Chapter 3 International Financial Markets Chapter learning objectives: Upon completion of this chapter, you will be able to describe the background and corporate use of the following international financial markets: Foreign exchange marketInternational money marketInternational credit marketInternational bond market, andInternational stock markets. 1.0 Introduction The growth in international business over the last 3 decades has led to the development of various international financial markets. Financial managers of MNCs need to understand these international financial markets in order to facilitate their international business transactions. 1.1 Foreign Exchange Market When MNCs and individuals engage in international transactions, they commonly need to exchange their local currency for a foreign currency or exchange a foreign currency for their local currency. The foreign exchange market allows for the exchange of one currency for another. Large commercial banks serve this market by holding inventories of each currency so that they can accommodate requests by individuals or MNCs for currency for various transactions. At any point in time, there is an exchange rate between any two currencies that specifies the rate at which one currency can be exchanged for another. In essence, the exchange rate represents the price at which one currency can be purchased with another currency. For example, if the exchange rate of the Mexican peso is $0.10, the cost of your spring break hotel in Mexico that charges 700 pesos per night would be 700 x $0.10 = $70. So, if the exchange rate was higher (e.g., 1 peso = $0.11), then your cost in dollars would be higher. 1.1.1 Foreign Exchange Transactions The largest foreign exchange trading centers are in London, New York, and Tokyo, but foreign exchange transactions occur on a daily basis in cities around the world. London accounts for about 33 percent of the trading volume and New York City for about 20 percent. Hence these two markets control more than half the currency trading in the world. Foreign Exchange Dealers – Forex dealers serve as intermediaries in the foreign exchange market by exchanging currencies desired by MNCs or individuals. Foreign exchange dealers include large commercial banks such as Citigroup, JPMorgan Chase & Co., Barclays (UK), UBS (Switzerland), and Deutsche Bank (Germany). These dealers have branches in most major cities and also facilitate foreign exchange transactions with an online trading service. Dealers that rely exclusively on online trading to facilitate forex transactions include FX Connect, OANDA (Canada), and XE.com (Canada). Customers establish an online account and can interact with the foreign exchange dealer’s website to transmit their foreign exchange order. In recent years, new trading platforms have been established that allow some MNCs to engage in foreign exchange transactions directly with other MNCs, thereby eliminating the need for a foreign exchange dealer. Spot Market – The most common type of foreign exchange transaction is for immediate exchange. The market where these transactions occur is known as the spot market. The exchange rate at which one currency is traded for another in the spot market is known as the spot rate. Spot Market Structure – Commercial transactions in the spot market are often completed electronically with banks or other financial institutions serving as intermediaries. The exchange rate at the time determines the amount of funds necessary for the transaction. Example 1 – Indiana Co. (U.S.) purchases supplies priced at 100,000 euros (€) from Belgo (Belgium supplier) on the first day of every month. Indiana instructs its bank to transfer funds from its account to Belgo’s account on the first day of each month. It only has dollars in its account, whereas Belgo’s account is denominated in euros. When payment was made last month, the euro was worth $1.08; hence Indiana Co. needed $108,000 to pay for the supplies (€100,000 x $1.08 = $108,000). The bank reduced Indiana’s account balance by $108,000, which was exchanged at the bank for €100,000. The bank then sent the €100,000 electronically to Belgo by increasing Belgo’s account balance by €100,000. Today, a new payment needs to be made. The euro is currently valued at $1.12, so the bank will reduce Indiana’s account balance by $112,000 (€100,000 x $1.12 = $112,000) and exchange it for €100,000, which will be sent electronically to Belgo. In this way, the bank not only executes the transactions but also serves as the foreign exchange dealer. Each month the bank receives dollars from Indiana Co. in exchange for the euros it provides. In addition, the bank facilitates other transactions for MNCs in which it receives euros in exchange for dollars. The bank maintains an inventory of euros, dollars, and other currencies to facilitate these foreign exchange transactions. If the transactions cause it to buy as many euros as it sells to MNCs, then its inventory of euros will not change. However, if the bank sells more euros than it buys, then its inventory of euros will be reduced. If a bank begins to experience a shortage of a particular foreign currency, it can