Ten Important Points to Remember about International Finance - dummies

Ten Important Points to Remember about International Finance

By Ayse Evrensel

The following list reminds you of some important points you should remember about international finance. These points are not explained in great detail; here you find short reminders.

What is a relative price?

An exchange rate (at least, the nominal exchange rate) is nothing but a relative price of one currency in terms of another one. In terms of apples and oranges, the relative price of oranges in terms of apples implies the number of apples that you have to give up to buy one orange. Similarly, the dollar–euro exchange rate indicates the number of dollars necessary to buy one euro.

What makes a currency depreciate

Theories of exchange rate determination provide a set of nominal and real variables that affect the exchange rate. In terms of nominal variables, higher growth in the money supply, higher inflation rates, and higher nominal interest rates lead to the depreciation of a currency. In terms of real variables, most models predict depreciation in a currency when a country’s output growth rates and real interest rates are lower.

Higher nominal interest rates imply higher inflation rates

A positive relationship exists between nominal interest rates and inflation rates. Higher inflation rates lead to higher nominal interest rates. Therefore, be careful when you compare nominal returns on comparable debt securities in different countries. When you observe a nominal return of 15 percent on a country’s security and 5 percent in another, you find that inflation rates are higher in the former than those in the latter.

Pay attention to interest rate differentials when investing in foreign debt securities

As an international investor, you need to keep track of nominal returns and inflation rates in the countries you’re considering investing in. Using the Fisher equation, you can figure out your real returns in these countries. The real interest rate equals the difference between the nominal interest rates and the inflation rate. When considering two countries for investment purposes, you need to have an expectation regarding these countries’ future inflation rates.

Know the two parts of returns when investing in foreign debt securities

In international investment, in addition to considering interest rates or returns, you need to think about exchange rates. Therefore, you have two sources of possible income or profit (or loss) as an international investor. One source is your return on the financial instrument that you will hold for a certain period. The other is the possible change in the exchange rate while you are holding this instrument.

Adjust your expectations as information changes

International investment requires that investors keep track of the relevant countries’ economic and political conditions. In the case of debt securities, you know the nominal return that you will receive in all countries. What you don’t know at the time of the investment, and what can change during the period when you are holding another country’s financial instrument, is the inflation rate and the change in the exchange rate.

A change in government can introduce a more expansionary monetary policy, higher inflation rates, and depreciation of the currency down the line. All this can decrease your real return and possibly lead to a loss.

Foreign exchange markets are large

The foreign exchange market is highly liquid and very large. In 2010, the average daily turnover was estimated at almost $4 trillion. Central banks intervene in the foreign exchange market to prevent unwanted upward or downward pressure on their currency.

It’s true that the foreign exchange market is large, and this fact is probably why a number of developed countries’ central banks come together at times and intervene (a concerted intervention). The number of central banks and the amount of intervention is important for the effectiveness and success of this kind of intervention.

Use foreign exchange derivatives for the right reason

Remember that spot foreign exchange markets are volatile, which is risky for a multinational company. If a company has future receivables or payables in foreign currency and if spot exchange rates are volatile, it faces considerable exchange rate risk. Instead of relying on spot markets, this company can use foreign exchange derivatives to hedge against the exchange rate risk.

While volatility in spot foreign exchange markets is a problem for multinational companies, it presents an opportunity to speculators. Based on their expectations regarding the future spot rate, speculators can also use foreign exchange derivatives such as futures and options to make a buck.

Going back to the gold standard means dealing with fixed exchange rates

Especially in times of economic instability and pessimistic expectations, people tend to have nostalgic ideas about the gold standard era. The most remembered gold-standard episode is the Bretton Woods era (1944–1971). But what may be most remembered is the start of the Bretton Woods conference, when the U.S. emerged as the world’s new economic and military superpower. With its new status, the U.S. successfully imposed its wishes at the conference.

Among these wishes was the reserve currency setup, in which the dollar was pegged to gold and other currencies were pegged to the dollar. At the beginning, the dollar was perceived as good as or maybe better than gold because the dollar earned interest.

Problems started appearing as early as the late 1940s. Some of the problems were similar to those experienced in the earlier gold standard episodes. Buying gold at the Bretton Woods price and selling it at the market price became a profitable business for speculators toward the 1960s.

The Cold War and potentially dangerous crises such as the Cuban Missile Crisis in 1962 fueled increases in the market price of gold and make the policy adjustments difficult. However, in terms of the difficulty of keeping the exchange rate fixed and maintaining the internal and external balance, the Bretton Woods era was as unsuccessful as previous periods of metallic standard–based fixed exchange rate system.

Realize the value of policy coordination in a common currency

A common currency such as the euro offers important benefits to its member countries. The elimination of transaction costs in trade due to the existence of different currencies increases trade and financial integration, which in turn promotes price convergence and interest-rate convergence among countries.

But a common currency necessitates coordinating monetary and fiscal policies among the countries in the common currency area. In a monetary union, the most obvious and necessary coordination area is monetary policy. The European Central Bank (ECB) was established right before the introduction of the euro as an accounting currency in 1999.