International Finance

MBA 6651, International Finance 1

Course Learning Outcomes for Unit II Upon completion of this unit, students should be able to:

2. Examine critical relationships pertaining to foreign currency exchange rates. 2.1 Examine the international financial markets. 2.2 Explain exchange rate determination.

Course/Unit

Learning Outcomes Learning Activity

2.1

Unit Lesson Chapter 3, pp. 60–82 Article: “Long-Term Price Overreactions: Are Markets Inefficient?” Unit II Project

2.2

Unit Lesson Chapter 4 Article: “The Impact of Interest Rate Volatility on Financial Market Inclusion:

Evidence From Emerging Markets” Video: Real and Nominal Exchange Rates Unit II Project

Required Unit Resources Chapter 3: International Financial Markets, pp. 60–82 Chapter 4: Exchange Rate Determination In order to access the following resources, click the links below. Caporale, G. M., Gil-Alana, L., & Plastun, A. (2019). Long-term price overreactions: Are markets inefficient?

Journal of Economics and Finance, 43(4), 657–680. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=138771044&site=ehost-live&scope=site

Hajilee, M., & Niroomand, F. (2018). The impact of interest rate volatility on financial market inclusion:

Evidence from emerging markets. Journal of Economics and Finance, 42(2), 352–368. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=128333154&site=ehost-live&scope=site

Marginal Revolution University. (2014, August 28). Real and nominal exchange rates [Video]. Cielo24.

https://c24.page/8wruzk5wvq57kj8bbkxbz3epxr

Unit Lesson

International Financial Markets The global economy is comprised of many different national currencies, which all run through the foreign exchange market. This market is the largest financial market in terms of trading volume. It provides the structure that allows one country’s currency to be exchanged for that of another country. It is made up of the spot market, forward market, currency futures market, and the currency options market. Cash flows of

UNIT II STUDY GUIDE

International Markets and

Exchange Rates

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multinational corporations (MNCs) can be classified as either foreign trade with business clients, direct foreign investment, short-term investment or financing in foreign securities, or long-term financing. Commercial banks are used in the foreign exchange market to exchange currencies immediately in the spot market. International money markets are made of banks that accept deposits and provide short-term loans in different currencies. This market is used primarily by governments and large corporations. Those same banks make up the international credit markets where some of the deposits they receive are converted into loans for governments and large corporations. Long-term credit is facilitated in the international bond market. These bonds are placed by multinational syndicates of investment banks. Equity financing is obtained in foreign countries through the international stock markets. In this unit, you will learn about the foreign exchange marketplace and how these markets serve MNCs.

Foreign Exchange Market The foreign exchange market encompasses the entire globe. Currencies are traded, and prices move somewhere in the world every hour of every business day. The trading day begins each morning in Sydney and Tokyo and then moves west toward Hong Kong and Singapore. It then passes to the Middle East and makes its way to the European markets of Frankfurt, Zurich, and London. Next comes New York, Chicago, and then finally San Francisco and Los Angeles. The major players in the foreign exchange market include commercial banks, MNCs, asset-management and insurance companies, and central banks. Individuals also participate in the foreign exchange market when they buy foreign currency; however, these transactions are not a significant portion of foreign exchange trading. Commercial banks are central to the foreign exchange market. Every material international transaction requires accounts at commercial banks in various financial centers to be debited or credited. Foreign exchange transactions typically involve different currencies and the exchange of bank deposits. Banks facilitate transactions by bringing buyers and sellers of currencies together. Corporations that operate in foreign countries often receive currencies not from their home country. Corporations often have need to convert currency. For example, workers in India or Mexico need to be paid in the currency of their country, so companies headquartered in the United States would need to convert dollars to rupees or pesos in order to pay workers. Institutional investors, such as mutual funds, pension funds, and insurance companies, use hedge funds, which are not bound by government regulations that limit mutual fund strategies and actively trade in the foreign exchange market. Central banks occasionally make low-volume foreign exchange transactions, which can have a great impact on the marketplace. Central bank actions are watched closely by participants in the foreign exchange market for indications of any future macroeconomic policies that might affect exchange rates.

International Money Market Securities issued through the international money market are generally considered to be very safe. This is due to the short-term nature of the securities. Commercial banks serve the international money market by taking deposits and providing loans in various currencies. These financial institutions serve as dealers in the exchange market. They facilitate short-term loans in different currencies to help MNCs pay for imports denominated in those currencies. They also provide loans to MNCs that need cash to support local operations. The loans are often in a currency with a lower interest rate, which is to the advantage of the MNC when they expect future payments denominated in that same currency. Another strategy used by the MNC is to borrow a currency anticipated to depreciate against the domestic currency. This allows the company to pay back the short-term loan with a better exchange rate, which means the cost of borrowing is less than the interest rate for the currency. International money market securities are, however, exposed to exchange rate risk. If the currency denominated in the security differs from the home currency of the investor, the return on investment will decrease if the money market security currency declines or weakens against the home currency.

