Tag: International Finance Mumbai University BMS Notes

International equity markets are an important platform for global finance. They not only ensure the participation of a wide variety of participants but also offer global economies to prosper.

An equity market is a market in which shares of companies are issued and traded, either through exchanges or over-the-counter markets. Also known as the stock market, it is one of the most vital areas of a market economy. It gives companies access to capital to grow their business, and investors a piece of ownership in a company with the potential to realize gains in their investment based on the company’s future performance.

To understand the importance of international equity markets, market valuations and turnovers are important tools. Moreover, we must also learn how these markets are composed and the elements that govern them. Cross-listing, Yankee stocks, ADRs and GRS are important elements of equity markets.

The secondary equity markets provide marketability and share valuation. Investors or traders who purchase shares from the issuing company in the primary market may not desire to own them forever. The secondary market permits the shareholders to reduce the ownership of unwanted shares and lets the purchasers to buy the stock.

The secondary market consists of brokers who represent the public buyers and sellers. There are two kinds of orders:

Market order: A market order is traded at the best price available in the market, which is the market price.

Limit order: A limit order is held in a limit order book until the desired price is obtained.

There are many different designs for secondary markets. A secondary market is structured as a dealer market or an agency market.

In a dealer market, the broker takes the trade through the dealer. Public traders do not directly trade with one another in a dealer market. The over-the-counter (OTC) market is a dealer market.

In an agency market, the broker gets client’s orders via an agent.

Cross-listing

Cross-listing refers to having the shares listed on one or more foreign exchanges. In particular, MNCs do this generally, but non-MNCs also cross-list. A firm may decide to cross-list its shares for the following reasons:

• Cross-listing provides a way to expand the investor’s base, thus potentially increasing its demand in a new market.
• Cross-listing offers recognition of the company in a new capital market, thus allowing the firm to source new equity or debt capital from local investors.
• Cross-listing offers more investors. International portfolio diversification is possible for investors when they trade on their own stock exchange.
• Cross-listing may be seen as a signal to investors that improved corporate governance is imminent.
• Cross-listing diminishes the probability of a hostile takeover of the firm via the broader investor base formed for the firm’s shares.

Trading In International Equities

A greater global integration of capital markets became apparent for various reasons:

• Investors understood the good effects of international trade.
• The prominent capital markets got more liberalized through the elimination of fixed trading commissions.
• Internet and information and communication technology facilitated efficient and fair trading in international stocks.
• The MNCs understood the advantages of sourcing new capital internationally.

American Depository Receipts (ADR)

An ADR is a receipt that has a number of foreign shares remaining on deposit with the U.S. depository’s custodian in the issuer’s home market. The bank is a transfer agent for the ADRs that are traded in the United States exchanges or in the OTC market.

ADRs offer various investment advantages. These advantages include:

• ADRs are denominated in dollars, trade on a US stock exchange, and can be purchased through the investor’s regular broker. This is easier than purchasing and trading in US stocks by entering the US exchanges.
• Dividends received on the shares are issued in dollars by the custodian and paid to the ADR investor, and a currency conversion is not required.
• ADR trades clear in three business days as do U.S. equities, whereas settlement of underlying stocks vary in other countries.
• ADR price quotes are in U.S. dollars.
• ADRs are registered securities and they offer protection of ownership rights. Most other underlying stocks are bearer securities.
• An ADR can be sold by trading the ADR to another investor in the US stock market, and shares can also be sold in the local stock market.
• ADRs frequently represent a set of underlying shares. This allows the ADR to trade in a price range meant for US investors.
• ADR owners can provide instructions to the depository bank to vote the rights.

There are two types of ADRs: sponsored and unsponsored.

• Sponsored ADRs are created by a bank after a request of the foreign company. The sponsoring bank offers lots of services, including investment information and the annual report translation. Sponsored ADRs are listed on the US stock markets. New ADR issues must be sponsored.
• Unsponsored ADRs are generally created on request of US investment banking firms without any direct participation of the foreign issuing firm.

Global Registered Shares (GRS)

GRS are a share that are traded globally, unlike the ADRs that are receipts of the bank deposits of home-market shares and are traded on foreign markets. The GRS are fully transferrable GRS purchased on one exchange can be sold on another. They usually trade in both US dollars and euros.

The main advantage of GRS over ADRs is that all shareholders have equal status and the direct voting rights. The main disadvantage is the cost of establishing the global registrar and the clearing facility.

International Equity Market Benchmarks

The World Equity Benchmark Series (WEBS) was an international fund traded on the American Stock Exchange. It was introduced in 1996 by Morgan Stanley and was a type of hybrid security that possesses qualities of both open-end and closed-end funds.

In 2000, WEBS was renamed to iShares MSCI Emerging Markets Exchange Traded Fund (ETF). The iShares MSCI Emerging Markets ETF seeks to track the investment results of the MSCI Emerging Markets Index, an index composed of large- and mid-capitalization emerging market equities.

A closed-end fund is a fund formed as a publicly traded investment. These funds can raise a designated amount of capital with an initial public offering. The money collected goes into a fund that is then listed as a stock and traded on a public exchange. It is a specialized stock portfolio with a one-time fixed number of shares. An open-end fund is a conventional mutual fund, made up of a pool of money from many investors for investing in stocks and bonds. Investors share gains and losses in proportion to their investment in the fund.

An organization that used a WEBS owned each of the securities traded on the MSCI country indexes. Ownership was in an approximate ratio to the initial capitalization or investment. A WEBS could be bought, sold, and traded like stocks.

Investors could use the WEBS to achieve international diversification. The World Equity Benchmark Series was available for many different countries, including Australia, Austria, Belgium, Canada, France, Germany, Hong Kong, Italy, Japan, Malaysia, Mexico, the Netherlands, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The name change of the World Equity Benchmark Series (WEBS) to iShares MSCI Emerging Markets ETF was intended to reflect the consistent brand name for all exchange-traded funds managed by Barclays Global Investors (now BlackRock).

At the time, the indexes included iShares MSCI Australia, iShares MSCI Austria, iShares MSCI Belgium, iShares MSCI Canada, iShares MSCI France, iShares MSCI Germany, iShares MSCI Hong Kong, iShares MSCI Italy, iShares MSCI Japan, iShares MSCI Malaysia, iShares MSCI Mexico, iShares MSCI Netherlands, iShares MSCI Singapore, iShares MSCI South Korea, iShares MSCI Spain, iShares MSCI Sweden, iShares MSCI Switzerland, and iShares MSCI United Kingdom.

