International Finance International Finance by Ayse Y Evrensel, PhD International Finance For Dummies® Published by John Wiley & Sons, Inc 111 River St Hoboken, NJ 07030-5774 www.wiley.com Copyright © 2013 by John Wiley & Sons, Inc., Hoboken, New Jersey Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning or otherwise, except as permitted under Sections 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the Publisher Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 7486008, or online at http://www.wiley.com/go/permissions Trademarks: Wiley, the Wiley logo, For Dummies, the Dummies Man logo, A Reference 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www.wiley.com/techsupport Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-on-demand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Control Number: 2013933936 ISBN: 978-1-118-52389-6 (pbk); ISBN 978-1-118-59182-6 (ebk); ISBN 978-1-118-59189-5 (ebk); ISBN 978-1-118-59191-8 (ebk) Manufactured in the United States of America 10 About the Author Ayse Y Evrensel holds a PhD from the University of Zurich (Switzerland) in Economic and Social Geography (1984) and a PhD in Economics from Clemson University (1999) As a geographer, she worked at University of Zurich and Clemson University (SC) In geography, her areas of teaching and research focused on international migration, economic development, multilateral organizations, and the European Union As an economist, she worked at Ball State University, Portland State University, and University of California San Diego In Economics, she has taught a wide range of courses such as Macroeconomics, Microeconomics, Econometrics, International Finance, International Trade, and Financial Markets She has published on the effects of IMF programs, banking regulations, banking crises, preferential trade arrangements, corruption, and the relationship between institutional quality and culture Ayse is currently an associate professor of Economics at Southern Illinois University Edwardsville She lives in Edwardsville, Illinois Dedication I dedicate this book to Myles Wallace, my teacher and dear friend Author’s Acknowledgments I have been teaching International Finance for many years Over the years, my students have become my teachers, especially when it comes to how to teach the subject I am deeply grateful for their genuine involvement and contribution to the course I could not have had the courage to get involved in this project without David Lutton and Erin Calligan Mooney holding my hand and showing me the ropes at the very beginning of the writing process I am very appreciative of their support, encouragement, and trust I wish I could give everything I write to Linda Brandon for editing because she is such an amazing editor I hope to have learned one or two things from her about writing I am grateful to Linda for her patience and professionalism I also thank Krista Hansing for her involvement in the project I am very grateful to technical editors Jerry Dwyer and Allen Brunner for their valuable comments and suggestions Publisher’s Acknowledgments We’re proud of this book; please send us your comments at http://dummies.custhelp.com For other comments, please contact our Customer Care Department within the U.S at 877-762-2974, outside the U.S at 317-572-3993, or fax 317-572-4002 Some of the people who helped bring this book to market include the following: Acquisitions, Editorial, and Vertical Websites Composition Services Project Editor: Linda Brandon Acquisitions Editor: Erin Calligan Mooney Copy Editor: Krista Hansing Assistant Editor: David Lutton Editorial Program Coordinator: Joe Niesen Project Coordinator: Katie Crocker Layout and Graphics: Carl Byers, Melanee Habig, Joyce Haughey Proofreaders: John Greenough Eveylun Wellborn Indexer: BIM Indexing & Proofreading Services Technical Editors: Allan