inflation, interest rates, and exchange rates.pptx

8/20/2019 Inflation, Interest Rates, and Exchange Rates.pptx

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Infation, Interest Rates,

and Exchange RatesLower infation leads to lower interest rates, soborrowing in low-interest countries may appearattractive to multinational rms.

However, currencies in low-infation countries tend toappreciate against those in high-infation ratecountries, so the true interest cost increases over thelie o the loan.


2/45

!ypes o "inancial #ar$ets

• %hysical &sset versus "inancial &sset#ar$et

• #oney #ar$et versus 'apital #ar$et

• %rimary versus (econdary #ar$et

• )pen versus *egotiated #ar$et

• (pot versus "utures #ar$et


3/45

Recent !rends in "inancial#ar$ets

• +lobaliation

• erivatives

• (toc$ )wnership %atterns


4/45

hat /arious !ypes o Ris$s &risehen Investing )verseas0

• 'ountry ris$1 &rises rom investingor doing business in a particularcountry. It depends on the

country2s economic, political, andsocial environment.

• Exchange rate ris$1 I investment is

denominated in a currency otherthan the dollar, the investment2svalue will depend on what happens

to exchange rate.


5/45

!he 'ost o #oney

• hat do we call the price, or cost, odebt capital0

• hat do we call the price, or cost, o e3uity capital0


6/45

"undamental "actors &4ecting the'ost o #oney

• %roduction opportunities

• !ime preerences or consumption

• Ris$• Expected infation


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• International nancial mar$et comprise o1 – International 'apital #ar$et

• )btaining external nancing.

• #ain purpose is to provide a mechanism throughwhich those who wish to borrow or invest moneycan do so e5ciently.

– "oreign-Exchange #ar$et6made up o1 – over-the-counter 7)!'8

» commercial and investment ban$s

» ma9ority o oreign-exchange activity

– security exchanges

» trade certain types o oreign-exchange instruments


8/45

Essential !erms

• (ecurity - a contract that can beassigned a value and traded 7stoc$s,bonds, derivatives and other

nancial assets8

• (toc$s : & instrument representingownership

• ;onds - a debt agreement

• erivatives - the rights to ownership7nancial instruments< utures,

orwards, options, swaps8


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Essential !erms II

• (toc$ exchange, share mar$et or bourse - is acorporation or mutual organiation which providesacilities or stoc$ bro$ers and traders, to tradecompany stoc$s and other securities

• )ver-the-counter 7)!'8 trading - is to tradenancial instruments such as stoc$s, bonds,commodities or derivatives directly between twoparties. It is contrasted with exchange trading,

which occurs via corporate-owned acilitiesconstructed or the purpose o trading 7i.e.,exchanges8, such as utures exchanges or stoc$exchanges.


10/45

'apital #ar$et

• System that allocates financial resources according

• to their most efficient uses

• Common capital market intermediaries:• Commercial Banks

• Investment Banks

Debt1 Repay principal plus interest Bond has timed principal & interest payments

Equity1 %art ownership o a company Stock shares in fnancial gains or losses


11/45

International 'apital #ar$et7I'#8

• Network of people, firms, financial institutions andgovernments borrowing and investing internationally

• %urposes

•Borrowers

Expands money supply

educes cost of money

!=enders

Spread / reduce risk Oset gains / losses


12/45

International 'apital#ar$et rivers

"nformation technology

#eregulation

$inancial instruments

%securiti&ation'


13/45

orld "inancial 'enters

• &t present, the three main nancial centers areLondon !e" #ork and $okyo

• London is one o the three leading world nancial

centres. It is amous or its ban$s and Europe>slargest stoc$ exchange, that have been establishedover hundreds o years 7e.g. =loyd>s o =ondon,=ondon (toc$ Exchange8. !he nancial mar$et o=ondon is also commonly reerred to as the 'ity. It

has historically been situated around the part o=ondon called (3uare #ile, but in the ?@AB>s and?@@B>s a large part o the 'ity o =ondon>s wholesalenancial services relocated to 'anary har.


