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International Financial Management

Notes users and suppliers of foreign currencies. At the next, or second level, are the commercial banks
which act as clearing houses between users and earners of foreign exchange. At the third level
are foreign exchange brokers through whom the nation’s commercial banks even out their
foreign exchange inflows and outflows among themselves. Finally, at the fourth and highest
level is the nation’s central bank which acts as the lender or buyer of last resort when the nation’s
total foreign exchange earnings and expenditures are unequal. The central bank then either
draws down its foreign exchange reserves or adds to them.

Self Assessment

State whether the following statements are true or false:
1. Communications, pertaining to international financial transactions, are handled mainly
by a large network called System for Worldwide Interbank Financial Telecommunications
(SWIFT).
2. The principle function of the Foreign Exchange Market is the transfer of funds from one
nation and Currency to another.

3.2 Foreign Exchange Rates

This section tries to demonstrate how the exchange rates are determined under a flexible exchange
rate system.
Assume, for simplicity, that there are only two nations, the US and the UK, with dollars ($) being
the domestic Currency and the pound sterling (£) as the foreign Currency. The exchange rate (R)
between the dollar and the pound is equal to the number of dollars needed to purchase one
pound. That is R = $/£. For example, if R = $/£=2, this means that two dollars are required to
purchase one pound.

Figure 3.1: Exchange Rate under a Flexible Exchange Rate System
R = $/£
S
£
4 A F

B
3 G

E
2

1
H D £

0 10 20 30 40 50 60 70 Million
£/day
Quantity of Pounds

Figure 3.1 shows the determination of the equilibrium exchange rate between US and UK under
a flexible exchange rate system. The vertical axis measures the dollar price of pounds or the

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