Unit 7: International Financial Markets

I. Orientation

International financial markets connect borrowers, lenders, investors, governments, banks, and firms across national borders. Their central function is to transfer funds and manage financial risks internationally, especially the risk created by different currencies. The foreign exchange market determines the relative value of currencies, while exchange-rate arrangements establish how that value is managed by governments and central banks.

• Governing principle: The price of one currency is expressed in another currency, such as ₹83 per US$1 or US$1.09 per €1.
• International transactions: Trade, investment, tourism, remittances, and borrowing create demand for and supply of foreign currencies.
• Exchange-rate risk: A future change in currency value can alter the domestic-currency cost of imports, exports, loans, and investments.
• Market participants: Commercial banks, central banks, corporations, institutional investors, governments, brokers, and individuals participate for trade, investment, speculation, or hedging.
• Two quotation conventions: A direct quote states domestic currency per unit of foreign currency; an indirect quote states foreign currency per unit of domestic currency.
• Core distinction: The spot market handles near-immediate exchange, whereas the forward, futures, options, and swap markets manage future exchange and currency risk.

II. Foreign Exchange Market Mechanism — How Currencies Are Exchanged

The foreign exchange market is a decentralized global network in which currencies are bought and sold, mostly through electronic transactions between banks and financial institutions.

A. Foreign exchange market mechanism

The mechanism operates through currency demand, currency supply, quotations, settlement, and market expectations.

• Currency demand: An Indian importer purchasing American goods demands US dollars and supplies Indian rupees. The importer’s bank normally obtains dollars through the interbank market.
• Currency supply: An American exporter receiving rupees from an Indian buyer supplies dollars and demands rupees when converting the receipt into US currency.
• Interbank structure: Large banks quote simultaneous buying and selling prices to one another. The bid is the price at which a dealer buys a currency; the ask is the price at which the dealer sells it.
• Bid-ask spread: If a bank quotes ₹82.90/US$ bid and ₹83.05/US$ ask, the spread is ₹0.15. It compensates the dealer for operating costs, inventory risk, and market volatility.
• Spot transaction: A spot transaction exchanges currencies at the current market rate, with settlement commonly occurring within two business days.
• Forward transaction: A forward contract fixes an exchange rate today for delivery on a specified future date. It allows an importer or exporter to reduce uncertainty.
• Other instruments: Currency futures are standardized exchange-traded contracts; options provide a right but not an obligation to exchange; swaps combine currency exchanges and later reversals.
• Arbitrage: Dealers may exploit inconsistent prices across markets. Under competitive conditions, arbitrage tends to bring equivalent currency prices into alignment.
• Cross-rate calculation: If US$1 = €0.92 and US$1 = ₹83, then the euro-rupee cross-rate is approximately:

€1 = ₹83 / 0.92 = ₹90.22

Here, ₹ denotes Indian rupees, € denotes euros, and US$ denotes US dollars.

• Central-bank role: A central bank may buy or sell foreign currency, change interest rates, impose controls, or communicate policy intentions to influence market conditions.
• Settlement risk: A transaction can expose one party to the possibility that the counterparty fails to deliver the agreed currency, although clearing systems reduce this risk.

III. Exchange Rate Arrangement — Rules for Managing Currency Values

An exchange-rate arrangement is the framework through which a country determines, fixes, or permits movements in the value of its currency against other currencies.

A. Exchange rate arrangement

Arrangements range from rigidly fixed systems to freely floating systems, with several intermediate forms.

• Fixed exchange rate: The government or central bank maintains a stated parity, such as 1 currency unit = US$0.10, by buying or selling foreign exchange.
• Currency board: A monetary authority issues domestic currency only when supported by foreign reserves, creating a strong commitment to a fixed exchange rate.
• Pegged arrangement: A currency is linked to another currency or basket of currencies. A country may periodically adjust the peg to correct persistent imbalances.
• Crawling peg: The official rate is changed gradually according to an announced rule, such as inflation differentials or a predetermined monthly adjustment.
• Managed float: The currency generally responds to market forces, but the central bank intervenes to limit excessive volatility or correct disorderly movements.
• Free float: The exchange rate is primarily determined by private demand and supply, with little routine official intervention.
• Appreciation and depreciation: Under a floating system, an appreciation means the currency rises in value; a depreciation means it falls. Under a fixed system, an official increase is a revaluation and an official decrease is a devaluation.
• Policy trade-off: The “impossible trinity” states that a country cannot simultaneously maintain a fixed exchange rate, completely free capital movement, and an independent monetary policy.
• Reserve requirement: A fixed-rate system requires adequate foreign reserves. If residents persistently demand foreign currency, reserves may fall and the peg may become unsustainable.
• Advantages of fixed rates: Stable rates support pricing, long-term contracts, and international trade by reducing currency uncertainty.
• Costs of fixed rates: Maintaining the rate may require high interest rates, reserve use, capital controls, or restrictions on domestic economic policy.
• Advantages of floating rates: Floating rates permit monetary-policy independence and allow external imbalances to be adjusted through currency movements.
• Costs of floating rates: Large or unpredictable changes can increase import prices, debt-servicing costs, and uncertainty for international firms.

