Madura: International Financial Management

Chapter 3

Chapter

International Financial Markets

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This topic identifies and discusses the

various international financial markets used by MNCs.

The international financial markets facilitate

day-to-day operations of MNCs, including foreign exchange transactions, investing in foreign markets, and borrowing in foreign markets.

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Motives for Using International Financial Markets

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.

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Motives for Using International Financial Markets

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 diversification. to capitalize on lower foreign interest rates; and when they expect foreign currencies to depreciate against their own.
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Borrowers borrow in foreign markets:

Foreign Exchange Market

The foreign exchange market allows currencies
to be exchanged in order to facilitate international trade or financial transactions.

The system for exchanging foreign currencies

has evolved from the gold standard (1876-1913), to agreements on fixed exchange rates (19441971), to a floating rate system (1973 onward).

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Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour

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Foreign Exchange Transactions

The market for immediate exchange is
known as the spot market.

Trading between banks occurs in the

interbank market. Within this market, brokers sometimes act as intermediaries.

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Foreign Exchange Transactions

The forward market enables an MNC to lock in
the exchange rate at which it will buy or sell a certain quantity of currency on a specified future date.

Customers in need of foreign exchange are

concerned with quote competitiveness, special banking relationship, speed of execution, advice about current market conditions, and forecasting advice.
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Foreign Exchange Transactions

Banks provide foreign exchange services
for a fee: a banks bid (buy) quote for a foreign currency will be less than its ask (sell) quote. bid/ask spread = ask rate bid rate ask rate Example Suppose bid price for = $1.52, ask price = $1.60.

Spread = (1.60 1.52) = .05 or 5% 1.60

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Factors That Affect the Spread

1. Order costs: Costs of processing orders, including clearing
costs and the costs of recording transactions.

2. Inventory costs: Costs of maintaining an inventory of a

particular currency.

3. Competition: The more intense the competition, the smaller

the spread quoted by intermediaries.

4. Volume: Currencies that have a large trading volume are

more liquid because there are numerous buyers and sellers at any given time.

5. Currency risk: Economic or political conditions that cause

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the demand for and supply of the currency to change abruptly.

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Interpreting Foreign Exchange Quotations

The exchange rate quotations published in
newspapers normally reflect the ask prices for large transactions.

Direct quotations represent the value of a

foreign currency in terms of the home currency (eg or euro), while indirect quotations represent the number of units of a foreign currency per unit of home currency.
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Interpreting Foreign Exchange Quotations

Notation
$1.6 to the 1 can be written as: $1.6/ or $1.6:1

and treated as $1.6 = 1

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Interpreting Foreign Exchange Quotations

Indirect quotation = 1 Direct quotation

So with the RM as the home currency $0.2632 / RM1 = 1 / (RM3.8 / $1)

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Interpreting Foreign Exchange Quotations

A cross exchange rate reflects the amount of
one foreign currency per unit of another foreign currency. Example Direct quote: $1.5:1, $.009:1 Indirect quote: 0.67:$1, 111.11:$1

Value of in = value of in $ value of in $ = $1.50:1 = 166.67:1 $.009:1

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Currency Derivatives
1. Forward Contracts: agreements between a foreign exchange dealer and an MNC that specifies the currencies to be exchanged, the exchange rate, and the date at which the transaction will occur.

The forward rate is the exchange rate specified by the forward contract. The forward market is the over-the-counter market where forward contracts are traded.
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Currency Derivatives
2. Futures Contracts: similar to forward contracts but sold on an exchange

Specifies a standard volume of a particular currency to be exchanged on a specific settlement date. The futures rate is the exchange rate at which one can purchase or sell a specified currency on the specified settlement date. The future spot rate is the spot rate that will exist at a future point in time and is uncertain as of today.
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Currency Derivatives
3. Currency Options Contracts
a.

Currency Call Option: provides the right to buy currency at a specified strike price within a specified period of time. Currency Put Option: provides the right to sell currency at specified strike price within a specified period of time.
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b.

