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CHAPTER 9
INTERNATIONAL FINANCIAL MARKETS
LEARNING OBJECTIVES:
9.1 Explain the importance of the international capital market
9.2 Describe the main components of the international capital market.
9.3 Outline the functions of the foreign exchange market.
9.4 Explain the different types of currency quotes and exchange rates.
9.5 Describe the instruments and institutions of the foreign exchange market.
CHAPTER OUTLINE:
Introduction
Importance of the International Capital Market
Purposes of National Capital Markets
Role of Debt
Role of Equity
Purposes of the International Capital Market
Expands the Money Supply for Borrowers
Reduces the Cost of Money for Borrowers
Reduces Risk for Lenders
Forces Expanding the International Capital Market
World Financial Centers
Offshore Financial Centers
International Capital Market Components
International Bond Market
Types of International Bonds
Interest Rates: A Driving Force
International Equity Market
Spread of Privatization
Economic Growth in Emerging Markets
Activity of Investment Banks
Advent of Cybermarkets
Eurocurrency Market
Appeal of the Eurocurrency Market
The Foreign Exchange Market
Functions of the Foreign Exchange Market
Currency Conversion
Currency Hedging
Currency Arbitrage
Interest Arbitrage
Currency Speculation
Currency Quotes and Rates
Quoting Currencies
Copyright © 2019 Pearson Education, Inc.
Direct and Indirect Rate Quotes
Cross Rates
Spot Rates
Buy and Sell Rates
Forward Rates
Forward Contracts
Swaps, Options, and Futures
Currency Swaps
Currency Options
Currency Futures Contracts
Market Instruments and Institutions
Trading Centers
Important Currencies
Interbank Market
Clearing Mechanisms
Securities Exchanges
Over-the-Counter Market
Currency Restriction
Instruments for Restricting Currencies
Bottom Line for Business
Appendix: Calculating Percent Change in Exchange Rates
A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 9.
These slides and the lecture outline below form a completely integrated package that simplifies the
teaching of this chapter’s material.
Lecture Outline
I. INTRODUCTION
This chapter explores the two interrelated systems that comprise the international financial
markets, which are the international capital market and the foreign exchange market.
II. IMPORTANCE OF THE INTERNATIONAL CAPITAL MARKET
A capital market is a system that allocates financial resources in the form of debt and equity
according to their most efficient uses. Its main purpose is to provide a mechanism to borrow or
invest money efficiently.
A. Purposes of National Capital Markets
Help individuals and institutions borrow money from lenders; intermediaries exist to
facilitate financial exchanges.
1. Role of debt
a. Loans in which borrower repays borrowed amount (the principal) plus
interest. Company debt normally takes the form of bonds—debt
instruments specifying the timing of principal and interest payments.
b. Holder of a bond (the lender) can force the borrower into bankruptcy if
payment is not made on a timely basis. Bonds to fund investments are
issued by private-sector companies and by municipal, regional, and
national governments.
2. Role of equity
a. Equity is part ownership of a company in which the equity holder
participates with other part owners in the company’s financial gains and
losses. Equity normally takes the form of stock—shares of ownership in a
company’s assets that give shareholders a claim on the company’s future
cash flows.
b. Shareholders may be rewarded with dividends or by increases in the
value of their shares. They may also suffer losses through decreases in
the value of their shares. Dividend payments are not guaranteed, but
decided by the company’s board of directors and based on financial
performance.
c. Shareholders can sell one stock and buy another or liquidate exchange
stock for cash. Liquidity refers to the ease with which bondholders and
shareholders convert investments into cash.
B. Purposes of the International Capital Market
The international capital market is a network of individuals, companies, financial
institutions, and governments that invest and borrow across national boundaries. Large
international banks gather excess cash of investors and savers around the world and then
channel it to global borrowers.
