International Finance

(IF)
Subject Code : 4549221
 Module 1
(Marks 17)

• International Finance –Overview:

• Book reference ( V Sharan, Eun & Resnick, P G Apte,
Shapiro)
Globalization and Multinational firm, (Theory)
International Monetary System
Balance of payment (Theory) (P G Apte, Shapiro)
Market for Foreign Exchange (Theory)
International Parity Relationship (Jeff Madura, V. Sharan)
 Forecasting Foreign Exchange rate. (Theory &Numerical)
 Module 2
(Marks 18)
• Forward Exchange Arithmetic (Theory & Numerical):
• Book reference (Jeff Madura, V. Sharan, J.B. Gupta,
P.G. Apte)
Exchange Arithmetic (J.B.Gupta, V Sharan, V Pattabhi
Ram & S D Bala)
Forward Exchange contracts,
 Forward Exchange rate based on Cross rates
 Module 3
(Marks 17)

• International Financial Markets & Cash Management:

• Book reference (Jeff Madura, Cheol S. Eun & Bruce
G. Rusnick, V Sharan, P.G. Apte)
International Banking & Money market (Theory)
International Bond Market, LIBOR, (Theory)
International Equity Market (ADR, GDR, EURO)
Multinational Cash Management, (Theory)
 Module 4
(Marks 18)
• International Contract & Procedure:
Letter of credit-Meaning & Mechanism
Types of letter of Credit
Operation of Letter of Credit
Managing Exposure:(Theory & Numerical) (book V
Sharan, Strategic Financial Management by V
Pattabhi Ram & S.D.Bala, P G Apte, Eun & Resnick)
Management of Economic Exposure
Management of Transaction Exposure
Management of Translation Exposure
Globalization and the
Multinational Firm 1
Chapter One

Chapter Objectives:

Understand why it is important to study

international finance.

Distinguish international finance from domestic

finance.
Why to study International Financial Management
• Highly globalized and integrated world economy
• American consumers purchase
• oil imported from Saudi Arabia and Nigeria
• TV sets from Korea
• Automobiles from Germany and Japan,
• garments from China,
• shoes from Indonesia,
• handbags from Italy
• wine from France.

• Foreigners, in turn, purchase

• American-made aircraft,
• software, movies, jeans, smart phones, and other products.

• All the major economic functions -

• consumption,
• production, and
• Investment - are highly globalized
Why …..International Financial Management
• Multinational corporations’ (MNCs) relentless efforts to source inputs
and locate production anywhere in the world where costs are lower
and profits are higher.
• Personal computers sold in the world market might have been
assembled in Malaysia with Taiwanese-made monitors, Korean-
made keyboards, U.S.-made chips, and preinstalled software
packages that were jointly developed by U.S. and Indian
engineers.
• It has often become difficult to clearly associate a product with a
single country of origin.

• Financial markets have also become highly integrated

• This development allows investors to diversify their investment
portfolios internationally.
• IBM, Toyota, and British Petroleum, have their shares cross-listed on
foreign stock exchanges.
Company Exchange Industry
Dr. Reddy's Laboratories NYSE Pharma & Biotech
HDFC Bank NYSE Banks
ICICI Bank NYSE Banks
Infosys NYSE Software & Computer Services
MakeMyTrip Limited NASDAQ Travel & Leisure
Rediff.com India NASDAQ Newspaper and Magazine
Sesa Sterlite Limited NYSE Indust.Metals & Mining

Sify Technologies Limited NASDAQ Software&ComputerSvc

Tata Motors NYSE Industrial Engineer

Videocon d2h NASDAQ TV Services
Wipro NYSE Software&ComputerSvc
WNS Holdings NYSE Business Services
 Difference of international and domestic finance
International finance is different from purely domestic
finance
1. Foreign Exchange Risk
2. Political Risk
3. Market Imperfections
4. Expanded Opportunity Set
1. Foreign Exchange Risk
• The rate of exchange of one currency against
another is determined by demand / supply factor to
a large extent.
ii. Globally currencies are fast becoming commodities.
iii. With the growing trend of floating rates, risks have
multiplied in terms of fluctuation in foreign exchange.
iv. All companies engaged in international trading are
highly vulnerable to foreign exchange risk.
v. International finance is vulnerable to both exchange rate
and interest rate fluctuation.
1. Foreign Exchange Risk

• When firms and individuals are engaged in cross-border transactions,

they are potentially exposed to foreign exchange risk that they
would not normally encounter in purely domestic transactions.

• When different national currencies are exchanged for each other,

there is a definite risk of volatility in foreign exchange rates.

• Suppose Mexico is a major export market for your company and the
Mexican peso depreciates drastically against the U.S. dollar, as it did
in December 1994. This means that your company’s products can be
priced out of the Mexican market, as the peso price of American
imports will rise following the peso’s fall.
1. Foreign Exchange Risk
• If such countries as Indonesia, Thailand, and Korea are major export
markets, your company would have faced the same difficult situation
in the wake of the Asian currency crisis of 1997.

• The risk that foreign currency profits may evaporate in dollar

terms due to unanticipated unfavorable exchange rate
movements.
• Suppose $1 = ¥100 and you buy 10 shares of Toyota at ¥10,000
per share.
• One year later the investment is worth ten percent more in yen:
¥110,000
• But, if the yen has depreciated to $1 = ¥120, your investment
has actually lost money in dollar terms.
• Your $1,000 investment is only worth $916.67
1. Foreign Exchange Risk

• At present, the exchange rates among some major currencies such as

the US dollar, British pound, Japanese yen and the euro fluctuate in a
totally unpredictable manner.

• Exchange rates have fluctuated since the 1970s after the fixed
exchange rates were abandoned.

• Exchange rate variation affect the profitability of firms and all firms
must understand foreign exchange risks in order to anticipate increased
competition from imports or to value increased opportunities for
exports.
2. Political Risk
• Risk from unforeseen government actions or other events of a
political character such as acts of terrorism to outright
expropriation of assets held by foreigners.
• Sovereign country changes the ‘rules of the game’
• In 1992, for example, the Enron Development Corporation, a
subsidiary of a Houston-based energy company, signed a
contract to build India’s largest power plant.
• After Enron had spent nearly $300 million, the project was
cancelled in 1995 by nationalist politicians in the Maharashtra
state who argued India didn’t need the power plant.
• Thus, episode highlights the problems involved in enforcing
contracts in foreign countries, which are higher than the
domestic business.
3. Market Imperfections

• There are profound differences among nations’ laws, tax systems,

business practices and general cultural environments.

• Imperfections in the world financial markets tend to restrict the

extent to which investors can diversify their portfolio.
The Example of Nestlé’s Market Imperfection

• Nestlé used to issue two different classes of common

stock bearer shares and registered shares.
• Foreigners were only allowed to buy bearer shares.

• Swiss citizens could buy registered shares.

• The bearer stock was more expensive.

• On November 18, 1988, Nestlé lifted restrictions imposed

on foreigners, allowing them to hold registered shares as
well as bearer shares.
 Nestlé’s Foreign Ownership Restrictions

12,000

10,000
Swiss Francs

Bearer share
8,000
6,000
4,000
Registered share
2,000
0
11 20 31 9 18 24
Source: Financial Times, November 26, 1988 p.1. Adapted with permission.

1-29
The Example of Nestlé’s Market Imperfection
• Following this, the price spread between the two types of
shares narrowed dramatically.
• This implies that there was a major transfer of wealth from
foreign shareholders to Swiss shareholders.

• Foreigners holding Nestlé bearer shares were exposed to

political risk in a country that is widely viewed as a haven
from such risk.

• The Nestlé episode illustrates both the importance of

considering market imperfections and the peril of political
risk.
1-30
4. Expanded Opportunity Set

• It doesn’t make sense to play in only one corner of the sandbox.

• True for corporations as well as individual investors.

• Firms can locate production in any country or region of the world

to maximize their performance

• Firms can raise funds in any capital market where the cost of
capital is the lowest.

• Firms can gain from greater economies of scale when their tangible
and intangible assets are deployed on a global basis.
4. Expanded Opportunity Set

• Suppose you have a given amount of money to invest in stocks.

• You may invest the entire amount in U.S. (domestic) stocks.

• Alternatively, you may allocate the funds across domestic and

foreign stocks.
• If you diversify internationally, the resulting international
portfolio may have a lower risk or a higher return (or both)
than a purely domestic portfolio.
Valuation Model for an MNC
• Domestic Model

n
E CF$, t 
Value = 
t =1 1  k 
t

E (CF$,t ) = expected cash flows to be

received at the end of period t
n = the number of periods into the
future in which cash flows are received
k = the required rate of return by
investors
Valuation Model for an MNC
• Valuing International Cash Flows

m 
n 
 
E CFj , t  E ER j , t  
 j 1 
Value =   
t =1  1  k  t

 
E (CFj,t )= expected cash flows denominated in
currency j to be received by the U.S. parent at the
end of period t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to dollars at the end of
period t
k = the weighted average cost of capital of the
 Global Economy - A Historical Perspective
• At the end of the Second World War, the international economic
system was in a state of collapse. International markets for trade in
goods, services, and financial assets were essentially nonexistent.

• The new beginning started in the formation of International

Monetary Fund for world level monetary standard. It also led in the
establishment of various other international institutions like the
International Bank for Reconstruction and Development, General
Agreement on Trade and Tariff etc. Most national governments began
to lower their entry barriers, to make them more permeable for
world trade.
 Global Economy - A Historical Perspective

• The multilateral negotiations under the auspices of the

General Agreement on Trade and Tariffs(GATT) stand out as
the most prominent examples of reduction of barriers for
trade in goods.
• The years between 1970 and 1990 have witnessed the most
remarkable institutional harmonization and economic
integration among nations in the world history.
• The decade of 1980s also witnessed the practice of open
economy macroeconomic policies by many developing
countries.
• Latin American and Asian Countries had implemented
financial reform policies or eliminated Government control
of domestic interest rates, credit allocation and exchange
rate etc.
 Global Economy - A Historical Perspective

• Countries like Korea, Malaysia, Chile, Argentina, Uruguya, Japan,

Hong Kong, India and China have liberalized their economies.
Integration of the various segments of financial markets.
• Few events of 1990, which led to global financial and economic
integration.
• Disintegration of the Soviet Union,
• The emergence of market-oriented economies in Asia,
• The creation of a single European market,
• Formation of new era of trade liberalization through World Trade
Organization, etc
• Development of IT-based communication system and services
have significantly contributed in the further expansion of global
financial system.
 Financial Globalization
• Finance is extremely global in recent decades, changed
markedly over the past 40 years or so.
• During the early part of 1970s world economy witnessed
scarcity of international liquidity primarily due to gold linked
fixed monetary standard.
• There was also a growing realization that for achieving
sustained growth with stability, it would be necessary to
have open trade, liberalized external capital movements and
a relatively flexible domestic monetary policy.
• Industrialized countries and emerging market economies
took steps to liberalize capital account and allow capital to
move across the globe.
 Financial Globalization
• Three traceable aspects are

(i)Significant expansion and deepening of the existing markets,

(ii) Emergence of new financial markets like derivatives

(iii)Development of secondary markets for many instruments

• A number of developing countries, especially in Asia, that

moved early on to the path of economic liberalization had
experienced large capital inflows. Large capital inflows,
however, carried with it risk of financial sector vulnerability.
 Financial Globalization

• The world economy had witnessed many financial crises.

The experiences helped in for setting regulatory and
supervisory framework, in proper place, to ensure the safety
and stability of financial systems.

