examples are as follows:

​Direct Investment
​Debit: Ford Motor Company builds factory in Australia

Credit: Ford Motor Company sells its factory in Britain to British investors

​Portfolio Investment
Debit: An American buys shares of stock of a European food chain on the
Frankfurt Stock Exchange

Credit: the government of Korea buys US treasury bills to hold as part of

its foreign exchange reserves

​Net Financial Derivatives

​Debit: A US firm purchases a financial derivative like a currency swap in
London

Credit: A US firm sells a financial derivatives like a forward contract on

the dollar versus the pound to a London buyer

Other Investment
​ ebit: A US firm deposits $1 million in a bank balance in London
D

Credit: A US Firm generates an account receivable for exports to Canada

3.13​Classifying Transactions.​Classify each of the following as a transaction reported
in a sub-component of the current account or of the capital and financial accounts of the
two countries involved:

1. A U.S. food chain imports wine from Chile.

​i.​ ​Current account: goods- debit United States, and

credit Chile
2. A U.S. resident purchases a euro-denominated bond from a German company.
​i.​ ​Financial account: portfolio investment- debit

United States, and credit Germany.

3. Singaporean parents pay for their daughter to study at a U.S. university.
​i.​ ​Current account: services- debit Singapore, and

credit United States.

4. A U.S. university gives a tuition grant to a foreign student from Singapore.
​i.​ ​Current account: transfer- debit United States,

credit Singapore
5. A British Company imports Spanish oranges, paying with euro dollars on deposit
in London.
​i.​ ​Current account: goods- debit Great Britain, and

credit Spain.
6. The Spanish orchard deposits half its proceeds in a euro dollar account in
London.
​i.​ ​Current account: income- debit Great Britain, and

credit Spain.
7. A London-based insurance company buys U.S. corporate bonds for its
investment portfolio.
​i.​ ​Financial account: portfolio investment- debit

Great Britain, and credit United States.

8. An American multinational enterprise buys insurance from a London insurance
broker.
​i.​ ​Current account: service- debit United States,

and credit Great Britain.

9. A London insurance firm pays for losses incurred in the United States because of
an international terrorist attack.
​i.​ ​Current account: service- debit to Great Britain

and credit to United States.

10. Cathay Pacific Airlines buys jet fuel at Los Angeles International Airport so it can
fly the return segment of a flight back to Hong Kong.
​i.​ ​Current account: goods- debit Hong Kong, and

credit United States.

11. A California-based mutual fund buys shares of stock on the Tokyo and London
stock exchanges.
​i.​ ​A debit to the portfolio investment section of the

U.S. financial account; a credit to the portfolio

 investment section of the Japanese and British
financial accounts.
12. The U.S. army buys food for its troops in South Asia from local vendors.
​i.​ ​Current account: goods- debit United States, and

credit South Asia.

13. A Yale graduate gets a job with the International Committee of the Red Cross in
Bosnia and is paid in Swiss francs.
14. The Russian government hires a Norwegian salvage firm to raise a sunken
submarine.
​i.​ ​A debit to the service part of Russia's current

account; a credit to the service part of the

Netherlands' current account
15. A Colombian drug cartel smuggles cocaine into the United States, receives a
suitcase of cash, and flies back to Colombia with that cash.
​i.​ ​This imbalance would end up in the errors and

omissions part of the U.S. balance of payments

16. The U.S. government pays the salary of a foreign service officer working in the
U.S. embassy in Beirut.
​i.​ ​This payment would not be recorded in any

balance of payments accounts.

17. A Norwegian shipping firm pays U.S. dollars to the Egyptian government for
passage of a ship through the Suez Canal.
​i.​ ​No entry would appear in the U.S. balance of

payments. Norway would debit a purchase of

services, and Egypt would credit a sale of
services.
18. A German automobile firm pays the salary of its executive working for a
subsidiary in Detroit.
​i.​ ​Germany would record a debit in the income

payments/receipts in its current account; the

United States would record a credit in the
income payments/receipts in its current
account.
19. An American tourist pays for a hotel in Paris with his American Express card.
​i.​ ​A debit would be recorded in the services part of

the U.S. current account; a credit would be

recorded in the services part of the French
current account.
20. A French tourist from the provinces pays for a hotel in Paris with his American
Express card.
​i.​ ​In this instance, no entry would appear in either

country's balance of payments

21. A U.S. professor goes abroad for a year on a Fulbright grant.
 i.​ T
​ ​ he current transfers section of the host

country's current account would be credited.

3.18​BOP Transactions.​Identify the correct BOP account for each of the following
transactions:

1. A German-based pension fund buys U.S. government 30-year bonds for its
investment portfolio.
​i.​ ​Financial account: portfolio investment liabilities

2. Scandinavian Airlines System (SAS) buys jet fuel at Newark Airport for its flight to
Copenhagen.
​i.​ ​Current account: Goods: Exports FOB

3. Hong Kong students pay tuition to the University of California, Berkeley.

​i.​ ​Current account: Net Transfer: credit

4. The U.S. Air Force buys food in South Korea to supply its air crews.
​i.​ ​Current account: Goods: Imports

5. A Japanese auto company pays the salaries of its executives working for its U.S.
subsidiaries.
​i.​ ​Current account: Net Income: credit

6. A U.S. tourist pays for a restaurant meal in Bangkok.

​i.​ ​Current account: Services: debit

7. A Colombian citizen smuggles cocaine into the United States, receives cash, and
smuggles the dollars back into Colombia.
​i.​ ​Unrecorded but should be a current account

item.
8. A U.K. corporation purchases a euro-denominated bond from an Italian MNE.
​i.​ ​Does not enter the U.S. balance of payments.

