17 Sep Purchasing power parity (PPP) and the Fisher effect are two different theories used in calculating exchange rates. As you have learned this week, these are used internationally to eva
Purchasing power parity (PPP) and the Fisher effect are two different theories used in calculating exchange rates. As you have learned this week, these are used internationally to evaluate and compare different countries’ financial status. Consider how these two theories influence international finance.
With these thoughts in mind, address the following:
- Compare and contrast PPP and the Fisher effect.
- Explain whether you think that the PPP or the Fisher effect has the greatest impact on international finance. Support your response using this week’s Learning Resources.
By Day 4
Post a brief statement.
International Trade Finance
Chapter Twenty
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
CHAPTER 20 provides a brief introduction to trade financing and countertrade. An example of a typical foreign trade transaction explains the three primary documents that are used in trade financing: letter of credit, time draft, and bill of lading.
1
Chapter Outline
A Typical Foreign Exchange Transaction
Forfaiting
Government Assistance in Exporting
The Export-Import Bank and Affiliated Organizations
Countertrade
Forms of Countertrade
Some Generalizations about Countertrade
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2
Overview
Virtually impossible for a country to produce domestically everything its citizens need or demand
However, international trade is more difficult and riskier than domestic trade
Exporter may not be familiar with the buyer, and thus may not know if the importer is a good credit risk
Political instability makes it risky to ship merchandise abroad to certain parts of the world
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3
A Typical Foreign Exchange Transaction
Consider a U.S. importer, who is an automobile dealer, and who desires to purchase automobiles from a Japanese exporter, the manufacturer. The two do not know one another and are obviously separated by a great distance.
If the Japanese manufacturer could have his way, he would have the U.S. importer pay cash in advance for the shipment.
If the auto dealer could have his way, he ideally would prefer to receive the cars on consignment from the auto manufacturer. Second best would be to receive the car shipment on credit and then to make payment.
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In a consignment sale, the exporter retains title to the merchandise that is shipped. The importer only pays the exporter once he sells the merchandise.
The exporter bears all the risk in a consignment sale.
4
EXHIBIT 20.1 Process of a Typical Foreign Trade Transaction
20-5
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Exhibit 20.1 presents a schematic of the process that is typically followed in foreign trade.
Source: Adapted from Instruments of the Money Market, Federal Reserve Bank of Richmond, 1986.
5
Letter of Credit
U.S. importer placing an order with the Japanese exporter, asking if he will ship automobiles under a letter of credit (L/C)
A L/C is a guarantee from the importer’s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant documents specified in the L/C are presented according to terms
U.S. importer will apply to his bank for a letter of credit for the merchandise he desires to purchase, providing his bank with the terms of the sale
20-6
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We will now work our way through Exhibit 20.1, presented on the previous slide, in a narrative fashion.
On this slide, we examine steps 1 and 2.
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Time Draft
L/C is sent via the importer’s bank to the exporter’s bank
Once the L/C is received, the exporter’s bank notifies the exporter
Japanese exporter will then ship the cars
After shipping the automobiles, the Japanese exporter will present to his bank a time draft, drawn according to the instructions in the L/C, the bill of lading, and any other shipping documents that are required
A time draft instructs the importer, or his agent, to pay the amount specified on its face on a certain date
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Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
On this slide, we examine steps 1 and 2.
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Bill of Lading
Exporter’s bank presents shipping documents and time draft to the importer’s bank
Bill of lading (B/L) is a document issued by the common carrier specifying that it has received the goods for shipment; it can serve as title to the goods
After taking title to the goods via the bill of lading, the importer’s bank accepts the time draft, creating at this point a banker’s acceptance (B/A), a negotiable money market instrument for which a secondary market exists
Japanese exporter instructs its bank to have the B/A discounted by the importer’s bank
Japanese exporter instructs its bank to pay that amount
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Note that, related to step 8, one of several things can happen with the B/A. Step 8 details the action from Exhibit 20.1.
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Banker’s Acceptance
U.S. importer signs promissory note with his bank for the face value of B/A, due on maturity date of B/A
Importer’s bank provides auto dealer with shipping documents needed to take possession
Importer’s bank sells the B/A in the money market to an investor
B/A sells at a discount from face value
At maturity, importer’s bank will collect the face value of the B/A via the promissory note from U.S. importer
Money market investor presents B/A for payment to the importer’s bank
Importer’s bank pays face value of B/A to the investor
20-9
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
9
EXAMPLE 20.1 Cost Analysis of a Banker’s Acceptance
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10
Forfaiting
Forfaiting is a type of medium-term financing used to finance the sale of capital goods
Involves the sale of promissory notes signed by the importer in favor of the exporter
The forfait, usually a bank, buys the notes at a discount from face value from the exporter
Exporter receives payment and does not have to carry the financing
Began in Switzerland and Germany, but has spread throughout most of Western Europe and into U.S.
