12, 13 Financial Markets

8/6/2019 12, 13 Financial Markets

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Sessions: 12 and 13

Financial Markets


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The Market for Currencies

The price of any onecountrys currency in termsof another countryscurrency is called a foreigncurrency exchange rate

Every market, every country,and every firm may have itsown set of currency symbols


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Direct and Indirect Quotations

Most currencies are quoted in direct quotesversus the U.S. dollar

When an exchange rate of a currency isstated without using the U.S. dollar as a

reference, it is referred to as a cross rate


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Foreign Currency MarketStructure

The market for foreign currencies

is a worldwide market th

at isinformal in structure

The market is actually thethousands of telecommunications

links among financial institutionsaround the globe and it is opennearly 24 hours a day


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Market Size and CompositionUntil recently there was little data on the actualvolume of trading on world foreign currencymarkets

In the spring of 1986, the Federal Reserve Bankof New York along with others started surveyingthe activity of currency trading every three years

Growth of foreign currency trading has beennothing less than astronomical

The majority of the worlds trading in foreigncurrencies is still taking place in the cities whereinternational financial activity is centered,London, New York, and Tokyo


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Market Size and CompositionThree reasons typically given forthe enormous growth in foreign

currency trading are:Deregulation of international capital flows

Gains in technology and transaction costefficiency

The world is a risky place


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The Purpose of ExchangeRates

If countries are to trade,they must be able toexchange currencies

The exchange of onecountrys currency for

anoth

er sh

ould berelatively simple, but itsnot


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What is a Currency Worth?The exchange ratebetween currencies

should equalize itspurchasing power

The theory ofpurchasing powerparity (PPP) is

simply the rate thatequalizes the price ofthe identical productor service in twodifferent currencies

The version ofpurchasing power

parity that estimatesthe exchange ratebetween twocurrencies using justone good or service

as a measure of th

eproper exchange forall goods andservices is called theLaw of One Price


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Monetary Systems of the20th Century

Mixed/fixed floating

exch

ange rate system is inoperation today

Prior to this, the GoldStandard was in effect


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The Gold StandardThe gold standard began sometime inthe 1880s

It was premised on three basic ideas:A system of fixed rates of exchange existedbetween participating countries

Money issued by member countries had to bebacked by gold reserves

Gold acted as an automatic adjustment

Under this standard, each countryscurrency would be set in value perounce of gold


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The Bretton Woods Agreement

The governments of 44 of the Allied Powersgathered together in Bretton Woods, NewHampshire in 1944 to plan for the postwar

international monetary systemThis agreement called for the following:

Fixed exchange rates between member countries

The establishment of a fund of gold and currencies forstabilization of their currencies, the InternationalMonetary Fund

The establishment of a bank, the World Bank, thatwould provide funding for long-term developmentprojects


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Floating Exchange RatesSince March 1973, the worldsmajor currencies have floated

in value versus each otherThe inability of a country tocontrol the value of itscurrency on world marketshas been a harsh reality formost

Direct intervention

Coordinated intervention


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International MoneyMarkets

International money markets,often termed the Eurocurrencymarkets, constitute anenormous financial marketthat is in many ways outsidethe jurisdiction andsupervision of world financialand governmental authorities


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Defining InternationalFinancing

The definition of what constitutes

an international financialtransaction is dependent on twocharacteristics:

Whether the borrower is domestic or

foreignWhether the borrower is raising capitaldenominated in the domestic currency or aforeign currency


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International SecurityMarkets

The international debtsecurities markets haveexperienced the greatestgrowth in the past decade

It includes:

Bonds

Equities

Private placements


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International monetary system (IMF)The institutional arrangements thatcountries adopt to govern exchange rates

Dollar, Euro, Yen and Pound floatagainst each other

Floating exchange rate:

Foreign exchange market determinesthe relative value of a currency


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10-18

International monetary system (IMF)

Some countries use other institutionalarrangements to fix their currencys value

Pegged exchange rate Value fixed relative to a reference currency

Dirty float

Hold value within range of a reference currency

Fixed exchange rate Set of currencies are fixed against each other at

some mutually agreed upon exchange rate


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The foreign exchange market

Foreign exchange market:A

market for converting the currency ofone country into the currency of another.

Exchange rate:The rate at which one currency is

converted into anotherForeign exchange risk:

The risk that arises from changes inexchange rates


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Functions of the foreign exchangemarket

Two functions:

Converting currenciesReducing risk


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The foreign exchange market

(FX)Global network of banks, brokers and foreignexchange dealers connected by electroniccommunications systems

Londons dominance is explained by:History (capital of the first major industrializednation).

Geography (between Tokyo/Singapore and New

York).Two major features of the foreign exchangemarket:

The market never sleeps

Market is highly integrated


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Currency convertibility

Political decision.

Many countries have some kind ofrestrictions

Governments limit convertibility to

preserve foreign exchange reserves

Service international debt

Purchase imports

Government afraid of capital flight


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Counter trade

Barter-like agreements where

goods/services are traded forgoods/services

Helps firms avoid convertibility

issue


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Managerial implications

Exchange rates influence theprofitability of trade and investmentdeals

International businesses must

understand the forces that determineexchange rateForward exchange rate not an unbiasedpredictor

Inflation effects foreign exchange marketsInternational businesses need to take theproper precautions before trading orinvesting in a country


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Sources of funds182 nations pay into fund according to thesize of their economy

Funds remain their propertyBorrower repays loan in 1 to 5 years, withinterest

No nation has ever defaulted; some aregiven extensions


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Membership in the IMF

Open to any country willing to agree to itsrules and regulations

Must pay a deposit (quota)

Quota size reflects global importance of anations economy

Quota determines voting powers


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Exchange rates since 1973More volatile:

Oil crisis -1971

Loss of confidence in the dollar - 1977-78

Oil crisis 1979, OPEC increases price of oil

Unexpected rise in the dollar - 1980-85

Rapid fall of the dollar - 1985-87 and 1993-95

Partial collapse of European Monetary System- 1992

Asian currency crisis 1997


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Fixed versus floating exchange rates

Floating:Monetary policyautonomy

Restores control to

governmentTrade balanceadjustments

Adjust currency tocorrect tradeimbalances

Fixed:Monetary discipline

.Speculation

Limits speculators

UncertaintyPredictable ratemovements

Trade balance

adjustmentsArgue no link betweenexchange rates and trade

Link between savingsand investment


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IMF members exchange rate policy,2002


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Exchange rate regimes

Pegged Exchange Rates.

Peg own currency to a major currency ($).

Popular among smaller nations

Evidence of moderation of inflation

Currency Boards.

Country commits to converting domesticcurrency on demand into another currency ata fixed exchange rate

Country holds foreign currency reserves equalto 100% of domestic currency issued


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Crisis management by t

he IMF

Role has expanded to meet crisisCurrency crisis

when a speculative attack on a currencysexchange value results in a sharp depreciation ofthe currencys value or forces authorities to defendthe currency

Banking crisis

Loss of confidence in the banking system leadingto a run on the banks

Foreign debt crisis When a country cannot service its foreign debt

obligations


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Crises

have common underlying

causesCommon causes:

High inflation

Widening current account deficit

Excessive expansion of domestic borrowing

Asset price inflation


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Impact on the countries

Currency devaluationDeclining investment

Rising prices

Rising unemployment

Rising poverty

Rising resentment?


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Implications for business

Currency management

Business strategyForward exchange market (months notyears ahead)

Strategic flexibility

Corporate-government relations

Documents

12, 13 Financial Markets