International Finance

#1. Course Introduction

Chapter 1: Foreign Exchange Market and
the Exchange Rate

1
Course Method
 Inflation is an increase in the level of prices of the goods
and services that households buy. It is measured as the
rate of change of those prices. Typically, prices rise over
time, but prices can also fall (a situation called deflation).
 The most well-known indicator of inflation is the
Consumer Price Index (CPI), which measures the
percentage change in the price of a basket of goods and
services consumed by households.
 Annual CPI= Value of Basket in Current Year/Value of
Basket in the Prior Year ×100
 ​Inflation Rate= New CPI−Prior CPI/Prior CPI×100

2
Course Objective
 Ben bought a pack of juice for $2.00 in 2006. If Ben pays $3.60 for the
same juice pack in 2012, calculate the inflation rate. Remember the
formula is (B-A/A * 100. To determine this, we subtract $3.60 from $2.00
to get $1.60. Then we divide $1.60 by $2.00 to get 0.8. Finally, we
multiply 0.8 by 100 to give us an inflation rate of 80%.
 Calculate the inflation rate between 1960 and 1967 if the CPI in 1960 was
$400 and the CPI in 1967 was $550. The formula is Current CPI -
Previous CPI/ Previous CPI x 100. Applying the formula, we have 550 -
400/ 400 x 10. That equals 150/400 x 100. Therefore, the inflation rate is
37.5%.
 Ex 2
 Provided a gallon of milk cost $5 in 2004 and $5.60 in 2014 we can use
these numbers as CPI information to utilize the inflation rate formula. 5.60
minus 5 equals .60. Divide .60 by 5. The results are .12. Multiply by 100.
The inflation rate on a gallon of milk between 2004 and 2014 was 12%

3
Required Textbooks
2.1. What factors might lead a government to worry about a significant current
account deficit or surplus? Additionally, why would a government pay attention to
its official settlement balance, also known as the balance of payments? How
would you define inflation? What methods are used to calculate the inflation rate?
Provide some illustrative examples.
2.2. What are some reasons a government might be worried about a significant
current account deficit or surplus? Additionally, why would it be important for a
government to monitor its official settlement balance or balance of payments?
How would you explain the concept of inflation? What methods are used to
determine the inflation rate? Please provide an example.
2.3. What concerns might arise for a government regarding a substantial current
account deficit or surplus? Additionally, why is it crucial for a government to
monitor its official settlement balance, commonly known as the balance of
payments? How do you define inflation? What techniques are used to calculate
the inflation rate? Please include an example to clarify your
explanation.

4
References
1) Governments might be concerned about large current account deficits since they
indicate reliance on foreign imports and debt accumulation, while surpluses could
imply weak domestic demand and cause trade tensions. The official settlement
balance concerns typically revolve around unsustainable financial flows, loss of
foreign reserves, and the ability to maintain currency value and economic stability.
* Current Account Deficit (Surplus) and Official Settlement Balance
A significant current account deficit or surplus often indicates capital inflows or
outflows. A persistent deficit can lead to difficulties in financing, potentially causing
currency depreciation under a floating exchange rate or depleting foreign reserves
under a fixed exchange rate.
The official settlements balance includes:
1. Current account balance
2. Capital account balance
3. Non-reserve financial account balance
4. Statistical discrepancy
This balance is crucial for assessing a country's economic health. For
developing countries, maintaining adequate reserves is vital; a negative balance
may signal a crisis due to dwindling reserves or rising foreign debts.

5
References (cont’d)
2) Definition and Calculation of Inflation
Inflation is the sustained increase in the general price level of goods and services, indicating a
decline in currency purchasing power.
Calculating Inflation Rate:
Example:
• 2022 Prices:
o Bananas: 10,000 VND/kg
o Apples: 15,000 VND/kg
• 2023 Prices:
o Bananas: 12,000 VND/kg
o Apples: 18,000 VND/kg
Calculations:
• Bananas: (12,000-10,000)/10,000×100=20%(12,000-10,000)/10,000×100=20%
• Apples: (18,000-15,000)/15,000×100=20%(18,000-15,000)/15,000×100=20%
Average Price Increase: (20%+20%)/2=20%(20%+20%)/2=20%
Thus, the inflation rate is 20%.
Inflation Index Formula: Inflation Index=(Current CPI/Base CPI)×100
For example, if Vietnam's CPI was 100 in 2022 and increased to 115 in 2023, the calculation would
be:
Inflation Index=…

