Some economists, many of them European, are against the foreign exchange market. They see it as an ongoing illustration of the untold evils of capitalism. Price fluctuation, globalization of trade and more precisely the pronounced imbalance between the volume of transactions on the foreign exchange market and the much lower volume on the international goods market are thought to show that the exchange market is an evil nuisance that needs to be mastered. At the turn of the millennium, these economists impelled some governments, especially those in Europe, to implement the Tobin tax as a means of regulating foreign exchange markets. Conceived at the outset of the 1970s, the taxation proposed by James Tobin (who won the 1981 Nobel Prize in economics) was meant to equip the mechanisms of currency exchange markets with a grain or two of sand. It was a matter of levying small-scale customs duties any time that capital was converted from one currency into another. Capital would be submitted to customs charges, just as drivers pay a toll when using a motorway or turnpike. It was assumed that even minimal tax rates would paralyze speculation in so far as the latter feeds on infinitesimal fluctuations. The benefits derived from this operation would contribute favorably to the World Bank.
Our economists viewed this as a question of stemming the flow of the speculative capital that was supposedly causing financial and monetary crises. If speculators’ dealings were brought to an end, it was thought that currency fluctuations would diminish and monetary crises be avoided. In fact, even a small degree of taxation does have a significant impact on a speculative market; speculators do often bet on perhaps minimal price fluctuations. And yet those economists have forgotten that a transaction on the foreign exchange market involving two currencies is often the result of transactions between many other currencies. To use the same example as before, when a Turkish firm purchases Polish goods, it must sell the Turkish pounds in its possession for zlotys. But there is quite probably nobody who, at precisely the same time, needs to sell exactly the same quantity of zlotys for Turkish pounds. In order to perform this transaction, banks are compelled to purchase Turkish pounds from the firm and go on to sell them for a given quantity of euros; these will be sold for dollars; the dollars may perhaps be sold for yen; then the yen could be sold for roubles, which would be sold for the aforementioned zlotys. By levying even a token tax on each transaction, our economists render exchanges between the zloty and the Turkish pound unaffordable.
They have perhaps conveniently forgotten that the proposition formulated by James Tobin stems from a time (before 1971) when foreign exchange was fixed under the Bretton Woods agreement. His idea consisted in preserving some national monetary autonomy. Arbitrage tends to keep interest rates on the monetary market at the same level in all the currencies of the world once risk factors are taken into account. This prevents central banks from carrying out independent monetary policies. If a slight taxation of speculative movements has a negligible effect on an isolated transaction, it amputates an annual yield by 2.5 percent if there is only one movement per week. This taxation would leave a ‘‘margin’’ for central bankers to intervene on their interest rates. In a fixed-rate system within the framework of the Bretton Woods agreements, each member of the IMF pegged the value of its currency to that of gold, which meant in practice that it was pegged to the dollar at a time when the latter still respected the gold standard. In this system arbitrage transactions were numerous, but the present-day floating exchange rate system renders them exponentially greater. Parities result from transactions between two currencies, amid hundreds of others; in a ‘‘floating’’ rate system, adjustments are multiple and manifold. That is why intercurrency transactions are of much higher volume than that of the underlying, related transactions in goods. That is also why, according to the figures issued by the IMF, 80 percent of FX transactions are reversed in a week or less.
The pound sterling, Swiss franc, Canadian and Australian dollars as well as other currencies of comparable importance are negotiated on very many marketplaces but only on a more or less continuous basis. As for the other convertible currencies, they are quoted only when the issuing financial market is open. Non-convertible currencies are not subjected to market functioning; their prices are determined by the central bank. When it comes to exchanging Polish zlotys and Turkish pounds, banks may have to trade off zlotys against euros and euros against dollars; the yen may need to be brought into play. That is why the sun never sets on the foreign exchange market; but that is also why there need be several transactions involving a chain of several currencies so that a zloty can be converted into a Turkish pound.
