International Transactions and Financial Markets CHAPTER 12

Any transaction included in current account requires exchange of currencies. –Example:Importing Japanese cars to U.S., building a factory in India, purchase of financial assets from Germany Buyer must exchange domestic currency for foreign currency to purchase the good/asset. The Foreign Exchange Market

Foreign Exchange: –Currency or deposits in financial institutions in another country Financial assets may be: –Currency –Bank deposits –Highly liquid financial claims The Foreign Exchange Market

Foreign Exchange Market: –Never closes –Is reasonable free of obstructions for the industrialized and developing countries with open capital markets Freely Convertible Currencies: –The currencies in these countries –Money moves between countries without impediments as in goods/services trade –Estimates of daily volume of trade -$1.2 trillion The Foreign Exchange Market

Paying for Imports and Exports –Problem: substantial time lag due to transportation! Exporter wants to be paid at time of shipment. Importer only wants to pay when receiving goods. –Solution: A commercial bill of exchange or a bank draft: a written order instructing to pay on a certain date a specified amount of money. –Exporter can hold to maturity or sell right away at a discount. The Foreign Exchange Market

Time lag between purchase order and delivery can be substantial. In the meantime, exchange rate may change! Spot Exchange Rate: –Applies when the transaction is completed at the same time the price is agreed on Forward Exchange Rate: –Price of foreign exchange to be delivered at some point in the future Speculator takes risk in hopes of profit The Foreign Exchange Market

Speculators –Individual foreign-exchange traders, financial institutions or non-financial businesses buying and selling foreign exchange in order to gain short-run profits. –High returns and high risks The Foreign Exchange Market

Futures Contract: –A commitment to purchase or deliver a specified quantity of foreign currency on a designated future date. Option : –A contract that gives the holder the option to buy or sell foreign exchange in the future. Currency Swap: –Agreement between two parties to exchange different currencies over a specified time. Lower transactions costs The Foreign Exchange Market

Financial Intermediation –Putting two different market participants together to conduct an economic transaction –Reason to move money from one country to another: Higher rate of return –Capital flows from the developed to developing countries could make both countries better off Investors in developed countries can earn a higher rate of return. Developing countries get much needed capital increasing the rate of economic growth. International Financial Markets

Risk Diversification: –Holding financial assets with varying degrees of risk tends to be less risky than holding just one financial asset –Helps to explain two-way capital flow International Financial Markets

Eurocurrency Markets –Eurodollar: Dollar-denominated account that exists outside the U.S. Part of Eurocurrency Market –Eurocurrency: –An account denominated in a major currency that is located outside that country. Participants in the International Financial Markets