IFM Chapter 3

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International Financial MarketsChapter: 03

PowerPoint Lecture Presentationto accompany

International Financial Management

Dr. Samiul Parvez Ahmed, Assistant Professor, Independent University, Bangladesh


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To describe the background and corporate

use of the following international financial

markets:

Foreign exchange market,

Eurocurrency market,

Eurocredit market, Eurobond market, and

International stock markets.

Chapter Objectives


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Motives for Using

International Financial Markets The markets for real or financial assets are

prevented from complete integration by

barriers such as tax differentials, tariffs,quotas, labor immobility, communication

costs, cultural differences, and financial

reporting differences.

Yet, these barriers can also create unique

opportunities for specific geographic

markets that will attract foreign investors.


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Investorsinvest in foreign markets:

to take advantage of favorable economic

conditions; when they expect foreign currencies to

appreciate against their own; and

to reap the benefits of international

diversification.

Motives for Using

International Financial Markets


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Creditorsprovide credit in foreign

markets:

to capitalize on higher foreign interestrates;

when they expect foreign currencies to

appreciate against their own; and

to reap the benefits of international

diversification.

Motives for Using



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Borrowers borrow in foreign markets:

to capitalize on lower foreign interest rates;

and when they expect foreign currencies to

depreciate against their own.

Motives for Using



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Foreign Exchange Market

The foreign exchange market allows currenciesto be exchanged in order to facilitate

international trade/transactions or financial

transactions.

E.g. when travel abroad, people need foreign

currency; A Local MNC need foreign currency

when purchasing raw materials from another

country (if the price is denominated in foreigncurrency); or export oriented firms receive

foreign currencies and they need to convert

them into local currency .


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Who will perform this service: providing

various currencies against another currency?

Usually, banks hold various currencies and,

when in need, they exchange their currencies.

Bank maintains an inventory of various

currencies. E.g. when export sector receives

$/, they exchange it for local currency from a

bank; that increases $/ balance in the bank. Incontrast, when an import-base firm purchase

goods from U.S./England, it will purchase $/

from a bank; and that will reduce $/ balance of

that bank.


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History of Foreign Exchange

But, there must be an exchange

rate at which various currencies

would be exchanged.

1.Gold Standard

2.Agreement on fixed rates(Bret ton Woods Agreement)

3.Floating rate


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History of Foreign Exchange

The system for establishing exchange

rates has evolved over time.

From 1876 to 1913, each currency wasconvertible into gold at a specified rate, as

dictated by the gold standard.

The exchange rate between two currencies

was determined by their relative

convertibility rates per ounce of gold.


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This was followed by a period of instability,

as World War I began and the Great

Depression followed. The 1944 Bretton Woods Agreement (an

international agreement) called for fixed

currency exchange rates.

During this period, governments would

intervene to prevent exchange rates from

moving more than 1% above or below their

initial established level.


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By 1971, the U.S. dollar appeared to be

overvalued. The foreign demand for U.S. dollarswas substantially less than the supply of dollars

for sale.

The Smithsonian Agreementdevalued the U.S.

dollar and widened the boundaries for exchange

rate fluctuations.

The exchange rates were allowed to fluctuate by

2.25% in either direction from the newly setrates.

This was the first step in letting market forces

(supply & demand) determine the appropriate

price of a currency.


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Even then, governments still had difficulties

maintaining exchange rates within the

stated boundaries. In 1973, the officialboundaries for the more widely traded

currencies were eliminated and the floating

exchange rate systemcame into effect.


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Foreign ExchangeTransactions

There is no specific building or location where

traders exchange currencies. The transactions

usually conducted through commercial banks

over electronic or telecommunication network,around the clock.

The market for immediate exchange is known as

thespo t market

. The rate is known asspot rate.

The forward marketenables an MNC to lock in

the exchange rate at which it will buy or sell a

certain quantity of currency on a specified future

date.


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Hundreds of banks facilitate foreign

exchange transactions, though the top 20

handle about 50% of the transactions. The Deutsche Bank (Germany), Citibank

(U.S.) and J.P. Morgan Chase are the

largest traders of foreign exchange.

Foreign Exchange

Transactions


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At any point in time, arbitrage ensures that

exchange rates are similar across banks.

If a bank experience a shortage in aparticular currency, it can purchase that

currency from other banks. This trading

between banks occurs in what is often

referred to as the interbank market. Within

this market, foreign exchange brokerage

firms sometimes act as middlemen.

Foreign Exchange

Transactions


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Use of the U.S. Dollar in the spot market:

U.S. dollar is commonly accepted as a

medium of exchange by merchants inmany countries.

Foreign Exchange

Transactions


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Banks provide foreign exchange services

for a fee: the banks b id(buy) quote for a

foreign currency will be less than its ask(sell) quote. This is the bid /ask sp read.

bid/ask % spread = ask ratebid rateask rate

Example: Suppose bid price for = $1.52,

ask price = $1.60.

bid/ask % spread = (1.601.52)/1.60 = 5%

Foreign Exchange

Quotations


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The bid/ask spread is normally larger for

those currencies that are less frequently

traded. The spread is also larger for retail

transactions than for wholesale

transactions between banks or large

corporations.

Foreign Exchange

Transactions

NOTE: For our following discussions we will ignore the bid/ask

differences in order to understand various complex concepts at ease.


