BACC 121

Course Learning Outcomes

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At the end of the course, the Business
Administration Louisians are expected to:

T CO 1. To understand the fundamental principles

of how countries measure international
business activities.
2. To explore the purpose of the foreign
exchange market.
3. To understand the role and purpose of
the international monetary system.
4. To review the mechanical steps of how
exchange rate changes are transmitted
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into altered prices and eventually trade
volumes.
5. To understand how countries with
INTERNATIONAL different government policies toward
international trade and investment or
BUSINESS different levels of economic development.

AND TRADE
DO

BACC 121

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 For the only way in which a durable peace
can be created is by world-wide restoration
of economic activity and international trade.
James Forrestal

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MODULE FOUR: The International Flow of Funds and Exchange
Rates
The Balance of International Payments
OVERVIEW:

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International business transactions occur in may different forms over the course of a year. The
measurement of all international economic transactions between the residents of a country and
foreign residents is called the balance of payments (BOP). Government policy makers need such
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measures of economic activity to evaluate the general competitiveness of domestic industry, to set
exchange-rate or interest-rate policies or goals, and for many other purposes.
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LEARNING OBJECTIVES:

 Explain the balance of payments for a country.

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 Describe the foreign exchange market and its components.

 Discuss the development of International monetary systems.

 Explain exchange rate changes over time.

 Forecast exchange rates using difference methodologies.

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 MODULE OUTLINE:

I. What Is Balance of payments (BOP)?

A statement of all transactions between one country and the rest of the world during a
given periods; a record of flows of goods, services, and investments across borders.
International transactions take many forms. Each of the following examples is an
international economic transaction that is counted and captured in the U.S. balance of payments.
Examples:

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 U.S imports of Honda automobiles, which are manufactured in Japan.
 A U.S based firm, Betchel is hired to manage the construction of a major water-
treatment facility in the Middle East.


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An American tourist purchases a hand-blown glass figurine in Venice, Italy.

Sub Accounts:
1. Current Account an account in the BOP statement that records the results of
transactions involving merchandise, services and unilateral. Transfer between countries.

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Goods trade – This is the export and import of goods. Ex. Japanese cameras, French
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wines, Korean clothes. Etc.
 Services trade - This is the export and import of services. ex. Banks to foreign
importers, travel services of airlines, construction services of domestic firms,
consultations.
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 Income – This category is predominantly current income associated with

investments that were made in previous periods. Ex. Wages and salaries paid to
nonresident workers.
 Current Transfer – Transfers are the financial settlements associated with the
change in ownership of real resources or financial items. Any transfer between
countries that is one-way, a gift or a grant. Ex. U.S. government to aid in the
development of a less-developed nation.
2. Financial Account is an account in the BOP statement that records transactions
involving borrowing, lending, and investing across borders.

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 Fundamentals of Balance of payments
The balance of payments must balance. If it does not, something has either not
counted or counted properly. It is therefore improper to state that the BOP is in
disequilibrium. The supply and demand for a country’s currency may be imbalanced, but the
entire BOP of a single country is always balanced.
Three Elements of measuring international economic activity
1. Risk Premium
Identifying what is and is not international economic transaction.

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2. Foreign Direct Investment
Understanding how the flow of goods, services, assets, and money creates debits
and credits to the overall BOP
3. Statistical Discrepancy

entry.
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Foreign Exchange Market
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Understanding the bookkeeping procedures for BOP accounting, called double

Is an over-the-counter global marketplace that determines the exchange rate for

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currencies around the world. Participants are able to buy, sell, exchange and speculate on
currencies.
Purpose:
The foreign exchange market is the mechanism in which currencies can be bought
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and sold. A key component of this mechanism is pricing, or more specifically, the rate at
which a currency is bought or sold.

 Fixed-exchange-rate the government of a country officially declares that its

currency s convertible into a fixed amount of some other currency.
Example: South Korean won was fixed to the U.S dollar at 484 won equal to 1
U.S. dollar.

