ECONOMIC DYNAMICS OF INTERNATIONAL FINANCIAL
MARKETS
With the growing international trade flows of goods and services, as well as
capital flows have also increased. The company has two alternative sources of funds
that come from internal (the company's business operations) and external (transactions
in the financial market). Companies can use the financial market as a source of short-
term funding (less than one) With the growing international trade flows of goods and
services, so do capital flows that are also increasing. The company has two alternative
sources of funds that come from internal (the company's business operations) and
external (transactions in the financial market). Companies can use the financial markets
as a source of short-term funding (less than one
The international money market is commonly known as the Eurocurrency
market. Eurocurrency has no relationship with the Euro or any currency in Europe. This
name was given because the international money market consists of deposits or
accounts denominated by foreign currencies. Thus, not only currencies originating from
countries on the European continent can be referred to as Eurocurrencies. For example,
Japanese Yen deposited in Singapore will be referred to as Euroyen. Activity in the
international money market is driven by a lack of regulation or government intervention.
There are many types of interest rates that can be used and depend on the financial
centers involved such as London, New York, Singapore, or Hong Kong. The type of
interest rate that is often used is LIBOR or London interbank offer rate set by the British
Bankers Association. There are many short-term loans that are set on the basis of
LIBOR.
Companies from different countries can be involved in international money
markets for a variety of financial and non-financial reasons. Financial reasons can be
the acquisition of funding sources at a lower cost outside the borders of the country in
which the company operates. In addition, companies tend to use external funding
sources to run projects that are large-scale or require significant amounts of funding.
On the other hand, non-financial reasons can be a desire to maintain financial ties with
many countries. The company can also expand its shareholder base to various societies
or institutions originating from different countries.
A. Bond Market and Equity Market
The international bond market consists of all debt securities (bonds) issued by
companies, governments or other organizations outside the borders of a certain country.
The issuance of bonds in the international market can be one of the sources of financing.
Some of the parties who generally buy bonds are banks, pension fund management
institutions, and government agencies that have a large amount of fund reserves. One
of the instruments that companies can use to enter the international bond market is
Eurobond. Eurobonds are a type of bond issued outside the country whose currency is
denominated in. For example, a company in Switzerland issues bonds denominated in
US dollars and sells them in the UK, the Netherlands and Germany and is not available
in the United States. In addition, there are also foreign bonds which are a type of bond
that is sold outside the country of bond issuance and in the currency of the country
where the bond is sold. For example, a company in France issues bonds denominated
in Australian dollars and sells those bonds in Australia
The international equity market consists of any form of stock that is traded
outside the country of issue of the shares. The company often sells shares in the
international equity market. Some of the parties that generally act as buyers are other
companies, banks, mutual funds, pension fund management agencies and individual
investors. There are four factors that drive the development of the international equity
market. First, the development of the international equity market is greatly influenced
by privatization activities. Furthermore, economic growth in emerging market countries
also encourages the development of international equity markets through increased
investment flows. Global investment activities carried out by banks also contribute to
the development of international equity markets. In addition, the development of the
cybermarket that helps the transaction process between buyers and sellers also
contributes to the development of the international equity market. This cybermarket
allows companies to register their companies through electronic devices.
B. Main Functions of the Foreign Exchange Market
Unlike domestic transactions, international transactions involve two or more
currencies. This means that to conduct international transactions, companies need a
mechanism known as the foreign exchange market. This foreign exchange market is a
type of market that trades different types of currencies. Financial institutions convert
currencies using the exchange rate, which is the rate at which one currency is exchanged
for another. The exchange rate can be affected by various factors such as the size of the
transaction, economic conditions, including government policies
There are four main functions of the foreign exchange market. First, companies
can take advantage of the foreign exchange market to perform currency conversions.
This is important for companies that make foreign direct investment (FDI) in certain
countries. Second, companies can also take advantage of the foreign exchange market
to conduct currency hedging. Currency hedging aims to protect companies from
potential losses caused by exchange rate movements. Third, companies can also conduct
currency arbitrage through the foreign exchange market. Currency arbitrage is the
activity of buying and selling currencies in various different markets with the aim of
making a profit. Companies can also conduct interest arbitrage, which is the activity of
buying and selling securities that provide interest payments and are denominated in
different currencies. Fourth, companies can use the foreign exchange market to conduct
currency speculation, namely buying and selling currencies with the hope that the value
of the currency will increase in the future so that it can generate profits.
