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Lecture 7 August 23 th 2010
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Page 1: IBE303 Lecture 7

Lecture 7August 23th2010

Page 2: IBE303 Lecture 7

Balance of Payment

Page 3: IBE303 Lecture 7

Balance-of-Payments•Balance of payments accounts are a way

of keeping track of all economic transactions between the home country and the rest of the world over a specific time period (usually one year).

Page 4: IBE303 Lecture 7

Recent Growth of Trade and Capital Movements•The value of trade in goods and services

has increased from $582 billion in 1973 to $15.8 trillion in 2008.

• International transactions of the monetary sort have also grown very rapidly over the last few decades.

Page 5: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•Credit items reflect transactions that give rise to payments flowing into the home country.▫e.g., exports, foreign investment inflows,

interest payments on earlier investments•Debit items reflect transactions that give

rise to payments flowing out of the home country.▫e.g., imports, foreign investment outflows,

interest payments to foreigners

Page 6: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•The IMF groups items into four categories▫Category I: Current account,▫Category II: Direct investment and other long-

term financial flows,▫Category III: Short-term nonofficial financial

flows, and▫Category IV: Changes in reserve assets of

official monetary authorities (central banks).

Page 7: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•Category I: Current account▫Credit items include exports of goods and

services, interest and dividends from investments abroad, wages earned abroad, and gifts from abroad.

▫Debit items include imports of goods and services, interest and dividends paid to investors abroad, wages paid to foreigners, and gifts sent abroad.

Page 8: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•Category II: Direct investment and other long-term financial flows▫Credit entries: anything that causes a net

increase in the holdings of assets in the home country by the foreign country.

▫Debit entries: anything that causes a net increase in the holdings of assets in a foreign country by the home country.

Page 9: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•Category III: Short-term nonofficial financial flows▫These are mainly private flows, with

maturities under one year.▫Credit items: any increase in foreign holdings

of such assets in the home country.▫Debit items: any increase in home country

holdings of such assets in the foreign country.

Page 10: IBE303 Lecture 7

Credit and Debits in Balance-of-Payments Accounting

•Category IV: Changes in reserve assets of official monetary authorities (central banks)▫Credit items: whenever the foreign country

central bank acquires home country assets (such as bank accounts).

▫Debit items: whenever the home country central bank acquires foreign country assets.

Page 11: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

• In general, balance-of-payments accounting relies on double-entry bookkeeping.

•This means that any transaction must be added as a credit and a debit.

•This implies that the sum of all credits must equal the sum of all debits, and the total BOP is always in balance.

Page 12: IBE303 Lecture 7

Example

Page 13: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#1: Exporters in the U.S. send $6,000 of goods to Canada, receiving a short-term bank deposit of $6,000 from Canada.▫Credit: Category I: Export of goods +

$6,000▫Debit: Category III: Increase in short-term

private assets abroad -$6,000

Page 14: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#2: Consumers in the U.S. buy $10,000 of goods from Canada, paying with a short-term bank deposit of $10,000.▫Debit: Category I: Imports of goods -

$10,000▫Credit: Category III: Increase in foreign

short-term assets in the U.S. +$10,000

Page 15: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#3: U.S. residents send $5,000 to Mexico as gifts.▫Credit: Category I: Exports of +$5,000▫Debit: Category I: unilateral transfer of -

$5,000

Page 16: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#4: An American firm provides $2,000 of shipping services to a Canadian company, which pays by transferring money into its U.S. account.▫Credit: Category I: export of services +

$2,000▫Debit: Category III: Decrease in short-term

private assets in the U.S.: -$2,000

Page 17: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#5: A Canadian company sends $8,000 in dividends to bank accounts of American stockholders.▫Credit: Category I: investment receipts

from abroad +$8,000▫Debit: Category III: Decrease in short-term

private assets in the U.S.: -$8,000

Page 18: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#6: An American buys a long-term bond from a Mexican company for $2,000; transfers payment from her U.S. bank account.▫Debit: Category II: increase in long-term

asset abroad -$2,000▫Credit: Category III: Increase in short-term

private assets in the U.S.: +$2,000

Page 19: IBE303 Lecture 7

Sample Entries in the Balance-of-Payments Accounts

#7: Canadian banks wish to reduce holdings of dollars in U.S. banks by selling $800 to the Federal Reserve.▫Debit: Category III: Decrease in short-term

