Unit 7: International Financial Markets - Subjective Questions

The foreign exchange market is the global market in which currencies are bought and sold. It operates through a decentralized network of commercial banks, central banks, brokers, corporations, institutional investors, and individuals.

Its major functions are:

• Transfer of purchasing power: It enables payments between parties using different national currencies.
• Credit provision: Instruments such as letters of credit and bills of exchange facilitate international trade.
• Risk management: Forward contracts, futures, options, and swaps help participants manage exchange-rate risk.
• Price discovery: Demand and supply determine the market value of one currency relative to another.
• Liquidity provision: Continuous trading allows participants to convert currencies efficiently.

Thus, the market supports international trade, investment, borrowing, and financial risk management.

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

• Demand for foreign currency arises from imports, foreign travel, overseas investment, and repayment of foreign debt.
• Supply of foreign currency arises from exports, inward investment, remittances, tourism receipts, and foreign borrowing.
• If demand for a foreign currency rises while supply remains unchanged, that currency appreciates.
• If its supply rises relative to demand, it depreciates.

The equilibrium exchange rate occurs where demand equals supply. In a managed system, the central bank may influence this equilibrium by buying or selling currencies, changing interest rates, or imposing foreign exchange regulations.

Spot and forward transactions differ mainly in their settlement date and purpose.

• Spot transaction: An agreement to exchange currencies at the current spot rate, normally with settlement within two business days.
• Forward transaction: An agreement made today to exchange currencies on a specified future date at a rate fixed today.
• The spot market is mainly used for immediate payments, while the forward market is commonly used for hedging future exposure.
• A forward currency may trade at a premium or discount relative to its spot rate.
• Spot rates reflect current market conditions, whereas forward rates also reflect interest-rate differences and market expectations.

For example, an importer expecting to pay dollars after three months can purchase dollars forward to eliminate uncertainty about the future domestic-currency cost.

A direct quotation expresses the amount of domestic currency required to buy one unit of foreign currency. For an Indian resident, is a direct quotation.

An indirect quotation expresses the amount of foreign currency obtainable for one unit of domestic currency. The reciprocal quotation is:

Under a direct quotation:

• A rise from to indicates depreciation of the rupee.
• A fall to indicates appreciation of the rupee.

Under an indirect quotation, the interpretation is reversed. Direct and indirect rates are reciprocals, subject to differences caused by bid-ask spreads.

The bid rate is the rate at which a dealer buys a currency, while the ask rate is the rate at which the dealer sells it. The difference is the bid-ask spread:

Its significance includes:

• It represents part of the dealer's compensation for providing liquidity.
• A narrow spread generally indicates a liquid and competitive market.
• A wide spread increases the transaction cost for buyers and sellers.

The spread is influenced by:

• Trading volume and market liquidity
• Exchange-rate volatility
• Transaction size
• Political and economic uncertainty
• Dealer competition
• Information and settlement risks

Frequently traded currencies such as the US dollar and euro usually have narrower spreads than thinly traded currencies.

A cross exchange rate is the exchange rate between two currencies calculated through a third currency, commonly the US dollar.

Given:

The rupee value of one euro is:

Therefore:

The calculation assumes consistent quotation conventions and ignores bid-ask spreads and transaction costs. If the directly quoted rupee-euro rate differs materially from this implied rate, traders may identify an arbitrage opportunity.

Triangular arbitrage involves converting funds through three currencies to profit from inconsistent cross exchange rates.

The process is:

1. Convert the initial currency into a second currency.
2. Convert the second currency into a third currency.
3. Convert the third currency back into the initial currency.
4. Compare the final amount with the initial amount after transaction costs.

If the final amount is higher, an arbitrage profit exists. Arbitrage purchases increase demand for undervalued currencies, while sales increase the supply of overvalued currencies. These transactions quickly adjust quoted rates until the inconsistency disappears. Consequently, triangular arbitrage helps maintain alignment between direct exchange rates and implied cross rates. In efficient markets, opportunities are usually small and short-lived because computerized trading systems detect them rapidly.

Under a fixed exchange-rate arrangement, the monetary authority maintains the currency at or near an announced value against another currency or basket. Under a floating arrangement, market demand and supply largely determine the rate.

Fixed arrangement:

• Provides exchange-rate stability and predictability.
• May promote trade and investment.
• Requires adequate foreign exchange reserves and intervention.
• Restricts independent monetary policy.
• Can become vulnerable to speculative attacks if the fixed value is not credible.

