The Terms Frequently Used In International Trade
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The terms frequently used in international trade Net export are the value of its exports minus the value of its imports New Zealand selling its education to Chinese student raise NZ net export. Importing Chinese shoes reduces its net export. Net export also called trade balance. Trade surplus: an excess of exports over imports. If new Zealand sells more goods and services abroad than it buys from other countries, in this case, New Zealand is said to run a trade surplus.
The terms frequently used in international trade Trade deficit: an excess of imports over exports. If New Zealand sells fewer goods and services abroad than it buys from other countries. In this case, this country is said to run a trade deficit. Balanced trade: a situation in which exports equal imports.
Comparative Advantage Definition Absolute Advantage: The comparison among producers of a good according to their productivity. Opportunity Cost: Whatever must be given up to obtain some items. Production Possibilities Frontier: Shows the various mixes of output than an individual or an economy can produce. Comparative Advantage: The comparison among producers of a good according to their opportunity cost
Comparative Advantage A producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. The opportunity cost measures the tradeoff between two or more goods. Economists use the term Comparative Advantage when describing the opportunity cost of two producers. The producers who has the smaller opportunity cost of prodcuing a good is said to have a comparative advantage in producing that good.
• In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a price lower than his or her opportunity cost of that good.
Comparative Advantage
Opportunity Cost Of 1: Radio ( In Terms Potatoes ( In term Of Of Potatoes given Radio Given Up) Up) New Zealander
2
1/2
Japanese
1/8
8
THE BALANCE OF PAYMENTS What is the balance of payments? • The balance of payments is a statistical statement that records the transactions of one country with the rest of the world. • The balance of payments has three accounts: the current account, the capital account and the financial account • We only focus the current account and the capital account
THE BALANCE OF PAYMENTS • The current account is the sum of net income from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad. • The capital account is one of two primary components of the balance of payments. It tracks the movement of funds for investments and loans into and out of a country
THE BALANCE OF PAYMENTS • The capital account is the net result of public and private international investment flowing in and out of a country. This includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies. • The capital account only keeps track of the money being transferred (i.e., the worth of stocks is not taken into account as money when calculating figures for the capital account). Hence, a surplus in the capital account amounts to debtor status
Equilibrium and Disequilibrium in the Balance of Payment Nominal Exchange Rate: The rate at which a person can trade the currency of one country for the currency of another. For Example: if you go to bank, you might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S dollar, it will give you 80 Japanese yen
Equilibrium and Disequilibrium in the Balance of Payment Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. For Example: a dollar buys more foreign currency, that change is called an appreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. For example: a dollar buys less foreign currency, that change is called a depreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment • Real Exchange Rate The rate at which a person can trade the goods and services of one country for the goods and services of another. Real Exchange Rate = Nominal Exchange Rate * Domestic Price Foreign price
Equilibrium and Disequilibrium in the Balance of Payment Real and nominal exchange rates are closely related. To see how, consider an example. Suppose that a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? (Assume nominal exchange rate is one dollar=80 yen)
Equilibrium and Disequilibrium in the Balance of Payment Why does the real exchange rate matter? The real exchange rate is a key determinant of how much a country exports and imports Now let denote p = price index in domestic country. P* = price index in the foreign country. e = nominal exchange rate Real exchange rate = (e*p) / p*
Foreign Exchange • Exchange rate – The price of one currency in terms of another. • NZD / USD • USD / JPY
– The first currency is called Base currency – The 2nd currency is called quote or counter currency
Foreign Exchange • USD/RMB: Refer to the number Deutschemarks equal to 1US dollar. (Called “Indirect” or “European”quotation against dollar) • The indirect quotation is the most case in the world • DEM/USD: refer to the number of US dollars equal to 1Deutschemarks. Called “Direct quotation against dollar” • The code on the left is the base currency, always be 1. On the right is Variable Currency/counter currency/ quoted currency.
Foreign Exchange Key explanation Bank prepared to buy the base currency against the variable currency is called “bid’ for base currency. Bank prepared to sell the base currency against the variable currency is called “offer” of base currency
Foreign Exchange A rate between any two currencies, neither of which is the dollar, called cross-rate. Example: NZD/AUD. A useful website: http://www.hifx.co.uk/currency/converter.asp The difference between the two prices is called spread.
