International Finance

Chapter 8 Management of Transaction Exposure           

Foreign currency exposure into 3 types:

  1. Transaction Exposure-the sensitivity of “realized” domestic currency values of the firm’s contractual cash flows denominated in foreign currencies to unexpected exchange rate changes.  Short-term exposure when it faces contractual cash flows that are fixed in foreign currencies.  Unlike economic exposure well defined: the magnitude of transaction exposure is the same as the amount of foreign currency that is receivable or payable.  Alternative ways of hedging transaction exposure using various financial contracts and operational techniques:

Financial Contracts

  • Forward Market Hedge
  • Money market hedge
  • Option market hedge
  • Swap market hedge

Forward market Hedge

Most popular of hedging transaction exposure is by currency forward contracts.  The firm may sell or buy its foreign currency receivables (payables) forward to eliminate its exchange risk exposure.  Gains and losses from forward hedging can be computed as follows:  Gain= (F-St) x L10 Million.  Ex post in nature.  No one can know for sure what the future spot rate will be beforehand.  The firm must decide whether to hedge or not to hedge ex ante.  3 alternative scenarios: (St denotes the firm’s expected spot exchange rate for the maturity date).

Operational techniques

  1. Choice of the invoice currency
  2. lag strategy-A foreign exchange management strategy consisting of delaying payments or receipts in a foreign currency, on the expectation of the evolution of the foreign exchange rate. Opposite: Lead strategy-This strategy implies that firms will pay off foreign currency debts and collect foreign currency receipts early. This, typically, because the local currency is expected to weaken.
  3. Exposure netting-Offsetting exposures in one currency with exposures in the same or another currency, when exchange rates are expected to move in such a way that losses or gains on the first exposed position should be offset by gains or losses on the second currency exposure.
  4. Economic Exposure- the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.  Changes in exchange rates can have a profound effect on the firms competitive position in the world market and thus on its cash flows and market value.
  5. Translation exposure-the potential that the firms’ consolidated financial statements can be affected by changes in exchange rates.  Involves translation of subsidiaries’ financials statements from local currencies to the home currency.  Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post.  It does not provide a good measure of ex ante economic exposure.

Forward market Hedge

Most popular of hedging transaction exposure is by currency forward contracts.  The firm may sell or buy its foreign currency receivables (payables) forward to eliminate its exchange risk exposure. Gains and losses from forward hedging can be computed as follows:  Gain= (F-St) x L10 Million.  Ex post in nature.  No one can know for sure what the future spot rate will be beforehand.  The firm must decide whether to hedge or not to hedge ex ante.  3 alternative scenarios: (St denotes the firms expected spot exchange rate for the maturity date)

1.     St=F, gains or losses are 0.

Firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale.  The firm would be inclined to hedge as long as it is averse to risk.  Valid when the forward exchange rate is an unbiased predictor of the future spot rate.

2.     St<F

Firm’s expected future spot exchange rate is less than the forward rate; the firm expects a positive gain from forward hedging.  Since the firm expects to increase the dollar proceeds, while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario.  Implies that the firm’s management issues from the market’s consensus forecast of the future spot exchange rate as reflected in the forehand rate.

3.     St>f

Firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds for the foreign sale.  Firm less inclined to hedge under this scenario.  From perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk.  The firm can use a currency futures contract, rather than a forward contract, to hedge.  A future contract is not as suitable as a forward contact for hedging purpose for:

1.     Unlike forward contracts that tailor-made to firms specific needs, future contracts are standardized instruments in terms of contract size, delivery date, et.  Can hedge only approximately.

2.     Due to the marketing-to-marketing property, there are interim cash flows prior to the maturity date of the future contract that may have to be invested at uncertain interest rates.

Money Market Hedge

Firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.  Transactions: Borrow pounds-the maturity value of borrowing should be the same as the pound receivable; the amount to borrow can be computed as the discounted present value of the pound receivable.  Buy dollar spot with pounds, invest in the United States, Collect pound receivable=Net Cash Flow.  Apart from possible transactions, it is fully self-financing.

Options Market Hedge

Shortcoming of forward and money market hedges is that these methods completely eliminate exchange exposure.  Currency options provide such a flexible “optional” hedge against exchange exposure.  The firm (receivables).  Main advantage of options hedging is that the firm can decide whether to exercise the option based on the relaxed spot exchange rate on the expiration date.  The options hedge allows the firm to limit the downside risk while preserving the upside potential.  When a firm has an account payable rather than a receivable, in terms of a foreign currency, the firm can set a ceiling for the future dollar cost of buying the foreign currency amount by buying a call option on the foreign currency amount.  Break-even spot rate.

Chapter 8 problems

Q1: How would you define transaction exposure? How is it different from economic exposure?

Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly. The magnitude of transaction exposure is the amount of foreign currency that is receivable or payable.  Economic exposure is the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. The firms value already reflects the anticipated changes in exchange rates.  Both Transaction and economic exposures are cash exposures. The difference is that transaction exposure is caused by individual transactions of accounts receivable or payable, while the economic exposure is uncontrollable and affects the total value of the firm. An example of economic exposure is that a change in the exchange rate can change the overall competitiveness of the firm internationally.

Q4: What are the advantages of a currency options contract as a hedging tool compared with the forward contract?

A forward contract occurs when a firm sells its foreign currency receivables or buys its foreign currency payable forward to eliminate exchange risk exposure. It allows the company to lock in a future exchange rate today so that profits will not be affected by changes in the exchange rate. Forward contracts completely eliminate exchange exposure, but the firm has to forgo the opportunity to benefit from favorable changes in the exchange rate.  Currency options, on the other hand, provide a flexible “optional” hedge against exchange risk exposure. Currency options allow firms to limit the downside risk while preserving the upside potential. If the dollar depreciates the firm can use the currency option, while if the dollar appreciates the firm can allow the option to expire and use the spot rate. The firm pays for this flexibility with an option premium.

Q6: Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?

In a “perfect” capital market Exchange exposure management at the corporate level is redundant when the stockholders can manage the exposure themselves.  What matters in firm valuation is only systematic risk; corporate risk management may only reduce the total risk.  Relevant to maximizing the firms value.