1. Expands the money supply for borrowers
a. Companies unable to obtain funds from investors in the domestic market
seek financing in the international capital market.
b. Essential for firms in countries with small or developing capital markets
or emerging stock markets.
c. An expanded supply of money benefits small companies that might not
get financing under intense competition for capital.
2. Reduces the cost of money for borrowers
a. An expanded money supply reduces the cost of borrowing. The “price”
reflects supply and demand. Excess funds create a buyer’s market,
forcing interest rates lower.
b. Projects regarded as infeasible because of low expected returns might be
viable at a lower financing cost.
3. Reduces risk for lenders
a. The international capital market expands the available set of lending
opportunities. Investors reduce portfolio risk by spreading their money
over many debt and equity instruments.
b. Investors have a greater set of opportunities from which they can choose
and investing in international securities benefits investors because some
economies are growing while others are in decline.
C. Forces Expanding the International Capital Market
1. Information technology
Reduces time and money needed to communicate globally. Electronic trading
after close of formal exchanges facilitates fast response times.
2. Deregulation
Increases competition, lowers cost of financial transactions, and opens many
national markets to global investing and borrowing. Yet greater regulation
flowing out of the credit crisis of 2008–2009 may curtail growth in this market.
3. Financial instruments
Increased competition is creating the need to develop innovative financial
instruments. Securitization is the unbundling and repackaging of hard-to-trade
financial assets into more liquid, negotiable, and marketable financial
instruments, or securities. Here, too, regulation of securitization may curtail
growth of this market.
D. World Financial Centers
The three most important financial centers are London, New York, and Tokyo.
1. Offshore financial centers
Country or territory where financial sector features few regulations and few, if
any, taxes. They (1) are economically and politically stable; (2) are advanced in
telecommunications; (3) offer large amounts of funding in many currencies; and
(4) provide a less costly source of financing.
a. Operational centers see a great deal of financial activity (e.g., London for
currencies; Switzerland for investment capital).
b. Booking centers are usually located on a small, island nation or territory
with favorable tax or secrecy laws. Funds pass through on their way to
large operational centers. Typically, are offshore branches of domestic
banks used to record tax and currency exchange information.
III. INTERNATIONAL CAPITAL MARKET COMPONENTS
A. International Bond Market
Consists of all bonds sold by issuing companies, governments, and other organizations
outside their own countries. Buyers include medium- to large-size banks, pension funds,
mutual funds, and governments.
1. Types of international bonds
a. Eurobond
Issued outside the country in whose currency it is denominated (e.g.,
issued in Venezuela in U.S. dollars, and sold in Britain, France, and
Germany). It accounts for 75 to 80 percent of all international bonds.
Absence of regulation reduces the cost of issuing a bond but increases its
risk.
b. Foreign bond
Sold outside borrower’s country and denominated in currency of country
in which it is sold (e.g., yen-denominated bond issued by German
carmaker BMW in Japan’s bond market). It accounts for 20 to 25 percent
of all international bonds. Issuers must meet certain regulatory
requirements and disclose details about company activities, owners, and
upper management. Example: BMW’s samurai bonds (the name for
foreign bonds issued in Japan) would need to meet the same disclosure
and other regulatory requirements that Toyota’s bonds in Japan must
meet. Foreign bonds in the United States are called yankee bonds, and
those in the United Kingdom are called bulldog bonds. Foreign bonds
issued and traded in Asia outside Japan (and normally denominated in
dollars) are called dragon bonds.
2. Interest rates: a driving force
a. Borrowers from newly industrialized and developing countries borrow
money from nations where interest rates are lower.
b. Investors in developed countries buy bonds in newly industrialized and
developing nations to obtain a higher return.
c. Many emerging countries see the need to develop their own national
markets. Volatility in currency market hurts projects that earn funds in
those currencies and pay debts in dollars.
B. International Equity Market
Consists of all stocks bought and sold outside the issuer’s home country. Companies and
governments issue equity and buyers include other companies, banks, mutual funds,
pension funds, and individuals.
