1.10 International Economics

Financial markets are global. Understanding exchange rates, trade balances, and how U.S. investors access foreign markets is increasingly important - and tested on the SIE exam.

Why International Economics Matters

Exchange rates: Affect corporate profits, import/export costs

Global growth: Many U.S. companies earn revenue abroad

Foreign investment: Capital flows affect U.S. asset prices

Trade policy: Tariffs and agreements impact businesses

Exchange Rates

An exchange rate is the price of one currency expressed in terms of another.

Example

If USD/EUR = 1.10:

- $1.10 USD buys 1.00 EUR

- A stronger dollar means more euros per dollar

- A weaker dollar means fewer euros per dollar

Types of Exchange Rate Systems

Floating: Market forces determine rates (most major currencies)

Fixed/Pegged: Government maintains rate against another currency

Managed Float: Primarily market-driven with occasional intervention

Strong Dollar vs. Weak Dollar

Exchange rate movements create winners and losers:

Strong Dollar Effects

Who Benefits: U.S. importers; U.S. tourists abroad; Buyers of foreign goods

Who Suffers: U.S. exporters; Foreign tourists in U.S.; U.S. manufacturers

Weak Dollar Effects

Who Benefits: U.S. exporters; Foreign tourists in U.S.; U.S. manufacturers

Who Suffers: U.S. importers; U.S. tourists abroad; Buyers of foreign goods

Investment Impact

- Strong dollar: U.S. investors' foreign holdings worth less in dollar terms

- Weak dollar: U.S. investors' foreign holdings worth more in dollar terms

Balance of Trade

The balance of trade measures the difference between a country's exports and imports.

Trade Surplus: Exports greater than Imports (positive balance)

Trade Deficit: Imports greater than Exports (negative balance)

U.S. Trade Position

The U.S. typically runs a trade deficit - importing more than it exports. This affects:

- Dollar value (demand for dollars from foreigners)

- Employment in certain industries

- Political discussions about trade policy

Balance of Payments

The balance of payments is a broader measure that includes:

Current Account

- Trade in goods and services

- Income from investments abroad

- Transfers (foreign aid, remittances)

Capital Account

- Foreign direct investment (building factories, buying businesses)

- Portfolio investment (stocks, bonds)

- Central bank reserves

When one account has a deficit, the other typically has a surplus.

Investing in Foreign Securities

U.S. investors can access foreign markets through several methods:

American Depositary Receipts (ADRs)

ADRs are U.S. securities representing shares of foreign companies.

What they are: Certificates issued by U.S. banks

Where they trade: U.S. exchanges (NYSE, NASDAQ) or OTC

Currency: Priced and pay dividends in U.S. dollars

Convenience: No need for foreign brokerage account

ADR Levels

Level I: OTC only; Minimal requirements

Level II: NYSE/NASDAQ; Full SEC registration

Level III: NYSE/NASDAQ; Can raise capital in U.S.

Sponsored vs. Unsponsored ADRs

Sponsored: Foreign company participates, provides information

Unsponsored: Bank creates without company involvement

Currency Risk

Currency risk (or exchange rate risk) is the risk that exchange rate movements will affect investment returns.

Example

You invest $10,000 in a European stock fund:

1. Stock rises 10% in euro terms

2. But the euro falls 15% against the dollar

3. Your dollar return is negative despite stock gains

Managing Currency Risk

- Currency hedging - Using derivatives to offset currency movements

- Diversification - Spreading across multiple currencies

- Dollar-denominated investments - ADRs or U.S. companies with foreign exposure

Global Economic Indicators

International factors that affect U.S. markets:

Foreign GDP growth: Demand for U.S. exports

Central bank policies: Interest rate differentials

Political stability: Risk assessment, capital flows

Trade agreements: Market access, tariffs

Emerging Markets

Emerging markets are developing economies with faster growth potential but higher risk:

Characteristics

- Higher growth rates than developed markets

- Greater volatility

- Political and regulatory uncertainty

- Currency instability

- Less liquid markets

Examples

- China, India, Brazil, Mexico, South Africa

- "BRICS" nations (Brazil, Russia, India, China, South Africa)

Risk Considerations

Political risk: Government instability, policy changes

Currency risk: More volatile exchange rates

Liquidity risk: Harder to buy/sell

Regulatory risk: Less investor protection

Trade Policy

Government trade policies affect markets:

Key Terms

Tariff: Tax on imported goods

Quota: Limit on quantity of imports

Embargo: Complete ban on trade with a country

Free Trade Agreement: Reduces/eliminates trade barriers between countries

Market Impact

- Tariffs raise costs for importers and consumers

- Trade tensions create market uncertainty

- Free trade agreements can open new markets

Global Interconnectedness

Today's markets are highly connected:

- 24-hour trading - As one market closes, another opens

- Contagion risk - Problems in one market spread to others

- Supply chains - Disruptions anywhere affect companies globally

- Interest rate differentials - Capital flows to higher-yielding markets

Key Takeaways

- Exchange rates affect corporate profits, trade, and investment returns

- A strong dollar benefits importers but hurts exporters; a weak dollar does the opposite

- ADRs allow U.S. investors to buy foreign stocks on U.S. exchanges

- Currency risk can significantly impact international investment returns

- Emerging markets offer growth potential but carry higher risk

- Trade policy (tariffs, agreements) impacts corporate costs and market access

- Global markets are highly interconnected - events abroad affect U.S. markets