International Finance For Dummies (Ayse Evrensel, 2013)

Exchange rate (nominal exchange rate)

• The relative price of 2 currencies.
• It is important to multinational corporations (MNCs) with foreign agreements.
• Fixed rate
• No sudden changes in exchange rate.
• No need to forecast future exchange rates.
• Questionable price stability.
• Questionable economic stability and prosperity.
• Questionable price-specie flow mechanism.
• Imports of other countries' unemployment and inflation rates.
• Increase in precious metal reserves.
• Potential influence of precious metal producers.
• Flexible rate
• Insulation from other countries' problems.
• Automatic stabilisers.
• Monetary policy autonomy.
• Exchange rate risk.
• Potential for too much use of expansionary monetary policy.
• Questionable stabilising effects.
• Excessive volatility in exchange rates.
• Pegged rate
• Stability provided by a nominal anchor.
• Financing economic development through incoming portfolio flow.
• Prone to speculative attack.
• Hot money leaving the country fast if investors doubt the credibility of the peg.
• Hard peg
• Dollarisation
• Currency board
• Soft peg
• Crawling peg
• Attract foreign portfolio investment
• Identify the reasons for foreign investor's reservations
• Eliminate exchange rate risk
• Real exchange rate (RER) = nominal exchange rate x price of the foreign basket / price of the domestic basket
• Effective exchange rate = trade-weighted index, it attached to foreign currencies.
• Nominal effective exchange rate (NEER)
• Appreciation and depreciation.
• Revaluation and devaluation.
• Cross rates: switch between buyer and seller.
• Bid-ask spread: money changer's rate.
• Inflation rate depends on the exchange rates and consumer price index (CPI).
• Real interest rate = nominal interest rate - inflation rate.
• Floating exchange rate
• No need for international management of exchange rates.
• No need for frequent central bank intervention.
• No need for elaborate capital flow restrictions.
• Greater insulation from other countries' economic problems.
• Higher volatility.
• Use of scarce resources to predict exchange rates.
• Tendency to worsen existing problems.

Foreign exchange (Forex)

• Speculators: traders and brokers.
• Central banks: to influence the forex rate.
• Exchange rate regimes
• Import and export risk for MNCs.

FX derivatives

• Standardised regarding the amount of currency
• Forward contract: No
• Future contract: Yes
• Options: Yes
• Obligation to engage in the transaction on the specific da
• Forward contract: Yes
• Future contract: Yes
• Options: No
• Traded
• Forward contract: No
• Future contract: Yes
• Options: Yes
• Useful for MNCs
• Forward contract: Yes
• Future contract: Yes
• Options: Yes
• Useful for speculators
• Forward contract: No
• Future contract: Yes
• Options: Yes
• FX futures
• Credit risk
• Marking-to-market
• Maintenance margin
• FX Options
• Call option
• Put option
• Strike or exercise price
• Expiration or maturity date

Demand and supply

• Change of price due to the change in supply or demand curve.
• Ceteris paribus = everything else constant.
• Currency demand and supply determinants
• Inflation rate
• Growth rate
• Interest rate
• Government restrictions
• Does not deal with monetary policy while it deal with the consequences.

Monetary approach to balance of payments (MBOP)

• Monetary: exchange rate determination.
• Balance of payment (BOP): the account to keep track of a country's transaction.
• Current account: exports and imports
• Financial account: purchase and sales of foreign assets
• Basic assumptions
• No government intervention.
• International investor behaviour.
• Changes in real returns.
• Classical-neoclassical: the changes in the price level equal the changes in the nominal money supply.
• Keynesian: in the long run, we are all dead. The notion of short run.

Interest rate parity (IRP)

• It is the interest rate differential to the expected change in the exchange rate.
• The international Fisher effect: a hypothesis in international finance that suggests differences in nominal interest rates reflect expected changes in the spot exchange rate between countries.
• E.g. you are receiving an interest rate of 3% and has no problem with a country with 5% but have problem if a country giving 3% and below.
• Forward discount and forward premium.
• Covered interest arbitrage
• Get a forward contract and sell it at current rate.
• Convert it in the spot market.
• But treasury bills in that currency and hold for a year.
• Sell the contract at current rate.
• Carry trade: borrow in low-interest-rate currency and investing in a high-interest-rate currency.

Purchasing power parity (PPP)

• The relationship between inflation differentials and changes in the exchange rate.
• Absolute PPP: law of one price where the product is priced the same everywhere.
• Relative PPP: the change in currency will affect the product price.
• Economist uses Big Mac to determine the PPP around the world.

Pre-Bretton Woods Era

• History
• 3,000 years ago: pure commodity standard
• 1,500 AD: convertible paper money and gold standard
• Advantage of gold is it is interchangeable
• Price stability
• Economic stability and prosperity
• Disadvantage is people will keep the more valuable asset
• 1,973 AD: fiat money which was not backed by gold
• The race back to gold standard partially resulted in a race to higher interest rate which is called a deflationary vortex.

Bretton Woods Era

• Why it was formed
• Germany fell into hyperinflation state due to reparation for WWI.
• Great depression forces countries to introduce trade restriction to stop deficits and reserve loss.
• Fund wants to balance the current accounts on deficit countries.
• USA choose to lead the monetary system as they have proven to be the economic and military power in WWII.
• Organisations that were formed after this
• International Monetary Fund (IMF)
• International Bank for Reconstruction and Development (IBRD)
• General Agreement on Tariffs and Trade (GATT)
• As USA is entrusted to hold gold at a certain value, they can sell their dollar without inflation.
• Triffin's dilemma: the conflict of economic interests that arises between short-term domestic and long-term international objectives for countries whose currencies serve as global reserve currencies.
• Special drawing rights (SDR): a supplementary reserve to take over USD.

Euro

• 1950: Optimum Currency Area (OCA) become important after Bretton Woods system
• 1951: Paris treaty: European Coal and Steel Community (ECSC)
• 1957: Rome treaty: European Economic Community (EEC)
• 1979: European Monetary System (EMS)
• 1992: Maastricht treaty: European Currency Unit (ECU) / European Monetary Union (EMU)
• 1999: Exchange Rate Mechanism II (ERM II) / European Central Bank (ECB)
• 2010: European Financial Stability Facility (EFSF): €750 billion will be borrowed

Puzzles (for further reading)

• The home bias in trade puzzle: people prefers locally produced goods.
• The home bias in portfolio puzzle: invest prefers home equity.
• The Feldstien-Horioka puzzle: savings and investment are highly correlated at the country level.
• The consumption correlation puzzle: consumption is much less correlated across countries than output.
• The exchange rate disconnect puzzle: short-term volatility in exchange rates doesn't reflect that of the fundamentals.
• The purchasing power parity puzzle: short-term changes in exchange rates don't reflect inflation differentials between countries.