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International Financial Markets and Foreign Exchange

CHAPTER NINE

INTERNATIONAL

BUSINESS

The Challenges of Globalization

Canadian Edition

Wild • Wild • Valladares Montemayor

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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.

Understand how currencies are quoted and the different rates given.

In this chapter, you will explore international financial markets.

You will also:

Learn about the international bond, international equity, and Eurocurrency markets.
Understand the primary functions of the foreign exchange market.
And examine the main instruments and institutions of the foreign exchange market.

Chapter Objectives

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Explain how exchange rates influence the activities of domestic and international companies.

Describe the primary methods of forecasting exchange rates.

Identify the main instruments of the foreign exchange market.

Explain why and how governments restrict currency convertibility.

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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

A capital market allocates financial resources according to their most efficient uses and provides a way to borrow or invest money efficiently.

Debt is a loan in which the borrower repays the borrowed amount, called principal, plus interest.

Companies can raise money by issuing bonds—debt instruments that specify the timing of principal and interest payments.

Equity is part ownership of a company in which the equity holder participates with other owners in the company’s financial gains and losses.

Companies can also raise money by issuing stock—shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows.

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International Capital Market

Network of people, firms, financial institutions, and governments borrowing and investing internationally

Borrowers

Expands money supply
Reduces cost of money

Lenders

Spread / reduce risk

Offset gains / losses

The international capital market affects money markets in at least four ways:

It expands the money supply for borrowers by providing access to international sources of capital.
It reduces the cost of money for borrowers by increasing its supply and forcing down borrowing costs.
It reduces risk for lenders by expanding the set of available lending opportunities.
And it allows investors to offset gains in some economies with losses in others.

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International Capital
Market Drivers

Information technology

Deregulation

Financial instruments

Source : AFP Photo/Romeo Gacad/Newscom

A customer counts her Philippine pesos after exchanging US dollars at a moneychanger in Manila, the Philippines. The foreign exchange market gives Filipinos working overseas a safe way to wire money to relatives back home..

Three main forces are expanding the international capital market.

Information technology reduces the time and money needed to communicate globally and allows for 24-hour electronic trading.
Little regulation relative to other financial markets increases competition, lowers transaction costs, and opens up national financial markets.
And growth has resulted from securitization—the repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable securities.

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Offshore Financial Centers

Country or territory

whose financial sector

features few regulations

and few, if any, taxes

Operational center

Extensive financial activity

and currency trading

Booking center

Mostly for bookkeeping

and tax purposes

An offshore financial center tends to feature few regulations, few (if any) taxes, economic and political stability, and an advanced telecommunications infrastructure.

Offshore financial centers fall into two categories.

Operational Centers see a great deal of financial activity, such as London in currencies and Switzerland in investment capital.
Booking Centers are usually located on small island nations or territories with favorable tax and/or secrecy laws. Funds simply pass through these centers on their way to large operational centers.

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Discussion Question

What key factors are driving growth of the international capital market?

HSBC Bank International is based in Jersey, Channel Islands, and has

four other offshore centres located in Jersey, Hong Kong, Miami, and Singapore. Here, employees work in the dealing room of Standard Chartered Bank in Dubai, UAE.

What key factors are driving growth of the international capital market?

Global banking giant HSBC

recently added Dubai, United Arab

Emirates, to its list of key offshore

banking centres. The Dubai office

will serve customers from the

Middle East, North Africa, and

Pakistan. HSBC chose Dubai as its

offshore centre for Shariacompliant

products and services

(those complying with Islamic law).

HSBC Bank International is based

in Jersey, Channel Islands, and has

four other offshore centres

located in Jersey, Hong Kong,

Miami, and Singapore. Here,

employees work in the dealing

room of Standard Chartered Bank

in Dubai, UAE.

Source : © Ali Haider/epa/CORBIS. All

Rights Reserved.

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Answer to Discussion Question

First, the use of information technology is drastically reducing the costs of global communication.

Second, deregulation increases competition, lowers the cost of financial transactions, and opens national markets to global investing and borrowing.

And third, innovative financial instruments are increasing the number of options available to lenders and borrowers.

Answer:

First, the use of information technology is drastically reducing the costs of global communication. Second, deregulation increases competition, lowers the cost of financial transactions, and opens national markets to global investing and borrowing. And third, innovative financial instruments are increasing the number of options available to lenders and borrowers.

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International Bond Market

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

Foreign bond

Interest rates

Eurobond

A Eurobond is issued outside the country in whose currency it is denominated. For example, a bond issued in Venezuela in U.S. dollars and sold in Britain, France, and Germany is called a Eurobond.
A foreign bond is sold outside the borrower’s country and denominated in the currency of the country in which it is sold. For example, a yen-denominated bond issued by German carmaker BMW in Japan’s bond market is called a foreign bond.
Interest rates are driving growth in the international bond market. Borrowers in emerging economies seek to borrow money in developed nations where interest rates are lower, and investors in developed nations seek to buy bonds of companies in emerging economies to earn higher rates of return.