Brunner; Jerry Dwyer Senior Editorial Manager: Jennifer Ehrlich Editorial Manager: Carmen Krikorian Editorial Assistant: Rachelle S Amick Art Coordinator: Alicia B South Cover Photos: © klenger / iStockphoto.com Publishing and Editorial for Consumer Dummies Kathleen Nebenhaus, Vice President and Executive Publisher David Palmer: Associate Publisher Kristin Ferguson-Wagstaffe, Product Development Director Publishing for Technology Dummies Andy Cummings, Vice President and Publisher Composition Services Debbie Stailey, Director of Composition Services Index microeconomic approach, exchange rate determination, 14 micro-states, European, 263 Mill, John Stuart, 257 Monaco dollarization, 233 use of euro, 263 Monetary Approach to Balance of Payment (MBOP) See also foreign exchange markets basic assumptions, 88–89 combined MBOP, 111–114 comparing demand-supply model and MBOP approaches to exchange rate determination, 131–133 versus demand–supply framework, 89 versus interest rate parity, 138–139 linking to PPP, 156 money market, 90–92 money market equilibrium, 96–98 money supply, 93–96 nominal shocks, applying to, 120–126 nominal shocks, effects of, 128–131 overview, 87–88 real shocks, applying to, 115–120 real shocks, effects of, 126–128 monetary interdependence between countries, 223–224 monetary systems comparing alternatives, 246–253 convertible paper money and gold standard, 194–195 exchange rates in commodity standard system, 196 exchange rates in fiat money system, 197 factor in exchange rate determination, 14–15 fiat money, 195–196 metallic standard, 16, 18, 197–203, 210, 212–213 overview, 191–192 post–Bretton Woods, 227–232, 241–253 pre–Bretton Woods, 203–210 pure commodity standard, 192–194 monetizing the deficit, 240 money See also currency; metallic standard convertible paper money, 194–195 defined, 191–192 fiat, 16, 195–197 nominal money supply, 93–98 Quantity Theory of Money, 98, 120, 121, 123–124 real money supply, 93–94 money demand curve, 90–92 money market Australia, 129–131 defined, 90 equilibrium, 96–98 Euro-zone money market-related variables, 110–111 explicit money market, 113 money demand curve, 90–92 U.S money market–related variables, 109 money supply, 93–98 Montenegro, 263 Monthly Bulletin, ECB, 262 moral hazard, IMF and, 244–246 multinational firms, 40–42 •N• national central banks (NCB), 260 NEER (nominal effective exchange rates), 30 Netherlands in European monetary system, 258 in European Union, 263 London Gold Pool, 222 role in establishment of EEC, 256 New Zealand, 209 Nixon, Richard, 225 305 306 International Finance For Dummies noise (irrational) traders, 289 nominal effective exchange rates (NEER), 30 nominal exchange rate (exchange rate) See also MBOP absolutes and falsehoods, 20 applying relative price to, 22–23 appreciation, 28–30 appreciation (revaluation), 13 bid–ask spread, 35–37 calculating cross rates, 34–35 combined MBOP, 113–114 in commodity standard system, 196 defined, 12 depreciation, 28–30 depreciation (devaluation), 13 determining, 14 determining through demand–supply framework, 76–78 effective, 12, 25–26 Euro-zone, 19 exchange rate regimes, 66–68 in fiat money system, 197 floating (flexible) exchange rate regime, 12–13 importance of, 13 inflation rates and, 58 interest rates and, 61–65 international monetary systems, 18–19 nominal, 23 output and, 55–57 overview, 21 pegged exchange rate regime, 12–13 percent change, calculating, 27–28 percent change, defined, 15 as price of currencies, 22 as price of domestic currency, 33–34 as price of foreign currency, 32–33 random walk model, 152 real, 12, 23–25 short-term volatility, 15–16 type of money and, 16–18 visual approach to, 52–54 nominal interest rates exchange rate and, 61–65 factor in exchange rate determination, 14–15 inflation and, 274 nominal money supply central bank control of, 93–94 classical–neoclassical