Foreign Exchange Question USD/RMB:8.00/8.20 RMB/USD =?
Foreign Exchange Three types of trades take place in the foreign exchange market: • Spot-exchange rate. • Forward-exchange rate • Swap
Foreign Exchange • A spot transaction is an outright purchase or sale of one currency for another currency, for delivery two working days after the dealing date (the day on which the contract is made) • A forward outright is an outright purchase or sale of one currency in exchange for another currency for settlement on a fixed date in the future other than the spot value date. • Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together .
Foreign Exchange Forward outright rate may be seen both as the marker’s assessment of where the spot rate will be in the future, and as a reflection of current interest rates in the two currencies concerned. Forward outright = spot * 〔 1+(variable currency interest rate/year)*days 〕 1+(base currency interest rate/years)*days
Foreign Exchange Example • USD/DEM • Spot rate:1.6876 • DEM interest rate 3% for 31 days • USD interest rate 5% for 31 days • Forward outright = 1.6876*(1+(0.03/365)*31) (1+(0.05/365)*31) =1.6847
Foreign Exchange Although forward outright are an important instrument, bank do not in practice deal between themselves in forward outright, but rather in forward swaps. Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together.
Foreign Exchange Example: • 1) Spot USD/DEM 1.6874/1.6879 • 2) Forward outright: 1.7019/1.7029 • 3) Forward swap:0.0148/0.0150 (1)-(2)
Foreign Exchange Forward swap spot* 〔 (variable currency interest rate/year)*days-(base currency interest rate/years)*days 〕 1+(base currency interest rate/years)*days
Foreign Exchange Example: • 31 days DEM interest rate 3% • 31 day USD interest rate 5% • Spot USD/DEM: 1.6876 Forward swap: 1.6876*((0.03/365)*31)-(0.05/365)*31) 1+(0.05/365)*31 =-0.187
Basics of Option • An option is described as in the money when its exercise would produce profits for its holder. • An option is out of the money when exercise would be unprofitable. • Options are at the money when the exercise price and asset price are equal.
Basics of Option Why?
An exercise The March 2003 maturity put option on stock with an exercise price of $22.50, selling on March 4,2003,for $0.55. the expiration date is March 21. on 19 March, the market prices is $21.5. Does the stock holder have motivation to exercise the call option? if he exercise the option, how much would the value of the option be? And how much would profits be?
Option Strategies • Protective Put The purchase of a put option at the same time as taking a long position in the stock or other underlying defined in the put or while already long the underlying defined in the put.
Option Strategies Imagine you would like to invest in a stock, but you are unwilling to bear potential losses beyond some given level. Investing in the stock alone seems risky to you because in principle you could all the money you invest. You might consider snstead investing in stock and purchasing a put option on the stock.
Value of Protective Put Portfolio at Option Expiration •
St< and = X
St > X
Stock Put
St X-St
St 0
Total
X
St
Protective Put Pay off of Protective call
Pay off
X
X
St
Foreign exchange option • A foreign exchange option (commonly shortened to just FX option) is the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a preagreed exchange rate on a specified date
Foreign exchange option •
For example a USD/GBP FX option might be specified by a contract allowing the purchaser to exchange £1,000,000 into $2,000,000 on December 31st.
•
Question
• • •
what is the strike price? Which currency is call and which currency is put? If the dollar is stronger than 0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be exercised or not? Why? • If it is exercised, how much is the profits in terms of USD and in terms of GBP?
Foreign exchange option Exercise NZD/USD=0.6 is the strike price in Option contract. The contract is valid on 31th August. You plan to exchange 100 NZD into USD. On the expiration day, the market price is NZD/USD=0.7. What is your strategy?
Fixed Exchange Rate There are two ways the price of a currency can be determined against another. A fixed, or pegged. Foreign Exchange Rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency. (Usually the U.S. dollar)
The terms frequently used in international trade Trade deficit: an excess of imports over exports. If New Zealand sells fewer goods and services abroad than it buys from other countries. In this case, this country is said to run a trade deficit. Balanced trade: a situation in which exports equal imports.
