CHAPTER 6FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKETS

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Chapter Objectives 1

1. Describe how demand and supply determine the price of foreign exchange

2. Discuss the role of international banks in the foreign-exchange market

3. Assess the different ways firms can use the spot and forward markets to settle international transactions

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Chapter Objectives 2

4. Summarize the role of arbitrage in the foreign-exchange market

5. Discuss the important aspects of the international capital market

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Foreign Exchange

Foreign exchange is a commodity that consists of currencies issued by countries other than one’s own.

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Figure 8.1 Demand for Yen

Demand for Japanese Yen is Derived from Foreigner’s Demand for Japanese Products

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Figure 8.2 Supply of Yen

Supply for Japanese Yen is Derived from Japanese Demand for Foreign Products

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Figure 8.3 The Market for Yen

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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

tableUSDAmerican DollarGOgraphAmerican DollarAmerican DollarGO

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Figure 8.4 Direct and Indirect Exchange Rates

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Map 8.1 A Day of Foreign-Exchange Trading

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Foreign-Exchange Trading

The Chinese foreign-exchange trader is an important link in the $1.9 trillion-per-day global exchange market.

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Figure 8.5 Currencies Involved in Foreign-Exchange Market Transactions

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The Role of Banks Buy or sell major traded currencies Markets

Wholesale market Retail market

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Bank Foreign Exchange Clients

Commercial customers

Speculators

Arbitrageurs

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Spot and Forward Markets

Currency U.S. $ Equivalent

per U.S. $

Wed. Tues. Wed. Tues.

Britain (Pound) 1.8765 1.8762 .5329 .5330

30-Day Forward 1.8778 1.8775 .5325 .5326

90-Day Forward 1.8802 1.8798 .5319 .5320

180-Day Forward 1.8832 1.8829 .5310 .5311

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Mechanisms for Future Foreign Exchanges Currency future Currency option

Call option Put option

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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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Arbitrage

Arbitrage of Goods

Arbitrage of Money

Arbitrage of Goods

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.

Arbitrage of MoneyProfessional 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.

Arbitrage of Money

Two-point

Three-point

Covered-interest

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Figure 8.6 Three-Point Arbitrage

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Table 8.1 The World’s Largest Banks

Citigroup Fortis Credit Agricole HSBC Holdings BNP paribas

UBS Bank of America J.P. Morgan &

Chase Co. Deutsche Bank HBOS

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Establishment of Overseas Banking Operations

Subsidiary bank

Affiliated bankBranch bank

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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

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The International Bond Market Major source of debt financing for

World’s governments International organizations Larger firms

Two types of bonds Foreign bonds Eurobonds

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Figure 8.7 International Bond Issues 2005, by Currency (in billions of U.S. dollars)

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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

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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

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