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  Floating-exchange -rate the government possess no responsibility to declare
that its currency is convertible into fixed amount of some other currency.
- Managed-floating-exchange-rate is the contemporary international financial
environment in which exchange rates varies from day to day, but central
banks tray to influence their nations’ exchange rates by purchasing and
selling currencies to perpetuate a certain period.
- Independent-floating-exchange-rate major currency values are determined
by the demand for and supply of currencies.
 Losing sovereignty, national independence, and identity.

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 Reducing the powers of the national government.
 Increasing the probability of rising crime associated with ease of
cross-border movements.
Components of Foreign exchange markets

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1. Spot Market – is the exchange rate transacted at a particular moment by the buyer and
seller of a currency. When we buy and sell our foreign currency at a bank or at a
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American Express, it is quoted at the rate for the day. For currency traders though, the
spot can change throughout the trading day even by tiny fractions.
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2. Forward Market – is the currency market for transactions at forward rates. Forward
exchange rate is the exchange rate at which a buyer and a seller agree to transact a
currency at some date in the future. In this market, foreign exchange is always quoted
against the US dollar.
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3. Future Markets – this are market that require the exchange of a specific amount of
currency at a specific future date and at a specific exchange rate.
Understand How to Determine Exchange Rates
In general, when we quote currencies, we are indicating how much of one currency it takes
to buy another currency. This quote requires seven components:
1. Bid-ask spread Is the difference between bid and ask prices of a currency; the
transaction fee earned by the bank.

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 Ex. If the bid price for a stock is $19 and the ask price for the same stock is $20, then
the bid-ask spread for the stock in question is $1.
2. Direct Quotes which states the domestic currency price of one unit of foreign currency.
For example, a dollar-pound quote in American terms is USD/GP (US$/£) equals 1.56.
This is read as “1.56 US dollars are required to buy 1pound sterling.”
3. Indirect Quote states the price of the domestic currency in foreign currency terms. In an
indirect quote, the foreign currency is a variable amount and the domestic currency is
fixed at one unit.
For example, the pound-dollar quote in European terms is £0.64/US$1 (£/US$1). foreign

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exchange rates are expressed in terms of how many currency units can be exchanged
for a US dollar (the US dollar is the base currency).
4. Forward Rate - is the exchange rate at which a buyer and a seller agree to transact a

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currency at some date in the future. Forward rates are really a reflection of the market’s
expectation of the future spot rate for a currency.
For example, if a US company opted to buy cell phones from China with payment due in
ninety days, it would be able to access the forward market to enter into a forward
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contract to lock in a future price for its payment. This would enable the US firm to
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protect itself against a depreciation of the US dollar, which would require more dollars
to buy one Chinese yuan.
5. Discount or Currency Speculation refers to the practice of buying and selling a currency
with the expectation that the value will change and result in a lesser rate. Such changes
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could happen instantly or over a period of time.

6. Premium or Currency Arbitrage is the simultaneous and instantaneous purchase and

sale of a currency for a profit.

For example, trader sitting in one city, such as New York, monitoring currency prices on
the Bloomberg terminal. Noticing that the value of a euro is cheaper in Hong Kong than
in New York, the trader could then buy euros in Hong Kong and sell them in New York
for a profit.

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 7. Hedging refers to the technique of protecting against the potential losses that result
from adverse changes in exchange rates. Companies use hedging as a way to protect
themselves if there is a time lag between when they bill and receive payment from a
customer.

For example, a retail store in Japan imports or buys shoes from Italy. The Japanese firm
has ninety days to pay the Italian firm. To protect itself, the Japanese firm enters into a
contract with its bank to exchange the payment in ninety days at the agreed-on
exchange rate. This way, the Japanese firm is clear about the amount to pay and

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protects itself from a sudden depreciation of the yen. If the yen depreciates, more yen
will be required to purchase the same euros, making the deal more expensive.

