T op i c  International

8 Financial
Environment
LEARNING OUTCOMES
By the end of this topic, you should be able to:
1. Describe the functions of a foreign exchange market and how it
works;
2. Determine the conditions influencing the foreign exchange market;
3. Explain how international monetary systems determine exchange
rates; and
4. Summarise the features and roles of international capital, bond and
equity markets.

 INTRODUCTION
Welcome to Topic 8 on international financial environment. We start off this
topic by defining the functions and conditions that influence foreign exchange
markets. This is followed by a discussion on the evolution of international
monetary systems such as the Gold Standard (1876–1914), Bretton Woods System
(1944–1971) to present day fixed and floating exchange rate regimes.

Lastly, we will look at the money markets such as the capital, bond and equity
markets. These are also the key components of the international financial system.
Therefore, it is important to understand their roles and functions in the world of
financial market. Are you ready? Let us start the topic.

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8.1 FOREIGN EXCHANGE MARKET

Let us start this topic on basic knowledge of foreign exchange market. What do
you know about foreign exchange market? Well, let us look at its definition.

A foreign exchange market is a place where the foreign currencies of different

countries are bought and sold and the exchange rates are determined.

Now what does exchange rate means?

The exchange rate is simply the price of a currency. It measures the rate at
which one currency is converted into another currency.

Foreign exchange markets play an important role in facilitating cross-border

trade, investment and financial transactions. With increased growth in global
economic activity, trade, and investment, foreign exchange markets have become
even more significant. Foreign exchange markets enable companies to convert
local currencies into foreign currencies to facilitate trade and financial
transactions.

Let us look at Table 8.1 which shows you the exchange rates of major currencies.

Table 8.1: Foreign Exchange Rates

USD EUR GBP JPY CHF CAD AUD NZD HKD SGD

USD 1 0.7411 0.6208 100.216 0.9149 1.0447 1.0669 1.1992 7.7537 1.2464

EUR 1.34907 1 0.83723 135.197 1.23432 1.4094 1.4394 1.6179 10.4604 1.6813

GBP 1.61138 1.1944 1 161.4865 1.4743 1.6834 1.7193 1.9325 12.4945 2.0082

JPY 0.01 0.7395 0.0062 1 0.9129 1.0422 0.0107 0.012 0.0774 0.0124

CHF 1.093 0.8101 0.6783 109.538 1 1.1416 1.1662 1.3105 8.4745 1.362

CAD 0.9572 0.7095 0.5942 95.9275 0.8757 1 1.0219 1.148 7.4223 1.193

AUD 0.93715 0.6947 0.5816 93.923 0.8575 0.9791 1 1.124 7.267 1.1681

NZD 0.8337 0.618 0.5174 83.552 0.7628 0.871 0.8895 1 6.4645 1.039

HKD 0.129 0.0956 0.08 12.925 11.7995 0.1347 0.1376 0.1547 1 0.1607

SGD 0.8023 0.5947 0.498 80.415 0.734 0.8388 0.8563 0.9623 6.2216 1

Source: http://www.fxstreet.com/rates-charts/exchange-rates/

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ACTIVITY 8.1

List the major currencies of other countries that are used to facilitate
trade in the world market.

8.1.1 Functions of Foreign Exchange Market

In the previous section, you have learnt the definition of foreign exchange
market. Now, let us look at its function. A foreign exchange market serves three
major functions: conversion of currency, provision of credit for foreign trade and
insurance for foreign exchange risk. Let us look at further descriptions of these
functions:

(a) Conversion of Currency

Each country has its own currency in terms of its purchasing power.
Foreign exchange transactions normally involve participants in countries
who want to facilitate transactions of their own currency with different
currencies. The foreign exchange market provides a mechanism for the sale
or purchase of foreign currency thereby facilitating international trade. The
commonly traded currencies in the foreign exchange market are US Dollar
(USD), Japanese Yen (JPY) and Euro (EUR).

(b) Provision of Credit for Foreign Trade

Do you know that the movement of goods from one country to another in
international trade takes time? Most of the settlement of an international
trade transaction is done after the date of agreement. Because of the
transition in the movement of goods, trade must be financed. It supplies
short-term credits, for example, a letter of credit is the instrument used as a
source of credit to finance trade and the payment will be made at a future
stipulated date.

