FOREIGN EXCHANGE AND FOREIGN EXCHANGE AND INTERNATIONAL INTERNATIONAL FINANCIAL MARKETSFINANCIAL MARKETS

8-2

Foreign Exchange

Foreign exchange is a commodity that consists of currencies issued by

countries other than one’s own.

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Figure 8.1 Demand for Yen

Demand for Japanese Yen is Derived from Foreigner’s Demand for Japanese Products

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Figure 8.2 Supply of Yen

Supply for Japanese Yen is Derived from Japanese Demand for Foreign Products

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Figure 8.3 The Market for Yen

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Foreign-Exchange Rates

• Direct exchange rate

– Direct quote

– Price of the foreign currency in terms of home currency

• Indirect exchange rate

– Indirect quote

– Price of the home country in terms of the foreign currency

8-7

The Role of Banks

• Commercial Customers

• Speculators

• Arbitrageurs

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Bank Foreign Exchange Clients

Commercial customers

Speculators

Arbitrageurs

8-9

Spot and Forward Markets

Currency U.S. $ Equivalent

per U.S. $

Wed. Tues. Wed. Tues.

Britain (Pound) 1.8765 1.8762 .5329 .5330

30-Day Forward 1.8778 1.8775 .5325 .5326

90-Day Forward 1.8802 1.8798 .5319 .5320

180-Day Forward 1.8832 1.8829 .5310 .5311

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Mechanisms for Future Foreign Exchanges

• Currency future

• Currency option

– Call option

– Put option

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Arbitrage

Arbitrage is the riskless purchase of a product in one market for

immediate resale in a second market in order to profit from a price

discrepancy. There are two types of arbitrage activities that affect the

foreign-exchange market: arbitrage of goods and arbitrage of money.

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Arbitrage

Arbitrage of Goods

Arbitrage of Money

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Arbitrage of Money

Two-point

Covered-interestThree-point

8-14

Establishment of Overseas Banking Operations

Subsidiary bank

Affiliated bankBranch bank

8-15

The International Bond Market

• Major source of debt financing for

– World’s governments

– International organizations

– Larger firms

• Two types of bonds

– Foreign bonds

– Eurobonds

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Global Equity Markets

• Start-up companies are no longer restricted to raising new equity only from domestic sources

• Development of country funds

– Mutual fund specializing in a given country’s funds

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Offshore Financial Centers

• Focus on offering banking and other financial services to nonresident customers

• Locations

– Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands Antilles, Singapore, Luxembourg, Switzerland