6
 References (cont’d)
01 Understanding Current Account Deficit or Surplus

A current account deficit indicates that a country is importing more goods, services, and capital than it is exporting. A
surplus indicates the opposite. Governments are concerned about large deficits because they can signify a heavy reliance
on foreign capital, lead to currency depreciation, and potential solvency issues. On the other hand, surpluses may lead to
trade tensions with other countries and can reflect an economy that is not consuming enough, which may not be optimal
for growth.

02 Understanding the Official Settlements Balance

The official settlements balance, or balance of payments, is a record of all transactions made between entities in one
country and the rest of the world over a period. A government might be concerned about its balance of payments
because it reflects the country's financial condition to fund its international transactions. Deficits might indicate
borrowing from foreign entities which can lead to indebtedness to other nations, while surpluses might suggest that the
country's currency is potentially under upward pressure, which could affect export competitiveness.

03 Implications for Economic Policy

Both the current account and the official settlements balance can influence a government's economic policy decisions.
For example, a large deficit might prompt a government to implement policies aimed at boosting exports or reducing
imports, while a large surplus might lead to incentivizing domestic consumption or investment. When dealing with the
balance of payments, the government may need to adjust its fiscal or monetary policy to manage its currency and
international reserves appropriately.

7
Assessment and Grading
SECTION B – SHORT ANSWER
1.Answer all of the following questions (i)Since interest rates are equal, the current exchange rate must equal the expected future exch
a.A Californian purchases a $200 laptop from a store in Nevada. The Nevada store then transfers the $200 ange rate, in accordance with the interest parity condition.
payment to its account at a California bank. How would these transactions be recorded in the balance of p (ii)Let’s assume E(e) = 0.95, R(Australia) = 0.08, and R(Canada) = 0.04. Given the interest pa
ayments accounts for California and Nevada? What if the Californian pays using a credit card instead? rity condition: R(Australia)=R(Canada)+ [[E(e)−E]/E E=0.95/1.04≈0.9135
b.Assume the interest rate on the Australian dollar and the Canadian dollar is currently the same, at 4 perc
ent per year. What is the relationship between the current equilibrium AUD/CAD exchange rate and its ex
pected future value? If the expected future AUD/CAD exchange rate is
0.95 and remains unchanged while Australia’s interest rate rises to 8 percent per year, what will
be the new equilibrium AUD/CAD exchange rate if the Canadian interest rate remains constant? Hint:
a) Pay by check

Credit Debit

For California’s balance of p Purchase of Nevada’s laptop (Current Account, California’s go

-$200
ayment account od import from Nevada)
Sale of bank deposit by California bank (Financial Account, Ca
lifornia’s asset export to Nevada) +$200

Purchase of bank deposit from California bank (Financial Acco

For Nevada’s balance of p
unt, Nevada’s asset import from California) -$200
ayment account
Sale of Nevada’s laptop (Current Account, Nevada’s good exp
ort to California) +$200

b) Pay by cash

Credit Debit

For California’s balance of p Purchase of Nevada’s laptop (Current Account, California’s go

-$200
ayment account od import from Nevada)
Payment in cash by Californian (Financial Account, California’
s asset export to Nevada) +$200

Receiving cash payment from Californian (Financial Account,

For Nevada’s balance of p
Nevada’s asset import from California) -$200
ayment account
Sale of Nevada’s laptop (Current Account, Nevada’s good exp
ort to California) +$200
 Chapter 1:
Foreign Exchange Market and the
Exchange Rates

9
Outline
Exchange rate
Foreign exchange market
Equilibrium in the foreign exchange rate
The effect of changing interest rates on

the current exchange rate

The effect of changing expectations on

the current exchange rate

10
The Exchange Rate
Definition:

◦ The price of the foreign currency in terms of the

domestic currency.
◦ E.g) Exchange rate of VND vis-à-vis USD
 USD 1 = VND 20850 (E = 20850)

Exchange rate plays a central role in international

transactions
◦ By using exchange rates, we can compare the prices of
goods and services produced in different countries.
The Exchange Rate (cont’d)
Consider the case of VND/USD EXR:
◦ E = Exchange rate of VND against USD.
◦ E = 20.850 (VND/USD) (July 31, 2012)
Appreciation of VND against USD:
◦ Decrease in E (20.850 19.000).
Depreciation of VND against USD:
◦ Increase in E (20.850 22.000).