purchase that currency from other banks. This trading between banks occurs in what is often referred to as the interbank market. Spot Market Liquidity – The spot market for each currency is characterized by its liquidity, which reflects the level of trading activity. The more buyers and sellers there are for a currency, the more liquid the market for that currency is. The spot markets for heavily traded currencies such as the euro, the pound, and the yen are extremely liquid. In contrast, the spot markets for currencies of less developed countries are much less liquid. A currency’s liquidity affects the ease with which it can be bought or sold by an MNC. If a currency is illiquid, then the number of willing buyers and sellers is limited and so an MNC may be unable to purchase or sell that currency in a timely fashion and at a reasonable exchange rate. Bid/Ask Spread of Banks – Commercial banks charge fees for conducting foreign exchange transactions, hence they buy a currency from customers at a slightly lower price than the price at which they sell it. This means that a bank’s bid price (buy quote) for a foreign currency will always be less than its ask price (sell quote). The difference between the bid and ask prices is known as the bid/ask spread, which is meant to cover the costs associated with fulfilling requests to exchange currencies. A larger bid/ ask spread generates more revenue for commercial banks but represents a higher cost to individuals or MNCs that engage in foreign exchange transactions. The bid/ask spread is normally expressed as a percentage of the ask quote. Example 2 – To understand how a bid/ask spread could affect you, assume you have $1,000 and plan to travel from the United States to the United Kingdom. Assume further that the bank’s bid rate for the British pound is $1.52 and its ask rate is $1.60. Before leaving on your trip, you go to this bank to exchange dollars for pounds. Your $1,000 will be converted to £625, as follows: Amount of U.S dollars to be converted=$1,000=£625Price charged by bank per pound (ask price)$1.60 Now suppose that an emergency prevents you from taking the trip and so you now want to convert the £625 back into U.S. dollars. If the exchange rate has not changed, then you will receive only: £625 x (Bank’s bid rate of $1.52 per pound) = $950 Because of the bid/ask spread, you have $50 (5 percent) less than when you started. Comparison of Bid/Ask Spread among Currencies – The difference between a bid quote and an ask quote (bid/ask spread) in percentage can be calculated using the following formular: Bid/Ask spread=Ask rate – Bid rateAsk rate Example – Computation of the Bid/Ask Spread: CURRENCYBID RATEASK RATEAsk rate – Bid rate=BID/ASK % SPREADAsk rateBritish pound$1.52$1.60$1.60 – $1.52=0.05 or 5%$1.60Japanese yen$0.0070$0.0074$0.0074 – $0.0070=0.054 or 5.4%$0.0074 Factors That Affect the Spread – The spread on currency quotations is influenced by the following factors: ■ Order costs – Order costs are the costs of processing orders; these costs include clearing costs and the costs of recording transactions. ■ Inventory costs – Inventory costs are the costs of maintaining an inventory of a particular currency. Holding an inventory involves an opportunity cost because the funds could have been used for some other purpose. If interest rates are relatively high, then the opportunity cost of holding an inventory should be relatively high. The higher the inventory costs, the larger the spread that will be established to cover these costs. ■ Competition – The more intense the competition, the smaller the spread quoted by intermediaries. Competition is more intense for the more widely traded currencies because there is more business in those currencies. The establishment of trading platforms that allow MNCs to trade directly with each other is a form of competition against foreign exchange dealers, and it has forced dealers to reduce their spread in order to remain competitive. ■ Volume – Currencies that are more liquid are less likely to experience a sudden change in price. Currencies that have a large trading volume are more liquid because there are numerous buyers and sellers at any given time. This means that the market has enough depth that a few large transactions are unlikely to cause the currency’s price to change abruptly. ■ Currency risk – Some currencies exhibit more volatility than others because of economic or political conditions that cause the demand for and supply of the currency to change abruptly. For example, currencies in countries that have frequent political crises are subject to sudden price movements. Intermediaries that are willing to buy or sell these currencies could incur large losses due to such changes in their value. 