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.
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 1 in Britain would cost $2.00 in the U.S. if the exchange rate were 1/$2.00 U.S. If this exchange rate declined to 1/$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 falls. Assuming an exchange rate of 1 /$2.00 U.S., a $2.00 item in the U.S. costs 1 in Britain. If this exchange rate declined to 1/$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 1/$2.00 U.S. The amounts supplied and demanded by the market participants are in balance.
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 to S). 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 1/$2.00 U.S., however, a balance-of-payments surplus (for Britain) likely results.
In Figure 3, an initial exchange-rate equilibrium of 1/$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 to D). 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 to S). 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 to D). British investors are also less inclined to purchase U.S. securities, moving the supply schedule of pounds to the left (S to S). Both activities raise the equilibrium exchange rate of the British pound in terms of U.S. dollars.
3. Factors affecting foreign exchange rates
The exchange rate for any foreign currency depends on a multitude of factors reflecting economic and financial conditions in the country issuing the currency. One of the most important factors is the status of a nation's balance-of-payments position. When a country experiences a deficit in its balance of payments, it becomes a net demander of foreign currencies and is forced to sell substantial amounts of its own currency to pay for imports of goods and services. Therefore, balance-of-payments deficits often lead to price depreciation of a nation's currency relative to the prices of other currencies. For example, during most of the 1970s, 1980s, and into the 1990s, when the United States was experiencing deep balance-of-payments deficits and owed substantial amounts abroad for imported oil, the value of the dollar fell.