International Monetary System

these initiatives.
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Understanding the role of the IMF and the World Bank provides insight into how governments in
developing countries prioritize and fund projects and work with the private sector to implement

International monetary system refers to the system and rules that govern the use and exchange of
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money around the world and between countries. The system continues to evolve and each crisis
impacts it. There is not likely to be a final international monetary system, simply one that reflects
the current economic and political realities.

The purposes of the International Monetary Fund are as follows:

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1. To promote international monetary cooperation through a permanent institution which

provides the machinery for consultation and collaboration on international monetary
problems.
2. To facilitate the expansion and balanced growth of international trade, and to contribute
thereby to the promotion and maintenance of high levels of employment and real income
and to the development of the productive resources of all members as primary objectives of
economic policy.

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 3. To promote exchange stability, to maintain orderly exchange arrangements among
members, and to avoid competitive exchange depreciation.
4. To assist in the establishment of a multilateral system of payments in respect of current
transactions between members and in the elimination of foreign exchange restrictions
which hamper the growth of world trade.
5. To give confidence to members by making the general resources of the Fund temporarily
available to them under adequate safeguards, thus providing them with opportunity to
correct maladjustments in their balance of payments without resorting to measures

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destructive of national or international prosperity.
6. In accordance with the above, to shorten the duration and lessen the degree of
disequilibrium in the international balances of payments of members.“Articles of

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Agreement: Article I—Purposes,” International Monetary Fund, accessed May 23, 2011,

Gold Standard each country sets the price of its currency to gold, specifically to one ounce of
gold. A fixed exchange rate stabilizes the value of one currency vis-à-vis another and makes trade
and investment easier.
Advantages
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1. The gold standard dramatically reduced the risk in exchange rates because it established
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fixed exchange rates between currencies. Any fluctuations were relatively small.
2. Countries were forced to observe strict monetary policies. They could not just print money to
combat economic downturns.
3. Gold standard would help a country correct its trade imbalance.
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Collapsed of the Gold Standard

The gold standard eventually collapsed from the impact of World war I. During the war,
nations on both sides had to finance their huge military expenses and did so by printing more paper
currency.

Bretton Woods System

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 In July 1944, representatives from forty-four countries met in Bretton Woods, New
Hampshire, to establish a new international monetary system. It was formulated to gain agreement
among states about how to finance postwar reconstruction, stabilize exchange rates, fosters trade,
and prevent balance of payments crises from unraveling the system. The resulting Bretton Woods
Agreement created a new dollar-based monetary system, which incorporated some of the
disciplinary advantages of the gold system while giving countries the flexibility they needed to
manage temporary economic setbacks. By having a formal set of rules, regulations, and guidelines
for decision making, the Bretton Woods Agreement established a higher level of economic stability.

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Collapsed of Bretton Woods System

 Triffin Paradox situation where US did not have enough gold reserves to exchange all of the
US dollars in global circulation, named after the economist Robert Triffin, who identified

Development of the Flexible Exchange Rate System


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this problem. He noted that the more dollars foreign countries held, the less faith they had
in the ability of the US government to convert those dollars.

Smithsonian Agreement is the devaluation of US dollar per ounce of gold to increased the
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value of other countries’ currencies to the dollar.
 Jamaica Agreement established a managed float system of exchange rates, in which
currencies float against one another with governments intervening only to stabilize their
currencies at set target exchange rates.
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Valuing of (devaluing) Currencies

1. Special Drawing Rights is an international monetary reserve asset. It is a basket, or group of

currencies consists of the value of four of the IMF’s biggest members’ currencies—the US dollar,
the British pound, the Japanese yen, and the euro. The SDR is not a currency, but some refer to it
as a form of IMF currency. It does not constitute a claim on the IMF, which only serves to
provide a mechanism for buying, selling, and exchanging SDRs.
2. Clean Float Currency is a monetary system with minimal government intervention; largely
market determined. The process governments used in the 1970s if they wished to alter the

