166

$100 $1100 100 1100 100 1100

PCB =     
(1  0.08)1 (1  0.08) 2 1.08 1.08 2
1.00 1.1664

108  1100 1200

=  = 1035.66
1.1664 1.1664
PCB = 1.035.66. The coupon bond price is greater than the face value because the coupon rate
is greater than the market interest. The coupon rate is 10% (10% of 1000 = 100)
Assume that the market interest raised to 10%. What will be the coupon bond price?
100 1100
PCB = 
1  0.10 (1  0.10) 2

100 1100
= 1  10 
(1  1.1) 2

100 1100
= 
1.1 1.21
110  1100
=
1.21
1210
=
1.21
= 1000.00
As the market interest rate raises from 8% to 10% the price of the coupon bond fall from Br.
1,035-66 to Br. 1,000.00.
* Because the market rate and the coupon rate and the price & face value will be equal.

6.7 VALUING STOCKS AND OTHER ASSETS

Unlike debt instruments, equity instruments represent the ownership of a share of a firm like a
common stock. When is a stock a good buy? To answer this question, we must determine the
value of a share of stock. When a bank or other company has earnings, it can either (1) return
them to shareholders in the form of dividends, or (2) retain them within the firm. Dividends
represent a direct payment to shareholders.
The value of a firm at any point in time is the present value of all of the firm’s future earnings:

EE1 EE 2 EET
Value of a firm =   q. (8.1)
(1  i ) (1  i ) 2
(1  i ) T

where

167
 EET = represents the firm’s expected earnings at the end of year t
i = the interest rate
T = the number of years over which the firm will operate.
Stock valuation is more difficult than valuing Treasury bond.
Because
1. If you purchase a treasury bond you purchase a stream of known future payments. When
you purchase a stock, you purchase a share of the company’s future earnings, which are
far from known.
2. The maturity of a bond is known. The life of a firm T, is not known; the firm may live on
forever, or it may go bankrupt in one year. Therefore, the future earning of the firm is
forecasted

The value of the firm

Price of a share of stock = The N o of shares of stock issued by the Company

or

Value of the firm

Stock price =
Number of shares

The higher the interest rate, the lower the value of the firm. The lower the value of the firm, the
lower stock price. Holding everything else constant, the higher the interest rate, the lower the
price of a given firm’s stock.
There are two types of stocks: Income stocks and growth stock
Income stocks:
stocks: - are the stocks of companies that have a low level of retained earnings and thus
pay most of their earnings to shareholders. Purchase price equals a future
stream of a dividend payments.
Growth stocks: - are the stocks of companies that retain most of their earnings to reinvest them
within the firm. The purchaser of such stock essentially purchases a company
that acquires more and more assets today to pay higher dividends in the future.

Valuation of Income Stocks

168
They have a low level of retained earnings and high-level dividends. The dividend yield on a
stock is simply the ratio of the annual dividends per share to the stock price.

Annual dividends per share (d)

Dividend yield =
Ps

Where = Ps = the price of a share of the stock

Illustration
Assume that Ps = Br. 10 per share
d = 60 cents per share
0.6
Dividend yield = = 6%
10

The Annual dividends per share = d where PIS = Price of income stocks
PIS =
Interest rate i

Illustration
Expected earning = Br. 1 million each year
No of shares issued = 500,000
1,000,000.00
Dividend = 500,000
= Br. 2.00 per share

Market interest rate = 5%

d 2
PIS = = = Br. 40.00
i 0.05

Valuation of Growth Stocks

They have a highest level of retained earnings and a low (none) level of dividends.
Valuing a growth stock can be difficult in practice because the firms future earnings are far from
certain. However, some simplified assumptions make it possible to price the growth stock.

Suppose a firm’s earnings last year were EE, as investors expected. These earnings are expected
to grow at a rate of g each year from now on. Thus,
- At the end of this year, expected earnings are EE1 = (1+g)EE

169
 - At the end of the next year expected earnings are EE2 = (1+g)2EE
- At the end of the three years expected earnings are EE3 = (1+g)3EE, and so on.
: - the present value of the growth firm in this case is given by

EE1 EE 2 EE3 EEt

   t 1

Value of growth firm =  
(1  i ) (1  i ) 2
(1  i ) 3
(1  i ) t

EEt = (1+9)tEE

t
1  g 
: - Value of growth firm = EEX t 1 


 1 i 

If g > i the value of growth firm is infinite reflecting the fact that the firm is infinitely valuable.
This is unlikely since a firm cannot continue to grow forever at a rate that exceeds the market
rate of interest.

When g < i,
1 G 
Value of growth firm = EE x  
i G 

EE 1  g 
PGS = 
N  i  g 

If N-shares number of stock are outstanding, the price of a share of the firm’s stock will be the
fraction 1/N of the value of the firm.
Where: EE is expected earnings last year
g = the expected annual growth in those earnings
i = the interest rate
N = the number of shares of stock outstanding.

Illustration = The firm’s expected earning = $ 1 million

The expected growth rate = 3% annually
Number of shares outstanding = 500,000
Interest rate = 7%

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 Price of a share of this firm’s stock will be
* If interest rate fall to 5%
EE 1  g  EE 1  g 
PGS =   PGS =  
N i  g  N i  g 

1,000,000  1  0.03  1,000,000  1.03 

= =
500,000  0.07  0.03  500,000  0.02 

 1.03   1.03 
= 2 = 2
 0.04   0.02 
= 2[25.75] = 2[51.5]
= 51.50 = 103

: - The price of a growth stock increases as the interest rate declines; an inverse relationship
exists between interest rate and the price of a share of growth stock.
Similarly, the greater the growth rate in earnings, the higher the price of a growth stock.

Interest rates and stock prices

Interest S1 Interest
Rate (%) Rate (%)
Inverse relation between
interest rate and stock
prices
1
7
7
2
5
5
D1
D2
Stock price
Loanable Funds

Check Your Progress

1. Discuss the difference between the nominal and real interest rates.
…………………………………………………………………………………………………
…………………………………………………………………………………………………

171
 2. Assume X Company promised to pay 10% interest rate on his instrument issued on the
market. Based on this information calculate the following.
a) The real interest rates if inflation rate is 3%
b) The real interest rate, if income tax is 10%
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. You have invested Br. 10, 000.00 in Y Company at an interest rate of 10%.
a) What will be its future value in three years time?

