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1
International Linkages Through Foreign Exchange Rates
Topic 10
Blackwell, Griffiths, and Winters, Chapter 8
2
Foreign Exchange Rates
The rate at which one nation’s currency can be exchanged for another
Cash Flows--Investment Cash Flows
However, foreign investments have an additional risk, which is exchange rate risk.
The reason that foreign investments are exposed to exchange rate risk is that domestic investors demand their compensation in the domestic currency, so the cash flow from a foreign investment must be converted in the domestic currency.
Political cash flows (often called capital flight) are cash flows out of a foreign country.
The reason for political cash flows is political instability in a country. These cash flows occur because the government is unwilling or unable to protect property rights, so investors move their funds out of the country.
3
Cash Flows--Political Cash Flows
Political cash flows (often called capital flight) are cash flows out of a foreign country.
The reason for political cash flows is political instability in a country. These cash flows occur because the government is unwilling or unable to protect property rights, so investors move their funds out of the country.
Political cash flows often flow to the U.S. because the U.S. has strong laws protecting property rights and the U.S. government has not defaulted on any of its debt and is considered default-free.
Almost all other national governments have defaulted on their debt at some point in time, so foreign government debt is rated (Fig. 8-2)
4
Cash Flows—Speculative Cash Flows
Speculation is bearing risk for an expected return and speculation usually involves taking an investment position in the hope that a favorable price movement will occur.
Pure speculation is very risky because it is a bet on the direction of future market movements, and in efficient markets, market movements occur because of the arrival of new information.
But, speculative movements in the form of currency attacks can be in anticipation of an inability of central banks to stem movement
Therefore, the speculators take positions betting that when the temporary bank intervention stops, the exchange rate will return to (or at least move toward) their prior levels
Recent case study: the dollar against European currencies in 1978 and 1979
5
Exchange Rate Regimes
The gold standard
Bretton Woods Agreement: 1944-1971
• Set $35 equal to one ounce of gold and then set the exchange rate of all other currencies relative to the U.S. dollar.
• Required that every country manage its exchange rate within a band of +1% or -1% of its pre-determined exchange rate. After Bretton Woods,
After Bretton Ewoods• The exchange markets evolved
through several phases to our current market of free floating exchange rate blocs.
In the floating bloc system currencies are grouped together in a bloc with one lead currency.
• The other currencies in the bloc tie their exchange rates to the lead currency and these exchange rates are fairly constant.
Then between the blocs (or lead currencies) exchange rates float freely based on supply and demand.
This system allows for market determined exchange rates between the major currencies and reduces problems with ‘stale’ exchange rates with currencies that do not trade very much.
6
7
How Are Exchange Rates Expressed
American convention: exchange rates may be expressed as the number of foreign units per dollar
96 yen per dollar
1.45 marks per dollar
0.63 pounds per dollar
European convention: Exchange rates may also be expressed as the number of dollars per foreign currency unit
$0.0104167 per yen
$0.6896552 per mark
$1.5873016 per pound
Current exchange rates are available elsewhere on the course web site
8
FX Rates and the Value of GoodsExamples
CD ROM disk drive priced in yen (Y30,000) and exported to US
• If Y/$ is 120, the $ price is $250
Cellular telephone is price in dollars ($225) and exported to Japan
• If yen/$ rate is 120, the yen price is Y27,000
9
Appreciation
When the dollar appreciates it rises in value relative to the other country’s currency
• This means that it takes more of the foreign currency to by one dollar
• Example: Yen/$ rises from 96 to 99
When the dollar appreciates, the other currency depreciates
• This means that one unit of the foreign currency buys fewer dollar
• Example: $/Yen falls from $0.0104167 to $0.010101
10
Effects of Appreciation of the Dollar
Dollar price of imports falls
Example of an import: If a CD-ROM is priced at 25000 yen, and the Y/$ rate is 96, the dollar price would be 25000/96
or
$260.42
If Dollar appreciates so yen/$ is 99, the dollar price of the CD-ROM is 25000/99
or
$252.52
Dollar price of exports rises
Example of an export to Japan: If a cellular phone priced at $125, and the Y/$ rate is 96, the phone’s yen price would be 125*96
or
Y12,000
If dollar appreciates so yen/$ is 99, the yen price of the phone is 125*99
or
Y12,375
11
Depreciation
When the dollar depreciates it falls in value relative to the other country’s currency
• This means that it takes fewer foreign currency units to by one dollar
• Example: Yen/$ falls from from 96 to 93
When the dollar depreciates, the other currency appreciates
• This means that one unit of the foreign currency buys more dollar
• Example: $/Yen rises from $0.0104167 to $0.0107527
Effects of the dollar’s depreciation is the opposite from effects of appreciation
•Dollar price of imports rises
•Foreign unit price of US exports falls
12
Valuation Effects of Appreciation of the Dollar
Value of Foreign-Denominated Investment Abroad
Suppose that a US firm owns an office building in Tokyo valued at 1,152,000,000 yen
If the dollar exchange rate is 96, this investment is worth $12,000,000 to the US firm
Suppose that the $ appreciates so that the Y/$ rate is 99
The dollar value of the foreign investment is $11,636,364.
