1. Chapter 8 International Trade Foreign Exchange Nations engage in international trade for the same reason that individuals engage in domestic trade Comparative Advantage Specialization & Int. Trade The Foreign Exchange Improve productivity More Consumption, Income Increase standard of living Market International trade requires the exchange of currencies Currency exchange is often regulated by government. Thomson/South-Western 2006 1 2 The Foreign Exchange Market The Foreign Exchange MarketThe foreign exchange (ForEx) market is the market in International capital flowswhich parties exchange national currencies The acquisition of financial & real assets across national bordersIt is not a public outcry auction market, but rather operates as 90% of foreign exchange volume is associated witha computer driven over-the-counter market capital flows (investment markets) The direct or immediate participants (Dealers) U.S. &The volume of activity has escalated dramatically in response foreign commercial banks with international deposits &to the growth in world trade volume in goods & services. foreign branches The ultimate participants import & export firms, tourists & other travelers, & financial entities seeking to invest internationally. 3 4 The Foreign Exchange Rate The Foreign Exchange RateThe price at which one nations currency is exchanged for The price at which one nations currency is exchanged foranothers is the foreign exchange rate anothers is the foreign exchange rateAn exchange rate exists between each pair of nations that An exchange rate exists between each pair of nations thatengage in trade using different currencies engage in trade using different currenciesA currency appreciates against other currencies when a It depreciates against other currencies when when a singlesingle unit of that currency buys more units of these foreign unit of that currency buys less units of these foreign currencycurrency Last month: THB 34.50 / $ Last month: $ 1.54 / This month: THB 32.25 / $ This month: $ 1.33 / 5 6

2. Table 8-1 Figure 8-1 7 8 Fixed & Floating Exchange Rates Spot & Forward Exchange Markets Fixed exchange rates : exchange rates do not change& countries must act to maintain some predetermined level of Spot transactions involve the exchange of currenciesvalue for immediate or on the spot delivery & payment Bretton Woods exchange rate system(adjustable-peg) The exchange rate at which such transactions take place required countries get IMF approval to change their exchange rates is called the spot exchange rate. The system collapsed in the early 1970s Major industrial states currencies currently float according tosupply & demand for each currency Floating exchange rates : exchange rates continuouslychange according to supply & demand in the world 9 10marketplace. Spot & Forward Exchange Markets Forward Transaction Forward transactions involve the purchase and sale of Forward Contract Agreement toforeign currencies for delivery & payment at some specific exchange Thai Bahtfuture date, at a price specified in advance for USD The exchange rate at which these forward transactions take place is the forward exchange rate Price: At 33 Baht/USD Time: In the next 3 Forward exchange markets provide hedging for months investors to avoid possible large losses due to changes Amount: 100,000 Baht in the spot exchange rate. Sign ______ (today) 11 12

3. Spot Transaction Forward Transaction Watches Watches U.S. Swiss U.S. Swiss Importer Pay S Fr 100,000 Exporter Importer Pay S Fr 100,000 Exporter in 30 days in 30 daysToday Spot rate = S Fr 1.25 / USD Today Spot rate = S Fr 1.25 / USDExpected cost = USD 80,000 Today: Sign Forward Contract at S Fr 1.2489 / USD to deliver in 30 daysOn the delivery day If that days Spot rate = S Fr 1.20 /USD Actual cost = USD 80,070(next 30 days)Then the Actual cost = USD 83,333 On the delivery day Forward rate = S Fr 1.2489 / USD Actual cost = USD 80,070 13 14 The Importance of the Exchange Rate The Importance of the Exchange Rate A countrys exchange rate level is important because, together with Exchange rate influences Trade deficits/surplusdomestic prices, the exchange rate determines the cost of the nations products in foreign nations influencing the nations exports Because of the large influence of currency values the cost of foreign products sold in the country influencing imports upon trade, disputes among nations have arisenCurrency Appre products look more expensive over one governments decisions to intervene in the Export less foreign exchange market Import more Managed float system.. Trade DeficitCurrency Depre products look cheaper Export more Import less Trade Surplus 15 16 Exchange Rate Determination Figure 8-2The foreign exchange market is highly competitive many small buyers & small sellers relative to the total market homogenous product--a national currencyIn Freely Floating Exchange Rates, governments rarelyintervene exchange rates are driven entirely by supply & demandIn a Managed Float (the system in place today), governmentssometimes intervene in an effort to prevent exchange ratemovements perceived to be excessive or strongly at odds withnational interests. 17 18