Floating arrangement:

• Allows automatic adjustment to external imbalances.
• Provides greater monetary-policy independence.
• Requires fewer reserves for defending a particular rate.
• May produce volatility and uncertainty for international businesses.

The appropriate arrangement depends on economic size, capital mobility, inflation credibility, financial development, and exposure to external shocks.

These arrangements differ in the degree of exchange-rate flexibility and policy commitment:

• Conventional peg: The currency is maintained within a narrow margin around a fixed value against another currency or currency basket. The central bank intervenes when necessary.
• Crawling peg: The fixed value is adjusted periodically in small steps, often according to inflation differentials or external competitiveness.
• Currency board: Domestic currency is issued only against specified foreign reserve assets at a legally fixed exchange rate. Monetary discretion is highly restricted.
• Managed float: No permanent fixed value is announced, but the central bank occasionally intervenes to limit excessive volatility or guide the rate.

A currency board provides the strongest nominal commitment but the least policy flexibility. A managed float offers more flexibility but may be less transparent if intervention objectives are unclear.

A central bank can intervene through direct and indirect measures.

Direct intervention:

• To prevent domestic-currency depreciation, it sells foreign reserves and buys domestic currency.
• To prevent domestic-currency appreciation, it buys foreign currency and supplies domestic currency.

Indirect intervention:

• Raising interest rates may attract capital inflows and support the domestic currency.
• Lowering rates may weaken the currency.
• Capital controls, reserve requirements, and foreign exchange regulations may influence currency flows.
• Public announcements may alter market expectations.

Intervention is sterilized when the central bank offsets its effect on the domestic money supply through open-market operations. It is unsterilized when the monetary-base effect is allowed to remain. Persistent intervention can be costly and may fail if the target conflicts with economic fundamentals.

Purchasing power parity, or PPP, links exchange-rate movements to differences in national price levels.

Under relative PPP, the approximate expected percentage change in the exchange rate is:

where is domestic inflation and is foreign inflation when is expressed as domestic currency per unit of foreign currency.

If domestic inflation exceeds foreign inflation, domestic goods become relatively expensive. Imports tend to rise and exports become less competitive, increasing pressure for the domestic currency to depreciate. Lower domestic inflation tends to support appreciation.

PPP is more useful for explaining long-run trends than short-run movements because transport costs, tariffs, non-traded goods, capital flows, price rigidity, and speculation can cause substantial deviations.

Covered interest parity states that comparable domestic and foreign investments must provide the same covered return when exchange risk is eliminated through a forward contract.

Let:

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

One unit of domestic currency invested domestically becomes . Alternatively, it can be converted into units of foreign currency, invested abroad, and sold forward. Its covered domestic value becomes:

In equilibrium:

Therefore:

For small interest rates:

Thus, the currency with the higher interest rate normally trades at a forward discount under this quotation. Any significant deviation creates covered interest arbitrage, although transaction costs, taxes, credit risk, and capital controls may prevent exact equality.

Interest rates affect exchange rates mainly through international capital movements. A rise in domestic interest rates may increase the expected return on domestic financial assets, attracting foreign capital and raising demand for the domestic currency.

However, the effect depends on expectations:

• If higher rates reflect credible anti-inflation policy, the currency may appreciate.
• If they reflect rising sovereign risk or an inflation crisis, investors may still withdraw funds and the currency may depreciate.
• Investors compare expected returns after allowing for anticipated exchange-rate changes, taxes, liquidity, and risk.
• Expectations of future monetary tightening can influence the currency before the actual rate change.
• Unexpected policy announcements generally have a stronger immediate effect than fully anticipated decisions.

Therefore, nominal interest rates alone cannot predict exchange-rate movements; real returns, credibility, risk perceptions, and expected future policy must also be considered.

The balance of payments records a country's transactions with the rest of the world. These transactions create demand for and supply of currencies.

• A current-account deficit may increase demand for foreign currency because payments for imports exceed export receipts.
• A current-account surplus may increase the supply of foreign currency and support the domestic currency.
• Foreign direct investment and portfolio inflows create demand for the domestic currency.
• Capital outflows, debt repayments, and purchases of foreign assets create demand for foreign currency.
• A current-account deficit need not cause depreciation if it is financed by stable capital inflows.
• Sudden capital withdrawal can produce rapid depreciation even when trade flows change slowly.

The exchange-rate effect therefore depends on the combined current, capital, and financial account position, as well as the quality, duration, and stability of financing flows.