private assets in the U.S.: -$800▫Credit: Category IV: Increase in foreign

short-term official assets in the U.S.: +$800

Page 20: IBE303 Lecture 7

Assembling a BOP Summary Statement

Debits Credits

#1 Increase in short-term private assets abroad

-$6,000 Exports of goods +$6,000

#2 Imports of goods -$10,000 Increase in foreign short-term private assets in US

+$10,000

#3 Unilateral transfers -$5,000 Exports of goods +$5,000

#4 Decrease in foreign short-term assets in U.S

-$2,000 Exports of services +$2,000

#5 Decrease in foreign short-term assets in U.S

-$8,000 Investment income from abroad

+$8,000

#6 Increase in long-term assets abroad

-$2,000 Increase in foreign short-term private assets in US

+$2,000

#7 Decrease in short-term private assets in the U.S.:

-$800 Increase in foreign short-term official assets

+$800

-$33,800 +$33,800

Page 21: IBE303 Lecture 7

BOP SummaryCategory

I Exports of Goods +$11,000

Imports of goods -$10,000

Merchandise trade balance +$1,000

Exports of services +$2,000

Imports of services -$0

Balance of goods and services +$3,000

Factor income receipts from abroad +$8,000

Factor income payments abroad $0

Balance on goods, services, and investment income

+$11,000

Unilateral transfers received +$0

Unilateral transfers made -$5,000

CURRENT ACCOUNT BALANCE +$6,000

Page 22: IBE303 Lecture 7

BOP Summary (cont’d)

Category

II Net increase in foreign long-term assets in U.S.

+$0

Net increase in long-term assets abroad -$2,000

BASIC BALANCE +$4,000

III Net increase in foreign short-term private assets in U.S.

+$1,200

Net increase in short-term private assets abroad

-$6,000

OFFICIAL RESERVE TRANSACTIONS BALANCE

-$800

IV Net increase in foreign short-term official assets in U.S.

+$800

Net increase in official assets abroad -$0

TOTAL $0

Page 23: IBE303 Lecture 7

Statistical Discrepancy•The current account balance may not

exactly equal the financial account balance due to incomplete or imperfect data, illegal activities, and mismatches on the timing of data collection.

•To account for these, a category called “statistical discrepancy” is included in the BOP.

Page 24: IBE303 Lecture 7

U.S. International Transactions, 2007 (billions of $)

Exports of Goods +$1,148.5

Imports of goods -$1,967.9

Merchandise trade balance -$819.4

Exports of services +$497.2

Imports of services -$378.1

Balance of goods and services -700.3

Factor income receipts from abroad +$817.8

Factor income payments abroad -$736.0

Balance on goods, services, and investment income

-$618.5

Unilateral transfers, net -112.7

CURRENT ACCOUNT BALANCE -$731.2

Page 25: IBE303 Lecture 7

U.S. International Transactions, 2007 (billions of $)

Capital account, net -$1.8

U.S. official reserve assets, net +$0.1

U.S. government assets abroad (other than reserves), net

+$22.3

U.S. private assets abroad, net -$1,267.5

Foreign official assets in the U.S., net +$411.1

Other foreign assets in U.S., net (incl. financial derivatives)

+$1,653.1

Statistical discrepancy +$41.3

Page 26: IBE303 Lecture 7

International Investment Position of the U.S.•The BOP accounts are flow concepts– they

represent changes over a time period.•The international investment position is a stock concept – it involves totals up to the present.

• If foreign assets outweigh foreign liabilities, a country is a net creditor; otherwise it is a net debtor.

Page 27: IBE303 Lecture 7

Int’l Investment Position of the U.S. (end of 2007) – billions of $

A. U.S.-owned assets abroad

U.S. official reserve assets $277.2

U.S. gov’t assets (not reserve assets) 94.5

Financial derivatives 2,284.6

U.S. private assets abroad 14,983.7

direct investment abroad $3,332.8

foreign bonds 1,478.1

foreign corporate stocks 5,170.6

U.S. claims on foreigners by U.S. banks and nonbanks not reported elsewhere

5,002.2

TOTAL U.S. ASSETS ABROAD $17,640.0

Page 28: IBE303 Lecture 7

Int’l Investment Position of the U.S. (end of 2007) – billions of $

B. foreign-owned assets in the U.S.

Foreign official assets in the U.S. $3,337.0

Financial derivatives 2,201.1

Other foreign assets in the U.S. 14,543.7

foreign direct investment $2,422.8

U.S. Treasury securities 272.0

Corporate and other bonds 3,299.3

Corporate stocks 2,833.1

U.S. liabilities to foreigners not reported elsewhere

4,981.7

TOTAL FOREIGN ASSETS IN THE U.S. $20,081.8

Net international investment position of the U.S.

