The foreign-exchange market exists to facilitate the 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. Changes in exchange rates also affect the prices that consumers pay, the markets in which they shop, and the profits that firms earn.
This chapter’s learning objectives include the following:Describing how demand and supply determine the price of foreign exchange. Discussing the role of international banks in the foreign-exchange market. Assessing the different ways firms can use the spot and forward markets to settle international transactions. Summarizing the role of arbitrage in the foreign-exchange market.Discussing the important aspects of the international capital market.
Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own. Like the prices of other commodities, the price of foreign exchange—given a flexible exchange rate system—is set by demand and supply in the marketplace.
Let us look more closely at what this means by using the market between U.S. dollars and Japanese yen as an example. The graph above 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.
The graph above 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. 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.
This graph depicts the determination of the 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.Although this graph illustrates the dollar-yen foreign-exchange market, a similar figure could be drawn for every possible pair of currencies in the world, each of which would constitute a separate market, with the equilibrium prices of the currencies determined by the supply of and demand for them.
Foreign-exchange rates are published daily in most major newspapers worldwide. These 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 each other. By tradition—and sometimes for convenience—certain exchange rates are typically quoted on a direct basis and others on an indirect basis. For example, common U.S. practice is to quote British pounds on a direct basis but Japanese yen on an indirect basis.
This section focused on The Economics of Foreign Exchange. The discussion used the market between U.S. dollars and Japanese Yen to illustrate how the price of foreign exchange is set by demand and supply in the marketplace. It concluded by reviewing how foreign-exchange rates are quoted. The next section will focus on the Structure of the Foreign Exchange Market.
The foreign-exchange market consists of 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 $4.0 trillion per day. The largest foreign-exchange market is in London, followed by New York, Tokyo, and Singapore.
This graph shows the percentage share of foreign-exchange transactions involving selected currencies. Because two currencies are involved in each transaction, the percentages add up to 200 percent. Approximately 85 percent of foreign-exchange 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.
The foreign-exchange departments of large international banks such as JPMorgan Chase and Deutsche Bank in major financial centers like New York, London, and Hong Kong 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 spread between the bid and ask prices for foreign exchange. Sometimes international banks act as speculators, betting that they can guess in which direction exchange rates are headed. Such speculation can be enormously profitable, although it is always risky. As discussed later in this chapter, banks also may act as arbitrageurs in the foreign-exchange market.
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 , account for a majority of foreign-exchange transactions. Corporate treasurers, pension funds, hedge funds, mutual 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. Foreign tourists cashing in a traveler’s check for local currency at a bank or exchange office pay an even higher premium.
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 businessactivities. These activities include 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 use the market to hedge against 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.
Currencies that are freely tradable are called convertible currencies. Also called hard currencies, these include the euro, the British pound, the Swedish krona, the Canadian dollar, the Swiss franc, the Japanese yen, and the U.S. dollar. Currencies that are not freely tradable because of domestic laws or the unwillingness of foreigners to hold them are called inconvertible currencies, or soft currencies. The currencies of many developing countries fall into the soft category.
This section focused on the Structure of the Foreign Exchange Market. The discussion opened with a graphic illustrating the currencies involved in foreign-exchange transactions. It progressed by reviewing the role of banks in foreign exchange and compared the wholesale and retail foreign-exchange markets. The discussion concluded by examining the clients for foreign exchange and the types of currencies involved in those transactions. The next section will focus on Spot and Forward Markets in international transactions.
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? Fortunately, in addition to its geographic dimension, the foreign-exchange market also has a time dimension. Currencies can be bought and sold for immediate delivery or for delivery at some point in the future. As this section will show, the forward market, currency options, and currency futures facilitate international trade and investment by allowing firms to hedge, or reduce, the foreign-exchange risks of international transactions.
The spot market consists of foreign-exchange transactions that are to be consummated immediately (normally defined as two days after the trade date). Spot transactions account for 33 percent of all foreign-exchange transactions.The forward market consists of foreign-exchange transactions that willoccur sometime in the future. Prices are often published for foreign exchange that will be delivered one month, three months, and six months in the future. Normally, an international business that wants to buy or sell foreign exchange on a spot or forward basis will contract with an international bank to do so. Because of the bank’s extensive involvement in the foreign-exchange market, it can customize the spot, forward, or swap contract to meet the customer’s specific needs.