Problem 1: Cray Research sold a supercomputer to the Max Planck Institute in Germany on credit and invoiced 10 million euros payable in six months. Currently, the six month forward exchange rate is $1.10/euro and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/Euro in six months

What is the expected gain/loss from a forward hedge?

Gain=(f-S)* 10 million euros

Gain=(1.10$/Euro-1.05$/euro) * 10 million euros= $500,000

If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? why or why not?

I would recommend hedging  the euro receivable. With the hedge Cray Research would receive (1.1$/euro*10 million Euro)= $11,000,000 in six months opposed to (1.05$/euro*10 million Euro)= $10,500,000 in six months at the predicted spot rate. This way the Cray Research not only gains $500,000 but also eliminates exchange exposure.

Suppose the foreign exchange adviser predicts that the future spot rate will be the same as the forward exchange rate quoted today. would you recommend hedging in this case? Why or why not?

I would recommend hedging because if the predicted future spot rate is the same  as the forward exchange rate quoted today, the gains or losses would be approximately $0 and an averse to risk firm can eliminate exchange rate exposure.

Problem 2

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed 250 million yen payable in three months. 

Current spot rate:   $1=105 Yen

3-month forward rate: $1=100 Yen

U.S. interest rate:  8% per year

Japan interest rate:  7% per year

The management of IBM decided to use a money market hedge to deal with this yen account payable.

1. Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

A money market hedge involves investing an amount in domestic and foreign money markets today that, in the future, will adequately satisfy the payable as it becomes due.

In this case IBM will invest the PV of the payable at the Japanese interest rate of 7% per year and will then have the 250 million yen it needs to pay the payable in three months. To do this, IBM will have to put forth a certain dollar amount today to buy the yen at the current spot rate.

Step 1:  Compute the present value of the foreign currency payable.

FV= 250,000,000 Yen

Rate= 1.75% (7%/4 to get to quarterly rate)

Periods= 1 three-month period

PV= 245,700,246 Yen

Step 2: Compute the dollar amount needed today to invest.

Current spot rate: $1=105 Yen

1 Yen=$0.0095

245,700,246 Yen is equivalent to $2,340,002 today.

The dollar cost of meeting the yen obligation is the future value of the today’s dollar cost.

$2,340,002 x (1.02)=$2,386,802.39

(8%/4 to get quarterly rate)

1. Cash flow analysis

CF today CF at maturity
Dollars needed to invest in Japan 2340002
Buy Yen with dollars 245700246
-2340002
Invest Yen -245700246 250000000
Pay liability -250000000
Net cash flow 0

Chapter 9  Management of Economic Exposure Problems (Q4, Q7, Q8, Q9, Problem 1A)

Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.  Operating exposure cannot be determined from accounting statements as transaction exposure.

Q4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.

Competitive effect: how depreciation/appreciation affects operating cash flow by altering the firms competitive position in the marketplace.  This depends on the market structure of inputs and products: how competitive or monopolistic the markets facing the firm are.  Conversion effect: how depreciation/appreciation changes the operating cash flow by the firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.

Example: Due to the hyperinflation crisis in Zymbabwe, there was an extreme depreciation in the value of the Zymbabwe dollar.  Zymbabwe’s rate of inflation reached 79.6 Billion %! In effect, Zymbabwe grain, like many other Zymbabwe imports suffered significantly.  So, the exposure to grain companies had two components:

1. Competitive effect: difficulties and a increased costs for importing and selling grain

2. Conversion effect: lower dollar prices of imports due to foreign currency  exchange rate depreciation

8) What are the advantages and disadvantages to a firm of financial hedging of its operating exposure compared to operational hedges (such as relocating its manufacturing site)

Operational hedges

a. Selecting low-cost production sites

– Setting up in an area with relatively weak currency.  Giving you cheaper labor and production costs

b. Flexible sourcing policy

– Choosing to source operations from countries where input costs are low.

c. Diversification of the market

– Economies all around the world change all the time.  If you place your entire product line in one country, a lull in the economy can lead to huge decreases in the demand for your product.  This is much more unlikely if you place your product all around the world.

d. R&D efforts and product differentiation

– Positive R&D efforts can cut costs and lead to new, innovative product ideas

These options are certainly valuable and are frequently utilized by firms all around the world.  However, many times these options (which involve redeployment of resources) can become costly and impractical.  This is when financial hedging is a much better option.

Financial hedging

This is used to stabilize the firm’s cash flows by investing in currency forwards or options (also by lending and borrowing).  This will eliminate a large portion of the exchange rate risk.  However, since investing in these derivatives only takes in account the nominal value and not the real value (which is what you are interested in), financial hedging can only provide an approximate hedge against the firms operating exposure.

Q9: Discuss the advantages and disadvantages of maintaining multiple

manufacturing sites as a hedge against exchange rate exposure.

Advantages:

1. Business stability from less exposure to exchange rate volatility.

2. Production flexibility to maximize low-cost benefits of currency depreciation.

3. Global presence, which may catalyze market diversification (another hedge).

Disadvantages:

1. Increased risk (political, social etc.)

2. Increased production costs (inability to realize economies of scale). Unable to predict currency fluctuations long-term (currencies moving in unintended manner)

PROBLEM 1A)

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

Solution: (a)

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.

Exposure netting-hedging based on net exposure, no one hedges gross exposure

Exposure on assets and operating cash flow

Operating exposure having impact on operating cash flow based on exchange rates impacted on net income level

Determinants of operating exposure

Managing operating exposure-r and d, 5 items

Financial hedging is listed as something to be done for economic exposure, short-term in nature and is note effective as other items

Statistical perspective

Euro and foreign bonds characteristics-don’t need to know tax rules

Euro medium notes

Currency Distribution, nationality and blah skip

International bond ratings

jUST KNOW WHAT IS LOOKED AT FOR A CREDIT RATING

eRUO BON STURCUTRE AND PRCATICES, PRIMARY AND SECONDARY MARKETS WORK

Clearing procedures-skip

International Bond Market Index

Market Capitalization in developing countries vs.  others

Concentration very liquid and very diversified in mature, less concentrated and liquid in developing

Market structure, cost, and trading practices

Market Consolidation

Trading in International Equities

Yankee stock offerings

American Depository Receipts

International equity benchmarks

Eyeshares

Factors affecting international equity

Chapter 12 International Bond Market

The world’s Bond Markets: A statistical Perspective

More domestic bonds than international bonds are denominated in dollar and the yen while more international bonds than domestic bonds are denominated in the euro and the pound sterling

Foreign Bonds and Eurobonds

Foreign bonds-one offered by a freeing borrower to the investor in a national capital market and denominated in that nation’s currency.  Have colorful names that designate the country in which they are issued.

