International Finance, Foreign Exchange, and Foreign Exchange Risk
Foreign Exchange Markets
Definition: The FOREX market provides the infrastructure for currency exchange between nations and sets exchange rates.
Key Functions:
Facilitates the exchange of one country's money for another’s.
Acts as a mechanism for completing foreign exchange transactions based on fixed amounts at specified rates.
Geographic Extent of the Market
Global Reach: The FOREX operates globally with continuous trading around the clock.
Trading Locations:
Trading begins in Sydney and Tokyo, moves through Hong Kong and Singapore, continues to Europe, and ends in New York, USA.
Market Participants
Tiers of the Market:
Interbank/Wholesale Market
Client/Retail Market
Categories of Participants:
Bank and non-bank dealers.
Individuals and firms engaging in transactions.
Speculators and arbitragers.
Central banks and treasuries.
Foreign exchange brokers.
Transactions in the Interbank Market
Types of Transactions:
Spot Transactions: Immediate delivery.
Forward Transactions: Future delivery.
Swap Transactions: Simultaneous exchange of currencies with set value dates.
Example of Swaps:
A swap can be a 'spot against forward' where a dealer buys in the spot market and sells in the forward market to avoid exposure.
Size of the FOREX Market
Daily Turnover:
Estimated at USD 3.7 trillion (April 2010).
Breaking down:
Spot: $1,495 billion/day
Outright forwards: $475 billion/day
Swaps: $1,765 billion/day.
Geographical Breakdown:
55% of transactions are from the UK (London) and the US (New York).
London: 36.7%, US: 17.9%, Japan: 6.2%, Singapore: 5.3%, Switzerland: 5.2%, Hong Kong: 4.2%.
Exchange Rate Determination
Nominal Exchange Rate:
Focus on exports, investments, and income receipts vs payments affecting demand and supply of currency.
Flexible Exchange Rates
Advantages:
Independent monetary policy and automatic adjustment mechanisms.
Disadvantages:
Exposure to uncertainties, which can affect businesses' financial stability.
Fixed Exchange Rates
Advantages:
Reduces volatility and transaction costs.
Disadvantages:
Limits monetary policy and can create vulnerabilities to market instability.
International Parity Conditions
Interest Rate Parity (IRP):
Assumes perfect capital mobility and zero transaction costs.
Defines a relationship between interest rates and exchange rates through an expected forward premium.
Purchasing Power Parity (PPP):
Law of One Price suggests identical goods should have the same price across countries in the long run.
Key Implications of PPP
A country with a high inflation rate generally depreciates while a lower inflation rate generally appreciates the currency.
Managing Exchange Rate Risk
Foreign Exchange Risk:
Risks posed by currency value fluctuations affecting profits.
Policies to Manage Risks:
Matching currency cash flows, Risk-sharing agreements, Back-to-back loans, Currency swaps.
Detailed Examples of Managing Currency Risk
Matching Currency Cash Flows:
Acquire debt in the same currency to offset cash flow exposure.
Risk-sharing Agreements:
Contractual arrangements to share the impact of currency fluctuations.
Cross-Currency Swaps:
Convert debt obligations into different currencies to match cash flows.
Balance of Payments Accounts
Definition:
Measure of all economic transactions between residents of a country and the rest of the world over a period.
Components:
Current Account: Goods, services, income receipts.
Capital Account: Financial transactions and investments.
Balancing Equation:
The balance of payments must equal zero: current account + capital account + net official financing = 0.
Example Transaction Impact on Balance of Payments
Buying imported goods creates a debit in the current account while investment leads to credit.
Current Account Deficits and National Income Accounting
National Income Relationship:
CA = Y - (C + I + G), indicating net savings and investments affect external balances.