The Foreign Exchange Market & The Global Capital Market

Chapter 9 & Chapter Preview Discuss the international capital market Describe the international bond, international equity and Eurocurrency markets Identify the foreign exchange market’s functions Explain currency quotes and the rates given Identify the instruments of foreign exchange Discuss government restrictions on currencies

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

Chapter 9 & 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

Chapter 9 & International Capital Market Drivers Information technology Deregulation Financial instruments

Chapter 9 & 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

Chapter 9 & 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

Chapter 9 & International Equity Market Market of stocks bought and sold outside the issuer’s home country Privatization Investment banks Developing nations Electronic markets

Chapter 9 &  Governments  Commercial banks  International companies  Wealthy individuals Eurocurrency Market Unregulated market of currencies banked outside their countries of origin

Chapter 9 & Foreign Exchange Market Conversion: To facilitate sale or purchase, or invest directly abroad 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

Chapter 9 & 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

Chapter 9 & Currency Values Change in US dollar against Polish zloty February 1: PLZ 5/$ March 1: PLZ 4/$ %change = [(4-5)/5] x 100 = -20% US dollar fell 20% Change in Polish zloty against US dollar Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ %change = [( )/.20] x 100 = 25% Polish zloty rose 25%

Chapter 9 & 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 Indirect quote method 1) Quote on euro = $ /€ 2) Quote on yen = $ /¥ 3) $ /€ ÷ $ /¥ = ¥ / € 4) Final step: 1 ÷ € /¥ = € /¥ 5) Costs euros to buy 1 yen

Chapter 9 & 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

Chapter 9 & Forward Rate Rate at which two parties will exchange currencies on a specified future date  Forward Contract  Derivative  Premium vs. Discount

Chapter 9 & 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

Chapter 9 & Hour Trading

Chapter 9 & 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

Chapter 9 & Goals of Currency Restriction Protect a currency from speculators Protect a currency from speculators Constrain individuals and companies from investing abroad Constrain individuals and companies from investing abroad Preserve hard currency to repay debts owed to other nations Preserve hard currency to repay debts owed to other nations Preserve hard currency to pay for imports and finance trade deficits Preserve hard currency to pay for imports and finance trade deficits

Chapter 9 & Currency Restriction Policies Multiple exchange rate system Import deposit requirements What’s a firm to do?? “Countertrade” Quantity restrictions

Chapter 9 & Chapter Summary This chapter presents two systems that comprise international financial markets: the international capital market and the foreign exchange market. The international capital market offers advantages over domestic capital markets because it: (1) increases the supply of funds available to borrowers and lowers the cost of capital; and (2) provides a wider range of investment opportunities that allows investors to diversify their risk. The international capital market has grown dramatically because of information technology, deregulation by governments, and innovations in financial instruments. There are three main components of the international capital market: the international bond market; the international equity market; and the Eurocurrency market. The foreign exchange market is the market in which currencies are bought and sold and in which currency prices are determined. The foreign exchange market is not a place, but a network of banks, brokers, and dealers that exchange currencies 24 hours a day. The foreign exchange market is used for: (1) currency conversion, (2) currency hedging, (3) currency arbitrage, and (4) currency speculation.

International Financial Markets