Benchmarks are indexes created to include multiple securities representing some aspect of the total market. Benchmark indexes have been created across all types of asset classes. In the equity market, the S&P 500 and Dow Jones Industrial Average are two of the most popular large-cap stock benchmarks.

In fixed income, examples of top benchmarks include the Barclays Capital U.S. Aggregate Bond Index, the Barclays Capital U.S. Corporate High Yield Bond Index, and the Barclays Capital U.S. Treasury Bond Index. Mutual fund investors may use Lipper indexes, which use the 30 largest mutual funds in a specific category, while international investors may use MSCI Indexes. The Wilshire 5000 is also a popular benchmark representing all of the publicly traded stocks in the U.S. When evaluating the performance of any investment, it’s important to compare it against an appropriate benchmark.

Identifying and setting a benchmark can be an important aspect of investing for individual investors. In addition to traditional benchmarks representing broad market characteristics such as large-cap, mid-cap, small-cap, growth, and value. Investors will also find indexes based on fundamental characteristics, sectors, dividends, market trends, and much more. Having an understanding or interest in a specific type of investment will help an investor identify appropriate investment funds and also allow them to better communicate their investment goals and expectations to a financial advisor.

When seeking investment benchmarks, an investor should also consider risk. An investor’s benchmark should reflect the amount of risk they are willing to take. Other investment factors around benchmark considerations may include the amount to be invested and the cost the investor is willing to pay.

Factors Affecting International Equity Returns

Exchange Rates

Adler and Simon (1986) tested the sample of foreign equity and bond index returns to exchange rate changes. They found that exchange rate changes generally had a variability of foreign bond indexes than foreign equity indexes. However, some foreign equity markets were more vulnerable to exchange rate changes than the foreign bond markets.

Macroeconomic Factors

Solnik (1984) examined the effect of exchange rate fluctuations, interest rate differences, the domestic interest rate, and changes in domestic inflation expectations. He found that international monetary variables had only weak influence on equity returns. Asprem (1989) stated that fluctuations in industrial production, employment, imports, interest rates, and an inflation measure affect a small portion of the equity returns.

Industrial Structure

Roll (1992) concluded that the industrial structure of a country was important in explaining a significant part of the correlation structure of international equity index returns.

In contrast, Eun and Resnick (1984) found that the correlation structure of international security returns could be better estimated by recognized country factors rather than industry factors.

Heston and Rouwenhorst (1994) stated that “Industrial structure explains very little of the cross-sectional difference in country returns volatility, and that the low correlation between country indices is almost completely due to country-specific sources of variation.”

International capital budgeting is very complicated than the domestic capital budgeting because MNC’s are typically large and capital intensive, and because the process involves a larger number of parameters and decision variables. In general, It involves a consideration of more risk than domestic capital budgeting. But international capital budgeting involves the estimation of some measures or criteria that indicate the feasibility or otherwise of a project such as the Net Present Value (NPV). However, certain factors that are not considered in domestic capital budgeting should be taken into account in international capital budgeting because of the special nature of FDI projects.

It involves substantial spending capital investment in projects that are located in foreign countries, rather than in the home country of the MNC. Foreign projects differ from purely domestic projects concerning several factors- the foreign currency dimension, different economic indicators in different countries, and different risk characteristics with which the MNC is not as familiar as those about domestic projects. All these differences lead to a higher level of risk in international capital budgeting than in domestic capital budgeting.

Importance of International capital budgeting

Develop and Formulate Long-term Strategic Goals: The ability to set long-term goals is essential to the growth and prosperity of any business. The ability to appraisal investment projects via capital budgeting creates a framework for businesses to plan out future long-term direction.

Seek out New Investment Projects: Knowing how to evaluate investment projects gives a business the model to seek and evaluate new projects, an important function for all businesses as they seek to compete and profit in their industry.

Estimate and Forecast Future Cash Flows: Future cash flows are what create value for business over time. Capital budgeting enables executives to take a potential project and estimate its future cash flows, which then helps determine if such a project should be accepted.

Facilitate the Transfer of Information: From the time that a project starts as an idea to the time it is accepted or rejected, numerous decisions have to be made at various levels of authority. The capital budgeting process facilitates the transfer of information to the appropriate decision-makers within a company.

Monitoring and Control of Expenditures: Since a good project can turn bad if expenditures aren’t carefully controlled or monitored, this step is a crucial benefit of the capital budgeting process.

Benefits of International Capital Budgeting

• Valuable learning experience.
• Knowledge
• Globalization etc.

Factors Affecting International Capital Budgeting

• Blocked Funds.
• Amenities and Concessions Granted by Host Countries.
• Differing Rates of National Inflation.
• Political Risk involved in Foreign Investment.
• Exchange Rate Fluctuations.
• Subsidized Financing.
• Lost Exports.
• International Diversification Benefits.
• Host Government Incentives.

Major Issues in International Capital Budgeting

• “Parent against the project cash flow” the analyst estimates the relevant cash flows or the incremental cash flow of the particular project when the subsidiary transfer or subsidiary remits that cash flow to the parent company.
• “How to account for the increased economic and political risk of project.”

The foreign exchange market (Forex, FX, or currency market) is a global decentralized or over-the-counter (OTC) market for the trading of currencies. This market determines foreign exchange rates for every currency. It includes all aspects of buying, selling and exchanging currencies at current or determined prices. In terms of trading volume, it is by far the largest market in the world, followed by the credit market.

The main participants in this market are the larger international banks. Financial centers around the world function as anchors of trading between a wide range of multiple types of buyers and sellers around the clock, with the exception of weekends. Since currencies are always traded in pairs, the foreign exchange market does not set a currency’s absolute value but rather determines its relative value by setting the market price of one currency if paid for with another. Ex: US$1 is worth X CAD, or CHF, or JPY, etc.

The foreign exchange market works through financial institutions and operates on several levels. Behind the scenes, banks turn to a smaller number of financial firms known as “dealers”, who are involved in large quantities of foreign exchange trading. Most foreign exchange dealers are banks, so this behind-the-scenes market is sometimes called the “interbank market” (although a few insurance companies and other kinds of financial firms are involved). Trades between foreign exchange dealers can be very large, involving hundreds of millions of dollars. Because of the sovereignty issue when involving two currencies, Forex has little (if any) supervisory entity regulating its actions.

The foreign exchange market assists international trade and investments by enabling currency conversion. For example, it permits a business in the United States to import goods from European Union member states, especially Eurozone members, and pay Euros, even though its income is in United States dollars. It also supports direct speculation and evaluation relative to the value of currencies and the carry trade speculation, based on the differential interest rate between two currencies.