4. The Supply & Demand Model The Supply & Demand Model Demand Supply The demand curve for dollars stems from foreign buyers The supply curve for dollars stems from Americans of American goods & services, U.S. financial & real seeking to purchase foreign goods & services, financial & assets real assets The demand curve is downward sloping because, ceteris The supply curve slopes upward because, given other factors, an increase in the dollars value reduces the price paribus, a decline in the price of $ makes everything from of foreign items in the United States. the United States cheaper for foreign buyers. 19 20 Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants1. Relative Price Level Behavior (Inflation) 1. Relative Price Level Behavior (Inflation) Nations with chronically high inflation are likely to beNon-inflation factors weak-currency nationsi.e., they are likely to see their 2. preferences & product development (innovation) currencies depreciate over the years against currencies of 3. productivity behavior (growth) nations that experience lower inflation. 4. tariffs & quotas (trade restrictions) 21 22 Figure 8-3 Increase in Japanese Prices Purchasing Power Parity Theory S2$ The purchasing power parity (PPP) theory says thatExchange Rate exchange rates adjust completely to offset the effects of S1 $ different inflation rates in two countries Under highly restrictive & unrealistic conditions, PPP theory 132 would always be valid The law of one price states that the cost of a single D2$ homogeneous good must be the same to an American or a 120 foreigner, whether purchased at home or abroad D 1$ Q$ 23 24

5. Purchasing Power Parity Theory Purchasing Power Parity Theory Original exchange rate = 40 THB/USD Why PPP doesnt always work in the real world In Thailand, 1 hamburger = 80 THB In the real world, many products are not homogeneous in nature, some In U.S., 1 hamburger = 2 USD goods are non-tradable, some goods enjoy brand loyalty that keeps Thailand experiences inflation of 10% their prices artificially high, and some goods sell at higher prices simply In Thailand, 1 hamburger = 88 THB because of consumers forces of habit. 1 hamburger in Thailand = 1 hamburger in the U.S. 88 THB = 2 USD PPP theory works: The new exchange rate = 44 THB/USD well in accounting for major exchange rate movements 10% Inflation in Thailand 10% depre in THB poorly in explaining short-to-intermediate term changes 25 26 Figure 8-4 Long-Run Exchange Rate Determinants Non-inflation factors 2. preferences & product development (innovation) 3. productivity behavior (growth) 4. tariffs & quotas (trade restrictions) 27 28 Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants2. Preferences & Product Development 3. Productivity Japan produces new bread toaster improve in productivity production costs fall Foreigners start importing this new product Thai products have lower prices Foreigners demand more Yen products look more attractive in world market Yen appreciates more demand for THB THB appreciates 29 30

6. Long-Run Exchange Rate Determinants Long-Run Exchange Rate Determinants 4. Tariffs and Quotas 4. Tariffs and Quotas U.S. puts more tariffs more tax on U.S. puts more quotas imported products less quantity of imported products Imported products have higher prices U.S. people import less U.S. people import less supply less USD supply less USD USD appreciates USD appreciates 31 32 Spot - Forward Spot - Forward In your new business venture, you expect a shipment of Swiss watches in What is the actual cost in $ if the future spot rate = 5.8 S Fr/$ 90 days. Upon delivery 90 days from now, you must pay the Swiss Answer : Actual Cost = 142,000 / 5.8 = 24,482.76 USD. company 142,000 Swiss francs. If you enter 90 days Forward Contract and lock-in the forward rate at What risk are you taking if you wait 90 days and then buy the needed 6.15 S Fr/$, what is the expected cost? What is the actual cost? francs in the spot market? Answer : Expected Cost = 142,000 / 6.15 = 23,089.43 USD. Answer : I will face the foreign exchange rate risk. If Swiss francs is Actual Cost = 142,000 / 6.15 = 23,089.43 USD. appreciated in next 90 days, I need to use more USD, to buy 142,000 What is the benefit you get from entering Forward Contract? Swiss francs. Answer : Forward exchange markets provide hedging for me to avoid What is the expected cost in $ if the current spot rate = 6.3 S Fr/$ possible large losses due to Swiss Francs appreciated in the spot Answer : Expected Cost = 142,000/6.3 = 22,539.97 Swiss francs exchange rate 33 34 More Exercise Suppose you are importer, you expect a shipment of computers from United State of America in 60 days. Upon delivery 60 days from now, you must pay the US. company 200,000 USD.1. What is the expected cost in THB if the current spot rate = 33.40 THB./$? Answer: The expected cost = 200,000 * 33.4 = 6,680,000 THB2. What is the actual cost in THB if the future spot rate = 34.30 THB./$ ?86 Answer : The actual cost = 200,000 * 34.3 = 6,860,000 THB3. If you enter 60 days Forward Contract and lock-in the forward rate at 33.86 THB./$ what is the expected cost? What is the actual cost? Answer: The expected cost = 200,000 * 33.86 = 6,772,000 THB 35