SEU The United States Balance of Payments and Foreign Exchange Discussion

Question Description

I don’t know how to handle this Economics question and need guidance.

Select a country of your choice (other than Saudi Arabia) and observe the last balance of payments issued by that country. Does the country run a current account deficit or surplus? What are the driving factors for the deficit or surplus? What are the implications of the current account deficit or surplus for the overall economy? What actions may better the nation’s situation? Explain

2 attachmentsSlide 1 of 2attachment_1attachment_1attachment_2attachment_2.slider-slide > img { width: 100%; display: block; }
.slider-slide > img:focus { margin: auto; }

Unformatted Attachment Preview

INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 10:
The Balance of
Payments
© 2019 Cengage. All rights reserved.
2
Chapter Outline
Double Entry Accounting
Balance-of-Payments Structure
U.S. Balance of Payments
What Does a Current Account Deficit (Surplus)
Mean?
Balance of International Indebtedness
The Dollar as the World’s Reserve Currency
© 2019 Cengage. All rights reserved.
3
The Balance of Payments
The Balance of Payments is a record of the
economic transactions between the residents of
one country and the rest of the world
Records are kept annually and quarterly
An international transaction is an exchange of
goods, services, or assets between residents of
one country and those of another
• Residents include businesses, individuals,
and government agencies that make the
country their legal domicile
© 2019 Cengage. All rights reserved.
4
Double-Entry Accounting
(1 of 3)
Arranging international transactions into a balanceof-payments account requires that each
transaction be entered as credit or debit. This is
known as Double-Entry Accounting.
• A credit transaction results in a receipt of a
payment from foreigners; recorded with a +
• A debit transaction is one that leads to a
payment to foreigners; recorded with a ?
© 2019 Cengage. All rights reserved.
5
Double-Entry Accounting
(2 of 3)
• Examples of credits
•
•
•
•
•
•
Merchandise exports
Transportation and travel receipts
Income received from investments abroad
Gifts received from foreign residents
Aid received from foreign governments
Investments in U.S. by overseas residents
© 2019 Cengage. All rights reserved.
6
Double-Entry Accounting
(3 of 3)
• Examples of debits
•
•
•
•
•
•
Merchandise imports
Transportation and travel expenditures
Income paid on the investments of foreigners
Gifts to foreign residents
Aid given by the U.S. government
Overseas investment by U.S. residents
© 2019 Cengage. All rights reserved.
7
Balance-of-Payments Structure
(1 of 13)
Current Account
• The monetary value of international flows
associated with transactions in goods,
services, income flows, and unilateral
transfers
• Merchandise trade balance includes all
goods U.S. exports or imports; exports minus
imports gives merchandise trade balance
• When balance is negative, trade deficit
• When balance is positive, trade surplus
© 2019 Cengage. All rights reserved.
8
Balance-of-Payments Structure
(2 of 13)
To calculate a goods-and-services
balance, add services to the merchandise
trade account
• When balance +, surplus of goods-andservices transactions
• When balance ?, deficit of goods-andservices transactions
Goods-and-services balance is part of a
nation’s gross domestic product (GDP)
© 2019 Cengage. All rights reserved.
9
Balance-of-Payments Structure
(3 of 13) Figure 10.1
© 2019 Cengage. All rights reserved.
10
Balance-of-Payments Structure
(4 of 13)
• Capital and Financial Account
• Transactions include all international purchases or
sales of assets, including private sector and central
bank transactions
• Assets broadly defined to include titles to real estate,
corporate stocks & bonds, government securities, and
ordinary commercial bank deposits
© 2019 Cengage. All rights reserved.
11
Balance-of-Payments Structure
(5 of 13)
• Capital and Financial Account (cont’d)
• Major types of capital transfers are debt forgiveness
and migrants’ goods and financial assets
accompanying them as they leave or enter country
• Acquisition and disposal of nonfinancial assets
include sale and purchase of rights to natural
resources, patents, copyrights, and trademarks
© 2019 Cengage. All rights reserved.