C. Foreign Exchange in Various Values
Each foreign exchange has a different value. One of the factors that causes the
difference in foreign exchange value is the economy of the country concerned. If a
country's economic performance improves, the value of that country's currency tends to
strengthen. On the other hand, when economic conditions decline, the value of the
currency will also weaken. For example, when Indonesia experienced a crisis in 1997-
1998, the value of the Rupiah experienced a drastic decline against the US Dollar. The
value of this currency will also continue to fluctuate. Not only Indonesia, but the
currencies of various other countries will also continue to change. For example, Table
11.1 shows the exchange rate of the Rupiah against various types of foreign exchange
D. Foreign Exchange Market Instruments
The various benefits and roles of the foreign exchange market require business
people to know how the exchange rate is set. These business people must be aware of
the financial instruments available and can help them carry out various activities in the
foreign exchange market. The following is an explanation of some of the instruments
in the foreign exchange market.
1. Quoting Currencies
There are two important components in determining the currency
exchange rate, namely the quoted currency and the base currency. In determining
the exchange rate, the quoted currency is always in the numerator section and
the base currency is always in the denominator section. For example, if a certain
exchange rate indicates the amount of Rupiah needed to buy one US Dollar, then
the Rupiah acts as the quoted currency and the US Dollar acts as the base
currency. To buy 1 US Dollar, you need as much as 14,500 Rupiah. Because the
Rupiah acts as a quoted currency, in this case we make a direct quote to the
Rupiah and an indirect quote to the Dollar. If the value of the direct quote is
known, then to find the value of the indirect quote can be done by dividing the
number 1 by the value of the direct quote
In addition, international transactions between two types of currencies
without involving the US Dollar often use the US Dollar currency as an
intermediary. For example, there are consumers in Indonesia who buy goods
from companies in Japan. In this case, the buyer can convert the Rupiah currency
to the US Dollar to carry out payment activities. Furthermore, companies in
Japan that receive payments in U.S. Dollars will convert the currency into Yen.
In this transaction process, both the buyer and the company must know the
exchange rate of the Dollar against the Rupiah and Yen. The process of
calculating the exchange rate of one currency using the exchange rate of the other
two currencies is known as cross rates
2. Spot Rates
Spot rate is an exchange rate that requires the process of handing over the
traded currency within a period of two working days. In this case, currency
exchange activities occur in the spot market which has three functions. First, the
spot market can be used to convert the income of companies in other countries.
Second, the company can convert its country's currency to another currency to
pay international suppliers. Third, the company can convert currencies to invest
in other countries. This spot rate is only available for trading transactions that
involve a sizable amount of currency. This is what makes the spot rate only
available to banks or foreign exchange brokers.
3. Forward Rates
Forward rates are used when a company needs a specific foreign currency
in a specific period in the future. Forward rates are exchange rates when two
parties agree to exchange certain currencies in a certain period in the future.
Forward rates describe the expectations of the spot rate of a particular currency
in the future. These expectations also include economic conditions, as well as
political and economic situations. Transactions that use forward rates are known
as forward markets. Companies can use forward rates to protect themselves from
the risk of future exchange rate movements.
Forward rates can be used for various types of transactions that require
the use of foreign currencies in trading activities. In this case, the company can
use forward contracts, which are contracts when the buyer and seller agree to
trade currencies at an agreed amount and exchange rate. Forward contracts are
included in the group of derivative instruments (derivatives), namely financial
instruments whose value is derived from commodities or other financial
instruments.
