Unit 7: International Financial Markets - Subjective Questions

Foreign exchange market: The foreign exchange market is a global, decentralized market in which national currencies are bought and sold. It operates mainly through electronic networks connecting commercial banks, central banks, foreign exchange dealers, multinational enterprises, brokers, investors, and governments.

Major functions:

• Currency conversion: It enables businesses and individuals to convert one currency into another for international trade, investment, tourism, and remittances.
• Transfer of purchasing power: Funds can be transferred between countries through foreign currency transactions.
• Credit provision: Instruments such as letters of credit, bills of exchange, and bank guarantees facilitate international transactions.
• Hedging of exchange risk: Forward contracts, futures, options, and swaps help firms protect themselves against unfavorable exchange rate movements.
• Speculation: Traders may buy or sell currencies to profit from expected exchange rate changes.
• Arbitrage: Dealers exploit temporary price differences across markets, thereby promoting consistent exchange rates.
• Exchange rate determination: Demand and supply for currencies contribute to the determination of market exchange rates.

The main participants and their motives are:

• Commercial banks: Conduct foreign exchange transactions for customers and trade currencies on their own account. The interbank market forms the core of the foreign exchange market.
• Central banks: Buy or sell currencies to influence exchange rates, maintain foreign exchange reserves, and implement monetary or exchange rate policy.
• Multinational enterprises: Exchange currencies to pay for imports, receive export proceeds, remit profits, make foreign investments, and hedge currency exposure.
• Foreign exchange brokers and dealers: Match buyers and sellers or provide two-way currency quotations. They earn brokerage fees or bid-ask spreads.
• Institutional investors: Mutual funds, pension funds, insurance companies, and hedge funds trade currencies while managing international portfolios.
• Governments and public institutions: Exchange currencies for debt payments, official purchases, and international assistance.
• Individuals: Participate through tourism, education expenses, remittances, online trading, and overseas investments.
• Speculators and arbitrageurs: Speculators accept risk to earn profits, whereas arbitrageurs exploit price differences with relatively limited risk.

Spot transaction:

• Involves the purchase or sale of currency at the current market exchange rate.
• Settlement normally occurs within two business days.
• The applicable rate is called the spot exchange rate.
• It is suitable when a business requires immediate currency conversion.

Forward transaction:

• Involves an agreement today to exchange currencies at a specified future date.
• The exchange rate is fixed when the contract is made.
• The forward rate may be at a premium or discount relative to the spot rate.
• It is commonly used for hedging future receipts or payments.

Business application: Suppose an importer must pay after three months. If the domestic currency is expected to depreciate, the importer can purchase dollars through a three-month forward contract. This fixes the domestic-currency cost and eliminates uncertainty.

A forward contract therefore provides certainty of cash flows, protects profit margins, facilitates budgeting, and reduces transaction exposure. However, the firm cannot benefit from a favorable exchange rate movement after the forward rate has been fixed.

Direct quotation: It states the number of units of domestic currency required to purchase one unit of foreign currency. For India, is a direct quotation.

Indirect quotation: It states the number of units of foreign currency obtainable for one unit of domestic currency. The reciprocal of is:

Bid and ask rates:

• The bid rate is the rate at which a dealer buys the base currency.
• The ask rate is the rate at which a dealer sells the base currency.
• The difference is the bid-ask spread:

Cross-rate calculation:

Given:

and

Therefore:

Thus, the cross exchange rate is:

Cross rates are useful when two currencies are not quoted directly but are each quoted against a common third currency.

Under a market-based system, the exchange rate is determined by the interaction of demand for and supply of foreign currency.

Demand for foreign currency arises from:

• Imports of goods and services
• Overseas travel and education
• Foreign debt repayments
• Investment in foreign financial and real assets
• Expectations that the foreign currency will appreciate

Supply of foreign currency arises from:

• Exports of goods and services
• Foreign tourism receipts
• Remittances from abroad
• Foreign direct and portfolio investment inflows
• External borrowing and official transfers

The equilibrium exchange rate occurs where the quantity of foreign currency demanded equals the quantity supplied:

Here, is the equilibrium domestic-currency price of foreign currency.

