International Finance For Dummies
International finance is an ever-changing subject. It puts you at the cutting edge of the financial world and gives business a global perspective. Keeping current with the exchange rates and understanding basic financial equations and the big issues regarding how the international monetary system works will put you ahead of the class.
Working with Exchange Rates: Common Definitions and Predictions
There are some basic definitions in international finance which you should remember. Additionally, knowing the long-run relationships between macroeconomic fundamentals and exchange rates help you predict the direction of the change in exchange rates. Check out these tips to step up your exchange rate know-how:
Exchange rate as a relative price. The dollar-euro exchange rate indicates the amount of dollars necessary to purchase one euro. If the exchange rate is $1.31, it means that you need $1.31 per euro.
Real vs. nominal exchange rates. Nominal exchange rates imply the relative price of two currencies. As in the case of $1.31 per euro, the only information you get out of nominal exchange rates is how many of one currency you need to buy one unit of the other currency. Real exchange rates compare the price of a consumption basket in one country to that of another country in the same currency.
Terminology for the changes in exchange rates. If both currencies in an exchange rate are freely traded in foreign exchange markets, you refer to changes in this exchange rate as depreciation or appreciation. If $1.31 changes to $1.35 per euro, this indicates depreciation of the dollar (appreciation of the euro). If the Chinese Yuan (CNY)-dollar exchange rate changes from CNY6.21 to CNY6.15, this shows revaluation of the Chinese Yuan, because the value of the yuan with respect to other currencies is determined by the Chinese government.
Nominal macroeconomic variables and exchange rates. When it comes to the long-run effects of nominal macroeconomic variables on exchange rates, remember this: Higher money supply growth rates, inflation rates, and nominal interest rates depreciate a currency. While, lower money supply growth rates, inflation rates, and nominal interest rates appreciate a currency.
Real macroeconomic variables and exchange rates. In terms of the long-run effects of real macroeconomic variables on exchange rates, remember the following: Lower real interest rates and growth rates depreciate a currency and higher real interest rates and growth rates appreciate a currency.
Basic International Finance Equations to Remember
International finance is a subject based on numbers. And, with that comes calculations. Calculating the fundamentals of international finance puts the subject in perspective and gives it a visual component to help understand how things work. Here are some of the widely-used equations in international finance:
Inverting exchange rates. If you have the Chine Yuan (CNY)-dollar exchange rate, but need the dollar-Chinese Yuan exchange rate, just invert the former. Suppose you have the exchange rate as CNY6.22 per dollar. The dollar-Chinese Yuan exchange rate is:
Calculating cross rates. Suppose the dollar-British pound (GBP) and the dollar-Canadian Dollar (CAD) exchange rate is $1.51 and $0.97, respectively. Even if the Canadian dollar-British pound exchange rate is not listed, you can easily calculate the Canadian dollar-British pound exchange rate as CAD1.57:
Of course, if you need the British pound-Canadian dollar rate, take the inverse of CAD1.57:
Calculating real exchange rate (RER). The nominal exchange rate indicates the relative price of two currencies. The real exchange rate expresses the relative price of two countries’ consumption baskets in the same currency. If the price of the consumption basket in the U.S. and the Euro-zone is PUS and PE, respectively, and you have the dollar-euro exchange rate, the RER becomes:
By multiplying the exchange rate with the price of the European consumption basket, you convert the latter into dollar. Therefore, the dollar price of the European basket divided by the price of the U.S. basket (expressed in dollars) gives you the real exchange rate.