Yankee Bonds-dollar-denominated foreign bonds originally sold to U.S. investors, must be registered

Samurai Bonds-yen-denominated foreign bonds originally sold in Japan

Bulldogs-pound sterling-denominated foreign bonds sold in U.K.

Eurobond-one denominated in a particular currency but sold to investors in national capital markets other than the country that issued the denominating currency. Known by the currency in which they are denominated

Bearer Bonds and Registered Bonds

Bearer Bond-possession is evidence of ownership.  Does not keep any records indicating who is the current owner of a bond. Desirable for investors desiring privacy and anonymity-tax evasion, investors usually accept lower yield

Registered Bonds-owner’s  name is on the bond and it is also recorded by the issuer, or else the owner’s name is assigned to a bond serial number recorded by the issuer

National Security Regulations

U.S. securities Act of 1933

Securities and Exchange and Commission

Global Bonds-a very large international bond offering by a single borrower that is simultaneously sold in North America, Europe, and Asia.  Enlarge the borrower’s opportunities for financing at reduced costs.  Largest corporate bond the Deutsche Telecom multi currency offering.

Types of Instruments

Straight Fixed-Rate issues-have a designated maturity date at which the principal of the bond issue is promised to be repaid.  During the life of the bond, fixed coupon payments, which are a % of the face value, are paid as interest to the bondholders.  Annual coupon redemption is more convenient for the bondholders and less costly for the bond issuer because the bond-holders are scattered geographically.  The Euro, U.s., British Pound , and Japanese yen most common

Euro-Medium-Term Notes

typically fixed-rate notes issued by a corporation with maturities ranging from less than a year to about 10 years. have a fixed maturity and pay coupon interest on period dates.  Partially sold on a continuous basis through an issuance facility that allows the borrower to obtain funds only as needed on a flexible basis.  Damien Rice.  SOX-Sarbanes-Oxley Act is the U.s Law designed to eliminate corporate fraud

Floating-Rate Notes-

Medium-term bonds with coupon payments indexed to some reference rate.  LIBOR-interest rate index used by banks, similar to t-bill rate offered.  All bonds experience an inverse price change when the market rate of interest changes of interest changes.  Reset date-market price will gravitate back close to par value when the next period’s coupon payments are repriced to market expectations of future values of the reference rate, and subsequent coupon payments are repriced to market expectations of future values of the reference rate.

Equity-Related Bonds

  1. Convertible bond-allows the investor to exchange the bond for a predetermined number of equity shares of the issuer.  Floor-value-straight fixed-rate bond value.
  2. Bonds with equity warrants-straight fixed-rate bonds with the addition of a call option or warrant feature

Dual-Currency Bonds

Straight fixed-rate bond issued in one currency, that pays coupon interest in that same currency.  At maturity, the principal is repaid in another currency.  Coupon interest is frequently at a higher rate than comparable straight fixed-rate bonds.  The market value of a dual-currency bond in the in given country should equal the sum of the present value of the country currency stream discounted at the country market rate of interest plus the dollar principal repayment, converted to country currency as the expected future exchange rate, and discounted at the country market rate of interest.

Currency Distribution, Nationality, and Type of Issuer

Euro, U.S. dollar, British pound sterling, yen, Swiss Franc, and Canadian dollars have been the most frequently used currencies to denominate issues.  United States, Germany, the United Kingdom, France, and the Netherlands have been major issuers of international bonds during the past several years.  Financial institutions and governments have been the largest issuers of international bonds in recent years.

International Bond Market Credit Ratings

Fitch ratings, Moody’s Investors Service, and Standard and Poor’s have provided credit ratings on domestic and international bonds and their issuers.  Classify bond issues into categories based upon the creditworthiness of the borrower.  Based on analysis of current info regarding the likelihood of default and the specifies of th debt obligation.  Both reflect creditworthiness and exchange rate uncertainty.  Investment grade ratings-Aaa to Baa.  Disproportionate share of Euro-bonds have credit ratings in comparison to domestic and foreign bonds.  Issuers receiving low credit ratings invoke their publication rights and have had them withdrawn prior to dissemination.  Eurobond is accessible only to firms that have good credit ratings and name recognition to begin with, hence rate highly.

Tranches-?

Asymmetrical relationship-positive ratings events in one country have no impact on sovereign spreads in other countries, but negative ratings events are associated with a significant increase in spreads.  Attribute the spillover among countries to highly positively correlated capital and trade flows.

Eurobond Market Structure and Practices

Primary 

Market-borrower desiring to raise funds by issuing Eurobond to the investing public will contact an investment banker and ask it to serve as the lead manager of an underwriting syndicate that will bring the bonds to market

Underwriting syndicate-group of investment banks, merchant banks, and the merchant banking arms of commercial banks that specialize in some phase of a public issuance.

Lead manager will sometimes invite co-managers to form a managing group to help negotiate terms with the borrower, ascertain market conditions, and manage the issuance.  Rankings, are shown for the top overall underwriters (based on service clients, major currency sectors, and by-product) and by currency denomination of issues.

The managing group, along with other banks, will serve as underwriters for the issue, and will commit their own capital to by the issue from the borrower at a discount from the issue price.  The discount, or underwriting spread, is in the 2-2.5 % range.

Selling group-sells the bonds to the investing public.

Eurobonds initially purchased in the primary market from a member of the selling group may be resold prior to their maturities to other investors in the secondary markets.

Secondary market for Eurobonds-an over-the-counter market with

Secondary market comprises market makers and brokers connected by an array of telecommunications equipment.

Market makers-stand ready to buy or sell for their own account by quoting two-way bound ans ask prices.  Market makers trade directly with one another, through a broker, or with retail customers.  The bid-ask spread represents their only profit; no other commission is charged.

