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INTERNATIONAL
TRANSACTIONS
INTERNATIONAL FINANCE -
OVERVIEW
rates.
INTERNATIONAL MONETARY SYSTEM
Evolution of the International Monetary System
Current Exchange Rate Arrangements
European Monetary System
Euro and the European Monetary Union
The Mexican Peso Crisis
The Asian Currency Crisis
Fixed versus Flexible Exchange Rate Regimes
The international monetary system can be defined as the
Further the current account have divided into four finer categories
Merchandise trade, services, factor income and unilateral transfers
Merchandise trade represents exports and imports of tangible goods such as oil, wheat,
cloths, automobiles, computers and so on.
Services includes payments and receipts for legal consulting, and engineering services,
royalties for patents and intellectual properties, insurance premiums, shipping fees and
tourist expenditure.
Factor income consists largely of payments and receipts of interest, dividends, and other
income on foreign investments that were previously made.
Unilateral transfers involve ‘unrequited’ payments include foreign aid, reparations, official
and private grants and gifts. For the purpose of preserving the double-entry book keeping
rule, unilateral transfers are regarded as an act of buying goodwill from the recipients.
THE CAPITAL ACCOUNT
Capital account can be divided into three sub categories i.e. direct investment,
portfolio investment and other investment.
Direct investment occurs when the investor acquires a measure of control of the
foreign business. As per the US balance of payments acquisition of 10% or more of
the voting shares of business is considered giving a measure of control to the investor.
Firms undertake FDI when the expected returns from foreign investments
exceeded cost of capital allowing for foreign exchange and political risk.
Portfolio investments mostly represents sales and purchases of foreign financial
assets such as stocks and bonds that do not involve a transfer of control. Portfolio
investment comprises equity, debt and derivatives securities.
Other investment includes transactions in currency, bank deposits, trade credits and so
forth. These investments are quite sensitive to both changes in relative interest rates
between countries and the anticipated change in the exchange rate.
Official Reserves Account
Official reserves are held by the monetary authorities of a country
They consists of monetary gold, SDR allocations by the IMF and foreign
currency assets.
The foreign currency assets are normally held in the form of balances with
foreign central banks and investment in foreign government securities.
If the overall balance of payment is surplus, the surplus amount adds to the
official reserve account
If the overall balance of payment is deficit and if accommodating capital is
not available the official reserves account is debited by the amount of
deficit.
Balance of Payments - Format
Credit Debit Balance
A. Current Account
Merchandise import ***
Merchandise export ***
Balance of trade ***
Invisibles
Services (net) ***
Unilateral transfers (net) ***
Investment Income (net) *** ***
Non-monetary movement of gold (net) ***
Balance of current account ***
B. Capital account Long term
Direct investment abroad ***
Direct foreign investment inflow ***
Portfolio investment (net) ***
Loans – official and private net of repayments *** ***
Basic balance ***
Short term
Holding with banks ***
Other short-term transactions ***
Balance of capital accounts ***
C. Errors and Omissions
Overall balance (A+B+C) ***
D. Official reserves
SDR allocations ***
Net official reserves ***
Overall balance ***
Problem 1
Find out (a) the balance of trade and (b) balance of current account, if: inflow
on account of services $1000; outflow on account of services $800; outflow of
dividend, royalty etc., $1100; inflow of dividend etc., $560; export of goods
$10000; import of goods $12000; remittances $1200.
Solution:
Import -12000
Export 10000
Balance of trade -2000
Services (net) 200
Investment income (net) -540
Remittances (net) 1200
Balance of current account -1140
Problem 2
Find out the balance of capital account, if: inflow of loans $2000;
repayment of loan $2150; FDI inflow $7000; FDI outflow $1500; FII’s
investment in India $500; short term movement of funds -200.
Solution
Loan -150
FDI 5500
FII’s investment 500
Short term funds -200
Balance of capital accounts: 5650
BALANCE OF PAYMENT EQUATIONS
Solution
Foreign exchange reserve = opening balance of foreign exchange
reserve + balance of current account + balance of capital account
+ statistical discrepancy
= 70000 + (-5500) + 2000 + (-500)
= 66000
BALANCE OF PAYMENT
IDENTITY
When the balance of payments accounts are recorded correctly, the
combined balance of the current account, the capital account and the reserve
account must be zero
BCA + BKA + BRA = 0
BCA – balance of current account, BKA – balance of capital account and
BRA – balance of reserve account
Balance of payment identity indicates that a country can run a balance of
payments surplus or deficit by increasing or decreasing its official reserve.