• The sub-prime crisis, which engulfed the world economy,

has called for establishing a new international financial
architecture.
 International Trade – In India
• International trade in India is as old as the Indian civilization.
• Prior to colonial rule, India was known as the hub of
manufacturing goods and arti-facts.
• During the colonial rule India was converted to a raw materials
suppliers to rest of the World.
• On the eve of independence in 1947, foreign trade of India was
typical of a colonial and agricultural economy.
• Trade relations were mainly confined to Britain and other
commonwealth countries.
• Over the last 60 years, India's foreign trade has undergone a
complete change in terms of composition and direction.
• The exports cover a wide range of traditional and non-
traditional items while imports consist mainly of capital goods,
petroleum products, raw materials, and chemicals to meet the
ever-increasing needs of a developing and diversifying economy.
 International Trade – In India
• From 1947 till mid-1990s, India, with some exceptions, always
faced deficit in its balance of payments, i.e. imports always
exceeded exports.
• This was characteristic of a developing country struggling for
reconstruction and modernisation of its economy.
• Beginning mid-1991, the government of India introduced a
series of reforms to liberalize and globalize the Indian economy.
• Reforms in the external sector of India were intended to
integrate the Indian economy with the world economy. India's
approach to openness has been cautious, contingent on
achieving certain preconditions to ensure an orderly process of
liberalization and ensuring macroeconomic stability.
 India – As a open economy
• The basic indicators of openness
• Trade -GDP ratio, which has been increasing and staying
above 15 per cent which a good indicator of an open
economy.
• The ongoing process of reforms since 1993-94 indicating
thereby the progressive integration of domestic financial
markets with the international financial markets.
• Political risk, high transaction costs, high taxation, capital
controls and capital market imperfections, which were the
barriers of international trade and investments, have been
reduced significantly over the years.
• The economy has been consistently moving towards the
path of noticeable degree of globalization and integration
with the world financial markets.
Table 1.1 gives phenomenal growth during the
lase decade
Table 1.2 provides data on comparative average
annual growth rates in real GDP and exports
Figure 1.1 gives phenomenal growth during the lase
decade
India – As a open economy
• Quantitative restrictions have been removed and import
duties are removed – WTO commitments
• Foreign investments direct and portfolio – rise
• All restrictions on trade were abolished at the end of March
2001
• Significant growth in the inward and outward in FDI and FII
• Resident Indians – allowed to invest in shares of foreign
companies with an upper limit of 200000 US dollars.
• Foreign companies can raise equity capital in India by
issuing IDRs
• Latest amendments were made in IDRs in July 2009.
India – ranked as third most attractive destination for investment
after China and US, by transnational corporations (TNCs) – 2013-
15 survey
• Calendar year 2012, IT based cross border merger and
acquisition
US India Business Council (USIBC)- Indian Investments
US$11 billion and generated 100000 jobs there
European India Chamber (EICC) –Indian companies invested
US$56 billion across the continent during 2003-12
FII’s daily buy-sell
transactions
constitute a little over
30% of the total value
traded every day on
BSE and NSE taken
together.

Indian firms – tapping

– foreign equity
markets – by issues of
GDRs and ADRs

Foreign firms tap

Indian equity market
– IDRs.
Table 1.4 – India’s growing dependence on Indian Financial
Markets.

FIIs have been putting their funds in the Indian debt markets
Functions of International Financial Manager
• Three major functions:
(1) Financial planning and control (supportive tools)
• Financial manager establishes standards, such as budgets,
for comparing actual performance with planned
performance
• Once a company crosses national boundaries, its return on
investment depends on not only its trade gains or losses
from normal business operations but also on exchange gains
or losses from currency fluctuations.
• International reporting and controlling have to do with
techniques for controlling the operations of an MNC.
Functions of International Financial Manager
(2) Efficient allocation of funds among various assets (investment
decisions)
• There are 200 countries in the world where a large MNC, can
invest its funds.
• There are also more risks.
• Manager maximize their firm’s value through international
investment.
(3) Acquisition of funds on favorable terms (financing decisions).
• Funds are available from many sources at varying costs, with
different maturities, and under various types of agreements
• This requires obtaining the optimal balance between low cost
and the risk of not being able to pay bills as they become due.
• MNCs can still raise their funds in many countries thanks to
recent financial globalization.
Responsibilities of Finance Manager
1. To keep upto date with significant environmental changes
and analyze their implications
2. To understand and analyze the complex interrelationships
between relevant environments variables and corporate
responses – own and competitive – to the changes in
them
3. To be able to adapt the finance function to significant
changes in the firm’s own strategic posture
4. To take in stride past failure and mistakes to minimize
their adverse impact
5. To design and implement effective solutions to take
advantage of the opportunities offered by the markets and
advances in financial theory.
 The International
Monetary System 2
Chapter Two

Chapter Objective:

This chapter serves to introduce the institutional

framework within which:
1. International payments are made.
2. The movement of capital is accommodated.
3. Exchange rates are determined.
 The International Monetary System
• International monetary system is defined as a set of
procedures, mechanisms, processes, institutions to
establish that rate at which exchange rate is determined in
respect to other currency.

• To understand the complex procedure of international

trading practices, it is pertinent to have a look at the
historical perspective of the financial and monetary system.
Evolution of the
International Monetary System
EXCHANGE RATE REGIMES
A HISTORICAL PERSPECTIVE

• Bimetallism: Before 1875

• Classical Gold Standard: 1875-1914
• Interwar Period: 1915-1944
• Bretton Woods System: 1945-1972
• The Flexible Exchange Rate Regime: 1973-
Present
2-61
Bimetallism: Before 1875
• A “double standard” in the sense that both gold and silver
were used as money. (free coinage was maintained)
• Some countries(US) were on the gold standard, some (China,
India and Holland) on the silver standard, some (France) on
both. (mono-bi)
• While using both, some of the countries returned to one Coinage
act of 1873.
• British Pound (gold standard) vs. Franc (bimetal) exchanged
currencies on gold content of the two currencies.
• Franc (bimetal) and German mark (silver standard)
exchanged currencies on silver content of the currencies.
• British Pound (gold standard) vs. German mark (silver)
exchanged currencies by their exchange rates against the
franc.
Gresham’s Law: “bad”(abundant) money drives out
“good” (scarce) money.
• Gresham’s Law implies that it would be the least valuable
metal that would tend to circulate.
• More valuable currency will gradually disappear
• Since the exchange ratio between the two metals was fixed
officially, only the abundant metal was used as money, driving
more scarce metal out of circulation.
• This is Gresham’s law, according to which “bad” (abundant)
money drives out “good” (scarce) money.
• For example, when gold from newly Discovered mines in
California and Australia poured into the market. In the 1850s,
the value of gold became depressed, causing overvaluation of
gold under the French official ratio, which equated a gold
franc to a silver Franc 15½ times as heavy. As a result, the
franc effectively became a gold currency.
Classical Gold Standard: 1875-1914 :
Gold constitutes treasure, and he who possesses it has all he needs in
this world. Columbus
THE GOLD STANDARD
Gold Specie Standard | Gold Bullion Standard | Gold Exchange Standard
(fixed Gold content) (circulation consists paper) (rupees – dollars – gold)
Mint Parity: The exchange rate between any pair of currencies will be
determined by their respective exchange rates against gold

The gold standard regime imposes very rigid discipline on the policy makers:
 The money supply in the country must be tied to the amount of gold the
monetary authorities have in reserve.
 When a country loses (gains) gold, money supply must contract (expand).
 Domestic economy governed by external sector.
Classical Gold Standard: 1875-1914 :
Gold constitutes treasure, and he who possesses it has all he needs in
this world. Columbus

• During this period in most major countries:

• Gold alone was assured of unrestricted coinage
• There was two-way convertibility between gold and national
currencies at a stable ratio.
• Gold could be freely exported or imported.
• The exchange rate between two country’s currencies would be
determined by their relative gold contents.
• Banknotes need to be backed by a gold reserve of a
minimum stated ratio.
• Domestic money stock should rise and fall as gold flows in
and out of the country.
Classical Gold Standard: 1875-1914
For example, if the dollar is pegged to gold at U.S. $30 = 1
ounce of gold (28.3495231 gr), and the British pound is pegged
to gold at £6 = 1 ounce of gold, it must be the case that the
exchange rate is determined by the relative gold contents:

$30 = 1 ounce of gold = £6

$30 = £6
$5 = £1
For the entire period USD/Pound rate was in a range of 4.84$ and 4.90$

Highly stable exchange rates under the classical gold

standard
2-66
Classical Gold Standard: 1875-1914
Price-Specie-Flow Mechanism
• Misalignment of exchange rates and international imbalances of
payment were automatically corrected by the price-specie-flow
mechanism. (David Hume’s idea, Scottish philosopher (1711-
1776)
• Suppose Great Britain exported more to France than France
imported from Great Britain.
• This cannot persist under a gold standard.
• Net export of goods from Great Britain to France will be
accompanied by a net flow of gold from France to Great
Britain.
• This flow of gold will lead to a lower price level in France
and, at the same time, a higher price level in Britain.
• The resultant change in relative price levels will slow exports
from Great Britain and encourage exports from France.
Classical Gold Standard: 1875-1914
Ardent supporters of gold:
It is a hedge against price
Price-Specie-Flow Mechanism inflation. You can’t increase
its quantity. Money creation
Higher prices cause
will be automatic.
If Export is
export to decrease and
bigger than There are shortcomings:
imports to increase
import The supply of newly minted
gold is so restricted that the
growth of world trade and
+ Balance investment can be hampered
of Trade
for the lack of sufficient
Prices will
go up
monetary reserves.

Money
Supply will
Increase

2-68
Interwar Period: 1915-1944
• World War I ended the classical Gold Standard in August 1914.
• Germany, Austria, Hungary, Poland, and Russia, suffered
hyperinflation
• The German experience provides a classic example of
hyperinflation: By the end of 1923, the wholesale price index in
Germany was more than 1 trillion (!) times as high as the
prewar level.
• Freed from wartime pegging, exchange rates among currencies
were fluctuating in the early 1920s.
• Exchange rates fluctuated as countries widely used “predatory”
depreciations of their currencies as a means of gaining
advantage in the world export market.
Interwar Period: 1915-1944
• Attempts were made to restore the gold standard, but
participants lacked the political will to “follow the rules of the
game”.
• The result for international trade and investment was
profoundly detrimental.
• Economic nationalism, economic and political instabilities, bank
failures, panicky flights of capital across borders, 1929 Great
Depression, all reasons required a new system.
• It is during this period that the U.S. dollar emerged as the
dominant world currency, gradually replacing the British pound
for the role.
Bretton Woods System: 1945-1972
• Named for a 1944 meeting of 44 nations at Bretton Woods,
New Hampshire.
• The goal was exchange rate stability without the gold
standard.
• The result was the creation of two new institutions, the IMF-
1945 and the World Bank.
It had following features:
 The US government undertook to convert the US dollar
freely into gold at a fixed parity of $35 per ounce
 Other member countries of the IMF agreed to fix the
parities of their currencies with the dollar with variation
within 1% on either side of the central parity being
permissible.
 Bretton Woods System:
Dollar based gold exchange standart 1945-1972

German
British mark French
pound franc
r Par Pa
Pa ue Value
Va r
lue
a l
V
U.S. dollar

Pegged at $35/oz.

Gold
2-72
It was an Adjustable Peg system. Central parity could be
changed in the face of “fundamental disequilibrium”.

Other countries accumulated and held dollar balances with which

they could settle their international payments, the US could in
principal buy goods and services from other countries simply by
paying with its own money.
Collepse of the Bretton Woods

• This system could work as long as other countries had

confidence in he stability of the US dollar and in the ability
of the US treasury to convert dollars into gold on demand
at the specified conversion rate.
• The system came under pressure and ultimately broke
down when this confidence was shaken due to various
political and some economic factors starting in mid 1960.
• On August 15, 1971, the US government abandoned its
commitment to convert dollars into gold at the fixed price
of $35 per ounce and the major currencies went on a float.
The Flexible Exchange Rate Regime:
1973-Present.
• January 1976 IMF members met in Jamaica and came
out Jamaica Agreement which is:
1. Flexible exchange rates were declared acceptable to the
IMF members.
Central banks were allowed to intervene in the exchange
rate markets to iron out unwarranted volatilities.
2. Gold was abandoned as an international reserve asset.
3. Non-oil-exporting countries and less-developed countries
were given greater access to IMF funds.
The Flexible Exchange Rate Regime:
1973-Present.
• Exchange rates are now more volatile.
Current Exchange Rate Arrangements
1. Exchange arrangemenets with no separate legal tender: Ecuador,
El Salvador, Panama using the US dollar. Some countries do not
bother printing their own currency. For example, Ecuador, Panama,
and El Salvador have dollarized. Montenegro and San Marino use the
euro.
2. Currency board: Legislative commitment to exchange domestic
currency for a specified foreign currecy at a fixed exchange rate.--In
2006, IMF classified - seven countries – Bosnia and Herzegovina,
Brunci, Bulgaria, Djibouti, Estonia, Hong Kong and Lithuania. --A
country with a currency board arrangement cannot have an
independent monetary policy.
3. Conventional fixed peg arrangements: identical to the Bretton
Woods system - country pegs its currency to another or to a basket of
currencies with a band of variation not exceeding 1% around the central
parity - Forty-nine IMF members had this regime as of 2006, or these,
forty-four had pegged their currencies to a single currency and the rest to
a basket.
4. Pegged exchange rates within horizontal bands: variation is
permitted within wider bands---between a fixed peg and a
Floating exchange rate---Six countries had such wide band
regimes in 2006---IMF has defined a regime titled as "Stabilised
Arrangement“---spot market exchange rate that remain within a
margin of 2 per cent for six months or more --- margin of
stability can be with respect to single currency or a basket of
currencies.
5. Crawling pegs:  limited flexibility regime---pegged to another
currency or a basket, but the peg is periodically adjusted—
changes are well-specified criterion or discretionary in response
to changes in selected quantitative indicators such as inflation
rate differentials --- Five countries were under such a regime in
2006---A "Crawl-like Arrangement" is where the exchange rate
remains within a narrow margin of 2 per cent relative to a
statistically defined trend for six months or longer. An annualised
rate of change of at least I per cent is expected.
6. Managed Floating with no Pre-announced Path for the Exchange Rate :
The central bank influences or attempts to influence the exchange rate by
means of active intervention in the foreign exchange market---buying or
selling foreign currency against the home currency--- without any
commitment to maintain the rate at any particular level or keep it on any pre-
announced trajectory---Fifty-three countries including India were classified as
belonging to this group in 2006.
7. Independently Floating: With central bank intervening only to moderate
the speed of change and to prevent excessive fluctuations, but not attempting
to maintain or drive it towards any particular level. In 2008, a little over one-
fifth of the member countries of IMF characterised themselves as independent
floaters.
Is evident from this that unlike in the pre-1973 years, one cannot characterise
the international me with a single label.
A wide variety arrangements exist and countries movie try to another at their
discretion. This has prompted some analysis to call it the international
monetary "nonsystem".
Fixed versus Flexible Exchange Rate Regimes

Which Exchange Rate Regime is better?