Exchange rates are influenced by several interacting determinants:

• Inflation differentials: Persistently higher inflation generally weakens a currency over time.
• Interest-rate differentials: Higher risk-adjusted returns can attract capital inflows.
• Economic growth: Growth can strengthen a currency through investment inflows but may also increase imports.
• Balance of payments: Trade flows, foreign investment, remittances, and debt payments affect currency demand and supply.
• Public debt and fiscal policy: Unsustainable debt can reduce confidence and increase risk premiums.
• Monetary policy: Money-supply growth and central-bank credibility influence inflation and expected returns.
• Political stability: Stable institutions generally encourage investment, while uncertainty promotes capital flight.
• Terms of trade: Higher export prices relative to import prices may support the currency.
• Market expectations and speculation: Anticipated policy or economic changes can cause immediate movements.
• Official intervention: Currency purchases, sales, and regulations can modify short-run market outcomes.

No determinant works in isolation, and short-run movements may differ from long-run fundamental trends.

The four concepts describe changes in currency value under different exchange-rate arrangements:

• Appreciation: A market-driven increase in the value of a currency under a floating system.
• Depreciation: A market-driven decrease in the value of a currency under a floating system.
• Revaluation: An official increase in the fixed or pegged value of a currency by the monetary authority.
• Devaluation: An official reduction in the fixed or pegged value of a currency.

If the rate changes from to , the rupee has appreciated under a floating regime because fewer rupees buy one dollar. If the government officially changes a fixed rate in the same direction, it is a revaluation. The economic effects may be similar, but the terminology identifies whether the change resulted from market forces or an official policy decision.

Domestic-currency depreciation makes foreign currency more expensive and can affect the economy through several channels.

Potential benefits:

• Exports become cheaper for foreign buyers, which may increase export demand.
• Imported goods become more expensive, encouraging substitution toward domestic products.
• Export-oriented industries may earn higher domestic-currency revenue.
• Improved net exports may raise output and employment.

Potential costs:

• Imported consumer goods, fuel, machinery, and raw materials become more expensive.
• Higher input costs may create cost-push inflation.
• Foreign-currency debt becomes more expensive to service in domestic currency.
• Businesses dependent on imports may experience lower profits.
• Real household income may fall as prices rise.

The final outcome depends on demand elasticities, spare productive capacity, import dependence, exchange-rate pass-through, foreign debt, and trading-partner conditions. Depreciation is therefore not automatically expansionary.

The Marshall-Lerner condition states that currency depreciation will eventually improve the trade balance if the sum of the absolute price elasticities of export and import demand exceeds one:

where is the export-demand elasticity and is the import-demand elasticity.

The J-curve effect describes the likely time path of adjustment:

• Immediately after depreciation, existing contracts and fixed quantities limit changes in trade volumes.
• The domestic-currency cost of imports rises quickly, so the trade balance may initially deteriorate.
• Over time, consumers and firms adjust their purchases, exports increase, and imports decrease.
• If the Marshall-Lerner condition is satisfied, the trade balance eventually improves.

When plotted over time, the initial decline followed by recovery resembles the letter J. The result can be weakened by low elasticities, supply constraints, imported inputs, or weak foreign demand.

Exchange-rate pass-through is the extent to which a change in the exchange rate alters domestic prices of imported goods and the general price level.

Pass-through may be:

• Complete: Import prices change in the same proportion as the exchange rate.
• Incomplete: Exporters, importers, or retailers absorb part of the change through lower profit margins.

Its extent depends on:

• Market competition and firms' pricing power
• Currency used for invoicing
• Duration of supply contracts
• Import content of domestic production
• Expected persistence of the exchange-rate movement
• Domestic demand conditions
• Inflation expectations and monetary-policy credibility
• Hedging practices and inventory levels

High pass-through makes depreciation more inflationary, while credible monetary policy and competitive markets may reduce second-round effects on wages and prices.

International businesses face three principal types of exchange-rate exposure:

• Transaction exposure: Risk that exchange-rate changes alter the domestic-currency value of contracted foreign-currency receipts or payments.
• Translation exposure: Accounting risk arising when foreign subsidiaries' financial statements are converted into the parent company's reporting currency.
• Economic exposure: Long-term risk that exchange-rate movements affect future cash flows, competitiveness, market share, and firm value.

Firms can manage these exposures through:

• Forward contracts, futures, options, and currency swaps
• Matching foreign-currency receipts with payments
• Foreign-currency borrowing to offset foreign assets or revenues
• Leading or lagging payments where commercially appropriate
• Diversifying production, sourcing, financing, and markets
• Including currency-adjustment clauses in contracts

Hedging reduces uncertainty but has costs. A firm should identify its net exposure, choose an appropriate horizon, and align hedging decisions with its risk tolerance and operating strategy.