Glossary

Absorption approach to the balance of trade A theory based on domestic spending for domestic goods (absorption) relative to domestic output.

Adjustable peg A system of fixed exchange rates, with periodic devaluations allowed when conditions warrant.

Adjusted present value The value today of future cash flows from operations plus related financial effects.

Adjustment mechanism The method by which the international economy reacts to remove a disequilibrium.

Airbill A bill of lading for goods shipped by air.

American depositary receipts (ADRs) Negotiable instruments certifying shares of a foreign stock held by a foreign custodian.

Arbitrage Buying in a market where the price is low and then selling in a market with a higher price.

Arm’s-length pricing Prices that an unrelated buyer and seller would willingly pay.

Asymmetric information Causes exchange rates to change due to traders’ fear that they are quoting prices to someone who knows more about current market conditions than they do.

Autocorrelation The errors from a regression equation are related over time.

Balance of payments A balance sheet recording a nation’s international transactions.

Balance of payments equilibrium When credits equal debits on some sub-account of the balance of payments.

Balance of trade Merchandise exports minus merchandise imports.

Bankers’ acceptance A time draft drawn on and accepted by a particular bank, to be paid at maturity.

Bank notes Actual paper currency.

Base money Currency plus commercial bank reserves held against deposits.

Basel rules Rules set by the Bank for International Settlements (BIS) to ensure banks have sufficient backing of their liabilities.

Basic balance The sum of the balances on the merchandise, services, unilateral transfers, and long-term capital accounts.

Basis point One-hundredth of a percent, or 0.0001.

Basket pegger A country that maintains a fixed exchange rate with a composite or weighted average of foreign currencies rather than against a single foreign currency.

Beta A measure of the portfolio risk associated with an individual asset.

Big Mac index An index produced by The Economist measuring the exchange rate adjusted cost of a good across countries.

Bill of lading Agreement issued by a shipping company to carry goods to a destination port.

Bimetallism Two metals, like gold and silver, serving as backing for the money supply.

Black market An illegal market in foreign exchange.

Bretton Woods agreement An adjustable peg agreement with the U.S. dollar as the anchor currency.

Broker An intermediary in the foreign exchange market.

Call option The right to buy currency at a stated price on or before a future date.

Capital account That part of the balance of payments that records trade in financial assets.

Capital budgeting Evaluating prospective investment alternatives in order to fund preferred Projects.

Capital controls Restrictions on international capital flows, like taxes or quotas.

Capital flight Large investment outflows associated with increased risk in a country.

Capital flow Funds that cross a geographic border.

Central bank The official bank of a government. For example, the Federal Reserve in the United States.

Chartists Forecasters who use the past history of exchange rates to predict future movements.

Closed economy An economy with little or no economic activity involving the rest of the world.

Commodity money standard Money has a fixed value relative to some commodity.

Comparative advantage A determinant of the pattern of world trade in terms of which country exports which goods.

Compensating balances Bank deposits that must be held as a form of compensation to the bank.

Country risk analysis An evaluation of the potential for default or rescheduling on loans made to a particular country.

Covariance A measure of the degree to which two variables move together.

Covered interest arbitrage Buying or selling assets internationally and using the forward market to eliminate exchange risk in order to take advantage of return differentials.

Crawling peg A system in which the exchange rate is held fixed in the short run but is adjusted at regular intervals to reflect supply and demand pressures.

Credit default swap A contract that ensures that a payment will be made on loan.

Cross rate The implied third exchange rate, given two exchange rates involving three currencies.

Currency board A government institution that exchanges domestic currency for foreign currency at a fixed rate of exchange.

Currency contract period The period immediately following a devaluation when contracts negotiated prior to the devaluation come due.

Currency swap Where two counterparties exchange streams of interest payments in different currencies for an agreed period of time and exchange principal amounts in the respective currencies at an agreed exchange rate at maturity.

Currency union A region within which exchange rates are fixed.

Current account In the balance of payments the sum of the merchandise, services, and unilateral transfers accounts.

Debt-equity swaps An exchange of debt for the debtor’s domestic currency, which is then used to buy equity positions in the debtor country.

Deep market A market with a large number of buyers and sellers, and assets traded, so that trading occurs at all times.

Depreciation A decrease in a currency’s value.

Destabilizing speculation Speculation causing exchange rates to fluctuate more than they would in the absence of such speculation.

Direct foreign investment Expenditures related to the establishment of foreign operating units, where the investment exceeds 10% ownership of the company.

Discount The forward pricing of a currency at less than the spot price.

Discount rate Rate of interest used to determine present value of future cash flow.

Diversified portfolio A mix of investments that lowers an investor’s risk.

Dock receipt A document issued by a shipping company listing the quantity and quality of the goods delivered to the dock.

Dollarization Occurs when a country unilaterally adopts another country’s currency in place of its own currency.

Domestic credit The domestic component of base money.

Durable goods Goods with useful lives of more than one year.

