Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
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
Ch 9: International Financial Markets
2
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
Ch 9: International Financial Markets
3
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.
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
Ch 9: International Financial Markets
4
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
2. Deregulation
Increases competition, lowers cost of financial transactions, and
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.
Ch 9: International Financial Markets
6
3. Activity of investment banks
a. Global banks facilitate the sale of stock worldwide by
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
2. Four sources of deposits:
a. Governments with excess funds from prolonged trade
3. Eurocurrency market is valued at around $6 trillion, with London
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.
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.
Ch 9: International Financial Markets
7
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 $1.5056. The difference is
the bid-ask spread; banks buy low and sell high, earning profits from the bid-ask
spread.
A. Functions of the Foreign Exchange Market
1. Currency conversion
Companies use the foreign exchange market to convert one
2. Currency hedging
Insuring against potential losses that result from adverse changes
3. Currency arbitrage
Instantaneous purchase and sale of a currency in different markets
for profit. Common among experienced foreign exchange traders,
4. Currency speculation
Purchase or sale of a currency with the expectation that its value
will change and generate a profit. Much riskier than arbitrage
because the value, or price, of currencies is quite volatile.
V. CURRENCY QUOTES AND RATES
A. Quoting Currencies
Two components to every quoted exchange rate: the quoted currency and
the base currency. In (¥/$), 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.
Ch 9: International Financial Markets
8
b. In $0.011852/¥, the dollar is the quoted currency; this is
called a direct quote on the dollar and an indirect quote on
the yen.
c. This formula derives a direct quote from an indirect quote:
d. In the example above, we were given an indirect quote on
the U.S. dollar of ¥ 84.3770/$. 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 $0.011852 to purchase one yen
(¥)—slightly more than one U.S. cent. We state this
84.3770/$ = € 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
Ch 9: International Financial Markets
9
$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
2. Currency option
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
Ch 9: International Financial Markets
10
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.
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:
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
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.
Copyright © 2019 Pearson Education, Inc.
Quick Study Questions
Quick Study 1
1. Q: What is the purpose of the international capital market?
A: First, it expands the money supply for borrowers. Companies unable to obtain
funds from investors in the domestic market can seek financing in the
2. Q: Unbundling and repacking hard-to-trade financial assets into more
marketable financial instruments is called what?
3. Q: What is the characteristic of an offshore financial center?
A: An offshore financial center is a country or territory whose financial sector
Ch 9: International Financial Markets
14
2. Q: Insuring against potential losses that may result from adverse changes in
exchange rates is called what?
3. Q: What do we call the instantaneous purchase and sale of a currency in different
markets to make a profit?
Quick Study 4
1. Q: The numerator in a quoted exchange rate, or the currency with which another
currency is to be purchased is called what?
2. Q: What is the name given to the risk of adverse changes in exchange rates?
3. Q: What do we call an exchange rate requiring delivery of a traded currency
within two business days?
exchange brokers because their trades are worth many millions of dollars. The
spot market assists companies in:
Converting income from sales abroad into the home-country
4. Q: What instruments are used in the forward market?
A: A forward contract is a contract in which two parties agree to exchange
currencies on a specified future date. Forward rates are helpful to a company that
Copyright © 2019 Pearson Education, Inc.
Quick Study 5
1. Q: Where does more than half of all global currency trading take place?
A: The world’s main foreign exchange trading centers are located in the United
Kingdom (London), the United States (New York), and Japan (Tokyo)—together
2. Q: A currency used as an intermediary to convert funds between two other
currencies is called what?
3. Q: What is another name for a freely convertible currency?
4. Q: Why do governments sometimes engage in currency restrictions?
A: Reasons nations restrict currency conversion:
1. Preserve a country’s reserve of hard currencies with which to repay debts
owned to other nations.
Policies nations use to restrict currency conversion:
1. Require all foreign exchange transactions to go through the nation’s
central bank.
2. Require importers to obtain import licenses—allowing governments to
Ch 9: International Financial Markets
16
Ethical Challenge
9-5 Q: What do you see as the “dark side” of deregulation, in terms of business
ethics?
A: The dark side of deregulation is the potential for the occurrence of those very
things that are mentioned in the question itself. However, deregulation does not
9-6 Q: Do you think the recent increase in regulation is effective in helping prevent
another global financial meltdown?
A: This is a good opportunity to discuss extraterritoriality. On the one hand,
should the U.S. government have the right to control and legislate U.S. business
activity abroad? And on the other hand, should U.S. firms be allowed to exploit a
9-7 Q: Do you think the warning of Adam Smith, one of the first philosophers of
capitalism against the dangers of “colluding producers,” applies to the financial-
services sector today?
Ch 9: International Financial Markets
17
Teaming Up
Research Project. Suppose your team works for a firm that has $10 million in excess cash
to invest for one month. Your team’s task is to invest this money in the foreign exchange
market to earn a profit—holding dollars is not an option. Select the currencies you wish
to buy at today’s spot rate, but do not buy less than $2.5 million of any single currency.
Track the spot rate for each of your currencies over the next month in the business press.
On the last day of the month, exchange your currencies at the day’s spot rate. Calculate
your team’s gain or loss over the one-month period. (Your instructor will determine
whether, and how often, currencies may be traded throughout the month.)
A: This project is excellent for instructors who want their students to acquire a better
grasp of the foreign exchange market and the reasons for currency fluctuations. Students
should be asked to research each of the currencies they purchase and pass these reasons
on to the instructor at the time of their initial purchase. Students should also follow the
business press to learn the reasons for daily fluctuations in the value of each currency.
Practicing International Management Case
Should We Cry for Argentina?
9-16 Q: Argentina’s peso was linked to the U.S. dollar through a currency board for
ten years before it was cut loose. Why did Argentina peg its currency to the dollar
in the first place?
A: Students can consult business and financial Web sites to update the situation
9-17 Q: Companies encounter many difficulties in adapting their strategies to deal with
the effects of a currency crisis that becomes an economic crash. How did local
and international companies adapt to the business environment at the height of
Argentina’s crisis?
A: The Argentine units of U.S. companies, which collect revenues in pesos, had a
Ch 9: International Financial Markets
18
9-18 Q: What has been the impact on the savings and purchasing power of ordinary
citizens?
A: Strapped for cash, the government seized the savings accounts of its citizens
and restricted how much they could withdraw at a time. When street protesters