Brokers-accept buy or sell orders from market makers and then attempt to find a matching party for the other side of the trade; may also trade for their own account.

Clearing Procedures

Euroclear and Clearstream International, have been established to hand most Eurobound trades.  Clearing system has a group of depository banks that physically store bond certificates.  Members of either system hold cash and bond accounts.

  1. The clearing systems will finance up to 90 percent of the inventory that a Euro bond market maker has deposited within the system
  2. The clearing systems will assist in the distribution of a new bond issue.  Will take physical possession of the newly printed bond certificates in the depository, collect subscription payments from the purchasers, and record ownership of the bonds.
  3. The clearing systems will also distribute coupon payments.  The borrower pays to the clearing system the coupon interest due on the portion of the issue held in the depository, which in turn credits the appropriate amojnts tothe nond owner’s cash accounts.

International Bond Market Indexes

J.P. Morgan and Company Domestic Government Bond Index, J.P. Morgan publishes a government bond index for 29 countries and regions, broken down in up to 17 maturity bonds.  Global Government Bond Index is a value-weighted representation of the individual country government bond indexes.

Wall Street Journal publishes daily values of yields to maturity for U.S., Australia, Canadian, German, Japanese, Swedish, Swiss, and British Government of 2 year and 10 yr to maturity.  Allow for a comparison of the term structures of interest rates of these major industrial countries with one another.  Another source of international bond data is the coupon rates, prices, and yields to maturity found in the daily”Benchmark Government Bonds” table in Financial Times.

Chatper 13

Chapter 9(Q4,Q7,Q8,Q9, Problem 1A)

Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.

Operating exposure cannot be determined from accounting statements as transaction exposure.

7. General Motors exports cars to Spain, but the strong dollar against the Euro hurts sales of GM cars in Spain.  In the Spanish market, GM faces competition from Italian and French car makers, such as Fiat and Renault, whose operating currencies are the Euro.  What kind of measures would you recommend so that GM can maintain its market share in Spain?

The strong dollar puts GM at a disadvantage competitively, as the Italian and French car makers will be able to sell their cars cheaper in Euro terms.  There are four strategies that GM can employ in an attempt to maintain its Spanish market share.  The first strategy is to locate production facilities in a foreign country where costs are low due to either undervalued currency or underpriced factors of production.  Secondly, they could employ a flexible sourcing policy for purchasing inputs for production.  This will allow them to take advantage of favorable exchange rates, providing for an overall lower cost of production.  Next, they should seek to establish product differentiation in the Spanish market. If GM is able to create a perception in the market that their product is different and better than that offered by their competitors the demand for GM cars will be less price sensitive.  Lastly, they can invest in R&D in hopes of finding ways to lower production costs and enhance productivity.   There are several other steps that GM could take to hedge against this foreign exchange risk, but these are the steps that would act to maintain market share specifically in Spain

3. Unable to predict currency

fluctuations long-term (currencies moving in unintended manner)

PROBLEM 1A)

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

Solution: (a)

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

Chapter 13 Problems

1.     On the Milan bourse, Fiat stock closed at EUR 14.67 per share on Tuesday, February 26, 2008. Fiat trades as an ADR on the NYSE. One underlying Fiat share equals one ADR. On February 26, the $/EUR spot exchange rate was $1.4889/EUR1.00

a.    At this exchange rate, what is the no-arbitrage U.S. dollar price of one ADR?

14.67*1.4889= $21.84

b. By comparison, Fiat ADRs closed at $21.94.  Do you think an arbitrage opportunity exist?

Yes, because in order for there to be no arbitrage opportunity, the shares would

Need to close at the same price when adjusted for the exchange rate. 

2. As an investor, what factors would you consider before investing in the emerging stock market of a developing country?

One of the factor an investor would consider is the measure of liquidity.  A measure of liquidity for a stock market is the turnover ratio; that is, the ratio of stock market transactions over a period of time divided by the size of the stock market. Higher the turnover ratio means the more liquid the market is. Another factor is the measure of market concentration. The more concentrated a national equity market is in a few stock issues, the less opportunity a global investor has to include shares from that country in an internationally diversified portfolio.

4. Discuss any benefits you can think of for a company to (a) cross-list its equity shares on more than one national exchange,, and (b) to source new equity capital from foreign investors as well as domestic investors.

A) pg 318-319 in more details

1. Cross-listing provides a means for expanding the investor base for a firm’s stock, thus potentially increasing its demand.

2. Establishes name recognition of the company in a new capital market, thus paving the way for the firm to source new equity or debt capital from local investors as demands dictate

3. Brings the firm’s name before more investor and consumer groups

4. cross-listing into developed capital markets with strict securities regulations and information disclosure requirements may be seen as a signal to investors that improved corporate governance is forthcoming

5. it may mitigate the possibility of a hostile takeover of the firm through the broader investor base created for the firm’s shares.

5. why might it be easier for an investor desiring to diversify his portfolio internationally to buy depository receipts rather than the actual shares of the company? Pg 320 in more details

1. ADRs are denominated in dollars, trade on a U.S. stock exchange, and can be purchased through the investor’s regular broker

2. dividends received on the underlying shares are collected and converted to dollars by the custodian and paid to the ADR investor, whereas investment in underlying shares requires the investor to collect the foreign dividends and make a currency conversion

3. ADR trades clear in three business days as do U.S. equities. It varies in foreign countries

4. ADR price quotes are in US dollars

5. ADRs are registered securities that provide for the protection of ownership rights, whereas most underlying stocks are bearer securities

6. ADR investment can be sold by trading the depository receipt to another investor in the US stock market

7. ADRs frequently represent a multiple of the underlying shares, rather than a one-for-one correspondence, to allow the ADR to trade in a price range customary for U.S. investors

8. ADR holders give instructions to the depositor bank as to how to vote the rights associated with the underlying shares.