In fixed exchange rate regime, countries maintain official reserves that
allow them to have balance of payments disequilibrium i.e. BCA + BKA is
non zero.
Under fixed exchange rate regime, the combined balance on the current and
capital accounts will be equal in size but opposite sign.
BCA + BKA = - BRA
For exp. If a country runs a deficit on the overall balance, that is BCA +
BKA is negative, the central bank of the country can supply foreign
exchanges out of its reserve holdings. But if the deficit persists, the central
bank eventually run out of its reserve, the country may forced to devaluate
its currency.
Under flexible exchange rate regime, central bank do not intervene in
foreign exchange markets. In fact central bank do not need to maintain
official reserves. Under this overall balance must be
BCA = - BKA
In other words current account surplus or deficit must be matched by a
capital account deficit or surplus
EXCHANGE RATE AND MONEY
SUPPLY
2. Forward Market
It refers to the market in which sale and purchase of foreign currency
is settled on a specific future date at a agreed upon today.
DIRECT AND INDIRECT QUOTE
Direct quote gives the home currency price of a certain amount of foreign
currency
For ex. If India quotes the exchange rate between India and US dollar in
direct way, the quotation will be written as Rs.60/US $
In-direct quotation quoting the value of one unit of home currency is
presented in terms of foreign currency.
For ex. If India adopts indirect quotation, the banks in India will quote the
exchange rate as US $ 0.01666/Re
If the quotation is published in third country to which neither of the two
currencies belongs, the usual practice is to put the stronger currency on
the numerator.
For ex. If the US $ - Indian Rupee rate is published in London, it will
be quoted as US $ 0.16667/Re.
Problem 1.
If direct quote is Rs.65/US $, how can this exchange rate be presented
under indirect quote?
US $ 1/Rs. 65 = US $ 1 / 65 = 0.0154/Re.
Problem 2
If in-direct quote is US $ 0.0162/Re, how can this exchange rate be
shown under direct quote?
Re.1/US $ 0.0162 = Rs. 1 / 0.0162 = 61.73/US $.
BUYING AND SELLING RATES
In foreign exchange normally two rates are published i.e. buying rates
and selling rates.
The buying rate is known as bid rate
Selling rate is known as ask rate or offer rate.
In other words the buying rate is the rate at which the banks purchase a
foreign currency from the customer.
Selling rate at which the banks sells a foreign currency to the customers.
The different between buying rate and selling rate is known as spread.
Spread = (Ask price – Bid price)/Ask price X 100
Problem 3
Consider the following bid – ask prices: Rs. 60-65/US $. Find the bid –
ask spread.
(65 – 60)/65 X 100 = 7.69%
Problem 4
Find out the bid rate if ask rate is Rs. 65/US $ and the bid – ask spread
is 6.45%.
(65 – x)/65 = 0.0645
65 – x = 0.0645 x 65
65 – 4.1925 = x
X = 60.81
FORWARD MARKET QUOTATION
The change in forward rates may be upwards or downwards. Which such
movements disparity arises between spot and forward rates. This known
as swap or forward rate differential.
If the forward rate is lower than spot rate, it will be a case of forward
discount. On other words, forward rate is higher than the spot rate it
would be known as forward premium.
It is computed as follows
=(n day forward rate – spot rate)/spot rate X 360 /n
Where n – is the length of forward contract expressed in number of days.
Problem 5
Find out the forward rate differential if spot rate of US $ is Rs. 65 and one
month forward rate is Rs. 66.
= 360 / 30 {[66 – 65]/65} X 100
= 18.46%
It is known as forward premium as the value of US $ has increased.
Problem 6
Find out one – month forward rate of US $ if spot rate is 60 and the forward
premium is 15%.
360 / 30 {[x – 65]/65} = 0.15
X – 65 = 0.15 x 65 x 30/360
X = 65 + 0.8125 = 65.8125
CROSS RATES
In this case, the selling rate of one currency is divided by the buying
rate of another currency and vice versa.
