Chapter 8 Foreign Exchange and International Financial Markets

Chapter 8: Foreign Exchange and International Financial Markets International Business, 4 th Edition Griffin & Pustay 8 -1 © 2004 Prentice Hall

Chapter Objectives_1 § Describe how demand 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 2 © 2004 Prentice Hall

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 3 © 2004 Prentice Hall

Foreign Exchange A commodity that consists of currencies issued by countries other than one’s own 4 © 2004 Prentice Hall

Figure 8. 1 Demand for Japanese Yen is Derived from Foreigner’s Demand for Japanese Products 5 © 2004 Prentice Hall

Figure 8. 2 Supply for Japanese Yen is Derived from Japanese Demand for Foreign Products 6 © 2004 Prentice Hall

Figure 8. 3 The Market for Yen 7 © 2004 Prentice Hall

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 8 © 2004 Prentice Hall

Figure 8. 4 Direct and Indirect Exchange Rates 9 © 2004 Prentice Hall

The Role of Banks § Wholesale market foreign exchange § Retail market foreign exchange § Clients – Commercial customers – Speculators – Arbitrageurs 10 © 2004 Prentice Hall

Map 8. 1 A Day of Foreign-Exchange Trading 11 © 2004 Prentice Hall

Figure 8. 5 Currencies Involved in Foreign-Exchange Market Transactions 12 © 2004 Prentice Hall

Tokyo is the third largest center foreignexchange trading, trailing only London and New York 13 © 2004 Prentice Hall

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 14 © 2004 Prentice Hall

Mechanisms for Future Foreign Exchanges § Currency future § Currency option – Call option – Put option 15 © 2004 Prentice Hall

Figure 8. 6 Foreign-Exchange Options on the Chicago Mercantile Exchange 16 © 2004 Prentice Hall

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 17 © 2004 Prentice Hall

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 18 © 2004 Prentice Hall

The prices these Mexican shoppers pay foreign-made goods are affected by fluctuations in the value of the peso in the foreign-exchange market 19 © 2004 Prentice Hall

Arbitrage of Money § Two-point (geographic arbitrage) § Three-point § Covered interest 20 © 2004 Prentice Hall

Figure 8. 7 Three-Point Arbitrage 21 © 2004 Prentice Hall

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 22 © 2004 Prentice Hall

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 23 © 2004 Prentice Hall

Establishment of Overseas Banking Operation § Subsidiary bank § Branch bank § Affiliated bank 24 © 2004 Prentice Hall

The Eurocurrency Market § Originated in the early 1950 s § 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 25 © 2004 Prentice Hall

The International Bond Market § Major source of debt financing for – World’s governments – International organizations – Larger firms § 2 types of bonds – Foreign bonds – Eurobonds 26 © 2004 Prentice Hall

Figure 8. 8 International Bond Issues, 2001, by Currency (in billions of U. S. dollars) 27 © 2004 Prentice Hall

Hong Kong residents seeking to buy shares in the Web portal firm tom. com 28 © 2004 Prentice Hall

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 29 © 2004 Prentice Hall

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 30 © 2004 Prentice Hall