Foreign exchange markets allow for the trading of one country's currency for another. This facilitates international trade and investment. The global foreign exchange market consists of major international banks trading various currencies. The major currencies traded are the US dollar, euro, yen, and pound. Arbitrage opportunities can exist when temporary price discrepancies allow traders to profit from buying low and selling high across different currency exchanges.

2. Foreign exchange is a commodity that consists of
currencies issued by countries other than one‟s own.
Functions of foreign exchange :
 To facilitate this conversion of currencies, thereby
allowing firms to conduct trade more efficiently across
national boundaries.
 To facilitates international investment and capital
flows.

3. Figure 8.1 Demand for Yen Figure 8.2 Supply of Yen
Demand for Japanese Yen is Supply for Japanese Yen is
Derived from Foreigner‟s Demand Derived from Japanese Demand
for Japanese Products for Foreign Products

4. Figure 8.3 The Market for Yen

5. EXCHANGE RATE
o Direct exchange rate ( or direct quote) is the price of the
home currency.
~ U.S resident, the direct exchange rate between the U.S
Dollar and the yen (￥) on Wednesday, September 3, was
$.009241/ ￥1.
o Indirect exchange rate ( or indirect quote) is the price of
the home currency in terms of the foreign currency.
~U.S resident’s perspective, the indirect exchange rate on
Wednesday, September 3, was ￥108.21/$1.

6. THE STRUCTURE OF THE FOREIGN-EXCHANGE MARKET
•The foreign-exchange market comprises buyers and sellers of
currencies issued by the world‟s countries.
•Dollar is used to facilitate most currency exchange, it is
known as the primary „transaction currency‟ for the foreign-
exchange market.

7. Structure of the Foreign-
Exchange Market
The Role of Banks
 Buy or sell major traded currencies.
 Markets : Wholesale market
Retail market
Example of large international banks are :-
 JPMorgan
 Chase
 Barclays
 Deutsche Bank

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The clients of the foreign-exchange departments of
banks :-
 Commercial customers
 Speculators
 Arbitrageurs

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2. Spot and Forward Markets
spot market – consist of foreign exchange transaction that are to be
consummated immediately.
Forward market - consist of foreign exchange transaction that are to occur
sometimes in the future.
Swap transaction – a transaction in which the same currency is bought
and sold simultaneously, but deliver is made at two different points in
time.

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The two mechanism for future foreign exchange:
 Currency future
Publicly trade on many exchange worldwide, a currency future is a
contract that resembles a forward contract.
 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 specified date.

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3. Arbitrage and the Currency Market
Arbitrage – 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 :-
 Arbitrage of goods
 Arbitrage of money

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 Arbitrage of goods – purchasing power parity
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.
Represented by theory of purchasing power parity (PPP).
the theory states that the price of tradable goods, when expressed in
common currency, will tend to equalize across countries as a result of
Exchange rate changes.

13. Arbitrage of money
 This method requires money to make money
 The concept is “buy low, sells high”
 When the equilibrium is not in foreign-exchange
market, professional traders can to arbitraging money to gain
profit.
 From an economic view:
 the effect of arbitrage dealings is to correct the equilibrium in the prices
of foreign exchange, or securities, or commodities.
 It is a force tending to equalize, establish parties among markets for the
same item through competition of arbitrageurs.

14. Arbitrage of Money
Two-point
Three-point Covered-interest
8-14

15. Two-point arbitrage
 Also known as geographic arbitrage
 Involves in profiting from price differences in two geographically
distinct markets.
 For example, let the spot exchange rate be £1 = $1.80 in London and
£1 = $2.00 in New York. We are quoting both exchange rate in
sterling.
 Currency A/currency B will give the amount for currency B.
 In London: USD/GBP = £1 / $1.80
= 0.556
 In New York : USD/GBP = £1 / $2.00
= 0.5

16. Three-point arbitrage (TRIANGLE ARBITRAGE)
 is based on the concept of “Relative Arbitrage” and was designed to
exploit price disparities amongst three currency pairs.
 Is the buying and selling of three different currencies to make
riskless profit.
 Example:
 Suppose that £1 can buy $2 in New York, Tokyo, and London, $1
can buy ¥120 in those three market, and £1 can buy ¥200 in all
three. There is three-point arbitrage opportunity exist.

17. Figure 8.6 Three-Point Arbitrage
8-17

18. Covered-interest arbitrage
 Is arbitrage that occurs when the difference between two countries‟
interest rates is not equal to the forward discount on their countries.
 Occurs because international bankers etc are continually scanning
money markets worldwide to obtain the best return on their short-
term excess cash balances and the lowest rates on short-term loans.
 This is to protect or cover themselves from exchange rate risks.
 Example:
 Suppose the annual interest rate for three month deposits is
12percent in London and 8 percent in New York. Investor in new
York will be eager to earn higher return available in London.

19. The International Capital Market
1. Major International Banks
The international banking system is centered in large money market
banks headquartered in the world’s financial centers.
Establishment of overseas Banking Operations :
Subsidiary bank – separate incorporated from the parent.
Branch bank – not separated incorporated.
Affiliate bank – ownership with a local or foreign partner.

20. World’s 20 largest banks

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 Commercial Banking Services.
For exporters and tourist : Exchange home currency or traveler’s checks
for local currency.
 Investment Banking Services.
Furnished by large securities firms like Nomura, Smith Barney, Goldman
Sachs and Merrill Lynch.
To package and locate long-term debt and equity funding.
To arrange mergers and acquisitions of domestic and foreign firms.

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2. The Eurocurrency market
 Originally called the Eurodollar 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
 The Euroloans are often quoted on the basis of LIBOR

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3. International bond market
 Represent a major source of debt financing for
 World’s governments
 International organizations
 Larger firms
 Consisted of two types of bond:
- Foreign Bond
- Eurobond
 As global market evolve, global bond are used as one such
innovative financial instrument.

24. International bond issues in 2007, by currencies (in
billions of U.S. dollars)

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4. GLOBAL EQUITY MARKET
• The growing importance of multinational
operations and improvement in
telecommunications technology have also
made equity markets more global.
• Start-up companies no longer restricted to
raise new equity solely from domestic
sources.
• Country fund is the mutual fund that
specializes in investing in a given country‟s
firms.

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5. Offshore financial centers
 Focus on offering banking and others financial services o nonresident
customers.
 MNCs often used to obtain low-cost Eurocurrency loans.
 Such benefits that they offers are:
- Political stability
- A regulatory climate that facilitates international capital transaction
- Excellent communication links to other major financial centers.
 Location:
 Bahamas, Bahrain, the Cayman Islands, Bermuda, the Netherlands
Antilles, Luxembourg, Singapore, Switzerland