5.5​Foreign Exchange Transaction.​Define each of the following types of foreign

exchange transactions:

1. Spot
a. A spot transaction is an agreement between two parties to exchange one
currency for another, with the transaction begin carried out at once for
commercial customers and on the second following business day for most
interbank (i.e. wholesale) trades.
2. Outright forward
a. A forward transaction is an agreement made today to exchange one
currency for another, with the date of the exchange being a specified time
 in the future - often one month, two months, or some other definitive
calendar interval. The rate at which the two currencies will be exchanged
is set today.
3. Forward-forward swaps
a. ​A more sophisticated swap transaction is called a “forwards forward”
swap. A dealer sells £20,000,000 forwards for dollars for delivery in, say,
two months at $1.6870/£ and simultaneously buys £20,000,000 forward
for delivery in three months at $1,6820/£. The difference between the
buying price and the selling price is equivalent to the interest rate
differential, i.e., interest rate parity, between the two currencies. Thus a
swap can be viewed as a technique for borrowing another currency on a
fully collateralized basis.

5.9 ​Foreign Exchange Rate Quotations.​Define and give an example of each of the
following:​ ​Bid rate quote and Ask rate quote

Interbank quotations are given as a bid and ask (also referred to as offer.) A bid is the
price (i.e., exchange rate) in one currency at which a dealer will buy another currency.
An ask is the price (i.e., exchange rate) at which a dealer will sell the other currency.
Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit
from the spread between the buying and selling prices.

5.10 ​Reciprocals.​ Convert the following indirect quotes to direct quotes and direct
quotes to indirect quotes:
a.​ ​Euro: €1.22/$ (indirect quote)
a.​ ​1/1.22 = $0.8197/€ (direct)
b.​ ​Russia: Rbl30/$ (indirect quote)
a.​ ​1/30 = $0.0333/Rub (direct)
c.​ ​Canada: $0.72/C$ (direct quote)
a.​ ​1/0.72 = C$1.3889/$ (indirect)
d.​ ​Denmark: $0.1644/DKr (direct quote)
a.​ ​1/0.1644 = Dkr 6.0827/$ (indirect)

7.4​ ​Futures and Forwards.​ How do foreign currency futures and foreign currency
forwards compare?

- individuals find futures contracts useful for speculation because they usually do not
have access to forward contracts.
- For businesses, futures contracts are often considered inefficient and burdensome
because the futures position is marked to market on a daily basis over the life of the
contract.

7.6​ ​Options Versus Futures.​ Explain the difference between foreign currency options
and futures and when either might be most appropriately used.

Option
- buyer right but not the obligation to buy or sell a given amount of foreign exchange at a
fixed price for a specified time period.
(choice of exercising or not)

Future
- standardized exchange-traded contract calling for future delivery of a standard amount
of foreign currency at a fixed time, place, and price.
(mandatory delivery)

7.7​ ​Call Option Contract.​ Suppose that exchange-traded American call options on
pounds sterling with a strike price of 1.460 and a maturity of next March are now quoted
at 3.67. What does this mean to a potential buyer?

- If you buy such an option, you may, if you wish, order the writer (opposite party) of the
option to deliver pounds sterling to you, and you will pay $1.460 for each pound.
$1.460/£ is called the "strike price." You have this right (this "option") until next March,
and for this right you will pay 3.67¢ per pound.

- The information provided to you does not tell you the size of each option contract,
which you would have to know from general experience or from asking your broker. The
contract size for pounds sterling on the IMM is £62,500 per contract, meaning that the
option will cost you £62,500 × $0.0367 = $2,293.75.

7.10​ ​Writing Options.​ Why would anyone write an option, knowing that the gain from
receiving the option premium is fixed but the loss, if the underlying price goes in the
wrong direction, can be extremely large?

The option is not exercised. In this case, the writer gains the option premium and still
has the underlying stock.

The option is exercised. If the option writer owns the stock and the option is exercised,
the option writer (1) gains the premium and (2) experiences only an opportunity cost
loss.

8.5​ ​Credit Spreads.​ What is a credit spread? What credit rating changes have the most
profound impact on the credit spread paid by corporate borrowers?
The costs of credit quality credit spreads are quite minor for borrowers of investment
grade. Speculative grade borrowers, however, are charged a hefty premium in the
market. It reflects the difference in yield between a treasury bond and another debt
security of the same maturity but different credit quality. Cost of debt can change due to
the credit quality or the maturity.

8.8​ ​Floating Rate Loan Risk.​ Why do borrowers of lower credit quality often find their
access limited to floating-rate loans?

As opposed to fixed rate loans, where the lender accepts both the risk of changing
interest rates and changing credit quality of the borrower on loan origination, a
floating-rate loan shifts interest rate risk to the borrower. Lenders are not generally
willing to accept both risks when lending to lower credit quality borrowers.

8.17​ ​Cross-Currency Swaps.​ Why would one company with interest payments due in
pounds sterling want to swap those payments for interest payments due in U.S. dollars?

It might be that the company in its continuing business received regular cash inflows in
U.S. dollars and would prefer to match the currency inflows with a same-currency cash
outflow. Swapping pounds sterling interest payments for dollar interest payments would
fulfill that objective.