• If demand exceeds supply, there is upward pressure on , meaning that the foreign currency appreciates and the domestic currency depreciates.
• If supply exceeds demand, falls, meaning that the foreign currency depreciates and the domestic currency appreciates.

The demand and supply curves may shift because of inflation, interest rates, income, trade flows, capital movements, expectations, or government intervention. Under a fixed exchange rate, the central bank must buy or sell foreign currency to maintain the official rate rather than allowing the market to clear freely.

Foreign exchange arbitrage is the simultaneous purchase and sale of currencies in different markets to profit from inconsistent exchange rates. It helps eliminate price differences and promotes market efficiency.

1. Locational arbitrage: It occurs when the same currency has different prices at two locations or banks. For example, if Bank A sells dollars at and Bank B buys dollars at , an arbitrageur can buy dollars from Bank A and immediately sell them to Bank B, earning per dollar before transaction costs.

2. Triangular arbitrage: It occurs when exchange rates among three currencies are inconsistent. Suppose market quotations imply:

The dollar-based cross rate should be:

Since the euro is quoted at in the direct rupee-euro market, a trader may purchase euros through dollars at and sell them for , subject to transaction costs.

Arbitrage buying raises the underpriced currency's price, while arbitrage selling reduces the overpriced currency's price. The inconsistency therefore tends to disappear quickly.

Under a direct quotation, the exchange rate represents units of domestic currency per unit of foreign currency.

• Domestic currency depreciation: An increase in means that more domestic currency is required to buy one unit of foreign currency. For example, a movement from to indicates depreciation of the rupee.
• Domestic currency appreciation: A decrease in means that fewer units of domestic currency are required to buy one unit of foreign currency. A movement from to indicates appreciation of the rupee.

The percentage change in the direct exchange rate is:

For a movement from to per dollar:

Thus, the dollar appreciates by against the rupee based on the direct quotation. The exact percentage depreciation of the rupee is measured using the reciprocal rates and need not be identical because percentage changes depend on the chosen base.

Fixed exchange rate: The monetary authority fixes the currency's value against another currency, a basket of currencies, or a commodity.

• Advantages: Stability for trade and investment, lower exchange risk, and monetary discipline.
• Limitations: Requires large reserves, limits monetary policy independence, and may cause speculative attacks when the fixed rate is unrealistic.

Freely floating exchange rate: The rate is determined mainly by market demand and supply, with little or no official intervention.

• Advantages: Automatic balance-of-payments adjustment, greater monetary policy autonomy, and no need to defend a particular rate.
• Limitations: Volatility, uncertainty for international businesses, and possible overshooting due to speculation.

Managed floating exchange rate: Market forces determine the rate, but the central bank intervenes to reduce excessive volatility or guide the currency toward a desired range.

• Advantages: Combines market flexibility with some degree of stability and permits intervention during disorderly market conditions.
• Limitations: Policy may lack transparency, intervention can be costly, and countries may manipulate the currency for competitive advantage.

The appropriate arrangement depends on economic size, trade openness, reserve adequacy, financial development, capital mobility, inflation history, and the credibility of monetary institutions.

Conventional currency peg:

• The domestic currency is fixed to another currency or currency basket.
• The central bank maintains the rate through foreign exchange intervention and monetary policy.
• The peg may be adjusted or abandoned when economic conditions change.
• Some limited monetary policy discretion remains.

Currency board:

• Domestic currency is issued only against foreign currency reserves at a legally fixed rate.
• The monetary base is generally backed fully, or nearly fully, by foreign reserves.
• Monetary policy discretion and the central bank's lender-of-last-resort function are severely restricted.
• It provides stronger credibility than a conventional peg but reduces flexibility during crises.

