INTERNATIONAL FINANCIAL MARKETS

The Market for Currencies₪ The Forex trading market is the market for currencies. It is a large network of central banks

and individual investors all engaged in the process of currency exchange.

₪ The price of any one country’s currency in terms of another country’s currency is called a foreign currency exchange rate. For example, the exchange rate between the Kenyan Shilling and the US dollar may be 83.15 Kenyan Shillings per US dollar or simply Ksh 83.15/$. This is the same exchange rate as when stated ‘1 US dollar= Ksh. 83.15’.

₪ Common symbols for currencies: ¥- Japanese yen,€ - Euro, £ - British pound sterling.

₪ Different countries and firms have different symbols for representing currencies. For instance, the British pound sterling can also be represented by GBP (Great Britain Pound), STG (British Pound Sterling) or ST £ (pound sterling).

Exchange rate quotations and terminology

₪Direct quotation. This is when the currency is quoted first.

₪An indirect quotation is when the subject currency is stated second. − Ksh 83.15/US$ is a direct quotation on the Kenyan Shilling and simultaneously an indirect quotation on

the US dollar.

₪ Spot transaction. This is the exchange of currencies for immediate delivery (normally occurs within 2 business days following the agreement).

₪ Forward exchange rates are contracts that provide for two parties to exchange currencies on a future date at an agreed upon exchange rate. They are typically traded for major volume currencies for maturities of 30, 90, 120, 180 and 360 days from the present date.

Direct and indirect quotations₪ European terms – Currencies are quoted in direct quotes versus the US dollar.

₪ American terms – Currencies quoted as US dollars per pound sterling or US dollars per Australian dollar. This is especially so for currencies that at one time or another associated with the British Commonwealth (including the Australian dollar) and now the European Euro.

Cross rates₪ Any currency’s values can be stated in terms of any other currency.

₪ Cross rate – this is when the exchange rate of a currency is stated without using the US dollar as a reference.

₪ For example, if the UAE Dirham and Kenyan Shilling are both quoted versus the US dollar, they would appear as UAE Dirham 3.6729/US$ and US$ 0.012/Ksh. If the UAE Dirham/Ksh is needed, it can be derived from the following multiplication:-

UAE Dirham 3.6729/US$ × US$ 0.012/Ksh = UAE Dirham/Ksh 0.0441

₪ If one of the above exchange rates changes dues to market forces, the others must adjust for the three exchange rates to again align. If they are out of alignment, it is possible to make a windfall profit; this is known as triangular arbitrage.

Percentage change of calculations₪ If the spot rate between the Kenyan Shilling and the US dollar changed from Ksh 80/US$ to Ksh

85/US$, the percentage change in the value of the Kenyan shilling is:Ksh 80/US$−85/US$

85/US$× 100 = −5.88%

₪ The Kenyan shilling has declined in value versus the US Dollar by 5.88%. The same result can be used for the inversed spot rates i.e. Ksh 80/US$ becomes US$ 0.0125/Ksh and 85/US$ becomes US$ 0.0118/Ksh. Thus:-

US$ 0.0118/Ksh−US$ 0.0125/KshUS$ 0.0125/Ksh

× 100 ≈ −5.88%

₪ Rounding up errors might result.

Foreign Currency Market Structure₪ The foreign currency market is informal

₪ It really is thousands of telecommunication links among financial institutions around the world operating almost 24/7.

Market size and composition₪ Currency market is enormous, data shows in April 1998, daily transactions exceeded US$1.5

trillion!

₪ Majority of the world’s trading in foreign currencies is still centered in New York, London and Tokyo.

₪ Reasons for enormous growth in currency trading:-1. Gains in technology and transaction cost efficiency

2. Deregulation in international capital flows

3. Greater risk increasing the velocity of capital flows across borders

What is a Currency worth?₪ The answer is its purchasing power.

₪ Purchasing power exchange rate – This is the rate that equalizes the price of the identical product or service in two different currencies:

𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝐾𝑒𝑛𝑦𝑎 = 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 × 𝑃𝑟𝑖𝑐𝑒 𝑖𝑛 𝑈𝑆

₪ If the price of the same product in each currency is PKsh and P$ and the spot exchange rate between the Kenyan shilling and the US Dollar is SKsh/$, the price in Kenyan shillings is simply the price in dollars multiplied by the spot exchange:-

PKsh= SKsh/$ × P$

The law of One Price₪ Law of One Price – This is 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.

₪ The product selected should be identical in quality and content in every country

MONETARY SYSTEMS OF THE 2OTH CENTURY

The Gold Standard₪ Introduced by the UK in 1840 and adopted by most countries by the 1870s.

