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Chapter 8:Foreign Exchange and International Financial Markets

International Business, 4th Edition

Griffin & Pustay

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Chapter Objectives_1

Describe how demand and supply determine the price of foreign exchange

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

Summarize the role of arbitrage in the foreign-exchange market

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Chapter Objectives_2

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

Discuss the important aspects of the international capital market

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Foreign Exchange

A commodity that

consists of currencies

issued by countries

other than one’s own

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Figure 8.1

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

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Figure 8.2

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

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Figure 8.4 Direct and

Indirect Exchange

Rates

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The Role of Banks

Wholesale market for foreign exchange Retail market for foreign exchange Clients

– Commercial customers

– Speculators

– Arbitrageurs

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Map 8.1 A Day of Foreign-Exchange Trading

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Figure 8.5 Currencies Involved in Foreign-Exchange Market Transactions

4 613

23

38

90

202 4

Canadian dollarSwiss francPound sterlingJapanese yenEuroU.S. dollarOther currenciesAustralian dollarHong Kong dollar

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Tokyo is the third largest center for foreign-

exchange trading,

trailing only London and New York

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Spot and Forward Markets

Lending and Purchasing on credit Spot market: foreign-exchange transactions

that are to be consummated immediately Forward market: foreign exchange

transactions that are to occur at some time in the future

Swap transaction: same currency is bought and sold simultaneously with delivery at different points in time

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Mechanisms for Future Foreign Exchanges

Currency future Currency option

– Call option

– Put option

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Figure 8.6 Foreign-Exchange

Options on the

Chicago Mercantile Exchange

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Arbitrage and the Currency Market

Arbitrage: the riskless purchase of a product in one market for immediate resale in a second market in order to profit from a price discrepancy– Arbitrage of goods

– Arbitrage of money

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Theory of Purchasing Power Parity (PPP)

The prices of tradable goods, when expressed in a common currency, will tend to equalize across countries as a result of exchange rate changes

Occurs because process of buying goods in a cheap market and reselling them in expensive market affects demand for (and price of) the foreign currency and the market price of the good in the two product markets in question

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The prices these Mexican shoppers pay

for foreign-made goods are affected by

fluctuations in the value of the peso in

the foreign-exchange market

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Arbitrage of Money

Two-point (geographic arbitrage) Three-point Covered interest

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Figure 8.7 Three-Point Arbitrage

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Importance of Arbitrage Activities

Constitutes a major portion of $1.2 trillion currencies traded globally each working day

Ties together the foreign-exchange markets

Overcomes differences in geography, currency type, time

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Table 8.1 The World’s 10 Largest Banks

Rank Company Country Assets ($ Mil)

1 Mizuho Holdings Japan 1,148,917

2 Citigroup US 1,051,450

3 Sumitomo Mitsui Banking Japan 820,083

4 Deutsche Bank Germany 813,619

5 Mitsubishi Tokyo Financial Group Japan 755,481

6 UBS Switzerland 752,332

7 BNP Paribas France 733,423

8 HSBC Holdings UK 694,238

9 J.P. Morgan Chase US 693,575

10 Bayerische Hypo Bank Germany 647,926

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Establishment of Overseas Banking Operation

Subsidiary bank Branch bank Affiliated 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

2 types of bonds– Foreign bonds– Eurobonds

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Figure 8.8 International Bond Issues, 2001, by Currency (in billions of U.S. dollars)

Other currencies, 24, 2%

U.S. dollar, 558, 48%

British pound, 66, 6%

Euro, 503, 44%

U.S. dollarEuroBritish poundOther currencies

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Hong Kong residents

seeking to buy shares in

the Web portal firm tom.com

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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 non-resident customers

Locations– Bahamas, Bahrain, the Cayman Islands,

Bermuda, the Netherlands Antilles, Singapore, Luxembourg, Switzerland