Economic exposure The exposure of the value of the firm to changes in exchange rates.

Effective return The foreign interest rate of a foreign investment plus the forward premium or discount.

Efficient market A market in which prices reflect all available information.

Elasticities approach to the balance of trade An analysis that addresses the conditions necessary for a devaluation to improve the trade balance.

Elasticity The responsiveness of quantity to changes in price.

Endogenous Determined by factors within a model.

Equation of exchange An equation stating that the money supply times the velocity of money is equal to the price level times the quantity of transactions.

Equilibrium approach An approach that says that changes in exchange rates are largely due to changing tastes or technology.

Eurobank A bank that accepts deposits and makes loans in foreign currencies.

Eurobond market The market engaging in direct offshore borrowing and lending through the sale of bonds denominated in one currency yet sold in many countries.

Eurocurrency market The offshore banking market where commercial banks accept deposits and make loans in foreign currencies.

European Central Bank The central bank that oversees the monetary policy of all countries included in the euro system.

European currency unit (ECU) A unit that preceded the euro, but was never issued in tangible form. An average of the values of EMS currencies.

European Monetary System (EMS) A monetary system within which exchange rates were fixed, since the countries involved floated jointly against the rest of the world.

Exchange rate The price of one nation’s currency in terms of another nation’s currency.

Exchange rate index A measure of the weighted average value of a currency.

Exchange risk The risk arising from uncertainty regarding future exchange rates.

Exogenous Determined by factors given to a model, outside of or independent of other variables in the model.

External balance A desired trade balance or desired international capital flows.

Factors Firms that buy accounts receivable and assume responsibility for collection.

Fisher effect The expected effect of inflation on the nominal interest rate.

Fisher equation An equation stating that the nominal interest rate is equal to the real rate plus expected inflation.

Fixed exchange rates When central banks set exchange rates at particular levels.

Flexible exchange rates Free market supply and demand determine the exchange rate.

Foreign exchange Bank deposits and currency denominated in foreign monetary units.

Foreign exchange market A market mostly comprising large commercial banks buying and selling foreign exchange from and to each other.

Foreign exchange swap The simultaneous exchange of two currencies on a specific date at a rate agreed at the time of the contract and a reverse exchange of the same two currencies at a date further in the future at a rate agreed at the time of contracting.

Forward discount A forward rate at less than the spot rate.

Forward exchange market A market for trading currencies among banks where delivery occurs at a future date.

Forward exchange rate The price of a currency to be delivered sometime in the future.

Forward premium A forward rate in excess of the spot rate.

Fundamental model Forecasts exchange rates based on variables that are believed to be important determinants of exchange rates.

Futures Contracts to buy and sell currency for future delivery that are traded on organized exchanges.

Gold exchange standard A standard whereby a currency is valued in terms of a gold equivalent and every other currency is to maintain fixed exchange rates against that currency.

Gold standard Currencies maintain a fixed price relative to gold.

Great recession The sharp slowdown in the end of 2007, following the financial crisis in the U.S.

Gresham’s law A law stating that cheap money drives out good money.

Hedging Taking a position to reduce risk.

IBFs International banking facilities—units of banks located in the United States that conduct Eurocurrency business.

IMF conditionality Economic adjustments imposed on a country by the IMF (International Monetary Fund) before loans will be made.

Inflation-adjusted exchange rate The exchange rate minus the inflation differential between two countries.

Interest rate parity The equivalence of the interest differential between two currencies to the forward premium or discount.

Internal balance Domestic economic growth consistent with a low unemployment rate.

International Monetary Fund (IMF) An international organization that provides loans to countries experiencing balance of payments problems.

International reserves The international component of base money, primarily foreign exchange.

Intervention The buying and selling of currencies by central banks to affect the exchange rate.

Inventory control Effect on exchange rates when traders alter quotes to maintain a balance between amount of currency bought and sold.

J-curve effect Following a devaluation, an initial decrease in the trade balance followed by an increase.

Law of one price A law stating that all goods sell for the same price worldwide when converted to a common currency.

Letter of credit A letter issued by a bank that obligates the bank to pay a specific amount of money to an exporter.

LIBOR London interbank offer rate—the interest rate that banks charge each other for short-term loans.

Liquid assets Assets that can easily be spent, like cash or checking account money.

Long position Buying a currency to be delivered in the future.

Managed float The floating of exchange rates with central bank intervention.

Margin Money deposited with a broker to finance futures trading.

Marginal propensity to import The change in imports given a change in income.

Marshall-Lerner condition The necessary international demand elasticities that will ensure an improvement in the trade balance following a devaluation.

Monetary approach to the balance of payments (MABP); monetary approach to the exchange rate (MAER) An analysis emphasizing money demand and money supply as determinants of the balance of payments under fixed exchange rates and of the exchange rate under floating rates.

Money multiplier The ratio of the money supply to base money.

Moral hazard An inducement to greater risk taking that occurs when the decision maker does not expect to bear the full cost of bad decisions.

