tying up substantial sums of money in foreign exchange by using cable
transfers.
When speed is not a critical factor, a mail transfer of foreign
exchange may be used. Such transfers are written orders from the holder of
a foreign exchange deposit to a bank to pay a designated individual or
institution on presentation of a draft. A mail transfer may require days to
execute, depending on the speed of mail deliveries.
. Bills of Exchange
One of the most important of all international financial instruments
is the Bill of Exchange. Frequently today the word draft is used instead of
bill. Either way, a draft or bill of exchange is a written order requiring
a person, business firm, or bank to pay a specified sum of money to the
bearer of the bill.
We may distinguish sight bills, which are payable on demand, from time
bills, which mature at a future date and are payable only at that time.
There are also documentary hills, which typically accompany the
international shipment of goods. A documentary bill must be accompanied by
shipping papers allowing importers to pick up their merchandise. In
contrast, a clean hill has no accompanying documents and is simply an order
to a bank to pay a certain sum of money. The most common example arises
when an importer requests its bank to send a letter of credit to an
exporter in another country. The letter authorizes the exporter to draw
bills for payment, either against the importer's bank or against one of its
correspondent banks.
. Foreign Currency and Coin
Foreign currency and coin itself (as opposed to bank deposits) is an
important instrument for payment in the foreign exchange markets. This is
especially true for tourists who require pocket money to pay for lodging,
meals, and transportation. Usually this money winds up in the hands of
merchants accepting it in payment for purchases and is deposited in
domestic banks. For example, U.S. banks operating along the Canadian and
Mexican borders receive a substantial volume of Canadian dollars and
Mexican pesos each day. These funds normally are routed through the banking
system back to banks in the country of issue, and the U.S. banks receive
credit in the form of a deposit denominated in a foreign currency. This
deposit may then be loaned to a customer or to another bank.
. Other Foreign Exchange Instruments
A wide variety of other financial instruments are denominated in
foreign currencies, most of this small in amount. For example, traveler's
checks denominated in dollars and other convertible currencies may be spent
directly or converted into the currency of the country where purchases are
being made. International investors frequently receive interest coupons or
dividend warrants denominated in foreign currencies. These documents
normally are sold to a domestic bank at the current exchange rate.
Foreign exchange rates
1. Determining foreign exchange rates
As I’ve already mentioned the prices of foreign currencies expressed
in terms of other currencies are called foreign exchange rates. There are
today three markets for foreign exchange: the spot market, which deals in
currency for immediate delivery; the forward market, which involves the
future delivery of foreign currency; and the currency futures and options
market, which deals in contracts to hedge against future changes in foreign
exchange rates. Immediate delivery is defined as one or two business days
for most transactions. Future delivery typically means one, three, or six
months from today.
Dealers and brokers in foreign exchange actually set not one, but two,
exchange rates for each pair of currencies. That is, each trader sets a bid
(buy) price and an asked (sell) price. The dealer makes a profit on the
spread between the bid and asked price, although that spread is normally
very small.
2. Supply and Demand for foreign exchange
The underlying forces that determine the exchange rate between two
currencies are the supply and demand resulting from commercial and
financial transactions (including speculation). Foreign-exchange supply and
demand schedules relate to the price, or exchange rate. This is illustrated
in Figure 1, which assumes free-market or flexible exchange rates.
Figure 1
[pic]
Before examining this figure, we need to define two terms.
Depreciation (appreciation) of a domestic currency is a decline (rise)
brought about by market forces in the price of a domestic currency in terms
of a foreign currency. In contrast, devaluation (revaluation) of a domestic
currency is a decline (rise) brought about by government intervention in
the official price of a domestic currency in terms of a foreign currency.
Depreciation or appreciation is the appropriate concept to deal with
floating, or flexible, exchange rates, whereas devaluation or revaluation
is appropriate when dealing with fixed exchange rates.
In the dollar-pound exchange market, the demand schedule for pounds
represents the demands of U.S. buyers of British goods, U.S. travelers to
Britain, currency speculators, and those who wish to purchase British
stocks and securities. It slopes downward because the dollar price to U.S.
residents of British goods and services declines as the exchange rate
declines. An item selling for Ј1 in Britain would cost $2.00 in the U.S. if
the exchange rate were Ј1/$2.00 U.S. If this exchange rate declined to
Ј1/$1.50 U.S., the same item is $.50 cheaper in the United States,
increasing the demand for British goods and thus the demand for pounds. The
supply schedule of pounds represents the pounds supplied by British buyers
of U.S. goods, British travelers, currency speculators, and those who wish
to purchase U.S. stocks and securities. It slopes upward because the pound
price to British residents of U.S. goods and services rises as the $ price
of the Ј falls. Assuming an exchange rate of Ј1 /$2.00 U.S., a $2.00 item
in the U.S. costs Ј1 in Britain. If this exchange rate declined to Ј1/$1.50
U.S., the same item is 33 percent more expensive in Britain, decreasing the
demand for dollars to buy U.S. goods and thus reducing the supply of
pounds. The equilibrium exchange rate in Figure 1 is Ј1/$2.00 U.S. The
amounts supplied and demanded by the market participants are in balance.
Figure 2
[pic]
To understand better the schedules, several of the factors that might
cause these curves to shift are discussed next. If there is a decrease in
national income and output in one country relative to others, that nation's
currency tends to appreciate relative to others. The domestic income level
of any country is a major determinant of the demand for imported goods in
that country (and hence a determinant of the demand for foreign
currencies). Figure 2 shows the effects of a decline in national income in
Britain (assuming all other factors remain constant). The decrease in
British income implies a decrease in demand for goods and services (both
domestic and foreign) by British people. This reduction in demand for
imported goods leads to a reduction in the supply of pounds, which is shown
by a leftward shift of the supply curve in Figure 2 (from S[pic] to
S[pic]). If the exchange rate floats freely, the British pound appreciates
against the U.S. dollar. If the exchange rate is artificially maintained at
the old equilibrium of Ј1/$2.00 U.S., however, a balance-of-payments
surplus (for Britain) likely results.
Figure 3
[pic]
In Figure 3, an initial exchange-rate equilibrium of Ј1/$2.00 U.S. is
assumed. Now presume the rate of price inflation in Britain is higher than
in the United States. British products become less attractive to U.S.
buyers (because their prices are increasing faster), which causes the
demand schedule for pounds to shift leftward (D[pic] to D[pic]). On the
other hand, because prices in Britain are rising faster than prices in the
U.S., U.S. products become more attractive to British buyers, which causes
the supply schedule of pounds to shift to the right (S[pic] to S[pic]). In
other words, there is an increased demand for U.S. dollars in Britain. The
reduced demand for pounds and the increased supply (resulting from British
purchases of U.S. goods) mandates a newer, lower, equilibrium exchange
rate. Furthermore, as long as the inflation rate in Britain exceeded that
in the United States, the British pound would continually depreciate
against the U.S. dollar.
Differences in yields on various short-term and long-term securities
can influence portfolio investments among different countries and also the
flow of funds of large banks and multinational corporations. If British
yields rise relative to others, an investor wishing to take advantage of
these higher interest rates must first obtain British pounds to buy the
securities. This increases the demand for British pounds shift the demand
schedule in Figure 4 to the right (D[pic] to D[pic]). British investors are
also less inclined to purchase U.S. securities, moving the supply schedule
of pounds to the left (S[pic] to S[pic]). Both activities raise the
equilibrium exchange rate of the British pound in terms of U.S. dollars.