12
Balance-of-Payments Structure
(6 of 13)
• Private Sector Financial Transactions
• Vast majority of transactions in capital and
financial account come from private financial
transactions; include
• Direct investment: residents of one country acquire
controlling interest (stock ownership of 10 percent or
more) in business of another country
• Securities: private-sector purchases of debt issued by
governments and private companies
• Bank claims and liabilities: loans, overseas deposits,
acceptances, foreign commercial paper, and foreign
government obligations
© 2019 Cengage. All rights reserved.
13
Balance-of-Payments Structure
(7 of 13)
• Private Sector Financial Transactions
• Capital and financial transactions recorded in
balance-of-payments statement by applying + (credit)
to capital and financial inflows and ? sign (debit) to
capital and financial outflows
• Financial inflow (credit entry) might occur when (1) U.S.
liabilities to foreigners rise (French resident purchases
securities of IBM); (2) U.S. claims on foreigners decrease
(Citibank receives repayment of loan to Mexican firm); (3)
foreign-held assets in U.S. rise (Toyota builds plant in U.S.);
or (4) U.S. assets overseas decrease (Coca-Cola sells
Japanese bottling plant to Japanese buyer).
• Financial outflows imply opposite movements
© 2019 Cengage. All rights reserved.
14
Balance-of-Payments Structure
(8 of 13)
• Official Settlement Transactions
• Movement of financial assets among official holders
such as U.S. Fed and Bank of England
• Official reserve assets (U.S. government assets
abroad)
• Liabilities to foreign official agencies (foreign official
assets in the U.S.)
© 2019 Cengage. All rights reserved.
15
Balance-of-Payments Structure
(9 of 13)
• Official Settlements Transactions (cont’d)
• Official holdings of reserves used for two
purposes
• Provide a country sufficient international liquidity to
finance short-run trade deficits, currency crises,
etc.
• Central banks sometimes buy or sell official
reserve assets in the private sector to stabilize
their currencies’ exchange rates
© 2019 Cengage. All rights reserved.
16
Balance-of-Payments Structure
(10 of 13)
Official reserve assets
• Stock of gold reserves held by U.S.
government
• Convertible currencies such as Japanese yen,
readily acceptable as payment in international
transactions
• Reserve position of U.S. in International
Monetary Fund (IMF)
© 2019 Cengage. All rights reserved.
17
Balance-of-Payments Structure
(11 of 13) Table 10.1
Selected Foreign Holders of U.S. Securities as of 2016
Country
Billions of Dollars
Percentage of World Total
Japan
1,959
11.4
China
1,630
9.5
Cayman Islands
1,524
8.9
United Kingdom
1,427
8.3
Luxembourg
1,349
7.9
Canada
950
5.5
Ireland
931
5.4
Switzerland
742
4.3
World Total
17,139
Source: U.S. Treasury Department, Report on Foreign Portfolio Holdings of U.S. Securities as of June 30, 2016.
© 2019 Cengage. All rights reserved.
18
Balance-of-Payments Structure
(12 of 13)
Special drawing rights, new reserve asset
created by the IMF as a supplement to the existing
reserves of member countries.
• can be transferred among nations in
settlement of balance-of-payments deficits or
stabilization of exchange rates
• Is basket of currencies that includes U.S.
dollar, Japanese yen, UK pound, and euro
© 2019 Cengage. All rights reserved.
19
Balance-of-Payments Structure
(13 of 13)
• Statistical Discrepancy: Errors & Omissions
• Data collection process for balance-of-payments
figures imperfect
• Government statisticians base figures partly on
information collected & partly on estimates
• When statisticians sum credits & debits, rarely match
• Since debits must equal credits, residual is inserted to
make them equal
• This correcting entry is statistical discrepancy, or
errors and omissions
© 2019 Cengage. All rights reserved.
20
U.S. Balance of Payments
(1 of 3)
Merchandise trade balance commonly referred
to as trade balance
In 2016, U.S. had merchandise trade deficit of $749.9 billion — difference between U.S.
merchandise exports and imports
Trade deficits not popular with U.S. residents &
policymakers
• Negatively affect terms of trade, employment
levels, stability of international money markets
© 2019 Cengage. All rights reserved.