12
The Exchange Rate (cont’d)

Value of the domestic currency E ( = Exchange rate)

Appreciation Increase Decrease

Depreciation Decrease Increase

13
Impact of Exchange Rate Changes
on Trade
 Example 1:
◦ Vietnam imports a laptop from Japan.
◦ The price of a Sony Vaio laptop is 1000 USD.
◦ The initial EXR is 20.850 VND/USD

 The VND price of a laptop before and after

appreciation of VND (20.850 18.000) is:
◦ (1000 USD) x (20.850 VND/USD) = 20.850.000 VND
◦ (1000 USD) x (18.000 VND/USD) = 18.000.000 VND

 Effect of VND appreciation:

◦ Import price from Japan will be cheaper in terms of VND.
14
Impact of Exchange Rate Changes
on Trade (cont’d)
 Example 2:
◦ Vietnam exports rice to Philippines.
◦ The price of one ton of rice is 10.000.000 VND.
◦ The initial EXR is 20.850 VND/USD

 The VND price of one ton of rice before and after

appreciation of VND (20.850 18.000) is:
◦ (10.000.000 VND) / (20.850 VND/USD) = 479,6 USD
◦ (10.000.000 VND) / (18.000 VND/USD) = 555,5 USD

 Effect of VND appreciation:

◦ Export price to Philippines will be higher in terms of USD.
15
Impact of Exchange Rate Changes
on Trade (cont’d)
Summary:
◦ When VND depreciates, Philippines residents find that
Vietnamese products are cheaper and Vietnamese
residents find that Japanese products are more
expensive. (in case that USD is used in trading)
◦ An appreciation of VND has opposite effects.
Philippines residents pay more for the Vietnamese
products and Vietnamese consumers pay less for the
Japanese products.

16
The Foreign Exchange Market
Forex Market:
◦The market in which international
currency trades take place.
◦A network of banks and other financial
institutions, liked by telephone and
computer, that buy and sell currencies.

18
The Foreign Exchange Market
(cont’d)
Major participants:
◦ Commercial banks: are at the center of the foreign
exchange market because almost every sizable
international transaction involves the debiting and
crediting of accounts at commercial banks in various
financial centers.
◦ Corporations: with operations in several countries
frequently make or receive payments in currencies other
than that of the country in which they are head-quartered.

19
The Foreign Exchange Market
(cont’d)
Major participants:
◦ Nonbank financial institutions: to offer their customers
services involving foreign exchange transactions.
◦ Central banks: are the most regular official participants
who intervene in the foreign exchange rate in order to
achieve macroeconomic objectives such as fighting
inflation and market stability.

