FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKE.docx

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FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKE.docx

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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