978-0134890494 Chapter 9

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

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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

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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

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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.

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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.

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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.

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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

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$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

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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.

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

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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

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

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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?

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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

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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