Comparative Advantage Definition Absolute Advantage: The comparison among producers of a good according to their productivity. Opportunity Cost: Whatever must be given up to obtain some items. Production Possibilities Frontier: Shows the various mixes of output than an individual or an economy can produce. Comparative Advantage: The comparison among producers of a good according to their opportunity cost
Comparative Advantage A producer that requires a smaller quantity of inputs to produce a good is said to have an absolute advantage in producing that good. The opportunity cost measures the tradeoff between two or more goods. Economists use the term Comparative Advantage when describing the opportunity cost of two producers. The producers who has the smaller opportunity cost of prodcuing a good is said to have a comparative advantage in producing that good.
• In other words, as long as two people have different opportunity costs, each can benefit from trade by obtaining a good at a price lower than his or her opportunity cost of that good.
Comparative Advantage
Opportunity Cost Of 1: Radio ( In Terms Potatoes ( In term Of Of Potatoes given Radio Given Up) Up) New Zealander
2
1/2
Japanese
1/8
8
THE BALANCE OF PAYMENTS What is the balance of payments? • The balance of payments is a statistical statement that records the transactions of one country with the rest of the world. • The balance of payments has three accounts: the current account, the capital account and the financial account • We only focus the current account and the capital account
THE BALANCE OF PAYMENTS • The current account is the sum of net income from trade in goods and services, net factor income (such as interest payments from abroad), and net unilateral transfers from abroad. • The capital account is one of two primary components of the balance of payments. It tracks the movement of funds for investments and loans into and out of a country
THE BALANCE OF PAYMENTS • The capital account is the net result of public and private international investment flowing in and out of a country. This includes foreign direct investment, plus changes in holdings of stocks, bonds, loans, bank accounts, and currencies. • The capital account only keeps track of the money being transferred (i.e., the worth of stocks is not taken into account as money when calculating figures for the capital account). Hence, a surplus in the capital account amounts to debtor status
Equilibrium and Disequilibrium in the Balance of Payment Nominal Exchange Rate: The rate at which a person can trade the currency of one country for the currency of another. For Example: if you go to bank, you might see a posted exchange rate of 80 yen per dollar. If you give the bank one U.S dollar, it will give you 80 Japanese yen
Equilibrium and Disequilibrium in the Balance of Payment Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy. For Example: a dollar buys more foreign currency, that change is called an appreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment Depreciation: a decrease in the value of a currency as measured by the amount of foreign currency it can buy. For example: a dollar buys less foreign currency, that change is called a depreciation of the dollar.
Equilibrium and Disequilibrium in the Balance of Payment • Real Exchange Rate The rate at which a person can trade the goods and services of one country for the goods and services of another. Real Exchange Rate = Nominal Exchange Rate * Domestic Price Foreign price
Equilibrium and Disequilibrium in the Balance of Payment Real and nominal exchange rates are closely related. To see how, consider an example. Suppose that a bushel of American rice sells for $100, and a bushel of Japanese rice sells for 16,000 yen. What is the real exchange rate between American and Japanese rice? (Assume nominal exchange rate is one dollar=80 yen)
Equilibrium and Disequilibrium in the Balance of Payment Why does the real exchange rate matter? The real exchange rate is a key determinant of how much a country exports and imports Now let denote p = price index in domestic country. P* = price index in the foreign country. e = nominal exchange rate Real exchange rate = (e*p) / p*
Foreign Exchange • Exchange rate – The price of one currency in terms of another. • NZD / USD • USD / JPY
– The first currency is called Base currency – The 2nd currency is called quote or counter currency
Foreign Exchange • USD/RMB: Refer to the number Deutschemarks equal to 1US dollar. (Called “Indirect” or “European”quotation against dollar) • The indirect quotation is the most case in the world • DEM/USD: refer to the number of US dollars equal to 1Deutschemarks. Called “Direct quotation against dollar” • The code on the left is the base currency, always be 1. On the right is Variable Currency/counter currency/ quoted currency.
Foreign Exchange Key explanation Bank prepared to buy the base currency against the variable currency is called “bid’ for base currency. Bank prepared to sell the base currency against the variable currency is called “offer” of base currency
Foreign Exchange A rate between any two currencies, neither of which is the dollar, called cross-rate. Example: NZD/AUD. A useful website: http://www.hifx.co.uk/currency/converter.asp The difference between the two prices is called spread.