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 current value of their currency. It was done by simply buying or selling their own currency in
the market using their reserves of other major currencies.
3. Dirty Float Currency is a monetary system with varying degrees of government intervention
to maintain a range of acceptable values against other currencies. This is a currency value
management method whereby the central banks of the major nations simultaneously
intervene in the currency markets, hoping to change a currency’s value.
 Dollarization it is a practice of using the dollar or some other foreign currency together with
or instead of a domestic currency in a country
 Hard currencies consist of leading world currencies of developed industrialized countries

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including the dollar, euro, yen and pound.
 Soft currencies emerge from market countries’ currencies that are less stable in value than
hard currencies and are sometimes pegged to hard currency values.

International Flows of Goods and Capital

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If countries are to trade, they must be able to exchange currencies. To buy wheat, or corn, or DVD
players, the buyer must first have the currency in which the product is sold. An American firm
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purchasing consumer electronic products manufactured in Japan must first exchange its U.S. dollars
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for Japanese yen, then purchase the products. And each country has its own currency.

 Law of one price the theory that the relative prices of any single good between
countries, expressed in each country’s currency, is representative of the proper or
appropriate exchange rate value. To apply the theory to actual prices across
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countries, we need to select a product that is identical in quality and content in

every country.
- Big Mac Index compares the actual exchange rate with the exchange rate
implied by the purchasing power parity measurement of comparing Big Mac
prices across countries. For example, say the average price of a Big Mac in
the United States on a given date is $3.57. On the same date, the price of a
Big Mac in China, in Chinese yuan, is Yuan 12.5. This then is used to calculate
the PPP exchange rate, SYuan/$, as before:

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 SYuan/$ =PYuan /P$ = Yuan 12:5 / $3:57 /= Yuan 3:50/$
The exchange rate between the Chinese yuan and the U.S. dollar should be
Yuan 3.50/$ according to a PPP comparison of Big Mac prices.
 Arbitrage buying goods in a lower priced market and selling them in a higher priced
market to make profits.
 Purchasing power parity (PPP) The theory that the price of internationally traded
commodities should be the same in every country, and hence the exchange rate
between the two currencies of those countries should be the ratio of prices in the
two countries.

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The purchasing power parity exchange rate is simply the rate that equalizes the price
of the identical product or service in two different currencies:
Price in Japan (in yen) = Exchange rate (yen per dollar) x Price in U:S: (in dollars)

𝑃¥ = S /$ x P
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¥ $
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If the price of the same product in each currency is P¥ and P$ , and the spot exchange
rate between the Japanese yen and the U.S. dollar is S¥/$, the price in yen is simply
the price in dollars multiplied by the spot exchange rate:
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If this is rearranged by dividing both sides by P$ , the spot exchange rate between
the Japanese yen and the U.S. dollar is the ratio of the two product prices:
S¥/$= P¥ / P$
These prices could be the price of just one good or service, such as the movie ticket
mentioned previously, or they could be price indices for each country that cover
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many different goods and services. Either form is an attempt to find comparable
products in different countries (and currencies) in order to determine an exchange
rate based on purchasing power parity. The question then is whether this logical
approach to exchange rates actually works in practice.

Inflation and Purchasing power parity

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 PUS(1 + IUS) = (1 + p)PE(1 + IE),

where PUS = price index of U.S. goods in dollars

PE = price index of European goods in dollars
IUS = inflation rate in the United States in dollar terms
IE = inflation rate in Europe in euro terms
p = percentage change in the euro, which equals the forward premium [(F – S)/S]
 100 with F the forward dollar/euro exchange rate and S the spot dollar/euro
exchange rate.

Given an exchange rate of $1.40 per euro, an initial PPP with PUS = $140 and PE = €100 or $140, and
10 percent U.S. inflation and 0 percent European inflation, we have

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$140(1.10) = (1+ p) $140(1),

such that the forward premium p = [($154 – $140)/$140]  100 = 10 percent.