-$2,441.8

Page 29: IBE303 Lecture 7

International Investment Position of the U.S.

•The U.S. is a net international debtor.•No other country in the world is as

indebted.•Disadvantages

▫We must transfer future goods and income abroad.

▫Foreign ownership may threaten U.S. sovereignty.

•Still, productive investments should allow repayment.

Page 30: IBE303 Lecture 7

Foreign Exchange

Page 31: IBE303 Lecture 7

The Foreign Exchange Rate and the Market for Foreign Exchange•Foreign exchange rate: the price of one

currency in terms of another.▫e.g., US$/€ or €/US$

•The foreign exchange rate is determined by the interaction of demand for and supply of foreign exchange.

•The foreign exchange market is the worldwide network of markets and institutions that exchange currencies.

Page 32: IBE303 Lecture 7

The Market for Foreign Exchange: Demand•Foreign exchange is demanded by those

▫wishing to buy goods and services from or send gifts or payments to another country.

▫wishing to purchase financial assets in another country.

▫wishing to profit from exchange rate changes (speculation).

▫wishing to minimize risk from exchange rate changes (hedging).

Page 33: IBE303 Lecture 7

The Market for Foreign Exchange: Supply•Foreign exchange is supplied by those

▫selling goods and services to or receiving gifts or payments from another country.

▫in other countries who wish to purchase financial assets in the home country.

▫wishing to profit from exchange rate changes (speculation).

▫wishing to minimize risk from exchange rate changes (hedging).

Page 34: IBE303 Lecture 7

The Market for Foreign Exchange

D€

Euros (€)

$/€ S€

Qeq

eeq

Initially, Qeq euros are traded, and the equilibrium price is eeq.

Page 35: IBE303 Lecture 7

The Market for Foreign Exchange

D€

Euros (€)

$/€ S€

Qeq

eeq

An increase in U.S. demand for euros causes an appreciation of the euro.

D'€

e'eq

Q'eq

Page 36: IBE303 Lecture 7

The Market for Foreign Exchange

D€

Euros (€)

$/€ S€

Qeq

eeq

An increase in the supply of euros causes a depreciation of the euro.

S'€

e'eq

Q'eq

Page 37: IBE303 Lecture 7

The Market for Foreign Exchange: Supply•The total supply and demand for foreign

exchange includes two components.▫One is related to current account

transaction.▫The other is related to financial flows,

including speculation and hedging.

Page 38: IBE303 Lecture 7

The Market for Foreign Exchange

DG&S

Euros (€)

$/€SG&S

The total equilibrium exchange rate will only be the same as the one for Good & Service (G&S) if the current account is exactly in balance.DTotal

eeq

Qeq

STotal

Page 39: IBE303 Lecture 7

The Spot Market•The spot market is the daily or current

market for foreign exchange.•The main participants are large

commercial banks trading with each other in the interbank market.

•There are many foreign exchange markets, but they all tend to generate the same exchange rate regardless of location.▫This is the result of arbitrage.

Page 40: IBE303 Lecture 7

Arbitrage•Arbitrage occurs when individuals see an

opportunity to buy something at a low price in one market, then sell it for a higher price in a second market.

•This causes prices in all markets to move towards each other.

•Arbitrage causes currency prices to be similar across markets, and makes cross rates between currencies consistent.

Page 41: IBE303 Lecture 7

Different Measures of the Spot Rate•How can we measure a country’s overall

exchange rate (not just a bilateral rate)?▫Nominal effective exchange rate (NEER)▫Real exchange rate (RER)▫Real effective exchange rate (REER)▫Purchasing power parity (absolute and

relative)

Page 42: IBE303 Lecture 7

Different Measures of the Spot Rate: NEER•The NEER is an index that measures the

change over time in the nominal value of a country’s currency.

