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Subject ECONOMICS

Paper No and Title 6: Advanced Macroeconomics

Module No and Title 1: Balance of Payments and International Financial Markets

Module Tag ECO_P6_M1

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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TABLE OF CONTENTS
1. Learning Outcomes
2. Introduction
3. Benefits of International Financial Markets
4. Types of International Financial Markets
5. Summary

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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1. Learning Outcomes
After studying this module, you shall be able to
 Know the concept of Financial Markets
 Understand the benefits of international financial markets
 Learn what the different types of international financial markets are.
 Identify the difference between appreciation and depreciation of exchange rates.

2. Introduction

Financial market is a very broad term describing any market place where financial assets
like stocks, bonds, currencies, derivatives, and other financial instruments are traded. In a
financial market, market forces determine the prices of various financial securities traded.
However, there are certain government restrictions that regulate the amount of trading in
these markets. Financial markets can be restricted to the operations within a country,
called domestic financial market, while it can be opened up to have buying and selling of
foreign securities as well. The later taken separately is called the international financial
market.

Opening up of the economy to the foreign securities necessitates an economy to balance

its both domestic accounts and external accounts. External accounts for financial assets of
an economy is called balance of payments. It is a record of all the international
transactions of the current, the capital and the financial accounts of an economy with the
rest of the world. Depending upon which kind of international financial instrument the
resident of an economy is trading in, the effect on balance of payments account will be
different. For instance, if trading is happening through bonds, it will have a different
impact on balance of payments account if the trading is happening directly in foreign
currency exchange.

In this module, we will study international financial markets, what are the benefits of
having trade in foreign securities, what are its benefits to investors and borrowers. In
section 4, we will study different types of international financial markets, and what are
the instruments traded in the financial markets.

3. Benefits of International Financial Markets

International financial markets play a crucial role for the economic agents who want to
park their funds in a foreign country. Investors typically invest in securities of foreign
country, because they expect to earn an extra post tax real rate of return, which they get
through the difference in the interest rates on foreign securities and domestic securities

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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plus any expected gain or loss from any exchange rate variation. For instance, when
investors expect domestic currency to depreciate in comparison to a foreign currency, or
in other words, when domestic currency loses its value, they reap an extra benefit from
international diversification, over and above the interest rates differential. Indeed they
would then shift from domestically denominated assets into foreign assets before the
expected depreciation to profit in terms of the domestic currency. More importantly, risk
factors are different in different countries. Diversifying the investment on international
financial markets allow an investor to reduce his expected costs due to different kind of
risks, especially political risk. An investor or a wealth holder would take into account
factors such as return, risk and liquidity to arrive at a portfolio of assets which maximizes
his utility. International Financial markets permit the investor a greater range of assets
with which the portfolio can be made of.

International financial markets allow borrowers to borrow funds from the country in
which interest rates are lowest. Moreover, if they expect the domestic currency to
appreciate, they will gain during the repayment of the funds. If on the other hand the
domestic currency were to depreciate, the advantage of borrowing at a lower rate could
be either partially or fully eroded. There could even be a loss if the rate of depreciation
were to be large enough to exceed the interest rate differential. Thus, depending upon
expectations of how the exchange rate would move, this geographical diversification
helps borrowers to reduce their costs of borrowings. By a similar logic, it would help
lenders to get a higher expected return for their funds.

Another benefit of international financial markets is that the financial assets traded are
highly liquid and the costs of transaction are low. This enables large scale arbitrage
operations. The opportunities for arbitrage arise, when the rates of exchange between
currencies, which should be the same in all the geographical areas of the market,
temporarily become different in the differing geographical areas or segments of the
market. Dealers engage in arbitrage operations all the time to take advantage of these
exchange rate differentials that occur in different segments of the market. Arbitrage is the
process in which a dealer simultaneously buys an instrument of a foreign currency from a
segment of the market where its price is low and sells it in the segment of the market
where its price is high. This operation is conducted by several dealers at the same time
with large amounts. This operation, while yielding profits to the dealers, has the effect of
equalizing the rates in different segments of the market. If there are no restrictions on
buying and selling of foreign currencies, this kind of arbitrage opportunities will ensure
that the price of domestic currency is equalized to the foreign currency in all market
segments.

All this applies to currencies which are fully convertible, i.e. convertible from one
currency to another without any restriction or limit. However, even if two currencies are
convertible, they may not be converted into one another directly. One of those currencies
would be first converted into an equivalent amount of United States dollars and then
those dollars then converted into the other currency. This is because the US dollar is

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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universally acceptable and serves as an international medium of exchange, or as a

‘vehicle currency’. Besides the dollar, the euro is to a lesser extent used as a vehicle
currency.

