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Chapter 7

Financial Markets

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Learning ObjectivesTo understand how currencies are traded and quoted on world financial marketsTo examine the links between interest rates and exchange ratesTo understand the similarities and differences between domestic sources of capital and international sources of capitalTo examine how the needs of individual borrowers have changed the nature of the instruments traded on world financial markets in the past decadeTo understand how the debt crises of the 1980s and 1990s are linked to the international financial markets and exchange rates

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The Market for Currencies

The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rateEvery market, every country, and every firm may have its own set of currency symbols

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Exchange Rate Quotations and Terminology

Direct quotation: when the subject currency is stated firstIndirect quotation: when the subject currency is stated second

Spot rates: when the exchange of currencies takes place immediatelyForward rates: when the currency exchange takes place at a later date and at an agreed upon exchange rate

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Direct and Indirect Quotations

Most currencies are quoted in direct quotes versus the U.S. dollarThe major exceptions are currencies associated with the British Commonwealth and the European euroWhen an exchange rate of a currency is stated without using the U.S. dollar as a reference, it is referred to as a cross rate

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Foreign Currency Market Structure

The market for foreign currencies is a worldwide market that is informal in structureThe “market” is actually the thousands of telecommunications links among financial institutions around the globe and it is open nearly 24 hours a day

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Market Size and Composition

Until recently there was little data on the actual volume of trading on world foreign currency marketsIn the spring of 1986, the Federal Reserve Bank of New York along with others started surveying the activity of currency trading every three yearsGrowth of foreign currency trading has been nothing less than astronomicalThe majority of the world’s trading in foreign currencies is still taking place in the cities where international financial activity is centered, London, New York, and Tokyo

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Market Size and Composition

Three reasons typically given for the enormous growth in foreign currency trading are:

Deregulation of international capital flowsGains in technology and transaction cost efficiency The world is a risky place

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The Purpose of Exchange Rates

If countries are to trade, they must be able to exchange currenciesThe exchange of one country’s currency for another should be relatively simple, but it’s not

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What is a Currency Worth?

The exchange rate between currencies should equalize its purchasing powerThe theory of purchasing power parity (PPP) is simply the rate that equalizes the price of the identical product or service in two different currencies

The version of purchasing power parity that estimates the exchange rate between two currencies using just one good or service as a measure of the proper exchange for all goods and services is called the Law of One Price

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Monetary Systems of the 20th Century

Mixed/fixed floating exchange rate system is in operation todayPrior to this, the Gold Standard was in effectPrior to that, the Bretton Woods Agreement was in effect

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The Gold StandardThe gold standard began sometime in the 1880sIt was premised on three basic ideas:

A system of fixed rates of exchange existed between participating countriesMoney issued by member countries had to be backed by gold reservesGold acted as an automatic adjustment

Under this standard, each country’s currency would be set in value per ounce of gold

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The Bretton Woods Agreement

The governments of 44 of the Allied Powers gathered together in Bretton Woods, New Hampshire in 1944 to plan for the postwar international monetary system

This agreement called for the following:Fixed exchange rates between member countriesThe establishment of a fund of gold and currencies for stabilization of their currencies, the International Monetary FundThe establishment of a bank, the World Bank, that would provide funding for long-term development projects

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Floating Exchange Rates

Since March 1973, the world’s major currencies have floated in value versus each otherThe inability of a country to control the value of its currency on world markets has been a harsh reality for most

Direct interventionCoordinated intervention

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The European Monetary System and the Euro

In 1979 a formalized structure was put in place among many of the major members of the European CommunityThe European Monetary System (EMS) officially began operation in March 1979 and once again established a grid of fixed parity rates among member currenciesThe EMS consisted of three elements:

First, all countries that were committing their currencies and their efforts to the preservation of fixed exchange rates entered the Exchange Rate Mechanism (ERM)Second, was the actual grid of bilateral exchange rates with their specialized band limitsThird, was the creation of the European Currency Unit (ECU)

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The Maastricht Treaty

The members of the European Union concluded this treaty in December 1991This treaty:

Laid out terms goals of harmonized social and welfare policies Specified a timetable for the adoption of a single currency to replace all individual currencies

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The Euro

On December 31, 1998, the final fixed rates between the 11 currencies and the euro were put into placeOn January 1, 1999,the euro was officially launched as a single currency for the European Union

The monetary policy for the EMU will be conducted by the European Central Bank (ECB) and has a single responsibility of safeguarding the stability of the euroOn January 4, 1999, the euro began trading on world currency markets

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International Money Markets

International money markets, often termed the Eurocurrency markets, constitute an enormous financial market that is in many ways outside the jurisdiction and supervision of world financial and governmental authorities

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Eurocurrency Markets and Eurocurrency Interest

RatesA Eurocurrency is any foreign currency denominated deposit or account at a financial institution outside the country of the currency’s issue

While there are hundreds of different major interest rates around the globe, the international financial markets focus on the interbank interest rates

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Defining International Financing

The definition of what constitutes an international financial transaction is dependent on two characteristics:

Whether the borrower is domestic or foreignWhether the borrower is raising capital denominated in the domestic currency or a foreign currency

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Defining International Financing

The two characteristics that define an international financial transaction form four categories:

Domestic borrower/domestic currencyForeign borrower/domestic currencyDomestic borrower/foreign currencyForeign borrower/foreign currency

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Structure of International Banking

Correspondent bank: an unrelated bank based in a foreign countryRepresentative bank: basically a sales office for a bank

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International Security Markets

The international debt securities markets have experienced the greatest growth in the past decadeIt includes:

BondsEquitiesPrivate placements

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The International Bond Market

The international bond market provides the bulk of financing

Foreign bondsEurobondsBearer bonds

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Private Placements

One of the largest and unpublicized capital markets A private placement is the sale of debts or equity to a large investor