14/45

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Operational centerExtensive financial activity

and currency trading

Operational centerExtensive financial activity

and currency trading

Booking center(ostly for bookkeeping

and tax purposes

Booking center(ostly for bookkeeping

and tax purposes

)4shore "inancial 'enters


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I#" denes )"' as1

• Curisdictions that have relatively largenumbers o nancial institutionsengaged primarily in business with non-

residents<• "inancial systems with external assets

and liabilities out o proportion todomestic nancial intermediation

designed to nance domesticeconomies< and

• #ore popularly, centers which providesome or all o the ollowing services1 low

or ero taxation< moderate or lightnancial re ulation ban$in secrec


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#ain 'omponents o I'#1

International ;ond #ar$et

Foreign bond Interest ratesEurobond

Bond that is

issued outside the

country in whose

currency the bond

is denominated

Bond sold outside a

borrower’s country

and denominated in

the currency of the

country in which it

is sold

Driving growth are

differential interest

rates between

developed and

developing nations

(arket of bonds sold by issuing companies,governments and others outside their own countries


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International E3uity #ar$et

(arket of stocks bought and soldoutside the issuer)s home country

$actors contributing towards growth:

• Spread of Privatization

•

Economic Growth in Developin Co!ntries• "ctivities of Investment Banks

• "dvent of C#$ermarkets


18/45

+overnments 'ommercial ban$s International companies

ealthy individuals

Eurocurrency #ar$et

*nregulated market ofcurrencies banked outside

their countries of origin


19/45

Introduction

• %oreign echange market' a

mar$et or converting the currencyo one country into the currency oanother.

• Echange rate' the rate at whichone currency is converted intoanother

• %oreign echange risk' the ris$that arises rom changes in

"oreign Exchange #ar$et


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"oreign Exchange #ar$et

'onversion1 $o (acilitate sale or purchase or

in)est directly abroad Hedging1 *nsure against potential losses (rom

ad)erse echange+rate changes

&rbitrage1 *nstantaneous purchase and sale o(

a currency in dierent markets (or proft (peculation1 Sequential purchase and sale ,or

)ice+)ersa- o( a currency (or proft

(arket in which currencies are bought and soldand their prices are determined


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!he "unctions o the"oreign Exchange #ar$et

• !he oreign exchange mar$etserves two main unctions1

– 'onvert the currency o one countryinto the currency o another

– %rovide some insurance against

oreign exchange ris$• %orein e&chane risk' the adverse

conse(!ences of !npredicta$le chanes inthe e&chane rates


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'urrency 'onversion

• 'onsumers can compare the relativeprices o goods and services in di4erentcountries using exchange rates

• International business have our mainuses o oreign exchange mar$ets

• To exchange currency received in

the course of doing business

abroad back into the currency of itshome country

• To pay a foreign company for its

products or services in its

country’s currency

• To invest excess cash for

short terms in foreign markets• To profit from the short-term

movement of funds from onecurrency to another in the

hopes of profiting from shifts

in exchange rates, also called

currency speculation


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Insuring against "oreignExchange Ris$

• & spot exchangeoccurs when twoparties agree to

exchange currencyand execute the dealimmediately

• !he spot exchangerate is the rate atwhich a oreignexchange dealerconverts onecurrency into

another currency ona articular da


24/45

Insuring against "oreignExchange Ris$

• "orward exchanges occur when two parties agree toexchange currency and execute the deal at somespecic date in the uture

– E&chane rates overnin s!ch f!t!re transactions arereferred to as forward e&chane rates

– %or most ma*or c!rrencies+ forward e&chane rates are(!oted for ,- da#s+ .- da#s+ and /0- da#s into the f!t!re

• hen a rm enters into a orward exchange contract,it is ta$ing out insurance against the possibility thatuture exchange rate movements will ma$e atransaction unprotable by the time that transactionhas been executed


25/45

!he *ature o the "oreignExchange #ar$et

• !he oreign exchange mar$et is a global networ$o ban$s, bro$ers and oreign exchange dealersconnected by electronic communications systems

• !he most important trading centers include1=ondon, *ew Dor$, !o$yo, and (ingapore• =ondon2s dominance is explained by1

– 1istor# 2capital of the first ma*or ind!strialized nation3 –

Georaph# 2$etween 4ok#o5Sinapore and 6ew 7ork3• !wo ma9or eatures o the oreign exchangemar$et1

– 4he market never sleeps – 8arket is hihl# interated


26/45

Institutions o"oreign Exchange #ar$et

• Interban$ #ar$et1 mar$et in which theworld2s largest ban$s exchange currenciesat spot and orward rates. – 'learing mechanismF

• (ecurities Exchanges1 exchangespecialiing in currency utures andoptions transactions.