Official dollarization:

• A country adopts a foreign currency, such as the US dollar, as legal tender and may eliminate its own currency.
• Exchange rate risk against the adopted currency disappears.
• The country loses independent monetary policy and seigniorage revenue.
• It also cannot devalue its own currency to restore external competitiveness.

Thus, the three arrangements involve progressively stronger commitments to exchange rate stability and progressively greater sacrifices of monetary autonomy.

A country should consider the following factors:

• Trade openness: Highly open economies may value exchange rate stability because currency fluctuations strongly affect trade prices.
• Economic size and diversification: Small, less-diversified economies may benefit from a stable anchor, while large economies may prefer monetary independence.
• Inflation history and policy credibility: A fixed rate can provide a nominal anchor where domestic monetary credibility is weak.
• Capital mobility: High capital mobility makes a fixed rate more difficult to maintain without sacrificing monetary autonomy.
• Foreign exchange reserves: A peg requires sufficient reserves to meet excess demand for foreign currency.
• Similarity with the anchor economy: Similar business cycles make a peg less costly.
• Financial market development: Deep markets can support floating rates and effective hedging.
• Exposure to external shocks: Flexible rates can act as shock absorbers.

Impossible trinity: A country cannot simultaneously achieve all three of the following:

1. A fixed exchange rate
2. Free international capital mobility
3. An independent monetary policy

It can choose only two. For example, a country maintaining a fixed rate and free capital movement must align its interest rates with those of the anchor country. A country wanting monetary independence and free capital movement must generally allow its currency to float. This policy trade-off is central to the choice of exchange rate arrangement.

Purchasing power parity (PPP) states that exchange rates tend to adjust according to differences in national price levels.

Absolute PPP: Under the law of one price, identical tradable goods should have the same price in different countries after currency conversion. If is the domestic price level and is the foreign price level, the equilibrium exchange rate expressed as domestic currency per unit of foreign currency is:

If a basket costs in India and in the United States, absolute PPP gives:

Relative PPP: Relative PPP focuses on changes in price levels rather than their absolute levels. The approximate percentage change in the exchange rate is:

where is domestic inflation and is foreign inflation. If domestic inflation is and foreign inflation is , the domestic currency is expected to depreciate by approximately .

Limitations: PPP may not hold in the short run because of transport costs, tariffs, non-tradable goods, price controls, different consumption baskets, sticky prices, capital flows, and speculation. It is generally more useful as a long-run explanation of exchange rate movements.

Covered interest parity (CIP) states that, after covering exchange risk through a forward contract, comparable domestic and foreign investments should provide the same return. Otherwise, covered interest arbitrage would occur.

Let:

• = spot rate in domestic currency per unit of foreign currency
• = forward rate in domestic currency per unit of foreign currency
• = domestic interest rate
• = foreign interest rate

One unit of domestic currency invested domestically becomes:

Alternatively, it can be converted into foreign currency, invested abroad, and converted back at the forward rate. Its covered domestic value becomes:

Under equilibrium:

Therefore:

or

For relatively small interest rates:

Thus, the currency of the country with the higher interest rate generally trades at a forward discount, while the lower-interest currency trades at a forward premium. Transaction costs, taxes, capital controls, and credit risk may create small deviations from parity.

Short-run determinants:

• Interest rate changes: Higher interest rates may attract portfolio capital and strengthen a currency, provided inflation and default risk do not increase.
• Market expectations: Expectations about future inflation, growth, policy, or political events can cause immediate currency movements.
• Speculation and market sentiment: Herd behavior, risk aversion, and technical trading may produce short-term volatility.
• Capital flows: Foreign portfolio investment and sudden capital withdrawals strongly affect demand and supply.
• Central bank intervention: Official purchases or sales of currencies can influence short-run rates.
• Political and geopolitical developments: Elections, conflict, sanctions, and policy uncertainty influence investor confidence.