4. Swaps, Options, dan Futures
In addition to future contracts, there are three other instruments that can
be used in future markets, namely currency swaps, currency options and currency
future contracts. Currency swaps are the buying and selling of foreign currencies
that occur in two specific periods of time at the same time. For example,
Indonesian consumers buy or import cars from companies in Australia. In this
case, the consumer must pay a certain amount of Australian Dollars when the car
has been received. Likewise, companies in Australia will also receive a certain
amount of money within a period of 40 days. Consumers in Indonesia will
exchange a certain amount of Rupiah at the spot market to pay companies in
Australia. At the same time, the consumer agreed on future contracts to sell a
certain amount of Rupiah and buy a certain amount of Australian Dollars in the
next 40 days. In this case, the consumer uses swap instruments to reduce
exchange rate risk and lock in future exchange rates
In addition to currency swaps, there are currency options that provide the
right or option to exchange a certain number of currencies at a certain rate and
period. Currency options differ from forward contracts in that they do not require
a currency exchange transaction to occur over a certain period of time. On the
other hand, currency future contracts are contracts that require currency
exchange at a certain exchange rate and period. In this case, all the requirements
that have been set cannot be changed.
E. Government Intervention in the Foreign Exchange Market
A currency that is traded freely in the foreign exchange market where its price
level is determined by the interaction between supply and demand is known as a
convertible (hard) currency. This type of currency is generally owned by countries that
have a stable financial position and a large amount of foreign exchange reserves. In
developing countries, governments generally intervene to limit the level of currency
restriction.
This government intervention has several objectives. One of the objectives of
this government intervention is to maintain the amount of foreign exchange reserves to
pay the state debt. Without sufficient liquidity reserves, there is a high risk of default
and subsequently affects future investment flows. Another purpose of currency
restriction is to maintain the amount of foreign exchange reserves to finance import
activities and trade deficits. Furthermore, government intervention also aims to protect
the currency from speculators in times of crisis. In addition, currency restriction policies
can also aim to inhibit investment activities in other countries.
Government interventions to limit currency convertibility can be carried out
through various policy instruments. One of them is by requiring all foreign exchange
transactions to obtain permission from the central bank. The same can also be done for
import activities by requiring an import license for all import activities carried out. The
government can also implement a multiple exchange rate system, which is the
determination of high exchange rates on several types of imported goods originating
from certain countries. Thus, the government can reduce the number of imported goods.
In addition, the government can also issue import deposit requirements that require
business people to deposit a certain amount of foreign exchange in order to obtain an
import license. In this case, the government can also set quantity restrictions that limit
the amount of foreign exchange that can be issued
F. Domestic and Foreign Activities That Can Affect the Foreign Exchange Market
The work of the foreign exchange market, including the value of foreign
exchange, is inseparable from various activities carried out, both domestic and foreign
activities. For example, companies that carry out export and import activities can
influence the value of foreign exchange through the demand and supply of foreign
exchange amounts. An increase in the number of imports in a country will increase the
demand for certain foreign exchange (US dollars). This is because the company needs
a certain amount of foreign exchange to finance the imported goods. The increase in the
number of demand will further encourage the strengthening of the value of the foreign
exchange in the market. The same applies to export and import activities carried out by
companies or business people in various countries.
Various policies set by the government also affect the foreign exchange market.
This policy can be in the form of monetary policy or fiscal policy. This is because
various policies set by the government affect interest rates and inflation rates, which in
turn affect the value of certain currencies in the foreign exchange market. Government
policies in the form of devaluation and revaluation affect the foreign exchange market
through changes in the value of currencies.
Devaluation is a government policy that aims to reduce the value of a country's
currency. On the other hand, revaluation is a government policy that aims to increase
the value of a country's currency. Devaluation can lower the export price of a country
and increase the price of imports because the value of the currency becomes lower in
the international market. The opposite applies to the revaluation policy, which is to
increase export prices and reduce the import prices of a country. Various foreign
policies, especially those set by countries with large economic powers such as the
United States and China, can greatly affect the foreign exchange market, including the
economy of other countries
G. Factors Affecting Foreign Exchange Value and Its Impact on International
Business Activities
To understand the various factors that affect the value of foreign exchange, it is
necessary to understand the concept of the law of one price and purchasing power parity.
The following is an explanation of the two concepts along with the factors that affect
the value of foreign exchange.
