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CHAPTER 8
Foreign Exchange and International Financial
Markets
Chapter Objectives
After studying this chapter, students should be able to:
1. Describe how demand and supply determine the price of foreign
exchange.
2. Discuss the role of international banks in the foreign-exchange market.
4. Summarize the role of arbitrage in the foreign-exchange market.
5. Discuss the important aspects of the international capital market.
LECTURE OUTLINE
OPENING CASE: The Loonie Takes Flight
This case discusses the increasing value of the Canadian dollar in relation to the U.S.
dollar, and the effect that increase has on U.S. trade and investment with Canada.
Key Points
• The loonie is the nickname given for the Canadian one-dollar coin.
• In 2007, the Canadian dollar increased 24 percent against the U.S. dollar.
• The increasing value of the Canadian dollar resulted from concerns about the U.S.
economy.
• With the decline of export, Canadian economists are predicting a significant loss in
jobs. At the same time, Canadian retailers are also suffering as Canadians head
south to the U.S. to take advantage of cheaper American goods.
• With the global recession of 2008-2009, commodity prices softened and the loonie
fell in value against the US Dollar.
CHAPTER SUMMARY
Chapter Eight introduces the student to the practical aspects of the foreign-exchange
market. The chapter discusses how currency prices are determined, the role and
activities of international banks in the foreign-exchange markets, how the spot and
forward markets are used in international trade transactions, arbitrage in the foreign-
exchange markets, and issues relating to the international capital markets.
THE ECONOMICS OF FOREIGN EXCHANGE
• Foreign exchange is a commodity that consists of currencies issued by countries other
than one’s own.
• The price of different currencies in the flexible exchange rate system is determined by
supply and demand. Demand for a currency occurs when the residents of a country buy
Teaching Note:
Instructors may find it worthwhile to create a scenario in which students
are asked to obtain a particular currency from another student to see the
supply and demand process in action.
• The exchange rate is the price of one currency in terms of another, at the equilibrium
price of the foreign currency. Discuss Figure 8.3 here.
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THE STRUCTURE OF THE FOREIGN EXCHANGE MARKET
BRINGING THE WORLD INTO FOCUS
A Brief Hint
This section helps the student better understand exchange rates by using “laymen’s
terms” to discuss the prices of currencies. Specifically, the section links the price of
currencies with the price of bread. It fits in well with a preliminary discussion of exchange
rates.
The foreign-exchange market consists of buyers and sellers of currencies, including
international banks, central banks, brokers, businesses, and speculators. Foreign
The Role of Banks
• The foreign-exchange departments of large international banks play a dominant role
in the foreign-exchange market.
E-WORLD
The Biggest Online Market
The foreign-exchange market does $4.0 trillion worth of business a day. It is the
world’s single biggest market and is moving online to take advantage of speed and
lower cost. FXall.com is a recently created multi-bank online partnership to serve as
a one-stop shop for currency traders.
• International banks operate in both the wholesale and retail markets as they trade for
their own accounts and those of customers. Commercial customers are involved in
the foreign-exchange market through their normal commercial activities. Speculators
take positions in currencies as they try to predict the direction of currency
fluctuations. In doing so, speculators deliberately assume exchange-rate risk.
Spot and Forward Markets
• Currencies can be traded in the spot market or in the forward market. Spot
transactions are delivered in two business days, while forward transactions are
delivered at the specified forward date of 30, 90, or 180 days. Most transactions in
the forward market are swap transactions in which the trader simultaneously buys
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Currency can also be obtained through currency options. A call option allows the
holder to purchase a specified quantity of foreign exchange at a specified price by a
specified date, while a put option allows a holder to sell a specified quantity of
foreign exchange at a specified price by a specified date. Options do not have to be
exercised.
Arbitrage and the Currency Market
• Arbitrage is 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 – Purchasing Power Parity. The law of one price suggests
that arbitrage activities will continue until the price of the good in question is equal in
both markets. The theory of purchasing power parity (PPP) states that the prices
of tradable goods, when expressed in a common currency, will tend to equalize
BRINGING THE WORLD INTO FOCUS
The Big Mac Index: Sandwiched
This box illustrates the concept of purchasing power parity by considering the price
of Big Macs around the world. The box is a useful one because most students can
relate to the product in question, and may have even purchased Big Macs in other
countries. The box fits in well with a discussion of PPP.
• Arbitrage of Money. In the financial markets, arbitrageurs attempt to make risk-free
profits by trading in foreign exchange. Two-point arbitrage (also known as
geographic arbitrage) allows a trader to capitalize on differences between currency
prices in two foreign-exchange markets. Three-point arbitrage involves buying and
selling three different currencies to make a risk-free profit. A currency’s cross-rate
VENTURING ABROAD
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The Carry Trade
This section explains a strategy where an investor attempts to exploit differences in the
interest rates between countries. An investor borrows a currency from a country with a
relatively low interest rate, and then uses those borrowed funds to purchase a different
currency from a country paying a higher interest rate.
