1. chapter 8 Foreign Exchange and International
Financial
Markets
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International Business, 6th Edition
Griffin & Pustay
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2. Chapter Objectives
Describe how demand and supply determine the price of foreign exchange
Discuss the role of international banks in the foreign-exchange market
Assess the different ways firms can use the spot and forward markets to settle international transactions
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3. Chapter Objectives (continued)
Summarize the role of arbitrage in the foreign-exchange market
Discuss the important aspects of the international capital market
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4. Foreign Exchange
Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own.
One factor that obviously distinguishes international business from domestic business is the use of more than one currency in commercial transactions. The foreign-exchange market exists to facilitate this conversion of currencies, thereby allowing firms to conduct trade more efficiently across national boundaries. The foreign-exchange market also facilitates international investment and capital flows. Firms can shop for low-cost financing in capital markets around the world and then use the foreign-exchange market to convert the foreign funds they obtain into whatever currency they require.
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5. Figure 8.1 Demand for Yen
Demand for Japanese yen is derived from foreigners’ demand for Japanese products
Figure 8.1 presents the demand curve for Japanese yen. Economists call this demand curve a derived demand curve because the demand for yen is derived from foreigners’ desire to acquire Japanese goods, services, and assets. To buy Japanese goods, foreigners first need to buy Japanese yen. Like other demand curves, it is downward sloping, so as the price of the yen falls, the quantity of yen demanded increases. This is shown as a movement from point A to point B on the demand curve.
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6. Figure 8.2 Supply of Yen
Supply for Japanese yen is derived from Japanese demand for foreign products
Figure 8.2 presents the supply curve for yen. Underlying the supply curve for yen is the desire by the Japanese to acquire foreign goods, services, and assets. To buy foreign products, Japanese need to obtain foreign currencies, which they do by selling yen and using the proceeds to buy the foreign currencies. Selling yen has the effect of supplying yen to the foreign-exchange market. As with other goods, as the price of the yen rises, the quantity supplied also rises; you can see this when you move from point A to point B along the supply curve in Figure 8.2. The supply curve for the yen thus behaves like most other supply curves: People offer more yen for sale as the price of the yen rises.
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7. Figure 8.3 The Market for Yen
Figure 8.3 depicts the determination of equilibrium price of yen. Points along the vertical axis show the price of the yen in dollars—how many dollars one must pay for each yen purchased. Points along the horizontal axis show the quantity of yen. As in other markets, the intersection of the supply curve (S) and the demand curve (D) yields the market-clearing, equilibrium price ($.009/yen in this case) and the equilibrium quantity demanded and supplied (200 million yen). This equilibrium price is called the exchange rate, the price of one country’s currency in terms of another country’s currency.
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8. Foreign-Exchange Rates
Direct exchange rate
Direct quote
Price of the foreign currency in terms of home currency
Indirect exchange rate
Indirect quote
Price of the home country in terms of the foreign currency
Foreign-exchange rates are quoted in two ways. A direct exchange rate (or direct quote) is the price of the foreign currency in terms of the home currency. An indirect exchange rate (or indirect quote) is the price of the home currency in terms of the foreign currency. Mathematically, the direct exchange rate and the indirect exchange rate are reciprocals of one another.
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9. Figure 8.4 Direct and Indirect Exchange Rates
Foreign-exchange rates are published daily in most major newspapers worldwide. Figure 8.4 presents rates for July 19, 2006, published in the Wall Street Journal. From the perspective of a U.S. resident, the direct exchange rate between the U.S. dollar and the yen (¥) on Wednesday, July 19, was $ /¥1. From the U.S. resident’s perspective, the indirect exchange rate on Wednesday, July 19, was ¥116.57/$1.
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10. Structure of the Foreign-Exchange Markets
comprises buyers and sellers of
currencies issued by the world’s
countries.
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11. Foreign-Exchange Trading
The largest center for foreign
exchange trading is London, followed
by New York and Tokyo.
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12. Figure 8.5 Currencies Involved in Foreign-Exchange Market Transactions
As Figure 8.5 indicates, approximately 89 percent of the transactions involve the U.S. dollar, a dominance stemming from the dollar’s role in the Bretton Woods system. Because the dollar is used to facilitate most currency exchange, it is known as the primary transaction currency for the foreign-exchange market.
