FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKE.docx
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FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKE.docx
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FOREIGNEXCHANGEANDINTERNATIONALFINANCIALMARKE
CHAPTER7
ForeignExchangeandInternationalFinancialMarkets
OBJECTIVES
Afterstudyingthischapter,studentsshouldbeableto:
>Describehowdemandandsupplydeterminethepriceofforeignexchange.
>Discusstheroleofinternationalbanksintheforeign-exchangemarket.
>Assessthedifferentwaysthatfirmscanusethespotandforwardmarketstosettleinternationaltransactions.
>Summarizetheroleofarbitrageintheforeign-exchangemarket.
>Discusstheimportantaspectsoftheinternationalcapitalmarket.
LECTUREOUTLINE
OPENINGCASE:
DollarMakesCanadaaLandoftheSpree
ThiscasediscussestheimpacttheweakCanadiandollarhashadoncross-borderbusinessbetweentheUSandCanada.AstheCanadiandollarhasdroppedinvalueagainsttheUScurrency,AmericanshavebeenabletobuymoreandmoreCanadiangoodsforthesameamountofUSdollars.
KeyPoints
∙TheCanadiandollar(knownasthe"loonie")hasbeendeclininginvalueagainsttheUSdollarforseveralyears,recentlytradingatlessthan70centsUSperCanadiandollar.
∙ThoughtheUSdollarhasbeengainingvalueagainstseveralcurrencies,Canada'sproximitymakesitanattractiveshoppingdestinationforAmericans.
∙AmericancompaniesareabletoacquireCanadianfirmsatbetterprices.
∙MailorderandInternetshoppingletAmericansshopforCanadianbargainswithoutevenleavinghome.
∙TheweakCanadiandollarisgoodforCanadianexporters,whofinditeasiertoselltheirgoods.
∙Canadianconsumersarethelosers,asAmericanimportsandtripsabroadhavebecomeincreasinglymoreexpensive.
CHAPTERSUMMARY
ChapterSevenintroducesthestudenttothepracticalaspectsoftheforeign-exchangemarket.Thechapterdiscusseshowcurrencypricesaredetermined,theroleandactivitiesofinternationalbanksintheforeign-exchangemarkets,howthespotandforwardmarketsareusedininternationaltradetransactions,arbitrageintheforeign-exchangemarkets,andissuesrelatingtotheinternationalcapitalmarkets.
I.THEECONOMICSOFFOREIGNEXCHANGE
∙Foreignexchangecanbedefinedascurrenciesissuedbyanothercountry.
∙Thepriceofdifferentcurrenciesintheflexibleexchange-ratesystemisdeterminedbysupplyanddemand.Demandforacurrencyoccurswhentheresidentsofacountrybuyforeignproducts,services,andassets.DiscussFigure7.1here.
∙Inordertopayfortheforeignproducts,residentsmustselltheirowncurrencyandbuytheothercountry’scurrency.Indoingso,theyincreasethesupplyoftheirowncurrency.DiscussFigure7.2here.
TeachingNote:
Instructorsmayfinditworthwhiletocreateascenarioinwhichstudentsareaskedtoobtainaparticularcurrencyfromanotherstudenttoseethesupplyanddemandprocessinaction.
∙Theexchangerateisthepriceofonecurrencyintermsofanother,attheequilibriumpriceoftheforeigncurrency.DiscussFigure7.3here.
∙Adirectquoteisthepriceoftheforeigncurrencyintermsofthehomecurrency,whileanindirectquoteisthepriceofthehomecurrencyintermsoftheforeigncurrency.DiscussFigure7.4here.
DiscussVenturingAbroad:
ABriefHint
ThisGoingGlobalBoxhelpsthestudentbetterunderstandexchangeratesbyusing“laymen’sterms”todiscussthepricesofcurrencies.Specifically,theBoxlinksthepriceofcurrencieswiththepriceofbread.TheBoxfitsinwellwithapreliminarydiscussionofexchangerates.
II.THESTRUCTUREOFTHEFOREIGNEXCHANGEMARKET
Theforeign-exchangemarketconsistsofbuyersandsellersofcurrencies,includinginternationalbanks,centralbanks,brokers,businessesandspeculators.Foreignexchangeistradedeveryminuteoftheday,inavolumeof$1.2trillion.Themajority(83%)oftransactionsinvolvetheU.S.dollar,anditisthereforeknownastheprimarytransactioncurrency.DiscussMap7.1andFigure7.5.
TheRoleofBanks
∙Theforeignexchangedepartmentsoflargeinternationalbanksplayadominantroleintheforeignexchangemarket.
DiscussWiringtheWorld:
TheBiggestOnlineMarket
Theforeignexchangemarketdoes$1.5trillionworthofbusinessaday.Itistheworld'ssinglebiggestmarketandismovingonlinetotakeadvantageofspeedandlowercost.
∙Internationalbanksoperateinboththewholesaleandretailmarketsastheytradefortheirownaccountsandthoseofcustomers.Commercialcustomersareinvolvedintheforeign-exchangemarketthroughtheirnormalcommercialactivities.Speculatorstakepositionsincurrenciesastheytrytopredictthedirectionofcurrencyfluctuations.Indoingso,speculatorsdeliberatelyassumeexchange-raterisk.Arbitrageurstrytomakerisk-freeprofitsastheycapitalizeonthedifferencesincurrencypricesbetweenmarkets.Centralbanksinterveneinthemarketunderfixedexchange-ratesystemstomaintainparvalues,butmayallowcurrenciestofloatfreelyunderflexibleexchange-ratesystems.