Example:
THE INTERNATIONAL CAPITAL MARKET
Major International Banks
• International banks play an important role in assisting companies with their
international transactions. International banks act both as commercial bankers and
as investment bankers. Their operations can take various forms. Discuss Table 8.1
here.
• Correspondent banking relationships involve setting up a reciprocal relationship
with a bank in another country. Under the agreement, each bank will then act as the
local bank for foreign customers. For example, a British bank may set up a
correspondent relationship with a Swiss bank in which the British bank acts as the
Swiss bank’s correspondent in Britain and the Swiss bank acts as the British bank’s
correspondent in Switzerland.
• Banks that have more extensive international operations may have a subsidiary
bank, a branch bank, or an affiliated bank. A subsidiary bank is an operation that is
The Eurocurrency Market
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• The Eurocurrency market involves currencies deposited outside of their country of
origin. For example, a Eurodollar is a dollar deposited in a bank outside of the
United States. Eurodollars make up the majority (approximately two-thirds) of the $9
trillion Eurocurrency market.
• The Euroloan market offers large, creditworthy borrowers an inexpensive source of
loans. Loans are inexpensive because the market is unregulated, transactions are
The International Bond Market
• Companies or governments seeking debt financing frequently turn to the
Global Equity Markets
• Equity markets are more global today, reflecting the role of multinational companies
and improved telecommunications. Financial services firms, recognizing this
phenomenon, have expanded their operations to participate in the major international
Offshore Financial Centers
• Offshore financial centers are designed to meet the needs of nonresident customers.
They typically have a lax regulatory climate, strict secrecy laws, good
communications with other financial enterprises, and political stability.
CHAPTER REVIEW
1. What determines demand for any given currency in the foreign-exchange market?
Supply and demand for currencies establishes prices in the foreign-exchange market.
Demand for a country’s currency increases when foreigners buy that country’s products.
2. What determines supply of any given currency in the foreign-exchange market?
The means by which equilibrium is reached in a fixed exchange system differs according to
the time frame in question. In the short term, equilibrium is reached as central banks buy or
3. How are prices established in the foreign-exchange market?
In a flexible exchange rate system, equilibrium is reached through the market forces of
4. What is the role of international banks in the foreign-exchange market?
The role of banks in the foreign-exchange market is varied. They play a major role in both
the wholesale and retail markets. In the wholesale market, international banks are
5. Explain the different techniques that firms can use to protect themselves from future
changes in exchange rates.
There are several techniques that firms can use as they try to protect themselves from future
foreign-exchange-rate changes. In most cases, a company will contract with an
international bank to buy or sell foreign exchange on either a spot or forward basis,
6. Discuss the major types of arbitrage activities that affect the foreign-exchange market.
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The major types of arbitrage activities that affect the foreign-exchange market are two-point
arbitrage, three-point arbitrage, and covered-interest arbitrage. A two-point arbitrage
7. Describe the various forms a bank’s overseas operations may take.
Banks’ overseas operations can take many forms. A subsidiary bank is one that is
incorporated separately from the parent company. In contrast, an operation that is not
8. What are Eurocurrencies?
Eurocurrencies are currencies deposited in countries other than their country of issue. (LO
9. What are the major characteristics of offshore financial centers?
Offshore financial markets are primarily located in small island states (e.g., the Bahamas)
that provide nonresident customers with banking and other financial services. They are
QUESTIONS FOR DISCUSSION
1. Suppose the Federal Reserve Bank unexpectedly raises interest rates in the United States.
How will this impact the foreign-exchange market?
If the Federal Reserve Bank unexpectedly raises interest rates in the United States,
investors, both U.S. and foreign, will buy dollar-denominated assets to capitalize on the
2. How important are communications and computing technologies to the smooth functioning
of the foreign-exchange market? If the technological advances of the past four decades
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were eliminated—for example, no PCs or satellite telecommunications—how would the
foreign-exchange market be affected?
Communications and computing technology are critical to the smooth functioning of the
foreign-exchange market. If the technological advancements of the past four decades were
3. Do you expect the U.S. dollar to maintain its position as the dominant currency in the
foreign-exchange market once the euro is fully established? Why or why not?