•The nominal effective exchange rate weights the exchange rates of each of a country’s trading partners by the volume of trade with each.

•NEER is a weighted average of a currency’s exchange rate against a bundle of other currencies.

Page 43: IBE303 Lecture 7

Different Measures of the Spot Rate: NEER•However, prices in the two countries may

not be constant.•Suppose the dollar appreciates against

the euro by 10%, but at the same time U.S. prices rose by more than European prices.▫The decline in U.S. competitiveness is more

than 10%.•RER=e€/$(price indexUS/price indexEur).

Page 44: IBE303 Lecture 7

Different Measures of the Spot Rate: NEER•The REER is an index that measures the

change over time in the real value of a country’s currency.

•The real effective exchange rate weights the real exchange rates of each of a country’s trading partners by the volume of trade with each.

•REER is a weighted average of a currency’s real exchange rate against a bundle of other currencies.

Page 45: IBE303 Lecture 7

Absolute Purchasing Power Parity

•In principle, a commodity should have the same price worldwide when measured in a common currency, due to arbitrage.

•PPPabs = price levelUS/price levelEur

•If cotton costs $0.5 per pound in the U.S., and €0.35 per pound in Europe, the exchange rate should be $1.43/€.

•However, transportation costs and other differences means absolute PPP doesn’t generally occur.

Page 46: IBE303 Lecture 7

Relative Purchasing Power Parity

•Relative PPP takes into account differences in price indexes

•PPPrel$/€ = (e $/€) (PIUS/PIEur).

•Relative PPP relates the change in the exchange rate to changes in the two countries’ price levels.

Page 47: IBE303 Lecture 7

The Forward Market•Most exchanges of currencies takes place

two business days after the contract has been completed.

•In general, forward exchange rates can be for any period of time into the future.

•Suppose a U.S. company agrees to buy 5 trucks from a French company at a price of €50,000 each, with delivery in 6 months, the equivalent of $70,000 at today’s spot exchange rate of $1.4/€.

Page 48: IBE303 Lecture 7

The Forward Market•What if the euro appreciates to $1.6/€?

▫Now the price in dollars has risen to $80,000.

•There are ways to hedge against this potential risk.▫The buyer and seller can agree to make the

sale at today’s forward exchange rate.▫The buyer can purchase a foreign currency

option This gives the buyer the right to a specific

exchange rate at a specific time in the future.

Page 49: IBE303 Lecture 7

Foreign Exchange and Financial Market

Page 50: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•The decision to invest internationally

depends on the expected rate of return on the international asset relative to domestic alternatives.

•Specifically, investors consider▫The domestic interest rate or expected rate

of return.▫The foreign interest rate or expected rate

of return.▫Any expected changes in exchange rates.

Page 51: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•An investor would be indifferent between

a $1 domestic or foreign investment if her expected return is the same after accounting for expected changes in the spot rate.

•Let iNY = 90-day interest rate in New York.•Let iParis = 90-day interest rate in Paris.•Let E(e) = the expected spot rate in 90

days.

Page 52: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets• An investor would be indifferent if

$1(1+iNY) =[($1)/(e)]x(1+iParis)[E(e)]

or

(1+iNY)/(1+iParis)=E(e)/e

• This can be approximated as

(iNY – iParis) ≈ xa

where ▫xa is the expected appreciation of the foreign currency.

Page 53: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•This is called uncovered interest parity

(UIP).

•If (iNY – iParis) > xa, investments in the U.S. will be more attractive to investors and investment funds would flow into the U.S.

•If (iNY – iParis) < xa, investments in France will be more attractive to investors and investment funds would flow into France.

Page 54: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•Naturally, individuals don’t have perfect

foresight.

•Since expectations can be wrong, there may be an additional premium required to undertake the risk:

(iNY – iParis) ≈ xa – RP

•If the risk premium is 1%, the gap between the interest rates must be higher for investors to be indifferent.

Page 55: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•So far, we’ve assumed any exchange rate

risk is borne by the investor.•In fact, the risk can be hedged in the

forward market.•The relationship between the spot and

forward rates is usually stated as p = [efwd/e] – 1

where ▫efwd is the forward exchange rate▫p is the premium (or discount).

Page 56: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•If the forward market exchange rate is

$1.72/€ and the spot market rate is $1.70/€,

•p = [1.72/1.70] – 1 = 1.2%.

