Reasons for buying and selling foreign currencies: payment of profit, interest and dividends between countries

International Trade and Globalisation – Foreign‑Exchange Rates

Learning Objective

Explain why individuals, firms and governments buy or sell foreign currencies – especially for the payment of profits, interest and dividends across borders – and relate these transactions to short‑run exchange‑rate movements.

Key Terminology

• Foreign‑exchange (FX) market: The worldwide over‑the‑counter market where currencies are bought and sold.
• Exchange rate: The price of one currency expressed in terms of another (e.g. \$ / £ = 1.30 means £1 = \$1.30).
• Current account: The part of the balance of payments that records trade in goods and services, investment income (profits, interest, dividends) and unilateral transfers.

1. Definition of a Foreign‑Exchange Rate

An exchange rate is the amount of foreign currency that can be obtained for one unit of the home currency (or vice‑versa). It may be quoted as:

• Direct quote – home currency per unit of foreign currency (e.g. £/$ = 0.77).
• Indirect quote – foreign currency per unit of home currency (e.g. $/£ = 1.30).

2. Why Economic Agents Need Foreign Currency

The Cambridge 0455 syllabus lists eight principal reasons. The first three are the focus of this topic; the others are included for completeness.

3. Exchange‑Rate Regimes

• Floating (flexible) rate: Determined entirely by market supply and demand. Appreciation = rise in value; depreciation = fall in value.

  • Advantages: automatic adjustment to shocks; no need for large reserves.
  • Disadvantages: can be volatile; may create uncertainty for traders.

• Fixed (or pegged) rate: Government or central bank sets a target rate and intervenes to keep the market close to that level.

  • Advantages: exchange‑rate stability; encourages trade and investment.
  • Disadvantages: requires large foreign‑exchange reserves; loss of independent monetary policy.

• Managed float (dirty float): Officially floating, but the central bank occasionally intervenes to smooth excessive volatility.

  • Advantages: combines stability with some flexibility.
  • Disadvantages: intervention can be costly and may send mixed signals to markets.

4. Determination of the Exchange Rate – Demand & Supply

The FX market can be represented by a simple demand‑supply diagram.

Key drivers of shifts (short‑run):

• Export demand ↑ → higher foreign‑currency supply → home currency depreciates.
• Import demand ↑ → higher foreign‑currency demand → home currency appreciates.
• Higher foreign interest rates (interest‑rate parity) → capital flows into that country → demand for its currency rises.
• Speculative expectations of future appreciation/depreciation shift demand accordingly.
• Profit, interest and dividend payments (the three main reasons) generate the same supply‑demand effects as listed in the table above.

5. Drivers of Short‑Run Exchange‑Rate Fluctuations (Cambridge Syllabus 6.3)

• Changes in the volume of exports and imports.
• Interest‑rate differentials and the expectations of future rates (interest‑rate parity).
• Capital‑flow movements for profit, interest or dividend payments.
• Speculative activity and market sentiment.
• Central‑bank interventions (buying or selling reserves to offset excessive moves).

6. Consequences of Exchange‑Rate Movements

• Export competitiveness: Depreciation makes a country’s goods cheaper abroad, boosting export volume; appreciation has the opposite effect.
• Import prices: Appreciation lowers the domestic price of imported goods, helping consumers but potentially hurting domestic producers.
• Investment income: When the home currency appreciates, the value of foreign‑earned profits, interest and dividends falls when converted back home, and vice‑versa.
• Inflation: A weaker currency can import inflation by raising the cost of imported inputs.
• Balance‑of‑payments: Persistent large outflows (e.g., continual profit repatriation) can lead to a current‑account deficit, prompting policy responses.

7. Illustrative Example – Profit Repatriation

BritCo (UK parent) has a US subsidiary that earns \$10 million in profit. The spot rate is \$/£ = 1.30.

\[

\text{Pounds needed} = \frac{\$10\,\text{million}}{1.30} \approx £7.69\,\text{million}

\]

BritCo sells \$10 million for £7.69 million. This creates a large demand for pounds, putting upward pressure on the £/\$. If the market expects further repatriations, the pound may appreciate.

8. Illustrative Example – Interest Payment

A Japanese corporation borrows €5 million at a 2 % annual rate. At the time of the loan the €/¥ rate is 130.

\[

\text{Yen required for interest} = €5\,\text{million} \times 0.02 \times 130 = ¥13\,\text{million}

\]

The corporation must obtain yen, increasing demand for yen and putting upward pressure on its value relative to the euro.

9. Illustrative Example – Dividend Payment

EuroCo (Germany) has 30 % of its shares owned by US investors. It declares a €2 million dividend. The current €/$ rate is 1.10.

\[

\text{US dollars needed} = \frac{€2\,\text{million}}{1.10} \approx \$1.82\,\text{million}

\]

EuroCo sells €2 million for \$1.82 million, creating demand for euros and putting upward pressure on the €/\$ rate (euro appreciation).

10. Summary Checklist for Exam Questions

• Identify the economic agent (firm, government, investor) and the type of transaction (profit, interest, dividend, export, import, etc.).
• State the direction of the currency flow (home → foreign or foreign → home).
• Explain whether the transaction increases demand or supply** of the home or foreign currency in the FX market.
• Predict the short‑run movement of the exchange rate (appreciation or depreciation) and give a brief rationale.
• Consider any mitigating actions (central‑bank intervention, hedging, forward contracts) that could offset the predicted move.

11. Suggested Diagram – Flow of Foreign Currency for the Three Main Reasons