21
U.S. Balance of Payments
(2 of 3) Table 10.3
U.S. Balance of Payments, 1980–2016 (Billions of Dollars)
Year
Merchandise
Trade-Balance
Services
Balance
Goods and
Services-Balance
Income Receipts and
Payments-Balance
Unilateral
Transfers-Balance
Current
Account-Balance
1980
?25.5
6.1
?19.4
30.1
?8.3
2.4
1984
?112.5
3.3
?109.2
30.0
?20.6
?99.8
1988
?127.0
12.2
?114.8
11.6
?25.0
?128.2
1992
?96.1
55.7
?40.4
4.5
?32.0
?67.9
1996
?191.3
87.0
?104.3
17.2
?42.1
?129.2
2000
?452.2
76.5
?375.7
?14.9
?54.1
?444.7
2004
?665.4
47.8
?617.6
30.4
?80.9
?668.1
2008
?820.8
139.7
?681.1
127.6
?119.7
?673.2
2012
?735.3
195.8
?539.5
198.6
?134.1
?475.0
2016
?749.9
249.3
?500.6
180.6
?161.2
?481.2
Source: From U.S. Department of Commerce, Survey of Current Business, various issues.
© 2019 Cengage. All rights reserved.
22
U.S. Balance of Payments
(3 of 3)
• Taken as a whole, U.S. international
transactions always balance
• Any force causing increase or decrease in one
balance-of-payments account leads to exactly
offsetting changes in balances of other accounts
• In Table 10.2, U.S. had deficit of -$481.2 billion in
2016
• Offsetting this deficit was a combined surplus of
$481.2 billion in remaining capital & financial
accounts (this includes statistical discrepancy)
© 2019 Cengage. All rights reserved.
23
What Does a Current Account
Deficit (Surplus) Mean? (1 of 14)
Net Foreign Investment & Current Account
Balance
• Current account balance synonymous with net
foreign investment in national income
accounting
• Current account surplus means an excess of exports
over imports; nation becomes lender to rest of world
• Current account deficit means an excess of imports over
exports; nation becomes borrower from rest of world
© 2019 Cengage. All rights reserved.
24
What Does a Current Account
Deficit (Surplus) Mean? (2 of 14)
• Impact of Capital Flows on the Current Account
• Capital and financial flows can initiate changes in the
current account
• In 1980s, massive financial inflow caused current
account deficit for U.S. — resulted from increase in
U.S. interest rates relative to interest rates abroad
• Higher interest rates caused by growing budget deficit
and decline in private savings
• Current account deficit may be driven by capital flows:
capital inflows keep dollar stronger than it otherwise
would be, boosting imports and suppressing exports
© 2019 Cengage. All rights reserved.
25
What Does a Current Account
Deficit (Surplus) Mean? (3 of 14)
When foreigners start purchasing more of our
assets than we are purchasing of theirs, the dollar
becomes more costly in the foreign exchange
market
• U.S. goods more expensive to foreigners, declining
exports;
• foreign goods become cheaper to Americans,
increasing imports.
© 2019 Cengage. All rights reserved.
26
What Does a Current Account
Deficit (Surplus) Mean? (4 of 14)
• Is Trump’s Trade Doctrine Misguided?
• President Trump wants revised NAFTA to reduce
America’s trade deficits with Canada and Mexico
• Bilateral trade deficit matters little for country’s
aggregate (global) trade balance
• America’s imports would move from Mexico to
other countries as production of relevant products
shifts, or America’s exports would move to
Mexico from other countries with negligible net
impact on overall balance
© 2019 Cengage. All rights reserved.