…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. Z Company promised you to pay Br. 20,000.00 in four years time. The market rate of
interest is 5% what is the present value?
…………………………………………………………………………………………………
…………………………………………………………………………………………………

6.8 SUMMARY

The most important factors that explain interest rates on different securities are (1) Term to
maturity, (2) risk of default, (3) tax treatment of bond income, (4) marketability and (5) special
features such as call, put and conversion options.

Most investors are concerned with after-tax yields on securities and the inflation rate involved.
Thus, investors require higher before-tax yields on securities whose income is taxed at higher
rates.

6.9 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 6.2.1

2. Refer section 6.2.1 (a)

172
 Refer section 6.2.2 (b)
3. Refer section 6.3.1
4. Refer section 6.3.2

6.10 KEY TERMS

Real interest rate Ex ante real interest

Nominal interest rate ex post real interest rate
Future value anticipated inflation
Present value the discount yield
Present value the yield at maturity

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UNIT 7: MONETARY POLICY

Contents
7.0 Aims and Objectives
7.1 Introduction
7.2 Meaning and Content of Monetary Policy
7.3 Objectives of Monetary Policy
7.3.1 Full Employment
7.3.2 Price Stability
7.3.3 Economic Growth
7.3.4 Equilibrium Balance of Payments
7.3.5 Interest Rate Stability
7.3.6 Stability of Financial Markets
7.4 Instruments of Monetary Policy
7.4.1 Quantitative Instruments
7.4.2 Qualitative Instruments
7.5 Summary
7.6 Answers to Check Your Progress
7.7 Key terms

7.0 AIMS AND OBJECTIVES

At the end of this unit, you are expected to:

 understand the meaning of a monetary policy
 identify the nature of a monetary policy
 understand the objectives of a monetary policy
 understand how the monetary policy achieve its objectives.

7.1 INTRODUCTION

In the monetary economy the medium of exchange is money. Hence, the value of money in any
economy determines the value of other items available for exchange. The value of money is also
determined by the quantity of money demanded and supplied. By controlling its demand and

174
supply, it is possible to control the value of money and there by the value of other transactions.
This is discussed in this unit.

7.2 MEANING AND CONTENT OF MONETARY POLICY

Monetary policy is usually defined as the central bank’s policy pertaining to the control of the
availability, cost and use of money and credit with the help of monetary measures in order to
achieve specific goals.

Monetary policy is basically concerned with the monetary system of the country. It deals with
monetary decisions and measures and such non-monetary decisions and measures as have
monetary effects. Monetary management is the main issue of monetary policy.

A monetary policy is regarded as Passive when the central bank decides to abstain deliberately
from applying monetary measures, and Active when it seeks to achieve certain ends through the
enforcement of positive monetary measures.

Monetary policy is only a means to an end and not an end in itself. Monetary and credit policies
operate on the following inter-related factors.
- availability of credit and its flow
- volume of money
- cost of borrowing, that is, the rate of interest; and
- general liquidity of the economy
There are two facets of monetary policy in a developing economy – positive and negative. In its
positive aspect, it sets out the promotional role of central banking in improving the savings ratio
and expanding credit for facilitating capital formation.

In its negative approach, it implies a regulatory phase of restricting credit expansion and its
allocation according to the absorbing capacity of the economy.

7.3 OBJECTIVES OF MONETARY POLICY

The following are the principal objectives of a monetary policy

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7.3.1 Full Employment

The meaning of full employment is confusing and vague. Hence, it is defined differently by
different economists. However, full employment does not mean literally no unemployment i.e., it
does not mean that every person in the community who is fit and free to work is employed
productively until he can work.

Keynes: - “Full employment means the absence of involuntary unemployment.” It is a situation

in which aggregate employment is inelastic in response to an increase in the
effective demand for its output.” Since the supply of output becomes inelastic at the
full employment level, any further increase in effective demand will lead to inflation
in the economy.
Lord Beveridge: - Full employment is a situation where there were more vacant jobs than
unemployed men so that the normal lag between losing one job and finding
another will be very short. However, full employment is not always full, i.e.
unemployment is not zero. There is always a certain amount of frictional
unemployment in the economy even when there is full employment.

American Economic Association Committee

“Full employment is a situation where all qualified persons who want jobs at current
wage rate find full time jobs.” It does not mean unemployment is zero.

UN experts on national and international measures for full employment

“Full employment may be considered as a situation in which employment cannot be
increased by an increase in effective demand and unemployment does not exceed the
minimum allowances that must be made for the effects of frictional and seasonal factors”.
The frictional and seasonal allowable level of unemployment was agreed to be 3%.
* Full employment can be achieved in an economy that follows an expansionary monetary
policy.

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7.3.2 Price Stability

Fluctuation in prices bring uncertainty and instability in the economy. Rising and falling prices
are both bad because they bring unnecessary loss to some and undue advantage to others. They
are associated with business cycles. So a policy of price stability keeps the value of money
stable, eliminates cyclical fluctuation, brings economic stability, helps in reducing inequalities of
income and wealth, secures social justice and promotes economic welfare

There are certain difficulties in pursuing a policy of stable price level. They are:
1. A problem related to the type of price level to be established such as the relative or general
price level, the wholesale or retail, and the consumers goods or producers goods
2. Innovations may reduce the cost of production but a policy of stable prices may bring larger
profits to producers at the cost of consumers and wage earners.
3. In an open economy which imports raw materials and other intermediate products at high
prices, the cost of production of domestic goods will rise. But a policy of stable prices will
reduce profits.
Price stability, however, does not mean unchanged and rigid price. Therefore, the price level
should be changed together with the changes that affect the cost of production.

Price stability can be maintained by following a counter-cyclical monetary policy, that is easy
monetary policy during recession and dear monetary policy during boom.

7.3.3 Economic Growth

It is defined as “the process whereby the real per capita income of a country increases over a
long period of time”

It is measured by the increase in the amount of goods and services produced in a country. In its
wider aspect, economic growth implies raising the standard of living of the people, and reducing
inequalities of income distribution.