Many users of the forward market engage in swap transactions, in which the same currency is bought and sold simultaneously, but delivery is made at two different times. The foreign-exchange market has developed two other mechanisms to allow firms to obtain foreign exchange in the future. 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, on a standard delivery date. 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. Currency futures represent only one percent of the foreign-exchange market.The second mechanism, the currency option, allows 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. Options are traded on organized exchanges worldwide, and account for five percent of foreign-exchange market activity.
The forward price of a foreign currency often differs from its spot price. The forward price represents the marketplace’s aggregate prediction of the spot price of the exchange rate in the future. Thus, the forward price helps international business-people forecast future changes in exchange rates. If the forward price (using a direct quote) is less than the spot price, the currency is selling at a forward discount. If the forward price is higher than the spot price, the currency is selling at a forward premium.Suppose that the British poundis selling at a forward discount. If so, the foreign-exchange market believes that the currency will depreciate over time. Firms may want to reduce their holdings of assets or increase their liabilities denominated in that currency. Conversely, if the British pound is selling at a forward premium, the foreign-exchange market believes the currency will appreciate over time. Firms may want to increase their holdings of assets and reduce their liabilities denominated in that currency.
This section covered Spot and Forward Markets and International Transactions. The discussion focused on spot and forward markets, futures transactions, and the forward pricing of currencies. The next section will examine Arbitrage and the Currency Market.
Another important component of the foreign-exchange market is arbitrage activities. 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. We explore two types of arbitrage activities that affect the foreign-exchange market: arbitrage of goods and arbitrage of money.
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 transaction 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 a good in the cheap market and reselling it in the expensive market affects the following: the demand for and the price of the foreign currency and the market price of the good itself in the two product markets in question.
Much of the $4.0 trillion in daily trading of foreign exchange stems from financial arbitrage. Whenever the foreign-exchange market is not in equilibrium, professional traders can profit by arbitraging money. These traders seek to profit from small differences in the price of foreign exchange in different markets. The following slides present an overview of three common examples: two-point, three-point, and covered interest arbitrage.
Two-point arbitrage (also called geographic arbitrage) involves profiting from price differences in two geographically distinct markets. Suppose €1 is trading for $2.00 in New York and $1.80 in Frankfurt. In this case, a profitable arbitrage opportunity is available. A foreign-exchange trader at JP Morgan Chase could purchase €1 for $1.80 in Frankfurt’s foreign-exchange market. The trader could then resell the euro for $2.00 in New York’s foreign-exchange market, thereby transforming $1.80 into $2.00 at no risk. Of course, this no-risk opportunity will attract other arbitrageurs who will perform similar transactions until the market reaches equilibrium, and there is no longer an opportunity for profitable arbitrage.
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 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.As illustrated in this graphic, 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 can be accomplished in three steps: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.
The third form of arbitrage we discuss is covered-interest arbitrage. It occurs when interest rate differences between two countries are not equal to the forward discount or premium on their currencies. In practice, it is the most important form of arbitrage in the foreign-exchange market. 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. In doing so, however, they often want to protect, or cover themselves from exchange rate risks. These investors can use covered-interest arbitrage to capture higher interest rates but avoid exchange rate dangers by using the forward market to cover their exposure. Returns to international investors will be equal—and arbitrage-driven capital flows will end—when the interest rate difference between the two markets equals the three-month forward discount on their currencies.
Short-term capital flows that result from covered-interest arbitrage are important to the foreign-exchange market. In practice, the short-term interest rate differential between two countries determines the forward discount or forward premium on their currencies. However, why do interest rates vary among countries in the first place? In 1930, Yale economist Irving Fisher demonstrated that a country’s nominal interest rate reflects the real interest rate (which he assumed to be constant across countries), plus expected inflation in that country. National differences in expected inflation rates thus yield differences in nominal interest rates among countries, a phenomenon known as the international Fisher effect. Because of the international Fisher effect and covered-interest arbitrage, an increase in a country’s expected inflation rate implies higher interest rates in that country. This in turn will lead to either a shrinking of the forward premium or a widening of the forward discount on the country’s currency in the foreign-exchange market. Because of this linkage between inflation and expected changes in interest rates, international business people and foreign currency traders monitors countries’ inflation trends carefully.
This section examined Arbitrage and the Currency Market. The discussion started by reviewing the arbitrage of goods and the concept of purchasing power parity. It then examined three important aspects of the arbitrage of money—two-point arbitrage, three-point arbitrage, and covered-interest arbitrage. The discussion closed with a review of the International Fisher Effect. The next section will focus on The International Capital Market.