1. Spread of privatization
a. A single privatization often places billions of dollars of new equity on
stock markets.
b. Increased privatization in Europe is expanding worldwide equity.
European Union integration has made investors willing to invest in stocks
from other European nations.
2. Economic growth in emerging markets
a. Growth in newly industrialized and developing countries contributes to
growth in the international equity market.
b. Because of a limited supply of funds in emerging economies, the
international equity market is a major source of funding.
3. Activity of investment banks
a. Global banks facilitate the sale of stock worldwide by bringing together
sellers and large potential buyers.
b. Becoming more common than listing a company’s shares on another
country’s stock exchange.
4. Advent of cybermarkets
a. Stock markets consisting of online global trading activities that allow
listing of stocks worldwide for electronic 24-hour trading.
C. Eurocurrency Market
1. All the world’s currencies banked outside their countries of origin are
Eurocurrency and trade on the Eurocurrency market (e.g., Eurodollars,
Europounds). It involves large transactions by the largest companies, banks, and
governments.
2. Four sources of deposits:
a. Governments with excess funds from prolonged trade surplus
b. Commercial banks with excess currency
c. International companies with excess cash
d. Extremely wealthy individuals
3. Eurocurrency market is valued at around $6 trillion, with London accounting for
about 20 percent of all deposits. Other important markets include Canada, the
Caribbean, Hong Kong, and Singapore.
4. Appeal of the Eurocurrency market
a. Complete absence of regulation lowers costs. Banks charge borrowers
less and pay investors more but still earn profit.
b. Low transaction costs because transactions are large.
c. Interbank interest rates are interest rates that the world’s largest banks
charge one another for loans. London Interbank Offer Rate (LIBOR) is
the interest rate charged by London banks to other large banks borrowing
Eurocurrency. London Interbank Bid Rate (LIBID) is the interest rate
offered by London banks to large investors for Eurocurrency deposits.
5. An unappealing feature of the Eurocurrency market is greater risk due to a lack
of government regulation. Still, Eurocurrency transactions are fairly safe because
of the size of the banks involved.
IV. THE FOREIGN EXCHANGE MARKET
Market in which currencies are bought and sold and in which currency prices are determined.
Exchange rates reflect the size of the transaction, the trader conducting it, general economic
conditions, and sometimes, government mandate.
If the British pound is quoted in U.S. dollars at $1.5054, the bank may bid $1.5052 to buy
British pounds and offer to sell them at $1.5056. The difference is the bid-ask spread; banks buy
low and sell high, earning profits from the bid-ask spread.
A. Functions of the Foreign Exchange Market
1. Currency conversion
Companies use the foreign exchange market to convert one currency into
another. They must convert to local currencies when they undertake foreign
direct investment. When a firm’s international subsidiary earns a profit and the
company wants to return some of it to the home country, it must convert the
local money into the home currency.
2. Currency hedging
Insuring against potential losses that result from adverse changes in exchange
rates. Companies use it to: (1) lessen the risk of international transfers; and (2)
reduce exposure in transactions where a time lag exists between billing and
receipt of payment.
3. Currency arbitrage
Instantaneous purchase and sale of a currency in different markets for profit.
Common among experienced foreign exchange traders, large investors, and
firms in arbitrage business.
a. Interest arbitrage is the profit-motivated purchase and sale of interest-
paying securities denominated in different currencies. Companies use
interest arbitrage to find higher interest rates abroad in government
treasury bills, corporate and government bonds, and even bank deposits.
4. Currency speculation
Purchase or sale of a currency with the expectation that its value will change and
generate a profit. Much riskier than arbitrage because the value, or price, of
currencies is quite volatile.
V. CURRENCY QUOTES AND RATES
A. Quoting Currencies
Two components to every quoted exchange rate: the quoted currency and the base
currency. In (¥/$), the yen is the quoted currency, the dollar is the base currency. The
quoted currency is always the numerator, and the base currency is always the
denominator.