1. Law of One Price
The rate indicates how much a particular currency has to pay to acquire a
certain amount from another currency. This rate does not reflect the price level
of a particular product in different countries. In other words, this rate does not
guarantee the purchasing power of a particular currency. The law of one price
states that the same type of product must have the same price level in different
countries. The law of one price helps determine which currencies are
undervalued and overvalued. This further affects international business activities
through the pricing of products in different countries. If there is a difference in
the price of a product in different locations, then this will cause an arbitrage
opportunity, which is the opportunity to buy a certain product in one country and
sell it in another country at a higher value or price
2. Purchasing Power Parity (PPP)
Based on the purchasing power parity (PPP) theory, various factors or
economic forces will push the actual exchange rate to the value determined by
the PPP. If this does not happen, there will be an arbitrage opportunity. This PPP
theory applies to products traded in international markets that are not limited by
trade barriers and have low transportation costs. In this case, if the business
person acting as an arbitrator must ensure that goods purchased at a low price in
one country can still have a lower price in another country after taking into
account transportation costs, taxes, tariffs and other costs. In this case, the price
level can be used to adjust the value of two types of currencies. In the context of
exchange rates, the PPP principle can be interpreted as the exchange rate between
two types of currencies that are the same as the ratio of the price level of goods
in the two countries.
Inflation arises from the interaction of supply and demand from
currencies. If the government increases the amount of money in circulation, but
the amount of output remains the same, then people will have a greater ability to
buy the same product. This will lead to an increase in product prices leading to
inflation. Thus, inflation can cause changes in purchasing power. Because
inflation can damage the purchasing power of the public, the government
generally carries out various policies to maintain price stability. This policy can
be in the form of fiscal policy or monetary policy. Monetary policy aims to
influence interest rates and the amount of money supply. On the other hand, fiscal
policy regulates the amount of government spending and the tax rate to influence
the money supply indirectly.
In the previous section, it was explained that people's purchasing power
is influenced by the inflation rate. Furthermore, this inflation rate is influenced
by the unemployment rate and interest rates. If there is a low unemployment rate,
then this describes the low availability of labor so that companies tend to offer
high wage levels to attract workers' attention.
Furthermore, to maintain the amount of profit obtained, the company will
increase the price level of the product. In other places, interest rates affect the
cost of borrowing funds. Low interest rates will encourage people to borrow for
investment purposes. In other words, high interest rates will reduce the amount
of loans and the amount of money in circulation.
3. Exchange Rate Prediction Method
Exchange rate movements have a significant role for business activities.
The higher the level of uncertainty in exchange rate movements, the greater the
costs associated with exchange rate risk. A stable and predictable exchange rate
can increase the accuracy level of future financial plans and cash flows. There
are two techniques that are generally used to predict exchange rates, namely
fundamental analysis and technical analysis.
Fundamental analysis predicts the exchange rate using statistical models
based on fundamental indicators of the economy. Techniques can be very
complex because there are various indicators that describe different economic
conditions. Some of the indicators that are commonly used are economic
variables such as inflation rates, interest rates, money supply, tax rates and
government spending. Fundamental techniques can also use the situation or
conditions of a country's balance-of-payment that have the potential to affect the
value of that country's currency
On the other hand, technical analysis uses different types of charts formed
from past currency price movement trends as well as other factors that affect
exchange rates. Using statistical models and charts formed from past data, an
analyst can find various conditions that cause changes in the exchange rate.
Furthermore, the time and direction of exchange rate movements in the future
can be estimated. These fundamental and technical analyses can be used
simultaneously to obtain accurate prediction results. Predicting the exchange rate
is not an easy task, even with the use of sophisticated statistical tools and models.
This is because there are almost no completely accurate prediction results
throughout the prediction timeframe. One of the factors that makes it difficult to
predict exchange rate movements is changes in government policy.
H. The Evolution of the International Monetary System
The international monetary system is a set of agreements and institutions that
regulate the movement of exchange rates. There are two monetary systems that are
generally used, namely the fixed exchange rate system and the floating exchange rate
system. The following is explained the evolution or development of the exchange rate
system since the beginning of international trade transactions.