Mortgage-backed security (MBS) A securitized instrument grouping a number of mortgages into a financial instrument that can be resold.

Multinational firm A business firm operating in more than one country.

Mundell-Fleming model A model of an economy with flexible exchange rates and perfect capital mobility.

Netting Consolidating payables and receivables in a currency so that only the difference must be bought or sold.

Nominal interest rate The interest rate actually observed in the market.

Nonsystematic risk Risk unique to an individual asset, which can be diversified away.

Official settlements balance The balance of payments account measuring the change in short-term capital held by foreign monetary authorities and official reserve asset transactions.

Offshore banking Accepting deposits and making loans in foreign currency—the Eurocurrency market.

Open economy An economy actively involved in international trade.

Opportunity cost The next-best alternative when undertaking some activity.

Optimum currency area The area that maximizes the economic gains of having exchange rates that are fixed among currencies in the area and flexible rates with other areas.

Options Contracts that give the right to buy or sell a certain amount of currency at a stated price on or before a future date.

Overshooting model A foreign exchange rate model that allows the exchange rate to overadjust by having prices staying fixed in the short run whereas capital markets are flexible.

Parallel market A free foreign exchange market that exists as an alternative to a regulated official market.

Paris Club An arrangement whereby creditor governments meet with debtor nations in Paris to restructure debts.

Pass-through The effects of a devaluation on prices—the devaluing country sees its import prices rise while export prices to foreign buyers fall.

Percent per annum The percentage return on a 12-month basis.

Perfect capital mobility The free flow of capital between nations because there are no significant transactions costs or capital controls.

Petrodollars Dollars earned by the export of oil, generally the earnings of the Organization of Petroleum Exporting Countries (OPEC).

Portfolio-balance approach A theory of exchange rate determination that considers relative supply and demand for bonds.

Premium The forward pricing of a currency at more than the spot price.

Present value The value today of some amount to be received in the future.

Pricing to market Adjusting domestic currency prices in response to exchange rate changes in order to maintain market share.

Purchasing power parity Absolute: the equivalence of the exchange rate to the ratio of the foreign and domestic price levels. Relative: the equivalence of the percentage change in the exchange rate to the inflation differential between two nations.

Put option The right to sell currency at a stated price on or before a future date.

Real exchange rate The nominal exchange rate for two currencies divided by the ratio of their price levels.

Real interest rate The nominal interest rate minus the rate of inflation.

Regression analysis A statistical technique for estimating the relationship between a dependent variable and one or more independent variables.

Relative price The price of one good relative to the price of another good.

Risk aversion The degree to which people wish to avoid risk.

Risk lover or risk preferrer An economics agent who enjoys risk.

Risk premium The difference between the forward exchange rate and the expected future spot rate.

Rogue trader A trader who does not follow the rules and regulations set up by the company.

Seigniorage The difference between the cost of issuing money and the real resources acquired by the money issuer.

Short position Selling a currency forward for future delivery.

Smithsonian agreement A December 1971 proclamation that the dollar was officially devalued and that currencies would now be allowed to fluctuate within ±2.25 percent of the new parity values.

Special drawing right (SDR) An international reserve asset created by the IMF.

Specie-flow mechanism A model showing that specie, e.g. gold, flows to create an equilibrium in the balance of payments.

Spot exchange rate The price of a currency for current delivery.

Spot market Buying and selling currency for immediate delivery.

Spread The difference between the buying and selling price of a currency or the differential between the interest rate on loans and deposits.

Stable-valued money A currency with a stable and low inflation rate.

Statistical significance A concept that allows one to relate estimated values to a hypothesized true value.

Sterilization The offsetting of international reserve flows with domestic credit.

Sterilized intervention Using open-market operations to offset the effect of intervention on the domestic money supply.

Strike price The price at which currency may be bought or sold in an option contract.

Swap The trade of one currency for another currency, combining a spot and forward transaction (or two forwards) in one deal.

Systematic risk The risk common to all assets.

Technical trading model Uses the past history of exchange rates to predict future movements.

Term structure of interest rates The return on an asset over different maturity dates.

Thin market A market with a small number of buyers and sellers, and assets traded.

Tiered exchange rates Different exchange rates applied to different classes of transactions.

Trade flow model An exchange rate model based on trade flows.

Transaction costs The costs associated with buying and selling activity.

Transaction exposure The foreign exchange risk associated with a particular transaction to be completed sometime in the future.

Transfer price The price charged to a subsidiary for internal goods transfers.

Translation The conversion of monetary values from one currency to another.

Translation exposure The difference between a firm’s foreign-currency-denominated assets and its foreign-currency-denominated liabilities.

Triangular arbitrage Infer cross rate from two currencies to compare with another, then buying where price is low and selling where price is high.

Unbiased The property of being correct on average.

Unilateral transfers A current account entry that represents one-sided transactions such as gifts, pensions, foreign aid.

Variance A measure of how a variable changes in value about its mean.