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International Koveos | Philippatos SECOND EDITION INTERNATIONAL FINANCIAL MARKETS AN OVERVIEW INTERNATIONAL Stressing the interrelatedness and complexity of the global economy, International Finan- cial Markets: An Overview helps students understand the international financial environ- MARKETS FINANCIAL INTERNATIONAL ment and its various implications. Over the course of seven chapters, students become familiar with foundational concepts in international finance. FINANCIAL MARKETS The first chapter introduces the foreign exchange market and describes its structure, conduct, and performance. In the second chapter, students examines major derivative products and markets. Chapter Three explains the interrelationships among the different AN OVERVIEW markets, covering topics including market efficiency, purchasing-power parity, forward-rate expectations, and more. Chapter Four discusses the international monetary system, while Chapter Five expands on the topic by presenting variables that influence exchange rates. Dedicated chapters examine exchange rate forecasting, exchange risk and exposure, and international bond and equity markets. By Peter E. Koveos and George C. Philippatos The second edition features significant updates and new material in every chapter to align with current events, trends, and research in the field. Rooted in a strong belief that all business students need to understand international finance, International Financial Markets can be used in courses in finance, accounting, and economics. Peter E. Koveos earned his Ph.D. at Pennsylvania State University. He is a finance profes- sor, department chair, and the director of the Kieback Center for International Business at Syracuse University. His research focuses on international business, finance, and market behavior, as well as Chinese and Asian business, and financial reform. George C. Philippatos was professor emeritus in the Haslam College of Business at the University of Tennessee, Knoxville. He held a Ph.D. in finance and investment from New York University and completed post-doctoral work in econometric at the Massachusetts Institute of Technology and game theory at Yale. www.cognella.com SKU 80876-2A International Financial Markets An Overview Second Edition BY Peter E. Koveos Syracuse University George C. Philippatos University of Tennessee –Knoxville Bassim Hamadeh, CEO and Publisher Carrie Montoya, Manager, Revisions and Author Care John Remington, Executive Editor Abbey Hastings, Production Editor Jess Estrella, Senior Graphic Designer Alexa Lucido, Licensing Coordinator Natalie Piccotti, Director of Marketing Kassie Graves, Vice President of Editorial Jamie Giganti, Director of Academic Publishing Copyright © 2021 by Cognella, Inc. All rights reserved. No part of this publication may be reprinted, reproduced, transmitted, or utilized in any form or by any electronic, mechanical, or other means, now known or hereafter invented, including photocopying, microfilming, and recording, or in any information retrieval system without the written permission of Cognella, Inc. For inquiries regarding permissions, translations, foreign rights, audio rights, and any other forms of reproduction, please contact the Cognella Licensing Department at [email protected]. Trademark Notice: Product or corporate names may be trademarks or registered trademarks and are used only for identification and explanation without intent to infringe. Cover image: Copyright © 2018 iStockphoto LP/gopixa. Printed in the United States of America. 3970 Sorrento Valley Blvd., Ste. 500, San Diego, CA 92121 Contents INTRODUCTION v 1 The Basics of the Foreign Exchange Market 1 2 Foreign Exchange Derivatives: Forwards, Futures, Options, and Swaps 31 3 Exchange Rates, Interest Rates, and Prices in Equilibrium 61 4 The International Monetary System 89 5 Exchange Rate Determination Theories 127 6 Exchange Rate Forecasting 151 7 Exchange Risk and Exposure: Nature and Management 167 8 International Bond and Equity Markets 203 CONCLUDING COMMENTS 225 APPENDIX 4.1 EUROPEAN UNION TIMELINE: 1945–2020 227 APPENDIX 4.2 EUROPEAN UNION CRISIS TIMELINE: 2009–2013 231 APPENDIX 5.1 EXCHANGE RATE DYNAMICS: ADDITIONAL FACTORS AND APPROACHES 233 APPENDIX 8.1. THE CREATION OF EURODOLLAR DEPOSITS: AN EXAMPLE 237 Introduction he book was written because we are both committed to the study of international finance T and believe that all students must understand the international financial environment and its implications. Whether you major in finance, accounting, economics, or any other field, knowing how our financial system works is necessary for survival. Our global economy does not give you any other options. International Finance is a fascinating subject. It borrows themes and concepts from finance, economics and accounting. It also shares issues with international relations, law, and other disciplines. Furthermore, it is not a topic that will lose its relevance tomorrow! As long as countries, banks, companies, and individuals want to trade or invest across national borders, the theories and methodologies of international finance will serve as useful tools. To better understand the nature and role of international finance, you must go beyond the textbook. By their nature, most textbooks are outdated between the time they are written and the time they are published. Events take place in rapid fashion! In international finance, a year can feel like a decade and a decade like a century! You should therefore be aware of current developments and of other information that can help you appreciate the richness of the field. A country’s financial institutions and markets perform a variety of functions within its national boundaries, thus enhancing the efficiency of its economic system. The orderly oper- ation of financial markets in converting savings into investment is both the generator and the hallmark of advanced economic development. Access to these markets is essential for participants in a dynamic environment if they are to build on their competitive advantages. As national economies interact with each other to an increasingly greater extent, developing new markets presents new opportunities and new risks for a variety of constituents. For the individual firm, international markets may mean access to new sources of funds. For the inves- tor, they may present the opportunity to diversify portfolio holdings. For governments, these new markets constitute both an opportunity and a special challenge as these markets have historically evaded regulations and grown beyond government control. International financial markets indeed have widespread and pervasive influence in today’s interconnected world. International financial markets perform functions similar to those of their domestic coun- terparts. The environment, however, is very different. Differences in the economic, regulatory, technological, and political environment present both rewards and challenges as goods, services, and capital flows across national or regional borders. Appreciating the nature of v these differences and acting on their implications is a fundamental prerequisite for survival in our complicated and competitive global economy. The first chapter of the book introduces us to the largest global financial market, the foreign exchange market. The chapter describes the structure, conduct, and performance of the foreign exchange market. It explains the functions of the market, the major participants, and the major pricing methods of the market. Chapter 1 primarily covers the spot market component of the foreign exchange market, while Chapter 2 describes the nature of the market’s derivative instruments (forward, futures, options and swaps). International finance is founded on a rich theoretical framework. The third chapter shows us how dependent individual financial markets are on each other. It also exposes us to the principal theories and concepts in international finance: market efficiency, Purchasing Power Parity, Interest Rate Parity Theorem, Forward Rate Theory of Exchange Rate Expectations, and the International Fisher Effect. One of the critical issues in global financial markets is identification and understanding of the forces that are behind the value of currencies. The system within which currencies attain their value, the international monetary system (IMS), is the subject of the fourth chap- ter. The Chapter examines the various forms that the IMS has taken over the years and the distinguishing elements of each form. It also describes the principal agencies and agreements supporting international trade and finance. Finally, it discusses important developments of the system and their implications. Chapter 5 expands on what we learned in Chapter 4 by presenting us with the various variables that move exchange rates from one equilibrium position to the next. These variables provide the foundations for the formulation of various theoretical frameworks. The chapter examines the various exchange rate determination theories. It also examines the dynamic relationships between exchange rates and macroeconomic variables. Forecasting exchange rates is one of the most challenging tasks of the international finan- cial manager. Chapter 6 discusses various forecasting approaches available and shows how they can be applied to alternative exchange rate systems. It also explains several measures for evaluating forecasts and notes some managerial implications of forecasting. The currency world has experienced a great deal of volatility during the post-Bretton Woods period.
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