Suppose one month forward rate in case of two currencies is Rs. 64.50-
64.80/US $ and C$ 0.79-0.83/US $. The forward rate of the Canadian $
in terms of the rupee can be found as
Rs. 64.80/C$ 0.79 = Rs. 82.03
Rs. 64.50/C$ 0.83 = Rs. 77.71
For ex. If the exchange rate £1 = $2, then British can exchange one
pound for two $ in the world market. Similarly an American can
exchange two $ to get one pound.
er = eP/P*
It is the interplay of the forces of demand and supply that determines the
exchange rate between two currencies in a floating rate regime.
The exchange rate between, the rupee and US dollar depends upon the
demand for US dollars and the supply of US dollars in the Indian foreign
exchange market.
The demand for foreign currency comes from individuals and firms who
have to make payments to foreigners in foreign currency mostly on account
of the import of goods and services and purchase of securities.
The supply of foreign exchange results from the receipt of foreign currency
normally on account of export or sale of financial securities to foreigners.
Factors influencing exchange rate
1. Inflation
Changes in market inflation cause changes in currency exchange rates. A
country with a lower inflation rate can be said that an appreciation in the
value of its currency and similarly country with high inflation rate
depreciation in its currency.
it takes the following equation
et / eo = (1+IA)t / (1+IB)t
Where IA and IB are the rates of inflation in country A and B, e o is the value
of A’s currency in terms of one unit of B’s currency in the beginning of the
period and et is the spot exchange rate in period t.
et/eo = (1+IA)t/(1+IB)t
e2= 60 (1+0.05)2/(1+0.03)2
Rs. 62.35/ US $
Problem 7
If exchange rate at the end of 2016-17 is Rs. 65.90/ US $ and if the ratio of inflation
in India and USA during 2017-18 is respectively 7% and 4%. Find, inflation ration
differential between the two countries and the exchange rate at the end of 2017-18.
Problem 8
If real interest rate is 5% and the inflation rate is 8%, what would be the
nominal interest rate?
1 + r = (1+a)(1+I), 1+r = (1.05) X (1.08)
1.134 – 1 = 0.134 = 13.4%
Problem 9
Find the real interest rate if nominal interest rate is 10% and rate of
inflation is 4%.
1 + r = (1+a)(1+I)
1.10 = (1+a)(1.04), 1.10 / 1.04 – 1 = 0.0577 = 5.77%
Problem 10
Find the rate of inflation if nominal and real interest rates are respectively
15% and 5%.
1 + r = (1+a)(1+I)
1.15 = (1.05)(1+I), 1.15 / 1.05 – 1= 0.0952 = 9.52%
3. Current Account / Balance of Payments
A country’s current account reflects balance of trade and earnings on foreign investment. It
consists of total number of transactions including its exports, imports, debt, etc. A deficit in
current account due to spending more of its currency on importing products than it is earning
through sale of exports causes depreciation. Balance of payments fluctuates exchange rate of its
domestic currency.
4. Government Debt
Government debt is public debt or national debt owned by the central government. A country
with government debt is less likely to acquire foreign capital, leading to inflation. Foreign
investors will sell their bonds in the open market if the market predicts government debt within a
certain country. As a result, a decrease in the value of its exchange rate will follow.
5. Political stability:
A country's political state and economic performance can affect its currency strength. A country
with less risk for political turmoil is more attractive to foreign investors , as a result, drawing
investment away from other countries with more political and economic stability. Increase in
foreign capital, in turn, leads to an appreciation in the value of its domestic currency. A country
with sound financial and trade policy does not give any room for uncertainty in value of its
currency. But, a country prone to political confusions may see a depreciation in exchange rates.
6. Recession
When a country experiences a recession, its interest rates are likely to fall,
decreasing its chances to acquire foreign capital. As a result, its currency
weakens in comparison to that of other countries, therefore lowering the
exchange rate.
7. Speculation
If a country's currency value is expected to rise, investors will demand
more of that currency in order to make a profit in the near future. As a
result, the value of the currency will rise due to the increase in demand.
With this increase in currency value comes a rise in the exchange rate as
well.
Determination of exchange rate in the forward market
The forward exchange rate is normally not equal to the spot rate.