• )ver-the-'ounter #ar$et1 Exchangeconsisting o a global computer networ$ ooreign exchange traders and other mar$etparticipants.


27/45

27

!he "oreign-Exchange #ar$et(ie o oreign-exchange mar$et

GBB billion spotG?. trillion in derivatives, ie

GJBB billion in outright orwardsG? trillion in orex swapsG?BB billion in "K options. 7JBBL8

M.(. dollar is the most important currency because it is1

• &n investment currency in many capital mar$ets

• & reserve currency held by many central ban$s

• & transaction currency in many international commoditymar$ets

• &n invoice currency in many contracts• &n intervention currency employed by monetary

authorities to infuence their exchange rates


28/45

Nuoting 'urrencies

9!oted c!rrenc# : n!merator Base c!rrenc# : denominator

9!oted c!rrenc# : n!merator Base c!rrenc# : denominator

2;5?S? dollar 2;5?S? dollar 7en is (!oted c!rrenc#+ dollar is $ase c!rrenc#7en is (!oted c!rrenc#+ dollar is $ase c!rrenc#


29/45

'urrency /alues

.hange in S dollaragainst 0olish 1loty

$ebruary +: -. /01

(arch +: -. 201

3change 4 5%26/'0/7 x +88 4 6983

*S dollar fell 983

.hange in 0olish 1lotyagainst S dollar

(ake &loty base currency %+ -.01' $ebruary +: 1!980-. (arch +: 1!9/0-.

3change 4 5%!9/6!98'0!987 x +88 4 9/3

olish &loty rose 9/3


30/45

'ross Rate

• Exchange rate calculated using two other exchange rates

• *se direct or indirect exchange rates against a third currency


31/45

'ross Rate Example

Direct quote method

/3 9!ote on e!ro : @ -?0A/5<

3 9!ote on #en : ; //A?-5<

,3

@ -?0A/5< ; //A?-5< : @ -?--FA5;A3 Costs -?--FA e!ros to $!# / #en

*ndirect quote method

/3 9!ote on e!ro : < /?/0/.5@

3 9!ote on #en : < -?--0F,A5;

,3 < /?/0/.5@ < -?--0F,A5; : @ /,?,5;

A3 %inal step' / @ /,?,5; : @ -?--FA5;

3 Costs -?--FA e!ros to $!# / #en


32/45

'urrency 'onvertibility

• +overnments can place restrictions on theconvertibility o currency

– " co!ntr#2s c!rrenc# is said to $e freelyconvertible when the co!ntr#2s overnment

allows $oth residents and nonresidents top!rchase !nlimited amo!nts of a forein c!rrenc#with it

– " c!rrenc# is said to $e externally convertiblewhen onl# nonresidents ma# convert it into aforein c!rrenc# witho!t an# limitations

– " c!rrenc# is nonconvertible when neitherresidents nor nonresidents are allowed to convertit into a forein c!rrenc#


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• +overnment restrictions can include – " restriction on residents2 a$ilit# to convert the

domestic c!rrenc# into a forein c!rrenc#

– )estrictin domestic $!sinesses2 a$ilit# to takeforein c!rrenc# o!t of the co!ntr#

• +overnments will limit or restrictconvertibility or a number o reasonsthat include1 – Preservin forein e&chane reserves

– " fear that free converti$ilit# will lead to a r!n ontheir forein e&chane reserves : known as capitalfliht


34/45

• +overnment restrictions can include – " restriction on residents2 a$ilit# to convert the

domestic c!rrenc# into a forein c!rrenc#

– )estrictin domestic $!sinesses2 a$ilit# to takeforein c!rrenc# o!t of the co!ntr#

• +overnments will limit or restrictconvertibility or a number o reasonsthat include1 – Preservin forein e&chane reserves

– " fear that free converti$ilit# will lead to a r!n ontheir forein e&chane reserves : known as capitalfliht


35/45

35

+overnmental Restrictions on "oreign-Exchange 'onvertibility

Restrictions used to conserve scarce oreign exchange

• =icensing6government regulates all oreign-exchangetransactions

– those who receive oreign currency re3uired to sellit to its central ban$ at the o5cial buying rate

– central ban$ rations oreign currency

• #ultiple exchange-rate system6di4erent exchange ratesset or di4erent transactions

• &dvance import deposit6re3uires importers to ma$e adeposit with central ban$ covering price o goods theywould purchase rom abroad