Result of the appreciation of the dollar: the dollar value of foreign-denominated US investments abroad declines as the dollar appreciates
13
Valuation Effects of Appreciation of the Dollar
Value of Foreign-Denominated Cash Flow From Abroad
Suppose that a US firm has a subsidiary located in Thailand
The Thai subsidiary is to send a dividend of 42,350,000 baht to the parent firm
• The parent firm must exchange the baht for dollar
• At a baht/dollar rate of 30, the dividend is worth $1,411,667
• If the dollar appreciates to 45 baht per dollar, the cash flow is worth $941,111.
Result of the appreciation of the dollar: the $ value of the repatriated foreign-denominated cash flows is reduced
14
Valuation Effects of Appreciation of the Dollar
Value of Dollar-Denominated (US) Investment to a Foreigner
Suppose that a Japanese firm owns a US Treasury bond valued at $10,000,000.
• If the dollar exchange rate is 96, this investment is worth 960,000,000 yen to the Japanese firm
• Suppose that the $ appreciates so that the Y/$ rate is 99
• The yen value of the US asset 990,000,000 yen
Result of the appreciation of the dollar: the value of $-denominated investments in US by foreigners rises as the dollar appreciates (as the foreign currency depreciates).
15
Valuation Effects of Appreciation of the Dollar
Value of Dollar-Denominated Cash Flow From US to Foreign Investor
Suppose that a Japanese firm has a subsidiary located in the US
• The US subsidiary is to send a dividend of $5,000,000 to the parent firm in Tokyo
• The parent firm must exchange the dollar for yen
• At a yen/$ of 96, the dividend is worth 480,000,000 yen
• If the dollar appreciates to 99 yen per dollar, the cash flow is worth 495,000,000 yen.
Result of the appreciation of the dollar: the foreign-currency value of the dollar-denominated cash flow increases
16
Valuation Effects of Depreciation of the Dollar
Opposite from appreciation
• Dollar price of imports rises
• Foreign currency price of US exports falls
• Dollar value of foreign-denominated investments abroad rises
• Dollar value of foreign-denominated cash flow increases
• Foreign value of $-denominated US investments held by foreigners falls
• Foreign value of $-denominated US cash flows to foreigners falls
17
The Arithmetic Of Appreciation and Depreciation
Results Depends on the Measurement Convention
Suppose• The euro/dollar rate is 0.90 and the dollar/euro rate is
1.1111
Next, suppose the dollar appreciates against the euro by 7.5%
• The new euro/dollar rate is 0.9675• The new dollar/euro rate is 1.033592
Based on $/euro convention the depreciation is 6.98
18
Influences on Exchange Values
Merchandise Trade Balance:• Difference between goods and services exported and imported• large deficits would
• Increase the supply of the domestic currency abroad• Increase the demand for the foreign currency to pay for the
growing volume of importsCapital Account
• If supply of a country’s securities held by foreigners increases, the demand for dollars increases to pay for those securities
Official Accounts• Changes reflect purchases/sales of current by central banks
These accounts are mirrors of each other and cancel each other out
19
Influences on Exchange Values
0 = Current Account Balance + Capital Account Balance +
Official Accounts Balance
Financial flows today dominate the determination of exchange rates
• Funds flow in response to expectations of financial gain
• As these funds shift, the exchange rate shifts
• The sheer size of financial flows and the churning in financial flows elevates the importance of capital flows in determining exchange rates
20
Historical Movements in Exchange RatesDollar Versus Currencies of Industrialized
Countries
German mark price of the dollar fell from 1975 through the end of 1979.