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13. The Role of Banks Buy or sell major traded currencies Markets
Wholesale market
Retail market
The foreign-exchange departments of large international banks such as JPMorgan Chase, Barclays, and Deutsche Bank in major financial centers like New York, London, and Frankfurt play a dominant role in the foreign-exchange market. These banks stand ready to buy or sell the major traded currencies. They profit from the foreign-exchange market in several ways. Much of their profits come from the spread between the bid and ask prices for foreign exchange. International banks are key players in the wholesale market for foreign exchange, dealing for their own accounts or on behalf of large commercial customers. Interbank transactions, typically involving at least $1 million (or the foreign currency equivalent), account for a majority of foreign-exchange transactions. Corporate treasurers, pension funds, hedge funds, and insurance companies are also major players in the foreign exchange market. International banks also play a key role in the retail market for foreign exchange, dealing with individual customers who want to buy or sell foreign currencies in large or small amounts. Typically, the price paid by retail customers for foreign exchange is the prevailing wholesale exchange rate plus a premium. The size of the premium is in turn a function of the size of the transaction and the importance of the customer to the bank.
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14. Map 8.1 A Day of Foreign-Exchange Trading
The foreign-exchange market comprises buyers and sellers of currencies issued by the world’s countries. Anyone who owns money denominated in one currency and wants to convert that money to a second currency participates in the foreign-exchange market. The worldwide volume of foreign-exchange trading is estimated at $1.9 trillion per day. Foreign exchange is being traded somewhere in the world every minute of the day (see Map 8.1). The largest foreign-exchange market is in London, followed by New York, Tokyo, and Singapore.
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15. Bank Foreign Exchange Clients
Commercial customers
Speculators
The clients of the foreign-exchange departments of banks fall into several categories:
• Commercial customers engage in foreign-exchange transactions as part of their normal commercial activities, such as exporting or importing goods and services, paying or receiving dividends and interest from foreign sources, and purchasing or selling foreign assets and investments. Some commercial customers may also use the market to hedge, or reduce, their risks due to potential unfavorable changes in foreign-exchange rates for moneys to be paid or received in the future.
• Speculators deliberately assume exchange rate risks by acquiring positions in a currency, hoping that they can correctly predict changes in the currency’s market value. Foreign-exchange speculation can be very lucrative if one guesses correctly, but it is also extremely risky.
• Arbitrageurs attempt to exploit small differences in the price of a currency between markets. They seek to obtain riskless profits by simultaneously buying the currency in the lower-priced market and selling it in the higher-priced market.
Arbitrageurs
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16. Foreign-Exchange Trading
The Tel Aviv foreign-exchange trader is an important link in the $3.2 trillion-per-day global exchange market.
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17. Spot and Forward Markets
Spot Market: foreign exchange transactions that are consummated immediately
Forward Market: foreign exchange transactions that are to occur sometime in the future
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18. Spot and Forward Markets
Many international business transactions involve payments to be made in the future. Such transactions include lending activities and purchases on credit. Because changes in currency values are common, such international transactions would appear to be risky in the post-Bretton Woods era. How can a firm know for sure the future value of a foreign currency? Currencies can be bought and sold for immediate delivery or for delivery at some point in the future. The spot market consists of foreign-exchange transactions that are to be consummated immediately. (Immediately is normally defined as two days after the trade date because of the time historically needed for payment to clear the international banking system.) Spot transactions account for 33 percent of all foreign-exchange transactions. The forward market consists of foreign-exchange transactions that are to occur sometime in the future. Prices are often published for foreign exchange that will be delivered 30 days, 90 days, and 180 days in the future. Many users of the forward market engage in swap transactions. A swap transaction is a transaction in which the same currency is bought and sold simultaneously, but delivery is made at two different points in time.
For example, the Wall Street Journal excerpt shown in the slide indicates that on Wednesday, July 19, 2006, the spot price of the British pound was $1.4429, while the forward price for pounds for delivery in 30 days was $ and for delivery in 180 days was $
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19. Mechanisms for Future Foreign Exchanges
Currency future
Currency option
Call option
Put option
The foreign-exchange market has developed two other mechanisms to allow firms to obtain foreign exchange in the future. Neither, however, provides the flexibility in amount and in timing that international banks offer. The first mechanism is the currency future. Publicly traded on many exchanges worldwide, a currency future is a contract that resembles a forward contract. However, unlike the forward contract, the currency future is for a standard amount (for example, ¥12.5 million or SwFr 125,000) on a standard delivery date (for example, the third Wednesday of the contract’s maturity month). As with a forward contract, a firm signing a currency-future contract must complete the transaction by buying or selling the specified amount of foreign currency at the specified price and time. This obligation is usually not troublesome, however; a firm wanting to be released from a currency-future obligation can simply make an offsetting transaction. In practice, 98 percent of currency futures are settled in this manner. Currency futures represent only 1 percent of the foreign-exchange market.