• Arguments in favor of flexible exchange rates:
• Easier external adjustments.
• National policy autonomy (independence).
• Arguments against flexible exchange rates:
• Exchange rate uncertainty may hamper
international trade.
• No safeguards to prevent crises.
External Adjustment Mechanism: Fixed
versus Flexible Exchange Rates
Fixed versus Flexible Exchange Rate Regimes
• A “good” (or ideal) international monetary system should
provide
(i) liquidity, (ii) adjustment, and (iii) confidence.
• In other words, a good IMS should be able to provide the
world economy with sufficient monetary reserves to support
the growth of international trade and investment.
• It should also provide an effective mechanism that restores
the balance-of-payments equilibrium whenever it is disturbed.
• Lastly, it should offer a safeguard to prevent crises of
confidence in the system that result in panicked flights from
one reserve asset to another.
• Politicians and economists should keep these three criteria in
mind when they design and evaluate the international monetary
system.
THE INTERNATIONAL MONETARY FUND (IMF)
• The Role of IMF
• Framework of the Articles of Agreement adopted at Bretton
Woods in1944
• Increasing international monetary cooperation
• Promoting the growth of trade
• Promoting exchange rate stability
• Establishing a system of multilateral payments, eliminating
exchange restrictions which hamper the growth of world
trade and encouraging progress towards convertibility of
member currencies
• Building a reserve base
• The Role of IMF
• The initial quantum of reserves was contributed by the members
according to quota fixed for each.
• The size of the quota for a country depends upon its GNP, its
importance in international trade and related considerations.
• Each - to contribute 25 per cent of its quota in gold and the rest
in its own currency.
• The quotas have been revised several times since then.
• The quotas decide the voting powers of the members within the
policy-making bodies of IMF.
• Fund has time to time borrowed from member (and non-
member) countries additional resources to fund its various
lending facilities.
• Since 1980, the Fund has been authorised to borrow from
commercial capital markets.
• Funding Facilities
• Operation of the adjustable peg requires a country to intervene in
the foreign exchange markets to support its exchange rate when it
threatens to move out of the permissible band
• When a country faces a BOP deficit, it needs reserves to carry out
the intervention it must sell foreign currencies and buy its own
currency.
• When its own reserves are inadequate it must borrow from other
• Member can borrow – part of quota - Reserve Tranche (slice) &
borrow up to 100 percent of its four further Tranches - Credit
Tranche.
• Other funding facilities such as ESAF (Enhanced Structural
Adjustment Facility) HIPC (Highly Indebted Poor Countries)
initiative etc. and their implications for recipient countries.
• IMF often criticized for imposing conditions which do more
damage than good.
• International Liquidity and Special Drawing Rights (SDR)

• International Liquidity and International Reserves

• International liquidity refers to the stock of means of

international payments
• International Reserves, are assets which a country can use in
settlement of payments imbalances that arise in its
transactions with other countries

International Reserves = Reserve position in IMF + SDRs + Forex

assets held by central bank

https://www.youtube.com/watch?v=Dlvtd3kMCqc
https://www.youtube.com/watch?v=zoI5Di_ClvM
• Special Drawing Rights (SDRs)
• SDR is international fiat money created by IMF and allocated to
member countries.
• Can be used by Central banks to settle payments among themselves.
Selected other institutions allowed to hold and use SDRs
• In order to make SDRs an attractive asset to hold, the Fund pays
interest on holdings in excess of a member's cumulative allocation
and it charges interest on any shortfalls
• Have not become popular as reserve asset
• This basket is re-evaluated every five years, and the currencies
included as well as the weights given to them can then change.
• A currency's importance is currently measured by the degree to
which it is used as a foreign exchange reserve asset and the amount
of exports sold in that currency.
THE INTERNATIONAL MONETARY FUND (IMF)

• The Role of IMF in the Post-Bretton Woods World

• Under the Bretton Woods system the IMF was responsible for the functioning of the
adjustable peg system

• The Fund has played an important role in tackling the debt crisis of developing
countries

• Fund is actively involved in designing debt reduction and financing packages involving
the World Bank and private lenders for heavily indebted countries, provided they
accept policies and programmes recommended by the Fund

• to provide a kind of guarantee to private lenders that the country would follow a
growth oriented open policy

• increases the country's creditworthiness and makes it possible for it to get new
financing
THE PROBLEM OF ADJUSTMENT
• Every open economy, from time to time faces the problem of
imbalance on its external transactions
• The BOP disequilibria may be transitory or permanent in nature

• The country must choose between financing the imbalance or

undertaking a programme of adjustment. Relevant factors:
• Exchange Rate Regime; Availability of Financing Creditworthiness of
the Country; Export-Import Demand Elasticities; Saving and Import
Propensities; Behaviour of Domestic Costs; State of the Economy

Adjustment more urgent for deficit countries.

European Monetary System
• European countries maintain exchange rates among their
currencies within narrow bands (+- 1.125 Although Smithsonian
Agreement (in December, 1971) requires + - 2.25), and jointly
float against outside currencies.
• This scaled down version was called as snake, adopted by EEC
(European Economic Community).
• Snake was replaced by European Monetary System (EMS) in
1979 with the following Objectives:
• To establish a zone of monetary stability in Europe.
• To coordinate exchange rate policies vis-à-vis (in comparision
with) non-European currencies.
• To cover the way for the European Monetary Union.
Chronology of European Unions
2016 – UK holds a Membership Referendum and votes to leave the European
Union
European Monetary System
• All EEC member countries, except the United Kingdom and
Greece, joined the EMS.
• The two main instruments of the EMS are the
• European Currency Unit and the
• Exchange Rate Mechanism.
• The European Currency Unit (ECU) is a “basket”
currency constructed as a weighted average of the
currencies of member countries of the European Union
(EU).
• The weights are based on each currency’s relative GNP and share
in intra-EU trade.
• The ECU serves as the accounting unit of the EMS and plays an
important role in the workings of the exchange rate mechanism.
• The Exchange Rate Mechanism (ERM) refers to the procedure by
which EMS member countries collectively manage their exchange
rates.
• The ERM is based on a “parity grid” system, which is a system of par values
among ERM currencies.
• The par values in the parity grid are computed by first defining the par values of
EMS currencies in terms of the ECU.
• Formation of the European Economic Community in 1958.
• The European Monetary System (EMS) was created in 1979 to
establish a European zone of monetary stability;
• Members were required to restrict Fluctuations of Their Currency
Exchange rates.
• With the launching of the euro on January 1, 1999, the European
Monetary Union (EMU) was created.
• The EMU is a logical extension of the EMS, and the European
Currency Unit (ECU) was the predecessor of the euro.
• Indeed, ECU contracts were required by EU law to be converted to
euro contracts on a one-to-one basis
Maastricht Treaty 1991 “convergence criterias” +from ecu to
euro, ems to emu
• Two main instruments of the EMS are ECU/EURO and Exchange Rate Mechanism.

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Euro

• The euro is the single currency of the European Monetary

Union which was adopted by 11 Member States on 1
January 1999. (Before ECU was available)
• These original member states were: Belgium, Germany,
Spain, France, Ireland, Italy, Luxemburg, Finland, Austria,
Portugal and the Netherlands.
31st January 2020
List of EU Member Countries        Greece
       Austria        Hungary
       Belgium         Ireland
       Bulgaria        Italy
       Croatia        Latvia
       Cyprus*        Lithuania
       Czechia        Luxembourg
       Denmark         Malta
(except the Faroe Islands and         Netherlands 
Greenland) (except Caribbean islands)
       Estonia        Poland
       Finland        Portugal
       France (except         Romania
some overseas regions and terri        Slovakia
tories        Slovenia
)        Spain
       Germany        Sweden
Value of the Euro in U.S. Dollars
https://www.macrotrends.net/2548/euro-
dollar-exchange-rate-historical-chart
Denominations of the Euro Notes and
Coins
• There are 7 euro notes and 8 euro coins.
• €500, €200, €100, €50, €20, €10, and €5.
• The coins are: 2 euro, 1 euro, 50 euro cent, 20 euro
cent, 10, euro cent, 5 euro cent, 2 euro cent, and 1
euro cent.
• The euro itself is divided into 100 cents, just like the
U.S. dollar.
European Monetary Union (EMU)

• Once a country adopts the common currency, it cannot have

its own monetary policy.

• The common monetary policy for the euro zone is now

formulated by the European Central Bank (ECB) that is
located in Frankfurt and closely modeled after the Bundes
bank, the German central bank. ECB is legally mandated to
achieve price stability for the euro zone.

• Euro has brought revolutionary changes in European finance.

Emergence of the Euro as a Global Currency

• Companies all over the world can benefit from this

development as they can raise capital more easily on
favourable terms in Europe.

• Since the end of World War I, the U.S. dollar has played the
role of the dominant global currency, displacing the British
pound.

• Foreign exchange rates of currencies are often quoted

against the dollar
The Benefits of Monetary Union
• Reduced transaction costs
• Elimination of exchange rate uncertainty.
• Reducing hedging costs
• Price transparancy will lead to Europe-wide competition
• Enhenced efficiency and competitiveness of the European
economy.
• Improves the continental capital markets
• One currency should promote political cooperation and
peace in Europe.
Costs of Monetary Union
• The main cost of monetary union is the loss of national monetary
and exchange rate policy independence.
• The more trade-dependent and less diversified a country’s economy is the
more prone to asymmetric shocks that country’s economy would be.
Asymmetric shocks
• When an economic supply or demand shock is different from one
region to another, or when the shocks do not move in tandem
(together). 
• Example: If Germany has a positive aggregate demand shock and
France has a negative aggregate demand shock, then these two
countries are experiencing asymmetric shocks. 
• Having similar, or symmetric, shocks is one of the criteria of an optimal
currency area. (Theory of Robert Mondell, Colombia Uiversity in 1961)
• Asymmetric shocks make it difficult for the central bank of a monetary
union to conduct monetary policy that is beneficial to each member of
the union. 
Costs of Monetary Union
• Finland, a country heavily dependent on the paper and pulp
(wood) industries faces a sudden drop in world paper and pulp
prices, hurting Finnish economy, causing unemployment and
income decline while scarcely affecting other euro zone countries.
• This is called an asymmetric shock.
• If Finland had monetary independence, they lower domestic
interest rates to stimulate the weak economy as well as letting its
currency depreciate to boost foreigners’ demand for Finland
products.
• As Finland in EMU, there is no monetary policy they can apply.
They have to act with euro zone and ECB will not tune its policy
depending on only one country.
• Without monetary solution, other options: lowering wage and
price levels will have the same effects similar to the depreciation
of the Finnish currency.
Costs of Monetary Union
• Or if the capital flows freely across the euro zone and workers are
willing to relocate these are also good for asymmetric shock
absorbation.
• If the countries factor mobilitiy (capital, labor) is high in a region,
the countries can have one currency. The theory of Robert
Mundell, optimim currency areas.
• Asymetric shocks can be in a country but the flexibility of wage
price and fiscal policy will have a successful response to these
shocks.
• In the US high degree of capital and labor mobility is available.
• It would be suboptimal if each 50 states to issue its own currency.
• Unemloyed living in Helsinki not very likely to move to Milan due
to cultural, religious, linguistic and other barriers but for the US?
• If the euro zone experiences a major asymmetric shocks, a
successful response will require wage, price and fiscal flexibility.
The Mexican Peso Crisis (1994)
• On 20 December, 1994, the Mexican government
announced a plan to devalue the peso against the dollar
by 14 percent.
• This decision changed currency trader’s expectations
about the future value of the peso.
• Early 1995 the peso fell against the US dollar by as much
as 40 percent. This is the first cross border flight of portfolio
capital: International mutual funds investment before crises were
54 billion dollar !!!
• In a system like this:
• 1. Having multinational safety net in place to safeguard the
world financial system is important.
• 2. Foreign capital influx causes a higher domestic inflation and
overvalued money, that hurts trade balances.
 The Mexican Peso Crisis (1994)
1.2