German mark price of the dollar rose from 1980 through late 1985. The dollar appreciated
Yen price of the dollar was more stable.
Between 1986 and 1988, the foreign unit price of the dollar fell, i.e., dollar depreciated, against both the mark and the yen
21
The Arithmetic of Cross Rates
Suppose that the euro/dollar is: 0.90
Suppose that the yen/dollar rate is: 120
The yen/euro rate is
(1/.90) x 120 = 1.3333
euro
yen
dollar
yen
euro
dollar
22
Changes in Nominal Exchange Rate
If the exchange rate is expressed in terms of foreign units per dollar, the percent change in the nominal exchange rate can be expressed as
If the exchange rate is expressed in terms of dollars per foreign units, the percent change in the nominal exchange rate can be expressed as
)inf(1
)inf(1))(%(1)(%1
d
frn e
efxchgfxchg
)inf(1
)inf(1))(%(1)(%1
f
drn e
efxchgfxchg
23
Changes in Nominal Exchange Rate(Continued)
When the exchange rate is expressed in terms of foreign currency units per dollar (e.g. yen /$ or euro/$):• If the calculated %chg in the nominal FX rate is positive: the
dollar appreciates• If the calculated %chg in the nominal FX rate is negative: the
dollar depreciates
When the exchange rate is expressed in terms of foreign currency units per dollar (e.g. yen /$ or euro/$):• If the calculated %chg in the nominal FX rate is positive: the
dollar depreciates• If the calculated %chg in the nominal FX rate is negative: the
dollar appreciates
24
Rationale
If domestic inflation is faster than foreign inflation,
• the nominal value of the exchange rate will fall by the difference between the inflation rates
WHY?
• Inflation is the rate at which a nation’s money losses value
• Movements in exchanges rates will reflect the relative change in the rate at which a country’s currency looses value compared with the rate at which other currency’s loose value
25
Implications of Different Inflation Rates Between Trading Partners
Suppose
• The pound/dollar rate is 0.606061.
• US inflation rate is expected to be 2.5%
• UK inflation rate is expected to be 3.5%
• no change in real rates is expected
Then:
% in nominal rate = ((1.00 x 1.035% / 1.025)-1)*100 = 0.97%
The dollar is expected to appreciate about 1% a year and the pound/dollar rate should rise from 0.606061 to 0.612122
Implications of Different Inflation Rates Between Trading Partners
Suppose
• The dollar/pound is 1.65
• US inflation rate is expected to be 2.5%
• UK inflation rate is expected to be 3.5%
• no change in real rates is expected
Then:
% in nominal rate = ((1.00 x 1.025% / 1.035)-1)*100 = - 0.97%
The dollar is expected to appreciate about 1% a year and the dollar/pound rate should fall from 1.65 to 1.6341
26
27
Dollar Depreciation
If expected US inflation is 5% and expected Euro currency area inflation is 3% over the next year, and the change in the real FX rate is 0, the dollar will depreciate by about 2%:
Expressed as /$
If the $/euro rate was 1.1500, the euro would depreciate and the dollar appreciate to 1.17233
Expressed as $/e
If the euro/$ rate was 0.8696, the euro would depreciate and the dollar appreciate to 0.8530
94.11.03
1.051.00)(%1 fxchg
905.11.05
1.031.00)(%1 fxchg
28
Interest Rates Also MatterHigher Real Rates Here
If real rates rise here compared with a foreign country, our currency becomes a more desirable currency
• International investors will sell the foreign currency and buy the dollar
• Demand for dollars increases and demand for foreign currency decreases
• Result: rise in the value of the dollar compared with the other currency i.e., the dollar will appreciate and the other currency will depreciate
• Real rate here will decline and real rate abroad will rise
29
Interest Rates Also Matter
If real US rates fall here compared with a foreign country, the foreign currency becomes a more desirable investment
• International investors will sell the dollar and buy the foreign currency
• Demand for dollars decreases and demand for foreign currency increases
• Result: fall in the value of the dollar compared with the other currency i.e., the dollar will appreciate and the other currency will appreciate
• Real rate here will rise and real rate abroad will drop
30
Implications of Different Real Interest Rates Between Trading Partners
Suppose that real rates are equal between the US and its foreign trading partners; next suppose that real US interest rates rise. This will lead to an appreciation of the dollar.