1.1.2 Foreign Exchange Quotations Exchange rate quotations for widely traded currencies, and even for many currencies that are not widely traded, are readily available on the Internet. They can be found at financial websites, at the websites of newspapers such as the Wall Street Journal, at the websites of foreign exchange dealers, and even by simply typing “euro-dollar exchange rate” or whatever exchange rate is wanted into a web browser. The rates are frequently updated as the exchange rates change throughout the day. At any moment in time, the exchange rate between two currencies should be similar across the various banks that provide foreign exchange services. If there is a large discrepancy, then customers (or other banks) could profit from purchasing a large amount of the currency from the low-quoting bank and immediately selling it to the high quoting bank. These actions would cause the low-quoting bank to quickly experience a shortage of that currency, while the high-quoting bank would quickly experience an excessive amount of that currency because it was willing to pay too much for the currency. As a result, the banks would rapidly adjust their exchange rate quotations, eliminating any discrepancy between the quotations. Direct versus Indirect Exchange Rates (Direct vs Indirect Quote) – The quotations of exchange rates for currencies normally reflect the ask prices for large transactions. Quotations that report the value of a foreign currency in dollars (number of dollars per unit of other currency) are referred to as direct quotations, whereas quotations that report the number of units of a foreign currency per dollar are known as indirect quotations. For example, if you type, “euro-dollar exchange rate” into your web browser, the result will be 1 euro = x dollars, which is a direct quotation. However, if you search for “dollar-euro exchange rate,” the result will be 1 dollar = x euros, which is an indirect quotation. Websites that provide exchange rates allow you to readily switch between direct and indirect quotations. An indirect quotation is the reciprocal (inverse) of the corresponding direct quotation. Example – If the spot rate of the euro is quoted at $1.25, this is a direct quotation because it represents the value of the foreign currency in dollars. The indirect quotation of the euro is the reciprocal of the direct quotation: Indirect quotation = 1/ (Direct quotation) = 1/$1.25 = 0.80 euro, meaning 0.80 euros = $1 If you initially received the indirect quotation, then you can take its inverse to obtain the direct quote. The direct quotation of the euro is the reciprocal of the indirect quotation: Direct quotation = 1/ Indirect quotation = 1/0.80 = $1.25 From the above examples of direct and indirect exchange rates, it follows that, if a currency’s direct exchange rate is rising over time, then its indirect exchange rate must be declining over time (and vice versa). Cross Exchange Rates – Most tables of exchange rate quotations express currencies relative to the U.S. dollar, but in some instances, a firm will be interested in the exchange rate between two non-dollar currencies. Cross Exchange Rates is the amount of one foreign currency per unit of another foreign currency. The relative value of any two non-dollar currencies is equal to the dollar value of one currency divided by the dollar value of the other. For example, suppose that a U.S. firm that trades with both Canada and Mexico has a large supply of Canadian dollars, but now it needs Mexican pesos to buy Mexican goods. The firm wants to use its Canadian dollars to obtain the pesos, so it needs to know the Mexican peso value relative to the Canadian dollar. Example – Suppose at the start of a month the peso is worth $0.12 (1 peso = $0.12) and the Canadian dollar is worth $0.66 (C$1 = $0.66). Calculate the value of one peso in Canadian dollars (C$): Value of peso in C$=Value of peso in $=$0.12Value of C$ in $$0.66 = C$0.182 Therefore, 1 Mexican peso is worth about C$0.182. The cross-exchange rate can also be expressed as the number of pesos that equal a single Canadian dollar. This figure can be computed by taking the reciprocal: 0.66/0.12 = 5.5, meaning 1 Canadian dollar is worth 5.5 pesos. 1.1.3 Derivative Contracts in the Foreign Exchange Market A currency derivative is a contract whose price is derived from the value of an underlying currency. Derivatives are used by MNCs to: Speculate on future exchange rate movements.Hedge exposure to exchange rate risk. The 3 types of currency derivatives often used by MNCs are – forward contracts, currency futures contracts, and currency options contracts. Forward Contracts – Is an agreement between two counterparties (e.g., MNC and a foreign exchange dealer) that specifies the quantity (amount) of currency to be exchanged, the exchange rate, and the date at which the transaction will occur. The forward rate is the exchange rate, specified in the forward contract, at which the currencies will be exchanged. In some cases, a MNC may prefer to lock in an exchange rate at which it can obtain a currency in the future. MNCs commonly request forward contracts to hedge future payments that they expect to make or receive in a foreign currency. In this way, they do not have to worry about fluctuations in the spot rate until the time of their future payments. Example – Today, Memphis Co (U.S.) has ordered from European countries some supplies whose prices are denominated in euros. It will receive the supplies in 90 days and will need to make payment at that time. It expects the euro to increase in value over the