Chapter 5 Questions

1.  Calculate the following exchange rates:

Euro to Swiss franc

Euro to Japanese yen

Euro to British pound

Swiss franc to Japanese yen

Exhibit 5.4 (p.117) Exchange Rates January 4, 2008
Country in US $ per US $
Euro 1.4744 .6783
Swiss franc .9036 1.1067
Japanese yen .009220 108.46
British pound 1.9717 .5072

Ex. Japanese yen per British pound:  = 108.46 yen/.5072 pounds

Canada dollar                  in US$                  per $

1-mos forward                  1.0040                   0.9960

3-mos forward.                  0027                   0.9973

6-mos forward                  1.0003                   0.9997

Swiss Franc                  in US$                  per $

1-mos forward                  1.0600                   0.9431

3-mos forward                  1.0609                   0.9426

6-mos forward                  1.0619                   0.9417

Data from The Wallstreet Journal Jan 26, 2011

Swiss Franc                  in Canada $         per Canada $

1-mos forward                  1.0561                  0.9469

3-mos forward                  1.0580                  0.9452

6-mos forward                  1.0616                  0.9420

6. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Canadian dollar versus the U.S. dollar using American term quotations.  For simplicity, assume each month has 30 days.  What is the interpretation of your results?  The forward premium or discount for the Canadian dollar versus the U.S dollar using American term quotations.

Spot Rate  .9984

1-month .9986

3-month .9988

6-month .9979

This shows that the Canadian dollar is selling at a premium to the dollar. The premium is increasing out to the 3-month mark. The U.S. dollar will depreciate compared to the Canadian dollar for 3 months and than appreciate compared to the Canadian dollar at month 6.

1-month forward premium=(.9986-.9984)/.9984*(360/30)=.240%

3-month forward premium=(.9988-.9984)/.9984*(360/60)=.240%

6 month forward premium=(.9979-.9984)/.9984*(360/180)=-.100%

9.  What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?

Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate. Certain banks specialize in making a direct market between nondollar currencies, pricing at a narrower bid-ask spread than the cross rate-spread. If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible.

10.  Doug Bernard specializes in cross-rate arbitrage.  He notices the following quotes:

Swiss franc/dollar = SFr 1.5971/$

Australian dollar/U.S. dollar = A$ 1.8215/$

Australian dollar/Swiss franc = A$ 1.1440/SFr

Ignoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes?  If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how much would he profit if he has $1,000,000 available for this purpose?

 

Ignoring transaction costs, Doug has an arbitrage opportunity of $3,064.73 trading with $1,000,000.  He would trade from US dollar to Swiss franc, from Swiss franc to Australian dollar, and then from Australian dollar to US dollar

$                     1,000,000

x                       1.5971

SFr                1,597,100  Sell US dollars for Swiss francs

x                       1.1440

A$               1,827,082.4 Sell Swiss francs for Australian dollars

/                        1.8215

$                   1,003,064.73  Sell Australian dollars for US dollars

–               1,000,000.00

$                        3,064.73  Arbitrage Profit

12.  The current spot exchange rate is $1.95/pound and the three-month forward rate is $1.90/pound. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/pound in three months. Assume that you would like to buy or sell 1,000,000 pounds.

A.   What actions do you need to take to speculate in forward market? What is the expected dollar profit from speculation?

– If you believe the spot exchange rate will be $1.92/pound in three months, you should short the three-month $/pound contract. By doing, you can by for $1.92/pound and then deliver it for $1.90/pound. This means you’ve made a profit of .02 per unit. The total profit is then $20,000.

B.    What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/pound?

– If the spot exchange rate actually turns out to be $1.86/pound, you’ve lost money. This means you are forced buy at $1.86/pound and then sell it at $1.90/pound. This means you would lose $40,000.

St=F, gains or losses are 0.

Firm can eliminate foreign exchange exposure without sacrificing any expected dollar proceeds from the foreign sale.  The firm would be inclined to hedge as long as it is averse to risk.  Valid when the forward exchange rate is an unbiased predictor of the future spot rate.

  1. St<F

Firm’s expected future spot exchange rate is less than the forward rate; the firm expects a positive gain from forward hedging.  Since the firm expects to increase the dollar proceeds, while eliminating exchange exposure, it would be even more inclined to hedge under this scenario than under the first scenario.  Implies that the firm’s management issues from the market’s consensus forecast of the future spot exchange rate as reflected in the forehand rate.

  1. St>f

Firm can eliminate exchange exposure via the forward contract only at the cost of reduced expected dollar proceeds for the foreign sale.  Firm less inclined to hedge under this scenario.

From perspective of a hedging firm, the reduction in the expected dollar proceeds can be viewed implicitly as an “insurance premium” paid for avoiding the hazard of exchange risk.  The firm can use a currency futures contract, rather than a forward contract, to hedge.  A future contract is not as suitable as a forward contact for hedging purpose for

  1. Unlike forward contracts that tailor-made to firms specific needs, future contracts are standardized instruments in terms of contract size, delivery date, et.  Can hedge only approximately.
  2. Due to the marketing-to-marketing property, there are interim cash flows prior to the maturity date of the future contract that may have to be invested at uncertain interest rates.

Money Market Hedge

Firm may borrow (lend) in foreign currency to hedge its foreign currency receivables (payables), thereby matching its assets and liabilities in the same currency.  Transactions: Borrow pounds-the maturity value of borrowing should be the same as the pound receivable; the amount to borrow can be computed as the discounted present value of the pound receivable.

Buy dollar spot with pounds, invest in the United States, Collect pound receivable=Net Cash Flow

Apart from possible transactions, it is fully self-financing

Options Market Hedge

Shortcoming of forward and money market hedges is that these methods completely eliminate exchange exposure.  Currency options provide such a flexible “optional” hedge against exchange exposure.  The firm (receivables).  Main advantage of options hedging is that the firm can decide whether to exercise the option based on the relaxed spot exchange rate on the expiration date.  The options hedge allows the firm to limit the downside risk while preserving the upside potential.  When a firm has an account payable rather than a receivable, in terms of a foreign currency, the firm can set a ceiling for the future dollar cost of buying the foreign currency amount by buying a call option on the foreign currency amount.  Break-even spot rate.

  1. Economic Exposure- the extent to which the value of the firm would be affected by unanticipated changes in exchange rates.  Changes in exchange rates can have a profound effect on the firm’s competitive position in the world market and thus on its cash flows and market value.
  2. Translation exposure-the potential that the firms’ consolidated financial statements can be affected by changes in exchange rates.  Involves translation of subsidiaries’ financials statements from local currencies to the home currency.  Resultant translation gains and losses represent the accounting system’s attempt to measure economic exposure ex post.  It does not provide a good measure of ex ante economic exposure.

