C H A P T E R 7
International financial markets and institutions
Chapter objectives
2. Examine the foreign exchange market, its operation and the main participants.
4. Show how firms can operate successfully in more than one currency without facing
unacceptable levels of exchange risk.
6. Describe the functioning of the euromarkets, both short-term and long-term.
8. Look at a countrys balance of payments and show what lessons can be drawn from it.
Chapter summary
1. International financial markets are relevant to companies, whether or not they become
2. The foreign exchange market is a mechanism through which transactions can be made
between one countrys currency and that of another. There are four major foreign exchange
3. Exchange risk is the probability that a company will be unable to adjust prices and costs to
offset changes in the exchange rate. There are a number of ways of protecting from
4. The multinational enterprise (MNE) generally utilizes local financial markets to perform
necessary local financial transactions, to hedge its local asset exposure through local
5. The scope of financial markets and instruments is predominantly domestic or fully
6. The international monetary system is a financial market in which only central banks and the
Chapter outline
Introduction
Foreign exchange markets
Foreign exchange markets in the United States
Determination of the exchange rate
Purchasing power parity (PPP)
International Fisher effect
Protecting against exchange risk
Alternatives to minimize exchange risk
Foreign money and capital markets
MNEs and national money markets
MNEs and national capital markets
Regional money and capital markets
The eurocurrency market
Rugman and Collinson, International Business, 6th edition, Instructor’s Manual
Other market characteristics
The IMF system
MNEs and international financial markets and institutions
Lecture outline
A. Introduction
1. International financial markets are relevant to companies. Purchases of imported
products or services may require transactions in foreign currencies. Companies also find
that borrowing funds abroad is less expensive than borrowing domestically, in the
B. Foreign exchange markets
1. The foreign exchange market is a mechanism through which financial instruments
2. There are four major ways of conducting foreign exchange in the United States:
between banks, using a broker, through forward transactions and through the futures
market. The interbank market for foreign exchange involves transactions between
banks. The brokers market consists of a small group of foreign exchange brokerage
3. There are three types of exchange rates that are important to those dealing in foreign
exchange: spot, forward and cross. A spot rate is the rate quoted for current
foreign currency transactions. The forward rate is the rate quoted for the delivery
Rugman and Collinson, International Business, 6th edition, Instructor’s Manual
C. Determination of the exchange rate
1. There are five major groups that are active participants in foreign exchange markets:
traders/brokers, speculators, hedgers, arbitrageurs and governments. Foreign exchange
traders work in commercial banks where they buy and sell foreign currency for their
2. Exchange rates are determined by the activities of the five groups discussed above, as
well as through purchasing power parity (PPP) and interest rate parity (Fisher effect).
3. In order to relate interest rates to exchange rates, it is first necessary to relate interest
rates to inflation. This is done through the Fisher effect, which describes the
relationship between inflation and interest rates in two countries. There are three key
4. The link between interest rates and exchange rates is explained by the international
Fisher effect (IFE), which holds that the interest rate differential is an unbiased
predictor of future changes in the spot exchange rate. So, if nominal interest rates in
Germany are higher than those in the United States, the value of the Euro will fall by
that interest rate differential in the future. This differential is also important in
5. Other factors also help determine exchange rates. These include confidence in the
currency and technical factors such as the release of national economic statistics,
seasonal demands for a currency, the slight strengthening of a currency followed by a
Rugman and Collinson, International Business, 6th edition, Instructor’s Manual
D. Protecting against exchange risk
1. Exchange risk is the probability that a company will be unable to adjust prices and costs
to offset changes in the exchange rate. There are a number of reasons why businesses
need to develop strategies for managing currency exchange rate risk. One reason is that