• Nuantity controls6limit the amount o currency thatresident can purchase or oreign travel

'urrency controls increase the cost o international businessand reduce overall international trade


36/45

3

How 'ompanies Mse "oreign Exchange

#ost oreign-exchange transactions involve international

departments o commercial ban$s• ;an$s buy and sell oreign currency< ban$s collect and

pay money in transaction with oreign buyers and sellers

• ;an$s lend money in oreign currency

'ompanies use oreign-exchange mar$et or1

•Import and export transactions

• "inancial transactions such as "I

&rbitrage6purchase o oreign currency on one mar$et orimmediate resale on another mar$et

• &rbitragers hope to prot rom price discrepancy

•

Interest arbitrage6investing in debt instruments indi4erent countries

(peculation6buying or selling oreign currency has both ris$and high prot potential


37/45

37

"oreign-Exchange !rading %rocess

'ompanies wor$ through their local ban$s to settle oreign-

exchange balances• 'ommercial ban$s in ma9or money centers became

intermediaries or small ban$s

#ost oreign-exchange activity ta$es place in traditionalinstruments

• 'ommercial and investment ban$s and other nancialinstitutions handle spot, outright orward, and "K swaps

• "oreign-exchange mar$et made up o about J,BBB dealerinstitutions worldwide

• #ost oreign-exchange ta$es place in )!' mar$et

ealers can trade oreign exchange1• irectly with other dealers

• !hrough voice bro$ers

• !hrough electronic bro$erage systems

– Internet trades o currency are more popular


38/45

3!

'ommercial and Investment ;an$s

+reatest volume o oreign-exchange activity ta$es place

with the big ban$s• !op ban$s in the interban$ mar$et in oreign

exchange are so ran$ed because o their ability to1

– trade in specic mar$et locations

– engage in ma9or currencies and cross-trades

– deal in specic currencies

– handle derivatives

» orwards, options, uture swaps

– conduct $ey mar$et research

• ;an$s may specialie in geographic areas,instruments, or currencies

– exotic currency6currency o a developingcountry

» oten unstable, wea$, and unpredictable


39/45

$op 23 .urrency $raders 7O o overall volume, #ay JBBP 8

"ank #ame $ of volume

% &eutsche 'ank %7()

2 *'+ %2(5

3 itigroup 7(5

.+' (

5 'arclays 5(/

0errill 1ynch 5(7

7 (( 0organ hase 5(3

! 4oldman +achs (

/ '# 0"6 (2

%) 0organ +tanley 3(/


40/45

International #onetary(ystem

• Rules and procedures by which di4erentnational currencies are exchanged oreach other in world trade.

• (uch a system is necessary to dene acommon standard o value or theworld>s currencies.

• Reer to the institutional arrangements

that countries adopt to governexchange rates – "loating – %egged exchange rate – irty foat – "ixed exchange rate


41/45

• "loating exchange rates occur

when the oreign exchangemar$et determines the relativevalue o a currency

• !he world2s our ma9orcurrencies : dollar, euro, yen,and pound : are all ree to foat

against each other• 0egged echange rates occurwhen the value o a currency isxed relative to a reerence


42/45

• Dirty 4oat occurs when countrieshold the value o their currencywithin a range o a reerencecurrency

• %ied echange rate occurswhen a set o currencies are xedagainst each other at some

mutually agreed upon exchangerate

• %egged exchange rates, dirty foats

and xed exchange rates all


43/45

Evolution o International #onetary(ystem

!he +old (tandard In place rom ?QBBs to ?@@ a monetary standard that pegs

currencies to gold and guarantees

convertibility to gold It was thought that gold standard

contained an automatic mechanism thatcontributed to the simultaneous

achievement o a balance-o-paymentse3uilibrium by all countries.

!he gold standard bro$e down duringthe ?@Bs as countries engaged in

competitive devaluations


44/45

!he +old (tandard

• Roots in oldmercantile trade

• Inconvenient toship gold,changed topaper-

redeemable orgold

• ant to achieve

balance-o-trade

*+Japan

G o l d

T r a d e


45/45

;alance o !rade E3uilibrium

Trade Surplus

GoldIncreased

money supply

= price

inflation.

Decreased

money supply

= price decline.

As prices decline, exports

increase and trade goes

into equilibrium.

inflation, interest rates, and exchange rates.pptx

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