In a typical foreign exchange transaction, a party purchases some quantity of one currency by paying with some quantity of another currency.

The modern foreign exchange market began forming during the 1970s. This followed three decades of government restrictions on foreign exchange transactions under the Bretton Woods system of monetary management, which set out the rules for commercial and financial relations among the world’s major industrial states after World War II. Countries gradually switched to floating exchange rates from the previous exchange rate regime, which remained fixed per the Bretton Woods system.

The foreign exchange market is unique because of the following characteristics:

• Its huge trading volume, representing the largest asset class in the world leading to high liquidity;
• Its geographical dispersion;
• Its continuous operation: 24 hours a day except for weekends, i.e., trading from 22:00 gmt on sunday (sydney) until 22:00 gmt friday (new york);
• The variety of factors that affect exchange rates;
• The low margins of relative profit compared with other markets of fixed income; and
• The use of leverage to enhance profit and loss margins and with respect to account size.

Benefits of Using the Forex Market

There are some key factors that differentiate the forex market from others, like the stock market.

• There are no clearing houses and no central bodies that oversee the forex market.
• There are fewer rules, which means investors aren’t held to the strict standards or regulations found in other markets.
• Most investors won’t have to pay the traditional fees or commissions that you would on another market.
• Because the market is open 24 hours a day, you can trade at any time of day, which means there’s no cut-off time to be able to participate in the market.
• Finally, if you’re worried about risk and reward, you can get in and out whenever you want, and you can buy as much currency as you can afford based on your account balance and your broker’s rules for leverage.

Determinants of exchange Rates:

International parity conditions: Relative purchasing power parity, interest rate parity, Domestic Fisher effect, International Fisher effect. To some extent the above theories provide logical explanation for the fluctuations in exchange rates, yet these theories falter as they are based on challengeable assumptions (e.g., free flow of goods, services, and capital) which seldom hold true in the real world.

Balance of payments model: This model, however, focuses largely on tradable goods and services, ignoring the increasing role of global capital flows. It failed to provide any explanation for the continuous appreciation of the US dollar during the 1980s and most of the 1990s, despite the soaring US current account deficit.

Asset market model: views currencies as an important asset class for constructing investment portfolios. Asset prices are influenced mostly by people’s willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of these assets. The asset market model of exchange rate determination states that “the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.”

Economic factors

Economic factors include:(a) economic policy, disseminated by government agencies and central banks, (b) economic conditions, generally revealed through economic reports, and other economic indicators.

Economic policy comprises government fiscal policy (budget/spending practices) and monetary policy (the means by which a government’s central bank influences the supply and “cost” of money, which is reflected by the level of interest rates).

Government budget deficits or surpluses: The market usually reacts negatively to widening government budget deficits, and positively to narrowing budget deficits. The impact is reflected in the value of a country’s currency.

Balance of trade levels and trends: The trade flow between countries illustrates the demand for goods and services, which in turn indicates demand for a country’s currency to conduct trade. Surpluses and deficits in trade of goods and services reflect the competitiveness of a nation’s economy. For example, trade deficits may have a negative impact on a nation’s currency.

Inflation levels and trends: Typically, a currency will lose value if there is a high level of inflation in the country or if inflation levels are perceived to be rising. This is because inflation erodes purchasing power, thus demand, for that particular currency. However, a currency may sometimes strengthen when inflation rises because of expectations that the central bank will raise short-term interest rates to combat rising inflation.

Economic growth and health: Reports such as GDP, employment levels, retail sales, capacity utilization and others, detail the levels of a country’s economic growth and health. Generally, the healthier and more robust a country’s economy, the better its currency will perform, and the more demand for it there will be.

Productivity of an economy: Increasing productivity in an economy should positively influence the value of its currency. Its effects are more prominent if the increase is in the traded sector.

Political conditions

Internal, regional, and international political conditions and events can have a profound effect on currency markets.

All exchange rates are susceptible to political instability and anticipations about the new ruling party. Political upheaval and instability can have a negative impact on a nation’s economy. For example, destabilization of coalition governments in Pakistan and Thailand can negatively affect the value of their currencies. Similarly, in a country experiencing financial difficulties, the rise of a political faction that is perceived to be fiscally responsible can have the opposite effect. Also, events in one country in a region may spur positive/negative interest in a neighboring country and, in the process, affect its currency.

Market psychology

Market psychology and trader perceptions influence the foreign exchange market in a variety of ways:

Flights to quality: Unsettling international events can lead to a “flight-to-quality”, a type of capital flight whereby investors move their assets to a perceived “safe haven”. There will be a greater demand, thus a higher price, for currencies perceived as stronger over their relatively weaker counterparts. The US dollar, Swiss franc and gold have been traditional safe havens during times of political or economic uncertainty.

Long-term trends: Currency markets often move in visible long-term trends. Although currencies do not have an annual growing season like physical commodities, business cycles do make themselves felt. Cycle analysis looks at longer-term price trends that may rise from economic or political trends.

“Buy the rumor, sell the fact”: This market truism can apply to many currency situations. It is the tendency for the price of a currency to reflect the impact of a particular action before it occurs and, when the anticipated event comes to pass, react in exactly the opposite direction. This may also be referred to as a market being “oversold” or “overbought”. To buy the rumor or sell the fact can also be an example of the cognitive bias known as anchoring, when investors focus too much on the relevance of outside events to currency prices.

Economic numbers: While economic numbers can certainly reflect economic policy, some reports and numbers take on a talisman-like effect: the number itself becomes important to market psychology and may have an immediate impact on short-term market moves. “What to watch” can change over time. In recent years, for example, money supply, employment, trade balance figures and inflation numbers have all taken turns in the spotlight.

Technical trading considerations: As in other markets, the accumulated price movements in a currency pair such as EUR/USD can form apparent patterns that traders may attempt to use. Many traders study price charts in order to identify such patterns.

Repatriation of profit is the ability of a firm to send foreign‐earned profits or financial assets back to the firm’s home country in hard currency such as USD, EUR and others, after meeting the host nation’s tax obligations.

Proponents of profit repatriation argue that it encourages foreign direct investments (FDIs). Opponents argue that profit repatriation boosts another country’s economy. Accordingly, different countries impose different restrictions for profit repatriation.

Repatriation in a larger context refers to anything or anyone that returns to its country of origin, which can include foreign nationals, refugees, or deportees.

In the corporate world, repatriation usually refers to the conversion of offshore capital back to the currency of the country in which a corporation is based.

