Chapter 8:
Foreign
Exchange and
International
Financial
Markets
International Business, 4th Edition
Griffin & Pustay
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Chapter Objectives_1
 Describe how demand and supply
determine the price of foreign
exchange
 Discuss the role of international banks
in the foreign-exchange market
 Summarize the role of arbitrage in the
foreign-exchange market
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Chapter Objectives_2
 Assess the different ways firms can use
the spot and forward markets to settle
international transactions
 Discuss the important aspects of the
international capital market
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Foreign Exchange
A commodity that
consists of currencies
issued by countries
other than one’s own
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Figure 8.1
Demand for Japanese
Yen is Derived from
Foreigner’s Demand
for Japanese Products
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Figure 8.2
Supply for Japanese
Yen is Derived from
Japanese Demand for
Foreign Products
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Figure 8.3 The Market for Yen
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Foreign Exchange Rates
 Direct exchange rate
– Direct quote
– Price of the foreign currency in terms of home
currency
 Indirect exchange rate
– Indirect quote
– Price of the home country in terms of the
foreign currency
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Figure 8.4
Direct and
Indirect
Exchange
Rates
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The Role of Banks
 Wholesale market for foreign exchange
 Retail market for foreign exchange
 Clients
– Commercial customers
– Speculators
– Arbitrageurs
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Map 8.1 A Day of Foreign-Exchange Trading
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Figure 8.5 Currencies Involved in
Foreign-Exchange Market Transactions
20
24 4 6
13
23
Canadian dollar
Swiss franc
Pound sterling
Japanese yen
Euro
U.S. dollar
Other currencies
Australian dollar
Hong Kong dollar
38
90
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Tokyo is the
third largest
center for
foreignexchange
trading,
trailing only
London and
New York
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Spot and Forward Markets
 Lending and Purchasing on credit
 Spot market: foreign-exchange transactions
that are to be consummated immediately
 Forward market: foreign exchange
transactions that are to occur at some time
in the future
 Swap transaction: same currency is bought
and sold simultaneously with delivery at
different points in time
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Mechanisms for Future Foreign
Exchanges
 Currency future
 Currency option
– Call option
– Put option
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Figure 8.6
Foreign-Exchange
Options
on the
Chicago
Mercantile
Exchange
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Arbitrage and the Currency Market
 Arbitrage: the riskless purchase of a
product in one market for immediate
resale in a second market in order to
profit from a price discrepancy
– Arbitrage of goods
– Arbitrage of money
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Theory of Purchasing Power Parity (PPP)
 The prices of tradable goods, when
expressed in a common currency, will tend
to equalize across countries as a result of
exchange rate changes
 Occurs because process of buying goods in
a cheap market and reselling them in
expensive market affects demand for (and
price of) the foreign currency and the
market price of the good in the two product
markets in question
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The prices these
Mexican shoppers pay
for foreign-made
goods are affected by
fluctuations in the
value of the peso in
the foreign-exchange
market
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Arbitrage of Money
 Two-point (geographic arbitrage)
 Three-point
 Covered interest
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Figure 8.7 Three-Point Arbitrage
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Importance of Arbitrage Activities
 Constitutes a major portion of $1.2
trillion currencies traded globally each
working day
 Ties together the foreign-exchange
markets
 Overcomes differences in geography,
currency type, time
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Table 8.1 The World’s 10 Largest Banks
Rank
Company
Country
Assets ($ Mil)
1
Mizuho Holdings
Japan
1,148,917
2
Citigroup
US
1,051,450
3
Sumitomo Mitsui Banking
Japan
820,083
4
Deutsche Bank
Germany
813,619
5
Mitsubishi Tokyo Financial Group
Japan
755,481
6
UBS
Switzerland
752,332
7
BNP Paribas
France
733,423
8
HSBC Holdings
UK
694,238
9
J.P. Morgan Chase
US
693,575
10
Bayerische Hypo Bank
Germany
647,926
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Establishment of
Overseas Banking Operation
 Subsidiary bank
 Branch bank
 Affiliated bank
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The Eurocurrency Market
 Originated in the early 1950s
 Eurodollars – U.S. dollars deposited in
European bank accounts
– Euroyen
– Europounds
 Eurocurrency – currency on deposit outside
in banks worldwide
 Euroloans quoted on basis of LIBOR
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The International Bond Market
 Major source of debt financing for
– World’s governments
– International organizations
– Larger firms
 2 types of bonds
– Foreign bonds
– Eurobonds
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Figure 8.8 International Bond Issues,
2001, by Currency (in billions of U.S. dollars)
U.S. dollar, 558,
48%
U.S. dollar
Euro
British pound
Other currencies
Other currencies,
24, 2%
British pound,
66, 6%
Euro, 503, 44%
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Hong Kong
residents
seeking to
buy shares in
the Web
portal firm
tom.com
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Global Equity Markets
 Start-up companies are no longer
restricted to raising new equity only
from domestic sources
 Development of country funds
– Mutual fund specializing in a given
country’s funds
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Offshore Financial Centers
 Focus on offering banking and other
financial services to non-resident
customers
 Locations
– Bahamas, Bahrain, the Cayman Islands,
Bermuda, the Netherlands Antilles,
Singapore, Luxembourg, Switzerland
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