Innovation tends to increase productive technologies of both capital and labor over time. But
there is very likelihood that an economy might not grow despite technological innovations due to
lack of demand which absorve products produced and lack of improvement in the quality of
labor in keeping with the new technologies.

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Growth has its own costs such as: it is limited because resources are scarce in every economy, all
factors have opportunity costs, new technologies replace the old machines which makes them
useless, workers are displaced, leades to urbanization and industrialization with their adverse
effects on the pattern of living and environment, people have to live in squalor and slums, the
environment becomes polluted and social tensions develop

It is difficult to say to what extent monetary policy can lead to the growth of the economy. The
monetary authority may influence growth by controlling the real interest rate through its effect
on the level of investment.

By an easy credit policy and lower interest rates, the level of investment can be raised which
promotes economic growth. Monetary policy helps in controlling hyperinflation, since rapid and
variable rates of inflation discourage investment and adversely affect growth.

So monetary policy should be such that encourages investment and at the same time controls
hyperinflation so as to promote growth and control economic fluctuations.

7.3.4 Balance of payments

Another objective of the monetary policy is to maintain equilibrium in the balance of payments.
It is related with the growth of trade in the world against the growth of international liquidity and
to avoid deficit balance of payments. Because a deficit balance of payment will lead to retard in
the attainment of other objectives and a sizeable outflow of gold.

What is the balance of payments target of a country? The balance of payments target of a country
is to achieve equilibrium between imports and exports or inflows and outflows of funds in to and
from a country. A country whose current reserves of foreign exchange are inadequate will have a
mild export surplus as its balance of payments target.
 When foreign exchange is inadequate  export surplus is necessary
 when there is satisfactory foreign exchange  export = Import
i.e., Accumulating foreign exchange leads to producing more than consuming and hence the
living standard of the people will be low.

178
How can monetary policy achieve it?
A balance of payments deficit is defined as equal to the excess of money supply through
domestic credit creation over extra money demand based on increased demand for cash balances.
Thus it means excessive money supply in the economy. As a result, people exchange their excess
money holdings for foreign goods and securities.

When there is excess supply of domestic currency, the central bank will have to sell foreign
exchange reserves and buy the domestic currency – under fixed exchange ate.
When there is low supply of domestic currency, the central bank will buy excess foreign
currency in exchange for domestic currency.

7.3.5 Interest Rate Stability

Another objective of monetary policy is attaining an interest rate stability. As the quantity of
money/supply of money increases the interest rate falls and vice versa.

Hence, the monetary authority tries to influence the interest rate by changing the supply of
money. As interest rate increase the monetary authority increases the money supply, to push
down the interest rate and as interest rate fall, the monetary authority pullout money from
circulation and decrease the money supply, to pull up the interest rate.

7.3.6 Stability of Financial markets

The financial market is the arrangement that facilitates the circulation of the financial assets
among the financial institutions. The financial market is an element of the monetary system of a
country. The financial market to be stable, the value of the financial instrument must be stable
and the value of the financial assets depends on the amount of money supply.

As money supply increases, interest rates of financial assets decreases and as money supply
decreases, interest rates of financial assets increases. Therefore, as the supply of money
fluctuates the stability of the financial markets also disturbed. Hence, the monetary authority to
attain stability by counter acting to the interest rates /values/ of the financial assets.

179
7.4 INSTRUMENTS OF MONETARY POLICY

They are two types of monetary policy instruments: Quantitative, general or indirect and
Qualitative, selective or direct.

7.4.1 Quantitative Instruments

They are meant to regulate the overall level of credit in the economy through commercial banks.
The monetary policy uses different tools under the quantitative instruments. They are discussed
as follows:
a) Bank Rate Policy
It is the minimum-lending rate of the central bank at which it rediscounts first class bills of
exchange and government securities held by the commercial banks.

When inflationary pressure have started the bank rate rises. Then it becomes costy to
commercial banks to borrow from central bank which makes the loan amount less. In turn,
commercial banks raise the rate of interest to borrowers which makes borrowing from
commercial banks costy. Thus, prices checked form raising. When prices are depressed, the
bank rate will be lowerd to encourage borrowing and investment, employment, income.
b) Open market operations
It refers to sale and purchase of securities in the money market by the central bank
When price increases, the central bank sells securities. Thus, reserves of commercial banks
will be lower, loanable amount will be lower, investment will be discouraged, price will be
checked.
When price decline central bank buys securities  reserves of commercial banks will be
high, loanable amount will be high. Investment, output, employment, income and demand
rise, price fall will be checked.
c) Changes in reserve ratios
- A minimum required reserve by law to keep a certain percentage of the bankers total
deposits in the form of a reserve fund in its values and also a certain percentage with the
central bank.

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 When price increases, the reserve ratio also increases. This will lead to low loanable funds,
investment and employment. When price falls the reserve ratio will also fall. Thus reserve of
commercial banks are raised,  loanable amount increased.

7.4.2 Qualitative Instruments

Selective/Quantitative Credit Controls

The aim of selective credit controls is to channelise the flow of bank credit from speculative and
other undesirable purposes to socially desirable and economically useful uses. They also restrict
the demand for money by laying down certain conditions for borrowers. The main types of
selective credit controls used by the central banks in different countries are discussed as follows.

i. Regulation of margin requirements

ii. Regulation of consumer credit
iii. Rationing of credit
iv. Direct action
v. Moral suasion
vi. Publicity

Check Your Progress Exercise

1. What is a monetary policy?

………………………………………………………………………………………………
………………………………………………………………………………………………
2. Who is responsible for the issuance of a money in Ethiopia?
………………………………………………………………………………………………
………………………………………………………………………………………………
3. Discuss the different nature of a monetary policy.
………………………………………………………………………………………………
………………………………………………………………………………………………
4. What are the main objectives of a monetary policy?
………………………………………………………………………………………………
………………………………………………………………………………………………

181
 5. Define full employment. Is it possible, in real terms, to attain full employment?
………………………………………………………………………………………………
………………………………………………………………………………………………
6. What is price stability? Can it be achieved in a real economy?
………………………………………………………………………………………………
………………………………………………………………………………………………
7. What is/are the main objectives and tools of the quantitative methods used by a monetary
policy?
………………………………………………………………………………………………
………………………………………………………………………………………………
8. What is/are the main objectives and tools of the quantitative methods of the monetary
policy?
………………………………………………………………………………………………
………………………………………………………………………………………………

7.5 SUMMARY

The monetary authority of any country is responsible to achieve the stability of the momentary
policy. The monetary policy is used to determine the availability, cost and use of money and
credit in an economy. The monetary policy is pursued to achieve some objectives such as full
employment, price stability, economic growth. Equilibrium balance of payment, interest rate
stability, and stability of financial markets.