In the global economy, many corporations based in the United States generate earnings abroad. However, today many companies choose not to repatriate their offshore earnings in order to avoid corporate taxes charged on repatriated funds.

Individuals might also repatriate funds. For example, Americans returning from a visit to Japan typically repatriate their currency, converting any remaining yen into U.S. dollars. The number of dollars they receive when they exchange their remaining yen will depend on the exchange rate between the two currencies at the time of the repatriation.

Risks Associated with Repatriation

When companies operate in more than one country, they generally accept the local currency of the economy that they transact business. For example, though Apple is a U.S. based corporation, an Apple store in France will accept euros as payment for product sales since the euro is the currency that French consumers transact in and get paid from their employers.

When a company earns income in foreign currencies, the earnings are subject to foreign exchange risk, meaning they could potentially lose or gain in value based on fluctuations in the value of either currency.

If Apple earned 1,000,000 euros in France from product sales, at an exchange rate of 1.15 dollars per euro, the earnings would equal $1,150,000 or (1,000,000 euros * 1.15). However, if the next quarter, Apple earned 1,000,000 euros, but the exchange fell to 1.10 dollars per euro, the earnings would equal $1,100,000 or (1,100,000 euros * 1.10).

In other words, Apple would have lost $50,000 in earnings based on the exchange rate decline despite having the same amount in sales in euros for both quarters. The volatility or fluctuations in the exchange rate is called foreign exchange risk, which companies are exposed to when they do business internationally. As a result, the volatility in exchange rates can impact a company’s earnings.

Investors who want to increase the diversification and total return of their portfolios are often advised to get into international assets. Many hesitate to take that advice.

There are, in fact, three big risks that investors add when they enter international investing. Knowing what they are and how you can mitigate those risks may help you decide if going global is worth the risk and potential rewards.

International equity is a great way to get exposure to companies and sectors which are not available in the Indian markets. E-commerce, search engines, payment infrastructure, cloud computing, electric mobility, enterprise software, digital OTT platforms are some of the sectors which are showing good growth globally but we don’t have listed companies in India. Exposure to international equity also provides us a hedge against the depreciating rupee, which can also add to returns in the long term. It also helps us to diversify our portfolio outside our home country, which will prove helpful in the long run.

1. Higher Transaction Costs

The biggest barrier to investing in international markets is the added transaction cost. Yes, we live in a relatively globalized and connected world, but transaction costs still vary greatly depending on which foreign market you are investing in. Brokerage commissions in international markets are almost always higher than U.S. rates.

2. Currency Volatility

When investing directly in a foreign market (and not through ADRs), you first have to exchange your U.S. dollars into a foreign currency at the current exchange rate.

Say you hold the foreign stock for a year and then sell it. That means you will have to convert the foreign currency back into USD. That could help or hurt your return, depending on which way the dollar is moving. It is this uncertainty that scares off many investors.

A financial professional would tell you that the solution to mitigating currency risk is to simply hedge your currency exposure. The available tools include currency futures, options, and forwards. These are not strategies most individual investors would be comfortable using.

A more user-friendly version of those tools is the currency exchange-traded fund (ETF). Like any ETF, these have good liquidity and accessibility and are relatively straightforward.

3. Liquidity Risks

Another risk inherent in foreign markets, especially in emerging markets, is liquidity risk. This is the risk of not being able to sell an investment quickly at any time without risking substantial losses due to a political or economic crisis.

There is no easy way for the average investor to protect against liquidity risk in foreign markets. Investors must pay particular attention to foreign investments that are or may become illiquid by the time they want to sell.

There are some common ways to evaluate the liquidity of an asset. One method is to observe the bid-ask spread of the asset over time. An illiquid asset will have a wider bid-ask spread relative to other assets. Narrower spreads and high volume typically point to higher liquidity.

Minimizing Currency Risk

Despite the perceived dangers of foreign investing, an investor may reduce the risk of loss from fluctuations in exchange rates by hedging with currency futures. Simply stated, hedging involves taking on one risk to offset another. Futures contracts are advance orders to buy or sell an asset, in this case, a currency. An investor expecting to receive cash flows denominated in a foreign currency on some future date can lock in the current exchange rate by entering into an offsetting currency futures position.

In the currency markets, speculators buy and sell foreign exchange futures to take advantage of changes in exchange rates. Investors can take long or short positions in their currency of choice, depending on how they believe that currency will perform. For example, if a speculator believes that the euro will rise against the U.S. dollar, they will enter into a contract to buy the euro at some predetermined time in the future. This is called having a long position. Conversely, you could argue that the same speculator has taken a short position in the U.S. dollar.

There are two possible outcomes with this hedging strategy. If the speculator is correct and the euro rises against the dollar, then the value of the contract will rise too, and the speculator will earn a profit. However, if the euro declines against the dollar, the value of the contract decreases.

When you buy or sell a futures contract, as in our example above, the price of the good (in this case the currency) is fixed today, but payment is not made until later. Investors trading currency futures are asked to put up margin in the form of cash and the contracts are marked to market each day, so profits and losses on the contracts are calculated each day. Currency hedging can also be accomplished in a different way. Rather than locking in a currency price for a later date, you can buy the currency immediately at the spot price instead. In either scenario, you end up buying the same currency, but in one scenario you do not pay for the asset upfront.

Investing in the Currency Market

The value of currencies fluctuates with the global supply and demand for a specific currency. Demand for foreign stocks is also a demand for foreign currency, which has a positive effect on its price. Fortunately, there is an entire market dedicated to the trade of foreign currencies called the foreign exchange market (forex, for short). This market has no central marketplace like the New York Stock Exchange; instead, all business is conducted electronically in what is considered one of the largest liquid markets in the world.

There are several ways to invest in the currency market, but some are riskier than others. Investors can trade currencies directly by setting up their own accounts, or they can access currency investments through forex brokers.

However, margined currency trading is an extremely risky form of investment, and is only suitable for individuals and institutions capable of handling the potential losses it entails. In fact, investors looking for exposure to currency investments might be best served acquiring them through funds or ETFs and there are plenty to choose from.

Some of these products make bets against the dollar, some bet in favor, while other funds simply buy a basket of global currencies. For example, you can buy an ETF made up of currency futures contracts on certain G10 currencies, which can be designed to exploit the trend that currencies associated with high-interest rates tend to rise in value relative to currencies associated with low-interest rates. Things to consider when incorporating currency into your portfolio are costs (both trading and fund fees), taxes (historically, currency investing has been very tax inefficient) and finding the appropriate allocation percentage.