next 90 days and therefore desires to hedge its payables in euros. Memphis buys a 90-day forward contract on euros to lock in the price that it will pay for euros at a future time. Meanwhile, Memphis will receive Mexican pesos in 180 days because of an order it received from a Mexican company today. It expects that the peso will decrease in value over this period and wants to hedge these receivables. Memphis sells a forward contract on pesos to lock in the dollars that it will receive when it exchanges the pesos at a specified time in the future. The forward market is the market in which forward contracts are traded. It is an over-the-counter market, and its main participants are the foreign exchange dealers and the MNCs that wish to obtain a forward contract. Many MNCs use the forward market to hedge their payables and receivables. For example, Google, Inc., normally has forward contracts in place that are valued at more than $1 billion. Currency Futures Contracts – Futures contracts are similar to forward contracts but are sold on an exchange instead of over the counter. A currency futures contract specifies a standard volume of a particular currency to be exchanged on a specific settlement date. Some MNCs involved in international trade use the currency futures markets to hedge their positions. The futures rate is the exchange rate at which one can purchase or sell a specified currency on the settlement date in accordance with the futures contract. Hence the futures rate’s role in a futures contract is similar to the forward rate’s role in a forward contract. Currency Options Contracts – Currency options contracts can be classified as calls or puts. A currency call option provides the right to buy a specific currency at a specific price (called the strike price or exercise price) within a specific period of time. It is used to hedge future payables. A currency put option provides the right to sell a specific currency at a specific price within a specific period of time. It is used to hedge future receivables. Currency call and put options can be purchased on an exchange. They offer more flexibility than forward or futures contracts because they are not obligations. That is, the firm can elect not to exercise the option. Although most MNCs use forward contracts, many also use currency options. 1.2 International Money Market Each country has a money market whereby surplus units (individuals or institutions with available short-term funds) can transfer funds to deficit units (institutions or individuals in need of funds). Financial institutions such as commercial banks serve the international money market by accepting deposits from surplus and redirecting the funds toward deficit units by providing loans in various currencies. The international money market has developed to accommodate the needs of MNCs as follows: (i). MNCs borrow short-term funds in different currencies to pay for imports denominated in those currencies. (ii). MNCs that need funds to support local operations may consider borrowing in a non-local currency that exhibits lower interest rates. This strategy is especially appropriate for firms expecting future receivables denominated in that currency. (iii). MNCs may consider borrowing in a currency that they anticipate will depreciate against their home currency, as this would enable them to repay the short-term loan at a more favorable exchange rate. In this case, the actual cost of borrowing would be less than the interest rate quoted for that currency. 1.3 International Credit Market MNCs and domestic firms sometimes obtain medium-term funds via term loans from local financial institutions or by issuing notes (medium-term debt obligations) in their local markets. However, MNCs also have access to medium-term funds through banks located in foreign markets. Loans of one year or longer that are extended by banks to MNCs or government agencies in Europe are commonly called Euro-credits or Euro-credit loans, which are transacted in the Euro-credit market. These loans can be denominated in dollars or in one of many other currencies, and their typical maturity is five years. Borrowers usually prefer those loans be denominated in the currency of the country in which they receive most of their cash flows, which eliminates the borrower’s exchange rate risk. International credit market activity has increased over time, yet the growth is mostly concentrated in regions where economic conditions are relatively strong. Those regions tend to have more funds deposited by MNCs as well as a strong demand for loans by MNCs that are expanding their business. Conversely, lending tends to decline in regions where economic conditions are weak because MNCs are less willing to expand and thus do not borrow additional funds. Banks then are also less willing to grant loans because credit risk is higher in regions where economic conditions are weak. 1.3.1 Syndicated Loans in the Credit Market Sometimes a single bank is unwilling or unable to lend the amount needed by a particular corporation or government agency. In this case, a syndicate of banks may be organized. Each bank within the syndicate participates in the