International Trade: Exchange Rates, Arbitrage, and Purchasing Power

This assignment provides an in-depth analysis of international trade, focusing on several key concepts. It begins by examining the impact of joining a monetary union on output stabilization and inflation control, contrasting fixed and floating exchange rates. The assignment then delves into exchange rate calculations, demonstrating arbitrage opportunities using gold and currency conversions between the US dollar and the French franc. It further explores the strategies employed by the Japanese central bank to influence the Yen-Dollar exchange rate, the justifications behind such interventions, and their effectiveness. The assignment also covers currency quotations, including direct and indirect quotes, and explores triangular arbitrage, providing calculations to determine profit potential. Finally, it analyzes relative purchasing power parity (PPP) and the International Fisher Effect, calculating exchange rates based on these theories and assessing their validity in a given scenario. The assignment concludes by summarizing the key findings related to international trade and currency exchange.

International trade
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TABLE OF CONTENTS
INTRODUCTION ..........................................................................................................................3
1........................................................................................................................................................3
a....................................................................................................................................................3
b....................................................................................................................................................3
2........................................................................................................................................................4
a....................................................................................................................................................4
b....................................................................................................................................................4
c....................................................................................................................................................4
3........................................................................................................................................................4
4........................................................................................................................................................5
a....................................................................................................................................................5
b....................................................................................................................................................5
c....................................................................................................................................................6
5........................................................................................................................................................6
a....................................................................................................................................................6
b....................................................................................................................................................6
c....................................................................................................................................................6
CONCLUSION ...............................................................................................................................7
REFERENCES................................................................................................................................8
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INTRODUCTION
International trade is referred to exchange of goods as well as services among the
countries. Such kind of trade results in giving rise to world economy under which prices, supply
and demand affects and are influenced by events at global level. International trade allows
greater competition and more competitive pricing within the market.
1.
a.
The statement that is a country deciding to join monetary union expects an increased
ability to stabilize output, and an increased ability in lowering inflation in comparison with initial
ability under flexible exchange rate is false. This is because with single currency monetary
efficiency is enhanced as it is accepted everywhere thus has more utility. However when country
fixes its exchange rate then it loses control over its own monetary policy. Therefore economic
stability is sacrificed (Manova, 2013). Floating exchange rate is more beneficial in comparison
with fixed as with this economy's output increases and output as well. Countries possessing their
own exchange rates results in shifting output of goods exported that has impact on exchange
rates. On the contrary with fixed rates there is limited ability of government to stabilize economy
as the state loses control over its monetary policy.
b.
US authorities have committed exchange an ounce of gold for $35. However French
authorities have committed exchange an ounce of gold for 60 French francs. Calculation of
exchange rate demonstrated below:
$35 = 1 ounce
FF60 = 1 ounce
$35 = FF60
$ = FF60/ 35
$ = FF1.71
Thus exchange rate is FF1.71/ 1$
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However, the standard exchange rate between French francs and US dollar as per case
scenario is FF2/ $1. Thus it can be said that exchange rate is not correct. Further arbitrage
opportunity does exist. This can be justified through example as under:
In case there are $1000, with this 28.57 ($1000/ $35) ounces of gold can be purchased.
When $1000 is exchanged in France then it becomes FF2000. With this 33.33 (FF2000/ FF60)
ounces gold can be purchased. This present arbitrage advantage as exchange of dollar can result
in benefit from the investment made in France (Novy, 2013).
2.
a.
The strategies used by Japanese central bank intervene and influence the exchange rate
between Yen and Dollar in foreign exchange market involves buying back of US dollars
(Winham, 2014). With this bank of Japan is controlling value of its exchange rate against
American currency.
b.
The Japanese government justified on the intervene that it is carried out with the aim to
prevent Yen rising to the levels that can push exports lower and send economy back into
recession (McGovern, 2015). The strong yen makes imports cheaper, this prolongs the cycle of
deflation which hurt Japan for years as consumers defer purchases in hope for further price falls.
c.
The intervention did not succeed because the day when Japanese government was trying
to depreciate the value of Yen the very next day the value of currency appreciated (Japan
intervenes to stem yen's rise, 2015). Thus this has resulted in making intervene unsuccessful.
