Chapter 5

• Free trade area


  Removes all barriers to the trade of goods and services among member countries, but members determine their own policies towards non-members
• Free trade area

  • NAFTA/USMCA
  • EFTA (Norway, Iceland, Liechtenstein, Switzerland)
• Customs union


  Eliminates trade barriers between members and adopts a common policy towards non-members
• Customs union


  • Russia, Belorussia & Kazakhstan
  • Andean Pact (Bolivia, Ecuador, Columbia, Peru)
• Common market


  Has no barriers to trade between members, a common policy towards non-members, and the free movement of the factors of production
• This is a significant step up from a customs union, and requires members to cooperate on fiscal, monetary and employment policies
• Common market


  • European Economic Area (EEA) combines the EU PLUS Norway, Iceland, and Liechtenstein
• Economic union


  Involves the free flow of the factors of production between members, the adoption of a common external trade policy, a common currency, harmonisation of tax rates, and a common monetary and fiscal policy
• An imperfect example is the EU
• Political union


  Requires the combination of independent states into a single union where the economic, social and foreign policy of members is coordinated
• Political union


  • The US or the UK are better examples
• Exchange markets


  Used to convert foreign exchange payments from exports, income from foreign investments or licensing agreements
• Foreign exchange


  Needed by firms to pay foreign companies for products or services, for short-term money market investments, for speculation, to insure against foreign exchange risk through hedging
• Currency supply


  Refers to the quantity of that currency available for trading
• Currency demand


  Refers to how much of that currency traders, investors, and others want to hold
• Increased demand for a currency

  Its value typically rises relative to other currencies
• Increased supply of a currency

  Without a corresponding increase in demand, the value of the currency may decline
• Factors that determine exchange rates

  • Relative price differences
  • Inflation and money supply
  • Interest rates
  • Productivity and balance of payments
  • Investor psychology
• Relative price differences


  Identical goods should have the same price (adjusted for taxes, transportation costs)
• Purchasing power parity (PPP) exchange rate

  The exchange rate at which the prices of identical goods in two countries would be equal
• If PPP exchange rate is higher than the actual exchange rate

  Country B's currency is undervalued compared to Country A's currency
• Inflation


  More money circulating will increase the price of goods, making the value of money depreciate
• If one country has a higher inflation rate than another


  Its currency will depreciate in the long term relative to the currency of the lower-inflation country
• Interest rates


  The central bank set interest's rates, influencing what commercial banks charge/pay their customers
• Higher interest rates (inflation adjusted)


  Attract buyers of the currency, leading to the currency to appreciate
• Productivity


  Increases in productivity can lead to a stronger economy, as more goods and services can be produced at lower costs
• A rise in a country's productivity


  Improves its competitive position, and tends to lead to a rise in the demand for, and value of its currency
• A boost in exports, creating a current account surplus

  That country will see its currency appreciate
• Investor psychology


  Short-term movements are influenced by investor psychology, such as the 'bandwagon effect'
• With more traders join the bandwagon

  Exchange rates move on group expectations exacerbating the initial idea
• Exchange rate systems


  • Floating
  • Pegged
  • Fixed
• Floating exchange rate


  A pure market solution: demand and supply conditions determine exchange rates, but more typical is a managed float whereby exchange rates are influenced by selective government intervention
• Pegged exchange rate


  Restricts its fluctuations within a narrow margin, to stabilize import and export prices or for high inflation countries to peg to more stable currencies
• Fixed exchange rate


  Manages financial unpredictability, compels governments to refrain from excessive expansion of the money supply to mitigate the risk of large currency fluctuations
• Types of foreign exchange risks

  • Transaction exposure
  • Translation exposure
  • Economic exposure
• Transaction exposure


  The risk that exchange rate fluctuations will affect the value of transactions denominated in foreign currencies
• Translation exposure


  The risk that exchange rate fluctuations will affect a company's financial statements
• Economic exposure


  The risk that exchange rate fluctuations will affect the present value of future cash flows
• Ways to manage economic currency risks

  • Knowing the risks
  • Good reporting
  • Risk avoidance
  • Hedging
• Strategic hedging


  Matching currencies of revenues and expenses