Chapter 3 - International Financial Markets Flashcards
International Financial Markets:
Foreign exchange market
International money market
International credit market
International bond market
International stock markets
Foreign Exchange Market
Allows for the exchange of one currency for another.
Exchange rate specifies the rate at which one currency can be exchanged for another.
Note: When MNCs and individuals engage in international transactions, they commonly need to exchange their local currency for a foreign currency, or exchange a foreign currency for their local currency. Theforeign exchange marketallows for the exchange of one currency for another. Large commercial banks serve this market by holding inventories of each currency so that they can accommodate requests by individuals or MNCs for currency for various transactions.
History of Foreign Exchange (Gold Standard (1876 – 1913))
Each currency was convertible into gold at a specified rate. When World War I began in 1914, the gold standard was suspended. Some countries tried to peg their currencies to USD or GBP.
Note: Gold Standard (1876 – 1913): Each currency was convertible into gold at a specified rate. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Each country used gold to back its currency.
Agreements on Fixed Exchange Rates
Bretton Woods Agreement 1944 – 1971: an international agreement called for fixed exchange rate between currencies in 1944. By 1971, USD had become overvalued. Major countries met to discuss and resulted in the Smithsonian Agreement to devalue USD within stated boundaries.
Smithsonian Agreement 1971 – 1973: However, central banks still had difficulty to maintain exchange rates within the boundaries. By 1973, the official boundaries had been eliminated and allow exchange rates to move more freely according to market forces
Bretton Woods Agreement 1944 – 1971: An exchange rate was set for each pair of currencies, and each country’s central bank was required to maintain its respective local currency’s value within1percentof the agreed-upon exchange rates. By 1971, the U.S. dollar had apparently become overvalued. Interventions by central banks could not effectively offset the large imbalance between demand and supply.
Smithsonian Agreement 1971 – 1973: the U.S. dollar’s value was devalued (reset downward) relative to the other major currencies. Exchange rates were also allowed to fluctuate by2.5percent. Even with the wider bands allowed by the Smithsonian Agreement, central banks still had difficulty maintaining exchange rates within the stated boundaries.
Floating Exchange Rate System
Widely traded currencies were allowed to fluctuate in accordance with market forces
Floating Exchange Rate System: By March 1973, the official boundaries imposed by the Smithsonian Agreement had been eliminated, thereby allowing exchange rates to move more freely. Since that time, the currencies of most countries have been allowed to fluctuate in accordance with market forces; however, some countries’ central banks still periodically intervene in the foreign exchange market to influence the market-determined exchange rate or to reduce the volatility
The over-the-counter (OTC) market:
is the telecommunications network where companies normally exchange one currency for another on a daily basis around the world.
The largest foreign exchange trading centers:
London (40%), New York (20%), Singapore, Hong Kong, Tokyo
Foreign exchange dealers
serve as intermediaries in the foreign exchange market: e.g. Citigroup, JP Morgan, Barclays, UBS etc.
Spot Market:
A foreign exchange transaction for immediate exchange is said to trade in the spot market. It’s the most common type of forex transaction. The exchange rate in the spot market is the spot rate.
Spot Market Structure:
Commercial transactions in the spot market are often completed electronically. If a bank begins to experience a shortage of
a particular foreign currency, it can purchase that currency from other banks. This trading between banks occurs in the interbank market.
Knowing that currencies are allowed to fluctuate in accordance with market forces in many countries nowadays, how do foreign exchange transactions take place? The foreign exchange market does not just locate at a certain building or location. Companies exchange currencies through commercial banks over the telecommunications network, which represents an over-the-counter market. London accounts for around 40% and New York City accounts for about 20% of the trading volume in the world.
And the most common type of foreign exchange transaction is for immediate exchange. The market where such transactions occurs is called spot market. And the exchange rate in the spot market is called the spot rate.
In the foreign exchange market, foreign exchange dealers serve as intermediaries by exchanging currencies desired by MNCs or individuals. These dealers include large commercial banks such as JP Morgan, Barclays, UBS etc.
If a bank has a shortage of a certain currency, it can buy this currency from other banks. Such trading between banks happens in the interbank market.
Use of the dollar in spot markets:
USD is the commonly accepted medium of exchange in the spot market. This is especially true in countries where the home currency is weak or subject to restrictions. Many merchants accept USD since they can easily use them to buy goods from other countries
Spot market time zones:
Foreign exchange trading is conducted only during normal business hours in a given location. Thus, at any given time on a weekday, somewhere around the world a bank is open and ready to accommodate foreign exchange requests. There is also night trading.
Spot market liquidity:
More buyers and sellers means more liquidity.
-heavily traded currencies (EUR, GBP, JPY) are extremely liquid
-currencies of less developed countries are less liquid
A currency’s liquidity affects the ease with which it can be bought or sold by an MNC. If a currency is illiquid, then the number of willing buyers and sellers is limited, so an MNC may be unable to purchase or sell a large amount of that currency in a timely fashion and at a reasonable exchange rate.
Attributes of Banks That Provide Foreign Exchange:
- Competitiveness of quote: better rate
- Special relationship with the bank: other services like cash management; hard-to-find currencies
- Speed of execution: efficiency matters especially for corporate clients
- Advice about current market conditions: assessment about foreign economies
- Forecasting advice: forecast of foreign economies and exchange rates
Bid/Ask Spread of Banks:
At any given point in time, a bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote.
Bid/Ask spread of banks: The bid/ask spread covers the bank’s cost of conducting foreign exchange transactions.
-A larger bid/ask spread generates more revenue for commercial banks, but represents a higher cost to individuals or MNCs that engage in foreign exchange transactions.
-The bid/ask spread is typically expressed as a percentage of the ask quote.
Comparison of Bid/Ask spread among currencies
The difference between a bid quote and an ask quote will look much smaller for currencies of lesser value. This differential can be standardized by measuring the spread as a percentage of the currency’s spot rate.
Factors That Affect the Spread:
The spread on currency quotations is influenced by the following factors:
- Order Costs
- Inventory Costs
- Competition
- Volume
- Currency Risk
Order costs:
Costs of processing orders, including clearing costs and the costs of recording transactions.
Inventory costs:
Costs of maintaining an inventory of a particular currency.
Competition:
The more intense the competition, the smaller the spread quoted by intermediaries.
Volume:
Currencies that have a large trading volume are more liquid because there are numerous buyers and sellers at any given time.
Currency risk:
Economic or political conditions that cause the demand for and supply of the currency to change abruptly. Intermediaries that are willing to buy or sell these currencies could incur large losses due to such changes in their value.
Direct versus indirect quotations at one point in time.
An indirect quotation is the reciprocal (inverse) of the corresponding direct quotation.
Direct Quotation represents the value of a foreign currency in dollars (number of USD per unit of a foreign currency).
Example: 1 euro = x dollars or x dollars per euro (USD1.11/Euro)
Indirect quotation represents the number of units of a foreign currency per dollar (i.e. number of a foreign currency per USD).
Example: 1 dollar = x euros or x euros per dollar (Euro0.9/USD)
Indirect quotation = 1 / Direct quotation
Direct versus indirect exchange rate over time
Exhibit 3.2 demonstrates that the indirect exchange rate is the inverse of the direct exchange rate and also shows relationship between direct exchange rate and indirect exchange rate.
When the euro is appreciating against the dollar (based on an upward movement of the direct exchange rate of the euro), the indirect exchange rate of the euro is declining.
When the euro is depreciating (based on a downward movement of the direct exchange rate) against the dollar, the indirect exchange rate is rising.
