Global Finance Dynamics: Markets, Systems, and Banking

International Finance Fundamentals

Three Reasons International Finance is Special:

• Political Risk: Foreign expropriation, unstable regimes, and tariffs.
• Exchange Rate Risk: Currency value changes significantly affect cash flows.
• Market Imperfections: Barriers, taxes, and information gaps.

Multinational Corporation Goals:

• Maximize global shareholder value, not just domestic.

Currency Depreciation Effects:

• ↓ Currency → Exports ↑, Imports ↓.

Currency Appreciation Effects:

• ↑ Currency → Exports ↓, Imports ↑.

Understanding Financial Contagion:

• Economic crises spread to other countries (e.g., Greek debt crisis, Asian currency crisis).

Evolution of Global Monetary Systems

Bimetallism (Pre-1875):

• Both gold and silver backed currencies.
• Problem: Gresham’s Law → bad money drives out good.

The Gold Standard (1875-1914):

• Currencies were tied to gold.

• Price-Specie Flow Mechanism:

  • Trade surplus → gold inflow → inflation → exports ↓.

Interwar Period (1914-1945):

• No stable system; competitive devaluations were common.

Bretton Woods System (1945-1971):

• The USD was tied to gold, while other currencies were pegged to the USD.
• The International Monetary Fund (IMF) was created.

Flexible Exchange Rate System (Post-1973):

• The Jamaica Agreement legalized floating rates.
• The IMF and central banks intervene during periods of volatility.

Key International Monetary Agreements:

• Smithsonian Agreement: Devalued the USD after the collapse of Bretton Woods.
• Jamaica Agreement: Legalized floating exchange rates.
• Plaza Accord: Depreciated the USD to fix trade imbalances.

Exchange Rate Regimes Explained

Fixed Exchange Rate Systems:

• Central banks maintain a target rate.
• Pro: Stability.
• Con: No monetary policy independence.

Flexible (Floating) Exchange Rate Systems:

• Market supply and demand set the rates.
• Pro: Policy flexibility.
• Con: Volatility.

The Incompatible Trinity:

• Cannot have all three simultaneously:

1. Free capital flows
2. Fixed exchange rate
3. Independent monetary policy

Currency Sterilization:

• A central bank neutralizes currency inflows or outflows (e.g., by buying or selling bonds).

The Triffin Dilemma:

• A reserve currency nation must run deficits to supply global liquidity, but this weakens trust in its currency.

Understanding the Balance of Payments

Balance of Payments Accounts:

• Current Account Components:

  • Includes goods, services, primary income (investment income), and secondary income (transfers).

• Financial Account Components:

  • Includes Foreign Direct Investment (FDI) and portfolio investment (stocks/bonds).

• Official Reserves Account:

  • Central bank reserves (gold, foreign exchange).

• Statistical Discrepancy:

  • A correction for missing data.

Balance of Payments Equation:

Current Account + Financial Account + Official Reserves + Statistical Discrepancy = 0

Debit vs. Credit in BOP:

• Debit: Money outflows (e.g., importing goods, buying foreign stocks).
• Credit: Money inflows (e.g., exporting goods, selling assets).

The J-Curve Effect:

• After a currency depreciation, the trade deficit worsens initially (due to inelastic contracts) before improving later.

International Banking & Forward Rate Agreements

Eurocurrencies Explained:

• Deposits of a home currency held outside the home country (e.g., USD in London).

Euronotes:

• Short-term promissory notes issued in international markets.

Eurocredits:

• Medium-term loans with floating interest rates (usually tied to LIBOR).

Basel Accords: Banking Regulations:

• Basel I: Mandated an 8% minimum capital requirement.
• Basel II: Added supervisory review and risk management.
• Basel III: Introduced stricter capital and liquidity standards (e.g., Common Equity Tier 1 ratio).

LIBOR Transition to SOFR:

• LIBOR is being phased out and replaced by SOFR (Secured Overnight Financing Rate).

Essential International Finance Formulas

Forward Rate Agreement (FRA) Settlement:

• If Reference Rate > Contract Rate → Seller pays buyer.
• If Reference Rate < Contract Rate → Buyer pays seller.

• Three-against-Nine FRA Example:

  • An FRA that starts in 3 months and lasts for 6 months.

SOFR Interest Payment Example: