INTERNATIONAL FINANCE

COURSE CODE: B6932MI

TOPIC 3
 FOREIGN EXCHANGE MARKETS
• After having studied this topic, the student
should be able to:
• Describe and discuss foreign exchange
markets.
• Describe and discuss the national money
markets in which interest rates are
determined.
 FOREIGN EXCHANGE MARKETS
• The foreign exchange market (currency, forex,
or FX) trades currencies.
• It lets banks and other institutions easily buy
and sell currencies.
• The purpose of the foreign exchange market is
to help international trade and investment.
• A foreign exchange market helps businesses
convert one currency to another.
 FOREIGN EXCHANGE MARKETS
(Cont.)
The foreign exchange market is unique because of:
• Its trading volume
• The extreme liquidity of the market
• Its geographical dispersion
• Its long trading hours: 24 hours a day except on
weekends.
• The variety of factors that affect exchange rates.
 FOREIGN EXCHANGE MARKETS
(Cont.)
• The low margins of profit compared with
other markets of fixed income (but profits can
be high due to very large trading volumes).
• The use of leverage.
 FOREIGN EXCHANGE MARKETS
(Cont.)
• The foreign exchange market is the largest and
most liquid financial market in the world.
• Exchange rates are determined by the
interaction of the households, firms, and
financial institutions that buy and sell foreign
currencies to make international payments.
 The Actors
• The major participants in the foreign exchange
market are commercial banks, corporations
that engage in international trade, nonbank
financial institutions such as asset-
management firms and insurance companies,
and central banks.
• Individuals may also participate in the foreign
exchange market (e.g. tourist who buys
foreign currency at a hotel’s front desk).
 The Actors (Cont.)
• Commercial banks – are at the center of the
foreign exchange market because almost
every sizable international transaction
involves the debiting and crediting of accounts
at commercial banks in various financial
centers.
• Thus, the vast majority of foreign exchange
transactions involves the exchange of bank
deposits denominated in different currencies.
 The Actors (Cont.)
• Corporations – with operations in several
countries frequently make or receive
payments in currencies other then that of the
country in which they are headquartered.
• For example, to pay workers at a plant in
Serowe, Botswana, Namibia Breweries Ltd
may need Botswana Pula.
 The Actors (Cont.)
• Nonbank financial institutions – institutional
investors such as pension funds often trade
foreign currencies. So do insurance
companies.
• Hedge funds, which cater to very wealthy
individuals and are not bound by the
government regulations that limit mutual
funds’ trading strategies, trade actively in the
foreign exchange market.
 The Actors (Cont.)
• Central banks – participants in the foreign
exchange market watch central bank actions
closely for clues about future macroeconomic
policies that may affect exchange rates.
• Government agencies other than central
banks may also trade in the foreign exchange
market, but central banks are the most regular
official participants.
 Characteristics of the Market
• Foreign exchange trading takes in many
financial centers, with the largest volumes of
trade occurring in such major cities as London
(the largest market), New York, Tokyo,
Frankfurt, and Singapore.
• Over the past two decades, global FX spot
trading volume has roughly increased, to over
$2 trillion per day by 2022.
 Characteristics of the Market (Cont.)
• Telephone, fax, and Internet links among
foreign exchange trading centers make each a
part of a single world market on which the sun
never sets.
• Economic news released at any time of the
day is immediately transmitted around the
world for participants.
 Characteristics of the Market (Cont.)
• Even after trading in New York has finished,
New York based banks and corporations with
affiliates in other time zones can remain active
in the market.
• Foreign exchange traders may deal from their
homes when a late-night communication
alerts them to important developments in a
financial center on another continent (e.g.
Asia, Latin America, European etc.).
 Money, Interest Rates & Exchange
Rates
• Money as a medium of exchange – the most
important function of money is to serve as a
medium of exchange, a generally accepted
means of payment.
• Money eliminates the enormous search costs
connected with a barter system (e.g. the
direct trade of goods or services for other
goods or services) because money is
universally accepted.
 Money, Interest Rates & Exchange
Rates (Cont.)
• Money – eliminates these search costs by
enabling an individual to sell the goods and
services she produces to people other than
the producers of the goods and services she
wishes to consume.
 Money as a Unit of Account
• Money’s second important role is as a unit of
account, that is, as a widely recognized
measure of value.
• Prices of goods, services, and assets are
typically expressed in terms of money.
• Exchange rates allow us to translate different
countries’ money prices into comparable
terms (e.g. Namibian dollars and British
Sterling/Pound).
 Money as a Unit of Account (Cont.)
• The convention of quoting prices in money
terms simplifies economic calculations by
making it easy to compare the prices of
different commodities.
• The international price comparisons in (see
next slide) which used exchange rates to
compare the prices of different countries
outputs, are similar to the calculations you
would have to do.
 Namibian Dollar per Foreign currency
unit