•That is, there is a 1.2% premium on the foreign currency.

Page 57: IBE303 Lecture 7

The Link Between the Foreign Exchange and the Financial Markets•An investor would be approximately

indifferent if(iNY – iParis) ≈ p

where ▫p is the percentage premium.

•We can also include transactions costs:

(iNY – iParis) ≈ p ± transactions costs

•This is called covered interest parity (CIP).

Page 58: IBE303 Lecture 7

Simultaneous Adjustments of the Foreign Exchange and Financial Mkts•What happens if

(iNY – iParis) > p ± transactions costs?

•Investment funds should move from Paris to New York, decreasing the supply of loan-able funds in Paris.

•This should put upward pressure on interest rates in Paris.

Page 59: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

iParis

S€

D€

iP

S'€

i'PParis money market

Page 60: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•The conversion of euros into dollars in the

spot market increases the supply of euros, thereby putting downward pressure on the euro spot rate (that is, causing the dollar to appreciate).

Page 61: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

e$/€

S€

D€

e'

S'€

e0 Spot market

Page 62: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•Investors wish to cover themselves

against exchange rate changes will now purchase euros in the forward market.

•This will put upward pressure on the euro forward rate.

Page 63: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

e$/€fwd

St€

Dt€

efwd'

Dt'€

efwd

Forward market

Page 64: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•When the new funds move to New York,

supply of loanable funds increases there.•This will put downward pressure on iNY.

Page 65: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

iNY

$

S$

D$

iNY'

S‘$

iNY N.Y. money market

Page 66: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•All of these adjustments work toward

reducing the initial inequality.•Eventually,

(iNY – iParis) = p ± transactions costs.

Page 67: IBE303 Lecture 7

International Bank Lending•Banks’ balance sheets commonly have

loans and deposits that are international in origin.

•As of 2008, gross international bank lending was $37.5 trillion!

Page 68: IBE303 Lecture 7

International Bank Lending•Gross international bank lending can be

divided into three components:▫domestic bank loans in domestic currency to

foreigners, ▫domestic bank loans in foreign currency to

foreigners, and▫domestic bank loans in foreign currency to

domestic residents.•The first is called “traditional foreign

bank lending.”•The second and third represent the

eurocurrency market.

Page 69: IBE303 Lecture 7

The Eurodollar Market•Eurodollar deposits arise when a U.S.

exporter wishes to sell goods to a foreigner, is paid in dollars, and wishes to leave the dollars in an account in a foreign bank.

•The Eurodollar market began to be important in the 1950s, as the USSR chose to put dollar-denominated deposits in British (rather than American) banks.

•Other factors, such as the oil shocks in the 1970s, increased Eurodollar holdings.

Page 70: IBE303 Lecture 7

The Significance of Eurodollar Markets•The rise of Eurodollar markets has

significantly increased the international mobility of financial capital.

•This means that interest rates have been increasingly linked across countries, and have moved toward each other.

•One drawback is that financial problems quickly spread worldwide, such as happened in 2008.

Page 71: IBE303 Lecture 7

The International Bond Market (Debt Securities)•Government and corporations can borrow

money by issuing bonds.•Bonds have a face value – this is the

amount that will be paid to the lender when the bond matures.

•Foreign bond markets and eurobond markets together comprise the international bond market.

•The stock of this sort of debt was $23.9 trillion as of 2008.

Page 72: IBE303 Lecture 7

Significance of the International Bond Market•As with the Eurodollar markets, the

increasing importance of international bond markets has increased the international mobility of financial capital, and countries’ interest rates have moved toward each other.

•This increased interdependence also helps spread financial problems.

Page 73: IBE303 Lecture 7

International Stock Markets•Ownership in companies (common stock)

is another asset that is traded internationally.

•Exact figures on the volume of international stock transactions are difficult to obtain, but most believe these have increased.

•This may create a tendency for movements of stock prices across countries to become more similar to each other.

Page 74: IBE303 Lecture 7

Significance of the Rise of International Stock Markets•The increasing importance of

international stock markets has facilitated the flow of financial capital to its most productive use.

•This increased interdependence can also allow financial problems to spread quickly, as was demonstrated in 2008.