school of economics (long-run analysis of economics), 94 Keynesian school of economics (shortrun analysis of economics), 95–96 short- and long-run effects of increase in, 97–98 nominal shocks applying to MBOP, 120–126 effects of, 128–131 nontradables, 164–165 North Korea, 263 Norway, 206 •O• OCA (optimum currency area) theory, 19, 256–257 OECD (Organization of Economic Cooperation and Development), 287 Onex Corporation, 42 open economy, 202 optimum currency area (OCA) theory, 19, 256–257 options American-type, 180 call, 179, 181–184 European-type, 179–180 expiration (maturity) date, 179 FX derivatives, 170 holder, 179 option premium, 180–181 overview, 168 put, 179, 184–187 strike (exercise) price, 179 writer, 179 Index Organization of Economic Cooperation and Development (OECD), 287 output (real GDP) comparing demand-supply model and MBOP approaches to exchange rate determination, 133 Eurozone, increase in, 118–120 exchange rate and, 55–57 growth rate, 80 U.S., increase in, 116–117 overshooting comparing MBOP with and without, 125–126 defined, 120–121 effect on exchange rate, 281 short- and long-run effects of nominal shock, 121–124 overvaluation, currency, 163–164, 236–237 •P• Paris Treaty of 1951, 256 parity, 196 See also gold parity; IRP parity curve (expected real returns), 102–105 pegged exchange rate regime See also unilaterally pegged exchange rates advantages and disadvantages, 252–253 in developing countries, 17–19 government role in, 12–13, 66–67 stability and, 283 unilateral currency pegs, hard pegs, 197, 232–235 unilateral currency pegs, IMF and, 242–244 unilateral currency pegs, overview, 232 unilateral currency pegs, soft pegs, 232, 235–241 percent change, exchange rate See also IRP; PPP calculating, 27–28 defined, 15 rupiah–dollar exchange rate, 58–60, 64–65 yen-dollar exchange rate, 56, 58 perfectly elastic curve, money supply, 93–94 perfectly inelastic curve, money supply, 93–94 peso problem effect, 289–290 Pharmaceutical Business Review, 40 Philip Morris Products (PMP), 40–41 pips, 180 PMP (Philip Morris Products), 40–41 Poland, 263 political risk, 153 portfolio investment, 239, 241 Portugal in European Union, 263 interest rates, 268 post–Bretton Woods monetary systems See also unilaterally pegged exchange rates comparing alternative international monetary systems, 246–253 floating (flexible) exchange rates, 227–232 IMF and currency crisis, 241–246 PPP (purchasing power parity) absolute PPP, 157, 161–164 application of, 160 Big Mac standard, 161–164 defined, 15 derivation of, 158–159 linking to MBOP, IRP, and IFE, 156 overview, 155–156 relative PPP, 157–158 short-term deviations, 290 pre–Bretton Woods monetary systems bimetallic era, 204–206 gold standard of pre-WWI era, 206–207 interwar years, 207–210 overview, 203–204 predictable excess, exchange rate disconnect puzzle, 289 307 308 International Finance For Dummies prediction rules, exchange rate determination, 14–15 premium, option, 180–181 present value (PV), 141 price demand–supply framework, 72–75 dollar market, 76–77 Law of One Price, 157, 161, 163, 280 relative, 22–24, 273 sticky, 95–96, 281 price factor, metallic standard internal balance, 198–199 price stability See stability price–specie–flow mechanism, 200, 207, 249 Prussian War, 206 purchasing power parity (PPP) absolute PPP, 157, 161–164 application of, 160 Big Mac standard, 161–164 defined, 15 derivation of, 158–159 linking to MBOP, IRP, and IFE, 156 overview, 155–156 relative PPP, 157–158 short-term deviations, 290 purchasing power puzzle, 290–291 pure commodity standard, 192–194 put options defined, 179 exercising, 185–186 overview, 184–185 selling, 186–187 puzzles, international finance consumption correlation puzzle, 288 exchange rate disconnect puzzle, 288–290 explanations related to market imperfections, 291–292 Feldstein–Horioka puzzle, 287 home bias in portfolio