FDI 5

22 flashcards · Other · by Daniel F.

1. Transaction risk

   Value of a transaction is unknown risk in exporting/importing

2. Translation risk

   Value of a firm’s assets and liabilities is unknown Main risk in FDI, foreign portfolio investment

3. Hedging

   Seeking a balance between liabilities in foreign currency and assets in foreign currency to cover the risk Example: Purchase of goods from U.S. payable in 30 days ($-liability) forward contract to buy $ in 30 days ($-asset) at predefined EUR/$ rate know in advance how many EUR to pay in 30 days No risk!

4. Speculating

   Taking over net asset or net liability positions in foreign currency to make a (potential) profit Example: Sign forward contract to buy $ in 30 days at predefined EUR/$ rate if future spot rate is above the forward rate: Profit (buy $ at cheap forward rate and sell at high spot rate)

5. Arbitrage

   Taking advantage of price differences in two markets If the rate of return between Home and Foreign (expressed in the same currency) is different, one can make a profit

6. how to compare foreign and domestic investment options

   forward rate (f): covered investment (hedging): Covered interest parity expected future spot rate (e_ex): uncovered investment (speculation) uncovered investment parity

7. Covered interest parity condition

   Assumption: Foreign and domestic assets are perfect substitutes domestic assets H gets you interest i_H foreign assets F get you interest i_F investments have to expressed in same currency 1 HCU today is worth 1/e FCU e = HCU/FCU 1 FCU in the future is worth f HCU 1 invested HCU in domestic assets yields (1+i_H) 1 invested HCU in foreign assets yields (1+i_F)*f/e Covered interest parity condition

8. Covered investment parity implications what changes if interest rates change

   Changes in interest rates will trigger changes in the current spot rate increase in i_F foreign assets more attractive increased demand for foreign currency in spot market foreign currency appreciates in spot market e raises increase in i_H home assets more attractive reduced demand for foreign currency in spot market foreign currency depreciates in spot market e falls Changes in interest rates will trigger changes in the forward rate increase in i_F foreign assets more attractive increase supp…

9. Uncovered investment

   domestic assets H gets you interest i_H foreign assets F get you interest i_F investments have to expressed in same currency 1 HCU today is worth 1/e FCU e = HCU/FCU 1 FCU in the future is worth f HCU 1 invested HCU in domestic assets yields (1+i_H) 1 invested HCU in foreign assets yields (1+i_F)*e_ex/e

10. uncovered investment parity implications what changes if interest rates change

    Changes in interest rates will trigger changes in the current spot rate Increase in i_H Domestic assets more attractive increased demand for domestic currency domestic currency appreciates e falls increase in i_F Foreign assets more attractive increased demand for foreign currency foreign currency appreciates e increases Changes in the expected future spot rate will trigger changes in the current spot rate Rise in e_ex (expected appreciation of for. curr.) foreign assets more attractive increas…

11. UIP expectations

    actual future return is unknown if the expected future rate is wrong the return on different from the the one investors used to make comparisons Risk averse investors prefer covered investment if otherwise the conditions are the same

12. testing for CIP vs UIP

    CIP hold up in normal times UIP does not People are risk averse: If there is an exchange rate risk, they want to be compensated for this. the interest rate differential reflects the risk premium

13. Exchange rates in the short run

    exchange rate movements are driven by the behavior of financial investors supply and demand for financial assets Differences in returns to financial investments are easily observable and financial portfolios can be repositioned almost very quickly and at almost zero cost. Uncovered interest parity implies a link between interest rates, expected, and actual exchange rates Anything that changes the expected return on foreign assets relative to domestic assets will trigger changes in the spot exch…

14. Exchange rates in the long run

    exchange rate movements are driven by the demand and supply for different countries’ goods and services sometimes there are arbitrage opportunities if many people make use of it the prices will converge Law of one price / purchasing power parity

15. Law of one price/purchasing power parity

    Products that are easily and freely tradable should have the same price everywhere (ε = 1) so that there are no international arbitrage opportunities in the long run the nominal exchange rates to move in the direction of the PPP exchange rate

16. Relative PPP (inflation)

    Changes in the exchange rate are related to changes in countries’ prices over time inflation describes relations between changes of prices Rate of change in exch. rate between time t and time t+1 = Difference in inflation rates

17. Implications of relative PPP

    relatively high inflation rate will -> depreciating currency declining nominal exchange rate value of its currency relatively low inflation rate -> appreciating currency increasing nominal exchange rate value of its currency The rate of appreciation or depreciation will be approximately equal to the percentage-point difference in the inflation rates.

18. What is driving the adjustment of the nominal exchange rate to the PPP exchange rate

    domestic prices are higher/rise faster than foreign prices Domestic goods become more expensive for foreigners/foreign goods become cheaper. Decline in exports/rise in imports. Less demand for domestic currency. Depreciation of the domestic currency.

19. testing for PPP

    Absolute PPP holds if the (effective) real exchange rate equals 1 Relative PPP holds if the (effective) real exchange rate is a horizontal line movements in e follow movements in PH and PF so that the change rate remains constant

20. Determinants of prices What can explain the national price level and the inflation rate

    Monetary Approach - that country’s inflation rates are directly linked to their rates of money growth and income growth.

21. Quantity Theory of Money

    Ms must equal Md Md depends on transaction demand Md = k (parameter: capital) * P (price lvl) * Y (gdp) Rewriting leads to: Or: ∆%𝑃 = 𝜋 = ∆%𝑀𝑈 − ∆%𝑌 -> An increase in the money supply (high rate of money growth ∆%𝑀) will trigger inflation

22. PPP and international income comparisons

    use PPP exchange rate to compare incomes in countries