Foreign exchange is a commodity that consists ofcurrencies issued by countries other than one‟s own.Functions of foreign exchange : To facilitate this conversion of currencies, therebyallowing firms to conduct trade more efficiently acrossnational boundaries. To facilitates international investment and capitalflows.
Figure 8.1 Demand for Yen Figure 8.2 Supply of YenDemand for Japanese Yen is Supply for Japanese Yen isDerived from Foreigner‟s Demand Derived from Japanese Demandfor Japanese Products for Foreign Products
EXCHANGE RATEo Direct exchange rate ( or direct quote) is the price of thehome currency.~ U.S resident, the direct exchange rate between the U.SDollar and the yen (￥) on Wednesday, September 3, was$.009241/ ￥1.o Indirect exchange rate ( or indirect quote) is the price ofthe home currency in terms of the foreign currency.~U.S resident’s perspective, the indirect exchange rate onWednesday, September 3, was ￥108.21/$1.
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.
Structure of the Foreign-Exchange MarketThe Role of Banks Buy or sell major traded currencies. Markets : Wholesale market Retail marketExample of large international banks are :- JPMorgan Chase Barclays Deutsche Bank
Continue…The clients of the foreign-exchange departments ofbanks :- Commercial customers Speculators Arbitrageurs
Continue…2. Spot and Forward Marketsspot market – consist of foreign exchange transaction that are to beconsummated immediately.Forward market - consist of foreign exchange transaction that are to occursometimes in the future.Swap transaction – a transaction in which the same currency is boughtand sold simultaneously, but deliver is made at two different points in time.
Continue…The two mechanism for future foreign exchange: Currency futurePublicly trade on many exchange worldwide, a currency future is acontract that resembles a forward contract. Currency optionAllows, but does not require, a firm to buy or sell a specified amount of aForeign currency at a specified price at any time up to specified date.
Continue…3. Arbitrage and the Currency MarketArbitrage – riskless purchase of a product in one market for immediateresale 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
Continue… Arbitrage of goods – purchasing power parityif the price of a good differs between two markets, people will tend to buythe good in the market offering the lower price, the “cheap” market, andresell 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 incommon currency, will tend to equalize across countries as a result ofExchange rate changes.
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.
Arbitrage of Money Two-point Three-point Covered-interest 8-14
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
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.
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.
The International Capital Market1. Major International BanksThe international banking system is centered in large money marketbanks 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.
Continue… Commercial Banking Services.For exporters and tourist : Exchange home currency or traveler’s checksfor local currency. Investment Banking Services.Furnished by large securities firms like Nomura, Smith Barney, GoldmanSachs and Merrill Lynch.To package and locate long-term debt and equity funding.To arrange mergers and acquisitions of domestic and foreign firms.
Continue… 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
Continue…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.
International bond issues in 2007, by currencies (inbillions of U.S. dollars)
Continue…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.
Continue…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