Chapter

3
INTERNATIONAL FINANCIAL
MARKETS

South-Western/Thomson Learning © 2003

CHAPTER OBJECTIVES

To describe the background and corporate use of the

following international financial markets:
 Foreign exchange market,
 Eurocurrency market,
 Eurocredit market,
 Eurobond market, and
 International stock markets.
MOTIVES FOR USING
INTERNATIONAL FINANCIAL MARKETS

The markets for real or financial assets are prevented

from complete integration by barriers such as tax
differentials, tariffs, quotas, labor immobility,
communication costs, cultural differences, and
financial reporting differences.
Yet, these barriers can also create unique opportunities
for specific geographic markets that will attract foreign
investors.- MNCs might want to do business in a
country to capitalize on favourable conditions unique
to that country – imperfect markets theory.
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.
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 international diversification.
MOTIVES FOR USING
INTERNATIONAL FINANCIAL
MARKETS
Borrowers borrow in foreign markets:
 to capitalize on lower foreign interest rates; and -
 when they expect foreign currencies to depreciate against their
own. – MNC can reduce exchange rate risk by having the subsidiary
borrow funds locally to support its business.
FOREIGN EXCHANGE
MARKET
The foreign exchange market allows currencies to be
exchanged in order to facilitate international trade or
financial transactions.
The system for establishing exchange rates has
evolved over time.
 From 1876 to 1913, each currency was convertible into gold at a
specified rate, as dictated by the gold standard.
FOREIGN EXCHANGE
MARKET

 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 fixed currency
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%.
 Even then, governments still had difficulties maintaining exchange
rates within the stated boundaries. In 1973, the official boundaries
for the more widely traded currencies were eliminated and the
floating exchange rate system came into effect.
FOREIGN EXCHANGE
TRANSACTIONS

There is no specific building or location where traders

exchange currencies. Trading also occurs around the
clock.- commercial banks or online
The market for immediate exchange is known as the
spot market.
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. – what
is a forward contract ?
FOREIGN EXCHANGE
TRANSACTIONS

Hundreds of banks facilitate foreign exchange transactions,

though the top 20 handle about 50% of the transactions.
( Deutsche Bank, Citibank)
Trading between banks occurs in the interbank market.
Within this market, foreign exchange brokerage firms
sometimes act as middlemen.
The following attributes of banks are important to foreign
exchange customers:
 competitiveness of quote
 special relationship between the bank and its customer
 speed of execution
 advice about current market conditions
 forecasting advice
FOREIGN EXCHANGE
TRANSACTIONS

Banks provide foreign exchange services for a fee: the

bank’s bid (buy) quote for a foreign currency will be
less than its ask (sell) quote. This is the bid/ask spread.

ask rate – bid rate

bid/ask % spread =
ask rate

Example: Suppose bid price for £ = $1.52, ask

price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%
FACTORS THAT AFFECT THE
BID/ASK SPREAD

Order costs
Inventory costs
Competition
Volume
Currency risk
FOREIGN EXCHANGE
TRANSACTIONS

The bid/ask spread is normally larger for those

currencies that are less frequently traded.
The spread is also larger for “retail” transactions than
for “wholesale” transactions between banks or large
corporations.
INTERPRETING
FOREIGN EXCHANGE
QUOTATIONS
Exchange rate quotations for widely traded currencies
are frequently 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.
INTERPRETING
FOREIGN EXCHANGE
QUOTATIONS
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.
Indirect quotation = 1/Direct quotation
Note that exchange rate quotations sometimes include
IMF’s special drawing rights (SDRs).
The same currency may also be used by more than
one country.
INTERPRETING
FOREIGN EXCHANGE
QUOTATIONS
A cross exchange rate reflects the amount of one
foreign 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 $
CURRENCY FUTURES AND OPTIONS
MARKET

