International Financial Management

11th Edition
by Jeff Madura

1 Lectured by CHHEANG Huy

 3 International Financial Markets
Chapter Objectives

Describe the background and corporate use of the

following International Financial Markets:
 Foreign exchange market
 International money market
 International credit market
 International bond market
 International stock markets
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 Foreign Exchange Market

1. Allows for the exchange of one currency

for another.
2. Exchange rate specifies the rate at which
one currency can be exchanged for
another.

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 History of Foreign Exchange

1. Gold Standard (1876 – 1913)

Each currency was convertible into gold at a
specified rate. When World War I began in 1914,
the gold standard was suspended.
2. Agreements on Fixed Exchange Rates
a.Bretton Woods Agreement 1944 - 1971
b.Smithsonian Agreement 1971 - 1973
3. Floating Exchange Rate System
Widely traded currencies were allowed to
fluctuate in accordance with market forces

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 Foreign Exchange Transactions

1. The over-the-counter market is the

telecommunications network where
companies normally exchange one currency
for another.
2. Foreign exchange dealers serve as
intermediaries in the foreign exchange
market
3. A foreign exchange transaction for immediate
exchange is said to trade in the spot market.
The exchange rate in the spot market is the
spot rate.
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4. Trading between banks occurs in the
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 Spot Market

1. The U.S. Dollar is the commonly accepted

medium of exchange in the spot market.
2. Spot market time zones - Foreign exchange
trading is conducted only during normal
business hours in a given location. Thus, at
any given time on a weekday, somewhere
around the world a bank is open and ready to
accommodate foreign exchange requests.
3. Spot market liquidity: More buyers and
sellers means more liquidity.

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 Attributes of Banks That Provide Foreign Exchange

1. Competitiveness of quote
2. Special relationship with the bank
3. Speed of execution
4. Advice about current market conditions
5. Forecasting advice

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 Foreign Exchange Quotations

1. At any given point in time, a bank’s bid (buy) quote

for a foreign currency will be less than its ask (sell)
quote.
2. The bid/ask spread covers the bank’s cost of
conducting foreign exchange transactions

Ask rate  Bid rate

Bid / ask spread 
Ask rate

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 Exhibit 3.1 Computation of the Bid Ask Spread

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 Factors That Affect the Spread

1. Order costs: Costs of processing orders, including

clearing costs and the costs of recording
transactions.
2. Inventory costs: Costs of maintaining an
inventory of a particular currency.
3. Competition: The more intense the competition,
the smaller the spread quoted by intermediaries.
4. Volume: Currencies that have a large trading
volume are more liquid because there are
numerous buyers and sellers at any given time.
5. Currency risk: Economic or political conditions
that cause the demand for and supply of the
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currency to change abruptly.
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 Interpreting Foreign Exchange Quotations

1. Direct Quotation represents the value of

a foreign currency in dollars (number of
dollars per currency).
Example: $1.40 per Euro

2. Indirect quotation represents the

number of units of a foreign currency per
dollar.
Example: €0.7143 per Dollar
Indirect quotation = 1 / Direct quotation

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 Exhibit 3.2 Direct and Indirect Exchange Rate Quotations

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 Interpreting Changes in Exchange Rates

1. When the euro is appreciating against

the dollar (based on an upward
movement of the direct exchange rate of
the euro), the indirect exchange rate of
the euro is declining.

2. When the euro is depreciating (based on

a downward movement of the direct
exchange rate) against the dollar, the
indirect exchange rate is rising.

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 Exhibit 3.3 Relationship Between the Direct and
Indirect Exchange Rates Over Time

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 Cross Exchange Rates (p.63)

1. Cross exchange rate is the amount of one foreign

currency per unit of another foreign currency
2. Example
Value of peso = $0.07
Value of Canadian dollar = $0.70

Value of peso in C$ = Value of peso in $

Value of C$ in $
= $0.07 = C$ 0.10
$0.70

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currency Bid Ask
USD/KHR 4049 4064
KHR/USD 1/4064 1/4049
MEAN 1/ASK 1/BID
currency Bid Ask
USD/KHR
USD/SGD
SGD/KHR ? ?

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 Example: The euro is quoted as EUR/USD:1.1610-1.1615
and Swiss franc is quoted as USD/CHF: 1.4100-1.4120.
What is the CHF/EUR quotation?

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 Currency Derivatives

1. Forward Contracts: agreements between

a foreign exchange dealer and an MNC
that specifies the currencies to be
exchanged, the exchange rate, and the
date at which the transaction will occur.
 The forward rate is the exchange rate
specified by the forward contract.
 The forward market is the over-the-
counter market where forward contracts
are traded.

