Chapter 6

International Trade and FinanceInternational Trade and Finance

© 2000 John Wiley & Sons, Inc.

2

Chapter Outcomes

Explain the importance of finance to the effective conduct of international commerce and investment

Describe how international payments are made

Describe the nature of foreign exchange markets

3

Chapter Outcomes(Continued)

Discuss the effect of exchange rates on international trade and explain arbitrage and exchange quotations

Explain the role of financial managers of businesses in reducing foreign exchange risks

Describe how world banking systems facilitate financing sales by exporters and purchases by importers

4

Chapter Outcomes(Concluded)

Show how the Export-Import Bank aids in financing international trade

Describe the components of the U.S. balance of payments

Discuss characteristics of the international financial system

5

Development of International Finance

Began about 5,000 years ago when Babylonian cities rose to importance as centers of trading

Centers of international finance shifted to the Greek city of Athens around 500 B.C.

Centers shifted to the Roman Empire and Rome around 100 B.C.

6

Development of International Finance (Continued)

Financial centers shifted to the northern European Cities during the 1500s

In more recent years, London, New York, and Tokyo became the leading financial centers

Today, physical centers are no longer necessary for carrying out international transactions

7

International Currency Transactions

FOREIGN EXCHANGE MARKETS:FOREIGN EXCHANGE MARKETS: Electronic network that connects the major financial centers of the world

CURRENCY EXCHANGE RATE:CURRENCY EXCHANGE RATE: Value of one currency relative to another currency

8

European Monetary Union (EMU)

A possible monetary union was first discussed in December, 1969

Treaty on European Union (known as the Maastricht treaty) was signed in February, 1992

Decision to call the future common currency the “Euro” was made in December, 1995

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European Monetary Union (EMU)(Continued)

11 founding members in May, 1998 (Austria, Belgium, Finland, France, Germany, Ireland, Italy, Luxembourg, Netherlands, Portugal, & Spain)

Official currency of the EMU became the Euro in January, 1999

National currencies of founding members to be exchanged for the Euro beginning in January, 2002

10

Exchange Rate Determination in the Foreign Exchange Market

Dollar price of one British pound

Dollar price of one British pound

Dollar price of one British pound

Dollar price of one British pound

Quantity of Pounds

Quantity of Pounds Quantity of Pounds

Quantity of Pounds

$1.60$1.61

$1.60

$1.62

S1

D1 D1

S1

D2

A B

C DS1

D1

D2

D3

D2

S1

S2

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Two Methods for Explaining Currency Exchange Rates

PURCHASING POWER PARITY: Currency of country with relatively higher inflation rate will depreciate relative to currency of country with relatively lower inflation rate

INTEREST RATE PARITY: Currency of a country with relatively higher interest rate will depreciate relative to currency of country with relatively lower interest rate

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Purchasing Power Parity (PPP) Model

FR1 = SR0[(1+InfRhc)/(1+InfRfc)] Where:

FR1 = forward rate in one year

SR0 = spot rate now in year zero

InfRhc = inflation rate expected for home country next year

InfRfc = inflation rate expected for foreign country next year

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Purchasing Power Parity (PPP) Example

Basic Information: spot rate for one British pound is $1.600; inflation is expected to be 6% in U.S. and 3% in Britain next year. What is the one-year forward rate in $U.S.?

FR1 = SR0[(1+InfRhc)/(1+InfRfc)]

FR1 = $1.600[(1.06)/(1.03)] = $1.600(1.0291) = $1.647

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Interest Rate Parity (IRP) Model

FR1 = SR0[(1+IntRhc)/(1+IntRfc)] Where:

FR1 = forward rate in one year

SR0 = spot rate now in year zero

IntRhc = inflation rate expected for home country next year

IntRfc = inflation rate expected for foreign country next year

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Interest Rate Parity (IRP) Example

Basic Information: spot rate for one British pound is $1.600; one-year government interest rates are 9% in the U.S. and 6% in Britain. What is the one-year forward rate in $U.S.?

FR1 = SR0[(1+IntRhc)/(1+IntRfc)]

FR1 = $1.600[(1.09)/1.06)] = $1.600(1.0283) = $1.645

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Other Factors Affecting Currency Exchange Rates

POLITICAL RISK: Risk associated with the possibility that a national government might confiscate or expropriate assets held by foreigners

ECONOMIC RISK: Risk associated with possible slow or negative economic growth and/or the variability of economic growth

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International Currency Arbitrage

ARBITRAGE: Buying commodities, securities, or bills of exchange in one market and immediately selling them in another market to make a profit from price differences in the two markets

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Instruments Used in Financing International Trade

DRAFT (BILL OF EXCHANGE): An unconditional order for the payment of money from one person to another

SIGHT DRAFT: Draft requiring immediate payment

TIME DRAFT: Draft that is payable at a specified future date

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Instruments Used in Financing International Trade (Continued)

ORDER BILL OF LADING: Document given by a transportation company that lists goods to be transported and terms of the shipping agreement

DOCUMENTARY DRAFT: Draft that is accompanied by an order bill of lading and other documents

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Instruments Used in Financing International Trade (Concluded)

COMMERCIAL LETTER OF CREDIT: Statement by a bank guaranteeing acceptance and payment of a draft up to a stated amount

TRUST RECEIPT: Instrument through which a bank retains title to goods until paid for

BANKERS’ ACCEPTANCE: Promise of future payment issued by a firm and guaranteed by a bank

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Other Aids to International Trade

EXPORT-IMPORT BANK:EXPORT-IMPORT BANK: Bank established to aid in financing and facilitating trade between the U.S. and other countries

TRAVELER’S LETTER OF CREDIT:TRAVELER’S LETTER OF CREDIT: Issued by a bank to banks in other countries authorizing them to cash checks or purchase drafts presented by the bearer

22

Exchange Rate Operations

FLEXIBLE EXCHANGE RATES: A system in which international exchange rates are determined by supply and demand

DIRTY FLOAT: Intervention by central banks to control exchange rates in the foreign exchange market’s flexible exchange system

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U.S. Balance-of-Payments Accounts

BALANCE OF PAYMENTS: Summary of economic transactions between one country and the world

BALANCE OF TRADE: Net value of a country’s exports of goods and services versus imports

MERCHANDISE TRADE BALANCE: Net difference between a country’s import and export of goods

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U.S. Balance-of-Payments Accounts (Continued)

CURRENT ACCOUNT BALANCE : Flow of income into and out of the U.S. during a specified time period

CAPITAL ACCOUNT BALANCE: Foreign government and private investments in the U.S. netted against similar U.S. investment in foreign countries

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Exchange Rate Developments for the U.S. Dollar

First-Half of 1980s: Appreciation of $U.S. due to inflation reduction & U.S. economic growth (after 1981-82)

Last-Half of 1980s: Depreciation of $U.S. due to shift to holding more foreign assets and fewer U.S. assets

Decade of 1990s: Continued $U.S. fluctuations but within a relatively narrow trading range