1.0

0.8

0.6

0.4

0.2

1994 1995
Despite a balanced budget inflation of 27 percent (versus 150
percent in 1987), Mexico had two problems:
• Foreign currency reserves fell from $30 billion in early 1994 to only $5
billion by November 1994 as the government pegged the peso at
artificially high levels
• Commercial banks and the government had rolled over $23 billion of
short-term peso debt into similar short-term tesebonos whose
principal was indexed to the dollar. These obligations rose with the
value of the dollar.
• Dec. 1994 - Jan. 1995: Peso falls 50 percent against the
dollar, doubling the peso value of Mexico’s tesebono
obligations.
• Mexico’s peso crisis was severe but relatively short-lived.
• The U.S. and the IMF assembled a $40 billion rescue package to
ensure liquidity.
• The low peso value increased exports by 30 percent and decreased
imports by 10 percent, resulting in a current account surplus of $7.4
billion (from a deficit of $18.5 billion in 1994).
 The Asian Currency Crisis (1997)
• Thailand fell first, with problems that resembled Mexico’s:
• Foreign currency reserves fell from $40 billion in 1996 to $10 billion by July
1997 as the government pegged the bhat.
• Massive short-term foreign currency borrowings were used to support highly
speculative property ventures.
• Current account deficit 8 percent of GDP.
• Declining competitiveness due to wage increases
• By 1998, the stock market had fallen by 50 percent.
• Like Thailand, Indonesia and Korea suffered from fixed exchange rates, large
current account deficits, large amounts of short-term foreign currency debt
used to support speculative property ventures, and declining competitiveness.
• The IMF assembled rescue packages of $58 billion for Korea, $43 billion for
Indonesia, and $17 billion for Thailand.
• IMF loans required fiscal and monetary restraint, financial market
liberalization, and structural reforms.
• The Asian currency crisis turned out to be far more serious
than the Mexican peso crisis in terms of the extent of the
contagion and the severity of the resultant economic and
social costs.
• On July 2, 1997, the Thai Baut, which had been largely fixed
to the U.S. Dollar, was suddenly devalued.
• Liberalization, allow free flows of capital across countries.
• Asian developing countries Eagerly borrowed foreign
currencies from U.S., Japanese, and European investors,
who were attracted to these fast-growing emerging markets
for extra returns for their portfolios.
• In 1996 alone, for example, five Asian countries—Indonesia,
Korea, Malaysia, the Philippines, and Thailand—
experienced an inflow of private capital worth $93 billion. In
contrast, there was a net outflow of $12 billion from the five
countries in 1997.
• Higher inflows of capital to Asian countries. Credit boom
directed to speculation on real estate, stock market .
• Yen’s depreciation against the dollar hurt Japan’s neighbours
more.
• Panickly flight of capital from the Asian countries cause the
crisis to become extended.
Financial Vulnerability indicators
• M2 stands for Bank sectors liabilities
• As a fear of currency crisis, lenders withdrew their capital
and refused to renew short-term loans, the former credit
boom turned into a credit crunch, hurting creditworthy as
well as marginal borrowers.
• The International Monetary Fund (IMF) came to rescue the
three hardest-hit Asian countries—Indonesia, Korea, and
Thailand—with bailout plans.
• IMF imposed a set of austerity measures, such as raising
domestic interest rates and curtailing government
expenditures, that were designed to support the exchange
rate.
• Many firms with foreign currency bonds were forced into
bankruptcy.
• The region experienced a deep, long-lasting recession.
• According to a World Bank report (1999), one year declines
in industrial production of 20 percent or more in Thailand
and Indonesia are comparable to those in the United States
and Germany during the Great Depression.
• IMF initially prescribed the wrong medicine for the afflicted
Asian economies.
• The IMF bailout plans were also criticized on moral hazard.
• IMF bailouts may breed dependency in developing countries
and encourage risk-taking on the part of international
lenders.
 Lessons from Asian Currency
Crisis
• Countries first strengthen their domestic financial system and then
liberalize their financial markets.
• Financial sector regulations and supervision is the most important.
Basel Committee on Banking Supervision rules...
• Encourage foreign direct investment and equity and long term
bond investment discourage short term investment even by using
Tobin tax
• “incompatible trinity” or “trilemma” a country can attain only two
of the following three conditions:
1. a fixed exchange rate system
2. free international flows of capital
3. an independent monetary policy.
China and India were not noticeably affected by the Asian currency
crisis because both countries maintain capital controls, segmenting
their capital markets from the rest of the world.
Renminbi (RNB) versus U.S. Dollar Exchange
Rate
• China maintained a fixed exchange rate between its currency,
renminbi (RMB), otherwise known as the yuan, and the U.S.
dollar at 8.27 RMB per dollar for a long while.
• from mid-July 2005 for about three years before it reverted
back to a (quasi-) fixed rate at around 6.82 RMB per dollar in
mid-July 2008.
• reversion is attributable to the heightened economic
uncertainty associated with the global financial crisis.
• In recent years, China has been gradually lowering barriers to
international capital flows.
• China’s currency has the potential to become a global currency.
However, China will need to meet a few critical, related
conditions, such as
(i) full convertibility of its currency,
(ii) open capital markets with depth and liquidity,
(iii) the rule of law and protection of property rights.
Note that the United States and euro zone satisfy these conditions.
 The Argentinean Peso Crisis (2002)
• In 1991 the Argentine government passed a convertibility
law that linked the peso to the U.S. dollar at parity.
(currency board)
• The initial economic effects were positive:
• Argentina’s chronic inflation was curtailed (limited)
• Foreign investment poured in
• As the U.S. dollar appreciated on the world market the
Argentine peso became stronger as well.
• The strong peso hurt exports from Argentina and caused a
protracted (extended) economic downturn that led to the
abandonment of peso–dollar parity in January 2002.
• The unemployment rate rose above 20 percent
• The inflation rate reached a monthly rate of 20 percent
Collapse of the Currency Board
Arrangement in Argentina
• There are at least three factors that are related to the
collapse of the currency board arrangement and the ensuing
economic crisis:
• Lack of fiscal discipline
• Labor market inflexibility
• Contagion from the financial crises in Brazil and Russia
• Reflecting the traditional sociopolitical divisions in the
Argentine society increased public sector indebtedness.
• Argentina is said to have a “European-style welfare system in
a Third World economy.”
• The federal government of Argentina borrowed heavily in
dollars throughout the 1990s.
• As the economy entered a recession in the late 1990s, the
government encountered increasing difficulty with rising
debts, eventually defaulting on its internal and external
debts.
• The hard fixed exchange rate that Argentina adopted under
the currency board system made it impossible to restore
competitiveness by a traditional currency depreciation.
• Further, a powerful labor union also made it difficult to
lower wages and thus cut production costs that could have
effectively achieved the same real currency depreciation
with the fixed nominal exchange rate.
• The situation was exacerbated by a slowdown of
international capital inflows following the financial crises in
Russia and Brazil. Also, a sharp depreciation of the Brazil real
in 1999 hampered exports from Argentina.
• Argentina refused to pay its debts and offered to pay only 25
% of NPV of the debts. Foreign bondholders have rejected
this. Finally, 30% of NPV of Debt was accepted.
Currency Crisis Explanations
• In theory, a currency’s value mirrors the fundamental
strength of its underlying economy, relative to other
economies. In the long run.
• In the short run, currency trader’s expectations play a much
more important role.
• In today’s environment, traders and lenders, using the most
modern communications, act by fight-or-flight instincts. For
example, if they expect others are about to sell Brazilian
currency for U.S. dollars, they want to “get to the exit first”.
• Thus, fears of depreciation become self-fulfilling
prophecies.
 Balance of Payments
3
Chapter Three

Chapter Objective:

This chapter serves to introduce the student to the

balance of payments. How it is constructed and
how balance of payments data may be interpreted.

3-
127
 Chapter Outline
• Balance of Payments Accounting
• Balance of Payments Accounts
• The Current Account
• The Capital Account
• Statistical Discrepancy
• Official Reserves Account
• The Balance of Payments Identity
• Balance of Payments Trends in Major Countries

3-
128
 Balance of Payments Accounting
• The Balance of Payments is the statistical record of
a country’s international transactions over a certain
period of time presented in the form of double-
entry bookkeeping.

N.B. when we say “a country’s balance of

payments” we are referring to the transactions of
its citizens and government.

3-
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 Balance of Payments Accounting
• Any transaction that results in a receipt from foreigners will
be recorded as a credit, with a positive sign, in the U.S.
balance of payments,
• whereas any transaction that gives rise to a payment to
foreigners will be recorded as a debit, with a negative sign.

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130
Balance of Payments Accounting Example
Balance of Payments Accounting Example
 Balance of Payments Accounts
• The balance of payments accounts are those that
record all transactions between the residents of a
country and residents of all foreign nations.
• They are composed of the following:
• The Current Account
• The Capital Account
• The Official Reserves Account
• Statistical Discrepancy

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133
 The Current Account
• Includes all imports and exports of goods and
services.
• Includes unilateral transfers of foreign aid.
• If the debits exceed the credits, then a country is
running a trade deficit.
• If the credits exceed the debits, then a country is
running a trade surplus.

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 The Current Account
• Exhibit 3.1 shows that U.S. exports were $2,843.7
billion in 2011 while U.S. imports were $3,182.8
billion. The current account balance, which is defined
as exports minus imports plus unilateral transfers
was -$473.6 billion.
• The United States thus had a balance-of-payments
deficit on the current account in 2011.
• The four divions of current accout are : Merchandise
Trade, Services, factor income, and unilateral
transfers.
 The Current Account
• Merchandise trade represents exports and imports of
tangible goods, such as oil, wheat, clothes, automobiles,
computers, and so on.
• As Exhibit 3.1 shows, U.S. merchandise exports were
$1,501.5 billion in 2011 while imports were $2,236.8
billion.
• Services, the second category of the current account,
include payments and receipts for legal, consulting, and
engineering services, royalties for patents and
intellectual properties, insurance premiums, shipping
fees, and tourist expenditures. These trades in services
are sometimes called invisible trade.
 The Current Account
• Factor income, consists of payments and receipts of interest,
dividends, and other income on foreign investments that were
previously made.
• If United States investors receive interest on their holdings of
foreign bonds, for instance, it will be recorded as a credit in the
balance of payments.
• Unilateral transfers, the fourth category of the current
account, involve “unrequited” payments. Examples include
foreign aid, reparations, official and private grants, and gifts.
act of buying goodwill from the recipients. So, a country that
gives foreign aid to another country can be viewed as
importing goodwill from the latter.
 The Current Account
• As can be expected, the United States made a net
unilateral transfer of $134.5 billion, which is the receipt of
transfer payments ($19.5 billion) minus transfer payments
to foreign entities ($154.0 billion).
• When a country’s currency depreciates against the
currencies of major trading partners, the country’s
exports tend to rise and imports fall, improving the trade
balance.
• Following a depreciation, the trade balance may at first
deteriorate for a while, it will tend to improve over time.
This particular reaction pattern of the trade balance to a
depreciation is referred to as the J-curve effect.
 Following a currency
The J-Curve Effect depreciation, the trade
balance may at first
deteriorate before it
Change in the Trade Balance

improves.
The shape depends on the
elasticity of the imports and
Time exports.

