International Money and Finance - Case Study Example

International Finance and Business International Finance and Business Introduction International finance is one of the fields of finance and economics which has been receiving numerous changes. In this 21st century, the financial market has become global. This is because international finance is encountering numerous changes and developments that lead to numerous implications on a broader perspective as discussed below. The monetary standards have changed over time due to influence of different factors in the global market. The terms and balance of payment normally affect imports and exports that are transacted by different nations. Hence, the evolution and changes in the international finance is bound to continue even in the future. International Monetary Arrangements In the global market today, international market relations are bound to change due to various implications that are normally brought by implications of time. The international monetary system started in the late 19th century during the gold standard era that has been recorded 1880 to 1914. Gold standard was the beginning of the international monetary standards where once ounce of gold was equivalent to $20.67 (Melvin & Norrbin, 2013). It was mainly used as it was a homogenous commodity and also possessed all the other characteristics of money which we all understand. It is highly portable, divisible and easy to carry around. This was followed by the interwar period from 1918 to 1938. All nationals in the world were largely strained by war and merchants could not easily access this rare commodity to transact numerous businesses. Political instability in different nations of the world led to unfavorable terms of trade during this time. The central governments of the operating nations encouraged the merchants to sell all their gold holdings to the government. This was followed by a high rate of inflation in 1925 which lead to monetary warfare among the operating nations. Every nation believed that their currencies should have the highest value in the market. This led to Bretton Woods agreements in 1944 (Melvin & Norrbin, 2013). The main aim of this conference was to reform the international monetary standards. The nations also agreed to maintain parity value of their currencies (Melvin & Norrbin, 2013). However, this did not last for long as the Bretton agreement did not last for long but ended up collapsing in the early 1960’s. The collapse was due to the dollar crisis. This was after numerous changes in the balance of exchange deficits (Melvin & Norrbin, 2013). Later, what followed was the increase in the demand for gold. The central banks of the trading nations tried to stabilize gold, but with a lot of pressures. Transition year followed in 1971-1973 with the help of Smithsonian agreements. During this conference, it was agreed that a dollar was to be exchanged between 35 and $39.02 (Melvin & Norrbin, 2013). The nations were to operate on fixed rates though they operated in open crisis. However, in the year 1972, the pound began to float (Melvin & Norrbin, 2013). This was largely caused by supply and demand conditions that existed in the international markets. This later led to international reserve currencies where gold and the dollar currency were the main components of the exchange. They were mainly used to settle international debts. The reserve currency played a number of roles. Firstly, it was used as the international unit of the account for all international transactions (Melvin & Norrbin, 2013). Secondly, it also served as the medium of exchange in the international markets. During this period, most nations of the world were transacting international trade in the form of imports and exports. The fixed rates systems helped to control and regulate the rate of inflation of the currencies (Melvin & Norrbin, 2013). Thirdly, the reserve currency serves as the store of value in terms of wealth between merchants and the trading nations. Further, there was floating exchange rates in 1973 which led to countries adopting other countries currencies like the dollar as their currency. With the setting up currency boards, there was organized and free-floating of currencies. Additionally, there was the emergence of the European monetary system that mainly operated in Euros; though it followed a fixed exchange rate system. Balance of payments The balance of payments role is to record all the countries international transactions (Melvin & Norrbin, 2013). This includes all the payments and receipts that are undertaken across the county’s borders. International trade in the form of imports and exports is the main avenue where the balance of payments applies. The payments use the concept of double-entry bookkeeping system (Melvin & Norrbin, 2013). In this particular case, each and every transaction has both a debit and credit entry. The system works in a very simple manner, for instance, if credits exceeds the debts, it is always concluded that there is a deficit of the surplus. Balance of payments normally upholds the current account (Melvin & Norrbin, 2013). It is the sum of merchandise, all investment income, and all services and transactions offered as well as unilateral transfer accounts. Any deficit in the existing account is more often than not balanced by the capital account surplus (Melvin & Norrbin, 2013). Balance of payments plays an important role in the international markets (Melvin & Norrbin, 2013). Dollar is the most used currency in transacting international trade among most nations (Melvin & Norrbin, 2013). All other factors held constant, both the current and current accounts must go in line in order to ensure that there is no deficit as it has to be financed in other ways if it happens to any trading nations (Melvin & Norrbin, 2013). One of the factors that have been known to affect the balance of payment is the global recession that led to the high rate of inflation in many nations. Of course, this has a major implication in the international trade and markets and hence the balance of payments system (Melvin & Norrbin, 2013). To counter this, the establishment international reserve currencies did help to offset this condition in a great way. Balance of trade is normally achieved by subtracting all the merchandise imports from the merchandise exports in order to arrive at the final figure. Further, the settlement balance reflects on all the financial assets held by all international monetary agencies and all the reserve assets transactions. A good example would be if a United Stated of America deposit in international bank increases, it leads to a total credit to the US capital in the long run and vice versa. From the history that we can clearly learn from the book, it is evident that the United Stated became an international debtor in the year 1986. In the balance of payment system, neither the surpluses nor deficits are good (Melvin & Norrbin, 2013). This is because they can either lead to balance of the equilibrium or disequilibrium in the balance of payments which affects the terms and conditions of the international trade. Floating exchange rates also affects the balance of payments systems. However, use of fixed exchange rates does not always restore the balance of payments systems (Melvin & Norrbin, 2013). Rather, it can only be reformed by the central bank of the trading nation imposing trade restrictions in order to restore the equilibrium. International parity