The initial transactions of a given day are registered in Sydney, Australia and Wellington, New Zealand. This is followed by the opening of the markets in Southeast Asia: Tokyo, Hong King, Singapore. Those of the Middle East follow suit. The markets of London, Paris, Frankfurt, Zurich and less widely renowned European centers of trade take to the task once the Asian markets have closed for the night. They are followed by those in Chicago and Toronto. And when, in their turn, the markets of Los Angeles and San Francisco call it a day, Wellington and Sydney open up yet another day of transactions. Under such conditions the market is continuous and functions non-stop, 24 hours a day. It does so successively on the various financial markets, five days out of seven. During the weekend transactions slow down; only the exchanges of the Arab world are systematically active. The interbank foreign exchange market is thus the first genuinely global or worldwide one.
It is common to distinguish among three broad types of financial assets: fixed income, equity, and derivatives. Fixed-income securitiespromise either a fixed stream of income or a stream securities of income that is determined according to a specified formula. For example, a corporate bond typically would promise that the bondholder will receive a fixed amount of interest each year. Other so-called floating-rate bonds promise payments that depend on current interest rates. For example, a bond may pay an interest rate that is fixed at two percentage points above the rate paid on U.S. Treasury bills. Unless the borrower is declared bankrupt, the payments on these securities are either fixed or determined by formula. For this reason, the investment performance of fixed-income securities typically is least closely tied to the financial condition of the issuer. Nevertheless, fixed-income securities come in a tremendous variety of maturities and payment provisions. At one extreme, the money market refers to fixed-income securities that are short term, highly marketable, and generally of very low risk. Examples of money market securities are U.S. Treasury bills or bank certificates of deposit (CDs). In contrast, the fixed-incomecapital market includes long-term securities such as Treasury bonds, as well as bonds issued by federal agencies, state and local municipalities, and corporations. These bonds range from very safe in terms of default risk (for example, Treasury securities) to relatively risky (for example, high yield or “junk” bonds). They also are designed with extremely diverse provisions regarding payments provided to the investor and protection against the bankruptcy of the issuer. We will take a first look at these securities in Chapter 2 and undertake a more detailed analysis of the fixed-income market in Part Three.
Unlike fixed-income securities, common stock, or equity, in a firm represents an ownership share in the corporation. Equity holders are not promised any particular payment. They receive any dividends the firm may pay and have prorated ownership in the real assets of the firm. If the firm is successful, the value of equity will increase; if not, it will decrease. The performance of equity investments, therefore, is tied directly to the success of the firm and its real assets. For this reason, equity investments tend to be riskier than investments in fixed-income securities. Equity markets and equity valuation are the topics of Part Four.
Finally, derivative securitiessuch as options and futures contracts provide payoffs that are determined by the prices of otherassets such as bond or stock prices. For example, a call option on a share of Intel stock might turn out to be worthless if Intel’s share price remains below a threshold or “exercise” price such as $30 a share, but it can be quite valuable if the stock price rises above that level.1Derivative securities are so named because their values derive from the prices of other assets. For example, the value of the call option will depend on the price of Intel stock. Other important derivative securities are futures and swap contracts. We will treat these in Part Five.
Derivatives have become an integral part of the investment environment. One use of derivatives, perhaps the primary use, is to hedge risks or transfer them to other parties. This is done successfully every day, and the use of these securities for risk management is so commonplace that the multitrillion-dollar market in derivative assets is routinely taken for granted. Derivatives also can be used to take highly speculative positions, however. Every so often, one of these positions blows up, resulting in well-publicized losses of hundreds of millions of dollars. While these losses attract considerable attention, they are in fact the exception to the more common use of such securities as risk management tools. Derivatives will continue to play an important role in portfolio construction and the financial system. We will return to this topic later in the text.
In addition to these financial assets, individuals might invest directly in some real assets. For example, real estate or commodities such as precious metals or agricultural products are real assets that might form part of an investment portfolio.
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