International Financial Markets CHAPTER 3 International Financial Markets © 2000 South-Western College Publishing 1

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 Several barriers deter the complete integration of the markets for real or financial assets. Examples include tax differentials, tariffs, quotas, labor immobility, cultural differences, financial reporting differences, and costs of communication. Yet, these barriers can also create unique opportunities for specific geographic markets that will attract foreign creditors and investors.

Motives for Using International Financial Markets Motives for investing in foreign markets: economic conditions exchange rate expectations international diversification Motives for providing credit in foreign markets: high foreign interest rates

Motives for Using International Financial Markets Motives for borrowing in foreign markets: low interest rates exchange rate expectations

Foreign Exchange Market The foreign exchange market allows currencies to be exchanged to facilitate international trade or financial transactions. The system for establishing exchange rates has changed over time: 1876-1913: gold standard WWI & Great Depression: period of instability 1944: Bretton Woods Agreement 1971: Smithsonian Agreement 1973: some official boundaries were eliminated

Bretton Woods

Stability until 1971 USD/NOK 1945-1988

Foreign Exchange Market There is no specific building or location where traders exchange currencies. Trading also occurs around the clock. The market for immediate exchange is known as the spot market. Trading between banks makes up what is often referred to as the interbank market. The forward market for currencies enables an MNC to lock in the exchange rate (called a forward rate) at which it will buy or sell a currency.

Spot and forward transactions

The largest market in the world

London is nr. 1

USD is the most important currency

Foreign Exchange Market Attributes of banks important to customers in need of foreign exchange: competitiveness of quote special relationship with the bank speed of execution advice about current market conditions forecasting advice Banks provide foreign exchange transactions for a fee: the bid (buy) quote for a foreign currency will be less than its ask (sell) quote.

Foreign Exchange Market bid/ask spread The bid/ask spread is normally greater for those currencies that are less frequently traded. Exchange rate quotations for widely traded currencies are listed in many newspapers on a daily basis. Forward rates and cross exchange rates may be quoted too.

Bid and ask rates

Foreign Exchange Market cross exchange rate : value of 1 unit of currency A in units = of currency B Quotations that represent the value of a foreign currency in dollars are referred to as direct quotations, while those that represent the number of units of a foreign currency per dollar are referred to as indirect quotations.

Foreign Exchange Market Some MNCs involved in international trade use the currency futures and options markets to hedge their positions. Futures are similar to forward contracts, except that they are sold on an exchange while forward contracts are offered by banks. Currency options are classified as either calls or puts. They can be purchased on an exchange too.

$ Eurocurrency Market U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars and are not subject to U.S. regulations. In the 1960s and 70s, the Eurodollar market, or what is now called the Eurocurrency market, grew to accommodate increasing international business. The market is made up of several large banks called Eurobanks that accept deposits and provide loans in various currencies.

$ Eurocurrency Market Although the market focuses on large-volume transactions, at times no single bank is willing to lend the needed amount. A syndicate of Eurobanks may then be composed. Two regulatory events allow for a more competitive global playing field: The Single European Act opens up the European banking industry and calls for similar regulations. The Basel Accord includes standardized guidelines on the classification of capital.

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.

Eurocredit Market LOANS Loans of one year or longer extended by Eurobanks to MNCs or government agencies are called Eurocredit loans. These loans are provided in the Eurocredit market. Eurocredit loans often have a floating rate, to lessen the risk resulting from a mismatch in the banks’ asset and liability maturities. Syndicated Eurocredit loans are popular among big borrowers too.

Eurobond Market BONDS There are two types of international bonds: A foreign bond is issued by a borrower foreign to the country where the bond is placed. Eurobonds are sold in countries other than the country represented by the currency denominating them. Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries. They are usually issued in bearer form.

BONDS Eurobond Market Eurobonds increased rapidly in volume when in 1984, the withholding tax was abolished in the U.S. and corporations were allowed to issue bonds directly to non-U.S. investors. Interest rates for each currency and credit conditions change constantly, causing the market’s popularity to vary among currencies. In recent years, governments and corporations from emerging markets have frequently utilized the Eurobond market.

Why Interest Rates Vary Among Currencies Interest rates, which can vary substantially for different currencies, 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. As the demand and supply schedules change over time for a specific currency, the equilibrium interest rate for that currency will also change.

Why U.S. Dollar Interest Rates Differ from Brazilian Real Interest Rates Quantity of $ Interest Rate for $ S D Quantity of Real Interest Rate for Real S D 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.

World Interest Rates

Global Integration of Interest Rates Many investors shift their savings around currencies to take advantage of higher interest rates. Borrowers sometimes also borrow a currency different from what they need to take advantage of a lower interest rate. Ultimately, the freedom to transfer funds across countries causes the demand and supply conditions for funds to be integrated, which in turn causes interest rates to be integrated.

International Stock Markets MNCs can obtain funds by issuing stock in international markets, in addition to the local market. By having access to various markets, the stocks may be more easily digested, the image of the MNC may be enhanced, and the shareholder base may be diversified. The proportion of individual versus institutional ownership of shares varies across stock markets. The regulations are different too.

International Stock Markets The locations of the MNC’s operations may affect the decision about where to place stock, in view of the cash flows needed to cover dividend payments in the future. Stock issued in the U.S. by non-U.S. firms or governments are called Yankee stock offerings. Non-U.S. firms can also issue American depository receipts (ADRs), which are certificates representing bundles of stock. The use of ADRs circumvents some disclosure requirements.

Use of International Financial Markets Foreign cash flow movements of a typical MNC: Foreign trade. Exports generate foreign cash inflows, while imports require cash outflows. Direct foreign investment. 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.

Impact of Global Financial Markets on an MNC’s Value Improved global image from issuing stock in global markets Cost of borrowing funds in global markets Cost of parent’s equity in global markets Cost of parent’s funds 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 period t k = the weighted average cost of capital of the U.S. parent

Chapter Review Motives for Using the International Financial Markets Motives for Investing in Foreign Markets Motives for Providing Credit in Foreign Markets Motives for Borrowing in Foreign Markets

Chapter Review Foreign Exchange Market Foreign Exchange Transactions Forward Markets Attributes of Banks that Provide Foreign Exchange Bid/Ask Spread of Banks Direct versus Indirect Quotations Cross Exchange Rates Currency Futures and Options Markets

Chapter Review Eurocurrency Market Development of the Eurocurrency Market Composition of the Eurocurrency Market Syndicated Eurocurrency Loans Standardizing Bank Regulations within the Eurocurrency Market Asian Dollar Market Eurocredit Market Eurobond Market Development of the Eurobond Market

Chapter Review Why Interest Rates Vary Among Currencies Global Integration of Interest Rates International Stock Markets Use of International Financial Markets How Financial Markets Affect an MNC’s Value