BUSFIN 4250: Ch 3 BOOK Notes

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Foreign Exchange Market

• Def.: market composed primarily of banks, serving firms and consumers who wish to buy or sell various currencies.

• allows for the exchange of one currency for another.

Exchange Rate

• between any two currencies specifies the rate at which one currency can be exchanged for another.

• represents the price at which one currency can be purchased with another currency.

Gold Standard (1st Event)

• From 1876 to 1913,

• exchange rates were dictated by _.

• Each currency was convertible into gold at a specified rate. Thus, the exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold.

• Each country used gold to back its currency.

• When World War I began in 1914, it was suspended.

Bretton Woods Agreement (2nd Event)

• Def: conference held in Bretton Woods, New Hampshire, in 1944, resulting in an agreement to maintain exchange rates of currencies within very narrow boundaries; this agreement lasted until 1971.

• called for fixed exchange rates between currencies.

• An exchange rate was set for each pair of currencies, and

• each country’s central bank was required to maintain its respective local currency’s value within 1 percent of the agreed-upon exchange rates. Ex. in book

Smithsonian Agreement (3rd Event)

• Def: conference between nations in 1971 that resulted in a devaluation of the dollar against major currencies and a widening of boundaries (2 percent in either direction) around the newly established exchange rates.

• the U.S. dollar’s value was devalued (reset downward) relative to the other major currencies. The degree to which the dollar was devalued varied with each foreign currency.

• Not only was the dollar’s value reset, but exchange rates were also allowed to fluctuate by 2.25 percent in either direction from the newly set rates. These boundaries of 2.25 percent were wider than the previous boundaries (of 1 percent), which enabled exchange rates to move within a wider range.

Floating Exchange Rate System

• By March 1973, the official boundaries imposed by the Smithsonian Agreement had been eliminated, thereby allowing exchange rates to move more freely.

• Since that time, the currencies of most countries have been allowed to fluctuate in accordance with market forces; however, some countries’ central banks still periodically intervene in the foreign exchange market to influence the market-determined exchange rate or to reduce the volatility in their respective currency’s exchange rate movements.

companies typically exchange one currency for another through a

commercial bank over a telecommunications network, which represents an over-the-counter market.

Foreign Exchange Dealers

• Def: dealers who serve as intermediaries in the foreign exchange market by exchanging currencies desired by MNCs or individuals.

• Ex. large commercial banks such as Citigroup (United States), JPMorgan Chase & Co. (United States),

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Spot Market

• Def: market in which exchange transactions occur for immediate exchange.

Spot Rate

• Def: current exchange rate of currency.

• The exchange rate at which one currency is traded for another in the spot market

Spot Market Structure

• completed electronically, with banks or other financial institutions serving as intermediaries.

• The exchange rate at the time determines the amount of funds necessary for the transaction.

Interbank Market

• Def: trading of currencies between commercial banks.

• If a bank begins to experience a shortage of a particular foreign currency, it can purchase that currency from other banks. This trading between banks occurs in the

Attributes of Banks That Provide Foreign Exchange/Characteristics Important To Customers

• Competitiveness of quote.

• Special relationship with the bank.

• Speed of execution.

• Advice about current market conditions.

• Forecasting advice.

Bid Price

• Def: price that a trader of foreign exchange (typically a bank) is willing to pay for a particular currency. BUY QUOTE

Ask Price

• Def: price at which a trader of foreign exchange (typically a bank) is willing to sell a particular currency. SELL PRICE

Bid/Ask Spread

• Def: difference between the price at which a bank is willing to buy a currency and the price at which it will sell that currency.

• meant to cover the costs associated with fulfilling requests to exchange currencies.

• A larger _ generates more revenue for commercial banks, but represents a higher cost to individuals or MNCs that engage in foreign exchange transactions. T

• typically expressed as a percentage of the ask quote.

bank’s bid price (buy quote) for a foreign currency will always be

less than its ask price (sell quote).

Factors That Affect Spread

• Order costs.

• Inventory costs.

• Competition.

• Volume.

• Currency risk.

Direct Quotations

• Def: quotation that reports the value of a foreign currency in dollars (number of dollars per unit of other currency).

