Chapter 3: International Financial Markets

What is the purpose of the foreign exchange market?

It allows for the exchange of one currency for another. The exchange rate between any two currencies specifies the rate at which one currency can be exchanged for another.

What is the gold standard in the foreign exchange market?

From 1876 to 1913 each currency was convertible into gold at a specified rate. The exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold.

When was the gold standard suspended?

When World War I began, in 1914

Briefly explain the Bretton Woods Agreement effect on exchange rates

Between 1944 and 1971, this agreement called for fixed exchange rates between currencies. An exchange rate was established for each pair of currencies and each country’s central bank was required to maintain within 1% of the respective rate.

Why was the Smithsonian Agreement established?

To offset the large imbalance between demand and supply, since the US dollar became overvalued by 1971. The US demand for some foreign currencies was substantially more than the supply.

What is the Smithsonian Agreement?

Conference between nations that resulted in the devaluing of the US dollar, relative to other major currencies. Exchange rates could also fluctuate by 2.25% from the newly set rates.

Briefly explain the floating exchange rate system

By 1973, the boundaries imposed by the Smithsonian Agreement were eliminated which allowed for exchange rates to move more freely. The currencies of most countries fluctuate with market forces.

What are foreign exchange transactions?

When companies exchange one currency for another through a commercial bank, over a telecommunications network known as an over-the-counter market.

Which two markets account for majority of the trading volume

London accounts for almost 40% and New York City for approximately 20%. They control over half the currency trading in the world.

What do foreign exchange dealers do?

They act as intermediaries in the foreign exchange market by exchanging currencies desired by MNCs or individuals.

What are some examples of foreign exchange dealers?

Large commercial groups such as: Citigroup & JP Morgan Chase (United States), Barclays (United Kingdom), UBS (Switzerland), and Deutsche Bank (Germany).

What is the Spot Market & Spot Rate?

The market in which exchange transactions occur for immediate change. The exchange rate at which one currency is traded for another within the spot market is known as the spot rate.

What is the structure of the spot market?

If a bank experiences a shortage of a certain foreign currency it can purchase it from other banks. This trading occurs in the interbank market.

What does the interbank market allow for?

Trading of currencies between commercial banks

How is the US dollar used in the Spot market?

It’s a commonly used medium of exchange in many countries, especially in countries where the home currency is weak or subject to foreign exchange restrictions.

Briefly explain the time zones for a spot market

Although foreign exchange is conducted during regular business hours, such hours vary among locations because of different time zones. When the market opens in the US each morning, rate quotations are based on rates quoted by banks where the markets opened earlier.

Why do some US banks do night trading?

To capitalize on overnight foreign exchange movements and accommodate requests for currency trades.

What is spot market liquidity?

Each currency is characterized by its liquidity, which reflects the trading level activity. The more buyers and sellers there are for a currency, the more liquid the market is. The spot markets for the Euro, the Yen and The pound are very liquid.

Briefly explain the attributes of banks that provide foreign exchange

1. Competitiveness of the Quote: Savings of $0.01 per unit for an order of 1 million, is worth $10,000.

2. Special relationship with the bank: The bank may offer additional services or be willing to make a special effort for the corporation

3. Speed of execution: A corporation would prefer a bank that conducts the transaction and deals with paper work promptly

4. Advice about current market conditions: Banks may provide assessments of foreign economies and relevant activities

5. Forecasting advice: Some banks may provide forecasts of the future state of foreign economies and value of exchange rates

What is the Bid/Ask spread of Banks?

Commercial banks charge fees for foreign exchange, such that, they buy a currency for less than it sells for. It’s the difference between the price at which a bank is willing to buy and the price at which a bank is willing to sell a currency.

What is the bid & ask price mean?

The bid price is the price that a foreign trader, typically a bank is willing to pay for a currency. The ask price is the price at which a bank is willing to sell a currency.

What is a direct quotation in foreign exchange?

A quotation that reports the value of a foreign currency in dollars.

• Ex. 1 euro = x dollars

What is an indirect quotation in foreign exchange?

A quotation that represents the number units of a foreign currency per dollar

• Ex. 1 dollar = x euros

What does the direct vs indirect exchange rate show overtime?

It demonstrates that the indirect exchange rate is the inverse of the direct exchange rate and the relationship between each currency during movements in both rates. If a currency’s direct exchange rate is appreciating, the indirect exchange rate must be depreciating and vice versa.

What is a cross exchange rate?

The exchange rate between currency A and B with respect to a third currency. As the exchange rates of the two currencies against the US dollar change, so do the cross exchange rates of these currencies.

Briefly explain the purpose of forward contracts

An agreement that specifies the currencies to be exchanged, the exchange rate and the date at which the transaction will occur between a MNC and a foreign exchange dealer. The forward rate, is the rate specified within the contract and the forward market is where the contract is traded on.

What are currency futures contracts?

Similar to forward contracts but, are sold on an exchange rather than an over-the-counter market. They specify the volume and date to be exchanged. The future rate is the rate at which an entity can buy or sell currency on the settlement date.

What is the difference between a future rate and a future spot rate

A future spot rate is the spot rate that will exist sometime in the future, the rate is uncertain today, unlike the future rate. The future rate is established within the contract.