4. Types of International Financial Markets

Essentially, there are five types of international financial markets. However, different
economists have different classifications of international financial markets. In this
section, we will describe different types of financial markets. These are foreign exchange
market on the one hand and what are known as the Euro Currency market, Euro Credit
Market, Euro Bond Market, and International Stock Market on the other. These markets
are essentially offshore markets. They are often referred to as Euro Markets, even though
they have nothing to do with the European Union (EU) currency the Euro as such. Let’s
discuss them in detail.

(A) Foreign Exchange Market

A foreign exchange market, or sometimes simply called forex market, is a market where
currencies of different countries are bought and sold. The requirement of a foreign
exchange market arises because different countries have different monetary systems. An
individual who wants to visit Hong-Kong on a holiday, which is a foreign country for
him, requires currency of Hong-Kong to incur his expenses over his holiday. He cannot
use his domestic country currency in Hong-Kong for transactions. Thus, the need for
foreign exchange market arises, and currencies are being traded in this market. Foreign
exchange market, thus promotes trade and international investments among countries, by
enabling currency conversion. Demand for foreign exchange comes from the people who
demand goods, services and financial assets of a foreign country at a retail level. At the
wholesale level, it comes from banks, non-bank financial institutions, large multinational
corporations and central banks. These also act as suppliers of foreign exchange.

The modern form of foreign exchange market began during the 1970s. It was the time
when countries moved away from the fixed exchange rates regime of Bretton Woods
System, almost nearly after three decades. Foreign exchange was then started trading on a
flexible exchange rates regime.

Foreign exchange market is basically an interbank market, or inter-dealer market, where

large international banks around the world function as channel of trade between large
number of buyers and sellers of foreign exchange. There are several levels at which this
market operates. These large international banks turn to a smaller number of financial
firms known as “dealers”. These dealers are actively involved in large quantities of
foreign exchange trading. These dealers are then directly linked to the buyers and sellers
of the foreign exchange.

Some of the key features of this market are as follows:

ECONOMICS Paper 6: Advanced Macroeconomics
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 It is by far the largest financial market in the world.

 Given the huge volume of financial assets traded, it provides high liquidity to the
assets.
 It is geographical dispersed as currency of any country can be traded on the
foreign exchange market. The reach of foreign exchange market is said to be
across the globe, with the principal centers being located in London, United States
and Tokyo.
 It is operated continuously round the clock, except on the weekends.

Different participants of foreign exchange markets are: commercial companies, central

banks, foreign exchange fixers, speculators or hedge funds managers, investment
management firms, retail foreign exchange traders, non-bank foreign exchange countries,
money transfer agents, and remittance companies. The trade in foreign exchange market
currently exceeds an average of $5 trillion per day. Transactions in foreign exchange
market do not occur at any physical place. All the market participants are linked
electronically through internet or mobile phones. The foreign exchange markets around
the world are linked through a satellite based communications network called Society of
Worldwide Interbank Financial Telecommunications (SWIFT). The biggest foreign
exchange market centre is in London.

There are two types of foreign exchange markets: retail and wholesale markets.
(i) Retail Market: deals with exchange of bank notes, bank drafts, currency and
travelers’ cheques between private customers, tourists and banks.
(ii) Wholesale Market: deals with central banks and other commercial banks. It is
sometimes called inter-bank market.

Exchange Rates
To understand the operations of foreign exchange market, we need to understand the
concept of exchange rates. The exchange rates represent the number of units of one
currency that can be exchanged for one unit of another currency. For instance, if one US
dollar can be exchanged for fifty Indian rupees, we say that the Rs/$ exchange rate is Rs
50/$. Thus, there are two ways to express exchange rates, Rs/$ exchange rate or $/Rs
exchange rate. One is the reciprocal of the other. Thus, if Rs 50 make one US dollar, then
1/50 or 0.02 US dollar make one rupee. In other words, if Rs/$ exchange rate is expressed
as E, and $/Rs exchange rate is expressed as V, then E=1/V. Note that one currency is
usually expressed in terms of another currency, rather than in terms of a commodity. For
instance, we say one US dollar is equal to Rs 50. We do not say that one US dollar is
equal to five Indian bananas. Thus, value of one currency is expressed in terms of another
currency.

Given that Rs/$ exchange rate is the reciprocal of $/Rs exchange rate; there are two ways
in which exchange rates are quoted, one being the reciprocal of the other.