In order to achieve these objectives, the monetary policy is using different tools such as, bank
rate policy, open market operations, required reserve ratio, selective credit control, regulation of
marginal requirements, regulation of consumer credit, credit rationing, direct action moral
suasion and publicity.

7.6 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 7.2 4. Refer section 7.3 8. Refer section 7.4.2

2. Use your answer 5. Refer section 7.3.1
3. Refer section 7.2 6. Refer section 7.3.2

182
7.7 KEY TERMS

- active monetary policy

- passive monetary policy
- positive monetary policy
- negative monetary policy
- full employment
- balance of payments

183
UNIT 8: MONEY IN INTERNATIONAL PAYMENT

Contents
8.0 Aims and Objectives
8.1 Introduction
8.2 The Foreign Exchange Market
8.3 Structure of the Foreign Exchange markets
8.4 Transfer Process of Funds Internationally
8.5 Spot and Forward Transactions
8.6 Financing International Trade
8.7 Factors Influencing Exchange Rates
8.8 The Balance of Payments and Balance of Trades
8.8.1 The Balance of Payments
8.8.2 The Balance of Trades
8.9 Summary
8.10 Answers to Check Your Progress
8.11 Key Terms

8.0 AIMS AND OBJECTIVES

At the end of this unit, you are expected to:

 understand how prices of goods quoted at different currencies are compared and choices
of prices made
 understand the nature of international transaction, payments and potential problems
 define foreign exchange market and identify the factors affecting exchange rate
determination
 understand the meaning of balance of payment and its main components.

8.1 INTRODUCTION

In this unit, we focus on the major forces and institutional factors that influence foreign exchange
markets. First we will explain why business firms that do international business frequently enter

184
into exchange or credit transactions designed to reduce their currency risk. Next we will discuss
the structure and its components of the foreign exchange market, the methods of fund transfers
internationally, the methods of rate determination and factors influencing the exchange rate
determination. We will discuss the balance-of-payments, its accounts: current and capital
accounts used to measure and account for foreign currency flows.

We will explain how changes in foreign currencies flows can be expected to influence currency
values in the long run and in the short-run. We will also explain how commercial banks
frequently arrange international credit and business-financing transactions that reduce that risk
for business firms that engage in international trade.

8.2 THE FOREIGN EXCHANGE MARKET

Foreign exchange market is the market in which different currencies are bought and sold for one
another. In these markets, individuals, corporations, banks and governments interact with each
other to convert one currency into another for any number of purposes. Foreign exchange
markets exist and grow to provide the following three major services.

The first service is providing a mechanism for transferring purchasing power from individuals
who normally deal in one currency to other people who generally transact business using a
different monetary unit. Importing and exporting goods and services are facilitated by this
conversion service because the parties to the transactions can deal in terms of medium of
exchange instead of having to rely on bartering.

The second service is providing a means for passing the risk associated with changes in
exchange rates due to professional risk takers. This “hedging” function is particularly important
to corporations in the present era of floating exchange rates.

The third service is the provision of credit. The time span between shipment of goods by the
exporter and their receipt by the importer can be considerable. While the goods are in transit,
they must be financed. Foreign exchange markets are one device by which this financing and
related currency conversions can be accomplished efficiently and at low cost.

185
 Exhibit 8.1 Steps in a letter-of-credit transaction

The bank that provides the letter of credit legally substitutes its credit promise for that of the
importer and guaranties payment if the correct documents are submitted.

Italy Ethiopia
Italian Ethiopian
exporter importer

Step 1: Application
for letter of credit
Step 4: Letter of

documentation
Step 5: Live

credit and

Italian
negotiation Importer’s Step 7:
Step 6: draft and documentation Ethiopian banker’s
bank
bank acceptances

8.3 STRUCTURE OF THE FOREIGN EXCHANGE MARKETS

There is no single formal foreign exchange market used worldwide. In fact, the foreign exchange
market is an over-the-counter market that is similar to the one for money market instruments.
More specifically, the foreign exchange market is composed of a group of informal markets
closely interlocked through international branch banking and correspondent bank relationships.
The participants are linked by telephone, telegraph, and cable. The market has no fixed trading
hours and a foreign exchange trading can take place at any time everyday of the year. There are
no written rules governing operation of the foreign exchange markets; however, transactions are
conducted according to principles and a code of ethics that have evolved over time.

The extent to which a country’s currency is traded in the worldwide market depends, in some
measure, on local regulations that vary from country to country. Virtually every country has
some type of active foreign exchange market.

186
Major/principal participants in the foreign exchange markets are the large multinational
commercial banks, foreign exchange dealers, brokers, firms and central banks. These parties
operate in the foreign exchange market at two levels.

First at the retail level, they deal with individuals and corporations. Second, at the wholesale
level, banks operate in the inter bank market. Major banks usually transact directly with the
foreign institutions involved. However, many transactions are mediated by foreign exchange
brokers. These brokers preserve the anonymity of the parties until the transaction is concluded.

Commercial banks dealing in foreign exchange are the “market makers” in the market i.e., they
quote buying and selling rates of currency in relation to another currency and are prepared to buy
and sell it at those rates.

The brokers act as middleperson between two banks. They strike the deal and collect
commission, but do not buy or sell currencies themselves. They inform the banks about rates at
which firm buyers and sellers are prepared to buy and sell the specific currency.

Firms need foreign currency (exchange) for making payments of imports and interests on foreign
loans, to convert exports receipts and hedging of receivables and payables, etc. They do not deal
in foreign exchange like banks.

Central bank intervenes in the foreign exchange market from time to time to influence the
exchange rates when the country does not have a fully flexible exchange rate system.