As an example, consider an imported good for which there is no

domestic producer. If demand is price inelastic, then following a
depreciation the trade balance gets worse (until domestic
production begins).
The Capital Account
• The capital account measures the difference between U.S.
sales of assets to foreigners and U.S. purchases of foreign
assets.
• U.S. sales (or exports) of assets are recorded as credits, as
they result in capital inflow . U.S. purchases (imports) of
foreign assets are recorded as debits, as they lead to
capital outflow.
• The capital account is composed of
• Foreign Direct Investment (FDI),
• portfolio investments and
• other investments.
• Direct investment occurs when the investor acquires a
measure of control of the foreign business. In the U.S.
balance of payments, acquisition of 10 percent or more of
the voting shares of a business is considered giving a
measure of control to the investor.
• Foreign direct investments take place as firms attempt to
take advantage of various market imperfections, such as
underpriced labor services and protected markets.
• Honda, a Japanese automobile manufacturer, built an
assembly factory in Ohio, it was engaged in foreign direct
investment (FDI) .
• Firms undertake foreign direct investments when the
expected returns from foreign investments exceed the cost
of capital, allowing for foreign exchange and political risks.
• The expected returns from foreign projects can be higher
than those from domestic projects because of lower wage
rates and material costs, subsidized financing, preferential
tax treatment, exclusive access to local markets, and the
like.
• The volume and direction of FDI can also be sensitive to
exchange rate changes.
• For instance, Japanese FDI in the United States soared in the
latter half of the 1980s, partly because of the sharp
appreciation of the yen against the dollar.
• With a stronger yen, Japanese firms could better afford to
acquire U.S. assets that became less expensive in terms of
the yen.
• The same exchange rate movement discouraged U.S. firms
from making FDI in Japan because Japanese assets became
more expensive in terms of the dollar.
• Portfolio investment , the second category of the capital
account, mostly represents sales and purchases of foreign
financial assets such as stocks and bonds that do not involve a
transfer of control.
• International portfolio investments have boomed in recent years,
partly due to the general relaxation of capital controls and
regulations in many countries, and partly due to investors’ desire
to diversify risk globally.
• Portfolio investment comprises equity, debt, and derivative
securities.
• Investors typically diversify their investment portfolios to reduce
risk.
• Investors diversify their portfolio holdings internationally rather
than purely domestically.
• In addition, investors may be able to benefit from higher
expected returns from some foreign markets.
 The Capital Account
Sovereign wealth funds (SWFs)

• Government controlled investment funds – known as Sovereign

wealth funds (SWFs) are playing an increasingly visible role in
international investments.
• Sovereign wealth funds (SWFs), are mostly domiciled in Asian and
Middle Eastern countries and usually are responsible for recycling
foreign exchange reserves of these countries swelled by trade
surpluses and oil revenues.
• SWFs invested large sums of money in many western banks that
were affected by subprime mortage –related losses
• Abu Dhabi Investment Authority invested $7.5 billion in Citigroup,
which needed to replenish its capital base in the wake of
subprime losses, whereas Temasek Holdings, Singapore’s state-
owned investment company, injected $5.0 billion into Merrill
Lynch, one of the largest investment banks in the United States.
• Although SWFs play a positive role in stabilizing the global
banking system and help the balance-of-payment situations of
the host countries, they are increasingly under close scrutiny
due to their sheer size and the lack of transparency about the
way these funds are operating.

• The third category of the capital account is other investment ,

which includes transactions in currency, bank deposits, trade
credits.
• These investments are quite sensitive to both changes in
relative interest rates between countries and the anticipated
change in the exchange rate.
• If the interest rate rises in the United States while other
variables remain constant, the United States will experience
capital inflows, as investors would like to deposit or invest in
the United States to take advantage of the higher interest rate.
• On the other hand, if a higher U.S. interest rate is more or
less offset by an expected depreciation of the U.S. dollar,
capital inflows to the United States will not materialize.
• Since both interest rates and exchange rate expectations are
volatile, these capital flows are highly reversible.
 Statistical Discrepancy
• There’s going to be some omissions and misrecorded
transactions
• Recordings of payments and receipts arising from
international transactions are done at different times and
places, possibly using different methods.
• As a result, these recordings, upon which the Balance of-
payments statistics are constructed, are bound to be
imperfect.
• The balance of payments always presents a “balancing”
debit or credit as a statistical discrepancies.
• The overall balance is significant because it indicates a
country’s international payment gap that must be
accommodated with the government’s official reserve
transactions.
• It is also indicative of the pressure that a country’s currency
faces for depreciation or appreciation.
• If, for example, a country continuously realizes deficits on
the overall balance, the country will eventually run out of
reserve holdings and its currency may have to depreciate
against foreign currencies.
• In 2011, the United States had a $15.9 billion surplus on the
overall balance. This means that the United States received
a net payment equal to that amount from the rest of the
world.
 The Official Reserves Account
• Official reserves assets include gold, foreign currencies, SDRs,
reserve positions in the IMF.
• When a country must make a net payment to foreigners because
of a balance-of payments deficit, the central bank of the country
(the Federal Reserve System in the United States) should either
run down its official reserve assets , such as gold, foreign
exchanges, and SDRs, or borrow anew from foreign central banks.
• On the other hand, if a country has a balance-of-payments
surplus, its central bank will either retire some of its foreign debts
or acquire additional reserve assets from foreigners.
• When the United States and foreign governments wish to support
the value of the dollar in the foreign exchange markets, they sell
foreign exchanges, SDRs, or gold to “buy” dollars.
• These transactions, which give rise to the demand for
dollars, will be recorded as a positive entry under official
reserves.
• The more actively governments intervene in the foreign
exchange markets, the greater the official reserve changes.

• Until the advent of the Bretton Woods System in 1945, gold

was the predominant international reserve asset.
• After 1945, however, international reserve assets comprise:
1. Gold.
2. Foreign exchanges.
3. Special drawing rights (SDRs).
4. Reserve positions in the International Monetary Fund
(IMF).
Composition of Total Official Reserves (in
percent)
• As can be seen from Exhibit 3.4 , the relative importance of
gold as an international means of payment has steadily
declined, whereas the importance of foreign exchanges has
grown substantially.
• As of 2012, foreign exchanges account for about 94 percent
of the total reserve assets held by IMF member countries,
with gold accounting for less than 1 percent of the total
reserves.
• Similar to gold, the relative importance of SDRs and reserve
positions in the IMF have steadily declined
 The Balance of Payments Identity
BCA + BKA + BRA = 0
where
BCA = balance on current account
BKA = balance on capital account
BRA = balance on the reserves account

Under the fixed exchange rate regime

BCA + BKA = - BRA
• If a country runs a deficit on the overall balance, that is, BCA
+ BKA is negative, the central bank of the country can supply
foreign exchanges out of its reserve holdings.
• But if the deficit persists, the central bank will eventually run
out of its reserves, and the country may be forced to
devalue its currency
 The Balance of Payments Identity
Under a pure flexible exchange rate regime,
BCA + BKA = 0
• Central banks will not intervene in the foreign exchange
markets.
• Central banks do not need to maintain official reserves.
• Under this regime, the overall balance thus must necessarily
balance, that is a current account surplus or deficit must be
matched by a capital account deficit or surplus, and vice
versa.
BCA = - BKA
U.S. Balance of Payments Data 2006
  Credits Debits
Current Account    
1 Exports $2,096.3  

2 Imports   ($2,818.0)

3 Unilateral Transfers $24.4 ($114.0)

  Balance on Current Account ($811.3)
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400)
  Balance on Capital Account $826.9  
7 Statistical Discrepancies ($18)
 
  Overall Balance ($2.4) 
Official Reserve Account $2.4
 U.S. Balance of Payments Data 2006

  Credits Debits
Current Account     In 2004, the
1 Exports $2,096.3  
U.S. imported
2 Imports   ($2,818.0)
3 Unilateral Transfers $24.4 ($114.0)
more than it
  Balance on Current Account ($811.3) exported, thus
Capital Account     running a
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1) current account
6 Other Investments
Balance on Capital Account
$690.4 ($400) deficit of
  $826.9  
7 Statistical Discrepancies ($18)
  $811.3 billion.
  Overall Balance ($2.4) 
Official Reserve Account $2.4

3-
157
 U.S. Balance of Payments Data 2006

  Credits Debits During the same

Current Account
1 Exports
 
$2,096.3
 
 
year, the U.S.
2 Imports   ($2,818.0)
attracted net
3 Unilateral Transfers $24.4 ($114.0) investment of
  Balance on Current Account ($811.3) $826.9 billion—
Capital Account    
4 Direct Investment $180.6 ($235.4)
clearly the rest
5 Portfolio Investment $1,017.4 ($426.1) of the world
6 Other Investments $690.4 ($400)
  Balance on Capital Account $826.9  
found the U.S.
7 Statistical Discrepancies   ($18) to be a good
Overall Balance
 
Official Reserve Account
($2.4) 
$2.4
place to invest.

3-
158
 U.S. Balance of Payments Data 2006

  Credits Debits
Current Account
1 Exports
 
$2,096.3
 
 
Under a pure
2 Imports   ($2,818.0)
flexible
3 Unilateral Transfers $24.4 ($114.0) exchange rate
  Balance on Current Account ($811.3) regime, these
Capital Account    
4 Direct Investment $180.6 ($235.4) numbers would
5 Portfolio Investment $1,017.4 ($426.1) balance each
6 Other Investments $690.4 ($400)
  Balance on Capital Account $826.9  
other out.
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4) 
Official Reserve Account $2.4

3-
159
 U.S. Balance of Payments Data 2006

  Credits Debits
Current Account
1 Exports
 
$2,096.3
 
 
In the real
2 Imports   ($2,818.0)
world, there
3 Unilateral Transfers $24.4 ($114.0) is a statistical
  Balance on Current Account ($811.3) discrepancy.
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400)
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance   ($2.4)
Official Reserve Account $2.4

3-
160
 U.S. Balance of Payments Data 2006

  Credits Debits
Current Account
1 Exports
 
$2,096.3
 
 
Including that,
2 Imports   ($2,818.0)
the balance of
3 Unilateral Transfers $24.4 ($114.0) payments identity
  Balance on Current Account ($811.3) should hold:
Capital Account    
4 Direct Investment $180.6 ($235.4) BCA + BKA = – BRA
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400)
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4) 
Official Reserve Account $2.4
($811.3) + $826.9 + ($18) = ($2.4)
3-
161
 Balance of Payments and the
Exchange Rate
  Credits Debits Exchange rate $
Current Account    
1 Exports $2,096.3   P S
2 Imports   ($2,818.0)
3 Unilateral Transfers $24.4 ($114.0)
  Balance on Current Account ($811.3)
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400) D
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4)  Q
Official Reserve Account $2.4

3-
162
 Balance of Payments and the
Exchange Rate
  Credits Debits Exchange rate $
Current Account    
1 Exports $2,096.3   P S
2 Imports   ($2,818.0)
3 Unilateral Transfers $24.4 ($114.0)
  Balance on Current Account ($811.3)
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400) D
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4)  Q
Official Reserve Account $2.4
As U.S. citizens import, they are supply dollars to the FOREX market.
3-
163
 Balance of Payments and the
Exchange Rate
  Credits Debits Exchange rate $
Current Account    
1 Exports $2,096.3   P S
2 Imports   ($2,818.0)
3 Unilateral Transfers $24.4 ($114.0)
  Balance on Current Account ($811.3)
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400) D
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4)  Q
Official Reserve Account $2.4
As U.S. citizens export, others demand dollars at the FOREX market.
3-
164
 Balance of Payments and the
Exchange Rate
  Credits Debits Exchange rate $
Current Account    
1 Exports $2,096.3   P S
2 Imports   ($2,818.0) S1
3 Unilateral Transfers $24.4 ($114.0)
  Balance on Current Account ($811.3)
Capital Account    
4 Direct Investment $180.6 ($235.4)
5 Portfolio Investment $1,017.4 ($426.1)
6 Other Investments $690.4 ($400) D
  Balance on Capital Account $826.9  
7 Statistical Discrepancies   ($18)
  Overall Balance ($2.4)  Q
Official Reserve Account $2.4
As the U.S. government sells dollars, the supply of dollars increases.
3-
165
 Balance of Payments Trends
• Since 1982 the U.S. has experienced continuous deficits on
the current account and continuous surpluses on the capital
account.
• During the same period, Japan has experienced the
opposite.

