1 Chapter 7 Financial Markets

2 Learning Objectives To understand how currencies are traded and quoted on world financial markets To examine the links between interest rates and exchange rates To understand the similarities and differences between domestic sources of capital and international sources of capital To examine how the needs of individual borrowers have changed the nature of the instruments traded on world financial markets in the past decade To understand how the debt crises of the 1980s and 1990s are linked to the international financial markets and exchange rates

3 The Market for Currencies The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate Every market, every country, and every firm may have its own set of currency symbols

4 Exchange Rate Quotations and Terminology Direct quotation: when the subject currency is stated first Indirect quotation: when the subject currency is stated second Spot rates: when the exchange of currencies takes place immediately Forward rates: when the currency exchange takes place at a later date and at an agreed upon exchange rate

5 Direct and Indirect Quotations Most currencies are quoted in direct quotes versus the U.S. dollar The major exceptions are currencies associated with the British Commonwealth and the European euro When an exchange rate of a currency is stated without using the U.S. dollar as a reference, it is referred to as a cross rate

6 Foreign Currency Market Structure The market for foreign currencies is a worldwide market that is informal in structure The “market” is actually the thousands of telecommunications links among financial institutions around the globe and it is open nearly 24 hours a day

7 Market Size and Composition Until recently there was little data on the actual volume of trading on world foreign currency markets In the spring of 1986, the Federal Reserve Bank of New York along with others started surveying the activity of currency trading every three years Growth of foreign currency trading has been nothing less than astronomical The majority of the world’s trading in foreign currencies is still taking place in the cities where international financial activity is centered, London, New York, and Tokyo

8 Market Size and Composition Three reasons typically given for the enormous growth in foreign currency trading are: Deregulation of international capital flows Gains in technology and transaction cost efficiency The world is a risky place

9 The Purpose of Exchange Rates If countries are to trade, they must be able to exchange currencies The exchange of one country’s currency for another should be relatively simple, but it’s not

10 What is a Currency Worth? The exchange rate between currencies should equalize its purchasing power The theory of purchasing power parity (PPP) is simply the rate that equalizes the price of the identical product or service in two different currencies The version of purchasing power parity that estimates the exchange rate between two currencies using just one good or service as a measure of the proper exchange for all goods and services is called the Law of One Price

11 Monetary Systems of the 20 th Century Mixed/fixed floating exchange rate system is in operation today Prior to this, the Gold Standard was in effect Prior to that, the Bretton Woods Agreement was in effect

12 The Gold Standard The gold standard began sometime in the 1880s It was premised on three basic ideas: A system of fixed rates of exchange existed between participating countries Money issued by member countries had to be backed by gold reserves Gold acted as an automatic adjustment Under this standard, each country’s currency would be set in value per ounce of gold

13 The Bretton Woods Agreement The governments of 44 of the Allied Powers gathered together in Bretton Woods, New Hampshire in 1944 to plan for the postwar international monetary system This agreement called for the following: Fixed exchange rates between member countries The establishment of a fund of gold and currencies for stabilization of their currencies, the International Monetary Fund The establishment of a bank, the World Bank, that would provide funding for long-term development projects

14 Floating Exchange Rates Since March 1973, the world’s major currencies have floated in value versus each other The inability of a country to control the value of its currency on world markets has been a harsh reality for most Direct intervention Coordinated intervention

15 The European Monetary System and the Euro In 1979 a formalized structure was put in place among many of the major members of the European Community The European Monetary System (EMS) officially began operation in March 1979 and once again established a grid of fixed parity rates among member currencies The EMS consisted of three elements: First, all countries that were committing their currencies and their efforts to the preservation of fixed exchange rates entered the Exchange Rate Mechanism (ERM) Second, was the actual grid of bilateral exchange rates with their specialized band limits Third, was the creation of the European Currency Unit (ECU)

16 The Maastricht Treaty The members of the European Union concluded this treaty in December 1991 This treaty: Laid out terms goals of harmonized social and welfare policies Specified a timetable for the adoption of a single currency to replace all individual currencies

17 The Euro On December 31, 1998, the final fixed rates between the 11 currencies and the euro were put into place On January 1, 1999,the euro was officially launched as a single currency for the European Union The monetary policy for the EMU will be conducted by the European Central Bank (ECB) and has a single responsibility of safeguarding the stability of the euro On January 4, 1999, the euro began trading on world currency markets

18 International Money Markets International money markets, often termed the Eurocurrency markets, constitute an enormous financial market that is in many ways outside the jurisdiction and supervision of world financial and governmental authorities

19 Eurocurrency Markets and Eurocurrency Interest Rates A Eurocurrency is any foreign currency denominated deposit or account at a financial institution outside the country of the currency’s issue While there are hundreds of different major interest rates around the globe, the international financial markets focus on the interbank interest rates

20 Defining International Financing The definition of what constitutes an international financial transaction is dependent on two characteristics: Whether the borrower is domestic or foreign Whether the borrower is raising capital denominated in the domestic currency or a foreign currency

21 Defining International Financing The two characteristics that define an international financial transaction form four categories: Domestic borrower/domestic currency Foreign borrower/domestic currency Domestic borrower/foreign currency Foreign borrower/foreign currency

22 Structure of International Banking Correspondent bank: an unrelated bank based in a foreign country Representative bank: basically a sales office for a bank

23 International Security Markets The international debt securities markets have experienced the greatest growth in the past decade It includes: Bonds Equities Private placements

24 The International Bond Market The international bond market provides the bulk of financing Foreign bonds Eurobonds Bearer bonds

25 Private Placements One of the largest and unpublicized capital markets A private placement is the sale of debts or equity to a large investor