Indirect Quotations

• Def: exchange rate quotation representing the value measured by number of units per dollar.

• the reciprocal (inverse) of the corresponding direct quotation.

if a currency’s direct exchange rate is rising over time, then its

indirect exchange rate must be declining over time (and vice versa).

Cross Exchange Rate

• Def: exchange rate between currency A and currency B, given the values of currencies A and B with respect to a third currency.

• reflects the amount of one foreign currency per unit of another foreign currency.

• can be easily determined with the use of foreign exchange quotations.

• The relative value of any two non-dollar currencies is equal to the dollar value of one currency divided by the dollar value of the other.

As the exchange rates of two currencies change against the U.S. dollar over time, the cross exchange rate of these currencies can

change as well.

A currency derivative is

• a contract with a price that is partially derived from the value of the underlying currency that it represents.

• Three types that are often used by MNCs are forward contracts, currency futures contracts, and currency options contracts.

Forward Contract

• Def: agreement to buy or sell a specified currency at a specified exchange rate on a specified future date.

• an agreement between an MNC and a foreign exchange dealer that specifies the currencies to be exchanged, the exchange rate, and the date at which the transaction will occur.

• MNCs commonly request_ to hedge future payments that they expect to make or receive in a foreign currency. With such arrangements in place, they do not have to worry about fluctuations in the spot rate until the time of their future payments.

Forward Rate

• Def: specified exchange rate within the forward contract.

• at which the currencies will be exchanged.

Forward Market

• Def: market in which forward contracts are created.

• the market in which forward contracts are traded.

• In this over-the-counter market, the main participants are the foreign exchange dealers and the MNCs that wish to obtain a forward contract.

Currency Futures Contracts

• Def: contract specifying a standard volume of a particular currency to be exchanged on a specific settlement date.

• are sold on an exchange instead of an over-the-counter market.

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Futures Rate

• Def: the exchange rate at which an entity can purchase or sell a specified currency on the settlement date in accordance with the futures contract.

Difference Between Futures Rate and Future Spot Rate

• The future spot rate is the spot rate that will exist at some future time; hence, that rate is uncertain today.

Currency Call Option

• Def: contract that grants the right to purchase a specific currency at a specific price (exchange rate) within a specific period of time.

Strike Price / Exercise Price

• Def: price (exchange rate) at which the owner of a currency call option is allowed to buy a specified currency; or the price (exchange rate) at which the owner of a currency put option is allowed to sell a specified currency.

Currency Put Option

• Def: contract granting the right to sell a particular currency at a specified price (exchange rate) within a specified period of time.

Currency Call and Put Options

• can be purchased on an exchange.

• They offer more flexibility than forward or futures contracts because they are not obligations: that is, the firm can elect not to exercise the option.

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Each country has a money market whereby

• surplus units (individuals or institutions with available short-term funds) can transfer funds to deficit units (institutions or individuals in need of funds).

• Financial institutions such as commercial banks accept short-term deposits from surplus units and redirect those funds toward deficit units.

The international money market developed to

accommodate the needs of MNCs.

MNC Borrowing/Needs Info

• First, many MNCs borrow short-term funds in different currencies to pay for imports denominated in those currencies.

• Second, MNCs that need funds to support local operations may consider borrowing in a nonlocal currency that exhibits lower interest rates

• Third, MNCs may consider borrowing in a currency that they anticipate will depreciate against their home currency, as this would enable them to repay the short-term loan at a more favorable exchange rate. In this case, the actual cost of borrowing would be less than the interest rate quoted for that currency.

some MNCs and institutional investors have incentives to

• invest short-term funds in a foreign currency.

• First, the interest rate on a short-term investment denominated in a foreign currency might exceed the interest rate on a short-term investment denominated in their home currency.

• Second, they may consider investing in a currency that they expect will appreciate against their home currency so that the return on their investment would be greater than the interest rate quoted for the foreign investment.

Eurodollars

• Def: dollar deposits in banks in Europe (and on other continents).

• (not to be confused with the euro, the currency used by many European countries).