20
Characteristics of the Market
 Forex trading takes place in many financial centers such as
London (the largest market), New York, Tokyo, Frankfurt, and
Singapore.
 The amount of forex transactions in major markets:
◦ USD 590 billion per day (April 1989)
◦ USD 1.2 trillion per day (April 2001)
◦ USD 1.88 trillion per day (April 2004)
◦ USD 3.98 trillion per day (April 2010) (Bank for Int’l Settlements)
 The amount of exports plus imports:
◦ USD 12.5 trillion per day (2001, World total)
◦ USD 1.91 trillion per day (2001, US total)
 The US dollar = vehicle currency:
◦ The US dollar is widely used in international transactions that do not
involve the US actors.
21
Functions of the Forex Market
Serve the international trade activities
Facilitate international capital movements
Determine exchange rates by supply and
demand forces
The place where Central Banks directly
intervene in exchange rates
Provide trading environment and hedging
instruments
22
Exchange Rate Classifications
 Bid rate: is the rate at which the quoting bank is ready to buy the
commodity currency.
 Offer (or Ask) rate: is the rate at which the quoting bank is ready to
sell the commodity currency.
 Spot rate is the rate formed directly via supply and demand forces
in the Forex market.
 Derivative rate: include rates used in the Forward, Swap, Future,
and Options. They are not directly formulated via the supply and
demand forces in the Forex market but calculated from the
available variables in the market such as spot rates, interest rates of
two currencies, etc. Derivative rates are terms rates. The exchange
rate is contracted today, but the value date is after at least three
working days.
23
Exchange Rate Classifications
(cont’d)
 Opening rate: is the rate used for the first transaction of the
business day.
 Closing rate: is the rate used for the last transaction of the
business day. Normally, the rates used for all contracts
conducted in a day are not published, but only the closing
rate is. Today’s closing rate is not opening rate of the next
business day.
 Cross rate: is the rate of two currencies derived from the
third one (or medium currency).
 Transfer rate: is the rate used for the transactions of the
currencies which are deposited at bank accounts.
24
Exchange Rate Classifications
(cont’d)
 Bank note rate: is the rate used for the cash transactions
such as coins, bank notes, travelers’ cheques and credit
cards. Normally, bank note bid rate is lower and bank note
ask rate is higher than the transfer rate.
 Telegraphic rate: is the rate used for the telegraphic-
transferred transactions. Nowadays, most of the
transactions are telegraphic-transferred transactions; thus,
the exchange rates quoted at the banks are telegraphic-
transferred rates.

25
Spot Rates and Forward Rates
 Spot exchange rates:
◦ The forex transactions that take place on the spot.
◦ The value date for a spot transaction (i.e., the date on which we
actually receive the funds) occurs 2 business days after the deal is
made
 Forward exchange rates:
◦ The exchange rate quoted in transactions that specify a value date
further away than 2 days (30 days, 90 days, 180 days, or longer).
◦ Forward and spot exchange rates are not necessarily equal, but do
more closely together (Figure 13-1, p.333 in Krugman & Obstfeld,
2006)

26
Forward Exchange Transactions
 Example:
◦ A Vietnamese company imports a car from the US (the contract date
is April 1st ).
◦ Current exchange rate (April 1st ): USD 1 = VND 20.850
◦ He must pay USD in 30 days to the US exporters

◦ Suppose he expects that VND will depreciate:

USD 1 = VND 20.850 (April 1st ) USD 1 = VND 22.000 (May 1st )

◦ To avoid the exchange rate risk, he can make a 30-day forward

exchange deal with his bank.

27
 Start Goal
(time T) (time T+1)
(VND interest rate)
RVND = 0.05
MD1 = VND
(MD1 = (1+ RVND )*MD0
10.500.000
MD0 = VND
10.000.000
(Rate of Return on MVN1 = VND
US Asset) 11.025.000
R$ = 0.1025
(VND/USD Rate)
E0 = 20.000 (VND/USD Rate)
(MS0 = MD0/E0) E1 = 21.000
(MVN1 = MS1*E1)

MS0 = USD MS1 = USD

500 (US interest rate) 525
RUS = 0.05
(MS1 = (1+ RUS )*MS0

28
Equilibrium in the Forex Market
 The Rate of Return:
◦ The percentage increase in value an asset offers over some time
period.

 Equilibrium in forex market:

◦ In equilibrium, deposits of all currencies must offer the same
expected rate of return.
◦ The rate of return on VND assets R
◦ The rate of return on USD assets:
 R* + (E(e) – E)/E
 The sum of (i) USD interest rate and (ii) the expected rate of
VND depreciation against USD.

29
Equilibrium in the Forex Market
(cont’d)
Interest Parity Condition:
◦ Expected returns on deposits of any two currencies
are equal when measured in the same currency.

R = R* + [E(e) – E]/E
◦ R: (today’s) VND interest rate
◦ R* : (today’s) USD interest rate
◦ E: (today’s) VND/USD exchange rate
◦ E(e): expected VND/USD exchange rate

30
Comparing VND Rates of Return on
VND and USD Assets
R R* E(e) E [E(e) – E]/E R*+[E(e) – E]/E
(1) 0.10 0.06 20.800 20.000 0.04 0.10
(2) 0.10 0.06 20.000 20.000 0.00 0.06
(3) 0.10 0.06 20.000 19.230 0.04 0.10
(4) 0.10 0.06 22.000 20.000 0.10 0.16
(5) 0.10 0.06 22.000 21.153 0.04 0.10
* Case 2: Excess demand for VND → E down → Case 3.
* Case 4: Excess demand for USD → E up → Case 5.

