Unit I Important Terms Flashcards
Balance of Payment (BOP)
An accounting record of a country’s international transactions over a particular period of time.
Features of the BOP
BOP follows the accounting procedure of double-entry book-keeping
Credits = Gains
Debits = Losses
Other Features of the BOP
The BOP will always balance.
A BOP deficit means that the debit entries will be less than the credits.
This imbalance applies only to a particular account or a component of the BOP.
Statistical discrepancies respond to any errors in order to redirect the balance back to zero.
Components of the BOP
Current Account = Capital Account + Financial Account
Capital Account
Financial Account—Public and Private
The sum of these three sections must equate to zero.
What must the BOP be equal to?
Zero.
Components of Current Account Entries
The current account includes the value of trade in merchandise, services, income from investments, and unilateral transfers.
Merchandise—tangible goods.
Services—include travel and tourism, banking, transport costs, and insurance.
Income from investments—interest, royalties, and dividends.
Unilateral transfers—include foreign aid, gift, and charity payments.
Capital Account Balance
This item is relatively small for all countries, including the US.
Consists of 2 sub-accounts:
Capital transfers
Acquisition of trade
Financial Accounts Entries
International capital flows involve international purchases and sales of financial assets.
Two types of transactions:
- Capital account activities
- Financial account activities
Capital Transfers
The inclusion of debt forgiveness.
Migrants’ transfers.
The transfer of title to fixed assets and the transfer of funds linked to the sale or acquisition of fixed assets, gift and inheritance taxes, death duties, uninsured damage to fixed assets and legacies.
Financial Account
Direct Investment
Purchases of Equity and Debt Securities
Bank Claims and Liabilities
U.S. Government Assets Abroad
Foreign Official Assets in the U.S.
Foreign Exchange Market
The Foreign Exchange Market (FEM) is the market where one country’s money is traded for that of another country.
The price of a country’s money in terms of another is called the exchange rate.
What is the Largest Market in the World Today?
a) New York Stock Exchange
b) London Stock Exchange
c) The Dow Jones
d) The Foreign Exchange Market
d) The Foreign Exchange Market
Exchange Rate (XR)
The price of one money in terms of another.
Types of Exchange Rates:
Spot XR vs. Forward XR
USD per foreign currency vs. foreign currency per USD
Cross XR
Spot Market
A spot market is where currencies are traded “on the spot,” that is, for immediate delivery. The exchange rate here is called spot XR.
Current rates are an alternative name.
Rates are established in continuous, real-time published quotes by the small group of large banks that trade the interbank rate. Thereon, the rates are published by forex brokers throughout the globe.
What is a “spread” in the FEM?
The difference between the buying (bid) and selling (offer) price of a currency.
The spread will tend to be higher for thinly or low-volume traded currencies or for high-risk currencies—such as if there are coupes, political instability, natural disasters, etc.
Exchange Rate Index
A weighted average of a currency’s value relative to other currencies, where the weights are based on the relative trade importance of each other.
Forward Rate
The price of foreign money for delivery at some future date
The price and contract are agreed on a certain date, but the delivery can occur months later.
What is Hedging?
Transactions aimed at reducing exposure to risk.
Forward Premium vs. Forward Discount
Forward Premium—when the forward exchange rate is greater than the spot rate.
Forward Discount—when the forward exchange rate is less than the spot rate.
Flat Currency—when the forward rate and spot rate are equivalent.
How are forward rates determined?
Forward rates are determined by the major financial institutions in the foreign exchange market using an idea (formula) called covered interested parity.
Forward Rate Formula
Forward Rate Formula: F=E*(i(usd)-i(yen) +1)
i = interest rate
Example: E=$2/pound
i(usd)=5%
i(br)=3%
E=$2*(0.05-0.03+1) = $2.04
Commercial banks outplay naïve investors by expecting that British investors would retrieve their money in pounds from dollars.
Companies may influence forward rates that may be beneficial to them.
Covered Interest Parity
Perfectly competitive markets would like to receive returns on investments by adjusting the current rate.
The formula is used by financial institutions to set the forward rate.
F = E * (i(usd) - i(yen) +1)
True or false: The forward rate will always depend on a spot rate.
True
Cross Rate
The price of one non-U.S. dollar currency in terms of another.
Since the dollar is actively traded with many currencies, any two exchange rates involving dollars can be used as a cross reference.
Foreign Exchange Swaps
An agreement to exchange currencies on one date and then reverse the trade on a different date.
About 47% of transactions amongst the FEM consist of Foreign Exchange Swaps.
Approximately 40% of transactions in the FEM are spot swaps.
Approximately 13% are forward swaps.
The swap combines activity in both spot and forward markets.
Foreign Currency Options
A contract that provides the right to buy or sell a given amount of currency at a fixed exchange rate on or before the maturity date.
What are some of the options when trading foreign currency?
Call option—gives right to BUY currency.
Put option—gives right to SELL currency.
Strike or Exercise Price—the price of the currency stated in an option contract.
Depreciation
When the value of one currency falls relative to another.
For example, if the US dollar depreciates against the British pound, then it takes more dollars to buy one pound.
Appreciation
When the value of one currency rises relative to another.
International Monetary System
The IMS refers to the framework of institutions and rules within which international financial transactions are conducted and balance of payments imbalances are settled.
Principal institutions of the IMS are the major commercial banks, central banks, and the IMF.
History of the IMS
The Gold Standard: 1880-1914
The Interwar Period: 1918-1939
The Bretton Woods System: 1944-1973
Today’s IMS: Since 1973—floating exchange rates
Price-Specie Flow Mechanism
Refers to the process by which a BOP imbalance self-corrects via international flows of gold and resultant price changes.
