Chap. 6 - Finance

What is the International Monetary System?

The institutions and mechanisms that foster international trade, manage capital flows, and determine exchange rates.

Where did international finance begin?

In Babylonian cities about 5,000 years ago.

Which city became a major financial center around 500 B.C.?

Athens.

Which empire became a major financial center around 100 B.C.?

The Roman Empire.

Which cities became leading financial centers in modern times?

London, New York, and Tokyo.

What was the gold standard?

A monetary system where currencies were convertible into gold at fixed exchange rates.

When did the gold standard operate?

Primarily before World War I.

Why was the gold standard abandoned?

Financial crises during the early 1930s.

What was the Bretton Woods System?

A fixed exchange rate system where the U.S. dollar was valued in gold and other currencies were pegged to the dollar.

When did the Bretton Woods System operate?

1945–1972.

What is the Flexible Exchange Rate System?

A system where exchange rates are determined by supply and demand.

When did the Flexible Exchange Rate System begin?

1973.

What is the European Union (EU)?

An organization established to promote trade and economic development among European countries.

What is the European Monetary Union (EMU)?

A group of European countries that share a common monetary policy and currency.

What is the euro?

The common currency of EMU member countries.

What was the European Economic Community (EEC)?

A European organization established in 1957 to promote economic cooperation.

What did the EEC become in 1978?

The European Community (EC).

What was the Maastricht Treaty?

A 1991 agreement providing for economic convergence, fixed exchange rates, and adoption of the euro.

What did the EC become in 1992?

The European Union (EU).

What are eurozone members?

Countries that use the euro and allow the ECB to conduct monetary policy.

What is the European Central Bank (ECB)?

The central bank responsible for monetary policy in eurozone countries.

What are currency exchange markets?

Markets where currencies are bought and sold.

What are FOREX markets?

Foreign exchange markets where currencies are traded.

What is a currency exchange rate?

The value of one currency relative to another currency.

What is the direct quotation method?

The amount of home currency needed to buy one unit of foreign currency.

What is the indirect quotation method?

The amount of foreign currency needed to buy one unit of home currency.

What four major factors affect exchange rates?

Supply and demand, inflation rates, interest rates, political risk, and economic risk.

What is Purchasing Power Parity (PPP)?

The theory that currencies of countries with higher inflation will depreciate relative to currencies with lower inflation.

What is Interest Rate Parity (IRP)?

The theory that currencies of countries with higher interest rates will depreciate relative to currencies with lower interest rates.

What is the PPP formula?

FR₁ = SR₀[(1 + InfRhc)/(1 + InfRfc)].

What does FR₁ represent in PPP?

The forward exchange rate one year in the future.

What does SR₀ represent in PPP?

The current spot exchange rate.

What does InfRhc represent?

The expected inflation rate in the home country.

What does InfRfc represent?

The expected inflation rate in the foreign country.

If the spot rate is $1.31 per euro, U.S. inflation is 6%, and EMU inflation is 3%, what is the forward rate according to PPP?

Approximately $1.35 per euro.

What is the IRP formula?

FR₁ = SR₀[(1 + IntRhc)/(1 + IntRfc)].

What does IntRhc represent?

The home country's interest rate.

What does IntRfc represent?

The foreign country's interest rate.

If the spot rate is $1.31 per euro, U.S. interest rates are 9%, and EMU interest rates are 6%, what is the forward rate according to IRP?

Approximately $1.35 per euro.

What is political risk?

The risk that a government may confiscate or expropriate foreign-owned assets.

What is economic risk?

The risk of slow, negative, or unstable economic growth.

What is arbitrage?

Buying an asset in one market and selling it in another to profit from price differences.

What happened to the U.S. dollar during the first half of the 1980s?

It appreciated.

What happened to the U.S. dollar during the second half of the 1980s?

It depreciated.

How did the U.S. dollar behave during the 1990s?

It fluctuated within a relatively narrow range.

What happened to the U.S. dollar after 2002?

It experienced a significant decline.

Why must firms manage foreign exchange risk?

Because exchange rate changes and political instability can affect profits.

What does the Foreign Corrupt Practices Act (FCPA) prohibit?

Bribing foreign government officials.

What is a draft (bill of exchange)?

An unconditional order for the payment of money.

What is a sight draft?

A draft requiring immediate payment.

What is a time draft?

A draft payable at a future date.

What is an order bill of lading?

A shipping document listing goods and shipping terms.

What is a documentary draft?

A draft accompanied by shipping and ownership documents.

What is a commercial letter of credit?

A bank guarantee that a draft will be accepted and paid.

What is a trust receipt?

A document allowing a bank to retain title to goods until payment is made.

What is a banker's acceptance?

A promise of future payment guaranteed by a bank.

What is the Export-Import Bank?

A bank that helps finance and facilitate international trade involving the United States.

What is a traveler's letter of credit?

A document authorizing foreign banks to cash checks or drafts for the bearer.

What is the balance of payments?

A summary of a country's economic transactions with the rest of the world.

What is the balance of trade?

The net value of exports minus imports.

What is the merchandise trade balance?

The difference between exports and imports of goods.

What is the current account balance?

The flow of income into and out of a country during a period.

What is the capital account balance?

Foreign investment in the U.S. minus U.S. investment abroad.

What determines exchange rates under a flexible exchange rate system?

Supply and demand.

Which monetary system used gold as the reserve asset?

The gold standard.

Which system pegged currencies to the U.S. dollar?

The Bretton Woods System.

Which system allows currencies to float freely?

The Flexible Exchange Rate System.

Which organization conducts monetary policy for eurozone countries?

The European Central Bank (ECB).

What is the primary difference between direct and indirect quotations?

Direct quotations show home currency per foreign currency, while indirect quotations show foreign currency per home currency.

What generally happens to a currency when inflation rises faster than in other countries?

The currency tends to depreciate.

What generally happens to a currency when interest rates are relatively higher?

The currency tends to depreciate according to IRP.

What are the two major theories explaining exchange rates?

Purchasing Power Parity (PPP) and Interest Rate Parity (IRP).

Which risk involves government actions against foreign investors?

Political risk.

Which risk involves uncertainty in economic growth?

Economic risk.

Which document guarantees payment of a draft?

A commercial letter of credit.

Which institution assists U.S. international trade financing?

The Export-Import Bank.