Benefits of International Equity

• Diversification

Diversification is the most obvious yet the most crucial benefit of global investing. A diversified portfolio acts as a source of stability during market volatility.

When you spread out your investments across geographies, there is a low correlation between them. This means that the volatility in one market is likely not to affect your other assets.

Many of the US-listed companies have global revenues. Over 40% of the revenues of the S&P500 companies come from outside the US. By investing in the US itself, you can build a globally diversified portfolio.

• Wide range of investment options

Global investing enables you to access investment opportunities that are not present domestically. Developed markets like the US are home to some of the world’s largest tech companies something you cannot access by investing in India.

You may even choose a theme or a combination of multiple sectors. For example, you can prefer the US market for technology, Europe for engineering, and Australia for commodities.

If you are interested in healthcare or pharmaceuticals, there are several options in the US and Europe.

You can access multiple geographies through ETFs. For example, you can invest in German equities through the US-listed EWG ETF or in the Brazilian market through the EWZ ETF.

• Investment Protection

Another significant benefit of global investing is the protection of investments against fraud and liquidations.

Developed market companies generally have strong regulations that ensure sound corporate governance and severe penalties for market abuse. This protects retail investors from potential scams and insider trading losses.

Remember, capital is always at risk, but many foreign financial institutions, offer protection from seizures and other threats such as liquidation of the broker-dealer. For instance, in the US, SIPC protects investments up to $500,000 if your broker-dealer faces liquidation.

• Currency Diversification

Investing overseas exposes you to currency appreciation (or depreciation). For example, the USD has been appreciating, on average, between 3-5 percent versus the INR over the last few years.

Emerging markets’ currencies depreciate over the longer term. Interest rates in domestic savings accounts are at a low of 3-4 percent on average.

By investing globally, portfolios have generally had the dual benefit of better markets and appreciating currencies.

Role of Forex Manager

Have an Idea about the Historical Development of the International Trade and Evolvement of Forex Management:

The Forex manager must have a fair idea of how the current international trade and Forex management has reached its present status. The continuously evolving changes in the alliances between the countries in the nature of political, economic, social conditions of the countries and the economic superpowers of the globe help to have a proper idea about the current Global Economic situation, and can also provide him with experiences of past.

Able to Forecast the Future Trends:

The Forex manager should be able to forecast about the future trends of the Global Economy from the history and current scenario, so as to be able to exploit the opportunities emerging out and in turn to reduce the risks faced by firm.

Able to analyse the Various Situation in a Comparative Manner (Comparative Analytical Skills):

The Forex manager should be able to comparatively analyse various situations currently arising with the past events and situations, and be able to forecast it properly.

He should also be able to analyse the various components of costs of the goods and services and changes in the various rates like shipping rates, insurance costs, other regulatory charges, etc. It is also required to decide whether it would be beneficial for organization to involve in export activities or to do domestic trade only or both and in which proportions.

Knowledge of Forex Market:

He should have an in-depth knowledge of the functioning of Forex Markets and the rules and regulations to be followed. He should also have in depth knowledge of the size, profile and movement of foreign currency exchange rates with various currencies of the globe, so as to have proper pricing of International Deals.

Knowledge of Interest Rates:

He should have an idea of interest rates prevailing and expected movement in interest rates of various countries of the globe, and to estimate and judge the expected future currency exchange rates. Such knowledge and skills will support him to take necessary steps to reduce the risks going to arise due to them.

Willingness to Undertake Risk:

He should be armed with the knowledge of Forex management, and should be able to take reasonable level of risks as and when needed, and try to reduce its overall impact on the organization.

Covering and Protection Strategies (Hedging Strategies):

He should have a proper understanding and awareness about the techniques useful for reducing the risk proportions and risk exposures. Hedging means to cover or protect the current position. As per Forex management, he should be able to hedge his positions to the best extent possible, keeping in view the timing and current changes in the Forex market.

FDI v/s FPI

Foreign Portfolio Investment (FPI) and Foreign Direct Investment (FDI) are the two essential and well-sought type of foreign capital by the countries, especially by the developing world. Post Union Budget FY 2019-20, most of you surely would have heard the words “FPIs” being used, in the context of the stock markets crash through financial news channels or social media platforms.

Foreign Direct Investment (FDI)

FDI pertains to foreign investment in which the investor obtains a lasting interest in an enterprise in another country.

It involves establishing a direct business interest in a foreign country, such as buying or establishing a manufacturing business, building warehouses, or buying buildings. Also, it tends to involve creating more of a substantial, long-term interest in the economy of a foreign country.

Due to the significantly higher level of investment required, FDIs are usually undertaken by MNCs, large institutions, or venture capital firms. FDI tends to be viewed more favorably since they are considered long-term investments, as well as investments in the well-being of the foreign country itself.

This kind of investment may result in the transfers of funds, resources, technical know-how, strategies, etc.

There are several ways of making FDI like:

• Creating a joint venture
• Through merger and acquisition
• By establishing a subsidiary company

Foreign Portfolio Investment (FPI)

FPI, on the other hand, refers to investing in the financial assets of a foreign country, such as stocks or bonds available on an exchange.

In simple words, FPI involves the purchase of securities that can be easily bought or sold.

The intent with FPI is generally to invest money into the foreign country’s stock market with the hope of generating a quick return.

Hence, this type of investment is at times viewed less favourably than direct investment because portfolio investments can be sold off quickly and are at times seen as short-term attempts to make money, rather than a long-term investment in the economy.

In India, FPIs includes investment groups of Foreign Institutional Investors (FIIs), Qualified Foreign Investors (QFIs) and subaccounts, etc. NRIs doesn’t come under FPI.

Role of FEDAI in Foreign Exchange Market

The Foreign Exchange Dealers Association of India (FEDAI) is an association of commercial banks that specializes in the foreign exchange (forex) markets in India. These institutions are also called Authorised Dealers or ADs.

Created in 1958 and incorporated under Indian law, Section 25 of The Companies Act of 1956, the Association regulates the rules that determine commissions, fees, and charges that are attached to the interbank foreign exchange business.

FEDAI is a self-regulatory body that evolved various rules and guidelines for transactions related to foreign exchange like rules regarding trading hours, Transit period, Crystallization, Forward covers, etc. Besides, it has prescribed a code of conduct in settling issues /matters related to forex dealing of member banks and provided a standardized settlement process for all market participants. FEDAI represents member banks while liaising with RBI and other organizations like Fixed Income Money Market and Derivatives Association (FIMMDA), the Forex Association of India, International Chamber of Commerce, and other world bodies related to foreign trade and business.  Further, it is liaising with other market participants, in its endeavor for reforms and development of the forex market.

