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INTERNATIONAL FINANCIAL MARKET & INTERNATIONAL MONETARY SYSTEM. Introduction. Fundamental difference between payment transactions Domestic transaction—use only one curency Foreign transaction—use two or more currencies
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Introduction • Fundamental difference between payment transactions • Domestic transaction—use only one curency • Foreign transaction—use two or more currencies • Foreign exchange— money denominated in the currency of another group of nations • Exchange rate—price of a currency • Number of units of one currency that buys one unit of another currency • Exchange rate can change daily
International financial market comprise of: • International Capital Market • Obtaining external financing. • Main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently. • Foreign-Exchange Market—made up of: • over-the-counter (OTC) • commercial and investment banks • majority of foreign-exchange activity • security exchanges • trade certain types of foreign-exchange instruments
Essential Terms • Security - a contract that can be assigned a value and traded (stocks, bonds, derivatives and other financial assets) • Stocks – A instrument representing ownership • Bonds - a debt agreement • Derivatives - the rights to ownership (financial instruments; futures, forwards, options, swaps)
Essential Terms II • Stock exchange, share market or bourse - is a corporation or mutual organization which provides facilities for stock brokers and traders, to trade company stocks and other securities • Over-the-counter (OTC) trading - is to trade financial instruments such as stocks, bonds, commodities or derivatives directly between two parties. It is contrasted with exchange trading, which occurs via corporate-owned facilities constructed for the purpose of trading (i.e., exchanges), such as futures exchanges or stock exchanges.
Capital Market • System that allocates financial resources according • to their most efficient uses • Common capital market intermediaries: • Commercial Banks • Investment Banks Debt: Repay principal plus interest • Bond has timed principal & interest payments Equity: Part ownership of a company • Stock shares in financial gains or losses
International Capital Market (ICM) Network of people, firms, financial institutions and governments borrowing and investing internationally Lenders • Spread / reduce risk • Offset gains / losses Purposes • Borrowers • Expands money supply • Reduces cost of money
International CapitalMarket Drivers Information technology Deregulation Financial instruments (securitization)
World Financial Centers • At present, the three main financial centers are London, New York and Tokyo • London is one of the three leading world financial centres. It is famous for its banks and Europe's largest stock exchange, that have been established over hundreds of years (e.g. Lloyd's of London, London Stock Exchange). The financial market of London is also commonly referred to as the City. It has historically been situated around the part of London called Square Mile, but in the 1980's and 1990's a large part of the City of London's wholesale financial services relocated to Canary Wharf.
Operational center Extensive financial activity and currency trading Country or territory whose financial sector features few regulations and few, if any, taxes Booking center Mostly for bookkeeping and tax purposes Offshore Financial Centers
IMF defines OFC as: • Jurisdictions that have relatively large numbers of financial institutions engaged primarily in business with non-residents; • Financial systems with external assets and liabilities out of proportion to domestic financial intermediation designed to finance domestic economies; and • More popularly, centers which provide some or all of the following services: low or zero taxation; moderate or light financial regulation; banking secrecy and anonymity.
Foreign bond Interest rates Eurobond Main Components of ICM: International Bond Market Market of bonds sold by issuing companies, governments and others outside their own countries Bond that is issued outside the country in whose currency the bond is denominated Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold Driving growth are differential interest rates between developed and developing nations
International Equity Market Market of stocks bought and sold outside the issuer’s home country • Factors contributing towards growth: • Spread of Privatization • Economic Growth in Developing Countries • Activities of Investment Banks • Advent of Cybermarkets
Eurocurrency Market Unregulated market of currencies banked outside their countries of origin • Governments • Commercial banks • International companies • Wealthy individuals
Foreign Exchange Market Introduction • Foreign exchange market: a market for converting the currency of one country into the currency of another. • Exchange rate: the rate at which one currency is converted into another • Foreign exchange risk: the risk that arises from changes in exchange rates
Foreign Exchange Market Market in which currencies are bought and sold and their prices are determined • Conversion: To facilitate sale or purchase, or invest directly abroad • Hedging: Insure against potential losses from adverse exchange-rate changes • Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit • Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit
The Functions of the Foreign Exchange Market • The foreign exchange market serves two main functions: • Convert the currency of one country into the currency of another • Provide some insurance against foreign exchange risk • Foreign exchange risk: the adverse consequences of unpredictable changes in the exchange rates
Currency Conversion • Consumers can compare the relative prices of goods and services in different countries using exchange rates • International business have four main uses of foreign exchange markets • To invest excess cash for short terms in foreign markets • To profit from the short-term movement of funds from one currency to another in the hopes of profiting from shifts in exchange rates, also called currency speculation • To exchange currency received in the course of doing business abroad back into the currency of its home country • To pay a foreign company for its products or services in its country’s currency