Why?• If real US rates are higher than foreign real interest rates, the
foreign currency is a more desirable investment• International investors will sell the foreign currency and buy
the dollar• This will increase the demand for dollars and decrease the
demand for the foreign currency. This will led to a rise in the value of the dollar compared with the other currency
31
Implications of Different Real Interest Rates Between Trading Partners
• The dollar will appreciate and the other currency will depreciate
• Process continues until the real interest rates are equalized between countries
32
Implications of Different Real Interest Rates Between Trading Partners
Suppose that real rates are equal between the US and its foreign trading partners; next suppose that real US interest rates fall. This will lead to a depreciation of the dollar.
Why?• If real US rates are lower than foreign real interest rates, the
foreign currency is a more desirable investment• International investors will sell the dollar and buy the foreign
currency• This will reduce the demand for dollars and increase the
demand for the foreign currency. This will led to a fall in the value of the dollar compared with the other currency
33
Implications of Different Real Interest Rates Between Trading Partners
• Process continues until the real interest rates are equalized between countries
• The dollar will depreciate and the foreign currency will appreciate
34
Models of Exchange Rate Determination
Interest Rate Parity
Covered Arbitrage
Purchasing Power Parity
International Fisher Effect
35
The Models
These models are mathematically identical
• BUT, their practical use differs:
Two are better suited for short-term horizons
• Interest rate parity
• Covered arbitrage
Two are better suited for long-term horizons
• Purchasing power parity
• International fisher effect
We will focus on covered arbitrage and the international Fisher effect
36
Suitability of Models to Different Horizons
Covered arbitrage
• Requires forward rates (next slide)
• BUT, forward rates are typically available only over short horizons. E.g. up to 180 days
• This limits practical use of the covered arbitrage model
International Fisher Effect and PPP Models
• Depends upon inflation expectations
• Some question as to whether inflation expectations are captured in short-term rates
37
Terms in the Covered Arbitrage Model
Spot exchange rate: Rate at which one nation’s currency can be exchanged for another. Currency is exchanged now.
Forward exchange rate: Rate at which one currency can be exchanged for another in agreements to exchange currencies at a specific future time.
• Most forward contracts have a maturity of less than two years
• Long-term forward contracts are not readily available and when obtainable have a large bid-ask spread
• Forward rates can be viewed as the markets forecast of the exchange rate that will prevail at the specified future time point
38
Forward and Spot Rates
The relation between the forward and spot rate shows the expected appreciation or depreciation of a currency
$/pound $/yen
Spot 1.5000 .01131
Fwd: 90 days 1.4850 0.8851% .01147 5.6587
Fwd 180 days 1.4775 1.07869% .01162 5.4819
If forward rates are higher than spot rates, the $ is expected to depreciate, i.e., markets expect it to take more dollars in the future to buy a unit of foreign currency
SPOT MARKET and Dealers
Dealers quote rates at which they are willing to buy foreign currency and one at which they are willing to sell a foreign currency
This is the bid-ask spread
Both bid and asked quotations are provided in the financial press
Dealers in the foreign exchange market are large international banks and other financial institutions that specialize in making markets in foreign exchange
Large international banks dominate the market
There is no organized exchange where foreign currency is traded
Instead, dealers are linked by telephone and by various information transfer services
Consequently, the foreign exchange market can best be described as an inter-bank OTC market
3939
40
Covered Arbitrage
Based on relationship between
• domestic interest rate
• rate on foreign instrument of comparable risk
• the spot exchange rate
• the forward exchange rate
Arbitrage assured that the relationship eliminates arbitrage profits
41
Covered Arbitrage
Ratio of the rate on the domestic instrument to the foreign instrument
is equal to
the ratio of the forward rate to the spot rate
Model recognizes the importance of the forward rate in determining the interest rate differential between financial instruments in two countries
42
Covered Arbitrage
Where Ft is the forward rate in period t for the spot rate today (period 0)• F and S are expressed in terms of foreign currency/$• E.g. the pound/rate is 0.671141, it means each dollar
commands 0.671141 pounds
If Ft < So, $ is expected to depreciate between today and period t
t
$
1
1
F
S
r
r o
f
43
Covered Arbitrage
Arbitrage look to the relationship between the domestic interest rate and the exchange rate adjusted foreign rate
t$ )1(1
F
Srr o
f
44
Covered Arbitrage
Suppose:
Here, the domestic rate is less than the exchange rate adjusted foreign rate. So, it would pay to either• sell the domestic asset and buy the foreign asset, if the
domestic asset is ownedor
• borrow dollars and invest in the foreign instrument and repay the dollar loan when the foreign instrument matures
t$ )(1 1
F
Srr o
f
45
Covered Arbitrage
Market pressure released by this process will
• raise US interest rate and lower the foreign rate
and/or
• lead to depreciation of spot $ exchange rate with no change in forward rate
and/or
• lead to appreciation in the forward rate
Process continues until there is no profit opportunity
46
Covered Arbitrage
Suppose:
Opposite occurs if the return on the dollar instrument exceeds the exchange rate adjusted return on the foreign investment• if the foreign instrument is owned, sell the foreign
instrument and buy dollars; use the dollar to buy the dollar instrument, or
• borrow the foreign currency and and invest in dollar instruments and repay the foreign loan when the dollar instrument matures
t
0$ )(1 1
F
Srr f
47
Implication
Arbitrage come from selling (or borrowing) in one market and investing in another market
• Process continues until there is no profit opportunity in moving between currencies
Effect: a FX hedged foreign investment and a domestic investment have comparable yield for the same level of risk
• Any difference between domestic yield and FX hedged foreign yield reflects risk
48
An Example
You are given the following eurocurrency rates
3-month sterling: 6.5%
(1.625% for 3 months)
3-month eurodollars: 3.5%
(0.875% for 3 months)
Pound/dollar exchange rates
spot: 0.664231
90 day forward: 0.668583
Exchange rate adjusted sterling rate
1.01625 x (0664231/0668583)
=
1.009635
or .9635% for 3 months
or 3.8539% annual rate
Decision:
•The sterling investment is preferable
RevisedRevised
49
Action
Action: If the US investment is owned, sell the US instrument, buy the foreign currency, and use the foreign currency to buy the foreign asset.
or
Borrow the foreign currency , and buy the foreign asset, and repay the foreign loan when the foreign instrument matures
Covered: Simultaneously with the investment in the pound instrument, sell the pound principal plus pound interest for dollar in the forward market for delivery in 90 bays
50
International Transmissions
Changes in monetary policy can be transmitted among industrialized countries through the covered arbitrage model• Suppose that the Federal Reserve changes its target for
the Federal Funds rate, raising it by 50 basis points from 5.5% to 6.0%
• All other short-term rates will likely also increase by roughly 50 bp
• Next suppose that other central banks do not follow the Federal Reserve action; I.e., they continue to peg their short-term domestic rates at a given level
51
International TransmissionsContinued
In this situation, there is a disruption n the equilibrium relationship between domestic short-term rates and the FX adjusted foreign rate
• Since the domestic rate is now higher, there would likely be an appreciation of the spot rate sufficient to restore the equilibrium relationship
t$ )(1 1
F
Srr o
f
52
International TransmissionsContinued
Alternatively, suppose that the German central bank cuts its short-term target rate
• Other short-term German rates will likely follow
• Result: The US domestic rate is higher than the FX adjusted foreign rate
• If the Federal Reserve matches the German policy shift, the equilibrium would be restored
• If the Federal Reserve does not match the German move, the spot exchange rate would appreciate
Finding the Theoretical Forward Rate
The spot exchange rate and the interest rates in two countries determine the forward exchange rate of their currencies
The relationship among the spot exchange rate, the interest rates in two countries, and the forward rate is called interest rate parity
Forward rates are determined by covered interest arbitrage
Solve for the forward rate, given the spot rate and the domestic and foreign interest rate in the covered arbitrage equation
Theoretical parity is rarely attained, since it is based on several assumptions
There are no transactions costs for executing an arbitrage strategy
Investors can borrow and lend at the same rate
There are no tax differences between different economies
There are no barriers to capital mobility between economies
53
t
$
1
1
F
S
r
r o
f
54
The International Fisher Effect
Domestic Fisher Effect
1 + rn = (1 + rr) x (1 + e(inf))
In the International Fisher Effect, the same must hold between countries
• 1 + rn$ = (1 + rr$) x [1 + e(inf$)]
and
• 1 + rnf = (1 + rrf) x [1 + e(inff)]
55
International Fisher Effect
On the assumption that real real rates are the same in both countries:
)(inf1)(inf1
11
ff ee
rr
$$
)(1
)(1 $$
ff e
err
infinf
)1(1
and
56
International Fisher Effect
If the domestic interest rate is less than the relative inflation adjusted foreign rate,
• It would pay to sell the domestic asset (if owned) and buy the foreign asset
• Process will continue, raising the domestic rate and lowering the foreign interest rate until the equality is restored
Why?
