The Foreign Exchange Markets

1
The Foreign Exchange Markets

• Chapter 5

2
MAIN OBJECTIVES

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

3
MARKET CHARACTERISTICS

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

4
PARTICIPANTS

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

5
PARTICIPANTS Governments

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

6
PARTICIPANTS Central Bank

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

7
PARTICIPANTS Businesses

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

8
PARTICIPANTS Traders

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

9
THE OBJECTIVES COLLIDE

• The incompatibility among objectives for foreign
  exchange become obvious in 1992
• 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

10
USING THE MARKETS

• 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
• Rate of inflation
• Monetary policy
• Governmental expenditure
• Taxation policy
• Enforcement

11
USING THE MARKETSInterest Rate Arbitrage

• Money that is free to move will tend to be
  attracted by the higher rate of interest in
  comparable risk
• 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

12
USING THE MARKETSEffect on Foreign Trade

• Flow of money from one country to another to take
  advantage of higher interest rates affects the
  balance of trade

13
GOVERNMENT AND THE MARKET

• 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
• Controls on current account transactions
• Controls on capital movements

14
GOVERNMENT AND THE MARKETExchange Controls

• During economic difficulties, government acting
  through its central bank or treasury in order to
  protect the nations foreign exchange reserve
• 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

15
ARTIFICIAL CURRENCIES

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

16
ARTIFICIAL CURRENCIES

• 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
• Clearing arrangements essentially require that
  all trade transactions between two countries are
  to be paid through special accounts in their
  central banks

17
THE EUROBackground

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

18
THE EUROEuropean Central Bank (ECB)

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

19
THE EUROConvergence

• To convert so many currencies into one, the
  economies of the individual countries must be in
  similar condition
• If they have different rate of inflation it will
  be difficult for them to use a single currency
• 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)

20
THE EUROConvergence

• Budget deficit no higher than 3 percent of the
  countrys GDP
• Public debt no more than 60 percent of the GDP
• 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

21
THE EUROOutlook

• As a European Monetary Union (EMU) is
  implemented, unforeseen problems are certain to
  arise
• The EMU established a central bank and common
  currency first, without political union
• 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

22
ACCOUNTING

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