8.4 TRANSFER PROCESS OF FUNDS INTERNATIONALLY

The international fund-transfer process is facilitated by inter bank clearing systems. The large
multinational banks of each country are linked through international correspondent relationships
as well as through their worldwide branching systems.

The method and financial instruments used to transfer funds varies with the purpose and time
frame of the transaction involved. Most international transfers of funds for business purposes are
handled by various types of orders to transfer deposits. The process is similar to domestic check
payments, although there is more variety in the form of international payments orders. Most
commonly, payments are made by telephone or cable, especially when speed is important or the

187
amounts are large. The Society for Worldwide International Financial Telecommunication
(SWIFT) and the Clearing House Inter bank Payments System (CHIPS) have added a new
dimension to the speed and efficiency with which the payment transfer and clearing process
works. These organizations were created by banks to transmit information and clear large
international payments, respectively. Ethiopian banks are also users of SWIFT, they bought a
fixed air time together and use it to transfer payments. They use it on shift bases.

Sight and time drafts are frequently used to make small and medium sized international
payments. Such drafts are negotiable instruments. In commercial banks, the trading in foreign
exchange is usually done by only a few persons. The pace of transactions is rapid, and traders
must be able to make on-the-spot judgments about whether to buy or sell a particular currency.
They have a dual responsibility in that on the one hand they must maintain the bank position
(inventory) to meet their customers’ needs, and on other hand they must not take large inventory
losses if the value of a currency falls. This is sometimes difficult, because currency values trend
to fluctuate rapidly and often widely-particularly since currencies are always subject to possible
devaluations by their governments.

8.5 SPOT AND FORWARD TRANSACTIONS

There are two basic types of foreign exchange quotations – spot and forward. The spot market
is the market in which foreign exchange is sold or purchased “on the spot. The rate at which a
currency is exchanged in this market is called the spot rate.
rate. Delivery of the currency in the spot
market must be made within two business days, but it is usually done immediately upon agreeing
to terms. Retail foreign exchange markets are mainly spot markets.

In the forward market,

market, the parties agree to exchange a fixed amount of one currency for a fixed
amount of a second currency, but actual delivery and exchange of the two currencies occurs at
some time “forward”. Typically, forward contracts are written for delivery of currency 30,60,90
or 180 days and sometimes even longer in the future, but it is possible to tailor the maturity of
the contract (as well as the amount of currency exchanged) to meet the special needs of the
parties involved. The exchange rate in this transaction implied by the fixed amounts of the two
currencies is called the forward rate.
rate. Note that the forward rate is established at the date on
which the agreement is make, but it defines the exchange rate to be used in the transaction in live

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of the spot rate prevailing at the time in the future when the two currencies are exchanged. This
characteristics is extremely important for facilitating international business transactions, because
it permits the two parties to the agreement to eliminate all uncertainties about the amounts of
currency to be delivered or received in the future.

As an example of the way in which foreign exchange markets are used by business, suppose that
an Ethiopian exporter sells coffee to an American firm for USD 100,000.00 to be paid in 90
days. If at the time of the transaction the spot rate is $1 = Br. 8.60, the delivery of coffee is worth
Br. 860,000.00. However, the actual number of Birr to be received for the coffee, which is the
relevant price to the Ethiopian exporter, is not really certain. That is, if the Ethiopian exporter
waits 90 day to collect the $100,000.00 and then sells it in the spot market for Birr, there is a risk
that the birr price of the dollar may have declined more than the market expected.

For instance, if dollar is worth only Br. 8.50, the Ethiopian exporter will receive only Br.
850,000.00. If the market did not expect dollar to fall that much, a loss in an amount up to Br.
10,000.00 would be realized because of the change in the exchange rate. To eliminate this risk
and ensure a certain future price, the Ethiopian exporter can hedge by selling the $100,000.00
forward 90 days. If the forward rate at the time of sale is $1 = Br. 8.58, the American exporter
will deliver the $100,000.00 to the banks in 90 days and receive Br. 858,000.00 in return. In this
case, since the spot rate on the day the exchange is made is $1 = Br. 8.60, the “savings” from
hedging is Br. 8,000.00 (a Br. 10,000.00 “loss” without hedging minus a Br. 2,000.00 “loss” with
hedging)

What about the Br. 2,000.00 loss incurred even with hedging? Can this be prevented? The
answer is that forward contracts cannot protect against expected changes in exchange rates, only
against unexpected changes. In the original pricing decision by the Ethiopian exporter, the
correct “price” would have to be defined in dollars. When converting this price to dollar. If the
account is to be paid for 90 days, then the 90 days forward rate should be used for the
computation instead of today’s spot rate. In this manner, the correct birr price is received via the
forward contract. Thus, in this example, a true loss of Br. 8,000.00 is realized if the transaction is
not hedged, and no unexpected loss occurs if the account is hedged. What would happen if the
spot rate in 90 days rise to Br. 8.70? The unhedged transaction would yield Br. 12,000.00 over
the expected return of Br. 858,000.00, a welcome happening, but the forward contract would

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again provide exactly the number of Brir anticipated. Although there may be regrets after the fact
because the forward contract prevented the company from receiving the benefits of the
strengthening dollar, most businesses would call leaving the account receivable exposed (that is
unhedged) “speculation”. Such loses can be protected by using a foreign currency options.

If the Ethiopian exporter were to buy a put option on the $100,000.00 maturing in 90 days at a
striking price of Br. 8.60, the firm would be protected against deterioration of the pound below
that price. If the spot rate in 90 days is Br. 8.50, the exporter can exercise the put and receive Br.
860,000. On the other hand, if the rate goes up to Br. 8.90, the Ethiopian exporter can let the put
expire and sell the dollar at the spot rate. The cost of this asymmetrical protection is the price of
the option – which would be substantial. Nonetheless, if the exporter prefers an option, his or her
commercial banker will usually sell the exporter one that suits the exporter’s needs. Commercial
banks earn fee income by selling options as well as from arranging forward currency
transactions.

8.6 FINANCING INTERNATIONAL TRADE

One of the most important services provided by the international banks is the financing of
imports and exports among countries. International transactions are far more complicated than
equivalent domestic financing because of the additional sources of risk that are involved. Three
problems in particular must be overcome before trade deals can be executed.