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Factors that affect the spread

Spread = f [order costs (+),

inventory costs (+), competition(-), volume (-), currency risks (+)]


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Factors that affect the spread

Order Cost: overall cost associated withan order to complete

Inventory cost: opportunity cost

Competition: higher competition results innarrow spread

Volume (trading volume): Large quantity

gets preferencial rate

Currency risk: e.g. economic and political

volatility/instability


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Direct quotat ion srepresent the value of a

foreign currency in dollars (number of

dollars per foreign currency)

Ind irect quotat ion srepresent the number

of units of a foreign currency per dollar.

Interpreting

Foreign Exchange Quotations


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A cros s exchange ratereflects the amount

of one foreign currency per unit of another

foreign currency.

Interpreting



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Forward, Futures and Options Market

In addition to the spot market, a forward

market for currencies enables an MNC to

lock in the exchange rate (called a forwardrate) at which it will buy or sell a currency.

A forward contract specifies the amount of a

particular currency that will be purchased or

sold by the MNC at a specified future point

in time and at a specified exchange rate.


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Commercial banks accommodate the MNCs

that desire forward contracts. MNCs

commonly use the forward market to hedgefuture payments that they expect to make or

receive in a foreign currency. In this way,

they do not have to worry about fluctuations

in the spot rate until the time of their futurepayments.


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Example: Memphis Co. has ordered supplies

from European countries that are

denominated in euros. It expects the euro toincrease in value over time and therefore

desires to hedge its payables in euros.

Memphis buys forward contracts on euros

to lock in the price that it will pay for eurosat a future point in time.


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A currency futu res contractspecifies a

standard volume of a particular currency

to be exchanged on a specific settlementdate. Unlike forward contracts however,

futures contracts are sold on exchanges.

Currency opt ions contractsgive the right

to buy or sell a specific currency at a

specific price within a specific period of

time. They are sold on exchanges too.


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Forward Vs Futures

Forward Contract Futures

Customized to customer

needs

Standardized

Used for Hedging Used for SpeculationNo initial payment

required

Initial margin payment

required

Negotiated directly by the

buyer and seller

Quoted and traded on the

exchange

Only contracting parties

are involved

Clearing hose involved in

the process

High counter-party risk Low counter-party risk


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$International Money Market:

Eurocurrency Market

As MNCs expanded their businesses during

1960s &70s, international financial

intermediaries emerged to accommodate their

needs. Because the U.S. dollar was widelyused even by foreign countries as a medium

for international trade, there was a consistent

need (Short-run)for dollars in Europe and

elsewhere. To conduct international trade with

European countries, corporations in the United

States deposited U.S. dollars in European

banks.


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$Eurocurrency Market

The banks were willing to accept the deposits

because they could lend the dollars to

corporate customers based in Europe. These

dollar deposits in banks in Europe (and onother continents as well) came to be known as

Eurodollars, and the market for Eurodollars

came to be known as the Eurocurrency market.

(Eurodollars and Eurocurrency should not

be confused with the euro, which is the

currency of many European countries today.)


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$

Like the European money market, the

Asian money market originated as a

market involving mostly dollar-denominated deposits. Hence, it was

originally known as the Asian dollar

market.The primary function of banks in

the Asian dollar market is to channelfunds from depositors to borrowers.

Asian Money Market


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$

The market emerged to accommodate the

needs of businesses that were using (mainly)

the U.S. dollar (and some other foreigncurrencies) as a medium of exchange for

international trade. These businesses could not

rely on banks in Europe because of the

distance and different time zones. Today, theAsian money market is centered in Hong Kong

and Singapore, where large banks accept

deposits and make loans in various foreign

currencies.

Asian Money Market

I t ti l M M k t I t t


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International Money Market: InterestRate Comparisons

The international money market rates varysubstantially among some currencies. This is dueto differences in the interaction of the total supply

of short-term funds available (bank deposits) in aspecific country versus the total demand forshort-term funds by borrowers in that country.

I t ti l M M k t I t t


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International Money Market: InterestRate Comparisons


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Eurocurrency Market Vs

Eurocredit market

Short Term Vs MediumTerm or Long Term


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International Bond Market

Although MNCs, like domestic firms, can obtain

long-term debt by issuing bonds in their local

markets, MNCs can also access long-term funds in

foreign markets. MNCs may choose to issuebonds in the international bond markets for three

reasons. First, issuers recognize that they may be

able to attract a stronger demand by issuing their

bonds in a particular foreign country rather than intheir home country. Some countries have a limited

investor base, so MNCs in those countries seek

financing elsewhere.


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International Bond Market

Second, MNCs may prefer to finance a specific

foreign project in a particular currency and

therefore may attempt to obtain funds where that

currency is widely used.

Third, financing in a foreign currency with a lower

interest rate may enable an MNC to reduce its costof financing, although it may be exposed to

exchange rate risk.


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International Bond Market:Eurobond Market

There are two types of international bonds.

Bonds denominated in the currency of the

country where they are placed but issuedby borrowers foreign to the country are

called fo reign bondsor paral lel bonds.

Bonds that are sold in countries otherthan the country represented by the

currency denominating them are called

Eurobonds.


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International Stock Markets

In addition to issuing stock locally, MNCs

can also obtain funds by issuing stock in

international markets. This will enhance the firms image and

name recognition, and diversify the

shareholder base.

Documents

IFM Chapter 3