₪ It was premised on three ideas:-

a) A system of fixed rates of exchange existed between participating countries

b) ‘Money’ issued by reserve countries had to be backed by reserves of gold

c) Gold would act as an automatic adjustment if imbalances in trade or investment did occur.

₪ Under the gold standard, each country’s currency would be set in value per ounce of gold; e.g. if the US Dollar was defined as US$14.5 per ounce, while the British pound sterling was defined as 5.75 per ounce. The determination of the exchange rate would be as follows:-

𝑈𝑆$14.5/𝑜𝑢𝑛𝑐𝑒

£5.75/𝑜𝑢𝑛𝑐𝑒= 𝑈𝑆$2.5217/£

The Inter-War Years (1919-1939)₪ The British pound sterling, the dominant currency prior to World War I was greatly weakened.

The US Dollar returned to the gold standard in 1919 but gold convertibility was largely untested across countries throughout the 1920s.

₪ With the economic collapse and bank runs of the 1930s, the US was force to once again abandon gold convertibility. Many countries resorted to isolationist policies and protectionism.

The Bretton Wood Agreement (1944-1971)₪ The governments of 44 of the Allied powers gathered together in Bretton Woods, New

Hampshire, USA in 1944 to plan for the post-war international monetary system. The agreement reached called for the following:-

1. Fixed exchange rates between member countries, termed as an ‘adjustable peg’.

2. Establishment of a fund of gold and currencies available to members for stabilization of their respective currencies (IMF).

3. Establishment of a bank that would provide funding for long term development projects (World Bank)

₪ All participants were to establish par values of their currencies in terms of gold.

₪ There was little if any convertibility of currencies of gold expected; convertibility was versus the US Dollar.

₪ The only currency convertible to gold was the US currency.

Floating Exchange Rates(1973-present)₪ Since March 1973, the world’s major currencies have floated in value versus each other.

₪ Direct intervention in the currency market. This happens when a government wished to alter the current value of its currency or slow its own currency in the market using its reserves of other major currencies. This was common in the 1970s.

₪ By the 1980s, the currency markets were too large to be moved by a few governments (e.g. US, Japan). The major tool left was altering macroeconomic variables such as interest rates.

During periods of inflation, raising the domestic interest rate attracts foreign capital ergo an appreciating currency exchange rate

₪ Coordinated intervention. In 1985, the G5 nations met in New York and drafted the Plaza agreement whose goals were to be accomplished through coordinated intervention among the central banks of the major nations.

Eurocurrency₪ Eurocurrency – This is any foreign currency-denominated deposit or account at a financial

institution outside the country of the country’s issuance. For instance, Japanese Yen held in a bank in Nairobi is known as Euroyen.

₪ The significance of foreign currency-denominated accounts is the purity of value that comes from no governmental interference or restrictions with their use.

₪ Eurocurrency accounts are not controlled or managed by governments. Therefore, the financial institutions pay no deposit insurance, hold no reserve requirements and normally are not subject interest rate restrictions with respect to such accounts.

Eurocurrency interest rates₪ Interbank interest rates charged by banks to banks in the major financial centers are generally

regarded as the ‘interest rate’ in the respective market.

₪ London Interbank Offer Rate (LIBOR). This is the interest rate that is used most often in international loan agreements is the Eurocurrency interest rate on US dollars (Eurodollars) in London between banks. It is the cost of funds ‘offered’ to those acquiring a loan. Because it is a Eurocurrency rate, it floats freely without regard to governmental restrictions on reserves, deposit insurance etc.

₪ London Interbank Bid Rate (LIBID) – The rate of interest other banks can earn on Eurocurrency deposits.

International financing₪ The definition of what constitutes an international financial transaction is

dependent on:-a) Whether the borrower is domestic or foreign

b) Whether the borrower is raising capital denominated in the domestic currency or a foreign currency

₪The categories include:-1. Domestic borrower/domestic currency

2. Foreign borrower/domestic currency

3. Domestic borrower/foreign currency

4. Foreign borrower/foreign currency

International Bond Market₪ Foreign bonds. These are bond issues e.g. in USA and United Kingdom in their respective

currencies by foreigners.

₪ Eurobonds refer to debt financing by both domestic and foreign borrowers, although in a foreign currency (denominated in a currency other than the currency of the country in which it is sold).

₪ Bearer bond(s) – it is owned officially by who is owning it, with no master registration list being held by government authorities who then track who is earning interest income from bond investments.

Private placements₪ Private placement – This is the sale of debt or equity to a large investor.

₪ It is normally a one-time-only transaction in which the buyer of the bond or stock purchases the investments and intends to hold it until maturity or until repurchased by the firm.

₪ It differs from normal bond or stock sales in that the securities are not resold on a secondary market.

₪ If the security was intended to be publicly traded, the issuing firm would have to meet a number of disclosure and registration requirements with the regulatory authorities.