Chapter-03 International Financial Markets

8/6/2019 Chapter-03 International Financial Markets

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International Financial MarketsInternational Financial Markets

33ChapterChapter

Mohammed Sohail Mustafa, Faculty, NSU


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Motives for Using International

Financial Markets

The markets for real or financial assets areprevented from complete integration by barriers

such as tax differentials, tariffs, quotas, laborimmobility, communication costs, cultural

differences, and financial reporting differences.

Yet, these barriers can also create unique

opportunities for specific geographic markets thatwill attract foreign investors.


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Investors invest 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 Investing inInternational Financial Markets


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Creditors provide credit in foreign markets: to capitalize on higher foreign interest rates;

when they expect foreign currencies to appreciate

against their own; and

to reap the benefits of international diversification.

Motives for Providing Credit inInternational Financial Markets


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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 Borrowing inInternational Financial Markets


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Foreign Exchange Market

The foreign exchange market allows currencies tobe exchanged in order to facilitate international

trade or financial transactions.

The system for establishing exchange rates hasevolved over time.

From 1876 to 1913, each currency was convertible

into gold at a specified rate, as dictated by the gold

standard.


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Foreign Exchange Market..contd.

This was followed by a period of instability, as World War I

began and the Great Depression followed.

The 1944 Bretton Woods Agreement called for fixedcurrency exchange rates.

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

Smithsonian Agreement devalued the U.S. dollar and

widened the boundaries for exchange rate fluctuations from

1% to 2%.


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Foreign Exchange Market.contd.

Even then, governments still had difficulties

maintaining exchange rates within the stated

boundaries. In 1973, the official boundaries for themore widely traded currencies were eliminated and

the floating exchange rate system came into effect.


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Major Foreign exchange Instruments

The Spot Market/Spot Rate/Spot Transaction: The duration of the Spot transaction is 2 working days.

The spot rate will be fixed/remain constant for 2 workingdays.

The volume of transaction is relatively small.

Usually tourist, overseas students & the dealer are the main

participants of this market


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Continued--------Major foreign exchange instruments

The Forward Market/Forward Rate/Forward Transaction: The duration of the forward transaction is 180 working days.

The seller of the currency determines the forward rate by

analyzing the the trend of movements of that currency. The forward rate will remain constant for maximum 180

working days.

The volume of transaction is relatively large.

Usually importers, exporters & other business peoples & the

dealer are the main participants of this market. A forward premium is charged at the time of transaction.


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Continued--------Major foreign exchange instruments

Options: An option is the right but not the obligation to buy or sella foreign currency within a certain time period or on a specific

exchange rate. An option can be purchased from both the OTC &

ETM. The option provides the company flexibility, because it can

walk away from th

e option if th

e strike price is not a good price. Futures: A foreign currency future resembles a forward contract

insofar as it specifies an exchange rate sometime in advance of the

actual exchange of currency. However a future is traded on an

ETM, not an OTC. Instead of working with bankers, company

likes to work with the exchange brokers when purchasing futurecontracts.


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1. competitiveness of quote

2. special relationship between the bank and its

customer

3. speed of execution

4. advice about current market conditions

5. forecasting advice

The Attributes ofBanks thatProvide Foreign Exchange


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Criteria to Select t

he top Foreign Exc

hange

Traders

Trade in specific Market locations.

Capability to handle major currencies; such as: US$, Euro.

Capability to handle major cross-trades; such as: betweeneuro& pound, or, euro & yen.

Capability to handle specific currencies.

Capability to handle derivatives (forwards, swaps, futures)

Capability to engage in market research.


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Banks provide foreign exchange services for a fee:the banks bid (buy) quote for a foreign currency

will be less than its ask (sell) quote. This is thebid/ask spread.

bid/ask % spread = ask rate bid rateask rate

Example: Suppose bid price for = $1.52, askprice = $1.60.

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

Foreign ExchangeTransactions


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The bid/ask spread is normally larger for thosecurrencies that are less frequently traded.

The spread is also larger for retail transactionsthan for wholesale transactions between banks or

large corporations.

Foreign ExchangeTransactions


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Interpreting Foreign Exchange Quotations

Exchange rate quotations for widely traded currencies arefrequently listed in the news media on a daily basis. Forward

rates may be quoted too.

The quotations normally reflect the ask prices for large

transactions. Direct quotations represent the value of a foreign currency in

dollars, while indirect quotations represent the number of units

of a foreign currency per dollar.

Note that exchange rate quotations sometimes include IMFsspecial drawing rights (SDRs).

The same currency may also be used by more than onecountry.


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A cross exchange rate reflects the amount of oneforeign currency per unit of another foreign

currency.

Value of 1 unit of currency A in units of currency B= value of currency A in $

value of currency B in $

Interpreting

Foreign Exchange Quotations.contd.


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Currency Futures and Options Market

A currency futures contract specifies a standardvolume of a particular currency to be exchanged on

a specific settlement date. Unlike forward contractshowever, futures contracts are sold on exchanges.

Currency options contracts give the right to buy orsell a specific currency at a specific price within a

specific period of time.Th

ey are sold on exch

angestoo.


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$$Eurocurrency Market U.S. dollar deposits placed in banks in Europe and

other continents are called Eurodollars.

In the 1960s and 70s, the Eurodollar market, orwhat is now referred to as the Eurocurrency market,

grew to accommodate increasing international

business and to bypass stricter U.S. regulations on

banks in the U.S.


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$$Eurocurrency Marketcontd. The Eurocurrency market is made up of several

large banks called Eurobanks that accept deposits

and provide loans in various currencies.