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International Equity Market

Market of stocks bought and sold outside

the issuer’s home country

Privatization

Investment banks

Emerging markets

Cybermarkets

Four factors lie behind the growth in the international equity market.

A single privatization often places billions of dollars of new equity on stock markets.
Some companies in emerging markets seek funding abroad to overcome domestic capital shortages.
Investment banks facilitate the sale of equity worldwide by bringing together sellers and potential buyers.
And cybermarkets now allow online global trading activities 24 hours a day.

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Governments
Commercial banks
International companies
Wealthy individuals

Eurocurrency Market

Unregulated market of currencies banked outside their countries of origin

All the world’s currencies banked outside their countries of origin are called Eurocurrency and trade on the Eurocurrency market.

Sources of Eurocurrency deposits include governments, commercial banks, international companies, and extremely wealthy individuals.
The appeal of the Eurocurrency market is its complete absence of regulation and low transaction costs.
The downside of this market is its greater risk due to a lack of government regulation.

Think – Pair - Share

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“Dirty money” obtained through drug trafficking, gambling, and other illicit activities use offshore financial centers to escape the same thing as respectable “clean capital”—national taxation and government regulations.

Some experts argue that institutions such as international currency markets and offshore tax havens reduce stability and are hostile to the public interest.

Do you think corporate use of offshore financial centers to avoid home-country bureaucracies and taxes is ethical? Why or why not?

Slide 13 is the first “Think-Pair-Share” in this chapter. These slides are intended to stimulate discussion between students. The activity requires students to consider the question individually, and then share their thoughts with one classmate or a small group. The goals of these slides are to 1) improve students’ conceptual understanding of the material, 2) hone critical thinking skills, and 3) improve problem solving.

This is a good opportunity to discuss extraterritoriality. On the one hand, should the Canadian government have the right to control and legislate Canadian business activity abroad? And on the other hand, should Canadian firms be allowed to exploit a loophole and avoid paying their fair share of taxes? Students supporting the use of an OFC to avoid taxation in national markets must explain why it is okay for some (usually large) companies to evade national taxation but not others (usually small companies with fewer resources). They must also justify letting a company using an OFC off the hook in terms of contributing to the national infrastructure, health care, education, and general welfare of the people of that nation. Students supporting a clampdown on the OFC system must explain why it is unethical to use an OFC to shelter income and avoid regulations.

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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

The foreign exchange market serves four main functions.

Currency conversion helps facilitate international transactions, investments abroad, and the repatriation of profits back to the home country.
Currency hedging helps insure against potential losses from adverse changes in exchange rates.
Currency arbitrage lets investors seek profits by conducting an instantaneous purchase and sale of a currency in different markets.
And currency speculation lets traders purchase or sell a currency with the expectation that its value will change over time and generate a profit.

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Largest Currency Markets

USA

Japan

Around $4 trillion worth of currency is traded on global foreign exchange markets every day.

Foreign exchange brokerage workers in Tokyo, Japan, dress in traditional Japanese kimonos for the first trading day of the year.

Currency exchange workers in Tokyo, Japan, wear traditional kimonos on the first trading day of the year.

The world’s three largest markets for currencies are the United States, the United Kingdom, and Japan.

Foreign exchange brokerage workers

in Tokyo, Japan, dress in traditional

Japanese kimonos for the

first trading day of the year. Around

$4 trillion worth of currency is

traded on global foreign exchange

markets every day.

Source : © Eriko Sugita/Reuters/

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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

Photo: Gerry Taft, Mount Royal University

Belarusian Rubles

50 Rubles = 5 Canadian Cents

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

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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

The correct answer is b. Hedging

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Quoting Currencies

Quoted currency = numerator

Base currency = denominator

(¥/$) = Japanese yen needed to buy one U.S. dollar

Yen is quoted currency, dollar is base currency

Two components of every exchange rate are the quoted currency and the base currency.

In the exchange rate of ¥90/$ (read as “90 yen to the dollar”), the yen is the quoted currency because it is the numerator, and the dollar is the base currency because it is the denominator. We also call this a direct quote on the yen and an indirect quote on the dollar.
To derive a direct quote from an indirect quote, simply divide the indirect quote into 1.
And, to derive an indirect quote from a direct quote, divide the direct quote into 1.