IV. Determinants of Exchange Rates — Forces Behind Currency Prices

The exchange rate is determined by the interaction of economic fundamentals, financial flows, expectations, and government policy. In the short run, financial-market factors may dominate; in the long run, purchasing power and productivity become more important.

A. Determinants of exchange rates

Exchange-rate changes reflect relative conditions between two countries rather than conditions in one country alone.

• Demand and supply: Demand for a currency rises when foreigners buy the country’s goods, services, assets, or financial instruments. Supply rises when domestic residents buy foreign goods or assets.
• Inflation: Higher domestic inflation generally reduces export competitiveness and increases demand for imports. Over time, the high-inflation currency tends to depreciate.
• Interest rates: Higher interest rates may attract foreign capital seeking better returns, increasing demand for the currency. The effect depends on whether the higher rates reflect strong returns or serious inflation and risk.
• Purchasing power parity: The theory suggests that identical goods should have similar prices after currency conversion. If a basket costs US$100 in the United States and ₹8,300 in India, the implied rate is:

₹8,300 / US$100 = ₹83 per US$1

Persistent differences in inflation can cause the market rate to move away from this relationship.

• Income and economic growth: Rising national income can increase imports and supply more domestic currency in exchange markets. Strong growth can also attract investment, so the final exchange-rate effect depends on which force is stronger.
• Balance of payments: A current-account deficit may create pressure for depreciation because imports exceed exports. Capital inflows can offset that pressure by increasing foreign demand for domestic currency.
• Government debt and fiscal policy: Large deficits or rising public debt may weaken confidence and increase expected depreciation, particularly where investors doubt the government’s ability to stabilize finances.
• Political stability: Stable institutions, predictable laws, and credible policy attract capital. Political conflict, sanctions, or policy uncertainty commonly reduce demand for the affected currency.
• Productivity and competitiveness: Higher productivity lowers unit production costs and can strengthen exports, increasing demand for the domestic currency.
• Terms of trade: An increase in export prices relative to import prices can improve foreign-exchange earnings and support appreciation, especially for commodity-exporting countries.
• Market expectations: If traders expect depreciation, they may sell the currency immediately. Such expectations can become self-reinforcing through speculative capital outflows.
• Central-bank intervention: Purchasing domestic currency supports its value; selling domestic currency and buying foreign reserves tends to weaken it.
• Foreign reserves and credibility: Large, liquid reserves improve a central bank’s capacity to defend a peg and reassure investors about external-payment ability.

V. Exchange Rate Movements and Their Impact — Economic and Business Consequences

Exchange-rate movements change the domestic-currency value of international transactions. Their effects depend on the direction and size of the movement, the time period, contract terms, and the responsiveness of trade volumes.

A. Exchange rate movements and their impact

An appreciation makes foreign goods and assets cheaper in domestic currency, while a depreciation makes them more expensive.

• Import prices: If the rate moves from ₹83/US$ to ₹88/US$, a US$10,000 machine rises from ₹830,000 to ₹880,000, ignoring taxes and other charges.
• Export competitiveness: Depreciation can make domestic exports cheaper for foreign buyers because fewer units of their currency are needed to purchase the same product.
• Imported inflation: Higher prices for oil, machinery, components, and food can pass through supply chains and raise the general price level.
• Trade balance: Depreciation may improve the trade balance when export and import quantities respond sufficiently to price changes. Initially, however, the trade balance can worsen because existing import contracts become more expensive; this pattern is known as the J-curve effect.
• Foreign-currency debt: A firm with US$1 million of unhedged debt owes ₹83 million at ₹83/US$, but ₹88 million after depreciation to ₹88/US$.
• Investment flows: Appreciation can increase the foreign-currency value of domestic assets and encourage confidence. Conversely, depreciation may attract investors seeking cheaper assets but can also signal financial instability.
• Profit translation: A multinational converts subsidiary earnings into the parent company’s currency. A stronger parent currency reduces the reported value of foreign earnings even if local operations perform unchanged.
• Transaction exposure: A known payable or receivable in foreign currency changes value between contract date and settlement date.
• Translation exposure: Foreign subsidiaries’ financial statements change in reported domestic value when consolidated into the parent’s accounts.
• Economic exposure: Long-term currency movements affect competitiveness, market share, sourcing decisions, and the location of production.
• Consumer effects: Appreciation increases purchasing power for imported products and overseas travel. Depreciation reduces that purchasing power but may support domestic tourism and locally produced substitutes.
• Interest-rate response: A central bank facing depreciation pressure may raise interest rates to attract capital, but higher rates can reduce investment, consumption, and employment.
• Hedging response: An exporter expecting a US$ receipt may sell dollars forward. The contract fixes the conversion rate and protects the budgeted domestic-currency amount, although it removes gains from a favorable movement.
• Distributional effects: Exporters and firms earning foreign currency may benefit from depreciation, while importers, consumers of imported goods, and borrowers in foreign currency may lose.
• Time horizon: Short-term movements are strongly affected by news, capital flows, and speculation; long-term movements are more closely related to inflation, productivity, external competitiveness, and fiscal credibility.