1. Direct and indirect rate quotes (See Table 9.1)
a. In ¥ 84.3770 /$, the yen is the quoted currency; this is called a direct
quote on the yen and an indirect quote on the dollar.
b. In $0.011852/¥, the dollar is the quoted currency; this is called a direct
quote on the dollar and an indirect quote on the yen.
c. This formula derives a direct quote from an indirect quote:
Direct Quote = ____1_____
Indirect Quote
And, for deriving an indirect quote from a direct quote, use:
Indirect Quote = ____1____
Direct Quote
d. In the example above, we were given an indirect quote on the U.S.
dollar of ¥ 84.3770/$. To find the direct quote on the dollar we simply
divide ¥ 84.3770 into $1: $1 ¥ 84.3770 = $0.011852/ ¥
This means that it costs $0.011852 to purchase one yen (¥)—slightly
more than one U.S. cent. We state this exchange rate as $0.011852/¥. In
this case, because the dollar is the quoted currency, we have a direct
quote on the dollar and an indirect quote on the yen.
Looking at Table 9.1 you can see that the direct quote on the euro is €
0.7883/$. The direct quote on the Japanese yen is ¥ 84.3770/$. To find
the cross rate between the euro and the yen, with the yen as the base
currency, we simply divide € 0.7883/$ by ¥ 84.3770/$: € 0.7883/$ ¥
84.3770/$ = € 0.0093/ ¥. See Table 9.2, it shows the Cross Rates for the
major world currencies.
2. Cross rates
a. Used when no access to the exchange rate between two nation’s
currencies, but have exchange rates for each nation’s currency with that
of a third nation. Cross rates can be calculated using either currency’s
indirect or direct exchange rates with another currency.
B. Spot Rates
Exchange rate that requires delivery of a traded currency within two business days. The
spot market helps companies to:
Convert income from sales abroad into the home-country currency.
Convert funds into the currency of an international supplier.
Convert funds into the currency of a country in which it will invest.
1. Buy and sell rates
The spot rate is available only to banks and foreign exchange brokers. Small
businesspeople exchanging currencies at their local bank receive a buy rate (the
bank’s rate to buy a currency) and an ask rate (the bank’s rate to sell a currency).
For example, if a bank quotes you an exchange rate between dollars and euros of
$1.268/78 per euro (€), it will buy dollars at $1.268/€ and sell them at peso
$1.278/€.
C. Forward Rates
Exchange rate at which two parties agree to exchange currencies on a specified future
date. Represent traders’ and bankers’ expectations of a currency’s future spot rate. Used
to insure against unfavorable changes in exchange rates.
1. Forward contract
a. Requires exchange of an agreed-upon amount of a currency on an
agreed-upon date at a specific exchange rate. Belong to a family of
financial instruments known as derivatives.
b. Commonly signed for 30, 90, and 180 days into the future, but
customized contracts are also possible.
D. Swaps, Options, and Futures
Three other types of currency instruments are used in the forward market.
1. Currency swap
Simultaneous purchase and sale of foreign exchange for two different dates.
Used to reduce exchange-rate risk and lock in a future exchange rate. Can be
viewed as a complex forward contract.
2. Currency option
Right, or option, to exchange a specific amount of a currency on a specific date
at a specific rate. Used to hedge against exchange-rate risk or obtain foreign
currency at a favorable rate.
3. Currency futures contract
Contract requiring the exchange of a specific amount of currency on a specific
date at a specific exchange rate, with all conditions fixed and not adjustable.
VI. MARKET INSTRUMENTS AND INSTITUTIONS
Electronic network of foreign exchange traders, currency trading banks, and investment firms
among major financial centers. Single-day trading volume on the foreign exchange market
(currency swaps and spot and forward contracts) is $4 trillion.
A. Trading Centers
The United Kingdom, United States, and Japan account for half of all global currency
trading. London dominates the foreign exchange market for historic and geographic
reasons.