If the dollar-Euro exchange, the euro price of the European basket, and the dollar price of the U.S. basket are $1.31, €135, and $121, the RER is:
Calculating the percent change in exchange rates. The percent change formula is a handy tool to calculate the change in exchange rates (or other variables). If a year ago the dollar-euro exchange rate was $1.32 and is now $1.31, then the change in the exchange dollar-euro exchange rate (ER) is 0.76 percent appreciation in the dollar:
Applying the interest rate parity (IRP). This concept relates the nominal interest rates in home (RH) and foreign country (RF) to the change in the exchange (ρ), which is referred to as forward premium or discount:
For smaller differences between two countries’ interest rates, you can use the following approximation:
After calculating ρ, you apply it to the spot rate (St) to calculate the IRP-suggested forward rate (FIRP):
If, for example, RH, RF, and St are 1 percent, 1.12 percent, and $1.32 per euro, the forward discount on euro is 0.12 percent:
In this case, the IRP-suggested forward rate is $1.318 per euro:
Using the purchasing power parity (PPP). The PPP relates home country’s inflation rate (πH) to that of foreign country (πF) to predict the change in the exchange rate (e):
For smaller differences between two countries’ inflation rates, you can use the following approximation:
After calculating e, you apply it to the spot rate (St) to calculate the PPP-suggested expected exchange rate :
If, for example, πH, πF, and St are 3 percent, 2 percent, and $1.31 per euro, the dollar is expected to depreciate by 0.98 percent against the euro:
Given the spot rate of $1.31 per euro, the PPP-suggested expected exchange rate is $1.323 per euro:
Key Issues about the International Monetary System
The international monetary system is a way for people to conduct business with each other from different parts of the world. The system covers types of money from different countries and the resulting exchange rates as well as the characteristics of various exchange rate regimes. The following points are good to keep in mind to understand how the international monetary system works:
Exchange rate regimes when money is based on a metallic standard. If money has an intrinsic value, in other words, if its value is based on a precious metal, it leads to a fixed exchange rate system. For most of history, money was based on some variation of a metallic standard. The last period with such a standard (called reserve currency standard) ended in 1971. One of the challenges of a metallic standard is that it doesn’t allow countries to conduct independent monetary policies.
Exchange rate regimes when money is fiat (no metallic standard). Fiat currency has no intrinsic value and doesn’t lead to a specific exchange rate regime. In this case, countries decide about their exchange rate regime. When the last metallic standard period (or a variation of it) ended in 1971, money in all countries was fiat money. However, most developed countries decided for flexible exchange rate regimes where the value of currencies is decided in foreign exchange markets with minimum interventions based on the demand for and supply of currencies.
Pegged regimes and their purpose in a fiat currency system. After 1971, most developing countries adopted a variety of pegged exchange rate regimes. One of the important factors that affect the type of the pegged regime is the extent to which the pegged regime can exercise control over monetary policy. Hard pegs such as currency board and dollarization don’t allow monetary policy to be used as much as soft pegs do. While hard pegs are used to signal stability, soft pegs can serve to make exports or imports cheaper or to attract foreign investors.
Optimum currency area and the Euro. The concept of the optimum currency area shows that under certain circumstances it would be more efficient to have a common currency in a region, consisting of countries with their own currencies. The term optimum implies the requirements for an efficiency-enhancing common currency. Countries in the common-currency region should experience similar economic shocks and have labor mobility among them. Despite benefits, a common currency requires a strong monetary policy coordination as well as fiscal policy coordination.
Tradeoffs associated with various exchange rate regimes. All exchange rate regimes have their costs and benefits, which implies tradeoffs. The table provides a summary of the costs and benefits associated with various exchange rate regimes.
Exchange Rate Regimes Pro Con Fixed
No sudden changes in ER
No need to forecast future exchange rates
Importing other countries’ domestic economic problems, such as inflation and unemployment
Monetary policy cannot be used as stabilization policy
Insulation of countries from other countries’ economic problems, such as inflation and unemployment
Ability to conduct monetary policy
Excessive volatility in exchange rates Pegged
Stability provided by a nominal anchor
Aiding economic development through adjusting the price of exports or imports as well as attracting portfolio flows
Efficiency cost of keeping prices of exports or imports low
Prone to speculative attack; hot money leaving the country fast if investors doubt the credibility of the peg