First, exporters often lack accurate information about the importer’s current and past business
practices and hence about the likelihood of payment. Importers are similarly concerned about the
ability or inclination of the exporter to fulfill all contractual obligations once payment has been
made.

Second, before the party bearing the exchange rate risk between the times the agreement is made
and payment must be delivered can hedge the risk with a forward contract (or an option
contract), the exact amounts and dates of payments must be known.

Finally, usually before a bank is willing to finance an international transaction, a means has to be
found to insulate the bank from non-financial aspects of the transaction that could lead to
disputes and to protracted legal proceedings, which delay recovery of its money.

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A number of specialized financial instruments have been developed to overcome these three
problems, there by minimizing the risk for institutions engaging in international transactions. In
particular, three types of trade documents, each with well-defined legal characteristics and each
serving a specific function, have evolved over time and serve to facilitate international
commerce. The three documents are the letter of credit, the draft and the bill of leading.

A letter of credit, LOC or L/C is a financial instrument issued by an importer’s bank that
obligates the bank to pay the exporter (or other designated beneficiary) a specified amount of
money once certain conditions are fulfilled. A draft is an instrument used as a request for
payment that is drawn up by the exporter (or by the exporter’s bank) and sent to the bank that
drew up the letter of credit for the importer. Drafts can be two types: sight drafts or time drafts.
Sight drafts, as the name implies, require the bank to pay on demand, assuming that all
documentation is in proper order and that all conditions have been met. Time drafts, however,
are payable at a particular time in the future, as pacified in the letter of credit.

Bill of leading is a receipt issued to the exporter by a common carrier that acknowledges
possession of the goods described on the face of the bill. It serves as a contract between the
exporter and the shipping company. Commercial banks, with their multinational network of
foreign branches and their international correspondent relationships, are prominent actors in this
financing process, and it is the use of these three documents for most transactions that makes the
process work smoothly.

But how does these banks effect payments using these instruments in the international
transaction of having different currencies? And how companies compare prices of items quoted
with different currencies? Assume that an Ethiopian importer is looking for a machine to buy.
But it is not available in the domestic market and forced to buy from a foreign market. Two
suppliers, one from America and the other form England were found ready to supply the same
machine.

Three main problems are associated with trade with foreigners. The first problem is the type of
currency used to pay i.e., is it going to be birr or dollar to the American exporter and, pound
sterling to the England exporter. The second difficulty is that no single country or super national

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organization has total authority over all aspects of the transactions. The third difficulty is
associated with financing purchases of goods and services from foreign sources.

The first problem-comparing suppliers who price their goods in currency units other than the
Ethiopian birr can be solved through the appropriate exchange rate quoted in the foreign
exchange market. All exchange rate is simply the price of one monetary unit, such as the
Ethiopian birr, stated in terms of another currency unit, such as the U.S. dollar.

Take the preceding example that an Ethiopian firm want to buy a machine. He found its price in
the domestic market for Br. 10,000.00, and U.S.D 1150.00 from the American supplier and
£950.00 from the England supplier. Which supplier should be chosen? In order to evaluate which
should be chosen, the exchange rate of currencies must be considered.

If the exchange rate between birr and dollar is Br. 8.5/dollar, the cost of the American supplier
will be ($1150.00) x (Br. 8.5/dollar) = Br.9.775.00. At this birr price, the Ethiopian firm will
prefer to buy the machine from the American supplier, if the cost includes all associated cost
(transportation, insurance, etc). If the exchange rate between birr and pound is Br. 12/pound, the
England machine will cost (£
(£950.00) x (Br. 12/pound) = Br. 11,400.00. Assuming that the cost
price quotation of £950.00 includes all other costs, it will be costy to an Ethiopian importer.
Hence, the Ethiopian firm will buy from the American supplier than the domestic or the England
supplier. Today exchange rates are free to move up and down in response to changes in the
underlying economic environment. If for some reason the exchange rate between the birr and the
pound falls from Br. 12 to Br. 10, the machine could be bought from the England supplier as its
cost will be £950 x 10/pound = Br. 9,500.00. Because it now takes fewer birrs to buy one British
pound or conversely, more pounds are needed to purchase one birr, it is correct to say that the
value of the pound has fallen against the birr or that the value of the birr has risen against the
pound. Hence, the purchase decision in the international market will depend up on the up ward or
downward movements of exchange rates.

The exchange rate also moves up ward or downward depending on the demand for the currency
of one country in the international market. Assume that, the foreign demand for a country’s
goods and services increases, the demand for its currency will also increase (assuming that the
goods are priced in the local currency) as more people seek to obtain it in order to pay for their

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purchases. In our example above, as the birr price of pound falls from Br. 12 to Br. 10, the lower
the birr price of British goods. The lower the price of British goods (and for pounds to pay for
them).

From the point of view of a British importer, though, the lower the price of pounds, the more
pounds must be given up in order to obtain birrs (or other foreign currencies) to buy foreign
goods. Thus the more likely residents of Britain are to switch from imported to domestic
products. When purchases diverted in this way to domestic goods, the demand by British
residents for foreign currencies to buy imported products is reduced. This also means that they
will supply fewer pounds to the foreign exchange markets because they no longer want to buy as
many imports. As the supply of pound decreases, the price of a pound will increase.

Exhibit 8.2 The Equilibrium Exchange Rate

Br. price

Supply of £ in
of £

exchange for other

currencies

Equilibrium Demand for £ in

exchange rate exchange for other
(Br. for £) currencies

Qo Quantity of £

The equilibrium exchange rate for a currency is the point of intersection of the supply and
demand curves for the country’s currency. At the rate of exchange (price), participants in the
foreign exchange market will neither be accumulating nor divesting a currency they do not wish
to hold.