Description Code Bank Selling Rate Bank Buying TT Bank Buying Notes

Euro EUR 20.209814 19.113031 18.818984

Pound Sterling GBP 23.894682 22.599211 22.251530

US Dollar USD 18.676475 17.669438 17.397600

Source: FNB, 2024

 Money as a Store of Value
• Because money can be used to transfer
purchasing power from the present into the
future, it is also an asset, or a store of value.
• Money’s usefulness as a medium of exchange,
however, automatically makes it the most liquid
of all assets.
• An asset is said to be liquid when it can be
transformed into goods and services rapidly and
without high transaction costs, such as brokers’
fees.
 What is Money
• Currency and bank deposits on which checks
may be written certainly qualify as money.
• These are widely accepted means of payment
that can be transferred between owners at
low cost.
How the Money Supply is Determined
• An economy’s money supply is controlled by
its central bank (e.g. Bank of Namibia, South
African Reserve Bank).
• The central bank directly regulates the
amount of currency in existence and also has
indirect control over the amount of checking
deposits issued by private banks.
 The Central Bank Balance Sheet and
the Money Supply
• The Balance Sheet – records the assets held by
the central bank and its liabilities.
 Balance Sheet
Central Bank Balance Sheet
Assets Liabilities

Foreign assets Deposits held by private banks

Domestic Assets Currency in circulation

 Balance Sheet (Cont.)
The assets side of the balance sheet:
• Foreign assets - consist of foreign currency bonds
owned by the central bank.
• These foreign assets make up the central bank’s
official international reserves, and their level
changes when the central bank intervenes in the
foreign exchange market by buying or selling
foreign exchange.
• A central bank’s international reserves also
include any gold that it owns.
 Balance Sheet (Cont.)
• The defining characteristics of international
reserves is that they be either claims on
foreigners or a universally accepted means of
making international payments (for example
gold).
• Domestic assets – are central bank holdings of
claims to future payments by its own citizens
and domestic institutions.
 Balance Sheet (Cont.)
• These claims usually take the form of
domestic government bonds and loans to
domestic private banks.
 Balance Sheet (Cont.)
The liabilities side of the balance sheet:
• The deposits of private banks – are liabilities of
the central bank because the money may be
withdrawn whenever private banks need it.
• Currency in circulation (both notes and coin) - is
considered a central bank liability main for
historical reasons: at one time, central banks
were obliged to give a certain amount of gold or
silver to anyone wishing to exchange domestic
currency for one of those precious metals.
 Foreign Exchange Intervention and
the Money Supply
• Suppose the Bank of Namibia goes to the
foreign exchange market and sell $100 worth
of foreign bonds for Namibia money.
• The sale reduces official holdings of foreign
assets, causing the assets side of the central
bank balance sheet to shrink.
• The payment the Bank of Namibia receives for
these foreign assets automatically reduces its
liabilities as well.
 Foreign Exchange Intervention and
the Money Supply (Cont.)
• If the Bank of Namibia is paid with domestic
currency, the currency goes into its vault and
out of circulation.
• Currency in circulation therefore also falls by
$100.
 Sterilization
• Central banks sometimes carry out equal
foreign and domestic asset transaction in
opposite directions to nullify the impact of
their foreign exchange operations on the
domestic money supply.
• The type of policy is called sterilized foreign
exchange intervention.
 Sterilization (Cont.)
• Suppose once again that the Bank of Namibia
sells $100 of its foreign assets and receives as
payment a $100 check on the private bank.
• This transaction causes the central bank’s
foreign assets and its liabilities to decline
simultaneously by $100, and there is therefore
a fall in the domestic money supply.
 Sterilization (Cont.)
• If the central bank wishes to negate the effect
of its foreign asset sale on the money supply,
it can buy $100 of domestic assets, such as
government bonds.
• This second action increases the Bank of
Namibia’s domestic assets and its liabilities by
$100 and thus completely cancels the money
supply effect of the $100 sale of foreign
assets.
 The Balance of Payments and the
Money Supply
• Balance of payments defined as country’s
balance of payments (or official settlements
balance) as net purchases of foreign assets by
the home central bank less net purchases of
domestic assets by foreign central banks.
• The international payments gap that central
banks must finance through their reserve