(c) Insurance for Foreign Exchange Risk

The foreign exchange market provides foreign exchange instruments to
minimise foreign exchange risk. The foreign exchange market provides
facilities of buying and selling at spot or forward exchange market, and
enables exporters and importers to hedge their exchange risks arising from
change in the foreign exchange rate.

Hedging facilities insure against potential losses arising from the transfer of
exchange risk to another party who is willing to carry the risk.

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Speculation involves the purchase and sale or vice-versa of a currency is

undertaken for a profit. Currency speculation involves short-term fund
movements in a currency to another currency in return for a profit.

Lastly, have you ever heard about arbitrage? Arbitrage is the simultaneous
purchase and sale of a currency is undertaken in different markets for a
profit.

SELF-CHECK 8.1

What are the major functions of a foreign exchange market?

8.1.2 Features of Foreign Exchange Market

Now, let us look at the features of the foreign exchange market. The foreign
exchange market has unique features. There are four features of foreign exchange
market and these are explained further in Table 8.2.

Table 8.2: Four Features of Foreign Exchange Market

Features Description
Whole world is It is the largest financial market in the world. It is primarily an over-
its market the-counter market which means that transactions occur through
online exchanges and via electronic means (by phone or Internet) and
not on the trading floor of an exchange.
Leverage Leverage foreign exchange trading takes place at the market.
trading Leverage refers to trading on margin. In other words, in leverage
trading, a small amount of funds can be used to gain control of a
bigger amount. The funds are the source of credit for speculative
activity in the foreign exchange market with the risk of making
profits or losses.
Large trading The whole world is its market. Large sums of money are traded daily
volume on the currency market. Global foreign exchange market turnover
totalled US$4 trillion in 2010 (taken from www.goforex.net).
The American dollar is the most traded currency, followed by Yen
and the Euro.
Trading opens Currencies in the foreign exchange market are traded 24 hours a day,
24 hours a day five days a week in most financial markets.
 

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These four features of foreign exchange market are simplified in Figure 8.1.

Figure 8.1: Features of foreign exchange market

8.1.3 Foreign Exchange Rate Quotations

Can you recall the definition of exchange rate? How about foreign exchange rate?
Do you know what it stands for?

A foreign exchange rate is a statement of willingness to buy or sell at an

announced rate.

Let us look at an example. The price of Malaysian Ringgit (MYR) against the US
dollar ($) is quoted as MYR3.2000/$.

Foreign exchange rates follow specific quoting conventions. Since most of the
foreign exchange rate transactions are done in US dollars, the exchange rate
quotes are in US Dollar prices. There are several pairs of quotations used in
foreign exchange businesses, two of which are as follows:

(a) Direct and Indirect Quote

A direct quote is a home currency price of a foreign currency unit
(e.g. MYR3.2/US$1) in Malaysia.

An indirect quote is a foreign currency price of a home currency unit

(US$0.31/MYR1) in Malaysia.

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(b) Spot and Forward Rates

Spot rate is the exchange rate used to conduct foreign exchange transactions
that occur on the spot (quoted for immediate settlement).

Forward rate is the exchange rate for a transaction that requires delivery of
a foreign exchange at a specified future date.

For example, the MYR is quoted against U.S$, a single spot rate and two
different forward rates are:

(i) Spot rate for MYR/$3.155

(ii) 3-month forward rate – 3.202

(iii) 6-month forward rate – 3.344

ACTIVITY 8.2

What are the exchange rates for Malaysian Ringgit to other foreign
currencies such as the US dollar, Singapore dollar and Indonesian
rupiah?

8.1.4 Foreign Exchange Market Players

Foreign exchange market players can be categorised into four major players as
shown in Figure 8.2.

Figure 8.2: Four major market players

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Now, let us look at further descriptions of these four major market players.

(a) Central banks – The role of a central bank in the foreign exchange market is
not over the profitability of currency trading but to support the value of
their own currencies. It ensures adequate trading conditions and intervenes
in economic or financial imbalance in the foreign exchange market. In
Malaysia, we have Bank Negara that act as Malaysia's central bank.