8.7 FACTORS INFLUENCING EXCHANGE RATES

We have seen that exchange rate are determined by the interaction of market forces that give rise
to a supply of and a demand for a currency. Supplies and demands for currencies, though,
depend on the underlying demand for and supply of goods and services and the underlying

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supply and demand for funds used to make short-term or long-term capital investments in
various countries. Specifically, the following factors will influence exchange rates.
1. Trade flows of goods and services
Anything that affects the demand for a country’s exports or imports has the potential to alter
the price of its currency in the foreign exchange market. The demand and supply of goods
and services in the international market is affected by factors such as: the relative costs of the
factors of production, the relative factor endowment among nations, consumer testes in the
various nations, the ability of a country to satisfy its own needs domestically, the existence
and nature of trade barriers and the rate at which national income is growing.
2. Financial factors and capital flows
Different interest and inflation rates motivate international capital flows.
i. Interest rate. An increase in the expected real rate of return on investments, not nominal
rate of return, in a country can attract investment capital from abroad and generate a
substantial increase in a currency’s exchange value.
ii. Inflation rate. Inflation causes prices to rise in a given country. During inflation, the
prices of domestic goods and services increase and the domestic buyers are likely to
switch from domestic goods to imported foreign goods. Similarly foreigners are likely to
switch from that country’s products to those countries other than that country. Thus the
demand for domestic country goods will tend to fall at the same time the demand for
domestic currency will also fall. Hence, that country is forced to supply more of the
domestic currency so as to buy from a foreign market. This causes the price of domestic
currency in terms of other foreign currencies to fall and hence, the exchange rate of that
currency, in terms of foreign currency will also fall.
iii. Capital flows. There are at least three types of international capital flows that can affect a
currency’s exchange rate. They are speculative capital flow, investment capital flow and
political capital flow.
Speculative capital flows, usually occur when central banks are trying to maintain a fixed
exchange rate for a currency when market forces suggest that the currency’s value is
incorrect. It may cause exchange rates to change if many speculators bet that a country’s
exchange rate is or will soon be mispriced because of future changes in interest rates,
inflation, or political and economic conditions.

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 Investment capital flows can be either the short-term money market flows motivated by
differences in interest rates or long-term capital investments in a nation’s real or financial
assets.
Political capital flows: when a country experiences political instability because of war or
domestic upheavals, it will often experience the phenomenon of capital flight in which
owners of capital transfer their wealth out of the country.
3. Government intervention in the foreign exchange market
By buying or selling assets, a government can affect the extent to which private transaction
pressures affect the exchange rate of its domestic currency. If a government sells assets to
foreigners, it acquires foreign currencies. The government can then use these currencies to
support the prices of its own domestic currency by buying its currency in the foreign
exchange markets. Alternatively, foreigners can be required to pay for their asset purchases
with the domestic currency. In this case, foreigners who wish to buy assets will first have to
trade their currencies in the foreign exchange markets for the government’s domestic
currency. As more people try to buy a country’s currency, its price will rise.

Governments can also seek to depress currency prices. A government that believes its currency is
becoming overvalued may tear that currency appreciation will hinder its producers’ abilities to
export goods and will encourage imports. In this case, a government may buy assets from
abroad. As the government trades its money for foreign assets, foreigners will hold more of its
money, and if they sell that money in the foreign exchange markets, its value will fall.
Governments may also sell securities abroad or borrow from foreign governments to obtain
claims on foreign funds. Those funds can in turn, be used to support the exchange rate of a
domestic currency by the government buying it in foreign exchange markets. If these assets
flows (and net sales of government liabilities to foreigners) are reversed, the domestic funds
leave the country, and the price of the domestic currency will fall in the foreign exchange
markets.

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8.8 THE BALANCE OF PAYMENTS AND BALANCE OF TRADE

8.8.1 The Balance of Payment

The balance of payments of a country is a systematic record of all its economic transactions with
the outside world in a given year. According to Bc Soderten “The balance of payments is merely
a way of listing receipts and payments in international transactions of a country.” It shows the
country’s trading position, changes in its net position as foreign tenders or borrowers, and
changes in its official reserve holding.

These records or accounts are kept in accordance with the rules of double-entry bookkeeping;
thus debit entries must be offset by corresponding credit entries. This implies that, overall, total
debits must equal total credits and that the account must always be in balance. If not, errors and
omissions account is required to balance international flows. Because of smuggling, tax evasion,
poor data, and unrecorded transfers, sometimes the international errors and omissions account is
quite large.

The terms surplus and deficit in the balance of payments refer to the net balances in various
components of the balance of payments accounts. Depending on the items included in each
component of the accounts, “surplus” and “deficit” have different implications for a country and
its exchange rate. If all the inflows are greater than the outflow, there will be a surplus balance of
payments and if the inflows are less than the outflows, there will be a deficit balance of
payments. All debts are recorded at the right side and all credits are recorded at the left side.
The principal items shown on the credit side are all the inflows or receipts of funds either
through export or debt. The main components included in this category are exports of goods and
services, unrequited (not returned) receipts in the form of gifts from foreigners, borrowings form
abroad, investments by foreigners in the country, money spend by tourists and students waiting
the country for travel and education, official sale of reserve assets including gold to foreign
countries and international agencies.

The principal items shown on the debit side include outflows or payments of funds for imported
goods or payment of debts. The main items include: imports of goods and services, transfer
payments to foreigners, lending to foreign countries, investments by residents to foreign

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countries, official purchase of reserve assets or gold from foreign countries and international
agencies, etc.

In the terminology of the balance of payment, initiating transactions are called autonomous
flows and the offsetting entries are referred to as accommodation flows.
flows. When autonomous
debts exactly equal autonomous credits for a country, the supply of the domestic currency
(demand for the foreign currency) by residents is exactly equal to the demand for the domestic
currency (supply of the foreign currency) by foreigners. This equality condition describes the
point of intersection of the supply and demand curves and defines the equilibrium exchange rate.
When autonomous debits exceed autonomous credits, the net debit position is referred to as a
deficit in the balance of payments; it generally causes downward pressure on the exchange rate
because citizens want to buy more foreign goods than foreigners want to buy from the domestic
market. Similarly a net credit position, or surplus in the balance of payments, often results in an
upward pressure on the exchange rate.

Balance of Payments Accounts

The balance of payments items are divided into three categories: The current account, the capital
account and the official settlements account or the official reserve assets account.