transactions.
 The Balance of Payments and the
Money Supply (Cont.)
• A home balance of payments deficit, for example,
means the country’s net foreign reserve liabilities
are increasing:
• Some combination of reserve sales by the home
central bank and reserve purchases by foreign
central banks is covering a home current plus
capital account deficit not fully matched by net
private sales of assets to foreigners, or a home
current account surplus that falls short of net
private purchases of financial claims on
foreigners.
 The Balance of Payments and the
Money Supply (Cont.)
• If central banks are not sterilizing and the
home country has a balance of payments
surplus, for example, any association increase
in the home central bank’s foreign assets
implies an increased home money supply.
• Similarly, any associated decrease in a foreign
central bank’s claims on the home country
implies a decreased foreign money supply.
The Demand for Money by Individuals
The determinants of individual money demand
is on three characteristics:
(1) The expected return the asset offers
compared with the returns offered by other
assets.
(2) The riskiness of the asset’s expected return.
(3) The asset’s liquidity.
 Expected Return
• Currency pays no interest.
• Checking deposits often do pay some interest,
but they offer a rate of return that usually fails to
keep pace with the higher returns offered by less
liquid forms of wealth.
• Stocks, for example, pay returns in the forms of
dividends and capital gains.
• The higher the interest rate, the more you
sacrifice by holding wealth in the form of money
(e.g. in a government bond).
 Risk
• Risk is not an important factor in the money
demand.
• It is risky to hold money because an
unexpected increase in the prices of goods
and services could reduce the value of your
money in terms of the commodities you
consume.
 Liquidity
• The main benefit of holding money comes
from its liquidity.
• Households and firms hold money because it
is the easiest way of financing their everyday
purchases.
• An individual’s need for liquidity rises when
the average daily value of his transactions
rises.
 Aggregate Money Demand
• Aggregate money demand is just the sum of
all the economy’s individual money demands.
Three main factors determine aggregate money
demand:
(1) The interest rate – a rise in the interest rate
causes each individual in the economy to
reduce her demand for money.
Aggregate Money Demand (Cont.)
(2) The price level – if the price level rises,
individual households and firms must spend
more money than before to purchase their usual
weekly baskets of goods and services.
To maintain the same level of liquidity as before
the price level increase, they will therefore have
to hold more money.
Aggregate Money Demand (Cont.)
(3) Real national income – when real national
income (GNP) rises (e.g. Namibia's potential for
green hydrogen and with its recent offshore oil
and gas discoveries), more goods and services
are sold in the economy.
This increase in the real value of transactions
raises the demand for money, given the price
level.
 Purchasing Power Parity (PPP)
• PPP explains movements in the exchange rate
between two countries currencies by changes
in the countries’ price levels.
• One factor affecting a country’s foreign
currency exchange rate with another country
is the relative inflation rate in each country
(which is directly related to the relative
interest rates in these countries).
 Purchasing Power Parity (PPP)
• The (nominal) interest rate spread between the
United States and South Africa reflects the
difference in inflation rates between the two
countries.
• As relative inflation rates (and interest rates)
change, foreign currency exchange rates that are
not constrained by government regulation should
also adjust to account for relative differences in
the price levels (inflation rates) between the two
countries.
 Purchasing Power Parity (PPP)
• According to PPP, foreign currency exchange
rates between two countries adjust to reflect
changes in each country’s price levels (or
inflation rates and, implicitly, interest rates) as
consumers and importers switch their
demands for goods from relatively high
inflation (interest) rate countries to low
inflation (interest) rate countries.
 Purchasing Power Parity (PPP)
• Specifically, the PPP theorem states that the
change in the exchange rate between two
countries’ currencies is proportional to the
difference in the inflation rates in the two
countries.
 Purchasing Power Parity (PPP)
• Thus, according to PPP, the most important
factor determining exchange rates is the fact
that in open economies, differences in price
(and, by implication, price level changes with
inflation) drive trade flows and thus demand
for and supplies of currencies.