Empirical tests of PPP have found mixed results:

hold in shorter periods.

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– PPP appears to hold in the long run for periods exceeding five years, but may not

– For countries with little difference in inflation rates, PPP does not reliably explain
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exchange rate changes.

PPP predictions are affected by:

– Transportation costs and trade barriers

– Government intervention in trade and exchange rates

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– Multinational firms with pricing power

– Market expectations about economic factors

– Goods not traded but that affect internal prices

Interest Rate Parity (IRP)

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 IRP is a theory regarding the relationship between the spot exchange rate and the expected spot
rate or forward exchange rate of the two currencies, based on interest rates. This holds that the
forward exchange rate should be equal to the spot currency exchange rate times the interest rate
of the home county, divided by the interest rate of the foreign country.

(1 + iUS) = (F/S)(1 + iE),

where iUS = interest rate on U.S. bond paid in euros

iE = interest rate on European bond paid in euros
F = forward dollar to euro exchange rate
S = spot dollar to euro exchange rate.

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This equation says that a dollar invested in a U.S. bond earns the same dollar return as a dollar
converted to euros and invested in European bonds with euro returns later repatriated to dollars. If

Importance of IRP
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1. To gain riskless profit.
2. To understand exchange rate determination.
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S is fairly stable over time, this IRP can be approximated with the following well-known formula:

(iUS – iE) = (F – S)/S = p

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Covered Interest rate parity refers to the state in which no-arbitrage is satisfied with the use of a
forward contract. In the covered IRP, investors would be indifferent as to whether to invest in their
home country interest rate or the foreign country interest rate since the forward exchange rate is
holding the currencies in equilibrium.
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Uncovered Interest rate parity refers to the state in which no-arbitrage is satisfied without the use
of forward contract. In the uncovered IRP, the expected exchange rate adjusts so that IRP holds.

Empirical evidence on IRP theories is mixed:

– Transactions cost is one impediment to achieving IRP.

– Political risk, legal restrictions, tax effects, managed-float rate regimes can disrupt
traders’ ability to arbitrage away profit differentials.

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 – Market psychology (herd behavior) can play a role in rate movements as traders
speculate in currencies.

– Central bank intervention may cause IRP not to hold at all points in time.

Forecasting Exchange Rates

 Using the forward rate in the covered IRP to forecast future spot rates:

F= s (1+p)

Rearrange value is (f/s)-1

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where F = forward rate, S = spot rate, and p = forward premium.

Example:


T=.05 or 5%

Using a multiple regression model:

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If the one year forward rate of the Australian dollar is $ .63, while the spot rate is $
.60. the expected percentage change in the Australian dollar is

= (.63/.60) -1
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A forecast may arise simply from a subjective assessment of the factors that affect
exchange rate.

X = b0 + b1(IUS – IE) + b2(iUS – iE) + b3(YUS – YE),

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where (IUS – IE) = difference in inflation rates

(iUS – iE) = difference in interest rates

 (YUS – YE) = difference in GDP growth rates.

b0 = constant

Building International Business and Trade Skills

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 Engage, Explore and Explain Activity
Reflection Paper
1. In this difficult times we are facing, Is the Big Mac a good or bad measure of purchasing
power parity?
2. What do you think should be done to prevent another global financial crisis?

Elaborate and Evaluation Activity

Research Paper Word Format maximum of 5 pages.

Identify two countries, one in Africa and one in either Asia or Latin America. Research each

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country’s history with the IMF and the World Bank. Has the country accepted loans from either
organization? What were the terms of the loans? Discuss whether the loans achieved the initial
purpose and whether the country is better or worse off as a result of working with these

multinational?

V. References
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institutions. Have the loans helped expand the prospects for businesses, local and
NO
DO

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 PY
T CO
NO
DO

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