INTERNATIONAL FINANCIAL

MARKETS AND INSTITUTIONS

International financial market and institution
International financial markets are relevant to companies, whether or not they become directly
involved in international business through exports, direct investment, and the like.
Purchases of imported products or services may require payment in foreign exchange, thus
involving exchange risk.

Why international financial markets

A company may choose to invest in a foreign business or security,
and face both different interest rates and different risks from those at home. Often companies find that borrowing
funds abroad is less expensive than borrowing domestically, in the
United States or in any other home country. The relatively unrestricted “euromarkets” generally
offer better terms to borrowers (and lenders) than do domestic financial markets in
any country. Likewise, in the 2000s, investors are discovering more and more opportunities
to diversify their portfolios into holdings of foreign securities. This chapter explores the
various foreign and international financial markets, including the foreign exchange
market, and examines ways to utilize them for domestic and international business.

Exchange risk
The risk of financial loss or
gain due to an unexpected
change in a currency’s value

Foreign exchange
Foreign-currencydenominated
financial
instruments, ranging from
cash to bank deposits to
other financial contracts
payable or receivable in
foreign currency

Eurocurrency
A bank deposit in any
country that is denominated
in a foreign currency.
A yen-denominated bank
deposit in Germany is a
euro-yen deposit, a form of
Eurocurrency

FOREIGN EXCHANGE MARKETS

Currencies, like any other products, services, or claims, can be traded for one another. The
foreign exchange market is simply a mechanism through which transactions can be made
between one country’s currency and another’s. Or, more broadly, a foreign exchange
market is a market for the exchange of financial instruments denominated in different currencies.
The most common location for foreign exchange transactions is a commercial
bank, which agrees to “make a market” for the purchase and sale of currencies other than
the local one. In the United States, hundreds of banks offer foreign exchange markets in
dozens of cities.However, over 40 per cent of all foreign exchange business is done through
the 10 largest banks in New York.
Foreign exchange is not simply currency printed by a foreign country’s central bank;
rather, it includes such items as cash, checks (or drafts), wire transfers, telephone transfers,
and even contracts to sell or buy currency in the future
Exchange rate
The value of one currency
in terms of another; for
example, $US 1.30 / € 1

Since no currency is necessarily fixed in value relative to others, there must be some means
of determining an acceptable price, or exchange rate. How many British pounds (£) should
one dollar buy? How many Brazilian reals should be paid to buy a dollar? Since 1973, most of
the industrialized countries have allowed their currency values to fluctuate more or less freely
(depending on the time and the country), so that simple economics of supply and demand
largely determine exchange rates.

Foreign exchange markets in the United States

The interbank market

Foreign exchange traders

Bankers who deal in foreign
exchange, buying and selling
foreign currencies on
behalf of clients and/or for
the bank itself; typically
they deal in foreigncurrency-
denominated
bank deposits

The brokers’ market

Foreign exchange broker

A company that provides
specialized services to
commercial banks in the
interbank foreign exchange
market, essentially functioning
to unite interested
buyers and sellers of foreigncurrency-
denominated bank
deposits; brokers intermediate
about half of all wholesale
foreign exchange
transactions in New York
and London

Spot rate
The exchange rate offered
on the same day as the request
to buy or sell foreign
currency; actual settlement
(payment) may occur one
or two days later

Forward rate
An exchange rate contracted
today for some future
date of actual currency
exchange; banks offer forward
rates to clients to buy
or sell foreign currency in
the future, guaranteeing
the rate at the time of the
agreement
The forward foreign exchange market

The futures market in currencies

The foreign exchange futures contract is an agreement to buy or sell a fixed

amount of foreign currency for delivery at a fixed future date at a fixed dollar price.