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International Money Market

1. Corporations or governments need short-term funds denominated in a currency different from their home currency. 2. The international money market has grown because firms:
a. May need to borrow funds to pay for imports denominated in a foreign currency. b. May choose to borrow in a currency in which the interest rate is lower. c. May choose to borrow in a currency that is expected to depreciate against their home currency
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Origins and Development

1. European Money Market: Dollar deposits in
banks in Europe and other continents are called Eurodollars or Eurocurrency. Origins of the European money market can be traced to the Eurocurrency market that developed during the 1960s and 1970s.

2. Asian Money Market: Centered in Hong Kong and

Singapore. Originated as a market involving mostly dollar-denominated deposits, and was originally known as the Asian dollar market.

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Money Market Interest Rates Among Currencies

The money market interest rates in any particular country are dependent on the demand for short-term funds by borrowers, relative to the supply of available short-term funds that are provided by savers. Money market rates vary due to differences in the interaction of the total supply of short-term funds available (bank deposits) in a specific country versus the total demand for short-term funds by borrowers in that country.
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Risk of International Money Market Securities

International Money Market Securities are debt

securities issued by MNCs and government agencies with a short-term maturity (1 year or less)

Normally, these securities are perceived to be very

safe from the risk of default.

Even if the international money market securities are

not exposed to credit risk, they are exposed to exchange rate risk when the currency denominating the securities differs from the home currency of the investors.
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International Credit Market

MNCs sometimes obtain medium-term funds through
term loans from local financial institutions or through the issuance of notes (medium-term debt obligations) in their local markets.

Loans of 1 year or longer extended by banks to

MNCs or government agencies in Europe are commonly called Eurocredits or Eurocredit loans.

To avoid interest rate risk, banks commonly use

floating rate loans with rates tied to the London Interbank Offer Rate (LIBOR).
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International Credit Market

Sometimes a single bank is unwilling or unable to
lend the amount needed by a particular MNC or government agency.

A lead bank may then organize a syndicate of

banks to underwrite the loan.

Borrowers that receive a syndicated loan typically

incur front-end management and commitment fees, in addition to the interest on the loan.
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Impact of the Credit Crisis on the Credit Market

The credit crisis of 2008 triggered by defaults
in subprime loans led to a halt in housing development, which reduced income, spending, and jobs.

Financial institutions became cautious with

their funds and were less willing to lend funds to MNCs

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International Bond Market

There are two types of international bonds:
Foreign bonds: Bonds denominated in the currency

of the country where they are placed but issued by foreign borrowers.
Eurobonds: Bonds sold in countries other than the

country of the currency in which the bonds denominated. The emergence of the Eurobond market was partly due to the 1963 U.S. Interest Equalization Tax (IET). They have become very popular, perhaps in part because they circumvent registration requirements.
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Risk of International Bonds

Credit Risk - represents the potential for default. Interest Rate Risk - potential for the value of bonds to
decline in response to rising long-term interest rates.

Exchange Rate Risk - represents the potential for the

value of bonds to decline (from the investors perspective) because the currency denominating the bond depreciates against the home currency.

Liquidity Risk - represents the potential for the value of

bonds to decline because there is not a consistently active market for the bonds.
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International Stock Markets

In addition to issuing stock locally, MNCs
can also obtain funds by issuing stock in international markets.

This will enhance the firms image and

name recognition, and diversify their shareholder base.

A stock offering may also be more easily

digested when it is issued in several markets.
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Factors that influence trading activity

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How Financial Markets Serve MNCs

Corporate functions that require foreign exchange markets. Foreign trade with business clients.

Direct foreign investment, or the acquisition of foreign real assets. Short-term investment or financing in foreign securities. Longer-term financing in the international bond or stock markets.
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How Financial Markets Affect an MNCs Value

Since interest rates commonly vary
among countries, an MNC may use the international financial markets to reduce its cost of capital, thereby achieving a higher valuation.

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Questions to Answer
Why do international financial markets
exist?

How do banks serve international financial

markets?

Which international financial markets are

most important to a firm that consistently needs short-term funds? What about a firm that needs long-term funds?
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