ECONOMICS Paper 6: Advanced Macroeconomics

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(i) Direct Quote: Number of units of domestic currency exchangeable for one unit of
foreign currency. For instance, Rs 50 per US dollar.
(ii) Indirect Quote: Number of units of foreign currency exchangeable for one unit of
domestic currency. For instance, 0.02 US $ per Indian rupee.

Exchange Rates Regimes may be represented by two extreme types, namely fixed
exchange rates regime and flexible exchange rates regime. Under the fixed exchange
rates regime, government fixes the value of currency either in terms of another currency
or in terms of gold. If the demand and supply in the foreign exchange market forces the
exchange rates to differ from this fixed rate, central bank intervenes to either purchase or
sell foreign currency to make sure that the fixed exchange rates are maintained. Under
flexible exchange rates regime, the central bank stands aside and the exchange rates are
determined by the market forces alone, through the demand and supply of foreign
exchange. In practice, the foreign exchange markets, the usual case is for the markets to
be characterized by managed floats, in which the central bank allows the market forces to
determine the exchange rates, but intervenes to limit the fluctuations or to sub serve some
other objectives.

Appreciation or Depreciation of currency

A currency appreciation takes place when the value of one currency rises in terms of
another currency. A currency depreciates if its value falls in terms of another currency.
For instance, if Rs/$ exchange rate falls, i.e. earlier one US dollar was of Rs 50, now it is
for Rs 40. It means that less Indian rupees are required to buy one US dollar. This implies
that Indian currency has appreciated, while US currency has depreciated. If, on the other
hand, Rs/$ exchange rate rises, i.e. earlier one US dollar was of Rs 50, now it is for Rs
70, this implies that more Indian rupees are required to buy one US dollar. This means
Indian rupee has depreciated while US dollar has appreciated. The rate at which the value
of a currency changes over time is called rate of appreciation or rate of depreciation (as
the case may be).

Different Transactions in Foreign Exchange Market

There are different types of transactions that take place in a foreign exchange market.
These are briefly discussed below:
(i) Spot Transaction: A spot transaction is a two-day delivery transaction, which
happens on the basis of the exchange rate that is prevailing “on the spot” when
the transaction occurs. Theoretically the delivery of foreign currency or
instruments denominated in foreign currency should take place on the spot.
However, two days are allowed for the delivery to take place and hence it is
called a two-day delivery transaction. With improvements in information
technology, the delivery will become feasible in a shorter time and so, the
transaction is likely to become more ‘spot’.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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(ii) Forward Transaction: It refers to the transaction which is decided at the exchange
rate determined at the time of the contract, which specifies the exchanging of
currencies at some future point in time, usually, at the interval of 30, 60, 90, or
180 days, irrespective of what the spot rate would be at that time.
(iii) Swap: In a swap, two parties exchange currencies at a decided exchange rate, for
a certain length of time and agree to reverse the transaction at a later date. It is
equivalent of a spot sale combined with a forward purchase, but with one
difference, that is, there is only one transaction instead of two separate ones,
thus saving brokerage costs.
(iv) Futures: Currency futures contracts are transferable (purchasable and saleable)
contracts specifying a standard volume of a particular currency to be
exchanged on a specific settlement date, but the rate of exchange is decided at
the time of purchase or sale. However, there is no need for the purchasers or
sellers to go through with the exchange on the contracted day. They may if
they choose to close the contract by selling or purchasing their contracted
obligations. They are commonly used by multinational corporations or MNCs
to hedge their currency positions.
(v) Options: A foreign exchange gives the owner the right but not the obligation to
exchange money denominated in one currency into another currency at a pre-
agreed exchange rate on a specified date. The options market is the deepest,
largest and most liquid market for options of any kind in the world.

(B) Offshore Financial Asset Markets

There are three different types of markets namely Euro Currency Market, also known as
Euro Money Market, Euro Credit Market, and Euro Bond Market. Let’s discuss these
markets briefly below:
(i) Euro Currency Market
The Euro Currency Market is a misnomer. It does not deal in Euros as such, and nor is it
confined to banks in the euro zone. It refers to currency deposits in banks outside of the
country where it is legal tender. It would be a type of an offshore market. An example
would be US dollar deposits placed in the banks of Europe is called Euro dollar or Euro
Currency. Euro Currency Market is composed of Euro banks, which accept/maintain
deposits of foreign currency, i.e. US dollar. Banks accept foreign currency deposit,
because these deposits are not subject to domestic regulations. For instance, banks are not
required to maintain statutory reserves against their Euro Currency deposits and do not
have to pay premium towards deposit insurance. This allows the banks to normally lend
these funds at rates lower than those of their own currency deposits. The rates offered to
depositors too tend to be greater, because of the higher risk that they face. For example,
there is no deposit insurance or any regulatory protection to the depositors.