Transactions are typically denominated in Swiss francs, euros, and U.S. dollars
20-11
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Government Assistance in Exporting
To achieve success in international trade, firms must be competitive in terms of extending credit to importers
Because of the benefits that accrue from exporting, the governments of most developed countries offer competitive assistance to domestic exporters in the form of subsidized credit that can be extended to importers
Credit insurance programs that guarantee financing extended by private financial institutions are common
20-12
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The Export-Import Bank and Affiliated Organizations
Export-Import Bank (Ex-Im Bank) of the United States was founded in 1934 and subsequently chartered in 1945, as an independent government agency to facilitate and finance U.S. export trade
20-13
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The Export-Import Bank and Affiliated Organizations (Continued)
Ex-Im Bank’s purpose is to provide financing in situations where private financial institutions are unable or unwilling to because:
Loan maturity is too long
Amount of the loan is too large
Loan risk is too great
Importing firm has difficulty obtaining hard currency for payment
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The Export-Import Bank and Affiliated Organizations (Concluded)
Provides service through four major programs:
Working Capital Guarantee Program encourages commercial lenders to make short-term working capital loans to U.S. exporters
Direct Loan Program facilitates direct credit to foreign buyers of U.S. exports
Loan Guarantee Program guarantees the loans made by private FIs to foreign importers
Export Credit Insurance Program protects U.S. exporters against loss should a foreign buyer or other foreign debtor default for political or commercial reasons
20-15
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Countertrade
Countertrade is an umbrella term used to describe many different types of transactions, each “in which the seller provides a buyer with goods or services and promises in return to purchase goods or services from the buyer.”
May or may not involve the use of money
Can be traced back to prehistoric times
Used throughout history whenever money was scarce
20-16
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Forms of Countertrade
The following forms of countertrade do not involve the use of money:
Barter is the direct exchange of goods between two parties
Clearing arrangement is a form of barter in which the counterparties (governments) contract to purchase a certain amount of goods and services from one another
Switch trade is the purchase by a third party of one country’s clearing agreement imbalance for hard currency, which is in turn resold
20-17
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Forms of Countertrade (Continued)
The following forms of countertrade involve the use of money:
A buy-back transaction involves a technology transfer via the sale of a manufacturing plant
A counterpurchase is similar to a buy-back transaction, but with some notable differences
In a counterpurchase, the merchandise the Western seller agrees to purchase is unrelated and has not been produced on the exported equipment
Offset transaction can be viewed as a counterpurchase trade agreement involving the aerospace/defense industry
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Some Generalizations about Countertrade
Negative incentives for a country to be in favor of countertrade:
Conservation of cash and hard currency, improvement of trade imbalances, and the maintenance of export prices
Positive reasons, from both the country and corporate perspectives:
Enhanced economic development, increased employment, technology transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus goods from inventory, and the development of marketing expertise
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Negative incentives are those that are forced upon a country or corporation whether or not it desires to engage in countertrade.
Whether countertrade transactions are good or bad for the global economy, it appears certain that they will increase in the near future as world trade increases.
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International Parity Relationships and Forecasting Foreign Exchange Rates
Chapter Six
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
1
Chapter Outline
Interest Rate Parity
Covered Interest Arbitrage
IRP and Exchange Rate Determination
Currency Carry Trade
Reasons for Deviations from IRP
Purchasing Power Parity
PPP Deviations and the Real Exchange Rate
Evidence on Purchasing Power Parity
Fisher Effects
Forecasting Exchange Rates
Efficient Market Approach
Fundamental Approach
Technical Approach
Performance of the Forecasters
6-2
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Law of one price (LOP)
Requirement that similar commodities or securities should be trading at the same or similar prices
Prevails when the same or equivalent things are trading at the same price across different locations or markets, precluding profitable arbitrage opportunities
Arbitrage equilibrium
Arbitrage is the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain, guaranteed profits
International Parity Relationships
6-3
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
Interest rate parity (IRP) is an arbitrage condition that must hold when international financial markets are in equilibrium
Manifestation of the LOP applied to international money market instruments and provides a linkage between interest rates in two different countries
Interest Rate Parity Defined
6-4
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
Suppose you have $1 to invest over a one-year period, and you will only consider default-free investments.