The main
difference between futures and forward contracts in the United States is that futures contracts
have fixed sizes (about $50,000 to $100,000, depending on the currency) and pre-established
maturity dates. (All are 3-, 6-, 9-, or 12-month contracts maturing on the third Wednesday of
March, June, September, or December.) Also, futures contracts are available for only a few currencies
(Canadian dollars, euros, Swiss francs, British pounds, Japanese yen, Mexican pesos,
Australian dollars, and a few others), and only if a buyer and a seller can be found at the time.

Arbitrageur
A person or firm that deals
in foreign exchange, buying
or selling foreign currency
with simultaneous contracting
to exchange back to
the original currency; arbitrageurs
thus do not undertake
exchange risk

DETERMINATION OF THE EXCHANGE RATE

Exchange rates are determined by the activities of the various actors described earlier. If
one could calculate the supply and demand curves for each exchange market participant
and anticipate government constraints on the exchange market, exchange rate determination
would be fairly simple. The composite supply and demand for foreign exchange
would be as depicted in Figure 7.1
Lacking this information, the analyst can still rely on two fundamental economic relationships
that underlie exchange rate determination. Note that this section considers only
economic factors; government restrictions on the exchange market are ignored.
The two fundamental economic relationships are purchasing power parity and the
international Fisher effect. The former posits that shifts in exchange rates will occur to offset
different rates of inflation in pairs of countries, and the latter proposes that exchange
rates will shift to offset interest rate differentials between countries.

Purchasing power parity

The theory of exchange
rate determination that
states that differences in
prices of the same goods
between countries will be
eliminated by exchange rate
changes

Purchasing power parity6

If a standard ton of polyurethane plastic costs $200 in the United States and € 190 in
Germany, purchasing power parity (PPP) requires an exchange rate of $US 1.05/€. The
same reasoning could be used for all products whose production processes are equivalent
in two countries and that are traded between these countries. The exchange rate that comes
closest to simultaneously satisfying all of these equilibrium conditions is the PPP rate—a
rate that equates the internal purchasing power of the two currencies in both countries.
Assuming we begin from that exchange rate, what will happen if Germany’s inflation is
5 per cent and the US inflation is 10 per cent in the following year? Purchasing power
parity requires that the exchange rate adjust to eliminate this differential. Specifically, it
requires that:
where:

This means that inflation in the United States relative to inflation in Germany should be
the same as the future exchange rate compared to the spot exchange rate. The relationship
can also be written in a form similar to the interest parity equation by rearranging terms:

Purchasing power in each currency will be retained if:

International Fisher effect

The international Fisher effect (IFE) translates Irving Fisher’s reasoning about domestic interest
rates to the transnational level. Fisher showed that inflation-adjusted (i.e., “real”) interest
rates tend to stay the same over time; as inflation rises or falls, so do nominal (unadjusted)
interest rates, such that real interest rates remain unchanged. At the transnational level, nominal
national interest rates are expected to differ only by the expected change in the national
currency’s price (i.e., the exchange rate). The international Fisher effect thus concludes that
interest differentials between national markets will be eliminated by adjustments in the
exchange rate. In terms similar to PPP, we see that:

where i = the interest rate, usually on a eurocurrency deposit denominated in the given
country’s currency.
If the eurodollar deposit rate is 3 per cent/year and the euro-euro rate is 6 per cent/year,
the euro will be expected to devalue in the coming year by:

Notice that the international Fisher effect will operate in a free market, because investors will
receive a higher return in euros otherwise. As more and more investors put their money in
euros, the spot price of the euro will rise. Similarly, as US investors return their euro earnings
to dollars at the end of the period (year), this increased demand for dollars will cause
the euro to devalue (in the future). Thus, dollar and euro earnings will tend to be equalized.

International Fisher
effect
Theory of exchange rate
determination that states
that differences in nominal
interest rates on similar-risk
deposits will be eliminated
by changes in the
exchange rate

Nominal interest rate

The actual rate of interest
offered by a bank, typically
given as an annual percentage
rate

Real interest rate

The nominal interest rate
adjusted for price changes.
Domestically, this means
adjusting for inflation; internationally,
this means adjusting
for exchange rate
(currency price) changes