Asian Money Market

• Def: market in Asia in which banks collect deposits and make loans denominated in U.S. dollars.

• accommodates dollar-denominated bank accounts because various businesses in Asia use dollars as the medium of exchange in international trade.

• Banks within usually lend to each other when some banks have excess dollars and other banks need more dollars.

In general, a country that experiences both a high demand for and a small supply of short-term funds will have

relatively high money market interest rates.

Conversely, a country with both a low demand for and a large supply of short-term funds will have

relatively low money market interest rates

The money market interest rate for a particular currency changes over time in response to

changes in the supply of and demand for short-term funds for that currency.

Secured Overnight Financing Rate SOFR

• Def: a benchmark interest rate used for loans and derivatives denominated in U.S. dollars. SOFR is a key replacement for the London Interbank Offered Rate (LIBOR), which was officially replaced in June 2023.

• a fully transaction-based rate, and less susceptible to market manipulation.

• It measures the cost of borrowing cash overnight, collateralized by Treasury securities with close to $1 trillion of daily transactions supporting SOFR calculation.

• When a currency’s _ rises, money market rates denominated in that currency tend to rise as well, just as U.S. money market rates tend to move with the federal funds rate (the interest rate charged on loans between U.S. banks).

London Interbank Offered Rate LIBOR

• Def: the rate most often charged for very short-term loans (such as for one day) between banks. LIBOR was replaced by the Secured Overnight Financing Rate (SOFR) on June 30, 2023.

LIBOR’S End

• historically measured as the average of the rates reported by banks at a particular time.

• In 2012, country governments detected that some banks were falsely reporting the interest rate they offered in the interbank market in an effort to manipulate the LIBOR, thereby boosting the values of their investments that were tied to LIBOR.

• This scandal prompted financial markets to devise ways of determining the market interest rate in a manner that does not rely on the rates reported by participating banks.

International Money Market Securities

• Def: debt securities issued by corporations or government agencies that are sold in the international money markets.

• When MNCs and government agencies issue debt securities with a short-term maturity (one year or less) in the international money market

International Money Market Securities Safety

• international money market securities are perceived to be very safe, especially when they are rated high by rating agencies.

• Also, because the typical maturity of these securities is one year or less, investors are less concerned about the issuer’s financial condition deteriorating by the time of maturity than if the securities had a longer-term maturity.

• Nevertheless, some international money market securities have defaulted, so investors in this market need to consider the possible credit (default) risk of the securities that are issued.

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Eurocredit Loans

• Def: loans of one year or longer that are extended by banks to MNCs or government agencies in Europe.

• these transactions occur in the Eurocredit market .

• can be denominated in dollars or in one of many other currencies, and their typical maturity is five years.

Eurocredit Market

• Def: collection of banks that accept deposits and provide loans in large denominations and in a variety of currencies. The banks that comprise this market are the same banks that comprise the Eurocurrency market; the difference is that the Eurocredit loans are longer term than so-called Eurocurrency loans.

Syndicate

• Def: group of banks that participate in loans.

• banks may be organized, in which each bank participates in the lending.

• The lead bank is responsible for first negotiating terms with the borrower; it then organizes a group of banks to underwrite the loans.

• For each bank involved, syndicated loans reduce the exposure to default risk to the extent of that individual bank’s participation.

Syndicate Borrowers

• Borrowers that receive a syndicated loan incur various fees besides the interest on the loan.

• Front-end management fees are paid to cover the costs of organizing the syndicate and underwriting the loan.

• In addition, a commitment fee of approximately 0.25 to 0.50 percent is charged annually on the unused portion of the available credit extended by the syndicate.

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International Bond Market

• Facilitates the flow of funds between borrowers who need long-term funds and investors who are willing to supply those funds.

• Major investors in the international bond market include institutional investors such as commercial banks, mutual funds, insurance companies, and pension funds from many countries.

3 Reasons MNCs May Choose To Issue Bonds In International Bond Market

• First, MNCs may be able to attract a stronger demand by issuing their bonds in a particular foreign country rather than in their home country.

• Second, MNCs may prefer to finance a specific foreign project in a particular currency and, therefore, may seek funds where that currency is widely used.