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Cross Rate Example

Direct quote method

Quote on euro = € 0.7883/$
Quote on yen = ¥ 84.3770/$
€ 0.7883/$ ÷ ¥ 84.3770/$ = € 0.0093/¥
Costs 0.0093 euros to buy 1 yen

This slide demonstrates how to find the cross rate between the euro and the yen from their exchange rates with the U.S. dollar.

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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

Businesses exchanging currencies at their local bank receive a buy rate (the rate at which a bank will buy a currency) and an ask rate (the rate at which a bank will sell a currency).

The spot market helps companies to:

Convert income from sales abroad into the home-country currency.
Convert funds into the currency of an international supplier.
And convert funds into the currency of a country in which it will invest.

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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

A forward rate is a rate at which two parties agree to exchange currencies on a specified future date.

A forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.
It is used to insure against unfavorable changes in exchange rates.
Forward contracts are commonly created for 30, 90, and 180 days into the future, but customized contracts are also possible.

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Currency swap

Simultaneous purchase and sale of foreign exchange

for two different dates

Currency option

Option to exchange a specific amount of a currency on a

specific date at a specific rate

Currency futures contract

Contract requiring the exchange of a specific amount of a currency

on a specific date at a specific rate, with all conditions

fixed and not adjustable

Swaps, Options, and Futures

The forward market has produced three additional types of currency instruments.

A currency swap is used to reduce exchange-rate risk and lock in a future exchange rate.
A currency option is used to hedge against exchange-rate risk and obtain foreign currency at a favorable rate.
And a currency futures contract is similar to a currency option but is an enforceable contract and all conditions are fixed.

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Discussion Question

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

Photo: Gerry Taft, Mount Royal University

500 Philippine Pesos = $12 CDN

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

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Answer to Discussion Question

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

Answer:

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

How Exchange Rates Influence
Business Activities

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A country with a currency that is weak will see a decline in the price of its exports and an increase in the price of its imports.

A company improves profits if it sells its products in a country with a strong currency while sourcing from a country with a weak currency.

Photo: Gerry Taft, Mount Royal University

A menu from a Pizza Place in Minsk, Belarus

A country with a currency that is weak (valued low relative to other currencies) will see a decline in the price of its exports and an increase in the price of its imports. Lower prices for the country’s exports on world markets can give companies the opportunity to take

market share away from companies whose products are priced high in comparison. Furthermore, a company improves profits if it sells its products in a country with a strongcurrency (one that is valued high relative to other currencies) while sourcing from a country with a weak currency.

Desire for Stability and Predictability

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Stable exchange rates improve the accuracy of financial planning and make cash flow forecasts more precise.

Predictable exchange rates reduce the likelihood that companies will be caught off-guard by sudden and unexpected rate changes.

Photo: Gerry Taft, Mount Royal University

20,000 Rupiah = $1.76 Cdn

stable exchange rates improve the accuracy of financial planning and make cash flow forecasts more precise. Predictable exchange rates reduce the likelihood that companies will be caught off-guard by sudden and unexpected rate changes.

Forecasting Exchange Rates

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Efficient Market View

As applied to exchange rates, this means that forward exchange rates are accurate forecasts of future exchange rates.

Inefficient Market View

holds that prices of financial instruments do not reflect all publicly available information.

Photo: Gerry Taft, Mount Royal University

2 Singapore dollars = $1.70 Cdn

FORECASTING EXCHANGE RATES

A. Efficient Market View

The efficient market view thus holds that prices of financial instruments reflect all publicly available information at any given time. As applied to exchange rates, this means that forward exchange rates are accurate forecasts of future exchange rates.

B. Inefficient Market View

The inefficient market view holds that prices of financial instruments do not reflect all publicly available information. Proponents of this view believe companies can search for new pieces of information to improve forecasting. But the cost of searching for further information must not outweigh the benefits of its discovery.

Forecasting Techniques

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Fundamental Analysis

uses statistical models based on fundamental economic indicators to forecast exchange rates.

Technical Analysis

uses charts of past trends in currency prices and other factors to forecast exchange rates

Difficulties of Forecasting

miscalculating the importance of economic news, placing too much emphasis on some elements and ignoring others

Forecasting Techniques

1. Fundamental Analysis

Fundamental analysis uses statistical models based on fundamental economic indicators to forecast exchange rates.

2. Technical Analysis

Another method of forecasting exchange rates is technical analysis —

a technique that uses charts of past trends in currency prices and other factors to forecast exchange rates.

D. Difficulties of Forecasting

Beyond the problems associated with the data used by these techniques, failings can be traced to the human element involved in forecasting. For example, people might miscalculate the importance of economic news becoming available to the market, placing too much emphasis on some elements and ignoring others.

Foreign Exchange Market Today

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The daily trading volume on the foreign exchange market (comprising currency swaps and spot and forward contracts) had grown by mid-2010 to an

unprecedented $4.0 trillion—an amount greater than the yearly gross domestic product of many

small nations.