conditions Forward-looking market instruments In the international market, the forward exchange rates refer to buying and selling of currencies which is later to be delivered on a future date. However, this does not take care of any factors such as inflation that leads to disequilibrium in the balance of payments. The major currencies traded in the forward exchange rates are the dollars, Euros, and the Swiss franc. Most countries in the global market have forward markets. Amounts and maturities are always set on every transaction (Melvin & Norrbin, 2013). There is advantage of the forward market once the specified exchange rate between different currencies is established and that there is no buying and selling of the currency. There is no transaction is needed till the set timeline in future. Further, there is what we call swap. This is a combination of both spot and forwards transactions but the same amounts of the currencies (Melvin & Norrbin, 2013). These transactions are mostly delivered on different dates, but they are normally of similar amounts. In most cases, this is a two-step which is being executed in one step. Commercial banks are known to swap transactions (Melvin & Norrbin, 2013). This is normally a contract between two parties to exchange both principal and interest payments of one currency in the form of loan to another party in the form of loan to a different currency, but the same amounts. Consequently, both parties by the end of the day benefit from having access to long-term foreign currency’s financing at a much lower cost that they could not obtain directly at the same cost. Further, futures are mostly standardized contracts traded on the established exchanges normally for deliveries of foreign currencies at different specified dates in the future. However, futures differ from forward markets. Only a few numbers of currencies are transacted in this market, and each of them has a standardized contract that specified amounts and set timelines. Additionally, the transactions are held at a specific location. The participants include traders, speculators. The reason behind the presence of speculators is that these contracts are normally traded before they mature. Finally, options are contracts that give the buyer the authority to transact currencies at a specific price and a set timeline. Rather, strike price is the price at which the owner of different contracts can sell them at a specific price (Melvin & Norrbin, 2013). The Eurocurrency market This is an offshore banking market. Different commercial banks in different countries can easily accept deposits and also offer loans to different customers in different currencies other than their local currency. The United States is known to conduct and encourage this kind of transaction as its dollar has always dominated most deposits and loans outside the country. It has been recorded to have the highest number of transactions in the offshore banking system. As compared to most local, domestic banks, Euro banks have a number of advantages. First and foremost, they have a lower operating cost as compared to other banks and systems. Secondly, they are less regulated because they normally operate in the international markets where different currencies are traded. It also takes into account fixed exchange rates and floating rates (Melvin & Norrbin, 2013). Hence, when we consider all these factors, we can clearly establish that they normally offer narrower spreads as compared to most domestic’s banks in different trading nations. Because these banks have fewer regulations, these banks have gained a lot of popularity among different merchants and trading countries in different parts of the world. They have adversely grown due to the increasing number of investors and the markets globally. This could be due to the numerous advantages that are attributed to it in the long term. This kind of market improves efficiency in the international finances. This is in terms of low-cost borrowing system that greatly attracts investors. Also, there are fewer government regulations towards the system that is a plus as it makes it easier to conduct foreign transactions more easily. Further, it ensures a stiff competition among these banks which is an advantage to the clients all over the world. LIBOR is an interest rate that is used as the benchmark for setting the rates for the loans that are offered in the Eurodollar markets (Melvin & Norrbin, 2013). Further, as we continue to explore, the international banking facilities are normally departments in the United States banks which have the authority to conduct Eurocurrency banking. This department plays an important role in enhancing international finance. However, these kinds of banks also measure the amounts of the credit which they extend to other banks which are not in their systems. Additionally, the Eurocurrency loans are normally executed by bank syndicates that can transact large sums of currencies in the global market. Prices and Exchange Rates: Purchasing Power Parity In the international market, interest parity relationship dictates the difference between investments of two currencies that are equal amounts or discounts. Hence, most of the covered international investments in cases where investors have forward contracts to cover themselves against risks. This may be unknown future in terms of inflation in the exchange rates between currencies. In finance terms, we can say a currency is at forward premium when its interest rate is lower. In addition, covered parity normally links four different types of rates. These are namely: Current spot exchange rate Current interest rate between two trading countries Current forward exchange rate In this particular situation, if one rate changes, the other rates must also change in order to maintain the interest parity. Consequently, covered interest arbitrage always ensures that there is interest parity (Melvin & Norrbin, 2013). However, sometimes deviation occurs in many different ways. Firstly, this could be a result of the transactions costs between the trading currencies. Also, there could be taxation differential. Different countries have different rates of transactions on different currencies. This largely depends on the balance of payment terms and the rate of inflation in that particular country (Melvin & Norrbin, 2013). Further, government controls may also affect this. Through imposition of transaction restrictions and taxation regulations, the government can control all these transactions. This way, the government can maintain favorable terms of payments, hence maintaining its equilibrium. Additionally, political risk also has an impact on this terms and conditions. Political stability attracts investors as there is a favorable environment for investments even to foreign investors. As we all know, when there is good business in the country, its currency will also increase its value by the end of the day. To get the real interest rate of any trading currency, we normally subtract the inflation rate from the nominal interest rate (Melvin & Norrbin, 2013). Further, the structure of different interest rates is normally the relationship of two interest rates on different bonds that have different timelines of maturity. Their differences, however, reflect when the expected exchange rates vary in different times. Reference Melvin, M., & Norrbin, S. C. (2013). International Money and Finance. Oxford: Elsevier Inc, Academic Press.Page 25-129. Read More