∙Notallcurrenciescanbetradedintheforeign-exchangemarket.Thosethataretradablearecallconvertibleorhardcurrencies,thosethatarenotarecalledinconvertibleorsoftcurrencies.
SpotandForwardMarkets
∙Currenciescanbetradedinthespotmarketorintheforwardmarket.Spottransactionsaredeliveredintwobusinessdays,whileforwardtransactionsaredeliveredatthespecifiedforwarddateof30,90,or180days.Mosttransactionsintheforwardmarketareswaptransactionsinwhichthetradersimultaneouslybuysandsellsthesamecurrencywithdifferentdeliverydates.
∙Currencyfuturesareusedtoobtainforeignexchange,however,unlikeforwardcontracts,theyaredesignedwithstandardamountsforstandarddeliverydates.Currencycanalsobeobtainedthroughcurrencyoptions.Acalloptionallowstheholdertopurchaseaspecifiedquantityofforeign-exchangeataspecifiedpricebyaspecifieddate,whileaputoptionallowsaholdertosellaspecifiedquantityofforeign-exchangeataspecifiedpricebyaspecifieddate.Optionsdonothavetobeexercised.Figure7.6,listingsomeoptionsavailableontheChicagoMercantileExchange,shouldbediscussedhere.
∙Hedgingisusedbyfirmstoreducetheirforeign-exchangerisk.
∙Iftheforwardpriceandthespotpriceofaparticularcurrencyaredifferent,thenthecurrencyissaidtobesellingataforwarddiscount(forwardpriceislowerthanthespotprice)orforwardpremium(forwardpriceishigherthanthespotprice.)
ArbitrageandtheCurrencyMarket
∙Arbitrageistherisklesspurchaseofaproductinonemarketforimmediateresaleinasecondmarketinordertoprofitfromapricediscrepancy.
∙ArbitrageofGoods--PurchasingPowerParity.Thelawofonepricesuggeststhatarbitrageactivitieswillcontinueuntilthepriceofthegoodinquestionisequalinbothmarkets.Thetheoryofpurchasing-powerparity(PPP)statesthatthepricesoftradablegoods,whenexpressedinacommoncurrency,willtendtoequalizeacrosscountriesasaresultofexchange-ratechanges.Inotherwords,arbitrageactivitiesaffectthedemand,andthereforetheprice,ofcurrencies.
∙ThetheoryofPPPisusedbyinternationaleconomistsastheycomparelivingstandardsacrosscountries,andbyforeign-exchangeanalystswhentheyforecastlong-termexchangeratechanges.
DiscussBringingtheWorldintoFocus:
BigMacCurrencies
ThisGoingGlobalBoxillustratestheconceptofpurchasingpowerparitybyconsideringthepriceofBigMacsaroundtheworld.TheBoxisausefulonebecausemoststudentscanrelatetotheproductinquestion,andmayhaveevenpurchasedBigMacsinothercountries.TheBoxfitsinwellwithadiscussionofPPP.
∙ArbitrageofMoney.Inthefinancialmarkets,arbitrageursattempttomakerisk-freeprofitsbytradinginforeignexchange.Twopointarbitrage(alsoknownasgeographicarbitrage)allowsatradertocapitalizeondifferencesbetweencurrencypricesintwoforeign-exchangemarkets.Threepointarbitrageinvolvesbuyingandsellingthreedifferentcurrenciestomakearisk-freeprofit.Acurrency’scross-ratecanbecalculatedthroughtheuseofathirdcurrency.DiscussFigure7.7here.
∙Coveredinterestarbitrageenablesatradertocapitalizeongeographicinterestratedifferentials,butavoidriskbycoveringexchange-rateexposureintheforwardmarket.InterestratesdifferamongcountriesasaresultoftheinternationalFishereffectwhichsuggeststhatnationaldifferencesinexpectedinflationratesyielddifferencesinnominalinterestratesamongcountries.
III.THEINTERNATIONALCAPITALMARKET
MajorInternationalBanks
∙Internationalbanksplayanimportantroleinassistingcompanieswiththeirinternationaltransactions.Internationalbanksactbothascommercialbankersandasinvestmentbankers.Theiroperationscantakevariousforms.DiscussTable7.1here.
∙Correspondentbankingrelationshipsinvolvesettingupareciprocalrelationshipwithabankinanothercountry.Undertheagreement,eachbankwillthenactasthelocalbankforforeigncustomers.Forexample,aBritishbankmaysetupacorrespondentrelationshipwithaSwissbankinwhichtheBritishbankactsastheSwissbank’scorrespondentinBritainandtheSwissbankactsastheBritishbank’scorespondentinSwitzerland.
∙Banksthathavemoreextensiveinternationaloperationsmayhaveasubsidiarybank,abranchbank,oranaffiliatedbank.Asubsidiarybankisanoperationthatisincorporatedseparatelyfromtheparent,whileabranchbankisnot.Anaffiliatedbankinvolvestakinganownershippositioninanoperationinconjunctionwithapartner.
∙
CommercialBankingServices.Commercialbanksprovideshort-termfinancingofinternationaltransactions,internationalelectronicfundstransfers,transactionsin
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