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 Currency Derivatives

2. Futures Contracts: similar to forward

contracts but sold on an exchange
 Specifies a standard volume of a particular
currency to be exchanged on a specific
settlement date.
 The futures rate is the exchange rate at which
one can purchase or sell a specified currency
on the specified settlement date.
 The future spot rate is the spot rate that will
exist at a future point in time and is uncertain
as of today.

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 Currency Derivatives

3. Currency Options Contracts

a. Currency Call Option: provides the right to
buy currency at a specified strike price within
a specified period of time.

b. Currency Put Option: provides the right to

sell currency at specified strike price within a
specified period of time.

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 International Money Market

1. Corporations or governments need short-term

funds denominated in a currency different
from their home currency.
2. The international money market has grown
because firms:
a. May need to borrow funds to pay for imports
denominated in a foreign currency.
b. May choose to borrow in a currency in which the
interest rate is lower.
c. May choose to borrow in a currency that is
expected to depreciate against their home
currency
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 Origins and Development

1. European Money Market: Dollar deposits in

banks in Europe and other continents are called
Eurodollars or Eurocurrency. Origins of the European
money market can be traced to the Eurocurrency
market that developed during the 1960s and 1970s.

2. Asian Money Market: Centered in Hong Kong

and Singapore. Originated as a market involving
mostly dollar-denominated deposits, and was
originally known as the Asian dollar market.

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 Money Market Interest Rates Among Currencies

1. The money market interest rates in any

particular country are dependent on the
demand for short-term funds by borrowers,
relative to the supply of available short-term
funds that are provided by savers.

2. Money market rates vary due to differences

in the interaction of the total supply of short-
term funds available (bank deposits) in a
specific country versus the total demand for
short-term funds by borrowers in that country.
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 Exhibit 3.4 Comparison of Money Market Interest Rates

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 Global Integration of Money Market Interest Rates (p.67)

1. Money market interest rates among countries

tend to be highly correlated over time.

2. When economic conditions weaken, the

corporate need for liquidity declines, and
corporations reduce the amount of short term
funds they wish to borrow.

3. When economic conditions strengthen,

there is an increase in corporate expansion,
and corporations need additional liquidity to
support their expansion.
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 Risk of International Money Market Securities

1. International Money Market Securities are

debt securities issued by MNCs and
government agencies with a short-term
maturity (1 year or less)
2. Normally, these securities are perceived to
be very safe from the risk of default.
3. Even if the international money market
securities are not exposed to credit risk,
they are exposed to exchange rate risk
when the currency denominating the
securities differs from the home currency of
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Lecturedinvestors.
by CHHEANG Huy
 International Credit Market (p.69)

1. MNCs sometimes obtain medium-term funds

through term loans from local financial
institutions or through the issuance of notes
(medium-term debt obligations) in their local
markets.
2. Loans of 1 year or longer extended by banks
to MNCs or government agencies in Europe
are commonly called Eurocredits or
Eurocredit loans.
3. To avoid interest rate risk, banks commonly
use floating rate loans with rates tied to the
London Interbank Offer Rate (LIBOR).
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 Regulations in the Credit Market

1. Single European Act:

 Capital can flow freely throughout Europe.
 Banks can offer a wide variety of lending, leasing,
and securities activities in the EU.
 Regulations regarding competition, mergers, and
taxes are similar throughout the EU.
 A bank established in any one of the EU countries
has the right to expand into any or all of the other EU
countries.

2. Basel Accord - Banks must maintain capital equal to

at least 4 percent of their assets. For this purpose,
banks’ assets are weighted by risk.
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 Regulations in the Credit Market (Cont.)

3. Basel II Accord - Attempts to account for differences

in collateral among banks. In addition, this accord
encourages banks to improve their techniques for
controlling operational risk, which could reduce
failures in the banking system. Also plans to require
banks to provide more information to existing and
prospective shareholders about their exposure to
different types of risk.

4. Basel III Accord - Called for new methods of

estimating risk-weighted assets that would increase
the level of risk-weighted assets, and therefore require
banks to maintain higher levels of capital.
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 Syndicated Loans in the Credit Market

1. Sometimes a single bank is unwilling or

unable to lend the amount needed by an
MNC or government agency.

2. A syndicate of banks can be formed to

underwrite the loans and the lead bank is
responsible for negotiating the terms with the
borrower.

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 Impact of the Credit Crisis on the Credit Market

1. The credit crisis of 2008 triggered by defaults

in subprime loans led to a halt in housing
development, which reduced income,
spending, and jobs.