27
What Does a Current Account Deficit
(Surplus) Mean? (5 of 14) Table 10.4
Global Production and Manufacturing Cost of the iPhone
Of the $179.02 wholesale cost of an iPhone in 2009, components came from
many countries to be assembled in China. Here’s the breakdown:
Manufacturing Cost (Labor and
Components)
Japan
In U.S. Dollars
$60.60
Percentage of Total
Manufacturing Cost
33.9%
Germany
30.15
16.8
South Korea
22.96
12.8
United States
10.75
6.0
China
6.50
3.6
Other
48.06
26.9
179.02
100.0
Source: Yuqing Xing and Neal Detert, How iPhone Widens the U.S. Trade Deficits with PRC, National Graduate
Institute for Policy Studies, Tokyo, Japan, November 2010.
© 2019 Cengage. All rights reserved.
28
What Does a Current Account
Deficit (Surplus) Mean? (6 of 14)
• Is a Current Account Deficit a Problem?
• Current account deficit arises because domestic
economy spends more than it produces
• Excess of demand met by net inflow of foreign
goods and services, leading to deficit
• Problem? Not necessarily
• Foreign capital inflows augment domestic capital
sources and keep domestic interest rates lower
than would otherwise be
• Benefit of deficit is ability to spend more than
produce
• Cost is debt service that must be paid on borrowing
© 2019 Cengage. All rights reserved.
29
What Does a Current Account
Deficit (Surplus) Mean? (7 of 14)
• Is a Current Account Deficit a Problem? (cont’d)
• Is it good or bad for country to incur debt?
• Depends on whether deficit used to finance more
consumption or more investment
• If used for investment, burden slight
• If used for consumption, no boost to future
productivity; and to meet debt service expense,
future consumption must be reduced
• In 1980s, U.S. saving decreased; U.S. used
foreign borrowing to increase current consumption
• In 1990s, deficits driven by increases in domestic
investment, made possible by foreign lending
© 2019 Cengage. All rights reserved.
30
What Does a Current Account
Deficit (Surplus) Mean? (8 of 14)
• Business Cycles, Economic Growth, and
the Current Account
• Rapid growth of production & employment
associated with growing trade & current account
deficits
• Slow output & employment growth associated
with growing surpluses
• During recession, saving & investment tend to
fall; current account balance tends to rise; trade
balance improves
• Opposite occurs during periods of boom
© 2019 Cengage. All rights reserved.
31
What Does a Current Account
Deficit (Surplus) Mean? (9 of 14)
• How the U.S. Has Borrowed at Very Low Cost
• In past 4 decades, U.S. current account moved from
small surplus to large deficit, financed by borrowing
from or selling assets to foreigners
• U.S. has become large net debtor; must make larger
payments of interest & principal to foreign lenders
• In past 2 decades, paradox: U.S. residents earned
more from foreign investments than foreigners earned
from U.S. investments
• U.S. has been large debtor without bearing negative
debt-service cost; suggests current account deficits
might be less burdensome than portrayed
© 2019 Cengage. All rights reserved.
32
What Does a Current Account
Deficit (Surplus) Mean? (10 of 14)
• How U.S. Has Borrowed at Very Low Cost
• What accounts for paradox?
• Asymmetric investment returns; rate-of-return advantage
generally 1–2% points; given political and economic
instability of other countries, U.S. firms take greater risks
investing in foreign firms; higher risk/reward
• U.S., by contrast, seen as safe haven; foreign investors
more likely to buy U.S. assets that offer low risk, return
• Future U.S. borrowing may be less favorable
• If interest rates rise, U.S. will pay higher rates
• Could swing U.S. investment income balance from
surplus to deficit
© 2019 Cengage. All rights reserved.
33
What Does a Current Account
Deficit (Surplus) Mean? (11 of 14)
• Do Current Account Deficits Cost Americans
Jobs?
• U.S. employment statistics don’t fit expected pattern of
negative relationship between current account deficit
and employment
• Trade deficit may hurt employment at some firms &
industries as workers displaced by imports, but
economy-wide, deficit matched by equal inflow of foreign
funds sustaining investment spending
• Current account deficit produces jobs as result of higher
employment in investment-oriented industries and
indirect effect of higher investment
© 2019 Cengage. All rights reserved.