The FEDAI’s core functions include:

• Advising and supporting member banks with issues that arise in their dealings
• Representing member banks on the Reserve Bank of India (India’s central bank)
• Announcement of daily and periodical interest rates to member banks
• Guidelines and Rules for Forex Business.
• Training of Bank Personnel in the areas of Foreign Exchange Business.
• Accreditation of Forex Brokers.

The other functions of FEDAI include circulating various policies matters and decisions related to foreign exchange business amongst the members, approving Foreign Exchange brokers, circulating ‘spot date’ to its members at the start of each trading day to ensure uniformity in a settlement between different market participants. It also provides at the end of a calendar month a schedule of forwarding rates to be used by AD’s for revaluating foreign currency denominated assets and liabilities.

Scope

Transfer Function

This function is to transfer finance and purchasing power from one country to another country. Through foreign bills or remittances which were made through telegraphic transfer, such type of transfer gets affected.

Hedging Function

This function is for hedging facilities such as; facilitate buying and selling spot or forward foreign exchange. Hedging refers to the “foreign exchange risk avoidance” as in foreign exchange market there might be gain or loss to the party because of change in the price of one currency in terms of another currency. In case of huge amount of net claims or net liabilities in foreign exchange then a person or a firm as the case may undertake a high exchange risk.

Such exchange risk should be reduced. In exchange, through forwarding contracts, foreign exchange market provides such facilities for anticipated hedging. A forward contract is a type of contract related to buying or selling foreign exchange against another currency in future at the fixed date on the agreed price. This type of contract makes it possible to avoid changes in exchange rate. This forward market helps in hedging exchange position.

Credit Function

This function is to issue credit for the purpose of international trade.

Foreign Exchange Markets helps in determining the value of foreign savings. It is a marketplace where the foreign money is bought and sold and we can also say it is a type of institutional arrangement where the foreign currencies are bought and sold. Under this, importers buy the foreign currency which is sold by the exporters.

In financial centers, this type of market merely forms a part of money market where the foreign money is bought and sold. Foreign exchange market is not restricted to any geographical area. It is a market for foreign currencies.

In foreign exchange markets, there are a wide variety of dealers such as banks. Banks which deal in foreign exchange have their branches in different countries. These are also called as “Exchange Banks” from where the services are available in all over the world.

Significance

• It acts as a central focus whereby prices are set for different currencies.
• With the help of foreign exchange market investors can hedge or minimize the risk of loss due to adverse exchange rate changes.
• Foreign exchange market transfers purchasing power across different countries, which results in enhancing the feasibility of international trade and overseas investment.
• Foreign exchange market allows traders to identify risk free opportunities and arbitrage these away.
• It facilitates investment function of banks and corporate traders who are willing to expose their firms to currency risks.

Exchange Rate Forecasts are derived by the computation of value of vis-à-vis other foreign currencies for a definite time period. There are numerous theories to predict exchange rates, but all of them have their own limitations.

Economists and investors always tend to forecast the future exchange rates so that they can depend on the predictions to derive monetary value. There are different models that are used to find out the future exchange rate of a currency.

Efficient Market Approach

Financial markets are said to be efficient if the current asset prices fully reflect all the available and relevant information (efficient market hypothesis).

Suppose that foreign exchange markets are efficient. This means that the current exchange rate has already reflected all relevant information, such as money supplies, inflation rates, trade balances, and output growth. The exchange rate will then change only when the market receives new information. News is unpredictable, the exchange rate will change randomly over time. -Incremental changes in the exchange rate will be independent of the past history of the exchange rate. If the exchange rate indeed follows a random walk, the future exchange rate is expected to be the same as the current exchange rate.

Random walk hypothesis suggests that today’s exchange rate is the best predictor of tomorrow’s exchange rate.

Those who subscribe to the efficient market hypothesis may predict the future exchange rate using either the current spot exchange rate or the current forward exchange rate.

Advantages:

Since the efficient market approach is based on market-determined prices, it is costless to generate forecasts. Both the current spot and forward exchange rates are public information. Everyone has free access to it.

Given the efficiency of foreign exchange markets, it is difficult to outperform the market-based forecasts unless the forecaster has access to private information that is not yet reflected in the current exchange rate.

Fundamental Approach

This is a forecasting technique that utilizes elementary data related to a country, such as GDP, inflation rates, productivity, balance of trade, and unemployment rate. The principle is that the ‘True worth’ of a currency will eventually be realized at some point of time. This approach is suitable for long-term investments.

• Relative Money supplies
• Relative Velocity of monies
• Relative National outputs

Steps

• Estimation of the structural model to determine the numerical values for the parameters such as betas.
• Estimation of future values of the independent variables.
• Substituting the estimated values of the independent variable into the estimated structural model to generate the exchange rate forecasts.

Technical Approach

In this approach, the investor sentiment determines the changes in the exchange rate. It makes predictions by making a chart of the patterns. In addition, positioning surveys, moving-average trend-seeking trade rules, and Forex dealers’ customer-flow data are used in this approach.

Performance of the Forecasters

Time Series Model

The time series model is completely technical and does not include any economic theory. The popular time series approach is known as the autoregressive moving average (ARMA) process.

The rationale is that the past behavior and price patterns can affect the future price behavior and patterns. The data used in this approach is just the time series of data to use the selected parameters to create a workable model.

To conclude, forecasting the exchange rate is an ardent task and that is why many companies and investors just tend to hedge the currency risk. Still, some people believe in forecasting exchange rates and try to find the factors that affect currency-rate movements. For them, the approaches mentioned above are a good point to start with.

Relative Economic Strength Model

The relative economic strength model determines the direction of exchange rates by taking into consideration the strength of economic growth in different countries. The idea behind this approach is that a strong economic growth will attract more investments from foreign investors. To purchase these investments in a particular country, the investor will buy the country’s currency – increasing the demand and price (appreciation) of the currency of that particular country.

Another factor bringing investors to a country is its interest rates. High interest rates will attract more investors, and the demand for that currency will increase, which would let the currency to appreciate.

Conversely, low interest rates will do the opposite and investors will shy away from investment in a particular country. The investors may even borrow that country’s low-priced currency to fund other investments. This was the case when the Japanese yen interest rates were extremely low. This is commonly called carry-trade strategy.

The relative economic strength approach does not exactly forecast the future exchange rate like the PPP approach. It just tells whether a currency is going to appreciate or depreciate.