Such expectations determine the trend of the future spot rate towards
appreciation or depreciation and thereby determine the forward rate that is
equal to, or close to, the future spot rate.
In other words, forward rate differs from spot rate by an amount that
represents the interest rate differential.
In this process, the country of a country with lower interest rate should be at a
forward premium in relation to the country of a country with higher interest
rate.
S 1 rA
Where and of country
are the interestFrates 1 S A and B. S – is spot rate and
A 1 rB
A – is time period of forward rate.
rA rB
Determination of forward exchange rate
Suppose interest rates in India and the USA are respectively 10% and 7%. The
spot rate is Rs. 40/ US $. The 90 day forward rate can be calculated thus,
40 1 0.10
F 1 40
360 / 90 1 0.07
40 1.10
F 1 40
4 1.07
= 40.28 / US $
This means that higher interest rate in India will push down the forward value of
rupee from 40 to 40.28 a dollar.
Problem 11
Calculate the 3-month forward rate, if spot rate is Rs.46 /US $; interest rate in
India and USA is respectively 6% and 3%.
46 1 0.06
F 1 46
360 / 90 1 0.03
46 1.06
F 1 46
4 1.03
= Rs. 46.34 /US $
Covered Interest Arbitrage
If the forward rate differential is not equal to the interest rate
differential, covered interest arbitrage will begin and it will continue
till the two differential became approximately equal.
Finally, the two differentials will be equal. In fact this is the point
where the forward rate is determined.
To explain the covered arbitrage,
Suppose the spot rate is Rs. 40 / US $ and the 3 month forward rate is Rs.
40.28 /US $ involving a forward differential of 2.8%. The interest rate is 18% in
India and 12% in the USA involving interest rate differential of 5.37%. Since the
two differential are not equal covered interest arbitrage will begin.
Find the amount of profit out of covered interest arbitrage if interest rate in India
and USA is respectively 9% and 4.50% and the 6-month forward and spot
exchange rates are respectively Rs. 45 /$ and Rs. 45.20 /$.
There will be covered interest arbitrage insofar as the interest rate and forward
rate differentials are not equal. To start with;
Rather the decision behind profit making depends upon the expectation
about the future spot rate, in as much as the interest rate differential
between two countries leads to changes in future spot rate.
(1 RB ) S
Where Se1 is the expected future spot rate, and RA and RB are the interest
rates in country A and B.
Problem 13
Interest rate in India and the USA is respectively 6% and 5%. Spot
exchange rate at present is Rs42.32/ US $. Because of the higher interest
rate arbitrageurs are tempted to make investment in rupee market. But by
the time of their investment matures, rupee is expected to depreciate to Rs.
45.20/ US $. Find whether there would be uncovered interest arbitrage. If
there will be arbitrage what will be the process?
Since two differential are not equal, uncovered parity does not exists.
Again under this situation, arbitrageurs will take back their investments out
of rupee maket for fear of lower return in terms of US dollar.
PURCHASING POWER PARITY (PPP)
The PPP forecasting approach is based on the theoretical law of one price, which
states that identical goods in different countries should have identical prices.
For example, this law argues that a pencil in Canada should be the same price as a
pencil in the U.S. after taking into account the exchange rate and excluding
transaction and shipping costs.
In other words, there should be no arbitrage opportunity for someone to buy
inexpensive pencils in one country and sell them in another country for a profit.
The PPP approach forecasts that the exchange rate will change to offset
price changes due to inflation based on this underlying principle.
To use the above example, suppose that prices of pencils in the U.S. are
expected to increase by 4% over the next year while prices in Canada
(dollar) are expected to rise by only 2%. The inflation differential between
the two countries is:
=4% - 2% = 2%
This means that prices of pencils in the U.S. are expected to rise faster
relative to prices in Canada.
In this situation, the purchasing power parity approach would forecast that
the U.S. dollar would have to depreciate by approximately 2% to keep
pencil prices between both countries relatively equal.
So, if the current exchange rate was 90% U.S. per one Canadian dollar,
then the PPP would forecast an exchange rate of:
(1+0.02) X (US $ 0.90 per C$ 1) = 0.918 or 92
It means that now, 91.8% US $ would take to buy one C$.