(b) Banks – Commercial and investment banks are natural players in foreign
exchange. All other foreign exchange trading players must deal with them.
Major banks also known as market makers invest in currencies for a return
or keep currencies as their inventories. As market makers, they can
influence exchange rate quotations. As for medium-sized banks, they
participate in currency markets to facilitate international trade on behalf of
their customers. Some examples include Bank Islam, Bank Rakyat and
Maybank.

(c) Firms/Individuals – They comprise exporters, importers, tourists and

immigrants who use local currency to purchase foreign-made products and
services. Individuals as investors are high net-worth individuals who
engage in foreign exchange by accessing commercial and investment banks.
Recently, new players in the currency market called hedge funds have
emerged in the form of partnership of high net-worth individuals who
invest large sums in foreign exchange trading.

(d) Speculators/Arbitrageurs – They act as foreign exchange traders who

directly buy and sell currencies to make profit from the speculation and
arbitrage activities. Can you differentiate between them? Well, speculators
seek to make short-term profit from currency price appreciation (based on
rumours with high risk) while arbitrageurs seek to make profit from
currency price differences in different markets.

8.1.5 Factors Influencing Foreign Exchange Market

The forex market is the most liquid market in the world now and accounted for
almost $4 trillion as daily turnover in 2010 (finance.mapsofworld, 2013). Like any
other market, the foreign exchange market is subject to volatility due to changes
in external environment such as political conditions, economic factors and
market psychology.

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As stated before, political stability plays an important role as one of the major
factors influencing foreign exchange market volatility. Any political disruption in
one country may affect the neighbouring countriesÊ currency exchange rates. For
example, political crisis such as civil war can cause loss of confidence in a
currency and it may subsequently fall in currency value.

Economic factors have significant impact on a countryÊs exchange rate and in

turn cause widespread repercussions on the exchange rates of other countries in
the rest of the world. Differentials in inflation, interest rates, balance of trade,
public debt and economic growth rates directly affect exchange rates.

For example, a country with higher inflation rate generally experiences

depreciation in its currency relative to the currencies of its trading partners. A
country with balance of trade deficit indicates that spending on imports exceed
sale of exports, hence, the country requires more foreign currency to pay for its
imports than it receives through sales of exports. Excess demand for foreign
currency leads to depreciation in the countryÊs exchange rates.

Major economic events in countries or regions can spark massive fluctuations in

exchange rates of countries in surrounding regions and the rest of the world. Let
us recall some of the events:

(a) The Asian financial crisis of 1997–98 found changes in the Thai baht
exchange rate which had an impact on prices, trading activities and fund
liquidity. This in turn triggered contagious effects and caused volatility of
exchange rates of Asian and even in Western countries.

(b) The recent global financial meltdown of 2008–2009 and current European
Debt Crisis too had tremendous impact on exchange rates of almost all
countries in the world.

Lastly, let us look at market psychology. Market psychology factors influence the
foreign exchange market in a variety of ways. Any destabilising international
events or crisis can change market expectations and perceptions including trader
and investor perceptions. This can lead to flight-to-quality and investors seeking
safe options. As a result there will be greater demand, hence a higher price, for
perceived currencies.

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In sum, many situational factors can cause currency movements. For instance, the
US budget deficits, Japanese recession, the rise of China as the new super
economic powerhouse and the debt crisis in Greece have an effect on the price of
currencies. Everyone can feel the impact of currency price movements directly or
indirectly. Do you agree with that?

SELF-CHECK 8.2

1. Do you think major political disasters such as the terrorist attacks

of 11 September 2001 and the war in Iraq in 2003 had an impact to
foreign exchange markets?

2. Where is the foreign exchange market located? What is the

original form of this market? What is the major advantage and
disadvantage of using the US dollar as the international trading
currency to facilitate trade and transactions?

Please visit these websites for additional information on the Asian Financial
Crisis:

(a) www.ifg.org/imf_asia.html

(b) www.imf.org/external/np/exr/facts/asia.HTM

8.2 INTERNATIONAL MONETARY SYSTEM

Have you ever heard about the international monetary system? What does it
refer to?

