Chapter 7

Chapter 7
Financial Markets
Learning Objectives
To understand how currencies are traded and
quoted on world financial markets
To examine the links between interest rates
and exchange rates
To understand the similarities and differences
between domestic sources of capital and
international sources of capital
To examine how the needs of individual borrowers
have changed the nature of the instruments traded
on world financial markets in the past decade
To understand how the debt crises of the 1980s
and 1990s are linked to the international financial
markets and exchange rates
The Market for Currencies
The price of any one
country’s currency in terms
of another country’s
currency is called a foreign
currency exchange rate
Every market, every country,
and every firm may have its
own set of currency symbols
Exchange Rate Quotations
and Terminology
Direct quotation:
when the subject
currency is stated
Indirect quotation:
when the subject
currency is stated
Spot rates: when
the exchange of
currencies takes
place immediately
Forward rates:
when the currency
exchange takes
place at a later
date and at an
agreed upon
exchange rate
Direct and Indirect
Most currencies are quoted in direct
quotes versus the U.S. dollar
The major exceptions are currencies
associated with the British
Commonwealth and the European euro
When an exchange rate of a currency is
stated without using the U.S. dollar as a
reference, it is referred to as a cross
Foreign Currency Market
The market for foreign
currencies is a worldwide
market that is informal in
The “market” is actually the
thousands of
telecommunications links
among financial institutions
around the globe and it is
open nearly 24 hours a day
Market Size and Composition
Until recently there was little data on the
actual volume of trading on world foreign
currency markets
In the spring of 1986, the Federal Reserve
Bank of New York along with others started
surveying the activity of currency trading
every three years
Growth of foreign currency trading has been
nothing less than astronomical
The majority of the world’s trading in foreign
currencies is still taking place in the cities
where international financial activity is
centered, London, New York, and Tokyo
Market Size and Composition
Three reasons typically given for
the enormous growth in foreign
currency trading are:
Deregulation of international capital flows
Gains in technology and transaction cost
The world is a risky place
The Purpose of Exchange
If countries are to trade,
they must be able to
exchange currencies
The exchange of one
country’s currency for
another should be
relatively simple, but it’s
What is a Currency Worth?
The exchange rate
between currencies
should equalize its
purchasing power
The theory of
purchasing power
parity (PPP) is
simply the rate that
equalizes the price of
the identical product
or service in two
different currencies
The version of
purchasing power
parity that estimates
the exchange rate
between two
currencies using just
one good or service
as a measure of the
proper exchange for
all goods and
services is called the
Law of One Price
Monetary Systems of the
20th Century
Mixed/fixed floating
exchange rate system is
in operation today
Prior to this, the Gold
Standard was in effect
Prior to that, the Bretton
Woods Agreement was in
The Gold Standard
The gold standard began sometime in
the 1880s
It was premised on three basic ideas:
A system of fixed rates of exchange existed
between participating countries
Money issued by member countries had to be
backed by gold reserves
Gold acted as an automatic adjustment
Under this standard, each country’s
currency would be set in value per
ounce of gold
The Bretton Woods Agreement
The governments of 44 of the Allied Powers
gathered together in Bretton Woods, New
Hampshire in 1944 to plan for the postwar
international monetary system
This agreement called for the following:
Fixed exchange rates between member countries
The establishment of a fund of gold and currencies for
stabilization of their currencies, the International
Monetary Fund
The establishment of a bank, the World Bank, that
would provide funding for long-term development
Floating Exchange Rates
Since March 1973, the world’s
major currencies have floated
in value versus each other
The inability of a country to
control the value of its
currency on world markets
has been a harsh reality for
Direct intervention
Coordinated intervention
The European Monetary
System and the Euro
In 1979 a formalized structure was put in place among
many of the major members of the European
The European Monetary System (EMS) officially began
operation in March 1979 and once again established a
grid of fixed parity rates among member currencies
The EMS consisted of three elements:
First, all countries that were committing their currencies and
their efforts to the preservation of fixed exchange rates
entered the Exchange Rate Mechanism (ERM)
Second, was the actual grid of bilateral exchange rates with
their specialized band limits
Third, was the creation of the European Currency Unit
The Maastricht Treaty
The members of the European
Union concluded this treaty in
December 1991
This treaty:
Laid out terms goals of harmonized social
and welfare policies
Specified a timetable for the adoption of a
single currency to replace all individual
The Euro
On December 31,
1998, the final fixed
rates between the 11
currencies and the
euro were put into
On January 1,
1999,the euro was
officially launched as
a single currency for
the European Union
The monetary policy
for the EMU will be
conducted by the
European Central
Bank (ECB) and has
a single
responsibility of
safeguarding the
stability of the euro
On January 4, 1999,
the euro began
trading on world
currency markets
International Money
International money markets,
often termed the Eurocurrency
markets, constitute an
enormous financial market
that is in many ways outside
the jurisdiction and
supervision of world financial
and governmental authorities
Eurocurrency Markets and
Eurocurrency Interest Rates
A Eurocurrency is
any foreign
deposit or
account at a
institution outside
the country of the
currency’s issue
While there are
hundreds of
different major
interest rates
around the globe,
the international
financial markets
focus on the
interbank interest
Defining International
The definition of what constitutes
an international financial
transaction is dependent on two
Whether the borrower is domestic or
Whether the borrower is raising capital
denominated in the domestic currency or a
foreign currency
Defining International
The two characteristics that define
an international financial
transaction form four categories:
Domestic borrower/domestic currency
Foreign borrower/domestic currency
Domestic borrower/foreign currency
Foreign borrower/foreign currency
Structure of International
Correspondent bank: an
unrelated bank based in
a foreign country
Representative bank:
basically a sales office
for a bank
International Security
The international debt
securities markets have
experienced the greatest
growth in the past decade
It includes:
Private placements
The International Bond
The international bond market
provides the bulk of financing
Foreign bonds
Bearer bonds
Private Placements
One of the largest and
unpublicized capital
A private placement is
the sale of debts or
equity to a large

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