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Chapter 7
Financial Markets
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Learning Objectives
To understand how currencies are traded andquoted on world financial markets
To examine the links between interest rates
and exchange ratesTo understand the similarities and differencesbetween domestic sources of capital andinternational sources of capital
To examine how the needs of individual borrowers
have changed the nature of the instruments tradedon world financial markets in the past decade
To understand how the debt crises of the 1980sand 1990s are linked to the international financialmarkets and exchange rates
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The Market for CurrenciesThe price of any onecountrys currency in terms
of another countryscurrency is called a foreigncurrency exchange rate
Every market, every country,and every firm may have itsown set of currency symbols
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Direct and Indirect
QuotationsMost currencies are quoted in directquotes versus the U.S. dollar
The major exceptions are currenciesassociated with the BritishCommonwealth and the European euro
When an exchange rate of a currency isstated without using the U.S. dollar as areference, it is referred to as a crossrate
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Foreign Currency Market
StructureThe market for foreigncurrencies is a worldwide
market that is informal instructure
The market is actually thethousands of
telecommunications linksamong financial institutionsaround the globe and it isopen nearly 24 hours a day
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Market Size and Composition
Until recently there was little data on theactual volume of trading on world foreigncurrency markets
In the spring of 1986, the Federal ReserveBank of New York along with others startedsurveying the activity of currency tradingevery three years
Growth of foreign currency trading has been
nothing less than astronomicalThe majority of the worlds trading in foreigncurrencies is still taking place in the citieswhere international financial activity iscentered, London, New York, and Tokyo
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Market Size and Composition
Three reasons typically given forthe enormous growth in foreign
currency trading are:Deregulation of international capital flows
Gains in technology and transaction costefficiency
The world is a risky place
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The Purpose of Exchange
RatesIf countries are to trade,they must be able to
exchange currenciesThe exchange of onecountrys currency for
another should berelatively simple, but itsnot
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What is a Currency Worth?The exchange ratebetween currenciesshould equalize itspurchasing power
The theory ofpurchasing powerparity (PPP)is
simply the rate thatequalizes the price ofthe identical productor service in twodifferent currencies
The version ofpurchasing powerparity that estimatesthe exchange ratebetween twocurrencies using justone good or serviceas a measure of theproper exchange forall goods andservices is called theLaw of One Price
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Monetary Systems of the
20th CenturyMixed/fixed floatingexchange rate system is
in operation today
Prior to this, the GoldStandardwas in effect
Prior to that, the BrettonWoods Agreementwas ineffect
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The Gold StandardThe gold standard began sometime inthe 1880s
It was premised on three basic ideas:A system of fixed rates of exchange existedbetween participating countries
Money issued by member countries had to bebacked by gold reserves
Gold acted as an automatic adjustment
Under this standard, each countryscurrency would be set in value perounce of gold
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The Bretton Woods Agreement
The governments of 44 of the Allied Powersgathered together in Bretton Woods, NewHampshire in 1944 to plan for the postwarinternational monetary system
This agreement called for the following:Fixed exchange rates between member countries
The establishment of a fund of gold and currencies forstabilization of their currencies, the International
Monetary FundThe establishment of a bank, the World Bank, thatwould provide funding for long-term developmentprojects
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Floating Exchange RatesSince March 1973, the worldsmajor currencies have floated
in value versus each otherThe inability of a country tocontrol the value of itscurrency on world markets
has been a harsh reality formost
Direct intervention
Coordinated intervention
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The EuroOn December 31,1998, the final fixedrates between the 11currencies and theeuro were put intoplace
On January 1,
1999,the eurowasofficially launched asa single currency forthe European Union
The monetary policyfor the EMU will beconducted by theEuropean CentralBank (ECB) and hasa singleresponsibility ofsafeguarding thestability of the euro
On January 4, 1999,the euro begantrading on world
currency markets
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International Money
MarketsInternational money markets,often termed the Eurocurrency
markets, constitute anenormous financial marketthat is in many ways outsidethe jurisdiction and
supervision of world financialand governmental authorities
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Eurocurrency Markets and
Eurocurrency Interest RatesA Eurocurrency isany foreign
currencydenominateddeposit oraccount at a
financialinstitution outsidethe country of thecurrencys issue
While there arehundreds of
different majorinterest ratesaround the globe,the international
financial marketsfocus on theinterbank interestrates
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Defining International
FinancingThe definition of what constitutesan international financialtransaction is dependent on twocharacteristics:
Whether the borrower is domestic or
foreignWhether the borrower is raising capitaldenominated in the domestic currency or aforeign currency
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Defining International
Financing
The two characteristics that define
an international financialtransaction form four categories:
Domestic borrower/domestic currency
Foreign borrower/domestic currencyDomestic borrower/foreign currency
Foreign borrower/foreign currency
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Structure of International
Banking
Correspondent bank: an
unrelated bank based ina foreign country
Representative bank:basically a sales officefor a bank
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The International Bond
Market
The international bondmarket
provides the bulk of financingForeign bonds
Eurobonds
Bearer bonds
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Private PlacementsOne of the largest andunpublicized capital
marketsA private placement isthe sale of debts orequity to a largeinvestor