2. Exchange risk avoidance is the elimination of exchange risk by doing business locally.
Exchange risk adaptation is the use of hedging to provide protection against exchange
rate fluctuations. Risk transfer is the use of an insurance contract or guarantee that
E. Foreign money and capital markets
1. In each country the MNE enters, it will be able to obtain some degree of access to local
financial markets. The MNE will generally utilize such markets to perform necessary
2. Those MNEs that are setting up operations in foreign markets will sometimes borrow
money from local banks and institutions because local governments commonly
subsidize such loans through tax breaks, lower interest rates and other financial
3. MNEs will also try to raise money through international money markets. One of the
most important of these is the eurocurrency market. Eurocurrency is any currency that is
banked outside its country of origin. For example, eurodollars are dollars banked
Rugman and Collinson, International Business, 6th edition, Instructor’s Manual
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F. Regional money and capital markets
1. The eurocurrency market is a wholesale market in which transactions are conducted by
governments, banks and major corporations. Deposits are primarily short-term and
2. There is also an international bond market that is available to both domestic and foreign
investors. This market consists of both foreign bonds and eurobonds. A foreign bond is
a bond sold outside the borrowers country but denominated in the currency of the
3. Euroequities are shares of publicly traded stocks traded on an exchange outside of the
issuing firms home country. They are bought and sold in shares denominated in the
G. The IMF system
1. The international monetary system is an institutional arrangement among the central
banks of the countries that belong to the International Monetary Fund (IMF). The
2. The goals of the IMF include the following: (a) to facilitate the balanced growth of
international trade; (b) to promote exchange stability and orderly exchange
3. The original IMF framework functioned well for about 15 years. However, by the 1960s
problems were beginning to develop. One reason was that the United States had been
supplying international liquidity through a steady net outflow of dollars for such things
4. The flexible exchange rate system that resulted after the IMFs decision of 1976 is
referred to as managed float because there is more to the determination of the rates
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5. There are a number of major problems and challenges that will have to be addressed by
the international monetary system during the new millennium. One of these is the
Answers to review and discussion questions
1. If your firm had a subsidiary in Japan and about 100 million yen in exposed assets (i.e.
plant and equipment), how would you protect it against exchange risk?
2. If you managed the European operations of a large US-based MNE, in what market(s)
would you seek long-term funding? Why?
3. Given that the euro areas inflation is about 3 percent per year at present, while US
inflation is about 2 percent per year, what do you expect to happen to the euro/dollar
exchange rate in the next few months? Why?
4. What is the difference between a eurobond and a domestic bond in the United States?
Which one would you prefer to issue as a company manager? Which one would you
prefer to buy as an investor? Why?
A eurobond is a bond denominated in foreign currency issued in any countrys financial market.
A domestic bond in the United States is issued in dollars. Eurobonds generally carry less interest
5. How can a firm such as Ajax Steel in Peoria, Illinois, utilize the eurodollar market to
minimize its financing costs? This firm is a medium-size manufacturer with no foreign
sales.
6. Assume that the interest rate on 12-month US dollar deposits in London is currently
2.6875 percent per year and the rate on British pound deposits there is 4.1875 percent
per year. The spot exchange rate is US $1.93/pound. What do you expect the exchange
rate to be in one year?
7. If you were offered the opportunity to establish a deposit in London-denominated in
euros, would you choose that rather than a deposit in British pounds or dollars? Why
or why not?
8. What are the important differences between the Bretton Woods fixed exchange rate
system and the current IMF system? How do these differences affect the MNE
manager?
The IMF system today differs dramatically from the model established at Bretton Woods in
1944. Flexible exchange rates have been substituted for fixed ones; gold has been greatly
9. How may the International Monetary Fund affect companies activities in
international business?
10. How would you hedge the value of your export sale of 10 million of computers to a
French customer? You will be paid in 180 days in euros. On what basis would you
choose among hedging methods?
Rugman and Collinson, International Business, 6th edition, Instructor’s Manual
Answers to real cases
HSBC
1. Since HSBC does business with the Peoples Republic of China and has substantial
holdings of Chinese yuan (renminbi) on hand, what risk does this pose for the bank?
2. How could HSBC manage its currency exchange rate risk?
3. As the British retail banks are merged to achieve cost savings and economies, does this
increase or decrease the barriers to entry for foreign banks wishing to do business in
the EU?
The merger of British retail banks might make it more difficult for small foreign banks to
World financial crises
1. How does a decrease in the value of the Mexican peso affect foreign direct investment?
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2. How is trade affected by currency devaluations as a result of a financial crisis?
3. How are customers in countries undergoing a financial crisis affected by the
devaluation of the peso?