Briefly explain the two currency option contracts

1. A currency call option: The right to BUY a specific currency, at a specific price, within a specific period of time.

2. A currency put option: The right to SELL a specific currency, at a specific price, within a specific period of time.

What is the International Money Market?

A market where individuals or institutions with available short-term funds can transfer funds to those in need of funds. It is designed to accommodate the needs of MNCs through..

• Borrowing short-term funds in different currencies to pay for imports denominated in those currencies

• Borrowing in a non-local currency that exhibits a lower interest rate

• Borrowing in a currency that they anticipate to depreciate against their home currency as this would yield a more favourable exchange rate.

What are Dollar-denominated accounts in Europe and Asia?

Banks are willing to lend dollars to corporate customers based in Europe, since the US dollar is commonly used as a medium of exchange for trade.These dollar deposits are known as “euro dollars”. In Asia, they have a similar market where loans and deposits are done in US dollars.

Briefly explain the money market interest rates among currencies

The interest rates are dependent on the supply of short-term funds provided by surplus units and the demand for short-term funds by deficit units in that currency. Money market interest rates are higher in developing countries because they are financing growth.

What is LIBOR?

The London Interbank Offer Rate is the interest rate most often charged for short-term loans between banks in international money markets.

Briefly explain what international money market securities are

When MNCs and government agencies issue debt securities with short-term maturity in the international money market (1 year or less). Although these are perceived to be very safe, they are exposed to exchange rate risk when the currency denominating differs from the investors home currency.

What is the international credit market?

MNC or domestic firms sometimes obtain medium-term funds from loans from local financial institutions or through issuance of notes. To avoid interest rate risk, banks use floating loans with rates tied to the Secured Overnight Financing Rate.

What are Eurocredits / Eurocredit loans

Loans of 1 year or longer extended by banks to MNCs or government agencies in Europe

What are syndicted loans in the credit market?

When a single bank is unwilling or unable to loan a specific amount to a corporation or agency, a group of banks will participate in the lending. The lead bank is responsible for negotiating terms and then organizes a group to underwrite loans.

What is the international bond market?

Facilitates the flow of funds between borrowers who need long-term funds and investors who are willing to supply those funds. An international bond issued by a borrower foreign to where the bond is placed is known as a foreign bond, sometimes called parallel bonds.

Briefly explain the eurobond market.

Eurobonds are bonds sold in countries other than the country whose currency is used to denominate the bond. “Euro” refers to external financing.

• Features of eurobonds: Issued in bearer form meaning no records of ownership, annual coupon payments, and callable (can be converted into common stock)

• Denominations: Denominated in a number of currencies. The US dollar accounts for 70-75% of eurobonds.

• Secondary Market: Market makers for Eurobonds also sell the primary issues

What are other bond markets besides the Eurobond market?

Asia, and South America. When economic conditions weaken, demand for funds declines with the decline in corporate expansion and vice versa when the economy is doing well.

What are the risks of international bonds?

1. interest rate risk: The potential for their value to decline in response to rising long-term interest rates

2. Exchange rate risk: The potential for a bond’s value to decline because the currency denominating the bond depreciates against home currency

3. Liquidity risk: The potential for prices to be lower since there isn’t a consistently active market for them.

4. Credit risk: The potential for default where interest or principal payments are suspended

Discuss the impact of the Greek Crisis on Bonds

In spring 2010 Greece faced weak economic conditions and sharp rise in government budget deficit. There was concern for Spain, Portugal, and Ireland due to their large deficits. Then, May 2010, European countries and IMF provided Greece with loans.

Why do firms issue stock in foreign markets?

They may readily attract funds from foreign investors by issuing stock in international markets, or do so to enhance their global image.

Why do firms issue foreign stock in the US?

If they need large amounts of funds, since the US market is so liquid. Non-US firms have their shares listed on US stock exchanges so they can be easily traded in the secondary market.

• Yankee Stock Offerings: Offerings of stock by non US firms in the US market

• American Depository Receipts (ADR): Certificates representing bundles of the firms stock.

What are factors that influence trading?

1. Rights: Shareholders in some countries have more rights than in others. This affects their influence on management issues

2. Legal protection: Shareholders in some countries have more power to sue publicly traded firms for committing financial fraud

3. Government enforcement: Shareholders are less susceptible to losses due to agency problems

4. Accounting laws: Rules used when preparing financial statements

Stock markets that incorporate these factors, attract more investors

Briefly explain the integration of Int stock markets and credit markets

Stock market conditions reflect the host country conditions, if the country is integrated, so will the stock market. The key link is the risk premium, which affects the rate of return required by financial institutions.

Briefly explain how financial markets serve MNCs

Corporate functions that require foreign exchange markets are:

• 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

What is the impact of the credit crisis on the credit market?

• 2008 subprime crisis reduced housing activity, income, and jobs

• Banks became more risk-averse and cut back lending, especially to MNCs

Briefly explain regulations in the credit market

• Single European Act: Free capital flow in EU; banks can operate across EU with similar regulations

• Basel Accords: Require banks to hold capital based on risk-weighted assets

  • Basel II: Better risk measurement, operational risk control, more disclosure

  • Basel III: Higher capital requirements due to stricter risk estimates