A euro bank is not necessarily located in Europe, and need not be in Europe. It is a bank
which accepts and maintains deposits of currency other than its own national currency.
The growth of Euro Currency Market occurred during 1960s and 1970s, when US

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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government imposed restrictive policies on trade on Euro dollar. Some of these

restrictions were related to maintenance of reserve requirements on deposits, special
charges and taxes, required concessionary loan rates, interest rate ceilings, and certain
rules that restrict bank competition. To accommodate to these restrictions, Euro Currency
Market came up. Euro currency market allows for deposits and loans. Loans up to a
maturity of one year come within the term Euro Currency Market. For giving loans,
London Inter-Bank Offer Rate is used, or what is called as LIBOR. Euro Currency
Market also gives an option to the borrower to switch the currency of loan so that he can
reduce his exchange rate risk. These are called multi currency clauses.

Asia also has its Euro Currency market, referred to as the Asian dollar market. The
primary function of banks in the Asian dollar market is to channel funds from depositors
to borrowers. It also allows for interbank lending and borrowing.

(ii) Euro Credit Market

Loans extended for more than one year by a Euro bank are called Euro Loans or Euro
Credit. The market that deals in such loans is called Euro Credit Market. The common
maturity for euro credit loans is 5 years. Euro banks accept short-term deposits and
provide long-term loans. This leads to a mismatch in the assets and liabilities of these
banks. To avoid this situation, Euro banks often extend loans on floating rate. The major
participants in Euro Credit Market are the ones who borrow and lend on regular basis in
this market. Some of these are: Euro banks, American, Japanese, British, Swiss, French,
German and Asian banks, Chemical Bank, JP Morgan, Citicorp, Bankers Trust, Chase
Manhattan Bank, First National Bank of Chicago, Barclay's Bank, National Westminster,
and BNP. Among the major borrowers are the banks, multinational groups, public
utilities, government agencies, and local authorities.

(iii) Euro Bond Market

A bond issued in a currency other than the currency of the country where it is issued, is
called a Euro Bond. In other words, a bond sold outside the country of currency
denomination is called Euro bond. An example is a Dutch borrower issuing dollar-
denominated bonds to investors in the UK and the USA. The Eurobond market is the
largest international bond market. It is originated in 1963 with an issue of Eurodollar
bonds by Autos trade, an Italian borrower. The market has since grown enormously in
size and is worth about $ 428 billion in 1994. They are used as vehicles for loans of a
maturity that exceeds the duration covered by euro credit. While the market for these
assets is global, Luxembourg has emerged as a primary listing centre.

There are some differences between Euro currency and Euro bond. Euro currency loans
use variable rates, have shorter maturities, have greater flexibility, and are obtained faster
than the Euro bonds. However, Euro Bonds have greater volume of transaction. There are
some other forms of instruments that are traded in Euro markets. These commercial
papers, Certificate of Deposits, and Euro Notes.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets
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(C) International Stock Market

Multinational Companies issue stocks to raise funds. These companies have an option to
issue stocks on international markets. This allows the companies to diversify their capital
base, raise more capital, increase efficiency by increasing competition, and can enhance
the company’s image at the international level. Stock issued in the United States by non-
U.S. firms or governments are called American depository receipts (ADRs), which are
certificates representing bundles of stock. Market characteristics are important in
determining the transactions in stocks. Stock markets may differ in size, trading activity
level, regulatory requirements, taxation rate, and proportion of individual versus
institutional share ownership from one country to another.

5. Summary

 Financial market is a market where financial assets like stocks, bonds, currencies,
derivatives, and other financial instruments are traded.
 Trade in foreign currency or the securities denominated in foreign currency are
traded in the international financial markets.
 There are two main types of international financial markets: Foreign Exchange
Market and markets for assets or instruments denominated other than the country
of the economic agent.
 A foreign exchange market is a market where currencies of different countries are
bought and sold.
 Price of one currency in terms of another is called exchange rate.
 Under fixed exchange rates regime, it is fixed by the government, while under
flexible exchange rates regime; market forces determine the exchange rates.
 Euro Markets are also called International Financial Markets.
 Different types of Euro Markets are: Euro Currency Market, Euro Credit Market,
and Euro Bond Market.

ECONOMICS Paper 6: Advanced Macroeconomics

Module 1: Balance of Payments and International Financial Markets