B. Important Currencies
A vehicle currency is used as an intermediary to convert funds between two other
currencies. Currencies most often involved in currency transactions are the U.S. dollar,
British pound, Japanese yen, and European Union euro.
C. Interbank Market
Market where the world’s largest banks exchange currencies at spot and forward rates.
Banks act as agents for clients and turn to foreign exchange brokers, who can obtain
seldom traded currencies.
1. Clearing mechanisms aggregate currencies that one bank owes another and then
carry out that transaction.
2. Today, clearing is a mostly digital, computerized affair, whereas in the past it
meant physically delivering currencies from one bank to another.
D. Securities Exchanges
Specializes in currency futures and options transactions. Securities brokers facilitate
currency transactions on securities exchanges. Transactions on securities exchanges are
much smaller than those in the interbank market and vary with each currency.
E. Over-the-Counter (OTC) Market
Consists of a global computer network of foreign exchange traders and other market
participants, but with no central trading location. Major players in the OTC market are
large financial institutions and investment banks. The OTC market has grown because
of several benefits:
1. Businesspeople search for the institution that provides the best (lowest) price for
transactions.
2. It offers greater opportunities for designing customized transactions.
F. Currency Restriction
A convertible (hard) currency is one that trades freely in the foreign exchange market,
with its price determined by the forces of supply and demand. Some countries do not
permit the free convertibility of their currencies. Goals of currency restriction include:
1. Preserve nation’s hard currencies to repay debts owed to other nations.
2. Preserve hard currencies to pay for imports and finance trade deficits.
3. Protect a currency from speculators.
4. Keep individuals and businesses from investing in other nations.
G. Instruments for Restricting Currencies
1. Nation’s central bank must perform all foreign exchange transactions.
2. Government controls amount of foreign currency leaving the country by
requiring importers to obtain import licenses.
3. Implement systems of multiple exchange rates that specify higher rates on the
imports of certain goods or on the imports from certain nations.
4. Issue import deposit requirements that require businesses to deposit certain
percentages of their foreign exchange holdings in special accounts before being
granted import licenses.
5. Issue quantity restrictions that limit the amount of foreign currency that
individuals can take out of the country when traveling abroad.
6. Countertrade
a. The exchange of goods or services between two parties without the use of
money. International companies can circumvent currency convertibility
restrictions and yet conduct business.
VII. INTERNATIONAL CAPITAL MARKETS AND BUSINESS
Continued growth in the international capital market is expected. It is crucial that managers
understand the fundamentals of exchange rates and how the foreign exchange market is
structured.
VIII. INTERNATIONAL FINANCIAL MARKETS AND BUSINESS
Key components of international financial markets are the international bond, equity, and
Eurocurrency markets.
APPENDIX: Calculating Percent Change in Exchange Rates
1. Exchange rate risk can jeopardize profits from current and future international
transactions. Managers minimize this risk by tracking percent changes in exchange
rates.
2. Take Pn as the exchange rate at the end of a period (a currency’s new price), and Po as
the exchange rate at the beginning of that period (a currency’s old price). Percent change
in the value of the currency is calculated with the following formula:
Percent change (%) = Pn – Po x 100
Po
3. Suppose on February 1, the exchange rate between the Norwegian krone (NOK) and the
U.S. dollar was NOK 5/$. On March 1, the exchange rate stood at NOK 4/$.
What is the change in the value of the base currency—the dollar? The value of the US
Dollar has fallen 20 percent. In other words, one US Dollar buys 20 percent fewer
Norwegian Krone pm March 1, than it did on February 1.
Percent change (%) = 4 – 5 x 100 = –20%
5
4 To calculate the change in the value of the Norwegian Krone, you must first calculate
the indirect exchange rate on the krone. This step is necessary because you want to make the
krone the base currency. Using the formula presented earlier, you obtain the exchange rate of
$.20/NOK (1/NOK 5 = .20)
Percent change (%) = .25 – .20 x 100 = 25%
.20
In other words, the value of the Norwegian Krone has risen 25 percent.