There are two alternative ways on investing your fund:
Invest domestically at the U.S. interest rate
If you choose this option, the maturity value in one year will be $1(1 + is), where is is the U.S. interest rate
Interest Rate Parity – Example
6-5
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
Suppose you have $1 to invest over a one-year period. There are two alternative ways on investing your fund:
Invest in a foreign country, say, the U.K., at the foreign interest rate and hedge the exchange risk by selling the maturity value of the foreign investment forward. This option requires the following steps:
Exchange $1 for a pound, that is, £(1/S) amount at the prevailing spot exchange rate (S)
Invest the pound amount at the U.K. interest rate (i£), with the maturity value of £(1/S)(1+i£)
Sell the maturity value of the U.K. investment forward in exchange for a predetermined dollar amount, that is, $[(1/S)(1+i£)]F, where F denotes the forward exchange rate
Interest Rate Parity – Example (Continued)
6-6
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Interest Rate Parity: Equivalent Investments
Effective dollar interest rate from the U.K. investment alternative is given by:
U.S. and U.K. investment examples are equivalent
Future dollar proceeds from investing in the two equivalent investments must be the same, implying the following:
or
6-7
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Arbitrage
IRP can be derived by constructing an arbitrage portfolio, which involves the following:
No net investment
No risk
No net cash flow generated in equilibrium
When IRP does not hold, the situation gives rise to covered interest arbitrage opportunities, allowing certain arbitrage profits to be made without the arbitrageur investing any money out of pocket or bearing any risk
6-8
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IRP and Exchange Rate Determination
Reformulating the IRP relationship in terms of the spot exchange rate yields:
Forward exchange rate can be viewed as the expected future spot exchange rate conditional on all relevant information being available
Combining the two equations yields the following:
6-9
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St+1 is the future spot rate when the forward contract matures
It denotes the set of information currently available
9
IRP and Exchange Rate Determination Continued
Two things are noteworthy from the following equation (presented on previous slide):
“Expectation” plays a key role in exchange rate determination (i.e., when people “expect” the exchange rate to go up in the future, it goes up now)
Exchange rate behavior will be driven by news events
6-10
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10
Uncovered Interest Rate Parity
When the forward exchange rate F is replaced by the expected future spot exchange rate, E(St+1), we obtain:
Uncovered interest rate parity
Interest rate differential between a pair of countries is (approximately) equal to the expected rate of change in the exchange rate
6-11
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
E(e) is the expected rate of change in the exchange rate
11
Currency Carry Trade
Unlike IRP, the uncovered interest rate parity often does not hold, giving rise to uncovered interest arbitrage opportunities
Currency carry trade involves buying a high-yielding currency and funding it with a low-yielding currency, without any hedging
The carry trade is profitable if the interest rate differential is greater than the appreciation of the funding currency against the investment currency
6-12
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
Since the interest rate in Japan has been near zero since the mid-1990s, the yen has been the most popular funding currency for carry trade, followed by the Swiss franc.
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EXHIBIT 6.3 Interest Rate Spreads and Exchange Rate Changes: Six-Month Carry Trade Periods for Australian Dollar–Japanese Yen Pair
6-13
Copyright © 2021 by the McGraw-Hill Companies, Inc. All rights reserved.
Note: For interest rates, interbank six-month rates are used for both countries. The interest rate spread and the rate of change in the exchange rate are plotted at the beginning of each six-month carry period.
Source: Interest rates and exchange rates are obtained from Datastream.
13
Reasons for Deviations from IRP
IRP holds quite well, but it may not hold precisely all the time due to (primarily) two main reasons:
Transaction costs
Interest rate at which the arbitrager borrows tends to be higher than the rate at which he lends, reflecting the bid-ask spread
There exist bid-ask spreads in the foreign exchange market as well, as the arbitrager must buy currencies at the higher ask price and sell at the lower bid price
Capital controls
Governments sometimes restrict capital flows, inbound and/or outbound via jawboning, imposing taxes, or outright bans
6-14
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EXHIBIT 6.4 Interest Rate Parity with Transaction Costs
6-15
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EXHIBIT 6.5: Deviations from Interest Rate Parity: Japan, 1978-1981 (in percent)
6-16
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Note: Daily data were used in computing the deviations. The zone bounded by +0.339 and −0.339 represents the average width of the band around the IRP for the sample period.
Source: Otani, I., and S. Tiwari. (1981). “Capital Controls and Interest Rate Parity: The Japanese Experience, 1978–81,” IMF Staff Papers 28: pp. 793−816.
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Purchasing Power Parity
When the law of one price is applied international to a standard consumption basket, we obtain the theory of purchasing power parity (PPP)
PPP states the exchange rate between currencies of two countries should be equal to the ratio of the countries’ price levels of a commodity basket
Let P$ be the dollar price of the standard consumption basket in the U.S. and P£ the pound price of the same basket in the U.K.
Absolute version of PPP states the exchange rate between the dollar and pound should be:
6-17
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S is the dollar price of one pound.
17
Purchasing Power Parity Continued
When the PPP relationship is presented in the “rate of change” form, instead of price level as in the absolute version of PPP, we obtain the relative version of PPP:
Where:
e is the rate of change in the exchange rate
π$ and π£ are the inflation rates in the United States and U.K., respectively
6-18
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e is the rate of change in the exchange rate
π$ and π£ are the inflation rates in the United States and U.K., respectively
18
PPP Deviations and the Real Exchange Rate
If there are deviations from PPP, changes in nominal exchange rates cause changes in the real exchange rates, affecting the international competitive positions of countries
Real exchange rate, q, is found by:
If PPP holds, the real exchange rate will be unity (i.e., q = 1), but when PPP is violated, the real exchange rate will deviate from unity
6-19
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19
Evidence on PPP
PPP has been the subject of a series of tests, yielding generally negative results, especially over short horizons
Generally unfavorable evidence about PPP suggests that substantial barriers to international commodity arbitrage exist
As long as there are nontradables (e.g., haircuts, housing, etc.), PPP will not hold in its absolu
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