puzzle, 286–287 home bias in trade puzzle, 285–286 purchasing power puzzle, 290–291 PV (present value), 141 •Q• quantity demand–supply framework, 72–75 dollar market, 76–77 Quantity Theory of Money defined, 98, 120 effects of nominal shock with overshooting, 123–124 effects of nominal shock without overshooting, 121 quota system, IMF, 219, 245–246 •R• random walk model, exchange rates, 152 real exchange rate (RER) defined, 12 overview, 23–25 purchasing power puzzle, 290 real GDP (real gross domestic product) comparing demand-supply model and MBOP approaches to exchange rate determination, 133 Eurozone, increase in, 118–120 exchange rate and, 55–57 growth rate, 80 U.S., increase in, 116–117 real interest rates comparing demand-supply model and MBOP approaches to exchange rate determination, 132 demand–supply framework, 81–82 dollar–euro exchange rate, 84–85 exchange rate and, 61–65 MBOP and, 89 real money supply, 93–94 real returns, MBOP and, 89 real shocks applying to MBOP, 115–120 effects on MBOP, 126–128 recidivism, IMF quota system, 245–246 reconstruction efforts, war-torn countries, 216 Index relative PPP empirical evidence on, 164–165 overview, 157–158 relative price applying to exchange rate, 22–23 barter economy, 22 defined, 273 nominal exchange rate, 23 real exchange rate, 23–24 reparation payments, Germany, 213 RER (real exchange rate) defined, 12 overview, 23–25 purchasing power puzzle, 290 reserve currency system (Bretton Woods system) collapse of, 223–225 defined, 196 deterioration of, 221–223 dollar shortage and Marshall Plan, 220–221 established at Bretton Woods conference, 217–218 gold parity in, 247 London Gold Pool, 222 overview, 211–212 Special Drawing Rights, 223 revaluation (appreciation) defined, 13 euro, 264 exchange rate, 28–32 risk, foreign exchange domestic firms, foreign subsidiary setting, 46 exporting firms, 44–45 importing firms, 45 speculation, 46–50 Romania, 263 Rome Treaty of 1957, 256 rupiah–dollar exchange rate 1970-2011, 54 pegged exchange rate regime, 67–68 percent change and consumer price index in Indonesia, 58–60 percent change and nominal and real discount rates in Indonesia, 64–65 percent change and real discount rate in Indonesia, 64 percent change and real GDP growth rates, 56–57 T-bill rate in Indonesia, 63 •S• San Marino, 263 Scandinavian Monetary Union, 206–207 SDR (Special Drawing Rights), 223 seignorage, 234 selling call options, 183–184 currency in spot (derivative) markets, 46–47 put options, 186–187 SGP (Stability and Growth Pact) of 1997, 260, 270 short-run analysis of economics (Keynesian school of economics) defined, 95–96, 214 nominal shocks, 120 short-run effects Australian contractionary monetary policy, 130–131 of nominal shock with overshooting, 123–124 of nominal shock without overshooting, 121–123 short-run rigidities (sticky prices), 95–96, 281 short-term liquidity facility (SLF), 245 short-term volatility, exchange rate, 15–16, 281 SLF (short-term liquidity facility), 245 Slovakia, 263 Slovenia, 263 309 310 International Finance For Dummies small economy, 202 Smithsonian Agreement, 225 Smoot–Hawley tariff, 210 SNB (Swiss National Bank), 229–231 soft pegs (crawling pegs) attracting foreign investors with, 238–241 defined, 232 general discussion, 235–238 South Africa, 249 sovereign debt crisis creating European Financial Stability Facility, 268 euro and, 268 intra-Euro-zone relationships, 269–270 utilizing European Financial Stability Facility, 268–269 Soviet Union Bretton Woods Conference and, 214 détente (easing of strained relations), 224 gold standard and, 218 Spain, 263 Special Drawing Rights (SDR), 223 specie, defined, 204–205 speculation, with exchange rates, 46–50 speculative attack, currency, 241 speculators defined, 170 foreign exchange markets, 42–43 spot (derivative) markets buying and selling currency in, 46–47 call options, 