Group 6 Chapter 8 problems

William  Atherton; Haroon Tekrawala; Bradley Wong; Nicole Decraene; Wesley REECE Sanford; Ethan Garber; Jenna Brock;

Q1How would you define transaction exposure? How is it different from economic exposure?

Transaction exposure arises from fixed-price contracting in a world where exchange rates are changing randomly. The magnitude of transaction exposure is the amount of foreign currency that is receivable or payable.

Economic exposure is the extent to which the value of the firm would be affected by unanticipated changes in exchange rates. The firms value already reflects the anticipated changes in exchange rates.

Both Transaction and economic exposures are cash exposures. The difference is that transaction exposure is caused by individual transactions of accounts receivable or payable, while the economic exposure is uncontrollable and affects the total value of the firm. An example of economic exposure is that a change in the exchange rate can change the overall competitiveness of the firm internationally.

Q4: What are the advantages of a currency options contract as a hedging tool compared with the forward contract?

○      A forward contract occurs when a firm sells its foreign currency receivables or buys its foreign currency payables forward to eliminate exchange risk exposure. It allows the company to lock in a future exchange rate today so that profits will not be affected by changes in the exchange rate. Forward contracts completely eliminate exchange exposure, but the firm has to forgo the opportunity to benefit from favorable changes in the exchange rate.

○      Currency options, on the other hand, provide a flexible “optional” hedge against exchange risk exposure. Currency options allow firms to limit the downside risk while preserving the upside potential. If the dollar depreciates the firm can use the currency option, while if the dollar appreciates the firm can allow the option to expire and use the spot rate. The firm pays for this flexibility with an option premium.

Q6: Recent surveys of corporate exchange risk management practices indicate that many U.S. firms simply do not hedge. How would you explain this result?

In a “perfect” capital market

Exchange exposure management at the corporate level is redundant when the stockholders can manage the exposure themselves

What matters in firm valuation is only systematic risk; corporate risk management may only reduce the total risk

Relevant to maximizing the firm’s value

Problem 1: Cray Research sold a supercomputer to the Max Planck Institute in Germany on credit and invoiced 10 million euros payable in six months. Currently, the six month forward exchange rate is $1.10/euro and the foreign exchange advisor for Cray Research predicts that the spot rate is likely to be $1.05/Euro in six months

What is the expected gain/loss from a forward hedge?

Gain=(f-S)* 10 million euros

Gain=(1.10$/Euro-1.05$/euro) * 10 million euros= $500,000

If you were the financial manager of Cray Research, would you recommend hedging this euro receivable? why or why not?

I would recommend hedging  the euro receivable. With the hedge Cray Research would receive (1.1$/euro*10 million Euro)= $11,000,000 in six months opposed to (1.05$/euro*10 million Euro)= $10,500,000 in six months at the predicted spot rate. This way the Cray Research not only gains $500,000 but also eliminates exchange exposure.

Suppose the foreign exchange adviser predicts that the future spot rate will be the same as the forward exchange rate quoted today. would you recommend hedging in this case? Why or why not?

I would recommend hedging because if the predicted future spot rate is the same  as the forward exchange rate quoted today, the gains or losses would be approximately $0 and an averse to risk firm can eliminate exchange rate exposure.

Problem 2

IBM purchased computer chips from NEC, a Japanese electronics concern, and was billed 250 million yen payable in three months. 

Current spot rate:   $1=105 Yen

3-month forward rate: $1=100 Yen

U.S. interest rate:  8% per year

Japan interest rate:  7% per year

The management of IBM decided to use a money market hedge to deal with this yen account payable.

  1. Explain the process of a money market hedge and compute the dollar cost of meeting the yen obligation.

A money market hedge involves investing an amount in domestic and foreign money markets today that, in the future, will adequately satisfy the payable as it becomes due.

In this case IBM will invest the PV of the payable at the Japanese interest rate of 7% per year and will then have the 250 million yen it needs to pay the payable in three months. To do this, IBM will have to put forth a certain dollar amount today to buy the yen at the current spot rate.

Step 1:  Compute the present value of the foreign currency payable.

FV= 250,000,000 Yen

Rate= 1.75% (7%/4 to get to quarterly rate)

Periods= 1 three-month period

PV= 245,700,246 Yen

Step 2: Compute the dollar amount needed today to invest.

Current spot rate: $1=105 Yen

1 Yen=$0.0095

245,700,246 Yen is equivalent to $2,340,002 today.

The dollar cost of meeting the yen obligation is the future value of the today’s dollar cost.

$2,340,002 x (1.02)=$2,386,802.39

(8%/4 to get quarterly rate)

  1. Cash flow analysis
CF today CF at maturity
Dollars needed to invest in Japan 2340002
Buy Yen with dollars 245700246
-2340002
Invest Yen -245700246 250000000
Pay liability -250000000
Net cash flow 0

Chapter 9 Problems
Operating exposure- the extent to which the firm’s operating cash flows would be affected by random changes in exchange rates.
Operating exposure cannot be determined from accounting statements as transaction exposure.
Q4. Explain the competitive and conversion effects of exchange rate changes on the firm’s operating cash flow.
1. Competitive effect: how depreciation/appreciation affects operating cash flow by altering the firms competitive position in the marketplace.  This depends on the market structure of inputs and products: how competitive or monopolistic the markets facing the firm are.
2. Conversion effect: how depreciation/appreciation changes the operating cash flow by the firm’s ability to adjust its markets, product mix, and sourcing in response to exchange rate changes.
Example: Due to the hyperinflation crisis in Zymbabwe, there was an extreme depreciation in the value of the Zymbabwe dollar.  Zymbabwe’s rate of inflation reached 79.6 Billion %! In effect, Zymbabwe grain, like many other Zymbabwe imports suffered significantly.  So, the exposure to grain companies had two components:
1. Competitive effect: difficulties and a increased costs for importing and selling grain
2. Conversion effect: lower dollar prices of imports due to foreign currency  exchange rate depreciation

8) What are the advantages and disadvantages to a firm of financial hedging of its operating exposure compared to operational hedges (such as relocating its manufacturing site)

Operational hedges –

a. Selecting low-cost production sites

– Setting up in an area with relatively weak currency.  Giving you cheaper labor and production costs
b. Flexible sourcing policy

– Choosing to source operations from countries where input costs are low.
c. Diversification of the market

– Economies all around the world change all the time.  If you place your entire product line in one country, a lull in the economy can lead to huge decreases in the demand for your product.  This is much more unlikely if you place your product all around the world.
d. R&D efforts and product differentiation

– Positive R&D efforts can cut costs and lead to new, innovative product ideas

These options are certainly valuable and are frequently utilized by firms all around the world.  However, many times these options (which involve redeployment of resources) can become costly and impractical.  This is when financial hedging is a much better option.