A currency futures contract specifies a standard

volume of a particular currency to be exchanged on a
specific settlement date. Unlike forward contracts
however, futures contracts are sold on exchanges.
What is the difference between a forward contract and
a futures contract?
OPTIONS MARKET
Currency options contracts give the right to buy or sell a
specific currency at a specific price within a specific period
of time. They are sold on exchanges too.
Options contracts can e classified as calls or puts
Call option- the right to buy a specific currency at a specific
price (strike price or exercise price) within a specific period
of time
Put Option – provides the right to sell a specific currency at
a specific price within a specific period of time.
Options contracts offer more flexibility than forward or
futures contracts because they do not require any
obligation, i.e. the firm can elect not to exercise the option.
INTERNATIONAL MONEY
MARKETS

The European Money Market

The Asian Money Market
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, or what 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.
EUROCURRENCY MARKET $
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 has historically
recycled the oil revenues (petrodollars) from oil-
exporting (OPEC) countries to other countries.
EUROCURRENCY MARKET $
The Eurocurrency market in Asia is sometimes referred
to separately as the Asian dollar market.
The primary function of banks in the Asian dollar
market is to channel funds from depositors to
borrowers.
Another function is interbank lending and borrowing.
EUROCURRENCY MARKET $
Although the Eurocurrency market focuses on large-
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.
INTERNATIONAL CREDIT
MARKET (EUROCREDIT
MARKET)
Loans of one year or longer are extended by Eurobanks
to MNCs or government agencies in the Eurocredit
market. These loans are known as Eurocredit loans.
Floating rates are commonly used, since the banks’
asset and liability maturities may not match -
Eurobanks accept short-term deposits but sometimes
provide longer term loans.
INTERNATIONAL BOND
MARKET (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.
The definition of the eurobond market can be confusing because
of its name. Although the euro is the currency used by
participating European Union countries, eurobonds refer neither
to the European currency nor to a European bond market. A
eurobond instead refers to any bond that is denominated in a
currency other than that of the country in which it is issued.
Bonds in the eurobond market are categorized according to the
currency in which they are denominated. As an example, a
eurobond denominated in Japanese yen but issued in the U.S.
would be classified as a euroyen bond.

Foreign bonds are denominated in the currency of the country in

which a foreign entity issues the bond. An example of such a
bond is the samurai bond, which is a yen-denominated bond
issued in Japan by an American company. Other popular foreign
bonds include bulldog and yankee bonds.

Global bonds are structured so that they can be offered in both

foreign and eurobond markets. Essentially, global bonds are
similar to eurobonds but can be offered within the country whose
currency is used to denominate the bond. As an example, a
global bond denominated in yen could be sold to Japan or any
other country throughout the Eurobond market.
A foreign bond has three characteristics:
The bond is either issued by a foreign entity (such as a
government, municipality, or corporation).
The bond is traded on a foreign market.
and, The bond is denominated in a foreign currency.
Foreign bonds are subject to currency risks, as when you hold the
bond it is denominated in a foreign currency. As bonds take a
specified time to mature, there is no guarentee of the return of
the bond given the currency exchange fluctuations.

A eurobond is a bond issued and traded in a country other than

the one in which its currency is denominated. A eurobond does
not necessarily have to originate or end up in Europe although
most debt instruments of this type are issued by non-European
entities to European investors. Meaning an entity can place a
bond on the German exchange denominated in American dollars.

Another difference is the composition of the underwriting

syndicate. Eurobonds are underwritten by an international
syndicate and is not subject to the rules and regulations of any
country. Foreign bonds, however, are underwritten in the country
of currency denomination, and are therefore subject to the
regulations of that country.
EUROBOND MARKET

Eurobonds are underwritten by a multi-national

syndicate of investment banks and simultaneously
placed in many countries through second-stage, and in
many cases, third-stage, underwriters.
Eurobonds are usually issued in bearer form, pay
annual coupons, may be convertible, may have
variable rates
EUROBOND MARKET