Long-run determinants:

• Relative inflation rates: Higher domestic inflation generally leads to currency depreciation over time.
• Productivity and competitiveness: Higher productivity can improve exports and strengthen the currency.
• Current account position: Persistent deficits may create depreciation pressure, although they can be financed by capital inflows.
• Economic growth: Growth may attract investment but can also increase imports, so the final effect depends on its source.
• Public debt and fiscal stability: Unsustainable debt can reduce confidence and weaken the currency.
• Terms of trade: Higher export prices relative to import prices may strengthen the currency.
• Structural and institutional quality: Stable institutions and credible policies support currency demand.

Exchange rates are therefore jointly determined by trade fundamentals, financial flows, policy decisions, and expectations.

The balance of payments records a country's transactions with the rest of the world. Its major components are the current account, capital account, financial account, and changes in official reserves.

• A current account surplus generates a net supply of foreign currency through exports and income receipts, which may create appreciation pressure on the domestic currency.
• A current account deficit creates excess demand for foreign currency to pay for imports and may cause depreciation.
• Foreign direct investment and portfolio inflows increase the supply of foreign currency and can strengthen the domestic currency.
• Capital outflows increase demand for foreign currency and can weaken the domestic currency.
• Under a floating rate, exchange rate changes help restore overall external equilibrium.
• Under a fixed rate, the central bank finances an overall deficit by selling foreign exchange reserves and absorbs a surplus by purchasing foreign currency.

A current account deficit does not always cause depreciation if it is financed by stable capital inflows. Similarly, a country may have a current account surplus but experience depreciation because of large capital outflows. Therefore, the exchange rate responds to the combined balance of current and financial transactions, expectations, and official intervention.

A central bank intervenes by buying or selling foreign currency to influence the exchange rate, reduce volatility, maintain a target, or build reserves.

To resist domestic currency depreciation:

• The central bank sells foreign currency reserves.
• It purchases domestic currency in the market.
• Demand for domestic currency rises, supporting its value.

To resist domestic currency appreciation:

• The central bank buys foreign currency.
• It supplies domestic currency to the market.
• This reduces upward pressure on the domestic currency.

Unsterilized intervention: The central bank allows intervention to change the domestic monetary base. Buying foreign currency increases domestic liquidity, while selling foreign currency reduces liquidity. The resulting change in interest rates reinforces the exchange rate effect.

Sterilized intervention: The central bank offsets the monetary impact through open-market operations. For example, after buying foreign currency and creating domestic money, it may sell government securities to withdraw the additional liquidity.

Sterilized intervention may influence rates through signaling and portfolio-balance effects, but its impact can be weaker or temporary. Intervention effectiveness depends on reserve adequacy, central bank credibility, market size, policy coordination, and whether the targeted exchange rate is consistent with economic fundamentals.

Depreciation:

• A fall in the value of a currency under a floating or market-determined exchange rate.
• It results from changes in demand and supply.
• For example, a movement from to represents rupee depreciation.

Devaluation:

• An official downward adjustment in the value of a currency under a fixed or pegged exchange rate system.
• It is a deliberate policy decision by the government or central bank.
• It is often used to improve export competitiveness or correct an external imbalance.

Appreciation:

• A market-driven increase in the currency's value under a floating system.
• A movement from to represents rupee appreciation.

Revaluation:

• An official upward adjustment in the currency's fixed or pegged value.
• It may be undertaken to reduce inflationary pressure or address a persistent external surplus.

Thus, depreciation and appreciation are normally market-driven changes, whereas devaluation and revaluation are official changes under fixed or managed arrangements.

Currency appreciation means that the domestic currency becomes more valuable relative to foreign currencies.

Impact on exporters:

• Domestic products become more expensive for foreign buyers.
• Export demand, sales revenue, and profit margins may decline.
• Export-oriented firms may reduce prices, improve productivity, or relocate production abroad.

Impact on importers:

• Imported goods, components, technology, and raw materials become cheaper in domestic currency.
• Firms dependent on imported inputs may experience lower production costs and improved margins.

Impact on consumers:

• Imported consumer products and foreign travel become cheaper.
• Consumers gain greater purchasing power over foreign goods and services.