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This system comprises currencies from individual countries and exchange rate
systems adopted by countries. The foreign exchange rate market forms the
primary institution for determining exchange rates based on the demand and
supply of any two currencies. There are three monetary systems that determine
exchange rates:

(a) Fixed exchange rate system in which the government of a country regulates
the rate at which a local currency is exchanged for other currencies.

(b) Pegged exchange rate system in which a countryÊs currency is tied to

another country currency.

(c) Floating or flexible exchange rate system in which the government does not
interfere in the valuation of its currency.

Next, we are going to look at a brief review of the evolution and history of the
international monetary system. This can give you a better understanding of the
present monetary system.

8.2.1 The Gold Standard (1876 to 1914)

Did you know that the gold standard gained acceptance as an international
monetary system in the 1970s? Under this system, each country pegged its
money to gold. In other words, the currency issued by a country is backed by
gold reserves. For example, the US dollar ($) is priced at $20.67 per ounce of gold,
while the British pound (£) is priced at £4.2472 per ounce of gold and the
exchange rate is simply the ratio of two prices. Hence, the exchange rate of US
dollar against British pound is $20.67/£4.2472 which means an exchange rate of
$4.866/£.

The government of each country agrees to buy or sell gold on demand at its own
fixed parity rate. Under this system, it is necessary for governments to maintain
sufficient supply of gold reserves to back up its currencyÊs value. The gold
standard operated until the outbreak of WW1 when movement of trade and gold
were restricted and it was then suspended.

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8.2.2 Interwar Years (1914 to 1944)

During the interwar years, currencies were allowed to fluctuate over fairly wide
ranges in terms of both gold and another currency. This caused widespread
speculation and fluctuations in exchange rates. World trade was hampered in the
1920s, thereby contributing to the Great Depression in the 1930s. The US returned
to a modified gold standard in 1934. This further devalued the currency. During
World War II and its aftermath, many of the major trading currencies lost their
convertibility into other currencies. The dollar was the major trading currency
that remained convertible.

8.2.3 The Bretton Woods System (1944 to 1973)

By the end of World War II in 1944, the governments of 44 Allied Powers
including Great Britain and the United States gathered in Bretton Woods, New
Hampshire, United States, to create a new international monetary system called
the Bretton Woods Agreement. This system was characterised by a fixed
exchange rate system in which the government of each member country pledged
to establish a pegged exchange rate for its currency (US dollar-based) or gold
price fixed at US$35 for each ounce of gold. This system implies that all
currencies are convertible with the US dollar which means the currency market
performance is dependent on the value of the US dollar and the state of the US
economy. In addition, under the agreement, two new institutions were set up,
namely, the International Monetary Fund (IMF) and the World Bank, to help
supervise and maintain stability in the international monetary system.

Unfortunately during this period, the US economy suffered from persistent

deficits in its balance of payments. This required a large amount of dollars to
finance the deficits and resulted in rising demand for dollars. There was lack of
confidence in the ability of the United States to meet its commitment to convert
dollars to gold. Hence in 1971, the US dollar was no longer convertible to gold. In
1973, many of the major currencies were allowed to float against the dollar which
led to the collapse of the Bretton Woods System. Figure 8.3 depicts the
development of the international monetary system from 1971 onwards.

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Figure 8.3: Global trade and the currency market: The big picture matters
Source: www.fxstreet.com

ACTIVITY 8.3

Visit the IMF (www.imf.org/) and the World Bank

(www.worldbank.org/) websites to learn more about IMF and World
Bank.

Can you find out the primary roles of the IMF and World Bank?

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8.2.4 The Floating Exchange Rate System

(1973 until present)
Since 1973, the worldÊs major currencies have floated their values against
each other. The floating exchange rate system was formally adopted after the
Jamaica Agreement in 1976. Under the agreement, floating rates were declared
acceptable, gold was no longer a reserve asset and more countries became IMF
members.