• Third, an MNC might attempt to finance projects in a foreign currency with a lower interest rate in an effort to reduce its cost of financing, although doing so would increase its exposure to exchange rate risk.

Foreign Bond

• Def: bond issued by a borrower foreign to the country where the bond is placed.

• Ex: a U.S. corporation may issue a bond denominated in Japanese yen that is sold to investors in Japan.

Parallel Bond

• Def: bonds placed in different countries and denominated in the respective currencies of the countries where they are placed.

Eurobonds

• Def: bonds that are sold in countries other than the country whose currency is used to denominate the bonds.

• misleading because the prefix Euro refers to external financing, rather than to Europe or the currency called the euro.

• There is also potential confusion because some financial market participants use the term when describing bonds issued in Europe that are denominated in euros.

Eurobond Features

• usually issued in bearer form, which means that no records are kept regarding ownership.

• Coupon payments are made yearly.

• Some carry a convertibility clause that allows for them to be converted into a specified number of shares of common stock.

• An advantage to the issuer is that they typically have few, if any, protective covenants.

• Furthermore, even short-maturity Eurobonds include call provisions.

Floating Rate Notes (FRNs)

• Def: a rate provision in some Eurobonds that adjusts the coupon rate over time according to prevailing market rates.

international bonds are subject to four forms of risk:

interest rate risk, exchange rate risk, liquidity risk, and credit (default) risk.

Interest Rate Risk INTER BONDS

• the potential for their value to decline in response to rising long-term interest rates.

• When long-term interest rates rise, the required rate of return by investors rises. Therefore, the valuations of bonds decline.

• Interest rate risk is more pronounced for fixed-rate bonds than for floating-rate bonds because the coupon rate remains fixed on fixed-rate bonds even when interest rates rise.

Exchange Rate Risk INTER BONDS

• the potential for a bond’s value to decline (from the investor’s perspective) because the currency denominating the bond depreciates against the investor’s home currency.

• As a result, the future expected coupon or principal payments to be received from the bond may convert to a smaller amount of the investor’s home currency.

Liquidity Risk INTER BOND

• represents the potential for their prices to be lower at the time they are sold by investors because no consistently active market exists for them.

• Thus, investors who wish to sell the bonds may have to lower their price to attract potential buyers.

Credit Risk INTER BOND

• the potential for default, whereby interest and/or principal payments to investors may be suspended either temporarily or permanently.

• This risk is especially relevant in countries where creditor rights are limited, because creditors may be unable to require that debtor firms take the actions necessary to enable debt repayment.

• As the credit risk of the issuing firm increases, the risk premium required by investors also increases. Any investors who want to sell their holdings of the bonds under these conditions must sell the bonds for a lower price to compensate potential buyers for the credit risk.

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Reasons MNCs May Issue Stock In Foreign Markets

• They may more readily attract funds from foreign investors by issuing stock in international markets.

• They typically have their stock listed on an exchange in any country where they issue shares, because investors in a foreign country are only willing to purchase stock if they can later easily sell their holdings locally in the secondary market.

• The stock is denominated in the currency of the country where it is placed.

• The stocks of some U.S.-based MNCs are widely traded on numerous stock exchanges around the world, which gives non-U.S. investors easy access to those stocks and also gives the MNCs global name recognition.

• issue stock in a country where they will generate enough future cash flows to cover dividend payments.

Yankee Stock Offerings

• Def: offerings of stock by non-U.S. firms in the U.S. markets.

• Non-U.S. corporations that need large amounts of funds sometimes issue stock in the United States (these are called _ ) because the U.S. new-issues market is so liquid.

• By issuing stock in the United States, non-U.S. firms may diversify their shareholder base; this, in turn, can lessen the share price volatility induced by large investors selling shares.

• Non-U.S. firms that issue stock in the United States have their shares listed on a U.S. stock exchange, so that the shares placed in the United States can be easily traded in the secondary market.

• Firms that issue stock in the United States are generally required to satisfy stringent disclosure rules regarding their financial condition.

Sarbanes Oxley Act

• 2002 required firms whose stock is listed on U.S. stock exchanges to provide more complete financial disclosure.