3-
166
 Balance of Payments Trends
• Germany traditionally had current account surpluses.
• From 1991 to 2001Germany experienced current account deficits.
• This was largely due to German reunification and the resultant
need to absorb more output domestically to rebuild the former
East Germany.
• Since 2001 Germany returned to its earlier pattern.
• What matters is the nature and causes of the disequilibrium.
Balance of Payments Trends in Major
Countries 1982-2006 Source: IMF International
Financial Statistics Yearbook,
1000
B alan ce o f P aym en ts

China BCA various issues

China BKA
500 Japan BCA
Japan BKA
0 Germany BCA
1982 1987 1992 1997 2002 2007 Germany BKA
-500 UK BCA
UK BKA
-1000 U.S. BCA
Year U.S. BKA
TOP US trading Partners, 2012 (in Billion Dollars)
 Mercantilism and the Balance of Payments

• Mercantilism holds that a country should avoid trade

deficits at all costs, even to imposing various restrictions
on imports.
• Mercantilist ideas were criticized in the 18th century by
such British thinkers as Adam Smith, David Ricardo, and
David Hume.
• They argued that the main source of wealth in a country
is its productive capacity not its trade surpluses.
Relationship between Balance of Payments and
National Income Accounting
• National income (Y), or gross domestic product (GDP) is equal
to
the sum of the nominal consumption (C) of goods and services,
private investment (I),
government spending (G), and
the difference between exports (X) and imports (M):
Y ≡ GDP ≡ C + I + G + (X – M)

• Private savings is defined as the amount left from national

income after consumption and taxes (T) are paid:
S ≡ Y – C – T or
S ≡ C + I + G + (X – M) – C – T
• Note that BCA ≡ X – M and we can rearrange the last equation as
(S – I) + (T – G) ≡ X – M ≡ BCA
• This shows that there is an intimate relationship between a country’s
BCA and how it finances its domestic investment and pays for
government spending.
• If (S – I) < 0 then a country’s domestic savings is insufficient to
finance domestic investment.
• Similarly, if (T – G) < 0, then tax revenue is insufficient to cover
government spending and a government budget deficit exists.
(S – I) + (T – G) ≡ X – M ≡ BCA
• When BCA < 0, government budget deficits and or part of domestic
investment are being financed by foreign-controlled capital.
• To reduce a BCA deficit, one of the following must occur:
• For a given level of S and I, the government budget deficit (T – G) must be
reduced
• For a given level of I and (T – G), S must be increased
• For a given level S and (T – G), I must fall.
 The Market for
Foreign Exchange
Topics to be covered
 Function and Structure of the FX Market
• Participants

 Function and
Function andStructure
Structureofof
thethe
FX FX
Market
Market
• The

 The Spot
 FXSpot Market
Market
Market Participants
• The

 The
 Forward
Forward
Spot Market
 Correspondent Banking Relationships
Market
Rate Quotations
 The Spot
 The Market
Bid-Ask

Forward RateSpread
Quotations
 Spot
 The

Long FX
andTrading
Forward Market
Short Forward Positions

 Cross Exchange
Forward Rate Quotations
Cross-Exchange Rates

 Triangular Arbitrage
Swap Transactions

 Spot Foreign
Forward Exchange Market Microstructure
Premium
 The Forward Market
Foreign Exchange Markets
• A network of systems and mechanisms through which
currencies are traded
• The foreign exchange market (also known as the currency,
forex, or FX) is where currency trading takes place. It is a
market where banks, companies, exporters, importers, fund
managers, individuals, central banks of different countries
buy and sell of foreign currencies.
• Market actors:
• Banks
• Brokers (Brokerage firms)
• Business entities (merchants, corporations, etc.)
• Individuals
• Governments
• Central banks
• International organizations
Foreign Exchange Rates
• A foreign exchange rate is the price of (one unit of) a
currency in terms of another currency
• As forex rates are quoted in pairs, e.g. Euro/US$,
US$/Japanese Yen, US$/INR, etc., a trader trading in
forex sells one of the currency pair and buys the
other.
• There are nearly 200 currencies of which few than 50
are commonly traded internationally
• Most currency trades take place in the form of
transfer of bank deposits and clear without actual
currency notes changing hands
The Function and Structure of the FX Market
• FX Market Participants
• Correspondent Banking Relationships
Structure of the Foreign Exchange market
 Foreign Exchange Market Participants
• The FX market is a two-tiered market:
1. Client Market (Retail)
• Turnover and average transaction size are very small.
• A tourist buys foreign currency in the spot market before
undertaking the journey.
• A UK patient visiting India to undertake an operation that
would have cost him a fortune at UK
• The spread between buying and selling prices is large.
• In the retail market, individuals (tourists, foreign students,
patients traveling to other countries for medical treatment)
small companies, small exporters and importers operate.
• Majority of retail trading happens in the spot market. Why?
• As retailers’ requirements are normally not repetitive in
nature, they buy or sell the currency as when the
requirement arises.
• Major part of the forex turnover in an economy comes from
banks – banks acting as forex dealers (provide two way
quotes) as well as acting as brokers.
• Table 4.2 shows the number of banks accounting for 75% of
foreign exchange turnover.
2.Interbank Market (Wholesale)
• Major forex trading in the wholesale forex markets is undertaken by banks –
popularly known as interbank market.
• banks and non-bank financial institutions transact with each other. banks and non-
bank financial institutions, multinational corporations, hedge funds, pension and
provident funds, insurance companies, mutual funds etc. participate in the wholesale
market.
• MNC earn their revenue and incur expenses in many different currencies.
• They undertake trading on behalf of customers, but majority of trading is undertaken
for their own account by proprietary desks.
• Transaction size is very large.
• Switzerland based Nestle operates in 86 countries across the globe
• Mutual funds with international equity portfolio are also major players in this market
 Foreign Exchange Market Participants

2 Foreign Exchange Dealers and Brokers:

• Dealers: Banks and some nonblank financial institutions act
as foreign exchange dealer. These dealers quote both
“bid” and “ask” for a particular currency pair (for spot,
forward and swap contracts) and take opposite side to
either buyers or sellers of currency.
• They make profit from the spreads between buying and
selling prices ie., bid and ask rate.
• Before the internet, the brokers, dealers and clients were
communicating over telephone or telex and through
satellite communication. SWIFT (Society for Worldwide
Interbank Financial Telecommunication) facilitated the
communication between these brokers and banks.
 Foreign Exchange Market Participants

• Brokers:
• Brokers on the other hand, help clients to get a better rate
on the currency trade by making available different quotes
offered by dealers.
• The broker compares the rates offered by the dealers and
provides the best rates to the clients i.e, highest bid prices
quoted by different dealers when the client wants to sell
and lowest ask price quoted by different dealers when
the clients wants to buy.
• In fact, RBI has sanctioned three different categories of
Authorized Dealers.
 Correspondent Banking Relationships

• Large commercial banks maintain demand deposit

accounts with one another which facilitates the efficient
functioning of the FX market.
Correspondent Banking Relationships
 Correspondent Banking Relationships

• Bank A is in London, Bank B is in New York.

• The current exchange rate is £1.00 = $2.00.
• A currency trader employed at Bank A buys £100m from
a currency trader at Bank B for $200m settled using its
correspondent relationship.

Bank A $200 Bank B

London £100 NYC
 Correspondent Banking Relationships
• International commercial banks communicate with one
another with:
1. SWIFT: The Society for Worldwide Interbank
Financial Telecommunications.
• SWIFT is the Society for Worldwide Interbank Financial
Telecommunication is a cooperative organization headquartered at
Belgium.
• The Swift network connects around 8300 banks, financial institutions
and companies operating 208 countries.
• SWIFT is a private non-profit message transfer system with
headquarters in Brussels, with intercontinental switching centers in
the Netherlands and Virginia.
• As the forex market is mainly an OTC market, SWIFT message
provides some kind of legitimacy to the transactions.
• SWIFT is solely a carrier of messages.
“.
• It does not hold funds nor does it manage accounts on behalf of
customers, nor does it store financial information on an on- going
basis.
• As a data carrier, SWIFT transports messages between two financial
institutions.
• This activity involves the secure exchange of proprietary data while
ensuring its confidentiality and integrity
 Correspondent Banking Relationships
2. CHIPS: Clearing House Interbank
Payments System

• The Clearing House (CHIPS) , formerly known as the

Clearing House Interbank Payments System , in
cooperation with the U.S. Federal Reserve Bank
System, called Fedwire, provides a clearinghouse for
the interbank settlement for over 95 percent of U.S.
dollar payments between international banks.
 Correspondent Banking Relationships
3. ECHO Exchange Clearing House Limited, the first global
clearinghouse for settling interbank FX transactions.
• In August 1995, Exchange Clearing House Limited (ECHO) , the first
global clearinghouse for settling interbank FX transactions, began
operation.
• ECHO was a multilateral netting system that on each settlement date
netted a client’s payments and receipts in each currency, regardless of
whether they are due to or from multiple counterparties.
• Multilateral netting eliminates the risk and inefficiency of individual
settlement.
• In 1997,ECHO merged with CLS Services Limited and operates
currently as part of CLS Group. Seventeen currencies are currently
eligible for settlement among 60 members.
 The Spot Market
• Spot Rate Quotations
• The Bid-Ask Spread
• Spot FX trading
• Cross Rates
Currency
• ISO and 3-letter currency code:
• 3- letter alphabetic code as well as 3-digit numeric code
• each currency is represented as 3-letter code as prescribed
by International Organization of Standardization (ISO).
• In “INR”, “IN” stands for India while “R” stands for “Rupee”.
• Peso is the currency of Mexico, as per the ISO standard, Mexico’s
currency is represented as “MXN”.

Entity Currency Alphabetic Code Number code

Argentina Argentine Peso ARS 032

Hong Kong Hong Kong Dollar HKD 344
Iraq Iraqi Dinar IQD 368
Maldives Rufiyaa MVR 462
 Spot Rate Quotations
• The spot market involves almost the immediate purchase
or sale of foreign exchange.

• Spot rate currency quotations can be stated in Direct

(American) or Indirect (European) terms.
• Direct quotation (American Terms)
• Units of the currency of that country per unit of a foreign
currency.
• One unit of the foreign currency in terms of the units of the
domestic currency.
• For India,
• USDINR = INR 70.4075 per USD
• EURINR = INR 80.1300 per EUR
• INR 63.5325 per JPY
• INR 89.5225 per GBP
• Direct quote for US would be
• USD 0.0142 per INR
• Indirect Quotation (European terms)
• The number of Units of Foreign currency per unit of the
home currency.
• One unit of the domestic currency in terms of the units of
the foreign currency.
• INRUSD - USD 0.0142 per INR
• INREUR - EUR 0.0124 per INR
• JPY 0.0157 per INR
• GBP 0.0112 per INR
 Spot Rate Quotations
USD equiv USD equiv Currency per USD Currency per
Country Friday Thursday Friday USD Thursday

Argentina (Peso) 0.3309 0.3292 3.0221 3.0377

Australia (Dollar) 0.7830 0.7836 1.2771 1.2762

Brazil (Real) 0.3735 0.3791 2.6774 2.6378

Britain (Pound) 1.9077 1.9135 0.5242 0.5226

1 Month Forward 1.9044 1.9101 0.5251 0.5235

3 Months Forward 1.8983 1.9038 0.5268 0.5253

6 Months Forward 1.8904 1.8959 0.5290 0.5275

Canada (Dollar) 0.8037 0.8068 1.2442 1.2395

1 Month Forward 0.8037 0.8069 1.2442 1.2393

3 Months Forward 0.8043 0.8074 1.2433 1.2385

6 Months Forward 0.8057 0.8088 1.2412 1.2364

 Spot Rate Quotations

USD equiv USD equiv Currency per USD Currency per

Country Friday Thursday Friday USD Thursday
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762
Brazil (Real) 0.3735 0.3791 2.6774 2.6378 The direct
Britain (Pound) 1.9077 1.9135 0.5242 0.5226 quote for
1 Month Forward
3 Months Forward
1.9044
1.8983
1.9101
1.9038
0.5251
0.5268
0.5235
0.5253
British pound
6 Months Forward 1.8904 1.8959 0.5290 0.5275 is:
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
£1 = $1.9077
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
 Spot Rate Quotations

Country
USD equiv
Friday
USD equiv
Thursday
Currency per USD
Friday
Currency per
USD Thursday
The indirect
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 quote for
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 British pound
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
is:
1 Month Forward
3 Months Forward
1.9044
1.8983
1.9101
1.9038
0.5251
0.5268
0.5235
0.5253
£0.5242 = $1
6 Months Forward 1.8904 1.8959 0.5290 0.5275
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395
1 Month Forward 0.8037 0.8069 1.2442 1.2393
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
 Spot Rate Quotations

Country
USD equiv
Friday
USD equiv
Thursday
Currency per USD
Friday
Currency per
USD Thursday
Note that the
Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 direct quote
Australia (Dollar) 0.7830 0.7836 1.2771 1.2762 is the
Brazil (Real) 0.3735 0.3791 2.6774 2.6378
Britain (Pound) 1.9077 1.9135 0.5242 0.5226
reciprocal of
1 Month Forward 1.9044 1.9101 0.5251 0.5235 the indirect
3 Months Forward 1.8983 1.9038 0.5268 0.5253 quote:
6 Months Forward 1.8904 1.8959 0.5290 0.5275
1
Canada (Dollar) 0.8037 0.8068 1.2442 1.2395 1.9077 =
1 Month Forward 0.8037 0.8069 1.2442 1.2393 .5242
3 Months Forward 0.8043 0.8074 1.2433 1.2385
6 Months Forward 0.8057 0.8088 1.2412 1.2364
 Spot Rate Quotations
• Most currencies in the interbank market are quoted in
European terms , that is, the U.S. dollar is priced in terms
of the foreign currency (an indirect quote from the U.S.
perspective).
• By convention, however, it is standard practice to price
certain currencies in terms of the U.S. dollar, or in what is
referred to as American terms (a direct quote from the
U.S. perspective).
• American and European term quotes are reciprocals of
one another
 Spot Rate Quotations
• A currency pair is denoted by the 3 letter SWIFT codes for
the two currencies separated by an oblique or hyphen
• USD/CHF: US Dollar- Swiss Franc
• GBP/JPY: Great Britain Pound - Japanese Yen
• USD/INR: US Dollar – Indian Rupee
• USD-SEK: US Dollar- Swedish Kroner

• The first currency in the pair is the “base” currency; the

second is the “quoted” currency.
• USD/CHF, US Dollar is the base currency, Swiss Franc is the quoted
currency.
• In GBP/USD, British Pound is the base currency, US Dollar is the
quoted Currency.
 Spot Rate Quotations
• The exchange rate quotation is given as number of units of
the quoted currency per unit of the base currency.