Students will probably take different perspectives in responding to this question. Some
students will suggest that the U.S. dollar cannot possibly maintain its position as the
dominant currency in the foreign-exchange market because at least 12 (and possibly more,
4. Suppose the spot pound and the 90-day forward pound are both selling for $2.00, while the
U.S. interest rates are 10 percent and British interest rates are 6 percent. Using the covered
interest arbitrage theory, describe what will happen to the spot price of the pound, the 90-
day forward price of the pound, interest rates in the United States, and interest rates in the
U.K. when arbitrageurs enter this market.
Under the current situation, traders would convert their pounds to dollars at $2.00/pound,
take advantage of the higher U.S. interest rate, and convert the dollars back to pounds in 90
5. How important is the creation of international banking facilities to the international
competitiveness of the U.S. banking industry?
The creation of international banking facilities is very important to the international
competitiveness of the U.S. banking industry. In the 1970s, U.S. banks believed they were
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6. What would be the impact on world trade and investment if there were only one currency?
If there were one currency, the main impact on world trade and investment would possibly
be stability. If all countries had the same currency, there would be no need for foreign–
BUILDING GLOBAL SKILLS
Essence of exercise
This exercise allows the student to test his/her knowledge of exchange rates and the forward
market. It involves simple mathematical calculations, as well as more thought-provoking
exercises that require the student to extend the basic mathematical calculations and
observations to draw conclusions about the implications of flexible exchange rates.
Answers to the follow-up questions (based on Figure 8.4):
1. What is the spot rate for the British pound on Wednesday in terms of the U.S. dollar? Or
stated differently, how many dollars does a pound cost? Or, from the U.S. perspective,
what’s the direct quote on pounds?
2. What is the spot price for the dollar on Wednesday in terms of the Swiss franc? (Or, from the
U.S. perspective, what is the indirect rate on Swiss francs?)
3. Calculate the cross rate of exchange between the British pound and the Swiss franc.
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4. Calculate the annualized forward premium or discount on the 180-day yen.
5. If you’re planning to go to Japan this summer, should you buy your yen today? Why or why
not?
The answer depends on the difference between the interest rate you would get on your
6. According to the covered-interest arbitrage theory, is the United States or Japan expected to
have higher interest rates?
7. According to the covered-interest arbitrage theory, what is the expected difference between
interest rates in the United States and Japan?
8. According to the international Fisher effect, is the expected inflation rate higher in Japan or
in the United States?
9. Did the value of the Canadian dollar rise or fall between Tuesday and Wednesday?
Other Applications
Students may find it interesting to “track” a particular currency over a three–year period by
looking up the exchange rates in the Wall Street Journal for the first day of each month
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CLOSING CASE
The Subprime Meltdown, Global Recession
The closing case examines the events leading to the financial crisis currently affecting the
global financial services industry and its impact on the world economy.
Key Points:
• This crises impacts people from all over the world.
• The key cause of the global recession was the globalization of the financial markets
that allowed the bursting of the real estate bubble around the world.
• The problem was made worse when the U.S. Federal Reserve cut interest rates in
an attempt to stimulate the economy. The lowering interest rates then created the
boom in the U.S. housing market.
• As housing prices increased, the lenders lowered the down payment requirement,
and started offering “no money down” mortgages, interest only and adjustable rate
mortgages, which came with some uncharacteristically low initial rates.
• This became a global crisis because many of these mortgages were sold into the
secondary market. Many of these mortgages were bundled together and sold to
investors as “Collateralized Debt Obligations” (CDO’s).
• As people started defaulting on their loans, these investors were left with properties
that continued to lose value.
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• In an attempt to maintain liquidity, many central banks (including the U.S. Federal
Reserve) released funds.
Case Questions
1. This case refers to the “classic trap of borrowing short and lending long.” Explain
what this means. What are the advantages of borrowing short and lending long?
What are the disadvantages?
Financial institutions tend to borrow money from depositors for short terms and lend
money out to clients for long terms. (For example: A depositor visits a bank and
acquires a 6-month Certificate of Deposit that pays an interest rate of, say, 2.5%.
The bank might then take that deposit and combine it with other short-term deposits
to give a prospective homeowner a 30-year mortgage with an interest rate of 5.5%.)
2. Why do the Sovereign Wealth Funds of Singapore, Abu Dhabi, and China choose to
invest in UBS, CITIGROUP, and Morgan Stanley at a time they were performing
“poorly”? Do these investments create any public policy issues? If so, what are
they?
Sovereign Wealth Funds are a new and controversial source of capital for the world
economy (see Venturing Abroad – Chapter 2 / p.44). They have decided to invest in
3. What happens to an economy when the housing bubble bursts?
4. The change in the mortgage lending standards in the United States created a global
financial crisis. Do you think an international financial regulatory agency should be
created to reduce the likelihood that such crises will arise in the future? Why or why
not?
Students will probably take different perspectives in responding to these questions.