Purchasing Power Parity Model

The purchasing power parity (PPP) forecasting approach is based on the Law of One Price. It states that same goods in different countries should have identical prices. For example, this law argues that a chalk in Australia will have the same price as a chalk of equal dimensions in the U.S. (considering the exchange rate and excluding transaction and shipping costs). That is, there will be no arbitrage opportunity to buy cheap in one count Econometric Models

It is a method that is used to forecast exchange rates by gathering all relevant factors that may affect a certain currency. It connects all these factors to forecast the exchange rate. The factors are normally from economic theory, but any variable can be added to it if required.

For example, say, a forecaster for a Canadian company has researched factors he thinks would affect the USD/CAD exchange rate. From his research and analysis, he found that the most influential factors are: the interest rate differential (INT), the GDP growth rate differences (GDP), and the income growth rate (IGR) differences.

The econometric model he comes up with is:

USD/CAD (1 year) = z + a(INT) + b(GDP) + c(IGR)

Now, using this model, the variables mentioned, i.e., INT, GDP, and IGR can be used to generate a forecast. The coefficients used (a, b, and c) will affect the exchange rate and will determine its direction (positive or negative).ry and sell at a profit in another.

Each currency carries an interest rate. It is like a barometer of the strength or weakness of an economy. If a country’s economy strengthens, the prices may sometime rise due to the fact that the consumers become able to pay more. This may sometimes result in a situation where more money is spent for roughly the same goods. This can increase the price of the goods.

When inflation goes uncontrolled, the money’s buying power decreases, and the price of ordinary items may rise to unbelievably high levels. To stop this imminent danger, the central bank usually raises the interest rates.

When the interest rate is increased, it makes the borrowed money more expensive. This, in turn, demotivates the consumers from buying new products and incurring additional debts. It also discourages the companies from expansion. The companies that do business on credit have to pay interest, and hence they do not spend too much in expansion.

The higher rates will gradually slow the economies down, until a point of saturation will come where the Central Bank will have to lower the interest rates. This reduction in rates is aimed at encouraging the economic growth and expansion.

When the interest rate is high, foreign investors desire to invest in that economy to earn more in returns. Consequently, the demand for that currency increases as more investors invest there.

Countries offering the highest RoI by offering high interest rates tend to attract heavy foreign investments. When a country’s stock exchange is doing well and offer a good interest rate, the foreign investors are encouraged to invest capital in that country. This again increases the demand for the country’s currency, and value of the currency rises.

In fact, it is not just the interest rate that is important. The direction of movement of the interest rate is a good pointer of demand of the currency.

The interest rate that impacts the stock market is the central funds rate. The central funds rate is the interest rate that depository institutions banks, savings and loans, and credit unions charge each other for overnight loans (whereas the discount rate is the interest rate that Central Reserve Banks charge when they make collateralized loans usually overnight to depository institutions).

The influences the central funds rate in order to control inflation. By increasing the central funds rate, the Central Reserve is effectively attempting to shrink the supply of money available for making purchases. This, in turn, makes money more expensive to obtain. Conversely, when the Central Reserve decreases the central funds rate, it increases the money supply. This encourages spending by making it cheaper to borrow. The central banks of other countries follow similar patterns.

When the Central Reserve acts to increase the discount rate, it immediately elevates short-term borrowing costs for financial institutions. This has a ripple effect on virtually all other borrowing costs for companies and consumers in an economy.

Because it costs financial institutions more to borrow money, these same financial institutions often increase the rates they charge their customers to borrow money. So, individuals’ consumers are impacted through increases to their credit card and mortgage interest rates, especially if these loans carry a variable interest rate. When the interest rate for credit cards and mortgages increases, the amount of money that consumers can spend decreases.

Consumers still have to pay their bills. When those bills become more expensive, households are left with less disposable income. When consumers have less discretionary spending money, businesses’ revenues and profits decrease.

So, as you can see, as rates rise, businesses are not only impacted by higher borrowing costs, but they are also exposed to the adverse effects of flagging consumer demand. Both of these factors can weigh on earnings and stock prices.

When Interest Rates Fall

When the economy is slowing, the Central Reserve cuts the central funds rate to stimulate financial activity. A decrease in interest rates by the Central Reserve has the opposite effect of a rate hike. Investors and economists alike view lower interest rates as catalysts for growth a benefit to personal and corporate borrowing. This, in turn, leads to greater profits and a robust economy.

Consumers will spend more, with the lower interest rates making them feel that, perhaps, they can finally afford to buy that new house or send their kids to a private school. Businesses will enjoy the ability to finance operations, acquisitions, and expansions at a cheaper rate, thereby increasing their future earnings potential. This, in turn, leads to higher stock prices.

Particular winners of lower central funds rates are dividend-paying sectors, such as utilities and real estate investment trusts (REITs). Additionally, large companies with stable cash flows and strong balance sheets benefit from cheaper debt financing.

Shifts in Demand and Supply in Financial Markets

Those who supply financial capital face two broad decisions: how much to save, and how to divide up their savings among different forms of financial assets. We will discuss each of these in turn.

Participants in financial markets must decide when they prefer to consume goods: now or in the future. Economists call this intertemporal decision making because it involves decisions across time. Unlike a decision about what to buy from the grocery store, decisions about investment or saving are made across a period of time, sometimes a long period.

Most workers save for retirement because their income in the present is greater than their needs, while the opposite will be true once they retire. So they save today and supply financial markets. If their income increases, they save more. If their perceived situation in the future changes, they change the amount of their saving. For example, there is some evidence that Social Security, the program that workers pay into in order to qualify for government checks after retirement, has tended to reduce the quantity of financial capital that workers save. If this is true, Social Security has shifted the supply of financial capital at any interest rate to the left.

By contrast, many college students need money today when their income is low (or nonexistent) to pay their college expenses. As a result, they borrow today and demand from financial markets. Once they graduate and become employed, they will pay back the loans. Individuals borrow money to purchase homes or cars. A business seeks financial investment so that it has the funds to build a factory or invest in a research and development project that will not pay off for five years, ten years, or even more. So when consumers and businesses have greater confidence that they will be able to repay in the future, the quantity demanded of financial capital at any given interest rate will shift to the right.

For example, in the technology boom of the late 1990s, many businesses became extremely confident that investments in new technology would have a high rate of return, and their demand for financial capital shifted to the right. Conversely, during the Great Recession of 2008 and 2009, their demand for financial capital at any given interest rate shifted to the left.