2. Financial institutions became cautious with

their funds and were less willing to lend
funds to MNCs

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 International Bond Market (p.70)

1. Foreign bonds are issued by borrower

foreign to the country where the bond is
placed.
2. Eurobonds are bonds sold in countries
other than the country of the currency
denominating the bond
 Partially a result of the Interest Equalization
Tax (EIT) imposed by the U.S. government in
1963 to discourage U.S. investors from
investing in foreign securities.

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 Eurobonds

1. Features:
 Bearer bonds
 Annual coupon payments
 Convertible or callable
2. Denominations
 commonly denominated in a number of currencies
3. Underwriting Process
 multinational syndicate; simultaneously placed in
many countries
4. Secondary Market
 market makers are in many cases the same
underwriters who sell the primary issues

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 Development of Other Bond Markets

1. Bond markets have developed in Asia and

South America
2. Bond market yields among countries tend
to be highly correlated over time.
3. When economic conditions weaken,
aggregate demand for funds declines with
the decline in corporate expansion.
4. When economic conditions strengthen,
aggregate demand for funds increases
with the increase in corporate expansion.

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 Risk of International Bonds

1. Credit Risk - represents the potential for

default.
2. Interest Rate Risk - potential for the value of
bonds to decline in response to rising long-term
interest rates.
3. Exchange Rate Risk - represents the
potential for the value of bonds to decline (from
the investor’s perspective) because the currency
denominating the bond depreciates against the
home currency.
4. Liquidity Risk - represents the potential for the
value of bonds to decline because there is not a
36 consistently active market for the bonds.
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 Impact of the Greek Crisis on Bonds

1. Spring 2010: Greece experienced weak

economic conditions and large increase in
the government budget deficit.

2. Concern spread to other European

countries such as Spain, Portugal, and
Ireland that had large budget deficits.

3. May 2010: many European countries and

the IMF agreed to provide Greece with
new loans.

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 International Stock Markets

1. Issuance of Stock in Foreign Markets -

Some U.S. firms issue stock in foreign markets
to enhance their global image.
2. Issuance of Foreign Stock in the U.S.
a. Yankee stock offerings - Non-U.S.
corporations that need large amounts of funds
sometimes issue stock in the United States
b. American Depository Receipts (ADR) -
Certificates representing bundles of stock.
ADR shares can be traded just like shares of
a stock.

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 Non-U.S. Firms Listing on U.S. Exchanges

1. Non-U.S. firms have their shares listed on

the New York Stock Exchange or the
Nasdaq market so that the shares can
easily be traded in the secondary market.

2. Effect of Sarbanes-Oxley Act on Foreign

Stock Listings - Many non-U.S. firms decided
to place new issues of their stock in the United
Kingdom instead of in the United States so that
they would not have to comply with the law.

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 Investing in Foreign Stock Markets

1. Many investors purchase stocks outside

of the home country.
2. Recently, firms outside the U.S. have
been issuing stock more frequently.

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 Exhibit 3.5 Comparison of Stock Exchanges (as of 2008)

Source: World Federation of Exchanges

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 How Market Characteristics Vary among Countries

1. Stock market participation and trading activity are

higher in countries where managers are
encouraged to make decisions that serve
shareholder interests, and where there is greater
transparency.
2. Factors that influence trading activity:
 Voting power
 Legal protection of shareholders
 Government enforcement of securities laws
 Corporate corruption
 Level of financial disclosure
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 Exhibit 3.6 Impact of Governance on Stock Market
Participation and Trading Activity

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 How Financial Markets Serve MNCs

1. Corporate functions that require foreign

exchange markets.
 Foreign trade with business clients.
 Direct foreign investment, or the acquisition of
foreign real assets.
 Short-term investment or financing in foreign
securities.
 Longer-term financing in the international bond or
stock markets.

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 Exhibit 3.7 Foreign Cash Flow Chart of an MNC

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 Summary

 The foreign exchange market allows currencies to be

exchanged in order to facilitate international trade or
financial transactions. Commercial banks serve as
financial intermediaries in this market.
 The international money markets are composed of
several large banks that accept deposits and provide
short-term loans in various currencies. This market is
used primarily by governments and large corporations.
 The international credit markets are composed of the
same commercial banks that serve the international
money market. These banks convert some of the
deposits received into loans (for medium-term periods)
to governments and large corporations.
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 Summary (Cont.)

 The international bond markets facilitate international

transfers of long-term credit, thereby enabling
governments and large corporations to borrow funds
from various countries. The international bond market
is facilitated by multinational syndicates of investment
banks that help to place the bonds.
 International stock markets enable firms to obtain
equity financing in foreign countries. Thus, these
markets help MNCs finance their international
expansion.

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