Under the flexible exchange rate system, governments can intervene directly and
take part in the currency market by buying and selling their own currency using
their reserves to stabilise their exchange rate. Capital inflows can be increased by
raising interest rates. However under such a system, exchange rates have become
more volatile and less predictable than the fixed exchange rate system. Floating
exchange rates can increase exposure to speculative activities that may result in
currency devaluation.

8.2.5 Contemporary Exchange Rate System

Lastly, let us look at the contemporary exchange rate system. In most
contemporary economies, exchange rates are managed in relation to monetary
policy. How are exchange rates determined? Exchange rates are determined by
market forces but a central bank can actively intervene in the foreign exchange
market in order to keep the exchange rate within a certain range. This is called
managed floater where the float is monitored by governments. This is to ensure
an orderly pattern of exchange rate changes against a predetermined rate but
allows the rate to vary.

The 1985 Plaza Accord, an agreement among G-5 countries (United States,
France, Germany, Japan, and the United Kingdom), was set up to work together
to deliberately weaken the US dollar's exchange rate. The objective of this
strategy was to help the United States improve its huge trade deficit (especially
against Japan) and to spur its economy to climb out of the 1980sÊ long recession.
The Louvre Accord of February 1987 was agreed by the G-6 nations (West
Germany, France, Great Britain, Japan, Canada and the United States) to stop the
United StatesÊ dollar depreciation.

Under the revived Bretton Woods II system which started in 2003 and lasted
until 2007, the new international system involves interdependency between
states with generally high savings in Asia (lending and exporting) to Western
states with generally high spending. This system was in response to the 1997
Asian financial crisis.

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Although most major currencies float in value against one another, some of the
developing countries pegged (fixed) their exchange rates to one of the major
currencies or to a basket of currencies. For example, the European UnionÊs Euro
under the European Monetary System (EMS) is pegged to a basket of chosen
currency mix and the Chinese currency (yuan) has been pegged to the US dollar
for a decade. Hence, todayÊs global economy is increasingly dominated by
currency blocs especially by the US dollar, EUÊs Euro and the Japanese Yen.

Have you ever heard of the European Monetary System (EMS)? Launched in
1979, it was the forerunner of the Economic and Monetary Union (EMU) which
led to the establishment of the Euro. It created an area of currency stability
throughout the European community by encouraging countries to co-ordinate
their monetary policies. It used an Exchange Rate Mechanism (ERM) to create
stable exchange rates in order to improve trade between EU member states and
thus help the development of the single market. The Euro was introduced in
practice in 2001 (Civitas, 2011).

8.3 INTERNATIONAL MONEY MARKET

Let us start this section by looking at the definition of international money
market. Have you ever heard about it? What does it stand for?

The international money market is a network of people, firms, financial

institutions and governments borrowing and investing internationally in
money market instruments.

There are three types of international money market:

(a) International capital market;

(b) International bond market; and

(c) International equity market.

Let us look at these types of market further in the next section.

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8.3.1 International Capital Market

What happens in this kind of market? This is the money market where foreign
capital such as Euro dollars is financed or invested. Euro dollars are US dollar
deposits in non-US banks.

For example, Sony and Hitachi borrowed US dollars from several banks in Tokyo
to finance their worldwide operations. Capital markets provide long-term debt
and equity finance for the government and corporate sector. Multinational
companies (MNCs) occasionally source foreign capital from international money
markets to finance global operations at a lower cost than is possible domestically.

Domestic capital markets tend to be illiquid and segmented, hence, at a higher

cost due to limited availability of capital. How about the international capital
market? The international capital market is liquid due to a large pool of funds
and market participants. The Euro currency market is a largely short-term
(usually less than one year of maturity) market for bank deposits and loans
denominated in any currency, except the currency of the country where the
market is located.

For example, in London, the Euro currency market is a market for bank deposits
and loans denominated in dollars, yen, franc, marks and any other currency
except British pounds. The main instruments used in this market are certificate of
deposits (CDs), time deposits and bank loans.

8.3.2 International Bond Market

What does international bond market stand for?

International bond markets are a place where company stocks are listed and
traded on foreign stock exchanges.

For example, some recent issuers of bonds are Google and Apple. Tencent
Holdings, China's largest Internet company by revenue, became the first Asian
borrower from the sector to issue global bonds. Can you define bonds?

