International finance
Question 1: Uses of the balance of payment data
It is used in the recording of economic transactions of the residents of a particular country to the rest of the world within a given period. Current account shows the total net amount a particular country is earning if it’s in excess or spending when in shortage. It’s calculated by net income from exports fewer payments from the imports. While the capital account; deals with the recording of the ownership of the foreign assets. It involves the reserve account and loans and investments a country and the rest of the world. The trade balance is sensitive to exchange rates conventionally because it’s one of the current account factors which is one of the primary causes of imbalances to the balance of payment. The current account is not relevant in assessing macroeconomic-macro financial issues in the U.S, because of conflicting views on its current biggest deficit in its balance of payment. Conventionally the factors of the current account are the only cause to these.
Question 2: Offshore banking;
This a bank located outside the residence country of the depositors and most of its account holders are non-residents of that country. Foreign account holders would prefer maintaining an account in the jurisdiction of little tax that will provide the legal and financial advantage. Offshore traced from France North-western coast where a collective group of bankers and the government officials had the vision to give an offshore remedy to banking which will be associated to low taxation and raise clients’ confidentiality. Following the summit that held in Algeria and Algiers in 1975, the countries that were members of OPEC expressed their commitment to set collectively aside the commercial facilities to help the developing countries. A special OPEC Fund established through which member countries would channel their aid to developing countries. As a result of its successful performance, the member countries decided to convert the temporary OPEC Fund into a permanent legal entity in 1980.
Question 3: Interest rate parity
This happens when the difference in interest rate between the two nations is equivalent to the difference between the spot rate and forward rate between those two countries. Such a situation is ideal and therefore very hard to happen to give the traders to arbitrage option positions to earn riskless returns on investments. When the no-arbitrage condition is satisfied resulting to uncovered interest rate parity, the adjustment is made such that dollar return on the dollar deposits is equal to the dollar returns on the euro deposits thereby removing uncovered interest arbitrage gains. The case of the covered interest the investors will still be indifferent among the present interest rates in the countries involved because the forward exchange sustains equilibrium such that dollar return on the foreign deposits equals to dollar returns on the dollar deposits. The rationale for claiming IRP can forecast exchange rate; assuming the forward exchange rate is an unbiased predictor of future spot rate then, the exchange rate determined by relative interest rates and the expected future spot, conditional on all the available information as of the present time. The expectation is, therefore, self-fulfilling since the data set updated as information gets into the market and therefore dynamic changes will occur in the exchange rates.
Question 4: Gold standard
It is a monetary system where a fixed quantity of gold used as a reference to the economic unit of account. One of the vital virtues of the gold standard is its long-term price stability. It makes so hard for the government to increase prices through increasing money supply, this is historical, associated with short-run price volatility thus leading to financial instability due to uncertainty in the value of debt. Under the gold standard, inflation is minimized, and hyperinflation is next to impossible because the supply of money will only increase when some Gold increases. The rise in inflation under gold standard can only witness when war occurs and as a result destroying bigger parts of the economy, therefore, reducing production of gold or when there are new discoveries on the new gold mine sites increasing production of gold.
The Gold standard gives fixed international exchange rates among the countries involved thereby reducing the uncertainty in the international trade. In the past the imbalances in trade were adjusted through a mechanism where gold was used to pay for the imports, the resulting effect was to reduce the money supply by the importing nations hence causing deflation making them competitive, but again deflation would punish the debtors. The increase in the real debt burden is going borrowers reduce their spending to settle the debts. On the other hand, importation of gold by the exporters would improve their money supply hence causing inflation and as a result making them less competitive. Uneven distribution in different countries makes the gold standard more advantageous to those nations which produce and got large gold mines. When the economy grows so should be the money supply. If the gold standard is us, its scarcity would mean the inability of the economy to produce more capital. Going by all these, it’s clear the disadvantages outweigh the advantages of using the gold standard. Therefore, it will not offer a solution to check for the imbalances.
Question 5
There are three steps to hedge against interest risk, first, build the risk profile and thus is by identifying the risks that you exposed. Examination of both product market changes and immediate risks from the competitors. Second, we should determine what to do with the identified risks and choices are involved: do nothing and allow the risk to pass through to the investors in the business, protect ourselves against the danger using different approaches. The last step is to increase our exposure to some of the risk because we feel that we have some significant advantage over the competitor. Hedging has the following benefits; tax law benefit, hedge against catastrophic reduce likelihood and the cost distress, reduction in the underinvestment problem, minimize exposure to some other risks and investors find the financial statements of the firms that do hedge against extraneous risk to be more informative than companies that do not.’ Then you hedge you neither make nor lose money’ when the benefits exceed the costs, you should hedge and if the value exceed the benefit, you should not. The benefits of hedging are hazy at best and non-existent at worst when we look at publicly traded firms. While many potential benefits for hedging have to list, there is little evidence that they are primary motivators for hedging for most companies.
Question 6: International Fisher Effect
According to the Fisher effect, an increase in the expected rate of inflation in any nation will make the interest rate to increase appropriately. Therefore, Fisher effect implies that the expected rate of inflation is the difference that exists between the nominal real interest rates in every nation. If the interest rate is similar between the countries due to perfect capital mobility, the IFE will suggest that the different in the nominal interest rate will indicate an expected change in the exchange rate especially if the USD = 5% and the UK pound =7%. Consequently, the dollar will appreciate by 2% per annum.
The general Fisher effect obtained by combining the Fisher effect and the relative version of PPP in its expectation form. Specifically, the Fisher effect holds that
E (π£) =I£ -ρ£
As per the lecture notes, PPP is expressed as e* = -Pi +Pj (or e*=Pj-Pi). Where e* represents the long-term exchange rates. However, e* rely on the differentials of the supply of money, income, economic growth, and the nominal interest rates. This can be put as follows: E*= f (-M, +y,-r). That is if the supply of money increases, more dollars are available, and most of it will depreciate. On the other hand, if income increases in the United States, the citizens in the US will demand additional dollars to run the economy. This made the USD scarcer as it appreciates. Therefore, a real interest rate is the same between the two countries, i.e. ρk= ρ£, and replacing outcome into the PPP, i.e., E (e) =E (π£)-E (π£), we obtain the international Fisher effect: E (e) =I¢-I£
Question 7: Determinants of foreign exchange rate
The difference in inflation; a country with stable inflation rate experience rise in the currency value (Madura 436). This is because its purchasing power increases about the other currency.
Public debt; in as much as the borrowing boosts the country’s internal activities; debts bare less attractive to foreign investors. Massive deficits increase inflation hence pay off will be in cheaper dollars in future.
Terms of trade if the export prices rise by a smaller margin than that of its imports, its currency value will decrease compared to the partner country, and the vice versa are correct.
Current account deficit; the excess demand for foreign currency lowers the country’s foreign exchange rate, making the domestic goods much cheaper for the foreigners.
Satisfying PPP, competition positions remain unchanged due adjusted rate changes. If not so, the price adjustment will affect relative competitiveness of countries. If a country appreciates or depreciates by more than is warranted by PPP, that will hurt or improves the nation’s competitive position in the world market.
Taking the weighted average of prices of the products in the two nations, then PPP holds that the currency exchange rates should be the same to the individual country’s price levels. Shown in the expression below:
S = P ÷ P*, S=spot exchange rate between the two nations; P = price Index for the quiet country and P* is the price index for the foreign country.
Works cited
Madura, Jeff. International Financial Management. 11th ed. Mason, Ohio: Thomson/South-
Western, 2014. Print.