A domestic market, also referred to as an internal market or domestic trading, is the supply and demand of goods, services, and securities within a single country. In domestic trading, a firm faces only one set of competitive, economic, and market issues and essentially must deal with only one set of customers, although the company may have several segments in a market.

Most countries have their own currencies, but not all. Sometimes small economies use the currency of an economically larger neighbor. For example, Ecuador, El Salvador, and Panama have decided to dollarize that is, to use the U.S. dollar as their currency. Sometimes nations share a common currency. The best example of a common currency is the Euro, a common currency used by 19 members of the European Union. With these exceptions duly noted, most international transactions require participants to convert from one currency to another when selling, buying, hiring, borrowing, traveling, or investing across national borders. The market in which people or firms use one currency to purchase another currency is called the foreign exchange market.

The term is also used to refer to the customers of a single business who live in the country where the business operates.

There are certain limitations when competing in a domestic market, many of which encourage firms to expand abroad. The main reasons why a business would decide to expand abroad are limited market size and limited growth within the domestic market.

In the retail currency exchange market, a different buying rate and selling rate will be quoted by money dealers. Most trades are to or from the local currency. The buying rate is the rate at which money dealers will buy foreign currency, and the selling rate is the rate at which they will sell the currency. The quoted rates will incorporate an allowance for a dealer’s margin (or profit) in trading, or else the margin may be recovered in the form of a commission or in some other way.

Different rates may also be quoted for different kinds of exchanges, such as for cash (usually notes only), a documentary form (such as traveller’s checks), or electronic transfers (such as a credit card purchase). There is generally a higher exchange rate on documentary transactions (such as for traveller’s checks) due to the additional time and cost of clearing the document, while cash is available for resale immediately.

Purchasing Power Parity

Purchasing power parity is a way of determining the value of a product after adjusting for price differences and the exchange rate. Indeed, it does not make sense to say that a book costs $20 in the US and £15 in England: the comparison is not equivalent. If we know that the exchange rate is £2/$, the book in England is selling for $30, so the book is actually more expensive in England

If goods can be freely traded across borders with no transportation costs, the Law of One Price posits that exchange rates will adjust until the value of the goods are the same in both countries. Of course, not all products can be traded internationally (e.g. haircuts), and there are transportation costs so the law does not always hold.

The concept of purchasing power parity is important for understanding the two models of equilibrium exchange rates below.

Balance of Payments Model

The balance of payments model holds that foreign exchange rates are at an equilibrium level if they produce a stable current account balance. A nation with a trade deficit will experience a reduction in its foreign exchange reserves, which ultimately lowers, or depreciates, the value of its currency. If a currency is undervalued, its nation’s exports become more affordable in the global market while making imports more expensive. After an intermediate period, imports will be forced down and exports will rise, thus stabilizing the trade balance and bringing the currency towards equilibrium.

Asset Market Model

Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows. In other words, money is not only chasing goods and services, but to a larger extent, financial assets such as stocks and bonds. The flows from transactions involving financial assets go into the capital account item of the balance of payments, thus balancing the deficit in the current account. The increase in capital flows has given rise to the asset market model.

Nominal Exchange Rate

A nominal value is an economic value expressed in monetary terms (that is, in units of a currency). It is not influenced by the change of price or value of the goods and services that currencies can buy. Therefore, changes in the nominal value of currency over time can happen because of a change in the value of the currency or because of the associated prices of the goods and services that the currency is used to buy.

Real Exchange Rate

The real exchange rate is the purchasing power of a currency relative to another at current exchange rates and prices. It is the ratio of the number of units of a given country’s currency necessary to buy a market basket of goods in the other country, after acquiring the other country’s currency in the foreign exchange market, to the number of units of the given country’s currency that would be necessary to buy that market basket directly in the given country. The real exchange rate is the nominal rate adjusted for differences in price levels.

A measure of the differences in price levels is Purchasing Power Parity (PPP). The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be on par with the purchasing power of the two countries’ currencies. Using the PPP rate for hypothetical currency conversions, a given amount of one currency has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency.

Calculating Exchange Rates

Imagine there are two currencies, A and B. On the open market, 2 A’s can buy one B. The nominal exchange rate would be A/B 2, which means that 2 As would buy a B. This exchange rate can also be expressed as B/A 0.5.

The real exchange rate is the nominal exchange rate times the relative prices of a market basket of goods in the two countries. So, in this example, say it take 10 A’s to buy a specific basket of goods and 15 Bs to buy that same basket. The real exchange rate would be the nominal rate of A/B (2) times the price of the basket of goods in B (15), and divide all that by the price of the basket of goods expressed in A (10). In this case, the real A/B exchange rate is 3.

Demanders and Suppliers of Currency in Foreign Exchange Markets

In foreign exchange markets, demand and supply become closely interrelated, because a person or firm who demands one currency must at the same time supply another currency and vice versa. To get a sense of this, it is useful to consider four groups of people or firms who participate in the market:

(1) Firms that import or export goods and services.

(2) Tourists visiting other countries.

(3) International investors buying ownership (or part-ownership) in a foreign firm.

(4) International investors making financial investments that do not involve ownership. Let’s consider these categories in turn.

Firms that sell exports or buy imports find that their costs for workers, suppliers, and investors are measured in the currency of the nation where their production occurs, but their revenues from sales are measured in the currency of the different nation where their sales happened. So, a Chinese firm exporting abroad will earn some other currency say, U.S. dollars but will need Chinese yuan to pay the workers, suppliers, and investors who are based in China. In the foreign exchange markets, this firm will be a supplier of U.S. dollars and a demander of Chinese yuan.

International tourists need foreign currency for expenses in the country they are visiting; they will supply their home currency to receive the foreign currency. For example, an American tourist who is visiting China will supply U.S. dollars into the foreign exchange market and demand Chinese yuan.

Financial investments that cross international boundaries, and require exchanging currency, are often divided into two categories. Foreign direct investment (FDI) refers to purchasing (at least ten percent) ownership in a firm in another country or starting up a new enterprise in a foreign country. For example, in 2008 the Belgian beer-brewing company InBev bought the U.S. beer-maker Anheuser-Busch for $52 billion. To make this purchase of a U.S. firm, InBev had to supply euros (the currency of Belgium) to the foreign exchange market and demand U.S. dollars.

The other kind of international financial investment, portfolio investment, involves a purely financial investment that does not entail any management responsibility. An example would be a U.S. financial investor who purchased bonds issued by the government of the United Kingdom, or deposited money in a British bank. To make such investments, the American investor would supply U.S. dollars in the foreign exchange market and demand British pounds.