• The high cost of compliance with this act subsequently prompted many non-U.S. firms to place new issues of their stock in the United Kingdom, rather than the in United States.

• Furthermore, some non-U.S. firms listed on U.S. stock exchanges before the Sarbanes-Oxley Act de-registered after its passage; such withdrawals may be attributed to the high cost of compliance.

American Depository Receipts (ADRs)

• Def: certificates representing ownership of foreign stocks, which are traded on stock exchanges in the United States.

• The use of ADRs circumvents some disclosure requirements imposed on stock offerings in the United States while enabling non-U.S. firms to still tap the U.S. market for funds

• the price of an ADR changes each day in response to demand and supply conditions. Over time, however, the value of an ADR should move in tandem with the value of the corresponding stock that is listed on the foreign stock exchange (after exchange rate effects are taken into account).

Factors That Enable Strong Governance, Therefore Increasing Trade Activity in Stock Market

• Rights

• Legal Protection

• Government Enforcement

• Accounting Laws

• Impact of Governance Characteristics

Rights TRADE ACTIVITY

Shareholders in some countries have more rights than those in other countries.

Legal Protection TRADE ACTIVITY

• Shareholders in some countries may have more power to sue publicly traded firms if their executives or directors commit financial fraud.

• In general, common-law countries such as Canada, the United Kingdom, and the United States allow for more legal protection than civil-law countries such as France and Italy.

• Managers are more likely to serve shareholder interests when shareholders have more legal protection.

Government Enforcement TRADE ACTIVITY

• A country might have laws to protect shareholders yet not adequately enforce those laws, which means that in a practical sense shareholders are not protected.

• Some countries also tend to have less corporate corruption than others. In these countries, shareholders are less susceptible to major losses due to agency problems, whereby managers use shareholder money for their own benefit.

Accounting Laws TRADE ACTIVITY

• Beginning in 2001, the International Accounting Standards Board issued accounting rules for public companies.

• Many countries now require public companies to use these rules in preparing their financial statements. As a result, there is more uniformity in accounting rules across countries, though some persistent differences might make it difficult to directly compare financial statements of MNCs across countries (GAAP for United States and IFRS for International).

• Shareholders are less susceptible to losses stemming from insufficient information when public companies are required to provide more transparency in their financial reporting.

Impact of Governance Characteristics TRADE ACTIVITY SUMMARY

• In general, stock markets that allow more voting rights for shareholders, more legal protection, more enforcement of the laws, and more stringent accounting requirements attract more investors who are willing to invest in stocks.

• Collectively, these factors produce more confidence in the stock market and greater pricing efficiency because a large set of investors monitor each firm.

• A stock market that does not attract investors will not attract companies in search of funds; in this case, companies must rely either on stock markets in other countries or on credit markets (bonds and bank loans).

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A financial market crisis in one country can lead to contagion effects in the financial markets of other countries.

• The consumers and businesses of the country that is experiencing an economic crisis have less money to spend, which causes a reduced demand for imported products produced by other countries.

• This effect is especially pronounced when the crisis country’s local currency has weakened substantially against other currencies. Thus, any country that relies heavily on consumers in the crisis country to buy its products could experience its own economic crisis.

• If many of the second country’s local financial institutions have major investments in or have provided loans to the crisis country, they could be subject to large losses or even bankruptcy.

• If the second country’s government has issued international debt, it could experience its own financial market crisis, just as the crisis country did.

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Four Corporate Functions

• require use of the foreign exchange markets.

• The spot market, forward market, currency futures market, and currency options market are all classified as foreign exchange markets.

The first function is foreign trade with business clients.

Exports generate foreign cash inflows, whereas imports require cash outflows.

A second function is direct foreign investment, or the acquisition of foreign real assets.

This function requires cash outflows but generates future inflows either through remitted earnings back to the MNC or through the sale of these foreign assets.

A third function is short-term investment or financing in

foreign securities in the international money market.

The fourth function is longer-term financing in the international bond or stock markets.

An MNC may use international money or bond markets to obtain funds at a lower cost than they can be obtained locally.