International Financial System: Unique Markets

Foreign Exchange Market

The functions of foreign exchange markets-conversion of currencies, obviously, one currency can be converted into another only if the exchange rate is known. It is the functions of foreign exchange markets to establish these exchange rates dependent on the forces of demand and supply. With the future movements in exchange rates being highly uncertain it is clear that holder of foreign exchange faces the risk of adverse movements in the exchange rate. Event those who have to receive a specified amount of foreign currency sometime in the future face the risk of downward movement in the exchange rate.

So, there have developed what we call ‘forward’ and ‘future’ markets to tackle the uncertain movement in exchange rates.

Forward Market

A forward market for foreign exchange is simply a market for foreign currencies that are to be delivered in the future. The operations can be compared with the forward market for commodities, which allows purchases and sales one any forward date. Forward markets enable participants to cover or hedge against the risk that exchange rated will vary during a [particular period, i.e., the rated at which currencies will be exchanged in future are decided in advance. Such rated are called forward rates.

All of us know that money has time value, as it is capable of earning interest. Hence, the differential between present market rates and forward rates will usually reflect the differential interest rates in the two currencies. What is more important, however is that some degree of certainty has been introduced, though at a cost,. The cost is the difference between the spot rated and the forward rate for that currency. They may be intermediaries, such as bank involved in bringing together the parties to a forward transaction

Futures Market

Future markets allow additional facilities as compared to forward markets. The crucial advantage is that of tradability. Such contracts are openly traded on organized exchanges. Tradability is made easier by specifying standard sizes and settlement dates for future contracts.

It is worth mentioning here that there is three other markets that have gained importance in the recent past as crucial components of the international financial system.

These three are: Option market, Euro market and inter bank market

Options Markets

The options market is another market to hedge risks arising from variable exchange rates. Here risk is traded separately from the financial instrument carrying this risk

What takes place at the options market?

First, let us concentrate on the word options. An option, by definition, is a choice available to the investor. What is the choice regarding?

The choice, dependent on a pre-specified price, is regarding honoring the contract to buy or sell a currency at some future date. Thus in a contract to buy, if the market price prevailing at that future date is higher than the pre-specified price, one will go in for the purchase of the currency at the contract price, ie., the contract will be honored. However, if the market price at that date is lower than the contract price, it would be advantageous not to honor the contract. The reverse is the position in the case of a sale contract.

Now, you will remember that this facility is not available in the forward market. Both future market and options market have grown to provide the much-needed flexibility to the forward market

Cross-border dealing between market participants, more so between institutional players, has lead to the development of Euro market. These are market without any nationality, that is financial instruments is such markets are denominated in currencies different form the currency of the country where the market. For example, dollar deposits that are accepted by an American bank in London are Euro dollars. Such marker’s are also free from national regulations and there by enjoy a great degree of independence. Users of Europe markers therefore are able to move funds at their discretion.

The Euro market can be loosely divided into a Euro currency market for short-term finance and a Eurobond markets for longer-term financing

A loan raised in the Euro currency market normally has maturates up to six months, though facilities for medium-term financing are also becoming available. With the Euro currency market, the most important and widely used currency is the Eurodollar, which is largely a reflection of the economic importance of USA in the world economy.

Eurobonds are denominate in one or more of the Euro currencies and arranged by international underwriting syndicated or investment banks. They can be sold in several countries simultaneously so that not only the underwriters but also the investors come from many countries.

Interbank Market

In foreign exchange markets, as you will recall, different currencies are traded. But except in some European centers, one does not see, the market anywhere. This is because most participants in the foreign exchange market find it convenient to conduct their business via the large commercial banks. It is these banks that comprise the interbank market.

Most large corporations find that the interbank market provides a reasonably priced service that is not worth by passing with other arrangements for direct access to the foreign exchange market. The role of bank is to act as ‘market makers’ that is they stand ready to by and sell foreign currencies.

Hence we can define and interbank markets as one where dealings in foreign currencies take place between banks themselves. Most of the interbank business is conducted by a small number of banks that have a worldwide network of branched. Is there room for more? Well as international trade grows, more and more banks will find it profitable to develop the expertise to handle foreign currencies