Interest rates for each currency and credit conditions in

the Eurobond market change constantly, causing the
popularity of the market to vary among currencies.
About 70% of the Eurobonds are denominated in the
U.S. dollar.
COMPARING INTEREST
RATES
AMONG CURRENCIES
Interest rates vary substantially for different countries,
ranging from about 1% in Japan to about 60% in
Russia.
Interest rates are crucial because they affect the
MNC’s cost of financing.
The interest rate for a specific currency is determined
by the demand for and supply of funds in that currency.
 WHY U.S. DOLLAR INTEREST RATES
DIFFER FROM BRAZILIAN REAL
INTEREST RATES
Interest Interest S
Rate Rate
for $ S for Real
D
D
Quantity of $ Quantity of Real
The curves are further to the right for the dollar because
the U.S. economy is larger.
The curves are higher for the Brazilian Real because of the
higher inflation in Brazil.
EQUILIBRIUM RATE OF INTEREST
THE INTEREST RATE THAT CLEARS
THE MARKET. ALSO CALLED THE
TRADE-CLEARING INTEREST RATE.
Equilibrium Rate of Interest
In money markets, an interest rate at which the
demand for money and supply of money are equal.
When a central bank sets interest rates higher than the
equilibrium rate, there is an excess supply of money,
resulting in investors holding less money and putting
more into bonds. This causes the price of bonds to rise,
driving down the interest rate toward the equilibrium
rate. The opposite occurs when interest rates are lower
than the equilibrium rate: there is excess demand for
money, causing investors to sell bonds to raise cash.
This decreases the price of bonds, causing the interest
rate to rise to the equilibrium point. Central banks can
use the equilibrium rate of interest as a tool in
determining the appropriate money supply.
COMPARING INTEREST
RATES
AMONG CURRENCIES
As the demand and supply schedules change over time
for a specific currency, the equilibrium interest rate for
that currency will also change.
Note that the freedom to transfer funds across
countries causes the demand and supply conditions for
funds to be somewhat integrated, such that interest
rate movements become integrated too.
INTERNATIONAL STOCK
MARKETS

In addition to issuing stock locally, MNCs can also

obtain funds by issuing stock in international markets.
This will enhance the firm’s image and name
recognition, and diversify the shareholder base. The
stocks may also be more easily digested.
INTERNATIONAL STOCK
MARKETS

Stock issued in the U.S. by non-U.S. firms or

governments are called Yankee stock offerings. Many
of such recent stock offerings resulted from
privatization programs in Latin America and Europe.
Non-U.S. firms may also issue American depository
receipts (ADRs), which are certificates representing
bundles of stock. ADRs are less strictly regulated.
INTERNATIONAL STOCK
MARKETS

The locations of the MNC’s operations can influence

the decision about where to place stock, in view of the
cash flows needed to cover dividend payments.
Market characteristics are important too. Stock
markets may differ in size, trading activity level,
regulatory requirements, taxation rate, and proportion
of individual versus institutional share ownership.
INTERNATIONAL STOCK
MARKETS

Electronic communications networks (ECNs) have been

created to match orders between buyers and sellers in
recent years.
As ECNs become more popular over time, they may
ultimately be merged with one another or with other
exchanges to create a single global stock exchange.
COMPARISON OF
INTERNATIONAL FINANCIAL
MARKETS
The foreign cash flow movements of a typical MNC can
be classified into four corporate functions, all of which
generally require the use of the foreign exchange
markets.
Foreign trade. Exports generate foreign cash inflows
while imports require cash outflows.
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.
 FOREIGN CASH FLOW CHART OF
AN MNC
Foreign
MNC Parent Exchange
Transactions

Export/Import Dividend
Remittance Foreign
& Financing Exchange
Foreign
Medium- & Markets
Business
Short-Term Long-Term
Clients
Investment Financing
Long-Term
& Financing Financing
Export/Import

Eurocurrency Eurocredit &

Market Eurobond International
Markets Stock Markets
Short-Term
Foreign Investment & Financing
Subsidiaries
Medium- & Long-Term Financing

Long-Term Financing
IMPACT OF GLOBAL FINANCIAL MARKETS
ON AN MNC’S VALUE
Improved global image from Cost of borrowing funds in
issuing stock in global markets global markets

m 
n 

E CFj , t E ER j , t   
 j 1 
Value =   
t =1  1  k  t

 
Cost of parent’s equity Cost of parent’s funds
in global markets borrowed in global markets

E (CFj,t ) = expected cash flows in currency j to

be received by the U.S. parent at the end of period
t
E (ERj,t ) = expected exchange rate at which
currency j can be converted to dollars at the end of