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Foreign exchange market

International Business ( International Monetary System & Capital Market ) Erasmus programme V Lecturer Dr Pavlos Dimitratos pdimitr@aueb.gr. Foreign exchange market. Foreign exchange risk Spot & forward exchange rate

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Foreign exchange market

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  1. International Business(International Monetary System & Capital Market)Erasmus programme VLecturer Dr Pavlos Dimitratos pdimitr@aueb.gr

  2. Foreign exchange market • Foreign exchange risk • Spot & forward exchange rate • The law of one price: in efficient markets free of transportation costs and trade barriers, identical products sold in different countries must sell for the same price • Three factors significantly affect future exchange rate of a currency: • Country’s price inflation & money supply • Country’s interest rate • Market psychology

  3. Inflation and money supply • If a basket of goods costs $100 in the US and £66.67 in the UK, the purchasing power parity theory predicts that the $/£ exchange rate will be (100/66.67=) 1.5 ($/£) • PPP theory stipulates that changes in relative prices (e.g. inflation) will result in changes (e.g. depreciation against countries with lower inflation) in exchange rates • Inflation rate is determined by money supply • The PPP theory appears to be accurate in the long-run but not necessarily in the short-run

  4. Interest rates • Interest rates reflect expectations about future inflation rates • For any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates • As before, this seems to be the case mainly in the longer-run Market psychology • Expectations are very important, especially in the short-run and tend to become self-filling prophecies (bandwagon effects)

  5. Monetary system • Floating exchange rate regime: when the market determines the relative value of a currency • Fixed exchange rate regime: the values of currencies are set against each other at mutually agreed exchange rates Intermediate cases • Pegged exchange rate: the value of the currency is fixed relative to a reference currency (which determines other exchange rates) • Dirty float: the value of the currency is hold within some range against a reference currency

  6. Monetary system (con’d) • The international monetary system has passed from the period of the gold standard (pegging currencies to gold)… • to a system of fixed exchange rates (Bretton Woods – whereby only the dollar was convertible into gold)… • IMF and • World Bank were established • to the floating exchange rate system (Jamaica agreement)

  7. Floating vs. fixed exchange rates • Floating • Monetary policy autonomy for a country • Smooth trade balance adjustments • Fixed • Monetary discipline • Combats speculation • Reduces uncertainty re currency movements • A different (than the B-W) fixed rate system might work and foster stability

  8. The international capital market • Mini-case discussion • Firms may use the international capital market in order to get access to wide liquidity of the international capital market and obtain lower cost of capital • Investors may use the international capital market in order to diversify efficiently their portfolio and reduce the level of risk

  9. Stock markets in different countries show low correlation because • Countries pursue different policies in different contexts • Capital controls occur • Eurocurrency is a currency backed outside its country of origin • No/little government regulation in this market • Depositors may earn more than deposits in home currency

  10. Foreign bonds are sold outside the borrower’s country and are denominated in the currency of the country in which they are issued (e.g. Siemens issues bonds in USA and sells them in the US -Yankee bonds) • Eurobonds are normally underwritten by an international syndicate of banks and placed in countries other than the one in whose currency the bond is denominated (e.g. Siemens issues bonds denominated in US dollars and sold to investors outside the US)

  11. Eurobonds are … • Absent of regulatory interference • Less stringent on disclosure requirements than domestic bond markets • Usually offer a more favorable tax status • … but foreign exchange risk may always be a problem

  12. Readings • Hill, chapters 9, 10 & 11 Recommended: • International Economics: Theory and Policy (6th Edition), Krugman P. R. and Obstfeld, 2004, Addison Wesley

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