International banks are important in the functioning of the foreign-exchange market and arbitrage transactions. They also play a critical role in financing the operations of international businesses. 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. They may also broker, facilitate, or finance mergers and joint ventures between foreign and domestic firms. The big international banks are continually developing new products to meet the needs of borrowers worldwide. Unfortunately, market participants may not fully appreciate the risks inherent in some of these new financial instruments.
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. These banks are involved in international commerce on a global scale. This table shows the eight largest banks in the world, ranked according to overall revenues in millions of U.S. dollars.
International banking takes many forms. Originally, most international banking was done through reciprocal correspondent relationships among banks located in different countries. In a correspondent relationship, one bank acts as a correspondent or agent for another bank in the first bank’s home country, and vice versa. Services performed include paying or collecting foreign funds, providing credit information, and honoring letters of credit. To facilitate these transactions, each bank maintains accounts at the other bank, denominated in the local currency.Larger banks often provide their own overseas operations, in order to improve their ability to compete internationally. 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.
International banks and their overseas operations are important providers of international commercial banking services. Exporters and tourists utilize such banking services when they exchange their home currency or traveler’s checks for local currency. Although the physical exchange of paper currency is part of international banking operations, a far more important part entails financing and facilitating everyday commercial transactions.
In addition to commercial banking services, most international banks provide investment banking services. Large securities firms like Nomura and Goldman Sachs also practice investment banking. Corporate clients hire investment bankers to package and locate long-term debt and equity funding and to arrange mergers and acquisitions of domestic and foreign firms. Competition has forced investment bankers to globalize their operations, in order to secure capital for their clients at the lowest possible cost.
The Eurocurrency market originated in the early 1950s. At first, the term Eurodollars was applied to U.S. dollars deposited in any bank account outside the United States. As other currencies became stronger, the market broadened to include Euroyen, Europounds, and other currencies. Today, a currency on deposit outside of its country of issue is defined as a Eurocurrency. The Euroloan market has grown up with the Eurocurrency market. 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. This market is a low-cost source of loans for large, creditworthy borrowers, such as governments and multinational enterprises. In 1981, the Federal Reserve Board authorized the creation of international banking facilities (IBFs).They are subsidiaries of U.S. banks; however, they are distinct from the domestic operations of those banks, and they may offer only international banking services. Because IBFs do not need to observe U.S. domestic banking regulations, they enable U.S. banks to compete with other international bankers in the Euroloan marketplace.
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 bondsForeign bonds are 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 by selling Eurobonds denominated in dollars to residents of Denmark and Germany. The international bond market has grown increasingly sophisticated. Syndicates of investment banks, securities firms, and commercial banks put together complex packages of international bonds to serve the borrowing needs of major MNEs, national governments, and international organizations. One such innovative financial instrument is a global bond—a large, liquid financial asset that can be traded anywhere at any time.
The growing importance of multinational operations and the improvements in telecommunications technology have made equity markets more global. Start-up companies are no longer restricted to raising new equity solely from domestic sources. Established firms can tap into the global equity market. Another innovation is the country fund, which is a mutual fund that specializes in investing in a given country’s firms. The globalization of equity markets has been facilitated by the globalization of the financial services industry. Most major financial services firms, such as Merrill Lynch, Daiwa Securities, and Deutsche Bank, have expanded operations from their domestic bases into the major international financial centers. These financial services firms are eager to raise capital, provide investment advice, offer stock market analyses, and put together financing deals for clients anywhere around the world.
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. Although they are not islands, Luxembourg and Switzerland are also important “offshore” financial centers.MNEs often use offshore financial centers to obtain low-cost Eurocurrency loans. Many MNEs 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.
This section focused on The International Capital Market. The discussion began by examining international banking. It progressed by examining the Eurocurrency market, the international bond market, and global equity markets. The discussion concluded with an overview of offshore financial centers. This presentation will close with an overview of the learning objectives for this chapter.
This concludes the PowerPoint presentation on Chapter 8, “Foreign Exchange and International Financial Markets.” During this presentation, we have accomplished the following learning objectives: Described how demand and supply determine the price of foreign exchange. Discussed the role of international banks in the foreign-exchange market. Assessed the different ways firms can use the spot and forward markets to settle international transactions. Summarized the role of arbitrage in the foreign-exchange market.Discussed the important aspects of the international capital market.For more information about these topics, refer to Chapter 8 in International Business.