International Credit Market Medium-term loans are sometimes issued by local financial institutions and banks in foreign markets. Interest rates for these loans depend on the currency in which the loan is denominated. LIBOR stands for London Interbank Offer Rate and is the interest rate typically charged for short-term loans between banks in the international markets. This rate is used regardless of whether the transaction passes through London. The

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LIBOR causes money market rates to rise when a currency’s LIBOR rises. To eliminate exchange rate risk, borrowers typically denominate their loans in the currency of the country in which they receive most of their cash flows. The loan interest rate, however, will depend on the currency denomination of the loan and adjusts over time in accordance with market interest rates, such as the LIBOR.

International Bond Market Long-term funds needed by national governments and MNCs are facilitated in the international bond market. Major investors, such as the commercial banks, mutual funds, insurance companies, and pension funds, often prefer to invest in international bond markets because they can earn a higher return based on foreign currency exchange rates. MNCs use international bonds to attract strong additional demand for their bonds, especially if they have limited investors in their home country. They might also use bonds to finance a foreign project using currencies with a lower interest rate, provided they can mitigate the exposure to exchange rate risk.

International Stock Markets When we think of the stock market, we are typically thinking of U.S. markets, such as the New York Stock Exchange or the Dow Industrial Average, but European markets, such as the Euronext and or the London Stock Exchange, and markets in Asia are also very strong and active around the world. MNCs issue stock in foreign markets to attract foreign investors when expected future cash flows from that stock issuance will be enough to pay dividends. Yankee stock offerings refer to non-U.S. companies that issue stock in the United States. This is often done so that foreign companies can diversify the shareholder base. This serves to decrease the volatility of stock prices because it lessens the impact of large investor stock selloffs. Non-U.S. companies also issue American depository receipts (ADRs). These are certificates that represent chunks of the company’s stock. Using ADRs allows foreign companies to bypass some of the disclosures required of U.S. stock offerings when entering the U.S. markets. ADRs can be traded just like individual shares of stock; therefore, the price of ADRs changes daily.

Exchange Rate Determination The exchange rate is the amount of currency needed to buy one unit of another currency. Anticipating factors that affect movement in exchange rates is crucial for managerial decision-making. The process of exchange rate determination in terms of capital flow and trade is based on a supply and demand model. Key economic factors such as relative inflation rates and interest rates influence exchange rate movements because of the effect they can have on supply and demand. Financial institutions use expectations and predictions of currency appreciation or depreciation to profit by investing in securities denominated in a specific currency.

Influencing Factors There are four influencing factors in exchange rate determination worth mentioning. These are inflation, interest, growth, and government. If domestic inflation is higher than foreign inflation, over time, domestic goods will become expensive compared to foreign goods. This leads to increased demand for foreign goods and a decline in demand for domestic goods. These changes are reflected in an increase in demand for the foreign currency and a decrease in supply of the foreign currency. If the domestic interest rate increases relative to the foreign interest rate, domestic financial assets become more profitable than foreign financial assets. This leads to a decrease in the demand for foreign exchange and an increase in the supply of foreign exchange. The effect of changes in relative inflation is seen in the current account of the balance of payments, while the effect of changes in interest rates is seen in the financial account. Relative growth is another influencing factor on exchange rates. Rapid growth is generally associated with profitability and net capital inflows, which makes domestic assets appealing to foreign investors. Thus, the supply of foreign exchange increases compared to demand, and the exchange rate falls. Governments influence exchange rates through macroeconomic policy that affects inflation, interest rates, and growth. They also affect supply and demand of currency exchange with tariffs, quotas, and taxes. This means that the desired effects on a currency due to lower inflation and higher interest could be eliminated by government imposition of tariffs or taxes.

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Opportunities in Exchange Rate Movement Financial institutions use information about influencing factors on foreign markets to make predictions about how the exchange rate will change to profit from expectations. If financial institutions can predict that a currency is valued too low, they can invest before the currency is revalued and then liquidate their position once it appreciates. They may also speculate based on the expected depreciation of a currency. This is done by borrowing funds in a currency that is overvalued and then paying back the loan when the currency depreciates. Carry trade is another speculative strategy by which investors try to profit on the difference in interest rates between two countries. Prevailing interest rates must also be considered in a carry trade. This type of trade also comes with the risk of the exchange rate moving in the opposite direction of what investors predicted.

Suggested Unit Resources In order to access the following resources, click the links below. This study investigates how multinational corporations (MNCs) can sway the growth of financial markets in developing countries with prevalent political corruption. Bahmani-Oskooee, M., Kholdy, S., & Sohrabian, A. (2013). Do MNCs spur financial markets in corrupt host

countries? Journal of Economics and Finance, 37(2), 308–317. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=85975668&site=ehost-live&scope=site

BREXIT is considered with regard to the main consequences for financial markets, with real economic implications taken into account. The role of the interest elasticity of the demand for money is emphasized for welfare analysis of BREXIT. The article assumes that elasticity will fall post-BREXIT. Welfens, P. J. J., & Xiong, T. (2019). BREXIT perspectives: Financial market dynamics, welfare aspects and

problems from slower growth. International Economics and Economic Policy, 16(1), 215–265. https://libraryresources.columbiasouthern.edu/login?url=http://search.ebscohost.com/login.aspx?direc t=true&db=bsu&AN=135395492&site=ehost-live&scope=site