In this lesson, you’re expected to learn about:
– international capital markets
– exchange rates
– currency devaluation and revaluation
– purchasing power parity
What Are International Capital Markets?
A capital market is basically a system in which people, companies, and governments with an excess of funds transfer those funds to people, companies, and governments that have a shortage of funds. This transfer mechanism provides an efficient way for those who wish to borrow or invest money to do so.
For example, every time someone takes out a loan to buy a car or a house, they are accessing the capital markets. Capital markets carry out the desirable economic function of directing capital to productive uses.
As we already know, there are two main ways that someone accesses the capital markets—either as debt or equity.
While there are many forms of each, very simply, debt is money that’s borrowed and must be repaid, and equity is money that is invested in return for a percentage of ownership but is not guaranteed in terms of repayment.
International capital markets work with the same mechanisms as domestic markets but in the global sphere, in which governments, companies, and people borrow and invest across national boundaries.
In addition to the benefits and purposes of a domestic capital market, international capital markets provide the following benefits:
– Higher returns and cheaper borrowing costs
– Diversifying risk
Purpose of International Capital Markets
The main purposes of international capital markets are to provide an expanded supply of capital for borrowers, lower the cost of money (interest rates) for borrowers, and lower the risk for lenders. The reasons for growth in this market are due to advances in information technology, deregulation of capital markets, and innovation in financial instruments.
The main elements of international capital markets consist of bonds sold by issuers outside their own countries, stocks bought and sold outside the home country of the issuing company, and Eurocurrency banked outside their countries of origin due to lack of government regulation and its lower cost of borrowing.
The Foreign Exchange Market & Financial Instruments
A foreign exchange market exists because individuals and institutions have a need to convert one currency into another, investors can insure against adverse changes in exchange rates, speculators use it to predict an increase in the value of a currency, and investors use it to earn a profit from the instantaneous purchase and sale of a currency.
Financial instruments that exist to reduce exchange-rate risk include a forward contract, a currency swap, a currency option, and a currency futures contract. The currency futures contract is the same as the forward contract except for non-negotiable terms.
World currencies are quoted in a number of different ways, such as an exchange-rate quote between currency A and currency B, expressed as (A/B), which means that it takes x units of currency A to buy one unit of currency B; a cross-exchange rate, which is a rate between two currencies by using their respective exchange rates with a common currency; a spot exchange rate, which requires delivery of the traded currency within two business days; and a forward exchange rate, where two parties agree to exchange currencies on a specified future date.
Determining Exchange Rates
Exchange rates are determined using two concepts:
(1) The law of one price, which applies to single products selling at identical price with the same content and quality in all countries.
(2) Purchasing power parity, which applies to a basket of goods based on relative ability of two countries’ currencies to buy the same basket of goods in those two countries.
Exchange rates affect the demand for global products in various ways:
• When a country’s currency is weak relative to other currencies, the prices of its exports decline, and the prices of its import increase. Lower prices on exports make the demand for exports increase. Higher prices on imports make the demand for imports decrease.
• When a country’s currency is strong relative to other currencies, the prices of its exports increase, and the prices of its imports decrease. Higher prices on exports make the demand for exports decrease. Lower prices on imports make the demand for imports increase.
• A country that is experiencing inflation higher than that of another country should see the relative value of its currency fall, leading to devaluation. Devaluation is the intentional decrease of the value of a currency, which decreases the price of exports and increases the price of imports.
• A country that is experiencing inflation lower than that of another country should see the relative value of its currency rise, leading to revaluation. Revaluation is the intentional increase of the value of a currency, which increases the price of exports and decreases the price of imports.
• Interest rates affect inflation because the former affects the cost of borrowing money. Low interest rates encourage more debt, cause more spending, and create inflation. High interest rates discourage debt, cause low spending, and do not create inflation.
Because real interest rates do not consider inflation and hence are equal across countries, any difference in the exchange rates of two countries must be due to different inflation rates.
PPPs are the rates of currency conversion that equalize the purchasing power of different currencies by eliminating the differences in price levels between countries.
In their simplest form, PPPs are simply price relatives that show the ratio of the prices in national currencies of the same good or service in different countries. PPPs are also calculated for product groups and for each of the various levels of aggregation up to and including GDP.
How is PPP calculated?
The calculation is undertaken in three stages.
1) The first stage is at the product level, where price relatives are calculated for individual goods and services. A simple example would be a liter of Coca-Cola.
If it costs €2.3 in France and $2 in the United States then the PPP for Coca-Cola between France and the USA is 2.3/2, or 1.15. This means that for every dollar spent on a liter of Coca-Cola in the US, 1.15 euros would have to be spent in France to obtain the same quantity and quality – or, in other words, the same volume – of Coca-Cola.
2) The second stage is at the product group level, where the price relatives calculated for the products in the group are averaged to obtain unweighted PPPs for the group.
Coca-Cola is for example included in the product group “Softdrinks and Concentrates”.
3) The third stage is at the aggregation levels, where the PPPs for the product groups covered by the aggregation level are weighted and averaged to obtain weighted PPPs for the aggregation level up to GDP (in our example, aggregated levels are Non-alcoholic beverages, Food…).
The weights used to aggregate the PPPs in the third stage are the expenditures on the product groups as established in the national accounts.
What are the major uses of PPPs?
The major use of PPPs is as a first step in making inter-country comparisons in real terms of gross domestic product (GDP) and its component expenditures. GDP is the aggregate used most frequently to represent the economic size of countries and, on a per capita basis, the economic well-being of their residents.
Calculating PPP is the first step in the process of converting the level of GDP and its major aggregates, expressed in national currencies, into a common currency to enable these comparisons to be made.