34
What Does a Current Account
Deficit (Surplus) Mean? (12 of 14)
• Can the U.S. Continue to Run Current
Account Deficits Indefinitely?
• Foreigners have remained willing to buy U.S.
assets such as Treasury securities
• Large increase in U.S. current account deficit not
possible without inflows of foreign capital from
nations with high savings, such as Japan & China
• China a major supplier of capital to U.S.
• China has followed exchange-rate policy of
keeping value of yuan low to export goods to U.S.
& create jobs for its workers
© 2019 Cengage. All rights reserved.
35
What Does a Current Account
Deficit (Surplus) Mean? (13 of 14)
• Can the U.S. Continue to Run Current
Account Deficits Indefinitely? (cont’d)
• China’s central bank has converted its dollar
holdings into U.S. securities that pay interest
• Enables U.S. to benefit from willingness of China to
finance current account deficit
• U.S. can “print money” that Chinese hold in order to
finance its excess spending
• Some analysts concerned that foreign investors may
view increasing U.S. foreign debt as unsustainable or
more risky and shift capital elsewhere; U.S. also seen
as politically reliant on China, giving latter leverage
© 2019 Cengage. All rights reserved.
36
What Does a Current Account
Deficit (Surplus) Mean? (14 of 14)
• Can the U.S. Continue to Run Current
Account Deficits Indefinitely? (cont’d)
• No automatic or economic reason why U.S. can’t
sustain current account deficit indefinitely, if
foreigners wish to purchase U.S. assets
• Consequences of current account deficit are
growing foreign ownership of capital stock and
rising fraction of U.S. income paid as interest &
dividends to foreigners
• Serious problem could emerge if foreigners lose
confidence in inability of U.S. to repay
© 2019 Cengage. All rights reserved.
37
Balance of International
Indebtedness (1 of 4)
Balance of international indebtedness
• Statement that summarizes fixed stock of
assets and liabilities against rest of world;
record of international position of U.S. at
particular time
• Shows accumulated value of U.S.-owned
assets abroad
• When accumulated value of U.S. owned assets
abroad exceeds value of foreign-owned assets in
U.S., U.S. is net creditor to rest of world
© 2019 Cengage. All rights reserved.
38
Balance of International
Indebtedness (2 of 4) Table 10.5
International Investment Position of the United States at Year End
(Billions of Dollars)
Type of Investment*
1995
2000
2016
U.S.-owned assets abroad (U.S. assets)
3,406
6,168
23,917
Foreign-owned assets in the United States (U.S.
liabilities)
3,906
8,010
32,027
Net international investment position
?500
?1,842
?8,110
Relative share: U.S. net international investment
position/U.S. gross domestic product
6%
15%
44%
*At current cost.
Source: From U.S. Department of Commerce, Bureau of Economic Analysis, The International Investment
Position of the United States at Year End, available at http://www.bea.gov. See also U.S. Department of
Commerce, Survey of Current Business, various June and July issues.
© 2019 Cengage. All rights reserved.
39
Balance of International
Indebtedness (3 of 4)
• Balance of international indebtedness
(cont’d)
• When reverse is case, U.S. is net debtor
• Balance of international indebtedness breaks
down international investment holdings into
several categories, so that policy implications
can be drawn from each separate category
about the liquidity status of nation
© 2019 Cengage. All rights reserved.
40
Balance of International
Indebtedness (4 of 4)
• U.S. As a Debtor Nation
• In early industrial development, U.S. was net
international debtor, relying on foreign funds
to build its industries
• After World War I, U.S. became net
international creditor
• By 1987, U.S. had become net international
debtor and has continued in that position, with
foreign investors placing more funds in U.S.
than U.S. residents have invested abroad
© 2019 Cengage. All rights reserved.
41
The Dollar as the World’s
Reserve Currency (1 of 8)
Dollar is main reserve currency in world today
• Almost 2/3 of world’s official foreign exchange
reserves held in dollars
• 4/5 of daily foreign exchange trades involve dollars
• Euro, second-most-important reserve currency, lags
far behind dollar
Widening trade deficits & expanding foreign debt
of U.S. have weakened prestige of dollar
Widespread use of dollar makes it difficult to
displace as world’s main reserve currency
© 2019 Cengage. All rights reserved.
42
The Dollar as the World’s
Reserve Currency (2 of 8)
Benefits to the United States
• Americans can purchase products at marginally
cheaper rates than nations that must exchange
their currency and pay a transaction cost
• Americans can borrow at lower interest rates for
homes & autos, & U.S. government can finance
larger deficits longer and at lower interest rates
• U.S. can issue debt in its own currency, pushing
exchange-rate risk onto foreign lenders
• Fall in dollar’s value could wipe out their returns
© 2019 Cengage. All rights reserved.
43
The Dollar as the World’s
Reserve Currency (3 of 8)
• Benefits to the United States (cont’d)
• But rising concern about continuing role of
dollar as world’s main reserve currency
• China fears U.S. digging hole with economy based
on huge deficits & massive borrowing
• Worries about volatility of dollar & destabilizing
effect it can have on international trade & finance
• Critics claim credit-based reserve currency (dollar)
inherently risky; promotes spread of financial
crises
© 2019 Cengage. All rights reserved.
44
The Dollar as the World’s
Reserve Currency (4 of 8)
Benefits to the United States (cont’d)
• Alternatives to the U.S. dollar
• not British pound (past)
• not Chinese yuan (far in future, if ever)
• not euro (weakening)
© 2019 Cengage. All rights reserved.
45
The Dollar as the World’s
Reserve Currency (5 of 8)
Will the Special Drawing Right or the Yuan
Become a Reserve Currency?
• In 2009, China proposed overhaul of
international monetary system in which
special drawing rights (SDRs) would replace
dollar as world’s main reserve currency
• Objective to adopt reserve currency disconnected
from single country and stable in long run
© 2019 Cengage. All rights reserved.
46
The Dollar as the World’s
Reserve Currency (6 of 8)
• Will the Special Drawing Right or the Yuan
Become a Reserve Currency? (cont’d)
• SDR now based on euro, yen, pound, and
dollar; China proposed currency basket be
expanded to include all major currencies,
including Chinese yuan and Russian ruble
© 2019 Cengage. All rights reserved.
47
The Dollar as the World’s
Reserve Currency (7 of 8)
Will the Special Drawing Right or the
Yuan Become a Reserve Currency? (cont’d)
• SDR would be managed by IMF
• Benefit: currency risk would be diversified
• Pitfall: SDR backed only by good faith and credit of IMF;
dollar, by contrast, backed by goods and services produced
by Americans and people’s willingness to exchange those
goods and services for dollars
© 2019 Cengage. All rights reserved.
48
The Dollar as the World’s
Reserve Currency (8 of 8)
• Will the Special Drawing Right or the Yuan
Become a Reserve Currency? (cont’d)
• For U.S., loss of reserve currency position costly
• Americans would pay more for imports as dollar depreciates,
since foreigners would no longer buy dollars as they did
when dollar was reserve currency
• Interest rates on private and governmental debt would
increase, since foreigners, holding fewer dollars, will
purchase fewer dollar-denominated assets
© 2019 Cengage. All rights reserved.
49
INTERNATIONAL
ECONOMICS
SEVENTEENTH EDITION
ROBERT J. CARBAUGH
© 2019 Cengage. All rights reserved.
1
Chapter 11:
Foreign
Exchange
© 2019 Cengage. All rights reserved.
2
Chapter Outline (1 of 2)
Foreign Exchange Market
Foreign Currency Trading Becomes Automated
Types of Foreign Exchange Transactions
Interbank Trading
Reading Foreign Exchange Quotations
Forward and Futures Markets
Foreign Currency Options
Exchange Rate Determination
© 2019 Cengage. All rights reserved.