Bonds are debt instruments used to finance long-term investments.

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The approximate worth of bond markets worldwide is more than $45,000 billion,
of which the US bond market, comprises a significant portion of the total value
(finance.mapsofworld.com). The Euro bond market is a long-term market for
bonds denominated in any currency outside the country in whose currency the
bond is denominated. A foreign bond is sold outside a borrowerÊs country and
denominated in the currency of the country in which it is sold.

8.3.3 International Equity Market

Lastly, let us look at international equity market. What happens in this kind of
market?

International equity market is a place where corporate and government bonds

are issued and traded in foreign countries.

For example, Google of the United States issued stocks on the New York Stock
Exchange. These markets provide financing for global operations but can also
improve organisational recognition and portfolio performance. MNCs that are in
need of financing use foreign stock markets as their additional sources of funds.
The Euro equity market issues US dollar-denominated stocks on non-US
exchanges for distribution among foreign markets. The stocks are underwritten by
investment banks and purchased by institutional investors in several countries.

SELF-CHECK 8.3
The average world inflation rate grew to 5.5% in 2008, the highest since
1999. How does rising inflation affect exchange rate and international
business?

ACTIVITY 8.4

1. For more information on bond market development in Malaysia,

visit www.sc.com.my.

2. Visit the website www.imf.org/external/pubs/ft/wp/2004/

wp04222.pdf for more information on currency bloc formation.

Share your findings with your coursemates.

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Before we conclude this topic, let us complete the following exercise. Good luck!

EXERCISE 8.1

1. _____________ is a market to convert one nationÊs currency to

another currency.

A. Foreign exchange market

B. Culture diagonal market

C. Open currency market

D. Currency exchange market

2. Foreign exchange market has two important functions which are

_____________.

A. to collect taxes of imported merchandise and to change a

nationÊs currency to another currency

B. to protect a company from foreign trading risks and to

determine the rate of benefit to the international investor

C. to collect taxes of imported merchandise and to determine

the rate of benefit to the international investor

D. to convert a nationÊs currency to another currency and to

protect the nation from foreign exchange trading risks

3. The value of one currency is determined by _____________.

A. demands and bidding interaction that is relative to the

demands and bidding of another currency

B. the international consortium of currency traders

C. the World Trade Organisation (WTO)

D. negotiations between the main banks from the top five

industrial supremacy countries

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4. The process of buying one unit of currency at a lower price and

selling at a higher price is known as _____________.

A. swapping

B. crawling

C. profit

D. arbitrage

5. Between two major currencies, the spot exchange rate is the rate
__________ and the forward exchange rate is the rate ___________.

A. today; on that date

B. at some specified future date; today

C. on that date; today

D. on that date; at some specified future date

6. Foreign bonds are sold primarily in ______________________.

A. the United States

B. Japan

C. Europe

D. the country of the currency of issue

7. The _____________ established a par value, or benchmark value,

for each currency initially quoted in terms of gold and the US
dollar.

A. Bretton Woods Agreement

B. Jamaican Agreement

C. World Trade Agreement

D. International Monetary Agreement

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 The foreign exchange market is a market to convert the currency of one

country to another country.

 Exchange rate is the rate at which one currency can be converted into other
currencies.

 The three main functions of foreign exchange markets are: currency

conversion, provision of credit for foreign trade and insurance for foreign
exchange risk.

 Foreign exchange market participants comprise central banks, commercial

and investment banks, corporations and individuals who buy or sell
currencies.

 Political conditions, economic factors and market psychology are factors that
can influence the foreign exchange market.

 There are five international monetary systems that determine exchange rates.
They are the gold standard, interwar years, Bretton Woods System, floating
exchange rate system and contemporary exchange rate system.

 There are three international money markets that borrow and invest
internationally in money market instruments – international capital market,
international bond market and international equity market.

Bretton Woods System International capital market

Currency bloc International equity market
Fixed exchange rate International Monetary System
Floating exchange rate Managed float
Foreign exchange market Speculation
Foreign exchange rate Spot rate
Forward rate Swap rate
International bond market

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