A country with BOP surplus > gains gold > money supply and domestic prices increase > surplus country loses trade competitiveness.
The opposite process happens in deficit a country.
Bretton Woods System: 1944-1973
An international conference in Bretton Woods, New Hampshire, in 1944 led to the creation of the World Bank and the IMF.
To participate in the Bretton Woods system, a country had to join the IMF and declare a par value for its currency in terms of the US dollar.
Famed economist John Maynard Keynes represented the UK.
Flaws of the Bretton Woods System
A major flaw was a dollar shortage, as it supplied liquidity to the rest of the world.
The IMF did not need to follow any procedures for a country to alter its par value by 10%.
The End of the Gold Standard
The gold window was closed in 1971, as the US dollar could not be traded in troy gold at a fixed rate.
Nixon in March of 1973 recognized that far too much gold had left their coffers, and officially ended the gold standard.
Rules of the IMF
Each member country has to pay a quota depending on the size of its economy and importance in world trade.
One quarter of the quota is paid in gold or dollars, and the rest in the country’s currency.
A country has automatic borrowing rights.
IMF can impose policy conditions on borrowing countries—so called IMF conditionality.
Objectives of the IMF
Programs of conditional assistance—insists that countries change their economic policies in rather drastic ways.
Requires greater openness towards foreign investment, lower taxes, greater oversight.
Examples: Indonesia and Argentina.
Governance of the IMF
Managing Director—typically from the EU.
24 Executive Directors.
Country quotas—created by a formula and subjects voting rights in the IMF.
US’s country quota is about 17%, and the EU’s is 40%. China holds 6% of the quota percentage.
Differentiation Between the IMF and World Bank
The IMF’s job was to ensure exchange rates remained stable
Providing loans for struggling nations.
The IMF is funded predominantly by quotas.
Major IMF funds are in Ukraine, Pakistan, and Greece.
The World Bank was designed to support the European nations recovering from WWII.
The WB focuses on developing nations and lifting those out of poverty.
The WB is funded by issuing bonds.
WB is the most prominent in Africa.
Devaluation
Refers to a deliberate and official decrease in the value of a country’s currency relative to other currencies in a fixed or managed exchange rate system.
Revaluation
Involves a deliberate and official increase in the value of a country’s currency relative to other currencies in a fixed or managed exchange rate system.
Destabilizing Speculation
Destabilizing speculation or a run on a currency occurs when speculation activity forces the equilibrium exchange rate.
Hard Pegs
No separate legal tender—another country’s currency circulates as legal tender.
Country voluntarily chooses to adopt another currency from a different country.
Currency board—domestic currency is backed by government holdings of foreign currency in fixed proportions.
Soft Pegs
Conventional fixed peg.
Horizontal band.
Crawling peg.
Crawling band.
Conventional Fixed Peg
Currency fluctuates within band of no more than +-1% of par.
Horizontal Band
Currency fluctuates within margins OF MORE than +-1% of par.
Crawling Peg
Currency fluctuates in a band +-1% par, and par is adjusted PERIODICALLY.
Crawling Band
Currency fluctuates in a band OF MORE THAN +-1% of par, and par is adjusted periodically.
Managed Floating
The exchange rate follows no predetermined path, but the central bank intervenes in the foreign exchange market.
Country Factors and Choice of Exchange Rate System
Country size—large countries tend to be less willing to subjugate their own domestic policies to maintain a fixed rate system.
Openness—more open economies tend to follow a pegged exchange rate to minimize foreign shocks, while closed economies prefer the floating rate.
Inflation rate—countries with more harmonious or stable inflation.
Floating vs. Fixed XR System
In a floating exchange rate system, the exchange rate is determined by market forces such as supply and demand for a currency in the foreign exchange market. Central banks do not typically intervene to control the rate.
In a fixed exchange rate system, the government or central bank actively manages the exchange rate by buying or selling its currency in the foreign exchange market to maintain a specific rate.
Uncovered Interest Rate Parity (UIRP)
Uncovered interest rate parity formula: E = exp(E t+1) / (i-iF+1)
Profitable Speculation
Given the forward rate (F) and the speculator’s
expected future spot rate at time t+1 [exp(Et+1)]:
* If F<exp(Et+1), then buy forward.
* If F>exp(Et+1), then sell forward.
Interest Rate (Forward Premium) Anomaly
Refers to the empirical finding of a negative covariance between the future change in the exchange rate and the interest rate differential.
Purchasing Power Parity
PPP refers to the concept that the same basket of goods SHOULD COST THE SAME when prices are measured in the same currency regardless of where it is located.
PPP Exchange Rate
Suppose that P is the price of a bundle of goods in the US, and PF is the price of an identical bundle of goods in a foreign country. If the two bundles are to have the same price, then the following must hold:
EPPP = P/PF, or P = EPPP * PF
The Theory of PPP
The PPP theory states that in the ideal world, the actual exchange rate should converge toward the PPP exchange rate.
In other words, EPPP is the long-run equilibrium value for the exchange rate E.
Absolute PPP
Absolute PPP indicates that the exchange rate between two currencies should be equal to the ratio of the two countries’ price levels.
E = EPPP = P/PF
P is the domestic price index
PF the foreign price index
E is the actual spot exchange rate
Law of One Price
States that the same good must sell for the same price in foreign and domestic markets.
Relative PPP
Relative PPP states that the percentage change in the exchange rate is equal to the difference between the percentage change in the domestic price level and the percentage change in the foreign price level.
