International Financial Markets 9

9 - 2 Chapter Objectives Discuss the purposes, development, and financial centers of the international capital market Describe the international bond, international equity, and Eurocurrency markets Discuss the four primary functions of the foreign exchange market Explain how currencies are quoted and the different rates that are given Identify the main instruments and institutions of the foreign exchange market Explain why and how governments restrict currency convertibility

9 - 3 Nintendo Exchange rates affect financial performance Convert foreign earnings into home currency Rising home currency means lower earnings

9 - 4 Capital Market System that allocates financial resources according to their most efficient uses Debt: Repay principal plus interest  Bond has timed principal & interest payments Equity: Part ownership of a company  Stock shares in financial gains or losses

9 - 5 International Capital Market Network of people, firms, financial institutions, and governments borrowing and investing internationally Borrowers  Expands money supply  Reduces cost of money Borrowers  Expands money supply  Reduces cost of money Lenders  Spread / reduce risk  Offset gains / losses Lenders  Spread / reduce risk  Offset gains / losses

9 - 6 International Capital Market Drivers Information technology Deregulation Financial instruments

9 - 7 Country or territory whose financial sector features few regulations and few, if any, taxes Country or territory whose financial sector features few regulations and few, if any, taxes Operational center Extensive financial activity and currency trading Operational center Extensive financial activity and currency trading Booking center Mostly for bookkeeping and tax purposes Booking center Mostly for bookkeeping and tax purposes Offshore Financial Centers

9 - 8 Discussion Question What key factors are driving growth of the international capital market?

9 - 9 Answer to Discussion Question Information technology is reducing the costs of global communication. Deregulation increases competition, lowers the cost of financial transactions, and opens national markets to global investing and borrowing. Innovative financial instruments expand the options available to lenders and borrowers.

International Bond Market Foreign bondInterest ratesEurobond Bond that is issued outside the country in whose currency the bond is denominated Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold Driving growth are differential interest rates between developed and developing nations Market of bonds sold by issuing companies, governments, and others outside their own countries

International Equity Market Market of stocks bought and sold outside the issuer’s home country Privatization Investment banks Emerging markets Electronic markets

 Governments  Commercial banks  International companies  Wealthy individuals Eurocurrency Market Unregulated market of currencies banked outside their countries of origin

Foreign Exchange Market Conversion: To facilitate transactions, invest directly abroad, or repatriate profits Hedging: Insure against potential losses from adverse exchange-rate changes Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit Market in which currencies are bought and sold and their prices are determined

Largest Currency Markets UK:$1.33 trillion US:$0.62 trillion Japan:$0.24 trillion Source: */Kyodo/Newscom

Discussion Question Using the foreign exchange market to insure against potential losses from adverse changes in exchange rates is called currency __________. a. Arbitrage b. Hedging c. Speculation

Answer to Discussion Question Using the foreign exchange market to insure against potential losses from adverse changes in exchange rates is called currency __________. a. Arbitrage b. Hedging c. Speculation

Quoting Currencies Quoted currency = numerator Base currency = denominator Quoted currency = numerator Base currency = denominator (¥/$) = Japanese yen needed to buy one U.S. dollar Yen is quoted currency, dollar is base currency

Currency Values Change in U.S. dollar against Norwegian krone February 1: NOK 5/$ March 1: NOK 4/$ %change = [(4-5)/5] x 100 = -20% U.S. dollar fell 20% Change in Norwegian krone against U.S. dollar Make krone base currency (1÷ NOK/$) February 1: $.20/NOK March 1: $.25/NOK %change = [( )/.20] x 100 = 25% Norwegian krone rose 25%

Cross Rate Exchange rate calculated using two other exchange rates Use direct or indirect exchange rates against a third currency

Cross Rate Example Direct quote method 1) Quote on euro = € /$ 2) Quote on yen = ¥ /$ 3) € /$ ÷ ¥ /$ = € /¥ 4) Costs euros to buy 1 yen

Spot Rate Exchange rate requiring delivery of traded currency within two business days Repatriate income from sales abroad Invest in another national market Pay supplier in its own currency

Forward Rate Rate at which two parties will exchange currencies on a specified future date  Forward Contracts  Reduce exchange-rate risk  30, 90, 180 days or custom lengths

Currency swap Simultaneous purchase and sale of foreign exchange for two different dates Currency option Option to exchange a specified amount of currency on a specified date at a specified rate Currency futures contract Contract requiring the exchange of a specified amount of a currency on a specified date at a specified exchange rate, with all conditions fixed and not adjustable Swaps, Options, and Futures

Discussion Question Why is exchange rate risk important to companies involved in international business?

Answer to Discussion Question Exchange-rate risk is important because it can jeopardize profits from current and future international transactions.

Hour Trading

Key Market Institutions Interbank market Securities exchange Market in which the world’s largest banks exchange currencies at spot and forward rates Market in which the world’s largest banks exchange currencies at spot and forward rates Exchange that specializes in currency futures and options transactions Exchange that specializes in currency futures and options transactions Global computer network of foreign exchange traders and other market participants Global computer network of foreign exchange traders and other market participants Over-the-Counter (OTC) market

Manager’s Briefcase: Managing Foreign Exchange 1. Match Needs to Providers 2. Work with the Major Banks 3. Consolidate Multiple Transactions 4. Get the Best Rate Possible 5. Embrace Information Technology

Goals of Currency Restriction Protect a currency from speculators Constrain individuals and companies from investing abroad Preserve hard currency to repay debts owed to other nations Preserve hard currency to pay for imports and finance trade deficits

Currency Restriction Policies Multiple exchange rate system Import deposit requirements What’s a firm to do? Countertrade Quantity restrictions Import licenses Central bank approval

Discussion Question A currency that trades freely in the foreign exchange market is called a __________ currency. a. Cross b. Vehicle c. Convertible

Answer to Discussion Question A currency that trades freely in the foreign exchange market is called a __________ currency. a. Cross b. Vehicle c. Convertible