CHAPTER 7 : FOREIGN EXCHANGE

AND INTERNATIONAL FINANCIAL

MARKETS

Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own.

Functions of foreign exchange :

To facilitate this conversion of currencies, thereby allowing firms to conduct trade more efficiently across national boundaries.

To facilitates international investment and capital flows.

Figure 8.1 Demand for Yen

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

Figure 8.2 Supply of Yen

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

Figure 8.3 The Market for Yen

o Direct exchange rate ( or direct quote) is the price of the home currency.

~ U.S resident, the direct exchange rate between the U.S Dollar and the yen (￥ ) on Wednesday, September 3, was $.009241/ ￥ 1.

o Indirect exchange rate ( or indirect quote) is the price of the home currency in terms of the foreign currency.

~U.S resident’s perspective, the indirect exchange rate on Wednesday, September 3, was ￥ 108.21/$1.

EXCHANGE RATE

THE STRUCTURE OF THE FOREIGN-EXCHANGE MARKET

•The foreign-exchange market comprises buyers and sellers of currencies issued by the world’s countries.•Dollar is used to facilitate most currency exchange, it is known as the primary ‘transaction currency’ for the foreign-exchange market.

Structure of the Foreign-Exchange Market

The Role of Banks

Buy or sell major traded currencies.

Markets : Wholesale market

Retail market

Example of large international banks are :-

JPMorgan

Chase

Barclays

Deutsche Bank

Continue…The clients of the foreign-exchange

departments of

banks :-

Commercial customers

Speculators

Arbitrageurs

Continue…2. Spot and Forward Marketsspot market – consist of foreign exchange transaction that are to be

consummated immediately.

Forward market - consist of foreign exchange transaction that are to

occur

sometimes in the future.

Swap transaction – a transaction in which the same currency is

bought

and sold simultaneously, but deliver is made at two different points

in time.

Continue…The two mechanism for future foreign exchange:

Currency future

Publicly trade on many exchange worldwide, a currency future is a

contract that resembles a forward contract.

Currency option

Allows, but does not require, a firm to buy or sell a specified

amount of a

Foreign currency at a specified price at any time up to specified

date.

Continue…3. Arbitrage and the Currency MarketArbitrage – 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 :-

Arbitrage of goods

Arbitrage of money

Continue… Arbitrage of goods – purchasing power parity

if the price of a good differs between two markets, people will

tend to buy

the good in the market offering the lower price, the “cheap”

market, and

resell it in the market offering the higher price, the

“expensive” market.

Represented by theory of purchasing power parity

(PPP).

the theory states that the price of tradable goods, when

expressed in

common currency, will tend to equalize across countries as a

result of

Exchange rate changes.

Arbitrage of money This method requires money to make moneyThe concept is “buy low, sells high” When the equilibrium is not in foreign-exchange market,

professional traders can to arbitraging money to gain profit.

From an economic view: the effect of arbitrage dealings is to correct the equilibrium in the prices

of foreign exchange, or securities, or commodities.   It is a force tending to equalize, establish parties among markets for the

same item through competition of arbitrageurs. 

Arbitrage of Money

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Two-point

Covered-interestThree-point

Two-point arbitrage

Also known as geographic arbitrageInvolves in profiting from price differences in two geographically

distinct markets.For example, let the spot exchange rate be £1 = $1.80 in London and

£1 = $2.00 in New York. We are quoting both exchange rate in sterling.

Currency A/currency B will give the amount for currency B.In London : USD/GBP = £1 / $1.80

= 0.556In New York : USD/GBP = £1 / $2.00

= 0.5

Three-point arbitrage (TRIANGLE ARBITRAGE)is based on the concept of “Relative Arbitrage” and was designed to

exploit price disparities amongst three currency pairs.Is the buying and selling of three different currencies to make

riskless profit.Example:

Suppose that £1 can buy $2 in New York, Tokyo, and London, $1 can buy ¥120 in those three market, and £1 can buy ¥200 in all three. There is three-point arbitrage opportunity exist.

Figure 8.6 Three-Point Arbitrage

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Covered-interest arbitrageIs arbitrage that occurs when the difference between two countries’

interest rates is not equal to the forward discount on their countries.Occurs because international bankers etc are continually scanning

money markets worldwide to obtain the best return on their short-term excess cash balances and the lowest rates on short-term loans.

This is to protect or cover themselves from exchange rate risks.Example:

Suppose the annual interest rate for three month deposits is 12percent in London and 8 percent in New York. Investor in new York will be eager to earn higher return available in London.

The International Capital Market1. Major International BanksThe international banking system is centered in large money

market

banks headquartered in the world’s financial centers.

Establishment of overseas Banking Operations :

Subsidiary bank – separate incorporated from the parent.

Branch bank – not separated incorporated.

Affiliate bank – ownership with a local or foreign partner.

World’s 20 largest banks

Continue… Commercial Banking Services.

For exporters and tourist : Exchange home currency or traveler’s checks

for local currency.

Investment Banking Services.

Furnished by large securities firms like Nomura, Smith Barney, Goldman

Sachs and Merrill Lynch.

To package and locate long-term debt and equity funding.

To arrange mergers and acquisitions of domestic and foreign firms.

Continue…

Originally called the Eurodollar market.Originated in the early 1950s.Eurodollars – U.S. dollars deposited in European bank accounts

EuroyenEuropounds

Eurocurrency – currency on deposit outside in banks worldwide The Euroloans are often quoted on the basis of LIBOR

2. The Eurocurrency market

Continue…

Represent a major source of debt financing forWorld’s governmentsInternational organizationsLarger firms

Consisted of two types of bond:

- Foreign Bond

- EurobondAs global market evolve, global bond are used as one such innovative

financial instrument.

3. International bond market

International bond issues in 2007, by currencies (in billions of U.S. dollars)

4. GLOBAL EQUITY MARKET• The growing importance of multinational

operations and improvement in telecommunications technology have also made equity markets more global.

• Start-up companies no longer restricted to raise new equity solely from domestic sources.

• Country fund is the mutual fund that specializes in investing in a given country’s firms.

Continue…

Continue…Focus on offering banking and others financial services o nonresident

customers.MNCs often used to obtain low-cost Eurocurrency loans.Such benefits that they offers are:

- Political stability

- A regulatory climate that facilitates international capital transaction

- Excellent communication links to other major financial centers.Location:

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

5. Offshore financial centers