The Foreign Exchange Markets Chapter 5 MAIN OBJECTIVES

The Foreign Exchange Markets Chapter 5

MAIN OBJECTIVES n Explain the use of the foreign exchange market n Demonstrate the relationship between foreign exchange and interest rates. n Describe the euro

MARKET CHARACTERISTICS n The global trading in many advanced economies is an unregulated financial market n Many developing countries in order to solve balance of payment problems, rationing limited foreign exchange earnings n Many countries limit access to foreign exchange and maintain fixed exchange rate under control of government

PARTICIPANTS n There are four major group of participants in the global foreign exchange markets: q q n Governments Central Bank Businesses Traders Each of these market participants has certain objectives, some of which overlap with those of other participants

PARTICIPANTS: Governments n Stability of exchange rates has been a continuing goal of governments and businesses n Stability means that the price for one currency remains basically constant in terms of other major currency n Stability it is when the buyers and sellers in the market are in equilibrium

PARTICIPANTS: Central Bank n n Although often seen as one, the government and its central bank may differ in countries where the central bank has great independence. The government’s focus is on the political consequences of an action, but the central bank is usually more concerned with the monetary effects

PARTICIPANTS: Businesses n Businesses become increasingly more global n Businesses have strong incentive to support governments’ goal of maintaining stable exchange rate n The establishment of the Exchange Rate Mechanism (ERM) provided investors and businesses with a degree of freedom from concern about exchange rate volatility

PARTICIPANTS: Traders n In the world country’s currency is freely convertible into other currencies since 1970 s, when rate of exchange has been determined by free-market trading between buyers and sellers n The emphasis foreign exchange traders has shifted over the decades from meeting the needs of importers and exporters to trading for profit

THE OBJECTIVES COLLIDE n The incompatibility among objectives foreign exchange become obvious in 1992 q q q Traders wanted profit Governments and central banks wanted stable exchange rates and the ability to manage their own internal money markets to maintain national economics growth and prosperity Businesses wanted stability for long-term investment decisions

USING THE MARKETS n n International finance today is a relative freedom of money to move from one country to another for short or long-term investment However, each currency remains a domestic currency whose market interest rates are basically determined by conditions within the country: n n n Rate of inflation Monetary policy Governmental expenditure Taxation policy Enforcement

USING THE MARKETS Interest Rate Arbitrage n Money that is free to move will tend to be attracted by the higher rate of interest in comparable risk n Fund flow through the foreign exchange market as funds in one currency are converted to those of another to be invested in higher-yielding instruments. This is the meaning of interest rate arbitrage

USING THE MARKETS Effect on Foreign Trade n Flow of money from one country to another to take advantage of higher interest rates affects the balance of trade

GOVERNMENT AND THE MARKET n n n Governments of all countries concerned with activities in the foreign exchange markets Developing countries control of the use of their currency is more direct, though regulation that limit how their currency may be used. These regulations are usually applied in two categories n n Controls on current account transactions Controls on capital movements

GOVERNMENT AND THE MARKET Exchange Controls n During economic difficulties, government acting through its central bank or treasury in order to protect the nation’s foreign exchange reserve n Each country establishes rules that are generally referred to as foreign exchange controls or regulations, which is often are accompanied by trade restriction, such as tariffs or quotes

ARTIFICIAL CURRENCIES n To reduce the impact of monetary changes, nations have found it advantageous to create artificial currencies for certain uses n These are two main forms: q q Baskets of currencies Clearing arrangements

ARTIFICIAL CURRENCIES n Basket of currencies is a group of national currencies weighted by specific formula. This combination may provide greater stability than would basing transactions on just one of the national currencies n Clearing arrangements essentially require that all trade transactions between two countries are to be paid through special accounts in their central banks

THE EURO Background n Meeting at Maastricht, Holland, in December 1991, the countries of the EU agreed upon a timetable for the creation of common currency-the euro n Its implementation will free country-to-country payments from the major risk of changing currency values

THE EURO European Central Bank (ECB) n The euro was issued by European Central Bank, which took over responsibility for monetary policy in the 11 countries n This bank become national units of the overall European System of Central Banks, which the ECB heads n ECB structure much like the Federal Reserve System in US and its independent of any of the EU governments or organizations

THE EURO Convergence n To convert so many currencies into one, the economies of the individual countries must be in similar condition n If they have different rate of inflation it will be difficult for them to use a single currency n The Maastricht treaty specified that if countries wishing to be part of the new single currency would have to coverage following criteria: (see next slide)

THE EURO Convergence q Budget deficit no higher than 3 percent of the country’s GDP q Public debt no more than 60 percent of the GDP q q q Foreign exchange rates have been within the boundaries of the Exchange Rate Mechanism for two years and within a 15 percent fluctuation range Inflation within 1. 5 percent of the three best EU countries Long-term interest rates within 2 percent of the three lowest EU countries

THE EURO Outlook n As a European Monetary Union (EMU) is implemented, unforeseen problems are certain to arise q The EMU established a central bank and common currency first, without political union q q This is an economic and monetary union, not political. Everything else remains in the power of each country It will take time for each level of the economies to make the transition from being a national economy to being regions of a much larger euro area

ACCOUNTING n Foreign exchange contracts are reflected in a bank’s balance sheet in contingent accounts n Outstanding contracts be included in calculating the capital ratio n Contracts of fewer than 14 days are excluded n Other contracts revalued based on the current market price n Contracts with the same party can be netted out