Insuring against Foreign Exchange Risk • A spot exchange occurs when two parties agree to exchange currency and execute the deal immediately • The spot exchange rate is the rate at which a foreign exchange dealer converts one currency into another currency on a particular day • Reported daily • Change continually
Insuring against Foreign Exchange Risk • Forward exchanges occur when two parties agree to exchange currency and execute the deal at some specific date in the future • Exchange rates governing such future transactions are referred to as forward exchange rates • For most major currencies, forward exchange rates are quoted for 30 days, 90 days, and 180 days into the future • When a firm enters into a forward exchange contract, it is taking out insurance against the possibility that future exchange rate movements will make a transaction unprofitable by the time that transaction has been executed
Insuring against Foreign Exchange Risk • Currency swap: the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates • Swaps are transacted between international businesses and their banks, between banks, and between governments when it is desirable to move out of one currency into another for a limited period without incurring foreign exchange risk
The Nature of the Foreign Exchange Market • The foreign exchange market is a global network of banks, brokers and foreign exchange dealers connected by electronic communications systems • The most important trading centers include: London, New York, Tokyo, and Singapore • London’s dominance is explained by: • History (capital of the first major industrialized nation) • Geography (between Tokyo/Singapore and New York) • Two major features of the foreign exchange market: • The market never sleeps • Market is highly integrated
Institutions of Foreign Exchange Market • Interbank Market: market in which the world’s largest banks exchange currencies at spot and forward rates. • “Clearing mechanism” • Securities Exchanges: exchange specializing in currency futures and options transactions. • Over-the-Counter Market: Exchange consisting of a global computer network of foreign exchange traders and other market participants.
The Foreign-Exchange Market • Size of foreign-exchange market • $600 billion spot • $1.3 trillion in derivatives, ie • $200 billion in outright forwards • $1 trillion in forex swaps • $100 billion in FX options. (2004) • U.S. dollar is the most important currency because it is: • An investment currency in many capital markets • A reserve currency held by many central banks • A transaction currency in many international commodity markets • An invoice currency in many contracts • An intervention currency employed by monetary authorities to influence their exchange rates
Quoting Currencies Quoted currency = numerator Base currency = denominator (¥/$) = Japanese yen needed to buy one U.S. dollar Yen is quoted currency, dollar is base currency
Currency Values Change in US dollar against Polish zloty February 1: PLZ 5/$ March 1: PLZ 4/$ %change = [(4-5)/5] x 100 = -20% US dollar fell 20% Change in Polish zloty against US dollar Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ %change = [(.25-.20)/.20] x 100 = 25% Polish zloty rose 25%
Cross Rate • Exchange rate calculated using two other exchange rates • Use direct or indirect exchange rates against a third currency
Cross Rate Example • Direct quote method • Quote on euro = € 0.8461/$ • Quote on yen = ¥ 114.50/$ • € 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥ • Costs 0.0074 euros to buy 1 yen • Indirect quote method • Quote on euro = $ 1.1819/€ • Quote on yen = $ 0.008734/¥ • $ 1.1819/€ ÷ $ 0.008734/¥ = € 135.32/¥ • Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥ • Costs 0.0074 euros to buy 1 yen
Currency Convertibility • Governments can place restrictions on the convertibility of currency • A country’s currency is said to be freely convertible when the country’s government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it • A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations • A currency is nonconvertible when neither residents nor nonresidents are allowed to convert it into a foreign currency
Government restrictions can include • A restriction on residents’ ability to convert the domestic currency into a foreign currency • Restricting domestic businesses’ ability to take foreign currency out of the country • Governments will limit or restrict convertibility for a number of reasons that include: • Preserving foreign exchange reserves • A fear that free convertibility will lead to a run on their foreign exchange reserves – known as capital flight
Governmental Restrictions on Foreign-Exchange Convertibility • Restrictions used to conserve scarce foreign exchange • Licensing—government regulates all foreign-exchange transactions • those who receive foreign currency required to sell it to its central bank at the official buying rate • central bank rations foreign currency • Multiple exchange-rate system—different exchange rates set for different transactions • Advance import deposit—requires importers to make a deposit with central bank covering price of goods they would purchase from abroad • Quantity controls—limit the amount of currency that resident can purchase for foreign travel • Currency controls increase the cost of international business and reduce overall international trade
How Companies Use Foreign Exchange • Most foreign-exchange transactions involve international departments of commercial banks • Banks buy and sell foreign currency; banks collect and pay money in transaction with foreign buyers and sellers • Banks lend money in foreign currency • Companies use foreign-exchange market for: • Import and export transactions • Financial transactions such as FDI • Arbitrage—purchase of foreign currency on one market for immediate resale on another market • Arbitragers hope to profit from price discrepancy • Interest arbitrage—investing in debt instruments in different countries • Speculation—buying or selling foreign currency has both risk and high profit potential