Impact on inflation:

• Lower import prices reduce imported inflation.
• Cheaper fuel, commodities, and intermediate goods may lower production costs and the general price level.

Macroeconomic impact:

• The trade balance may deteriorate because exports become less competitive and imports become cheaper.
• Foreign-currency debt becomes easier to service in domestic-currency terms.
• Capital inflows may increase if appreciation reflects strong confidence, although expectations of reversal can produce volatility.
• Employment may fall in export-competing industries but rise in sectors benefiting from cheaper imported capital goods.

The net impact depends on the economy's import dependence, export structure, price elasticities, currency denomination of contracts, and the duration of appreciation.

Currency depreciation makes exports cheaper to foreign buyers and imports more expensive for domestic buyers. It can therefore improve the trade balance, but the result depends on how quantities respond to price changes.

Marshall-Lerner condition: Depreciation improves the trade balance if the sum of the absolute values of the price elasticities of demand for exports and imports exceeds one:

where is export demand elasticity and is import demand elasticity.

If demand is sufficiently elastic, export volume rises and import volume falls enough to outweigh the adverse price effect. If demand is inelastic, the domestic-currency cost of imports may rise more than export earnings, worsening the trade balance.

J-curve effect: Immediately after depreciation, the trade balance may deteriorate before improving because:

• Existing contracts fix import and export quantities.
• Consumers and firms need time to find substitutes.
• Imported goods become more expensive before import volume falls.
• Export production takes time to expand.

Over time, quantities respond, and the trade balance may improve, tracing a path resembling the letter J.

Depreciation can also increase inflation, raise the domestic burden of foreign-currency debt, and increase input costs. Its final effect depends on spare productive capacity, supply responsiveness, exchange rate pass-through, and external demand.

1. Transaction exposure: It arises from contractual foreign-currency cash flows, such as export receivables, import payables, interest, and loan repayments.

Management methods:

• Forward and futures contracts
• Currency options and swaps
• Money-market hedging
• Leading and lagging payments
• Matching foreign-currency receipts and payments
• Invoicing in the home currency

2. Translation exposure: It arises when the financial statements of foreign subsidiaries are converted into the parent company's reporting currency. Exchange rate changes may alter the reported value of assets, liabilities, income, and equity without creating immediate cash flows.

Management methods:

• Balance-sheet hedging by matching exposed assets and liabilities
• Foreign-currency borrowing
• Derivative contracts where accounting rules and costs justify them
• Diversification across currencies

3. Economic exposure: It is the long-term effect of unexpected exchange rate changes on a firm's future cash flows, competitive position, market value, sales, and costs. It can affect even firms without explicit foreign-currency contracts.

Management methods:

• Diversifying production and sourcing locations
• Selling in multiple markets
• Flexible pricing and product strategies
• Matching the currency composition of revenue, costs, and debt
• Building strong brands and improving productivity

Transaction exposure is contractual, translation exposure is accounting-based, and economic exposure is strategic and long term.

Exchange rate pass-through is the extent to which a change in the exchange rate affects import prices and the general domestic price level.

A simple representation is:

where is the domestic-currency import price, is the domestic-currency price of foreign currency, and is the pass-through coefficient.

• If , pass-through is complete.
• If , pass-through is incomplete.
• If , import prices do not respond to the exchange rate movement.

Reasons for incomplete pass-through:

• Foreign exporters may reduce their profit margins to preserve market share.
• Importers may absorb exchange losses temporarily.
• Contracts may fix prices for a period.
• Firms may hedge exchange risk through derivatives.
• Distribution, taxation, and local production costs may form a large share of the final price.
• Strong competition may prevent immediate price increases.
• Firms may use pricing-to-market by charging different prices across countries.
• Policymakers may offset inflationary effects through monetary or fiscal measures.

High pass-through makes depreciation more inflationary and may force the central bank to tighten monetary policy. Low pass-through reduces the immediate inflation effect but may compress business profit margins.