For example, the Eurocurrency market hashistorically recycled the oil revenues (petrodollars)

from oil-exporting (OPEC) countries to other

countries.


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Although the Eurocurrency market focuses onlarge-volume transactions, there are times when no

single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed to

underwrite the loans. Front-end management and

commitment fees are usually charged for such

syndicated Eurocurrency loans.

$$Eurocurrency Marketcontd.


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The recent standardization of regulations aroundthe world has promoted the globalization of the

banking industry. In particular, the Single European Act has opened

up the European banking industry.

The 1988 Basel Accord signed by G-10 central

banks outlined common capital standards, such asthe structure of risk weights, for their banking

industries.

$$Eurocurrency Marketcontd.


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$$ The Eurocurrency market in Asia is sometimes

referred to separately as the Asian dollar market.

The primary function of banks in the Asian dollarmarket is to channel funds from depositors to

borrowers.

Another function is interbank lending and

borrowing.

Eurocurrency Marketcontd.


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LOANSLOANS

Eurocredit Market

Loans of one year or longer are extended byEurobanks to MNCs or government agencies in the

Eurocredit market. These loans are known asEurocredit loans.

Floating rates are commonly used, since the banksasset and liability maturities may not match -

Eurobanks accept short-term deposits but

sometimes provide longer term loans.


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Eurobond Market

There are two types of international bonds.

Bonds denominated in the currency of the country

where they are placed but issued by borrowers

foreign to the country are called foreign bonds or

parallel bonds.

Bonds that are sold in countries other than the

country represented by the currency denominating

them are called Eurobonds.

BONDSBONDS


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The emergence of the Eurobond market is partially due tothe 1963 Interest Equalization Tax imposed in the U.S.

The tax discouraged U.S. investors from investing in foreignsecurities, so non-U.S. borrowers looked elsewhere for

funds.

Then in 1984, U.S. corporations were allowed to issue bearerbonds directly to non-U.S. investors, and the withholding tax

on bond purchases was abolished.

Eurobond Marketcontd.BONDSBONDS


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Eurobond Marketcontd.

Eurobonds are underwritten by a multi-nationalsyndicate of investment banks and simultaneously

placed in many countries through second-stage, andin many cases, third-stage, underwriters.

Eurobonds are usually issued in bearer form, payannual coupons, may be convertible, may have

variable rates, and typicallyh

ave few protectivecovenants.

BONDSBONDS


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Interest rates for each currency and creditconditions in the Eurobond market change

constantly, causing the popularity of the market tovary among currencies.

About 70% of the Eurobonds are denominated inthe U.S. dollar.

In the secondary market, the market makers areoften the same underwriters who sell the primary

issues.

Eurobond Marketcontd.BONDSBONDS


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Comparing Interest Rates Among Currencies

Interest rates vary substantially for different countries, rangingfrom about 1% in Japan to about 60% in Russia.

Interest rates are crucial because they affect the MNCs cost offinancing.

The interest rate for a specific currency is determined by thedemand for and supply of funds in that currency.

As the demand and supply schedules change over time for aspecific currency, the equilibrium interest rate for that currency

will also change.

Note that the freedom to transfer funds across countries causesthe demand and supply conditions for funds to be somewhat

integrated, such that interest rate movements become integrated

too.


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International Stock Markets

In addition to issuing stock locally, MNCs can alsoobtain funds by issuing stock in international

markets.

This will enhance the firms image and namerecognition, and diversify the shareholder base. The

stocks may also be more easily digested.

Note that market competition should increase theefficiency of new issues.


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Stock issued in the U.S. by non-U.S. firms orgovernments are called Yankee stock offerings.

Many of such recent stock offerings resulted fromprivatization programs in Latin America and

Europe.

Non-U.S. firms may also issue American depository

receipts (ADR

s), wh

ich

are certificates representingbundles of stock. ADRs are less strictly regulated.

International Stock Marketscontd.


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The locations of the MNCs operations caninfluence the decision about where to place stock, in

view of the cash flows needed to cover dividendpayments.

Market characteristics are important too. Stockmarkets may differ in size, trading activity level,

regulatory requirements, taxation rate, andproportion of individual versus institutional share

ownership.



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Electronic communications networks (ECNs) havebeen created to match orders between buyers and

sellers in recent years.

As ECNs become more popular over time, they mayultimately be merged with one another or with

other exchanges to create a single global stock

exchange.



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Comparison of

International Financial Markets

The foreign cash flow movements of a typical MNCcan be classified into four corporate functions, all of

which generally require the use of the foreignexchange markets.

Foreign trade. Exports generate foreign cash

inflows while imports require cash outflows.


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Comparison of

International Financial Marketscontd.

Direct foreign investment (DFI). Cash outflows to

acquire foreign assets generate future inflows.

Short-term investment or financing in foreign

securities, usually in the Eurocurrency market.

Longer-term financing in the Eurocredit,

Eurobond, or international stock markets.


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Impact of Global Financial Marketson an MNCs Value

? A

v!n

tt

m

j tjtj

k1=

1

,,

1

ERECFE

=Value

E (CFj,t) = expected cash flows in currencyjto be received by

the U.S. parent at the end of period t

E (ERj,t) = expected exchange rate at which currencyjcan be

converted to dollars at the end of period t

k = weighted average cost of capital of the parent

Cost of parents funds

borrowed in global markets

Cost of borrowing funds inglobal markets

Improved global image fromissuing stock in global markets

Cost of parents equity in

global markets

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Chapter-03 International Financial Markets