Foreign-Exchange Trading Process • Companies work through their local banks to settle foreign-exchange balances • Commercial banks in major money centers became intermediaries for small banks • Most foreign-exchange activity takes place in traditional instruments • Commercial and investment banks and other financial institutions handle spot, outright forward, and FX swaps • Foreign-exchange market made up of about 2,000 dealer institutions worldwide • Most foreign-exchange takes place in OTC market • Dealers can trade foreign exchange: • Directly with other dealers • Through voice brokers • Through electronic brokerage systems • Internet trades of currency are more popular
Commercial and Investment Banks • Greatest volume of foreign-exchange activity takes place with the big banks • Top banks in the interbank market in foreign exchange are so ranked because of their ability to: • trade in specific market locations • engage in major currencies and cross-trades • deal in specific currencies • handle derivatives • forwards, options, future swaps • conduct key market research • Banks may specialize in geographic areas, instruments, or currencies • exotic currency—currency of a developing country • often unstable, weak, and unpredictable
Top 10 Currency Traders (% of overall volume, May 2005 )
International Monetary System • Rules and procedures by which different national currencies are exchanged for each other in world trade. • Such a system is necessary to define a common standard of value for the world's currencies. • Refer to the institutional arrangements that countries adopt to govern exchange rates • Floating • Pegged exchange rate • Dirty float • Fixed exchange rate
Floating exchange rates occur when the foreign exchange market determines the relative value of a currency • The world’s four major currencies – dollar, euro, yen, and pound – are all free to float against each other • Pegged exchange rates occur when the value of a currency is fixed relative to a reference currency
Dirty float occurs when countries hold the value of their currency within a range of a reference currency • Fixed exchange rate occurs when a set of currencies are fixed against each other at some mutually agreed upon exchange rate • Pegged exchange rates, dirty floats and fixed exchange rates all require some degree of government intervention
Evolution of International Monetary System The Gold Standard • In place from 1700s to 1939 • a monetary standard that pegs currencies to gold and guarantees convertibility to gold • It was thought that gold standard contained an automatic mechanism that contributed to the simultaneous achievement of a balance-of-payments equilibrium by all countries. • The gold standard broke down during the 1930s as countries engaged in competitive devaluations
The Gold Standard • Roots in old mercantile trade • Inconvenient to ship gold, changed to paper- redeemable for gold • Want to achieve ‘balance-of-trade equilibrium Trade USA Japan Gold
Balance of Trade Equilibrium Decreased money supply = price decline. Trade Surplus As prices decline, exports increase and trade goes into equilibrium. Increased money supply = price inflation. Gold
Between the Wars • Post WWI, war heavy expenditures affected the value of dollars against gold • US raised dollars to gold from $20.67 to $35 per ounce • Dollar worth less? • Other countries followed suit and devalued their currencies
Bretton Woods • In 1944, 44 countries met in New Hampshire • Countries agreed to peg their currencies to US$ which was convertible to gold at $35/oz • Agreed not to engage in competitive devaluations for trade purposes and defend their currencies • Weak currencies could be devalued up to 10% w/o approval • Created the IMF and World Bank
International Monetary Fund • The International Monetary Fund (IMF) Articles of Agreement were heavily influenced by the worldwide financial collapse, competitive devaluations, trade wars, high unemployment, hyperinflation in Germany and elsewhere, and general economic disintegration that occurred between the two world wars • The aim of the IMF was to try to avoid a repetition of that chaos through a combination of discipline and flexibility
International Monetary Fund • Discipline • Maintaining a fixed exchange rate imposes monetary discipline, curtails inflation • Brake on competitive devaluations and stability to the world trade environment • Flexibility • Lending facility: • Lend foreign currencies to countries having balance-of-payments problems • Adjustable parities: • Allow countries to devalue currencies more than 10% if balance of payments was in “fundamental disequilibrium”
Purposes of IMF • Promoting international monetary cooperation • Facilitating expansion and balanced growth of international trade • Promoting exchange stability, maintaining orderly exchange arrangements, and avoiding competitive exchange devaluation • Making the resources of the Fund temporarily available to members • Shortening the duration and lessening the degree of disequilibrium in the international balance of payments of member nations
To serve these purposes, the IMF: • monitors economic and financial developments and policies, in member countries and at the global level, and gives policy advice to its members based on its more than fifty years of experience. • For example: In its annual review of the Japanese economy for 2003, the IMF Executive Board urged Japan to adopt a comprehensive approach to revitalize the corporate and financial sectors of its economy, tackle deflation, and address fiscal imbalances.
The IMF commended Mexico in 2003 for good economic management, but said structural reform of the tax system, energy sector, the labor market, and judicial system was needed to help the country compete in the global economy. • In its Spring 2004 World Economic Outlook, the IMF said an orderly resolution of global imbalances, notably the large U.S. current account deficit and surpluses elsewhere, was needed as the global economy recovered and moved toward higher interest rates.