International macroe.. - Free

2 CHAPTER 1. SOME INSTITUTIONAL BACKGROUND1.1 International Financial MarketsWe begin with a description of some basic international Þnancial instrumentsand the markets in which they trade. As a point of reference,we view the US as the home country.Foreign ExchangeForeign exchange is traded over the counter through a spatially decentralizeddealer network. Foreign currencies are mainly bought andsold by dealers housed in large money center banks located around theworld. Dealers hold foreign exchange inventories and aim to earn tradingproÞts by buying low and selling high. The foreign exchange marketis highly liquid and trading volume is quite large. The Federal ReserveBank of New York [51] estimates during April 1998, daily volume of foreignexchange transactions involving the US dollar and executed withinin the U.S was 405 billion dollars. Assuming a 260 business day calendar,this implies an annual volume of 105.3 trillion dollars. The totalvolume of foreign exchange trading is much larger than this Þgure becauseforeign exchange is also traded outside the US—in London, Tokyo,and Singapore, for example. Since 1998 US GDP was approximately 9trillion dollars and the US is approximately 1/7 of the world economy,the volume of foreign exchange trading evidently exceeds, by a greatamount, the quantity necessary to conduct international trade.During most of the post WWII period, trading of convertible currenciestook place with respect to the US dollar. This meant thatconverting yen to deutschemarks required two trades: Þrst from yen todollars then from dollars to deutschemarks. The dollar is said to be thevehicle currency for international transactions. In recent years crosscurrencytrading, that allows yen and deutschemarks to be exchangeddirectly, has become increasingly common.The foreign currency price of a US dollar is the exchange rate quotedin European terms. The US dollar price of one unit of the foreigncurrencyistheexchangerateisquotedinAmerican terms. InAmericanterms, an increase in the exchange rate means the dollar currency hasdepreciated in value relative to the foreign currency. In this book, wewill always refer to the exchange rate in American terms.