182–184 covered versus uncovered interest arbitrage, 146–147 forward contracts, 171–175 put options, 184–186 spread, interest rate, 268 stability European Central Bank (ECB), 260–261 fixed exchange rates, 247–249 floating exchange rates, 250–251 IMF and, 244–246 metallic standard and, 283 pegged exchange rates and, 283 Stability and Growth Pact (SGP) of 1997, 260, 270 sterilized direct interventions, 230, 282 sticky prices (short-run rigidities), 95–96, 281 strike (exercise) price, options, 179 surpluses current account, U.S., 221 trade, American plan for managing, 215–216 trade, British plan for managing, 215 Sweden, 206, 263 Swiss National Bank (SNB), 229–231 Switzerland London Gold Pool, 222 monetary agreement, 206 Syria, 263 •T• T-bill (Treasury bill) rate, 61–63 trade restrictions demand–supply framework, 82–83 lessons learned from, 213 in response to current account deficits, 221–222 trade-weighted index, 25–26 transparency, ECB, 262 Treasury bill (T-bill) rate, 61–63 treaties Maastricht Treaty of 1992, 256, 259–260, 270, 277 Paris Treaty of 1951, 256 Rome Treaty of 1957, 256 Treaty on European Union, 260–261 Treaty on European Union, 260–261 Triffin’s dilemma, 222 Index trilemma under fixed exchange rate regime, 202–203 IMF restrictions due to, 219–220 Turkey currency overvaluation, 236–237 European Recovery Program, 221 •U• U.K (United Kingdom) See also Britain in European Union, 263 London Gold Pool, 222 uncovered interest arbitrage, 145 undervaluation, currency, 163–164, 237–238 unilaterally pegged exchange rates hard pegs, 197, 232–235 IMF and, 242–244 overview, 232 soft pegs, 232, 235–241 United Kingdom (U.K.) See also Britain in European Union, 263 London Gold Pool, 222 United Nations Monetary and Financial Conference in Bretton Woods (Bretton Woods Conference) American plan, 215–216 avoiding past mistakes, 213 British plan, 215 ideological views, 214 International Monetary Fund, 17, 219–220 overview, 212–213 setting reserve currency system, 217–218 United States bimetallic era monetary system, 204–205 Civil War, 204–205 current account deficits, 221–222 current account surpluses, 221 détente (easing of strained relations), 224 holding gold standard, 209–210 increase in output, 116–117 London Gold Pool, 222 money market–related variables, 109 proposal at Bretton Woods Conference, 215–216 role in collapse of Bretton Woods system, 223–225 unsterilized direct interventions, 230 •V• Vatican City, 263 volatility floating exchange rates, 228–229, 251 FX derivatives, 276, 279 short-term, 15–16, 281 •W• Washington Post, 41 welfare state, 214 West Germany, 256 White, Harry Dexter, 214, 215–216 White plan, 215–216 Wilmar International, 41 World Trade Organization (WTO), 216 writer, option, 179 WTO (World Trade Organization), 216 •Y• yen-dollar exchange rate 1970-2011, 52–53 general trend over 40 years, 52 growth rates in Japan’s real GDP, 55–56 nominal and real effective exchange rate index, 53 pegged exchange rate regime, 67 311 312 International Finance For Dummies yen-dollar exchange rate (continued) percent change and consumer price index, 58 percent change and real GDP growth rates, 56 T-bill rate in Japan, 62–63 yen–euro exchange rate, 265 yuan–dollar exchange rate pegged exchange rate regime, 68 percent change, 31–32 Yugoslavia, 247 Notes Notes ~StormRG~ ... subject, International Finance For Dummies helps you grasp the concepts and enjoy the journey International Finance For Dummies Part I Getting Started with International Finance Visit www .dummies. com... International Finance International Finance by Ayse Y Evrensel, PhD International Finance For Dummies Published by John Wiley & Sons, Inc 111... reader, will become equally (if not more) knowledgeable about international finance International Finance For Dummies International finance is an area of economics — more precisely, macroeconomics