lending. A lead bank is responsible for negotiating terms with the borrower, after which this bank organizes a group of banks to underwrite the loans. For each bank involved, syndicated loans reduce the exposure to default risk to the extent of individual bank’s participation. Borrowers that receive a syndicated loan incur various fees besides the interest on the loan. Syndicated loans can be denominated in different currencies. The interest rate depends on the currency the loan is denominated in, loan’s maturity, and creditworthiness of the borrower. Interest rates on syndicated loans are usually adjusted to reflect movements in market interest rates (such as an interbank lending rate), and the adjustment may occur every six months or every year. 1.3.2 Impact of the Credit Crisis In 2008, the United States experienced a credit crisis that affected the international credit market. The credit crisis was triggered by the substantial defaults on subprime (lower- quality) mortgages. Financial institutions in other countries, such as the United Kingdom, had also offered subprime mortgage loans and experienced high default rates. Because of the global integration of financial markets, the problems in the U.S. and U.K. financial markets spread to other markets. Some financial institutions based in Asia and Europe were common purchasers of subprime mortgages that originated in the United States and United Kingdom. Furthermore, the resulting weakness of the U.S. and European economies reduced their demand for imports from other countries. Thus the U.S. credit crisis blossomed into an international credit crisis and increased concerns about credit risk in international markets. Creditors reduced the amount of credit that they were willing to provide, and some MNCs and government agencies were not able to obtain funds in the international credit market. 1.4 International Bond Market The international bond market facilitates the flow of funds between borrowers who need long-term funds and investors who are willing to supply long-term funds. Major investors in the international bond market include institutional investors such as commercial banks, mutual funds, insurance companies, and pension funds from many countries. Institutional investors may prefer to invest in international bond markets, rather than in their respective local markets, when they can earn a higher return on bonds denominated in foreign currencies. Borrowers in the international bond market include both national governments and MNCs. MNCs can obtain long-term debt by issuing bonds in their local markets, and they can also access long-term funds in foreign markets. MNCs may choose to issue bonds in the international bond markets for three reasons: (i). To attract a stronger demand by issuing their bonds in a particular foreign country rather than in their home country. Some countries have a limited investor base, so MNCs in those countries naturally seek financing elsewhere. (ii). To finance a specific foreign project in a particular currency and thus may seek funds where that currency is widely used. (iii). To finance projects in a foreign currency with a lower interest rate in order to reduce its cost of financing, although doing so would increase its exposure to exchange rate risk. An international bond issued by a borrower foreign to the country where the bond is placed is known as a foreign bond. For example, a U.S. company may issue a bond denominated in Japanese yen that is sold to investors in Japan. 1.4.1 Eurobond Market Eurobonds are bonds sold in countries other than the country whose currency is used to denominate the bonds. They have become popular as a means of attracting funds because they circumvent registration requirements and avoid some disclosure requirements. Hence these bonds can be issued quickly and at a low cost. Eurobonds are underwritten by a multinational syndicate of investment banks and are simultaneously placed in many countries, providing a wide spectrum of fund sources to tap. U.S.-based MNCs such as McDonald’s and Walt Disney commonly issue Eurobonds, and non-U.S. firms (e.g., Guinness, Nestlé, Volkswagen) also use the Eurobond market as a source of funds. Those MNCs without a strong credit record may have difficulty obtaining funds in the Eurobond market because the limited disclosure requirements may discourage investors from trusting unknown issuers. Denominations – Eurobonds are denominated in a number of currencies. The U.S. dollar is used most often, accounting for 70 to 75 percent of Eurobonds., However, in 2015, some U.S.