The second mechanism, the 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 a specified date. A call option grants the right to buy the foreign currency in question; a put option grants the right to sell the foreign currency. Currency options are publicly traded on organized exchanges worldwide. Because of the inflexibility of publicly traded options, international bankers often are willing to write currency options customized as to amount and time for their commercial clients. Currency options account for 5 percent of foreign-exchange market activity.
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20. Arbitrage
Arbitrage is the 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 that affect the foreign-exchange market: arbitrage of goods and arbitrage of money.
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21. Arbitrage Arbitrage of Goods Arbitrage of Money 8-21
Arbitrage of Goods—Purchasing Power Parity.  Underlying the arbitrage of goods is a very simple notion: 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. Under the law of one price such arbitrage activities will continue until the price of the good is identical in both markets (excluding transactions costs, transportation costs, taxes, and so on). The arbitrage of goods across national boundaries is represented by the theory of purchasing power parity (PPP). This theory states that the prices of tradable goods, when expressed in a common currency, will tend to equalize across countries as a result of exchange rate changes. PPP occurs because the process of buying goods in the cheap market and reselling them in the expensive market affects the demand for, and thus the price of, the foreign currency, as well as the market price of the good itself in the two product markets in question.
Arbitrage of Money.  Professional traders employed by money market banks and other financial organizations seek to profit from small differences in the price of foreign exchange in different markets. Whenever the foreign-exchange market is not in equilibrium, professional traders can profit through arbitraging money. Numerous forms of foreign-exchange arbitrage are possible, but three forms are common: two-point, three-point, and covered interest.
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22. Arbitrage of Money Two-point Three-point Covered-interest 8-22
Two-point arbitrage involves profiting from price differences in two geographically distinct markets. Suppose £1 is trading for $2.00 in New York City and $1.80 in London. A foreign-exchange trader at JPMorgan Chase could take $1.80 and use it to buy £1 in London’s foreign-exchange market. The trader could then take the pound she just bought and resell it for $2.00 in New York’s foreign-exchange market. Professional currency traders can make profits through three-point arbitrage whenever the cost of buying a currency directly (such as using pounds to buy yen) differs from the cross rate of exchange. The cross rate is an exchange rate between two currencies calculated through the use of a third currency (such as using pounds to buy dollars and then using the dollars to buy yen). The U.S. dollar is the primary third currency used in calculating cross rates. The difference between these two rates offers arbitrage profits to foreign-exchange market professionals. The market for the three currencies will be in equilibrium only when arbitrage profits do not exist, which occurs when the direct quote and the cross rate for each possible pair of the three currencies are equal.
Covered-interest arbitrage is arbitrage that occurs when the difference between two countries’ interest rates is not equal to the forward discount/premium on their currencies. In practice, it is the most important form of arbitrage in the foreign-exchange market. It occurs because international bankers, insurance companies, and corporate treasurers are continually scanning money markets worldwide to obtain the best returns on their short-term excess cash balances and the lowest rates on short-term loans.
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23. Figure 8.6 Three-Point Arbitrage
Suppose that £1 can buy $2 in New York, Tokyo, and London, $1 can buy ¥120 in those three markets, and £1 can buy ¥200 in all three. Because the exchange rate between each pair of currencies is the same in each country, no possibility of profitable two-point arbitrage exists. However, profitable three-point arbitrage opportunities exist. Three-point arbitrage is the buying and selling of three different currencies to make a riskless profit.
Figure 8.6 shows how this can work:
Step 1: Convert £1 into $2.
Step 2: Convert the $2 into ¥240.
Step 3: Convert the ¥240 into £1.2.
Through these three steps, £1 has been converted into £1.2, for a riskless profit of £0.2.
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24. International Capital Market
Major International Banks
International Bond Market
Global Equity Markets
Offshore Financial Centers
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25. Table 8.1 The World’s Largest Banks
ING Group
Fortis
Citigroup
Dexia Group
HSBC Holding
BNP Paribas
Credit Agricole
Deutsche Bank
Bank of America Corp.
HBOS
Not only are international banks important in the functioning of the foreign-exchange market and arbitrage transactions, but they also play a critical role in financing the operations of international businesses, acting as both commercial bankers and investment bankers. As commercial bankers, they finance exports and imports, accept deposits, provide working capital loans, and offer sophisticated cash management services for their clients. As investment bankers, they may underwrite or syndicate local, foreign, or multinational loans and broker, facilitate, or even finance mergers and joint ventures between foreign and domestic firms. The international banking system is centered in large money market banks headquartered in the world’s financial centers—Japan, the United States, and the European Union.