Financial hedging

This is used to stabilize the firm’s cash flows by investing in currency forwards or options (also by lending and borrowing).  This will eliminate a large portion of the exchange rate risk.  However, since investing in these derivatives only takes in account the nominal value and not the real value (which is what you are interested in), financial hedging can only provide an approximate hedge against the firms operating exposure.

Q9: Discuss the advantages and disadvantages of maintaining multiple
manufacturing sites as a hedge against exchange rate exposure.
Advantages:

1. Business stability from less exposure to exchange rate
volatility.

2. Production flexibility to maximize low-cost benefits of currency
depreciation.

3. Global presence, which may catalyze market diversification (another hedge).
Disadvantages:  1. Increased risk (political, social etc.)

2. Increased production costs (inability to realize economies of scale). Unable to predict currency fluctuations long-term (currencies moving in unintended manner)

PROBLEM 1A)

1. Suppose that you hold a piece of land in the City of London that you may want to sell in one year. As a U.S. resident, you are concerned with the dollar value of the land. Assume that, if the British economy booms in the future, the land will be worth £2,000 and one British pound will be worth $1.40. If the British economy slows down, on the other hand, the land will be worth less, i.e., £1,500, but the pound will be stronger, i.e., $1.50/£. You feel that the British economy will experience a boom with a 60% probability and a slow-down with a 40% probability.

(a) Estimate your exposure b to the exchange risk.

Solution: (a)

E(P) = (.6)($2800)+(.4)($2250) = $1680+$900 = $2,580

E(S) = (.6)(1.40)+(.4)(1.5) = 0.84+0.60 = $1.44

Var(S) = (.6)(1.40-1.44)2 + (.4)(1.50-1.44)2

= .00096+.00144 = .0024.

Cov(P,S) = (.6)(2800-2580)(1.4-1.44)+(.4)(2250-2580)(1.5-1.44)

= -5.28-7.92 = -13.20

b = Cov(P,S)/Var(S) = -13.20/.0024 = -£5,500.


Canada dollar                  in US$                  per $
1-mos forward                  1.0040                   0.99603-mos forward.                  0027                   0.99736-mos forward                  1.0003                   0.9997Swiss Franc                  in US$                  per $1-mos forward                  1.0600                   0.94313-mos forward                  1.0609                   0.94266-mos forward                  1.0619                   0.9417Data from The Wallstreet Journal Jan 26, 2011Swiss Franc                  in Canada $         per Canada $1-mos forward                  1.0561                  0.94693-mos forward                  1.0580                  0.94526-mos forward                  1.0616                  0.94206. Using Exhibit 5.4, calculate the one-, three-, and six-month forward premium or discount for the Canadian dollar versus the U.S. dollar using American term quotations.  For simplicity, assume each month has 30 days.  What is the interpretation of your results?  The forward premium or discount for the Canadian dollar versus the U.S dollar using American term quotations.Spot Rate  .99841-month .99863-month .99886-month .9979This shows that the Canadian dollar is selling at a premium to the dollar. The premium is increasing out to the 3-month mark. The U.S. dollar will depreciate compared to the Canadian dollar for 3 months and than appreciate compared to the Canadian dollar at month 6.1-month forward premium=(.9986-.9984)/.9984*(360/30)=.240%3-month forward premium=(.9988-.9984)/.9984*(360/60)=.240%6 month forward premium=(.9979-.9984)/.9984*(360/180)=-.100%9.  What is triangular arbitrage? What is a condition that will give rise to a triangular arbitrage opportunity?Triangular arbitrage is the process of trading out of the U.S. dollar into a second currency, then trading it for a third currency, which is in turn traded for U.S. dollars. The purpose is to earn an arbitrage profit via trading from the second to the third currency when the direct exchange rate between the two is not in alignment with the cross-exchange rate. Certain banks specialize in making a direct market between nondollar currencies, pricing at a narrower bid-ask spread than the cross rate-spread. If their direct quotes are not consistent with cross-exchange rates, a triangular arbitrage profit is possible.10.  Doug Bernard specializes in cross-rate arbitrage.  He notices the following quotes:Swiss franc/dollar = SFr 1.5971/$Australian dollar/U.S. dollar = A$ 1.8215/$Australian dollar/Swiss franc = A$ 1.1440/SFrIgnoring transaction costs, does Doug Bernard have an arbitrage opportunity based on these quotes?  If there is an arbitrage opportunity, what steps would he take to make an arbitrage profit, and how much would he profit if he has $1,000,000 available for this purpose? Ignoring transaction costs, Doug has an arbitrage opportunity of $3,064.73 trading with $1,000,000.  He would trade from US dollar to Swiss franc, from Swiss franc to Australian dollar, and then from Australian dollar to US dollar

$                     1,000,000

x                       1.5971

SFr                1,597,100  Sell US dollars for Swiss francs

x                       1.1440

A$               1,827,082.4 Sell Swiss francs for Australian dollars

/                        1.8215

$                   1,003,064.73  Sell Australian dollars for US dollars

–               1,000,000.00

$                        3,064.73  Arbitrage Profit

12.  The current spot exchange rate is $1.95/pound and the three-month forward rate is $1.90/pound. On the basis of your analysis of the exchange rate, you are pretty confident that the spot exchange rate will be $1.92/pound in three months. Assume that you would like to buy or sell 1,000,000 pounds.

A.   What actions do you need to take to speculate in forward market? What is the expected dollar profit from speculation?