1. The Gold Standard
At the beginning of international trade, gold was used as a means of
payment for international transactions of goods and services. The use of gold as
a means of international transactions has several advantages. First, the limited
amount of gold can lead to a high level of demand for gold. Second, gold is made
of a material that is anti-rust so that it can be easily stored for a long period of
time. Third, gold can be used for both small and large transactions because it can
be easily shaped into coins or gold bars. However, the use of gold as a transaction
tool also has various disadvantages. One of them is that the large size causes the
high cost of gold transportation. In addition, there is a risk of losing gold in
transportation journeys, especially by sea. To overcome this problem, countries
use the gold standard, which is the international monetary system when the value
of paper currencies of countries is directly linked to a certain value of gold
This gold standard requires a country to set the value of its currency in
units of one ounce of gold. The value of the currency expressed in this unit of
gold is known as par value. The calculation of par value is based on the concept
of purchasing power parity. Since all countries have to fix their currencies to the
gold unit, they indirectly link their currencies to each other. Thus, this gold
standard is included in the fixed exchange-rate system, which is an exchange rate
system when the conversion of one currency to another is determined by the
approval of international governments
This gold standard has several advantages. First, the use of this monetary
system can reduce the risk of exchange rate movements. In addition, the gold
standard also establishes a strict monetary policy on all countries participating in
this system. The gold standard also helps countries to overcome the problem of
trade balance imbalances. However, despite its various advantages, the existence
of World War I has prompted the collapse of this monetary system. This is
because the countries involved in World War I need huge costs to meet the needs
and equipment of war. To meet this need, the country prints paper currency in
large quantities. This certainly violates the basic principle of the gold standard
so that many countries ignore this system.
2. Bretton Woods Agreement
In 1944, as many as 44 countries met in New Hampshire, precisely in the
city of Bretton Woods. This meeting became the foundation for the establishment
of a new monetary system based on the value of the United States Dollar. Unlike
the gold standard, this system provides flexibility for countries to overcome
monetary difficulties in their respective countries. This system has several
characteristics. First, The Bretton Woods Agreement uses a fixed exchange rate
system by binding or assigning the value of the U.S. Dollar directly to the value
of gold and assigning the value of other currencies to the value of the Dollar.
Second, this system has built-in flexibility. This is because this system allows for
devaluation of the fundamental condition of disequilibrium, which is an
economic condition characterized by a trade deficit that causes a permanent shift
in a country's balance of payments. Third, this system established the World
Bank to help economic development in various countries. Fourth, The Bretton
Woods Agreement also established the International Monetary System (IMF) to
regulate the fixed exchange rate system and implement various regulations.
However, this system was also abandoned again when the United States
experienced a large trade and budget deficit
3. Floating Exchange Rate System
The Bretton Woods Agreement was abandoned due to its high reliance on
the stability of the Dollar. This system cannot work properly if the value of the
Dollar weakens. To overcome this shortcoming, a new monetary system has
emerged known as a floating monetary system (floating exchange rate). In
January 1976, world leaders met to draft the Jamaica Agreement, an agreement
among IMF members to establish a floating exchange rate system as a new
monetary system. The Jamaica Agreement has several provisions. First, this
system adheres to a managed float system, which is an exchange rate system
when there is a value that floats between one currency against another. This, the
government can intervene to stabilize the value of their currency against a certain
exchange rate. Second, the system no longer considers gold as the main reserve
in the IMF. In addition, this system also designates the IMF as the lender of the
last resort for countries that have difficulty in the balance of payments.
Furthermore, between 1980 and 1985, the value of the Dollar increased
in value very drastically against other currencies. This encourages an increase in
export prices which in turn causes a trade deficit. In this case, the five countries
known as the G5 formed the Plaza Accord agreement in 1985 to lower the value
of the Dollar. The five countries are the United Kingdom, France, Germany,
Japan and the United States. In 1987, there were concerns again that the value of
the dollar was at a level that was too low. This is what prompted the meeting in
Paris held by the G7 (G5 members plus Italy and Canada) to form a new
agreement. This meeting formed the Louvre Accord which made an intervention
effort in order to maintain the stability of the value of the Dollar. Today, most of
the international monetary system uses a controlled inflating exchange rate
system.