31
The Equilibrium Exchange Rate
How are equilibrium exchange rates
determined?
◦ See Figure 13-4 (p.346) in K&O (2006).
◦ Assume that the expected future VND/USD
exchange rate (E(e)) is given
◦ Suppose that interest rates are determined in each
country’s market.
◦ Then, (current) exchange rates always adjust to
maintain interest parity.

32
Figure 13-4: Determination of
Equilibrium VND/USD EXR
EXR

Return on
VND deposits

E2 2

E1 1

E3 3

Expected return on
dollar deposits

R Rates of
return (in VND
terms)
33
The Effect of Changing Interest Rates
on the Current Exchange Rate
Effect of a rise in the VND interest rate:
◦ A rightward shift of the vertical VND deposit
schedule.
◦ VND appreciates. (Fig. 13-5)
◦ Expected VND return on USD deposits increases.
Effect of a rise in the USD interest rate:
◦ The downward-sloping schedule shifts to the right.
◦ VND depreciates. (Fig. 13-6)
◦ Expected VND return on USD deposits decreases.

34
Figure 13-5: Effect of a rise in the VND
interest rate
EXR

Return on
VND deposits

1 1’
E1

E2 2

Expected return on
dollar deposits

R1 R2 Rates of
return (in VND
terms)
35
Figure 13-6: Effect of a rise in the Dollar
interest rate
EXR

Return on
VND deposits

E2 2

E1 1

Expected return on
dollar deposits

R Rates of
return (in VND
terms)
36
The Effect of Changing Interest Rates
on the Current Exchange Rate
Summary:
◦ All else equal, an increase (decrease) in the VND
interest rate causes the VND to appreciate
(depreciate) against the USD.

Comment on the assumption of a constant

expected future exchange rate:
◦ This assumption is unrealistic, but useful to
understand the exchange rate determination.

37
The Effect of Changing Expectations
on the Current Exchange Rate
The effect of a rise in E(e) on today’s exchange
rate (E):
◦ Increase in the expected depreciation rate of the
VND.
◦ The downward-sloping schedule shifts to the right.
◦ The VND depreciates to reach equilibrium.

Summary:
◦ A rise (fall) in the expected future exchange rate
causes a rise (fall) in the current exchange rate.

38
Figure: Effect of changing expectations
on current EXR
EXR

Return on
VND deposits

E2 2

E1 1

Expected return on
dollar deposits

R Rates of
return (in VND
terms)
39
Questions
How many dollars would it cost to buy an
Edinburgh Woolen Mill sweater costing 50
British pounds if the exchange rate is 1.80
dollars per one British pound?
(a) 40 dollars
(b) 90 dollars.
(c) 50 dollars
(d) 100 dollars
(e) 95 dollars

40
Questions
How many British pounds would it cost to buy
a pair of American designer jeans costing $45
if the exchange rate is 1.50 dollars per British
pound?
(a) 10 British pounds
(b) 20 British pounds
(c) 30 British pounds
(d) 35 British pounds
(e) 25 British pounds

41
Questions
How many British pounds would it cost to buy
a pair of American designer jeans costing $45
if the exchange rate is 2.00 dollars per British
pound?
22.5 British pounds
32.5 British pounds
12.5 British pounds
40 British pounds
30 British pounds

42
Questions
How many British pounds would it cost to buy
a pair of American designer jeans costing $45
if the exchange rate is 2.00 dollars per British
pound?
22.5 British pounds
32.5 British pounds
12.5 British pounds
40 British pounds
30 British pounds

43
Questions
What is the expected dollar rate of return on
dollar deposits with today's exchange rate at
$1.10 per euro, next year's expected
exchange rate at $1.165 per euro, the dollar
interest rate at 10%, and the euro interest rate
at 5%?
10%
11%.
-1%
0%
None of the above
44