Photo: Gerry Taft, Mount Royal University

1 Malaysian Ringgit = 33 cents Cdn

Electronic network of foreign exchange traders, currency trading banks, and investment firms among major financial centers. Single-day trading volume on the foreign exchange market (currency swaps and spot and forward contracts) is $4 trillion.

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Trading Centres, 24-Hour Trading

Exchanges in at least one of the three major centres (London, New York, and Tokyo) keep the market open for 22 hours a day. Trading does not stop during the two hours these exchanges are closed because other trading centres (including San Francisco and Sydney, Australia) remain open.

The foreign exchange market today is a collection of physical locations and an electronic network of traders, banks, and investment firms.

Major trading centers are the United Kingdom, the United States, and Japan. London dominates the foreign exchange market for historic and geographic reasons.
A vehicle currency is used as an intermediary to convert funds between two other currencies.
The most popular vehicle currencies include the U.S. dollar, British pound, Japanese yen, and the European Union euro.

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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

Global managers should observe several points to get the best deals on foreign exchange transactions.

1. Match the company’s foreign currency needs with the best provider the company can afford.

2. Major banks located in financial centers often have cost and service advantages over local banks.

3. Consolidate individual money exchanges into larger ones to reduce fees.

4. Get the best rate possible by developing relationships with big banks and monitoring fees charged.

5. Technology can help reduce errors, speed execution, and reduce time needed to exchange currencies.

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Important Currencies

A vehicle currency is used as an intermediary to convert funds between two other currencies.

Currencies most often involved in currency transactions are the U.S. dollar, British pound, Japanese yen, and European Union euro.

Because the US dollar is so widely

used in world trade, it is considered a vehicle currency —a currency used as an intermediary to

convert funds between two other currencies. The currencies most often involved in currency

transactions are the US dollar, European Union euro, Japanese yen, and British pound.

Currency Convertibility

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A convertible (hard) currency is one that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand.

Photo: Gerry Taft, Mount Royal University

10 Hong Kong Dollars = $1.36 Cdn

A convertible (hard) currency is traded

freely in the foreign exchange market, with its price determined by the forces of supply and

demand

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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

A convertible (hard) currency is one that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand.

Countries that restrict the convertibility of their currencies may be trying to:

Preserve the nation’s hard currencies to repay debts owed to other nations.
Preserve hard currencies to pay for imports and finance trade deficits.
Protect its currency from speculators.
And keep individuals and businesses from investing in other nations.

Think – Pair - Share

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The use of different national currencies creates a barrier to further growth in international business activity.

What are the pros and cons, among companies and governments, of replacing national currencies with regional currencies?

Do you think a global currency would be possible someday? Why or why not?

Slide 36 is the second “Think-Pair-Share” in this chapter. These slides are intended to stimulate discussion between students. The activity requires students to consider the question individually, and then share their thoughts with one classmate or a small group. The goals of these slides are to 1) improve students’ conceptual understanding of the material, 2) hone critical thinking skills, and 3) improve problem solving.

The issue of replacing national currencies with a regional or global one creates a problem for national governments because they lose a great deal of their ability to manipulate the domestic economy through monetary and fiscal policies. This is perhaps the main impediment to the creation of one global currency for all the nations of the world. On the other hand, companies would benefit greatly from such a move because exchange rate risk would be eliminated, the costs of converting currencies would disappear, and estimating future earnings and expenses in currencies other than the home-country currency would be far simpler.

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Currency Restriction Policies

Multiple exchange rate system

Import deposit requirements

What’s a firm to do?

Countertrade

Quantity restrictions

Import licenses

Central bank approval

Policies for restricting currency convertibility include:

Demanding central bank approval of all foreign exchange transactions.
Requiring import licenses to control the amount of currency leaving the country in transactions.
Implementing multiple exchange rates that impose less favorable rates on the imports of certain goods or certain nations.
Issuing import deposit requirements that require businesses to place a portion of their foreign exchange holdings in special accounts before receiving import licenses.
Issuing quantity restrictions that limit the amount of foreign currency that individuals can take out of the country when traveling abroad.

Companies thwarted by currency restrictions may engage in countertrade—exchanging goods or services without using money. Countertrade is covered fully in Chapter 13.

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Discussion Question

A currency that trades freely in the foreign exchange market is called a __________ currency.

a. Cross

b. Vehicle

c. Convertible

A currency that trades freely in the foreign exchange market is called a __________ currency.

a. Cross

b. Vehicle

c. Convertible

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Answer to Discussion Question

A currency that trades freely in the foreign exchange market is called a __________ currency.

a. Cross

b. Vehicle

c. Convertible

The correct answer is c. Convertible (hard)