International BusinessInternational Business

((International Monetary System & International Monetary System & Capital MarketCapital Market))

Erasmus programme VErasmus programme V

Lecturer Dr Pavlos Dimitratos Lecturer Dr Pavlos Dimitratos pdimitr@aueb.grpdimitr@aueb.gr

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Foreign exchange marketForeign exchange market• Foreign exchange riskForeign exchange risk• Spot & forward exchange rateSpot & forward exchange rate• The law of one price: in efficient The law of one price: in efficient

markets free of transportation markets free of transportation costs and trade barriers, identical costs and trade barriers, identical products sold in different countries products sold in different countries must sell for the same pricemust sell for the same price

• Three factors significantly affect Three factors significantly affect future exchange rate of a currency:future exchange rate of a currency:• Country’s price inflation & money Country’s price inflation & money

supplysupply• Country’s interest rateCountry’s interest rate• Market psychologyMarket psychology

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Inflation and money supplyInflation and money supply

• If a basket of goods costs $100 in the US If a basket of goods costs $100 in the US and £66.67 in the UK, the purchasing and £66.67 in the UK, the purchasing power parity theory predicts that the $/£ power parity theory predicts that the $/£ exchange rate will be (100/66.67=) 1.5 exchange rate will be (100/66.67=) 1.5 ($/£)($/£)

• PPP theory stipulates that changes in PPP theory stipulates that changes in relative prices (e.g. inflation) will result in relative prices (e.g. inflation) will result in changes (e.g. depreciation against changes (e.g. depreciation against countries with lower inflation) in countries with lower inflation) in exchange ratesexchange rates

• Inflation rate is determined by money Inflation rate is determined by money supplysupply

• The PPP theory appears to be accurate in The PPP theory appears to be accurate in the long-run but not necessarily in the the long-run but not necessarily in the short-runshort-run

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Interest ratesInterest rates• Interest rates reflect expectations about Interest rates reflect expectations about

future inflation ratesfuture inflation rates

• For any two countries, the spot exchange For any two countries, the spot exchange rate should change in an equal amount rate should change in an equal amount but in the opposite direction to the but in the opposite direction to the difference in nominal interest ratesdifference in nominal interest rates

• As before, this seems to be the case As before, this seems to be the case mainly in the longer-runmainly in the longer-run

Market psychologyMarket psychology• Expectations are very important, Expectations are very important,

especially in the short-run and tend to especially in the short-run and tend to become self-filling prophecies become self-filling prophecies (bandwagon effects)(bandwagon effects)

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Monetary systemMonetary system• Floating exchange rate regime: Floating exchange rate regime:

when the market determines the when the market determines the relative value of a currencyrelative value of a currency

• Fixed exchange rate regime: the Fixed exchange rate regime: the values of currencies are set against values of currencies are set against each other at mutually agreed each other at mutually agreed exchange ratesexchange rates

Intermediate casesIntermediate cases• Pegged exchange rate: the value of Pegged exchange rate: the value of

the currency is the currency is fixedfixed relative to a relative to a reference currency (which reference currency (which determines other exchange rates)determines other exchange rates)

• Dirty float: the value of the Dirty float: the value of the currency is hold currency is hold within some rangewithin some range against a reference currencyagainst a reference currency

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Monetary system (con’d)Monetary system (con’d)

• The international monetary system The international monetary system has passed from the period of the has passed from the period of the gold standard (pegging currencies gold standard (pegging currencies to gold)…to gold)…

• to a system of fixed exchange rates to a system of fixed exchange rates

(Bretton Woods – whereby only the (Bretton Woods – whereby only the dollar was convertible into gold)…dollar was convertible into gold)…

• IMF andIMF and• World Bank were establishedWorld Bank were established

• to the floating exchange rate to the floating exchange rate system (Jamaica agreement)system (Jamaica agreement)

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Floating vs. fixed exchange Floating vs. fixed exchange ratesrates

• FloatingFloating

• Monetary policy autonomy for a Monetary policy autonomy for a countrycountry

• Smooth trade balance adjustmentsSmooth trade balance adjustments

• FixedFixed

• Monetary disciplineMonetary discipline• Combats speculation Combats speculation • Reduces uncertainty re currency Reduces uncertainty re currency

movementsmovements

• A different (than the B-W) fixed rate A different (than the B-W) fixed rate system might work and foster system might work and foster stabilitystability

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The international capital The international capital marketmarket

• Mini-case discussionMini-case discussion Firms may use the international Firms may use the international

capital market in order to get access capital market in order to get access to wide liquidity of the international to wide liquidity of the international capital market and obtain lower cost capital market and obtain lower cost of capitalof capital

Investors may use the international Investors may use the international capital market in order to diversify capital market in order to diversify efficiently their portfolio and reduce efficiently their portfolio and reduce the level of riskthe level of risk

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Stock markets in different Stock markets in different countries show low correlation countries show low correlation becausebecause Countries pursue different Countries pursue different policies in different contextspolicies in different contexts

Capital controls occurCapital controls occur

Eurocurrency is a currency Eurocurrency is a currency backed outside its country of backed outside its country of originorigin No/little government regulation in No/little government regulation in this marketthis market

Depositors may earn more than Depositors may earn more than deposits in home currencydeposits in home currency

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Foreign bonds are sold outside the Foreign bonds are sold outside the borrower’s country and are borrower’s country and are denominated in the currency of the denominated in the currency of the country in which they are issued country in which they are issued (e.g. Siemens issues bonds in USA (e.g. Siemens issues bonds in USA and sells them in the US -Yankee and sells them in the US -Yankee bonds)bonds)

Eurobonds are normally Eurobonds are normally underwritten by an international underwritten by an international syndicate of banks and syndicate of banks and placed in placed in countries othercountries other than the one in than the one in whose currency the bond is whose currency the bond is denominated (e.g. Siemens issues denominated (e.g. Siemens issues bonds denominated in US dollars bonds denominated in US dollars and sold to investors outside the US)and sold to investors outside the US)

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Eurobonds are …Eurobonds are … Absent of regulatory interferenceAbsent of regulatory interference Less stringent on disclosure Less stringent on disclosure

requirements than domestic bond requirements than domestic bond marketsmarkets

Usually offer a more favorable tax Usually offer a more favorable tax statusstatus

… … but foreign exchange risk may but foreign exchange risk may always be a problemalways be a problem

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ReadingsReadings Hill, chapters 9, 10 & 11Hill, chapters 9, 10 & 11

Recommended:Recommended: International Economics: Theory and Policy International Economics: Theory and Policy

(6th Edition), Krugman P. R. and Obstfeld, (6th Edition), Krugman P. R. and Obstfeld, 2004, Addison Wesley2004, Addison Wesley