• USD/INR quotation will be given as number of rupees per

dollar, a GBP/USD quote will be given as number of dollars
per pound.

• A quotation consists of two prices. The price shown on the

left of the oblique or hyphen is the “bid” price, the one on
the right is the “ask” price.
• The bid price is the price a dealer is willing to pay you for
something.

• The ask price is the amount the dealer wants you to pay for
the thing.

• The bid-ask spread is the difference between the bid and

ask prices.
The Bid-Ask Spread
Table 12.1: Bid-Ask rates
Spot Rate by SBI Bid Ask
Euro/INR 76.5025 76.5048

Euro is the base currency while INR is variable/term/quote currency.

Bid-ask price is always expressed in terms of base currency.
 
The bid rate indicates that, SBI is willing to buy 1 Euro from the counterparty and
pay INR 76.5025.
The ask rate indicates that SBI is willing to sell (or give) 1 Euro to counterparty
and accept (or receive) INR 76.5048.
In other words, for every Euro SBI buys and sells, it makes a profit of INR
 
0.0013. Bid rate is always lesser than ask rate.
 
While buying a currency, the traders pay a higher amount compared to selling the
same amount of the currency.

The bid-ask spread is what the bank/foreign exchange dealer profits.

 The Bid-Ask Spread
• A dealer could offer
• Bid price of $1.25 per €

• Ask price of $1.26 per €

• While there are a variety of ways to quote that,

• The bid-ask spread represents the dealer’s expected profit.

The Bid-Ask Spread
 The Bid-Ask Spread

big small figure

figure Bid Ask
S($/£) 1.9072 1.9077
S(£/$) .5242 .5243
• A dealer would likely quote these prices as 72-77.
• It is presumed that anyone trading $10m already knows
the “big figure”.
 Spot FX trading
• USD/ ITL 1542.80/4.30 interpreted as 1542.80/1544.30

• Some currencies (e.g., the Colombian peso, Indian rupee,

Indonesian rupiah) quotations in European terms are
carried out to zero or only two or three decimal places

• In American terms the quotations may be carried out to as

many as seven decimal places.
RBI Reference Rate

• Everyday Reserve bank of India publishes reference

rate for spot USD/INR and spot EUR/INR.

• The rates are arrived at by averaging the mean of the

bid / offer rates polled from a few select banks around
12 noon every week day (excluding Saturdays).
 Cross rate
• A cross-exchange rate is an exchange rate between a currency pair
where neither currency is the U.S. dollar.

• The cross-exchange rate can be calculated from the U.S. dollar exchange
rates for the two currencies, using either European or American term
quotations.

• An Indian company imports textile yarns from South Africa for which the
payment has to be made in ZAR (South African Rand). As none of the
Indian banks directly offer, INRZAR quotations, the exporter has to sell
INR and buy USD and then sell USD and buy ZAR to make the payment.
 Cross Rates
• For example, the S(¥/$) (Yen/Dollar) cross-rate can be
calculated from American term quotations as follows:

• Suppose that S(€/$) = 1.50 and that S(¥/€) = 50

• Find S (¥/$) cross rate?

S (¥/$) = S(¥/€) S(€/$)

50 X 1.50
=
= $ 75
 Cross Rates
• (GBP/USD) bid = given, (IEP/USD) bid = given, then find
(GBP/IEP) bid = ?

• (GBP/IEP) bid = (GBP/USD) bid X (USD / IEP) bid

= (GBP/USD) bid X 1 / (IEP/ USD) ask

• (GBP/USD) ask = given , (IEP/USD) ask = given, then find

(GBP/IEP) ask = ?

• (GBP/IEP) ask = (GBP/USD) ask X (USD / IEP) ask

= (GBP/USD) ask X 1 / (IEP/ USD) bid
Cross Rates
  Spot r Bid-Ask Rates  
USDCAD USDAUD  
Bid Ask Bid Ask

1.1641 1.1646 1.2948 1.2956

CADUSD AUDUSD
0.85866 0.85903 0.77184 0.77232

From the above quotations, cross rate between AUD/CAD can be

calculated as follows:
 
• Bank buys 1USD and pays (sells) 1.1641 CAD
• Bank sells 1 USD and receives (buys)1.1646 CAD
• Bank buys 1 USD and pays (sells) 1.2948 AUD
• Bank sells 1 USD and receives(buys) 1.2956 AUD
• (GBP/IEP) ask = (GBP/USD) ask X (USD / IEP) ask
= (GBP/USD) ask X 1 / (IEP/ USD) bid

AUDCAD ask = AUDUSD ask X USDCAD ask

= AUDUSD ask X 1 / CADUSD bid
= 0.77232 X 1 / 0.85866
= 0.89944
AUDCAD bid = AUDUSD bid X USDCAD bid
= AUDUSD bid X 1 / CADUSD ask
= 0.77184 X 1 / 0.85903
= 0.89850
CADAUD bid = 1/0.89944 = 1.111802
CADAUD ask = 1/0.89850 = 1.112966
Cross Rates
• To get the bid rate for CADAUD (CAD as base currency
and AUD as quote currency), the bank must sell AUD and
buy CAD. This is achieved in two steps. That is
• The bank must sell AUD and buy USD
• Simultaneously sell USD and buy CAD.
• CAD = 1.1118 AUD.
• To get the ask rate for CADAUD, the bank must sell CAD and
buy AUD. This is achieved in two steps ie. the bank must sell
CAD buy USD and simultaneously sell USD and buy AUD.
• 1 CAD = 1.1129 AUD.
CADAUD cross rates
Bid Ask
1.1118 1.1129
 Triangular Arbitrage
• If direct quotes are not consistent with cross-exchange
rates, a triangular arbitrage profit is possible.
• 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.
Triangular Arbitrage
• Three different banks are quoting spot rates for three
currency pairs given below.
• Bank of Japan quotes : St USDJPY= 100
• Bank of America quotes: St GBPUSD= 1.60
• Bank of England quotes St GBPJPY = 140
• If we consider the first two quotes, then GBPJPY

• GBPJPY = GBPUSD * USDJPY

• = 1.60 * 100 = 160 , 1 GBP = 160 JPY as per the
cross rates formula
• However bank of England quotes GBPJPY = 140
• It indicates that Bank of England is undervaluing GBP.
• The triangular arbitrage happens:
• Borrow 100 USD
• Convert it to 10000 JPY at Bank of Japan.
• Convert 10,000 JPY to GBP at Bank of England.
Receive 71.428 GBP.
• Convert 71.428 GBP to USD at Bank of America.
Receive 114.285 USD.
• Profit of 14.285 USD before adjusting for USD
borrowing cost.
 The Forward Market
• Forward Rate Quotations
• Long and Short Forward Positions
• Forward Cross Exchange Rates
• Swap Transactions
• Forward Premium
 The Forward Market
• A forward contract is an agreement to buy or sell an
asset in the future at prices agreed upon today.

• If you have ever had to order an out-of-stock textbook,

then you have entered into a forward contract.
 Forward Rate Quotations
• The forward market for FX involves agreements to buy
and sell foreign currencies in the future at prices
agreed upon today.

• Bank quotes for 1, 3, 6, 9, and 12 month maturities are

readily available for forward contracts.

• Longer-term swaps are available.

 Forward Premium
• The interest rate differential implied by forward
premium or discount.
• For example, suppose the € is appreciating from
S(€$) = 1.25 to F180(€$) = 1.30
• The 180-day forward premium is given by:

F180($/€) – S($/€) 360 1.30 – 1.25

f180,€v$ = × = × 2 = 0.08
S($/€) 180 1.25
 Long and Short Forward Positions
• If you have agreed to sell anything (spot or forward), you
are “short”.
• If you have agreed to buy anything (forward or spot), you
are “long”.
• If you have agreed to sell FX forward, you are short.
• If you have agreed to buy FX forward, you are long.
Payoff Profiles

profit
If you agree to sell anything in the
future at a set price and the spot
price later falls then you gain.

0 S180($/¥)

F180($/¥) = .009524
If you agree to sell anything in the
future at a set price and the spot
loss price later rises then you lose. Short position
 Forward Cross Exchange Rates
• It’s just an “delayed” example of the spot cross rate
discussed above.
• In generic terms
Notice that the “$”s cancel.

FN ( j / $) * FN ($ / k )
FN ( j / k ) 

and
FN (k / $) * FN ($ / j )
FN (k / j ) 
 Forward Cross Exchange Rates

USD equiv USD equiv Currency per USD

Country Friday Thursday Friday The forward
Argentina (Peso) 0.3309 0.3292 3.0221
pound-Canadian dollar
Australia (Dollar) 0.7830 0.7836 1.2771
Brazil (Real) 0.3735 0.3791 2.6774
cross rate
Britain (Pound) 1.9077 1.9135 0.5242
1 Month Forward 1.9044 1.9101 0.5251
GBP1.00 USD1.00
×
3 Months Forward 1.8983 1.9038 0.5268 USD1.8904 CAD1.2412
6 Months Forward 1.8904 1.8959 0.5290
Canada (Dollar) 0.8037 0.8068 1.2442
1 Month Forward 0.8037 0.8069 1.2442 GBP1.00
3 Months Forward 0.8043 0.8074 1.2433 =
6 Months Forward 0.8057 0.8088 1.2412
CAD2.3464
 Practice Problem
The current spot exchange rate is $1.55/£ and the three-month forward
rate is $1.50/£. Based on your analysis of the exchange rate, you are
confident that the spot exchange rate will be $1.52/£ in three
months. Assume that you would like to buy or sell £1,000,000.
 a. What actions do you need to take to speculate in the forward
market? What is the expected dollar profit from speculation?
 b. What would be your speculative profit in dollar terms if the spot
exchange rate actually turns out to be $1.46/£?
c. Graph your results.
 Solution
 a. If you believe the spot exchange rate will be $1.52/£ in three
months, you should buy £1,000,000 forward for $1.50/£. Your
expected profit will be:
$20,000 = £1,000,000 × ($1.52 – $1.50)
 
b. If the spot exchange rate actually turns out to be $1.46/£ in
three months, your loss from the long position will be:
–$40,000 = £1,000,000 × ($1.46 – $1.50)
Solution

profit

$20k

0 S180(£/$)
1.46 1.52
F180(£/$) = 1.50

–$40k
loss
Understanding forex futures contract specification:
• Unit of trading of USD 1000 indicates that whenever a
trader is taking position in 1 futures contract, the trader is
taking position to buy/sell 1000 USD.
• 1 long futures contract at say INR 45.25 per USD, indicates
that, the trader has agreed to buy 1000 USD and pay INR
45,250 in future.
• Tick size of INR 0.25
• Contract cycle of 12 months indicate that a trader can
take position maximum upto 12 months.
• Base price indicates the theoretical price based on spot rate
and interest rate prevailing in both countries
• M-T-M margin
PARITY CONDITIONS AND
CURRENCY FORECASTING
Arbitrage and The Law Of One Price
I. THE LAW OF ONE PRICE
A. Law states:
Identical goods sell for the same price worldwide.
B. Theoretical basis:
If the prices after exchange-rate adjustment were not equal,
arbitrage of the goods ensures eventually they will worldwide.
Arbitrage And The Law Of One Price
Five Parity Conditions Result From These Arbitrage Activities