3.
USD Bank Quotations Direct
American Terms
Indirect
European Terms
Bid Ask Bid Ask
Between £ and $ 1.5924 1.5929 0.6278 0.6280
Between € and $ 1.3509 1.3514 0.7400 0.7402
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Between £ and € (1.3509/1.59
29) =0.8481
(1.3514/1.59
24) =0.8486
(0.6278/
0.7402)
=0.8481
(0.6280/
0.7400)
=0.8486
Direct quote and direct quote
Bid rate = Divide the term currency bid by the base currency ask
Ask rate =Divide the term currency ask by the base currency bid
Indirect quote and indirect quote
Bid rate = Divide the base currency bid by the term currency ask
Ask rate =Divide the base currency ask by the term currency bid
4.
a.
Triangular arbitrage is referred to as the procedure of trading out of US dollar into second
currency later trading it for third currency that in turn traded for US dollars. This is done with the
aim to earn arbitrage profit through trading from the second to the third currency when direct
exchange among the two is not in alignment with the cross exchange rate. Not all but most of
transaction related with currency go through dollar (Meade, 2013). There is presence of certain
banks specialized in making direct market among non dollar currencies, pricing at narrower bid-
ask spread as compared to cross rate spread. The implied cross rate bid ask quotations imposes a
discipline on non dollar market makers. In situation when direct quotes are not consistent with
cross exchange rates then triangular arbitrage profit is possible.
b.
1£ = $1.8403
1€ = $1.3225
1$ = 1/ 1.8403£
1$ = 1/ 1.3225€
1/ 1.3225€ = 1/ 1.8403£
1£ = 1.8403/1.3225
1£ = 1.3915€
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As stated as per case that 1£ = 1.3647€, thus this eliminates triangular arbitrage.
c.
Calculation of triangular arbitrage profit by trading at these prices:
Buy 1£ by investing 1.3647€
Sell 1£ for 1.8403$
Buying 1€ by selling 1.8403$
1$ = 1/ 1.3225€
1$ = 1.8403/ 1.3225€
=1.3915€
Profit = 1.3915€ - 1.3647€
= 0.0268€
5.
a.
Relative purchasing power parity is referred as economic theory that predicts a
relationship among inflation rates of two countries over specified period as well as the movement
in the exchange rate among their two currencies over same period. It is dynamic version of
absolute PPP theory.
Current pound rate in dollar = (1+ 3.5%)/ (1+ 4.5%) * 1.60
1£ = 1.5847
b.
No PPP does not hold in this case. This is because there is certain difference that is as per case
current spot is $ 1.576/£ and as per PPP it is $ 1.5847/£
c.
International Fisher Effect is hypothesis in international finance that states differences in
nominal interest rates reflect expected changes within spot exchange rate among countries.
1£ = (1+ 0.5%)/ (1+ 0.75%) * 1.576
1£ = 1.572
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CONCLUSION
It can be concluded from the study that international trade is effective in benefiting the
country as it involves exchange of currencies. This results in uplifting the economy to a greater
extent.
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REFERENCES
Journals and Books
Manova, K., 2013. Credit constraints, heterogeneous firms, and international trade. The Review
of Economic Studies. 80(2). pp.711-744.
Winham, G.R., 2014. International trade and the Tokyo Round negotiation. Princeton University
Press.
McGovern, E., 2015. International trade regulation (Vol. 2). Globefield Press.
Wagner, J., 2012. International trade and firm performance: a survey of empirical studies since
2006. Review of World Economics. 148(2). pp.235-267.
Meade, J.E., 2013. A Geometry of International Trade (Routledge Revivals). Routledge.
Novy, D., 2013. Gravity redux: measuring international trade costs with panel data. Economic
Inquiry. 51(1). pp.101-121.
Online
Japan intervenes to stem yen's rise. 2015. [Online]. Available through:
<http://www.telegraph.co.uk/finance/currency/8003554/Japan-intervenes-to-stem-yens-
rise.html>. [Accessed on 21st January 2016].
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