3 3
Chapter Outline (2 of 2)
Indexes of the Foreign-Exchange Value of the
Dollar: Nominal & Real Exchange Rates
The Forward Market
Interest Arbitrage, Currency Risk, and Hedging
Foreign Exchange Market Speculation
Foreign Exchange Trading as a Career
© 2019 Cengage. All rights reserved.
4 4
Foreign Exchange Market (1 of 2)
Foreign exchange market
• Organizational setting in which individuals,
businesses, governments, and banks buy and
sell foreign currencies and other debt
instruments
• Largest and most liquid market in world
• Dominated by four currencies
• U.S. dollar, Euro, Japanese yen, British pound
© 2019 Cengage. All rights reserved.
5
Foreign Exchange Market (2 of 2)
• Foreign exchange market (cont.)
• Three of largest markets located in London,
New York, and Tokyo
• Foreign Exchange Market functions at 3
levels:
• Transactions between commercial banks and
commercial customers
• Domestic interbank market conducted through
brokers
• Active trading in foreign exchange with banks
overseas
© 2019 Cengage. All rights reserved.
6
Types of Foreign Exchange
Transactions (1 of 4)
Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, and swap
• Spot market
• Foreign exchange bought and sold for delivery
immediately
• Spot transaction
• Outright purchase or sale of currency now, as in “on the
spot”
• Spot dealing simplest way to meet currency
requirements but carries high risk of exchange rate
fluctuations because there’s no certainty of rate until
transaction complete
© 2019 Cengage. All rights reserved.
7
Types of Foreign Exchange
Transactions (2 of 4)
• Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, swap (cont.)
• Forward transactions
• Receiving or paying an amount of foreign currency on a
specific date in future, months to years from now
• Fixed exchange rate
• Protect against unfavorable movements in exchange
rate but will not allow gains to be made, should
exchange rate move in one’s favor

• Forward market
• Foreign exchange bought/sold for delivery at future
date?exists mainly for widely traded currencies
© 2019 Cengage. All rights reserved.
8
Types of Foreign Exchange
Transactions (3 of 4)
• Banks typically engage in 3 types of foreign
exchange transactions: spot, forward, swap (cont.)
• Currency swaps
• Conversion of one currency to another currency at
one point in time
• Agreement to reconvert it back to original
currency at specified time in future
• Rates of both exchanges agreed to in advance
• Involves single transaction in which traders
agree to pay/receive stipulated amounts of
currencies at specified rates
© 2019 Cengage. All rights reserved.
9
Types of Foreign Exchange
Transactions (4 of 4)
TABLE 11.1 Global Distribution of Foreign Exchange Transactions, 2016
AVERAGE DAILY VOLUME (BILLIONS OF DOLLARS)
Foreign Exchange Instrument
Foreign exchange/currency swaps
Amount
Percentage
$2,460
48.6
1,652
32.6
Forward transactions
700
13.8
Foreign exchange options
254
5.0
5,066
100.0
Spot transactions
Total
Source: From Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and
Derivatives Market, 2016. See also Federal Reserve Bank of New York, 2016, Triennial Central Bank Survey of
Foreign Exchange and Derivatives Market, available at http://www.newyorkfed.org/.
© 2019 Cengage. All rights reserved.
10
Interbank Trading
(1 of 3)
Retail transactions
• Bank purchases from and sales to customers
• Less than 1 million currency units
Wholesale transactions
• More than 1 million currency units
• Between banks or with large corporate
customers
© 2019 Cengage. All rights reserved.
11
Interbank Trading
(2 of 3)
TABLE 11.2 Top Ten Banks by Share of Foreign Exchange Market, 2016
Bank
Share of Foreign Exchange Market
Citi (United States)
12.91
JP Morgan (United States)
8.77
UBS (Switzerland)
8.76
Deutsche Bank (Germany)
7.86
Bank of America Merrill Lynch (United States)
6.40
Barclays (United Kingdom)
5.67
Goldman Sachs (United States)
4.65
HSBC (Hong Kong)
4.56
XTX Markets (United Kingdom)
3.87
Morgan Stanley (United States)
3.19
Source: From “Foreign Exchange Survey,” Euromoney, 2016, available at www.euromoney.com.
© 2019 Cengage. All rights reserved.
12
Interbank Trading
(3 of 3)
• Earning profits in foreign-exchange
transactions (24-hour basis)
• Bid rate – price that bank is willing to pay for
unit of foreign currency
• Offer rate – price at which bank is willing to
sell unit of foreign currency
• Spread – difference between bid and offer
rate
• A bank’s bid quote < its offer quote to make a profit © 2019 Cengage. All rights reserved. 13 Reading Foreign Exchange Quotations (1 of 2) Exchange rate • Price of one currency in terms of another • Number of units of foreign currency required to purchase one unit of domestic currency Exchange rate reported • Midrange between bid and offer prices © 2019 Cengage. All rights reserved. 14 Reading Foreign Exchange Quotations (2 of 2) • Currency depreciation • More units of a nation’s currency required to purchase a unit of foreign currency • Currency appreciation • Fewer units of a nation’s currency required to purchase a unit of foreign currency • Cross-exchange rate • Exchange rate between any two currencies (such as Swiss franc and British pound) © 2019 Cengage. All rights reserved. 15 Forward and Futures Markets (1 of 6) Foreign exchange can be bought & sold for delivery immediately (spot market) or in future (forward market) Foreign exchange can also be traded in futures market • Parties agree to future exchanges of currencies and set applicable exchange rates in advance • Only some leading currencies traded • Trading takes place in standardized contract amounts and in specific geographic location © 2019 Cengage. All rights reserved. 16 Forward and Futures Markets (2 of 6) TABLE 11.4 Forward Contract versus Futures Contract Forward Contract Futures Contract Issuer Commercial bank International Monetary Market (IMM) of the Chicago Mercantile Exchange and other foreign exchanges such as the Tokyo International Financial Futures Exchange Trading “Over the counter” by telephone On the IMM’s market floor Contract size Tailored to the needs of the exporter/importer/investor; no set size Standardized in round lots Date of delivery Negotiable Only on particular dates Contract costs Based on the bid/offer spread Brokerage fees for sell- and buy-orders Settlement On expiration date only, at prearranged price Profits or losses paid daily at close of trading © 2019 Cengage. All rights reserved. 17 Forward and Futures Markets (3 of 6) • International Monetary Market (IMM) • Chicago Mercantile Exchange, 1972 • Extension of commodity futures market • Size of each contract • On the same line as the currency’s name and country • First column • Maturity months © 2019 Cengage. All rights reserved. 18 Forward and Futures Markets (4 of 6) TABLE 11.5 Foreign Currency Futures, April 24, 2017 Open High Low Settle Change Open Interest JAPAN YEN (CME)—12.5 million yen; $ per 100 yen May .9084 .9126 .9070 .9118 ?.0046 487 June .9090 .9139 .9075 .9130 ?.0046 202,972 Source: From Chicago Mercantile Exchange, International Monetary Market, available at http://www.cme.com/trading. © 2019 Cengage. All rights reserved. 19 Forward and Futures Markets (5 of 6) • Open • Price at which currency first sells when IMM opens in morning • High • Contract’s highest price for day • Low • Contract’s lowest price for day • Settle • Contract’s closing price for day © 2019 Cengage. All rights reserved. 20 Forward and Futures Markets (6 of 6) • Change • Compares today’s closing price with closing price as listed in previous day’s paper • (+) means prices ended higher • (?) means prices ended lower • Open interest • Total number of contracts outstanding © 2019 Cengage. All rights reserved. 21 Foreign Currency Options (1 of 3) Option • Agreement between holder (buyer) and writer (seller) • Holder has right, but not obligation, to buy or sell financial instruments at any time through specified date • Writer (seller) has obligation to fulfill a transaction • Used by firms seeking to hedge against rate risk; also used by speculators seeking profit © 2019 Cengage. All rights reserved. 22 Foreign Currency Options (2 of 3) • Foreign currency options • Options holder has right to buy or sell fixed amount of foreign currency at prearranged price within specified period • Can choose which exchange