Unit 7: International Financial Markets

I. Orientation — The International Financial System

International financial markets connect borrowers, lenders, investors, firms, governments, and central banks across national borders. Their central coordinating variable is the exchange rate: the price at which one currency exchanges for another. Foreign-exchange transactions support international trade, investment, speculation, risk management, and official monetary intervention.

• Defining properties:
  • Global integration: Financial centres such as London, New York, Singapore, Tokyo, and Hong Kong operate across overlapping time zones, creating nearly continuous trading.
  • Currency denomination: Cross-border claims are expressed in currencies such as the US dollar (USD), euro (EUR), Japanese yen (JPY), and Indian rupee (INR).
  • Decentralized trading: Foreign exchange is predominantly an over-the-counter market, where banks and dealers transact electronically rather than through one central exchange.
  • Price interdependence: Interest rates, inflation, capital flows, expectations, and government policies jointly influence currency values.
  • Two-sided quotation: Dealers provide a bid price, at which they buy a currency, and an ask price, at which they sell it.
  • Risk and opportunity: Exchange-rate variability can create transaction losses, but it also enables hedging, arbitrage, and speculative profit.
  • Official influence: Central banks affect currency markets through interest-rate policy, reserve transactions, exchange controls, and public communication.

II. Foreign Exchange Market Mechanism — Trading and Price Formation

The foreign exchange market is the institutional network through which currencies are bought, sold, delivered, and priced. Its mechanism brings together commercial demand for currency, international investment flows, dealer intermediation, and central-bank operations.

A. Foreign exchange market mechanism

The mechanism converts orders to buy and sell currencies into exchange rates through decentralized dealer trading.

• Participants:
  • Commercial banks: Quote currencies, execute customer orders, maintain currency inventories, and trade with other banks.
  • Corporations: Exchange export receipts, pay foreign suppliers, repatriate profits, and hedge contractual exposures.
  • Institutional investors: Pension funds, mutual funds, and insurers exchange currencies while purchasing or selling foreign assets.
  • Central banks: Buy or sell currencies to manage reserves or influence the exchange rate.
  • Speculators and arbitrageurs: Assume risk for expected profit or exploit temporary price inconsistencies.
• Market levels:
  • Retail market: Individuals and smaller firms transact through banks, brokers, or payment providers.
  • Interbank market: Major financial institutions trade large amounts at narrow bid–ask spreads.
• Direct quotation: States the domestic-currency price of one unit of foreign currency; for India, ₹83 per US$1 is a direct quote.
• Indirect quotation: States the foreign-currency amount obtainable for one unit of domestic currency; ₹83 per dollar equals approximately US$0.01205 per rupee.
• Bid–ask spread: Compensates dealers for operating costs, inventory risk, and market uncertainty.

Spread = Ask price − Bid price
Percentage spread = [(Ask − Bid) / Ask] × 100

Here, ask is the dealer’s selling price and bid is the dealer’s buying price.

B. Instruments and settlement

Foreign-exchange instruments distinguish immediate currency delivery from agreements fixing future conversion terms.

• Spot transaction: Exchanges currencies at the current spot rate, normally with settlement within the market’s standard settlement cycle.
• Forward contract: Fixes today the rate for exchanging a specified currency amount on a future date; firms commonly use it to hedge receivables or payables.
• Currency swap: Combines currency exchanges across two dates, often a spot purchase and forward resale.
• Currency futures: Standardized, exchange-traded contracts with margin requirements and daily settlement.
• Currency options: Give the holder a right, but not an obligation, to buy or sell currency at a stated exercise price.
• Arbitrage discipline: Dealers buy in the cheaper market and sell in the dearer one, pushing equivalent quoted prices toward consistency.

III. Exchange Rate Arrangement — Rules Governing Currency Values

An exchange-rate arrangement is the framework under which a country permits, manages, or fixes its currency’s value relative to another currency, a basket of currencies, or market demand and supply. Actual practices lie on a continuum from rigid pegs to unrestricted floating.

A. Exchange rate arrangement

Exchange-rate arrangements determine how much price flexibility markets possess and how strongly monetary authorities must intervene.

1. Fixed or pegged arrangements:

   • Fixed peg: Authorities maintain the currency near a declared parity against an anchor currency or basket by buying and selling foreign reserves.
   • Currency board: Domestic monetary liabilities are backed by foreign reserve assets under strict conversion rules, sharply limiting discretionary monetary policy.
   • Dollarization or currency substitution: A country officially adopts another country’s currency, eliminating its independent national exchange rate.
   • Main advantage: A credible peg reduces exchange uncertainty and may discipline inflation.
   • Main limitation: Defending parity can exhaust reserves and force contractionary interest-rate or fiscal measures.

2. Flexible arrangements:

   • Free float: Market demand and supply primarily determine the rate, with no routine target maintained by the central bank.
   • Managed float: Authorities allow market movement but intervene to reduce volatility or resist unwanted trends.
   • Crawling peg or band: Parity changes gradually, or the currency fluctuates within specified margins around a central rate.
   • Main advantage: Exchange-rate adjustment absorbs external shocks and preserves greater monetary-policy autonomy.
   • Main limitation: Volatility can raise trade, financing, and inflation uncertainty.