-based MNCs including Coca-Cola, BlackRock, AT&T, and Kinder Morgan, issued Eurobonds denominated in euros to take advantage of the low interest rates in the eurozone. Similarly, some firms have issued debt denominated in Japanese yen in order to take advantage of Japan’s extremely low interest rates. Because credit conditions and the interest rates for each currency change constantly, the popularity of particular currencies in the Eurobond market changes over time. 1.4.2 Risk of International Bonds From the perspective of investors, international bonds are subject to four forms of risks: interest rate riskexchange rate riskliquidity risk, andcredit (default) risk. Interest Rate Risk – The interest rate risk of international bonds is the potential for their value to decline in response to rising long-term interest rates. When long-term interest rates rise, the required rate of return by investors rises. Therefore, the valuations of bonds decline. Interest rate risk is more pronounced for fixed rate than for floating rate bonds because the coupon rate remains fixed on fixed-rate bonds even when interest rates rise. Exchange Rate Risk – Exchange rate risk is the potential for a bond’s value to decline (from the investor’s perspective) because the currency denominating the bond depreciates against the investor’s home currency. As a result, the future expected coupon or principal payments to be received from the bond may convert to a smaller amount of the investor’s home currency. Liquidity Risk – Liquidity risk of bonds represents the potential for their prices to be lower at the time they are sold by investors because no consistently active market exists for them. Consequently, investors who wish to sell the bonds may have to lower their price in order to attract potential buyers. Credit Risk – The credit risk of international bonds is the potential for default – interest and/or principal payments to investors to be suspended either temporarily or permanently. This risk is especially relevant in countries where creditor rights are limited, because creditors may be unable to require that debtor firms take the actions necessary to enable debt repayment. As the credit risk of the issuing firm increases, the risk premium required by investors also increases. Any investors who want to sell their holdings of the bonds under these conditions must sell the bonds for a lower price to compensate potential buyers for the credit risk. 1.5 International Stock Markets Just as some MNCs issue stock outside their home country, many investors purchase stocks outside their home country. Below are some of the reasons MNCs and investors purchase stocks outside their home country: (i). Investors may expect favorable economic conditions in a particular country and therefore invest in stocks of the firms in that country. (ii). Investors may wish to acquire stocks denominated in currencies that they expect to strengthen over time, because that would enhance the return on their investment. (iii). Some MNCs invest in stocks of other countries as a means of diversifying their portfolio. Hence their investment is less sensitive to possible adverse stock market conditions in their home country. 1.5.1 Issuance of Stock in Foreign Markets MNCs may issue stock in foreign markets for various reasons. MNCs may more readily attract funds from foreign investors by issuing stock in international markets. They have their stock listed on an exchange in any country where they issue shares, because investors in a foreign country are only willing to purchase stock if they can later easily sell their holdings locally in the secondary market. The stock is denominated in the currency of the country where it is placed. A MNC’s stock offering may be more easily digested when it is issued in several markets. The stocks of some U.S.-based MNCs are widely traded on numerous stock exchanges around the world, which gives non-U.S. investors easy access to those stocks and also gives the MNCs global name recognition. Many MNCs issue stock in a country where they will generate enough future cash flows to cover dividend payments. 1.5.2 Issuance of Foreign Stock in the United States Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are called Yankee stock offerings) because the U.S. new-issues market is so liquid. Because many financial institutions in the United States purchase non-U.S. stocks as investments, non-U.S. firms may be able to place an entire stock offering in the United States. By issuing stock in the United States, non-U.S. firms may diversify their shareholder base; this can lessen the share price volatility induced by large investors selling shares. Many of the recent stock offerings in the United States by non-U.S. firms have resulted from privatization programs in Latin America and Europe. 1.6 How Financial Markets Serve MNCs The foreign cash flow movements of a typical MNC can be classified into four corporate functions, all of which generally require use of the foreign exchange markets (spot market, forward market, currency futures market, and currency options market): Foreign trade with business clients. Exports generate foreign cash inflows while imports require cash outflows.Direct foreign investment, or the acquisition of foreign real assets. This function requires cash outflows but generates future inflows either through remitted earnings back to the MNC or through the sale of these foreign assets.Short-term investment or financing in foreign securities in the international money market.Longer-term financing in the international bond or stock markets. A MNC may use international money or bond markets to obtain funds at a lower cost than they can be obtained locally.
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