1. Purchasing Power Parity (PPP)

2. The Fisher Effect (FE)

3. The International Fisher Effect (IFE)

4. Interest Rate Parity (IRP)

5. Unbiased Forward Rate (UFR)

Five Key Theoretical Relationships

Expected percentage
change of Spot
Exchange rate of
foreign currency -3%
IFE
UFR
PPP
Forward discount or Interest rate
Premium on foreign differential
Currency – 3% IRP
+3%

Expected FE
Inflation rate
Differential
+3%
Purchasing Power Parity
• PPP was first started by the Swedish Economist Gustav Cassel
in 1918.
• It is often used to forecast future exchange rates.
• Theory of exchange rate determination which compares the
average costs of goods and services between countries.
• Price of a Big Mac is USD3.57 in the USA and INR 99 in India
• Implied purchasing power parity is INR 27.73 per USD.
However the actual exchange rate is INR 48 per USD.
• This indicates that INR is undervalued valued by [(27.73-
48)/48]*100= -42.29%.
• It indicates that INR should appreciate in near future.
• PPP calculated by comparing price of one good across in
different currencies is known as Absolute PPP
Purchasing Power Parity
• The spot rate between two countries can be determined by
comparing the price index of a basket of similar goods and
services.
 basket of goods & services costs INR 5000 and USD300, the
spot exchange rate on that date should be
Purchasing Power Parity and Law of One
Price
• PPP is based on the concept of “Law of One Price”.
• Nokia E75 model mobile phone costs INR 26,000 in India
and the same model costs Bangladeshi Taka of 35000 BTK.
• Suppose the exchange rate between BTKINR is INR
0.642/BTK, handset costs INR 22470 at Bangladesh.
• Indian people would sell INR and buy BTK and purchase the
mobile in Bangladesh and sell the handset in India at a price
of INR26000. For every handset sold in India, the trader
makes a profit of INR3530.
• This profit is the arbitrage profit i.,e buying low and selling
high and no risk.
• So many people would flock to sell INR to buy BTK.
Purchasing Power Parity and Law of One
Price
• Suppose exchange moves 0.746/BTK, cost is INR 26110.
• selling in India becomes a loss making proposition.
• The traders would buy the handset in India and start selling
Bangladesh.
• This process will go on till the price of the handset is same in
both countries.
Relative Purchasing Power Parity
• Relative PPP postulates that the change in inflation rate
governs the change in exchange rate.

• St is the spot rate of foreign currency/domestic currency

• P(t) is the price level prevailing now and P(t-1) price level
prevailing before one period 
• For example, the inflation rate in 2008 is 8.39% in India and
in USA during 2008 is 4%.
• 1.04/1.0839 is 0.96. This indicates that INR should
depreciate by 4%.
Relative Purchasing Power Parity

• IF the spot exchange rate

• USD 0.0217/INR (INR 45 per USD) at S(t-1) then it should be USD
0.0208/INR (INR (47.91 per USD) at S(t)

• With two countries having different inflation rate, the relative

prices of goods in the two countries, will change so that the
goods and services offered in these countries are priced same.

• PPP states that spot exchange rates between currencies will

change to the differential in inflation rates between countries.
PURCHASING POWER PARITY
1. In mathematical terms:

et

1  ih  t

e0 1  i f
t

where et = future spot rate

e0 = spot rate
ih = home inflation
if = foreign inflation
t = the time period
PURCHASING POWER PARITY
2. If purchasing power parity is expected to hold, then the
best prediction for the one-period spot rate should be

et  e0
1  ih  t

1  i  f
t
PURCHASING POWER PARITY
3. A more simplified but less precise relationship is
et
 ih  i f
e0
that is, the percentage change should be approximately equal
to the inflation rate differential.

4. PPP says
The currency with the higher inflation rate is expected to
depreciate relative to the currency with the lower rate of
inflation.
 PURCHASING POWER PARITY
• If the United States and Switzerland are running annual
inflation rates of 5% and 3%, respectively, and the spot rate
is SFr 1 = $0.75, then the PPP rate for the Swiss franc in
three years should be
 The Fisher Effect (FE)
• The relationship between the real interest rate, nominal interest rate and
inflation is known as “Fischer Effect”
• Irving Fischer postulated that the nominal interest arte in an economy is
equal to real rate of return and inflation rate
N = R + I
• Country specific Fischer effect is expressed as
(1+ ius) = (1+ rus) (1+ InflationRateus)
(1 + iIndia ) = (1 + rIndia )(1 + InflationRateIndia )
• Nominal interest rate is 10%, i.e an bank fixed deposit holder is earning 10%
per annum as interest rate
• Expected Inflation rate during this period is 6%.
•  (1+10%) = (1+r)(1+6%). Solving for r, the real rate (r) is 3.77%.
• If the expected inflation rate increases to 13%, then real interest rate is -3%.
The Fisher Effect
The exact form of this relationship is expressed by Equation

With no government interference nominal rates vary by

inflation differential or
r h - r f = ih - i f

According to the Fisher Effect,

countries with higher inflation rates have higher interest rates
The Fisher Effect
• If inflation rates in the United States and the United
Kingdom are 4% and 7%, respectively,
• the Fisher effect says that nominal interest rates should be
about 3% higher in the United Kingdom than in the United
States
The International Fisher Effect (IFE)
• International Fisher Effect postulates that the estimated change
in the current exchange rate between any two currencies is
directly proportional to the difference between the two
countries' nominal interest rates at a particular time.
• The spot rate adjusts to the interest rate differential between
two countries.
• IFE = PPP + FE

t
et (1  rh )

e0 (1  r f ) t
The International Fisher Effect (IFE)
• Mathematically, International Fischer effect is expressed as:

• For example, if the nominal interest rate in India is 12% per

annum and it is 8% in USA, then INR is expected to depreciate
vis-a vis USD. Plugging the interest rate in the right

• The differential in the nominal interest rate prevailing in Indian

and USA indicates that INR will depreciate by 3.57% by the end
of one year
The International Fisher Effect (IFE)
• 1st January 2010, the exchange rate is INR 40/USD.
• On this date an investor invest INR 1600 at his disposal.
• He invests INR 800 on a Govt. of India paper at 12% interest per
annum.
• He converts the other INR 800 to USD (USD 20) and invests in
Govt. of USA paper for 1 year.
• After a year, he has INR 896 and USD21.6 from INR and USD
investment respectively. 
• According to the International Fisher’s effect, the spot exchange
rate on 1st January 2011 will be decided by these two
investment returns i.e USD 21.6 = INR 896.
• Hence the spot rate on 1st January 2011 will be INR41.48/USD.
The International Fisher Effect (IFE)
• USD appreciation amount would be governed by
The International Fisher Effect (IFE)
• The International Fisher’s effect relates the nominal interest rate
between two countries and the movement of exchange rate
between the currencies of two countries.
• It indicates that the country with lower nominal (higher) interest
rate will appreciate (depreciate) compared to the other currency.
• If the spot rate is INR40/USD and 1 year interest rate is 12% in
India and 8% in US respectively, then INR is expected to
depreciate or USD is expected to appreciate.
• The % appreciation and depreciation will be governed by Interest
rate differential.
• Currency with the lower interest rate expected to appreciate
relative to one with a higher rate.
• IFE insures interest rate differential is an unbiased predictor of
change in future spot rate.
The International Fisher Effect (IFE)
• Illustration on Page number 165
Example
•  Suppose the current U.S. price level is at 112 and the Swiss
price level is at 107, relative to base price levels of 100. If
the initial value of the Swiss franc was $0.98, then according
to PPP, the dollar value of the franc?
• [0.98 × (112/107)] = $1.0258,
• an appreciation of Swiss Franc of 4.67%.

• On the other hand, if the Swiss price level now equals 119,
then the franc?
• [0.98 × (112/119)] = $0.9224
• Depreciation of Swiss Franc by about 5.88%
Interest Rate Parity (IPR)
• Interest rate parity is one of the most important fundamental
economic relation relating differential interest rate and forward
exchange rate between a pair of currency.
• The parity condition requires that the spot price and the forward or
futures price of a currency pair would be governed by interest rate
differentials between the two currencies.
• In other words, the interest rates paid on two currencies should be
equal to the differences between the spot and forward rates.
• The forward discount or premium is closely related to the interest
differential between the two currencies.
• According to interest rate parity (IRP) theory, the currency of the
country with a lower interest rate should be at a forward premium in
terms of the currency of the country with the higher rate.
• More specifically, in an efficient market with no transaction costs, the
interest differential should be (approximately) equal to the forward
differential.
Interest Rate Parity (IPR)
• Let us assume that interest rate prevailing in India is 8% per year
while in
• USA it is 3% per year. Suppose the spot rate INR 47/USD. The
interest parity says, that
• one year forward rate would be governed by the interest rate
differential.
Interest Rate Parity (IPR)
• Spot rate prevailing on today is INR47/USD.
• A person intends to invest INR 47 for year at 8% interest in India.
• Otherwise, he can convert INR 47 to 1 USD and invests in USA at 3%
per annum and simultaneously buys a forward cover to sell 1.03 USD
after a year.
• In both options, the investor should have the same return.
• Option 1: investing in INR at 8% would result in INR 50.76.
• Option 2: Investing in USD would result in USD 1.03.
• If the actual forward rate differs from the interest rate parity, the
arbitrage will happen.
• The forward exchange rate must be such that, if the investors sell USD
1.03, he must earn INR 50.76.
• Hence the 1-forward rate prevailing in the spot date would be
INR49.28/USD give rise to interest rate arbitrage.
Interest Rate Parity (IPR)
• Now let us take scenarios: actual forward rate is either INR
50.25/USD
• Scenario 1: Actual forward rate prevailing: INR 50.25/USD.
• INR 47 investment in India at a rate of 8% results in INR 50.76.
• If investor converts it to USD and invests in US market, the
investor receives USD1.03.
• The investor sells in forward market at a rate of Rs.50.25 for
1.03USD, he receives INR 51.7575.
• like to borrow money in Indian market, sell INR and buy USD,
invest in USD and simultaneously enter into a contract to sell
USD forward.
• borrowing in INR would increase.
• Interest rate prevailing in India would increase.
Interest Rate Parity (IPR)
• As in both scenarios, the arbitrage benefit accrues to
investors only when they take
• forward cover, this parity condition is known as “covered
interest rate parity”.
Example of Interest Rate Parity

• If the investor chooses to invest in euros on a hedged basis,

he will
1. Convert the $1, 000, 000 to euros at the spot rate of
€0.74000/$. This yields €740, 000 available for investment.
2. Invest the principal of €740, 000 at 1.5% for 90 days. At the
end of 90 days, the investor will have €751, 100.
3. Simultaneously with the other transactions, sell the €751,
100 in principal plus interest forward at a rate of €0.73637/$
for delivery in 90 days. This transaction will yield €751,
100/0.73637 = $1, 020, 000 in 90 days.
The Relationship Between The Forward and The
Future Spot Rate
I. THE UNBIASED FORWARD RATE

States that if the forward rate is unbiased, then it

should reflect the expected future spot rate.

B. Stated as
f t = et
Exchange Rate Forecasting
1. Technical Forecasting
• Use of historical data to predict future values
• Useful for Speculators
• Predicting day-to day movements
• Limited use to MNCs due to limited range estimates
2. Fundamental Forecasting
• Fundamental relationships between economic variables and
exchange rates
• Subjective assessments, quantitative measurements based on
regression models and sensitivity analyses
• Limited by – uncertain timing of impact of factors – need to
forecast factors that have an immediate impact on exchange rates
– omission of factors that are not easily quantifiable – changes in
the sensitivity of currency movements to each factor over time
Exchange Rate Forecasting
3. Market-Based Forecasting
• It uses Market indicators to develop forecasts.
• The current spot/ forward rates are often used, since speculators
will ensure that the current rates reflect the market expectation of
the future exchange rate
4. Mixed Forecasting
• It refers to the use of a combination of forecasting techniques.
• The actual forecast is a weighted average of the various forecasts
developed.