1. The current account

It consists of all transactions relating to trade in goods and services plus investment income and
gifts or grants made to other countries such as: travel and transportation payments, income and
payments on foreign investments, transfer payments related to gifts, foreign aid, pensions,
private remittances (received from foreign individuals and governments to foreigners), charitable
donation, etc.
2. The capital accounts
It consists of transactions in financial assets in the form of short term and long-term lending and
borrowings, private and official investments. It indicates/represents a change in the countries’
foreign assets and liabilities. Long term capital transactions related to international capital
movements with maturity of one year or more, and include direct investments like building of a
foreign plant, portfolio investment like the purchase of foreign bonds and stocks and

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international loans. Short-term international capital transactions are for a period ranging between
three months to less than one year.
3. The official settlements accounts or official reserve assets account
This is part of the capital account. It measures the change in nation’s liquid and non-liquid
liabilities to foreign official holders and the change in a nations official reserve assets during the
year. The official reserve assets of a country include its gold stock, holdings of its convertible
foreign currencies.

The sum of current account and capital account is known as the basic balance.
balance.

The difference between exports and imports of a country is its balance of trade.
trade.
If visible exports exceed visible imports the balance of trade is favorable. In the opposite case it
is unfavorable. Unfortunately, because many international transactions are not reported, such as
capital fleeing from countries, smuggling proceeds, illegal activity transactions, tax evasion
activities and so forth, the statistical discrepancy is often quite large and it is variable in sign. As
a result, substantial imprecision exists in the balance of payments accounts.

8.8.2 Balance of Trade

If the total receipts from foreigners on the credit side exceed the total payments to foreigners on
the debit side, the balance of payments is said to be favorable. On the other hand, if the total
payments to foreigners exceed the total receipts from foreigners, the balance of payments is
unfavorable. The balance of trade is the difference between the value of goods and services
exported and imported. The balance of payments is Y = C – I – G + (X-M)
where Y = refers to national income
C = refers to consumption expenditure
I = refers to investment expenditure
G = refers to government expenditure
X = refers to export of goods and services
M = refers to imports of goods and services
X-M denotes the balance of trade

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If the difference between X and M is zero, the balance of trade balances. If X is greater than M,
the balance of trade is favorable, or there is surplus balance of trade and if X is less than M, the
balance of trade is in deficit or is unfavorable.

Check Your Progress

1. If a Killo of corn costs Br. 3.00 and a British pound is worth Br. 10.00, how many pounds
would a person receive for 100,000 kilos of corn sold in Britain in the spot market? If the
delivery were to occur in three months and the interest rate in Ethiopia exceeded the British
rate by 2 percent per year, what would likely to received in the forward exchange market for
a conversion arranged now if the current spot rate is Br. 10.00 per British pound? Explain.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
2. Assume that the spot and one-year forward rates for the pound are respectively $1.60 and
$1.55 and in German are 1.50 and 1.40 D-marks per dollar. If interest rates in the United
States are 5 percent, in British are 8 percent, and in Germany are 3 percent, where can you
get the best return on a covered one-year investment?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
3. Why are international banks able to earn large fees from providing letters of credit and
forward currency transactions to their currencies?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
4. What are the difficulties associated with international trades? Discuss
…………………………………………………………………………………………………
…………………………………………………………………………………………………

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 5. If the Japanese yen were to change from 100 per dollar to 90 per dollar, would the U.S.
balance of payments be likely to improve (become more positive) or not? In answering,
consider what effect the exchange rate change would have both on U.S. exports and imports
to and from Japan and on purchase decisions made by manufacturers or importers located in
other countries.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
…………………………………………………………………………………………………
6. How does inflation affect a country’s spot and forward exchange rates? Why? Is it absolute
inflation or inflation relative to other countries that is important?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
7. Identify the different documents used in the international market.
…………………………………………………………………………………………………
…………………………………………………………………………………………………
8. Will the domestic balance of payments be helped or hurt if foreign investment inflows in to
the country increase?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
9. What are the components of a balance of payments? What is the objective of a monetary
authority related to the balance of payments?
…………………………………………………………………………………………………
…………………………………………………………………………………………………
10. Are balances of payment and balance of trade the same? Or different? discuss.
…………………………………………………………………………………………………
…………………………………………………………………………………………………

8.9 SUMMARY

When people buy goods or services or invest in other countries, they first must convert their
domestic currency into the foreign currency they need in order to make their purchases – they
can exchange one currency for another in the foreign exchange markets.

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When the demand for a country’s goods and services exceeds its demand for goods and services
sold by foreigners, the country will tend to run a balance of payments surplus on current account
and many foreigners will demand its currency in the foreign exchange market so they can buy
goods and services produced in that country. This will often cause the value of its currency to
rise relative to foreign currencies. Conversely, when a country runs a deficit on current account,
there may be surplus of its currency offered for sale on the foreign exchange markets. This will
often cause a currency to loss value (fall in price) relative to other currencies.

Surpluses or deficits on current account may cause the price of a currency to vary relative to
other currencies. However, that will be the case only if there is an insufficient flow of capital to
offset a current account imbalance in the balance of trade. A country can fund a current account
deficit with an inflow of capital if it offers attractive interest rates and an attractive investment
environment to the world and thereby attracts investments funds from similarly, a country with a
trade surplus may be able to keep its currency price from rising if it invests its surplus foreign
exchange earned from trade in investments in foreign countries.

Capital flows that offset trade imbalances can be politically motivated, investment flows for the
long-term or short-term, or speculative flows of designed to profit from expected changes in
exchange rates. When capital flows occur to take advantage of high real interest rates or to free
inflation or the threat of political risk, exchange rates between currencies will vary.

8.10 ANSWERS TO CHECK YOUR PROGRESS

1. Refer section 8.2 6. Refer section 8.7

2. Refer section 8.5 7. Refer section 8.6
3. Refer section 8.6 8. Refer section 8.8.1
4. Refer section 8.3 9. Refer section 8.8.1
5. Refer section 8.8 10. Refer section 8.8.2

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8.11 KEY TERMS

Foreign exchange Autonomous flows sight draft

Exchange rate Accommodation flows Time draft
Speculative capital flows Current account Bill of lading
Investment capital flows Capital account
Political capital flows Spot market
Fixed exchange rates Forward market
Flexible exchange rates Letter of credit

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