Inflation, Interest Rates,

and Exchange Rates

Lower inflation leads to lower interest rates, so
borrowing in low-interest countries may appear
attractive to multinational firms.
However, currencies in low-inflation countries tend to
appreciate against those in high-inflation rate
countries, so the true interest cost increases over the
life of the loan.

Types of Financial Markets

Physical Asset versus Financial Asset
Market
Money Market versus Capital Market
Primary versus Secondary Market
Open versus Negotiated Market
Spot versus Futures Market

Recent Trends in Financial

Markets
Globalization
Derivatives
Stock Ownership Patterns

What Various Types of Risks Arise

When Investing Overseas?
Country risk: Arises from investing
or doing business in a particular
country. It depends on the
countrys economic, political, and
social environment.
Exchange rate risk: If investment is
denominated in a currency other
than the dollar, the investments
value will depend on what happens
to exchange rate.

The Cost of Money

What do we call the price, or cost, of
debt capital?
What do we call the price, or cost, of
equity capital?

Fundamental Factors Affecting the

Cost of Money

Production opportunities
Time preferences for consumption
Risk
Expected inflation

 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 Marketmade 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
Purposes
Borrowers
Expands money supply
Reduces cost of money

.Lenders
Spread / reduce risk
Offset gains / losses

International Capital
Market 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.

Offshore Financial Centers

Operational
Operational center
center
Extensive
Extensive financial
financial activity
activity
and
and currency
currency trading
trading
Country
Country or
or territory
territory
whose
whose financial
financial sector
sector
features
features few
few regulations
regulations
and
and few,
few, if
if any,
any, taxes
taxes
Booking
Booking center
center
Mostly
Mostly for
for bookkeeping
bookkeeping
and
and tax
tax purposes
purposes

IMF defines OFC as:

Jurisdictions that have relatively large
numbers of financial institutions
engaged primarily in business with nonresidents;
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

Main Components of ICM:

International Bond Market
Market of bonds sold by issuing companies,
governments and others outside their own countries
Eurobond

Foreign bond

Interest rates

Bond that is
issued outside the
country in whose
currency the bond
is denominated

Bond sold outside a

borrowers 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 issuers 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

Introduction
Foreign Exchange Market
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

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 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
countrys currency

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

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

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

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
Londons 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
worlds 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

27

Quoting Currencies
Quoted
Quoted currency
currency == numerator
numerator
Base
Base currency
currency == denominator
denominator
(/$)
(/$) == Japanese
Japanese yen
yen needed
needed to
to buy
buy one
one U.S.
U.S. dollar
dollar
Yen
Yen is
is quoted
quoted currency,
currency, dollar
dollar is
is base
base currency
currency

Currency Values

Change in US dollar
against Polish zloty
February 1: PLZ 5/$
March 1: PLZ 4/$

Change in Polish zloty

against US dollar
Make zloty base currency (1 PLZ/$)
February 1: $.20/PLZ
March 1: $.25/PLZ

%change = [(4-5)/5] x 100 = -20%

%change = [(.25-.20)/.20] x 100 = 25%

US dollar fell 20%

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
1)
2)
3)
4)

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

1)
2)
3)
4)
5)

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 countrys currency is said to be freely
convertible when the countrys 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

 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 ForeignExchange Convertibility

Restrictions used to conserve scarce foreign exchange
Licensinggovernment 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 systemdifferent exchange rates
set for different transactions
Advance import depositrequires importers to make a
deposit with central bank covering price of goods they
would purchase from abroad
Quantity controlslimit the amount of currency that
resident can purchase for foreign travel
Currency controls increase the cost of international business
and reduce overall international trade
35

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
Arbitragepurchase of foreign currency on one market for
immediate resale on another market
Arbitragers hope to profit from price discrepancy
Interest arbitrageinvesting in debt instruments in
different countries
Speculationbuying or selling foreign currency has both risk
and high profit potential

36

Foreign-Exchange Trading Process

Companies work through their local banks to settle foreignexchange 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
37

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 currencycurrency of a developing
country
often unstable, weak, and unpredictable
38

Top 10 Currency Traders

(% of overall volume, May 2005 )

Rank
1
2
3

Name
Deutsche Bank
UBS
Citigroup

% of volume
17.0
12.5
7.5

4
5
6

HSBC
Barclays
Merrill Lynch

6.4
5.9
5.7

7
8
9
10

J.P. Morgan Chase

Goldman Sachs
ABN AMRO
Morgan Stanley

5.3
4.4
4.2
3.9

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 worlds 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

 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

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

ad
Tr
e

Roots in old
mercantile trade
Inconvenient to
ship gold,
changed to
paperredeemable for
gold
Want to achieve
balance-of-trade

Japan

Go
ld

USA

Balance of Trade Equilibrium

Decreased
money supply
= price decline.

Trade Surplus

As prices decline, exports

increase and trade goes
into equilibrium.

Gold

Increased
money supply
= price
inflation.