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International Transactions and Financial Markets CHAPTER 12
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Any transaction included in current account requires exchange of currencies. –Example:Importing Japanese cars to U.S., building a factory in India, purchase of financial assets from Germany Buyer must exchange domestic currency for foreign currency to purchase the good/asset. The Foreign Exchange Market
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Foreign Exchange: –Currency or deposits in financial institutions in another country Financial assets may be: –Currency –Bank deposits –Highly liquid financial claims The Foreign Exchange Market
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Foreign Exchange Market: –Never closes –Is reasonable free of obstructions for the industrialized and developing countries with open capital markets Freely Convertible Currencies: –The currencies in these countries –Money moves between countries without impediments as in goods/services trade –Estimates of daily volume of trade -$1.2 trillion The Foreign Exchange Market
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Paying for Imports and Exports –Problem: substantial time lag due to transportation! Exporter wants to be paid at time of shipment. Importer only wants to pay when receiving goods. –Solution: A commercial bill of exchange or a bank draft: a written order instructing to pay on a certain date a specified amount of money. –Exporter can hold to maturity or sell right away at a discount. The Foreign Exchange Market
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Time lag between purchase order and delivery can be substantial. In the meantime, exchange rate may change! Spot Exchange Rate: –Applies when the transaction is completed at the same time the price is agreed on Forward Exchange Rate: –Price of foreign exchange to be delivered at some point in the future Speculator takes risk in hopes of profit The Foreign Exchange Market
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Speculators –Individual foreign-exchange traders, financial institutions or non-financial businesses buying and selling foreign exchange in order to gain short-run profits. –High returns and high risks The Foreign Exchange Market
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Futures Contract: –A commitment to purchase or deliver a specified quantity of foreign currency on a designated future date. Option : –A contract that gives the holder the option to buy or sell foreign exchange in the future. Currency Swap: –Agreement between two parties to exchange different currencies over a specified time. Lower transactions costs The Foreign Exchange Market
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Financial Intermediation –Putting two different market participants together to conduct an economic transaction –Reason to move money from one country to another: Higher rate of return –Capital flows from the developed to developing countries could make both countries better off Investors in developed countries can earn a higher rate of return. Developing countries get much needed capital increasing the rate of economic growth. International Financial Markets
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Risk Diversification: –Holding financial assets with varying degrees of risk tends to be less risky than holding just one financial asset –Helps to explain two-way capital flow International Financial Markets
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Eurocurrency Markets –Eurodollar: Dollar-denominated account that exists outside the U.S. Part of Eurocurrency Market –Eurocurrency: –An account denominated in a major currency that is located outside that country. Participants in the International Financial Markets
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