Foreign Exchange Question USD/RMB:8.00/8.20 RMB/USD =?
Foreign Exchange Three types of trades take place in the foreign exchange market: • Spot-exchange rate. • Forward-exchange rate • Swap
Foreign Exchange • A spot transaction is an outright purchase or sale of one currency for another currency, for delivery two working days after the dealing date (the day on which the contract is made) • A forward outright is an outright purchase or sale of one currency in exchange for another currency for settlement on a fixed date in the future other than the spot value date. • Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together .
Foreign Exchange Forward outright rate may be seen both as the marker’s assessment of where the spot rate will be in the future, and as a reflection of current interest rates in the two currencies concerned. Forward outright = spot * 〔 1+(variable currency interest rate/year)*days 〕 1+(base currency interest rate/years)*days
Foreign Exchange Example • USD/DEM • Spot rate:1.6876 • DEM interest rate 3% for 31 days • USD interest rate 5% for 31 days • Forward outright = 1.6876*(1+(0.03/365)*31) (1+(0.05/365)*31) =1.6847
Foreign Exchange Although forward outright are an important instrument, bank do not in practice deal between themselves in forward outright, but rather in forward swaps. Forward swap is the difference between the spot and the forward outright. The forward outright rate can be seen as a combination of the current spot rate and the forward swap rate added together.
Foreign Exchange Example: • 1) Spot USD/DEM 1.6874/1.6879 • 2) Forward outright: 1.7019/1.7029 • 3) Forward swap:0.0148/0.0150 (1)-(2)
Foreign Exchange Forward swap spot* 〔 (variable currency interest rate/year)*days-(base currency interest rate/years)*days 〕 1+(base currency interest rate/years)*days
Foreign Exchange Example: • 31 days DEM interest rate 3% • 31 day USD interest rate 5% • Spot USD/DEM: 1.6876 Forward swap: 1.6876*((0.03/365)*31)-(0.05/365)*31) 1+(0.05/365)*31 =-0.187
Basics of Option • An option is described as in the money when its exercise would produce profits for its holder. • An option is out of the money when exercise would be unprofitable. • Options are at the money when the exercise price and asset price are equal.
Basics of Option Why?
An exercise The March 2003 maturity put option on stock with an exercise price of $22.50, selling on March 4,2003,for $0.55. the expiration date is March 21. on 19 March, the market prices is $21.5. Does the stock holder have motivation to exercise the call option? if he exercise the option, how much would the value of the option be? And how much would profits be?
Option Strategies • Protective Put The purchase of a put option at the same time as taking a long position in the stock or other underlying defined in the put or while already long the underlying defined in the put.
Option Strategies Imagine you would like to invest in a stock, but you are unwilling to bear potential losses beyond some given level. Investing in the stock alone seems risky to you because in principle you could all the money you invest. You might consider snstead investing in stock and purchasing a put option on the stock.
Value of Protective Put Portfolio at Option Expiration •
St< and = X
St > X
Stock Put
St X-St
St 0
Total
X
St
Protective Put Pay off of Protective call
Pay off
X
X
St
Foreign exchange option • A foreign exchange option (commonly shortened to just FX option) is the owner has the right but not the obligation to exchange money denominated in one currency into another currency at a preagreed exchange rate on a specified date
Foreign exchange option •
For example a USD/GBP FX option might be specified by a contract allowing the purchaser to exchange £1,000,000 into $2,000,000 on December 31st.
•
Question
• • •
what is the strike price? Which currency is call and which currency is put? If the dollar is stronger than 0.5GBP/USD come December 31st (say at 0.55GBP/USD) then the option will be exercised or not? Why? • If it is exercised, how much is the profits in terms of USD and in terms of GBP?
Foreign exchange option Exercise NZD/USD=0.6 is the strike price in Option contract. The contract is valid on 31th August. You plan to exchange 100 NZD into USD. On the expiration day, the market price is NZD/USD=0.7. What is your strategy?
Fixed Exchange Rate There are two ways the price of a currency can be determined against another. A fixed, or pegged. Foreign Exchange Rate is a rate the government (central bank) sets and maintains as the official exchange rate. A set price will be determined against a major world currency. (Usually the U.S. dollar)
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