• Because at the original levels of interest rates, there was inadequate compensation (compared with the inflation adjusted foreign rate) for holding the domestic instrument
57
International Fisher Effect and Exchange Rates
In the previous example, to invest in the foreign asset, dollars must be sold and the foreign currency purchased
• This will put downward pressure on the dollar
• It will loose value relative to the foreign currency
• That is, it will depreciate as part of the process of restoring equilibrium
Even after equilibrium between the domestic rate and the inflation adjusted foreign rate is achieved, there will be a continuous effect upon exchange rates, if there is a difference in expected inflation rates
The domestic currency is expected to depreciate at a rate equal to the ratio of the inflation rates which is approximately equal to the difference between the inflation rates
In terms of movements in the spot rate, recall from an earlier slide that the % change in the nominal spot rate is equal to the % change in the real exchange rate plus the foreign inflation rate minus the domestic inflation rate
An Example
You are given the following information:
10-year Canadian bond 6.69%
10-year US bond 6.38%
Expected US inflation 2.5%
Expected Canadian inflation ?
Based on the international fisher effect, what is the expected rate of inflation in Canada?
58
)(inf1025.1
0669.10638.1fe
1 + E(inff) = 1.0298
IF markets are in equilibrium, expected Canada inflation 3%, given the expected US inflation
59
International Transmission
If expected US inflation rises compared with Canadian inflation,
• The equilibrium would be disturbed
• Funds would flow from US to foreign countries
• Effect:• US long-term rates would rise
• and/or Canadian long-term rates would fall
• The dollar would depreciate
• Effect would be to restrain growth here relative to foreign growth
60
International Fisher Effect and Covered Arbitrage
t
$$
)inf(1
)inf(1
1
1
F
S
e
e
r
r o
ff
Recall that the ratio of interest rates is equal to the ratio of the forward rate to the spot rate
This is the same as the ratio of the expected future spot rate to the spot rate
Hence, the various models can be joined together
61
Exchange Rate Changes and International Investments
Changes in the a country’s exchange will affect investment values in both countries
The dollar value of US investments in the Pacific rim countries plunged during the latter part of 1997 as a result of their currencies’ depreciation (appreciation of the dollar)
The local currency value of investments by Pacific rim countries in the US has increased as a result of the dollar’s appreciation
The were additional costs and benefits as a result of the crisis pacific rim crisis
• For US investors, the local currency value of their investment declined
• E.g., stocks on the Japanese exchanges declined in terms of yen and the dollar appreciated versus the yen
• For the pacific rim investor, the dollar price US financial assets generally rose since the crisis onset
• E.g., US bonds rose as a result of the decline in bond yields
• As a result, the yen value of bonds rose because the dollar price rose and the yen depreciated
62
International Risks
The local currency price of an asset may change
• The local currency price may change due to a change in the market’s assessment of any of the general and instrument specific risks
• The local currency is the currency in which the asset is denominated
• US stock values may rise in dollar term
• British stock may rise in terms of pounds
• The value of an office building in Kuala Lumpur may change
The foreign exchange rate may change
International investors are concerned with the home currency return on an international investment
The home currency is the country in which the investor is domiciled
The home currency value of a foreign investment can change due to
• A change in the foreign currency (the local currency) value
• A change in the exchange rate between the home currency and the local currency
The Current Account
The Current Account -- (Export – Import) of goods, services, and military transactions.
Goods • Trade goods
Services • Interest & Dividend Income• Tourism Revenue / Expenses• Financial charges paid & received• Transportation expenses
Unilateral Transfers• Remittance - made / received• Foreign Aid received / given• Pensions
The Capital Account• Measures capital flows. • the difference between the wealth invested
by the public and government in other countries and the wealth invested by foreigners in the home country.
Short-term Investments < 1 Year MaturityPortfolio Investment Purchase of financial
assets with maturity > 1 YearDirect Investment (DFI – Direct Foreign
Investment) Purchase or investment in financial assets/firm that allows for management control or out of a country.
Surpluses (deficits) in the capital accounts offset deficits (surpluses) in the current account.
Pressure on exchange rates from the current account is reversed with capital account flows.
63
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