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26. Establishment of Overseas Banking Operations
Subsidiary bank
Branch bank
Affiliated bank
An overseas banking operation can be established in several ways. If it is separately incorporated from the parent, it is called a subsidiary bank; if it is not separately incorporated, it is called a branch bank. Sometimes an international bank may choose to create an affiliated bank, an overseas operation in which it takes part ownership in conjunction with a local or foreign partner.
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27. The Eurocurrency Market
Originated in the early 1950s
Eurodollars – U.S. dollars deposited in European bank accounts
Euroyen
Europounds
Eurocurrency – currency on deposit outside in banks worldwide
Euroloans quoted on basis of LIBOR
Another important facet of the international financial system is the Eurocurrency market. Originally called the Eurodollar market, the Eurocurrency market originated in the early 1950s when the communist-controlled governments of Central Europe and Eastern Europe needed dollars to finance their international trade but feared that the U.S. government would confiscate or block their holdings of dollars in U.S. banks for political reasons. The communist governments solved this problem by using European banks that were willing to maintain dollar accounts for them. Thus Eurodollars—U.S. dollars deposited in European bank accounts—were born.
As other banks worldwide, particularly in Canada and Japan, began offering dollar-denominated deposit accounts, the term Eurodollar evolved to mean U.S. dollars deposited in any bank account outside the United States. As other currencies became stronger in the post-World War II era—particularly the yen, the pound, and the German mark—the Eurocurrency market broadened to include Euroyen, Europounds, and other currencies. Today a Eurocurrency is defined as a currency on deposit outside its country of issue.
The Euroloan market is extremely competitive, and lenders operate on razor-thin margins. Euroloans are often quoted on the basis of the London Interbank Offer Rate (LIBOR), the interest rate that London banks charge each other for short-term Eurocurrency loans.
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28. The International Bond Market
Major source of debt financing for:
World’s governments
International organizations
Larger firms
Two types of bonds
Foreign bonds
Eurobonds
The international bond market represents a major source of debt financing for the world’s governments, international organizations, and larger firms. This market has traditionally consisted of two types of bonds: foreign bonds and Eurobonds. Foreign bonds are bonds issued by a resident of country A but sold to residents of country B and denominated in the currency of country B. For example, the Nestlé Corporation, a Swiss resident, might issue a foreign bond denominated in yen and sold primarily to residents of Japan.
A Eurobond is a bond issued in the currency of country A but sold to residents of other countries. For example, American Airlines could borrow $500 million to finance new aircraft purchases by selling Eurobonds denominated in dollars to residents of Denmark and Germany. The euro and the U.S. dollar are the dominant currencies in the international bond market.
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29. Figure 8.7 International Bond Issues 2007, by Currency (in billions of U.S. dollars)
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30. Global Equity Markets
Start-up companies are no longer restricted to raising new equity only from domestic sources
Development of country funds
Mutual fund specializing in a given country’s funds
The growing importance of multinational operations and improvements in telecommunications technology have also made equity markets more global. Start-up companies are no longer restricted to raising new equity solely from domestic sources. For example, Swiss pharmaceutical firms are a major source of equity capital for new U.S. biotechnology firms. Established firms also tap into the global equity market. When expanding into a foreign market, a firm may choose to raise capital for its foreign subsidiary in the foreign market. Numerous MNCs also cross-list their common stocks on multiple stock exchanges. British Airways, for instance, is listed on both the London Stock Exchange and the New York Stock Exchange, thereby enabling both European and American investors to purchase its shares conveniently. Another innovation is the development of country funds. A country fund is a mutual fund that specializes in investing in a given country’s firms.
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31. Offshore Financial Centers
Focus on offering banking and other financial services to nonresident customers
Locations
Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands Antilles, Singapore, Luxembourg, Switzerland
Offshore financial centers focus on offering banking and other financial services to nonresident customers. Many of these centers are located on island states, such as the Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands Antilles, and Singapore. Luxembourg and Switzerland, although not islands, are also important “offshore” financial centers.
MNCs often use offshore financial centers to obtain low-cost Eurocurrency loans. Many MNCs locate financing subsidiaries in these centers to take advantage of the benefits they offer: political stability, a regulatory climate that facilitates international capital transactions, excellent communications links to other major financial centers, and availability of legal, accounting, financial, and other expertise needed to package large loans. The efficiency of offshore financial centers in attracting deposits and then lending these funds to customers worldwide is an important factor in the growing globalization of the capital market.
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