– If you believe the spot exchange rate will be $1.92/pound in three months, you should short the three-month $/pound contract. By doing, you can by for $1.92/pound and then deliver it for $1.90/pound. This means you’ve made a profit of .02 per unit. The total profit is then $20,000.

B.    What would be your speculative profit in dollar terms if the spot exchange rate actually turns out to be $1.86/pound?

– If the spot exchange rate actually turns out to be $1.86/pound, you’ve lost money. This means you are forced buy at $1.86/pound and then sell it at $1.90/pound. This means you would lose $40,000.


Group 6 Chapter 8 problems

William  Atherton; Haroon Tekrawala; Bradley Wong; Nicole Decraene; Wesley REECE Sanford; Ethan Garber; Jenna Brock;


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Chapter 9-International Finance in International Economics

  1. Unemployment-What steps can be taken to ensure full employment in the economy open to trade?
  2. Savings-affects domestic employment and future levels of national wealth
  3. Trade Imbalances
  • Exports rarely=imports
  • Play roll in distribution of wealth amongst countries and main channel through which one country’s macroeconomic policies affect its trading policies
  • Source of international discord
  1. Money and Price level
  • Barter point of view: Good are exchanged directly for other goods on basis of relative prices
  • More convenient to use money as a medium of exchange
  • Fluctuations in Supply and Demand of money affect output and employment
  • Effects of money exchange in one country can spill over to another

GDP

Excludes intermediate goods, 2nd hand goods-goods moving out of inventory, Illegal activity, non-market transactions, U.S. firms producing services, unreported illegal activity, health care and life expectancy, leisure time, environmental quality, purely financial transactions, and public transfer payments

C=Domestic Consumption                        G=government purchases                        M=

I=Domestic Investment                        T=                                                            S=

Y=GNP or National Income                        X=

Y=C+I+G all output consumed or invested by citizens or government

Y=C+I+G+X-M

CA=X-M; change in output and employment; measures size and direction of international borrowing; Current Account Balance

GNP (Gross National Product)-equals GDP plus net receipts of factor income from the rest of the world:

  • Represents the sum of the following expenditure categories: consumption, investment, government purchases, and the current account balance
  • Includes the market value, of all final goods and services within a given period of time
  • In an open economy holding GNP and consumption spending constant and where private spending constant and where private savings equals domestic investment, a government budget deficit must be matched by: a current account deficit
  1. Open-economy:
  • Private Savings + Public Savings=I + CA
  • CA=GNP-C-I-G
  • May spend some of their income on imports
  • Country’s foreign trade is rarely balanced exactly
  • CA deficits add up to large foreign debt
  • Closed Economy Savings
  • National Savings=portion of output, Y, not devoted to household consumption or government surplus
  • S=Y-C-G
  • Y=C+I+G
  • Therefore S=I
  • Open economy Y=C +I+G+CA
  • S=I+CA
  • Can save either by building its capital stock or by acquiring foreign wealth
  • Ex:

New Zealand builds a new hydroelectric plant; Increase I

Imports raw materials from U.S.

This is a decrease in CA

New Zealand’s Savings (S) didn’t have to change, Even though I rises

  1. Closed Economy:

CA=X-M=Y-(C+I+G)

  • CA surplus means national output Y > National Consumption=Foreign wealth of surplus country is rising
  • CA deficit means Y is < National Consumption=It is borrowing shortage from foreigners to pay for excess imports; Foreign wealth of surplus country is falling

Private savings=Y-C-T

Government Savings=T-G

Investment=Private Savings+Government Savings

Closed economy can increase its wealth only by accumulating new capital

Balance of Payments: Current account +financial account + capital account=0

CA=Exports of goods and services+Invest income received in the United States-Imports of goods and services-Income paid abroad by the U.S.+Net unilateral transfers

Export Expenditure: Credit, Current Account

Income Payments: Debit, Current Account

Foreign Assets held in the U.S.: Credit, Financial Account

Official Reserve Assets:  Credit, Financial Account

U.S. Assets held abroad: Debit, Financial Account

Capital Account: In the current Post-Industrial economy, international trade in services (including banking and finance) is relatively small.  Net increase in foreign ownership of U.S.-based reserve assets+Net increase in foreign ownership of U.S.-based nonreserve assets-Net increase in U.S. Private assets abroad-net increase in the U.S. government’s nonreserve foreign assets

Statistical discrepancy=-1 x (Current account + Capital account)

For example, U.S. Government sells gold for dollars= credit in the capital account.  Migrant worker in California sends 500 home to his village in Mexico=debit in the current account.  An American mutual fund manager uses the deposits of his fund investors to buy Brazilian telecommunication stocks=debit in the capital account.  Japanese firm in Tennesse buys car parts form a subsidiary in Malaysia=Debit in the current account.  An American church donates five tons of rice to the Sudan to help with famine relief: Debit in the current account.  An American retired couple flies from Seattle to Tokyo on Japan Airlines=Debit in the current account.  The Mexican government sells pesos to the United States Treasury and buys dollars=debit in the capital account

Positives of having a large trade deficit: can signal the positive expectations of the future prospects of the economy, can signal that foreigners have confidence in the current set of economic policies, and a it allows for a higher level of investment than possible solely from domestic savings.  Countries official reserve assets are mostly composed of other country’s currencies.  After the breakdown of the Bretton Woods system, the dominant exchange rate regime in the U.S. was a managed float.  If the U.S. dollar depreciates in terms of the Euro: American goods would be cheaper for Europeans.  A fall in the value of the pound sterling affects British consumers because foreign goods are now relatively more expensive.  British consumers are hurt.  This fall in the value of the pound affects American exporters by making them worse off.  A contract that contains a promise that a specified amount of foreign currency will be delivered on the specified data in the future is traded in the forward market.  Current account will increase if the real exchange rate depreciates or disposable income goes down.  Some countries peg to a basket of currencies.  A currency devaluation under fixed exchange rates in the short run an increase in exports

In a fixed exchange rate system:

countries address the problem of currency market pressures that threaten to lower or raise the value of their currency: If demand rises, countries must fill the excess demand for foreign currency by selling their reserves, If demand falls, then countries must increase demand by buying up the excess supply with domestic currency