The international financial system performs the same roles and functions that domestic money and capital markets do around the globe. It attracts savings and allocates capital for investment purposes toward the most promising projects, stimulating the international economy to grow.

• One of the most significant sources of information on world trade and the flow of savings (capital) between nations is provided by each country’s balance-of-payments (BOP) accounts, which summarize economic and financial transactions between residents of a nation and the rest of the world. The principal components of a nation’s balance of payments are the current account (which focuses primarily upon flows of merchandise and services between nations), the capital account (which traces long- and short-term capital flows between nations), and official reserve transactions (which are used by governments and central banks to aid in the settlement of balance-of-payments deficits).



• One of the most significant risks in the international financial system is currency or foreign exchange risk. Crossing national and regional borders with capital or merchandise usually is accompanied by transactions involving two or more different currencies whose relative values can change quickly, threatening losses on trade and in the value of capital investments.



• Reducing currency risk has been a continuing goal of nations, individuals, and businesses for centuries. Nations have resorted in the past to tying their currencies to assets (such as gold) recognized as having universal appeal and value. However, restrictions on the availability of gold and transaction costs as well as lack of flexibility in a nation’s money and credit policy eventually led to a much more flexible currency standard, referred to today as the managed floating currency standard. Each nation chooses its own currency standard, taking into account the welfare of other nations.



• The exchange rate between one currency and another is determined by the foreign exchange (FOREX) market through the interplay of the demand and supply for each nation’s currency. Currencies are traded over the counter in a relatively informal marketplace and prices are quoted as “double barrel” quotations—the price of one foreign currency expressed in terms of another.



• Foreign currency markets today are three-tiered, divided into spot, forward, and futures and options markets. While spot transactions involve immediate currency exchanges, forward, futures, and options markets are designed to hedge against currency.



• The supply and demand forces that shape foreign currency prices are influenced by a few powerful factors, including a nation’s balance-of-payments position, speculation over future currency values, domestic economic conditions, and central bank policy.



• The forward exchange market is designed to protect against losses due to currency price fluctuations. The functions of forward currency contracts include (a) commercial covering designed primarily to affect export/import values; (b) hedging an investment position against loss in market values; (c) speculation about future currency values; and (d) covered interest arbitrage to help protect the yield on an investment instrument (such as a government bond).



• The principle of interest rate parity in international currency markets rests on the fact that the net return to the investor from any foreign investment is equal to the interest earned on the investment plus or minus the forward premium or discount on the price of any foreign currency involved in the transaction. The parity principle argues that the interest-rate differential between two nations is closely related to the forward discount or premium on their currencies.



• Foreign currency futures contracts call for the future delivery of a specific currency at a price agreed upon today and are designed to transfer currency risk to another investor willing to bear that risk. Importers of goods and services typically use a buying hedge in currency futures while a selling hedge is often employed by investors who purchase foreign securities and want to protect their earnings from a drop in currency values.



• Newer and more innovative methods for dealing with currency risk include currency swaps, where two parties exchange payments in different currencies; the use of local loans to avoid currency trading; dual currency bonds, with principal and interest payments made in at least two different currencies; the bartering of goods or property; and the risk-adjusted pricing of goods and services in order to take into account foreign exchange risk.



• Government intervention in foreign exchange markets has become less common today. However, most governments will intervene to change currency values when emergency shocks occur (such as terrorist attacks or a sudden plunge in the values of stock or bonds) that could damage a nation’s economic welfare.