B. Policy trade-offs and intervention

The chosen arrangement distributes adjustment between the exchange rate, interest rates, reserves, output, and domestic prices.

• Impossible trinity: A country cannot simultaneously maintain all three of the following:
  • A fixed exchange rate.
  • Free international capital movement.
  • Independent monetary policy.
• Sterilized intervention: The central bank offsets the domestic money-supply effect of reserve purchases or sales through domestic-asset operations.
• Unsterilized intervention: Reserve transactions change the monetary base and may therefore exert a stronger monetary effect.
• Devaluation and revaluation: Under a fixed system, official decisions lower or raise the currency’s parity.
• Depreciation and appreciation: Under a floating system, market forces lower or raise the currency’s external value.

IV. Determinants of Exchange Rates — Economic and Financial Drivers

Exchange rates respond to currency demand and supply, which arise from trade, investment, monetary conditions, political risk, and expectations. The importance of each determinant varies by time horizon and policy regime.

A. Determinants of exchange rates

Relative economic conditions and expected returns influence whether market participants prefer domestic or foreign currency assets.

• Inflation differentials: Persistently higher domestic inflation tends to reduce the currency’s purchasing power and competitiveness, creating depreciation pressure.
• Interest-rate differentials: Higher interest rates may attract capital and support a currency, provided investors do not expect inflation, depreciation, or default to erase the return.
• Balance of payments: Export receipts generate demand for domestic currency, whereas import payments create demand for foreign currency.
• Economic growth: Strong growth can attract investment, but import-intensive growth may widen the current-account deficit.
• Fiscal and public debt conditions: Large deficits or doubtful debt sustainability may increase inflation, taxation, or default concerns.
• Monetary policy: Tighter policy generally supports a currency through higher yields and lower expected inflation; expansionary policy can have the opposite effect.
• Political and institutional stability: Predictable government, credible regulation, and secure property rights reduce risk premiums.
• Expectations and speculation: Anticipated policy changes or crises may move rates before the underlying event occurs.
• Market intervention: Central-bank currency purchases increase demand for the purchased currency; sales increase its market supply.

B. Parity relationships

Parity conditions provide benchmarks linking exchange rates to prices, interest rates, and forward quotations.

• Purchasing power parity (PPP): Relative PPP associates exchange-rate change with the inflation differential.

Expected percentage change in S ≈ πd − πf

Here, S is the domestic-currency price of foreign currency, πd is domestic inflation, and πf is foreign inflation. If domestic inflation is 6% and foreign inflation is 2%, PPP suggests roughly 4% domestic-currency depreciation.

• Covered interest parity: Forward rates tend to offset interest-rate differences when exchange risk is contractually hedged.

F / S = (1 + id) / (1 + if)

Here, F is the forward rate, S the spot rate, id the domestic interest rate, and if the foreign interest rate.

• Limitation: Transaction costs, capital controls, risk premiums, policy intervention, and changing expectations can cause observed rates to depart from parity benchmarks.

V. Exchange Rate Movements and Their Impact — Exposure and Adjustment

Exchange-rate movement changes the domestic value of foreign receipts, payments, assets, and liabilities. Its effects depend on the direction of quotation, the economy’s trade structure, contractual currency, and ability to adjust prices.

A. Exchange rate movements and their impact

Appreciation and depreciation redistribute gains and losses among exporters, importers, borrowers, investors, consumers, and governments.

1. Domestic-currency depreciation:

   • Exports: Domestic goods become cheaper to foreign buyers if export prices do not rise proportionately.
   • Imports: Foreign goods and inputs become more expensive in domestic currency.
   • Inflation: Higher import costs may pass through to consumer and producer prices.
   • Foreign-currency debt: Domestic servicing costs rise when liabilities are denominated in an appreciating foreign currency.
   • Trade balance: Improvement may be delayed because contracts and quantities adjust slowly, producing a possible J-curve effect.

2. Domestic-currency appreciation:

   • Exports: Foreign buyers face higher prices, potentially weakening export competitiveness.
   • Imports: Imported consumption goods, machinery, energy, and intermediate inputs become cheaper.
   • Inflation: Lower import prices can reduce inflationary pressure.
   • Foreign-currency debt: Domestic repayment costs decline.
   • Investment: Domestic investors gain purchasing power over foreign assets, while foreign investors receive fewer units of their currency when repatriating unchanged domestic returns.

B. Business exposure and management

International businesses classify exchange-rate risk according to whether it affects contracts, accounting values, or long-run competitiveness.

• Transaction exposure: Arises from contracted foreign-currency cash flows, such as a US$100,000 payable due in 90 days.
• Translation exposure: Occurs when a multinational converts foreign subsidiaries’ financial statements into the parent company’s reporting currency.
• Economic exposure: Reflects long-term changes in sales, costs, market share, and competitive position caused by currency movements.
• Internal management:
  • Matching: Uses receipts in one currency to meet payments in the same currency.
  • Leading and lagging: Accelerates or delays payments according to expected currency movements.
  • Operational diversification: Spreads sourcing, production, and sales across currencies and countries.
• External hedging: Uses forwards, futures, options, and swaps to reduce uncertainty.
• Strategic qualification: Hedging stabilizes cash flows but carries fees, may sacrifice favourable movements, and cannot fully eliminate long-term economic exposure.