Chapter 7 Foreign Exchange and International Finance

Money - Anything people will accept for the exchange of goods and services

5 main characteristics

  1. Acceptability 

  2. Scarcity

  3. Durability

  4. Divisibility

  5. Portability

Why is money used?

  1. Medium of Exchange

  2. Measure of Value 

  3. Store of Value-Ex. Money deposited in a bank for future use.

Foreign Exchange - Process of converting the currency of one country into that of another.

Exchange Rate - Amount of currency of one country that can be traded for one unit of the currency of another country

Balance of Payment - Measure of total flow of money coming in minus money going out. If unfavorable, usually results in decline in value of nation’s currency.

Economic Conditions

All countries face inflation and changing interest rates.

Interest rate - cost of using someone else’s money

Interest rates are affected by 3 factors:

  1. Money supply and demand-more borrowers, higher rates.

  2. Risk-higher risk, higher interest rate

  3. Inflation - prices rise, buying power declines

Dollarization-Country uses currency of more stable country

Soft Currency - 

Currency not easy to exchange for other currencies

Usually developing countries

Hard (Strong) Currency - 

` Monetary unit that is easily converted into others 

Usually industrialized countries

Floating Exchange rate - 

currency values based on supply and demand.

Demand increases -value increases

Foreign Exchange Market

Network of banks and other financial institutions that buy and sell different currencies

Exchange Controls - government restrictions to regulate the amount and value of a nation’s currency.

International Financial Agencies

World Bank-Bank whose major function is to provide economic assistance to less developed countries.

Funds build communication systems, transportation networks, and energy plants.

International Monetary Fund (IMF)

  • Agency that helps promote economic cooperation

  • Sets the exchange rate for currencies in different countries

  • Maintains an orderly system of world trade and exchange rates.

Before this, a country could change value of its currency to attract foreign customers. As countries lost business, they impose trade restrictions or lower the value of currency. Trade wars resulted.

IMF Functions:

Analyze economic situations

Suggest economic policies

Provide loans

International Financial Transactions

Payment Methods:

Cash in Advance - pay before receiving goods - risky

Letter of Credit - financial document from a bank for an importer. guarantees payment Allows importer to pay for goods before they are received, but after they are shipped.

Bill of lading - proof that goods have been shipped.

Credit Terms - Time required for payment and other conditions of sale on account.

More Payment Methods

Promissory Note - A document that states a promise to pay a set amount by a certain date.

Commercial Invoice-Document prepared by an exporter that includes details about the buyer, seller, merchandise, amounts, prices, shipping method, date of shipment and terms of payment

Sources of International Financing

Short-Term Financing - 30 days usually

Trade Credit - buying or selling on account

Accounts Receivable-amount due from a customer to a company that sells on credit

Accounts Payable-Amount owed to a supplier

Other Payment Methods

Promissory note-document that states a promise to pay a set amount

by a certain date.

Bill of Exchange -Written order by an exporter to an importer to make payment

Electronic Funds Transfer (EFT) - After importer received the goods, a bank can be instructed to transfer payment for the merchandise to the exporter’s bank. Advantage-Prompt Payment

Wire Transfer-Payment moves money between a buyer’s bank account and a seller’s bank account in different countries.

Bond-When a company needs to borrow money over a long period of time

Letter of Credit - Allows importer to pay for goods before they are received but after they are shipped.

Commercial Invoice-Prepared by exporters

Description of merchandise and terms of sale

Insurance Certificate-Explains the amount of insurance coverage for fire, theft, water or other damage during shipment. Lists names of insurance company and exporter

Country with high foreign demand for products - Demand results in a strong currency for the country. Prices rise, interest rates rise

Its manufacturers want to be paid in their own currency.

Supply/Demand Relationship

Low Supply

Demands Rise

Prices rise

Interest Rates Rise

Exchange Control

When a company limits the amount of its currency that tourists may take out of the country

Currency Debt Relationship - As Country’s Debt increases, the currency value declines

Low Inflation increases value of currency.

Shells were used once for money - They did not work well because:

  • They are not scarce

  • They are fragile

  • It is difficult to get anyone to accept them as money

Cause of increased interest rates:

Political Uncertainty

Inflation is Increasing

Balance of Payments

Short Term Financing

Trade Credit - Buying or selling on account

Accounts Receivable - Amount due from a customer to a company that sells on credit

Accounts payable - Amount owed to a supplier

Long Term Financing

Capital Projects 

An expensive, long-term financial activity.

  • Buying new computers

  • Buying Manufacturing robotics

  • Buying a delivery vehicle

Bond

A certificate representing money borrowed by a company over a long period of time, usually between 5 and 30 years.

Represents company’s promise to repay the money by a certain date with interest.

Credit Terms

Time required for payment and other conditions of a sale on account.

2/10, n/30 means customers can take a 2% discount if they pay within 10 days or they may pay the full amount in 30 days with no interest.