Page 75: IBE303 Lecture 7

Basic International Financial Linkages: Review•Investors will be indifferent between

domestic and foreign investment when

(ihome – iforeign) ≈ p = xa – RP, where

p is the forward exchange rate premium.

Page 76: IBE303 Lecture 7

Basic International Financial Linkages: An Example•How does the Eurodollar market change

our understanding of financial linkages?•Suppose

Lending iNY 7% Lending iLondon 8%

Lending iEuro$ London 6.5% Lending iEurosterling NY 7.5%

Deposit iNY 5% Deposit iLondon 6%

Deposit iEuro$ London 5.5% Deposit iEurosterling NY 6.5%

Spot e$/£ 1.691 3-months forward e$/£ 1.687

Page 77: IBE303 Lecture 7

Basic International Financial Linkages

• If covered interest arbitrage parity holds, after dividing the annual interest rate difference by 4 to approximate a 3-month rate we get

(ihome – iforeign) ≈ p

(0.07 -0.08)/4 ≈ (1.687 – 1.691)/1.691

-0.0025 ≈ -0.0025.

Page 78: IBE303 Lecture 7

Basic International Financial Linkages

•What happens if the Federal Reserve raises U.S. interest rates by ½ of a percentage point? ▫Now, the eurodollar deposit rate will rise to

6% and the eurodollar lending rate will rise to 7%.

•We’d also expect the forward rate to rise (the dollar depreciates) and the spot rate to fall (the dollar appreciates)

Page 79: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

i

$

S$

D€

i

S'$

i' NY money market

Page 80: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•The higher interest rate in New York

increases demand for eurodollars.•This will put upward pressure on the

eurodollar rate.

Page 81: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments

i

$

S$

D$

i'

D‘$

i0

London money market (eurodollars)

Page 82: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•The higher U.S. interest rate leads to an

increased supply of pounds on the spot market▫This additional supply is hedged in the

forward market.

Page 83: IBE303 Lecture 7

e$/£

£

Spot market

S'£

e$/£

e'$/£

International Financial and Exchange Rate Adjustments

Page 84: IBE303 Lecture 7

e$/£

St€

e'$/£

D'£

Forward markete$/£

International Financial and Exchange Rate Adjustments

Page 85: IBE303 Lecture 7

International Financial and Exchange Rate Adjustments•Further adjustments might occur in the

U.K.’s money market and the eurosterling market that would lead to higher interest rates there, but the Bank of England may intervene to prevent this.

Page 86: IBE303 Lecture 7

Hedging Eurodollar Interest Rate Risk

•New instruments, called derivatives, have emerged to hedge interest rate risk.

•Derivatives are financial contracts whose value is derived from an underlying asset such as stocks, bonds, commodities, etc.

Page 87: IBE303 Lecture 7

Commonly Used Derivatives•Maturity mismatching•Future rate agreements•Eurodollar interest rate swaps•Eurodollar cross-currency interest rate

swaps•Eurodollar interest rate futures•Eurodollar interest rate options•Options on swaps•Equity financial derivatives

Page 88: IBE303 Lecture 7

The Current Global Derivatives Market

•Futures have been traded on metals and agricultural commodities for more than a century, so the idea of derivatives isn’t new.

•However, in the past 25 years there has been an explosion in the use of global derivatives.

•Annual growth rates have been in the range of 20%-30%.

Page 89: IBE303 Lecture 7

Values of Selected Global Derivatives, 1987-2008

(in billions of dollars) 1987 2008

A. Exchange-traded instruments

$730 $59,797

Interest rate futures 488 19,271

Interest rate options 123 35,161

Currency futures 15 102

Currency options 60 126

Stock mkt index futures

18 729

Stock mkt index options

28 4,409

B. Over-the-counter instruments

866 683,725

Interest rate swaps 683 356,772

Currency swaps 183 16,307

Interest rate swaps 0 62,162

Page 90: IBE303 Lecture 7

The Current Global Derivatives Market

•Why have derivatives become so important?

•Participants in the international financial markets have discovered that derivatives can▫ increase their returns and/or▫ lower their risk.

•Derivatives allow for an unbundling of exposure to foreign exchange risk, interest rate risk, and price risk.

Page 91: IBE303 Lecture 7

The Current Global Derivatives Market

•However, as the global financial crisis of 2007-08 has shown, derivatives cannot eliminate risk.


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