Key Formulas and Concepts in International Finance
Formulas
GDP = GDI
GNI = GDI + Resident’s Net Factor Income from Abroad
%Δ in Foreign Currency Value = [(1/S1) – (1/S0)] / (1/S0)
%Δ in Value of Dollar = (S1-S0)/S0
Bilateral RER = (Foreign Currency / Domestic Currency) / (Pfor / Pdom)
The %Δ in the Real Exchange Rate = %Δ in the Nominal Exchange Rate – the Inflation Differential (from US perspective means US on the bottom or second in the subtraction equation)
Current Account = X-M
Trade Balance (X-M) + Services Balance + Net Factor Income from Abroad + Net Transfers from Abroad = Current Account
BoP = X-M + CAPAC + FANCB
Saving/Investment Balance = I-S = (T-G) + (M-X)
Parity Relationship = (1+Rmex)/(1+Rus) = F/S
Covered IR Parity: Rfor – Rdom = (F-S)/S
1-yr Forward = [(1+Rth)/((1+Rus)]*Exchange Rate
Definitions and Important Ideas
- American Convention: EUR/USD is quoted the opposite way → $1.04 per Euro
- (GBP/USD) is known as “Cable”
- European Convention: USD/MXP → Quoted the opposite way “$17.05 per Mexican Peso
- The REER is calculated by adjusting the NEER for inflation.
- PPP Exchange Rate: The exchange rate that would make comparable goods sell for the same price in different countries.
- In 2008, EM accounted for 1/2+ world GDP for the first time since Britain industrialized over two centuries ago.
- Williams’s Consensus: Fiscal discipline, redirection of public spending, tax reform, interest rate and trade liberalization, privatization, deregulation, secure property rights (didn’t work because of privatization).
- $6.6 trillion daily volume in FX.
- 80% of currency trades are against the $.
- Only if the nominal exchange rate does not move in lock step with relative inflation in the two countries will the RER change.
- Bilateral RER can change if nominal exchange rate changes, relative prices change, or both.
- Monetarists: Changes in nominal exchange rates and prices reflect a common underlying factor: changes in relative money supplies.
- Currency Board: Fixed exchange rate backed by foreign reserves.
- A country can have an independent monetary policy, a stable exchange rate, or open capital markets, but NOT all three.
- CAPAC: Unilateral transfers like debt forgiveness or foreign donations.
- FANCB: Direct investments, portfolio investments, and purchases/sales of financial assets.
- If a country is running a CA surplus and has a floating exchange rate: net supplier of capital to the rest of the world. The floating exchange rate will serve as an equilibrium mechanism and match the current account surplus with a financial account deficit. The country will in effect be using its foreign exchange earnings to buy investments abroad.
- If a country is running a CA surplus and has a fixed exchange rate: Its central bank is gaining international reserves. There is an increase in demand for the domestic currency since people are buying a lot of stuff from that country and that leads to currency appreciation. The central bank will buy foreign currency and sell domestic currency to maintain the fixed rate. Putting more currency on the market lowers the appreciation.
- Saving/Investment Balance: I – S = (T – G) + (M – X) If a country wants to invest more than is available from domestic savings: (1) It can run a government budget surplus (which is government saving) so T – G > 0 (2) It can run a current account deficit, M – X > 0, financed with capital inflows. The savings come from abroad.
- Central banks hold domestic assets (DA) such as bonds and discount window loans to banks for foreign assets (FACB). Their liabilities are most high powered money (H) = cash (C) and bank reserves (R). Banks can trade their reserve deposits at the central bank at any time for cash. The money supply (M) is high powered money times the money multiplier (m), or M = mH. High powered money is also called the monetary base.
- Sterilization: Suppose a U.S. investor wants to buy assets in Chile, which is committed to supporting a fixed exchange rate. The U.S. investor exchanges dollars for pesos at a Chilean commercial bank, which sends the dollars to the central bank of Chile to get pesos. The central bank of Chile takes in the dollars and credits the commercial bank’s reserve account in pesos. FACB (the dollars), bank reserves, and therefore high powered money will go up, and if the central bank does nothing else, the money supply will go up by an amount equal to mΔH. But the central bank may not want the money supply to go up because it could be inflationary. It can try to offset the increase in its reserves by selling bonds in the domestic bond market (an open market sale): It will try to reduce domestic assets (DA) by the amount its foreign assets (FACB) have gone up.
- By selling a foreign exchange forward an investor can lock in a rate of return on a foreign investment today. This is called obtaining forward cover.
- Covered IR Parity: The returns on two similar risk-free assets in different currencies should be equal once hedged against exchange rate fluctuations using a forward contract.
- Uncovered IR Parity: The expected appreciation or depreciation of a currency should offset the interest rate differential between two countries. Unlike CIRP, it does not use a forward contract to hedge exchange rate risk.
- The forward discount (or premium) can be interpreted as the market’s forecast of where exchange rates are headed in the future.
- Peso Problem: “The tendency of assets to price in a probability of an event that may not occur during a sample period has been termed a “peso problem.” More generally, peso problems can arise when the possibility that some infrequent or unpredictable event may occur that affects asset prices today.
- Defending against a spec attack: (1) CB can spend their reserves, borrow from IMF or other central banks, raise domestic rates. “Make the spread larger and increase the hurdle for short sellers to make money.”