Chapter 3

International Financial
Markets
 Chapter Objectives

• To 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
 Motives for Using International
Financial Markets (1)
• The markets for real or financial assets are
prevented from full integration by barriers
like tax differentials, tariffs, quotas, labor
immobility, communication costs, cultural,
and financial reporting differences.
• Yet, such market imperfections also create
unique opportunities for specific geographic
markets, helping these markets attract
foreign creditors and investors.
 Motives for Using International
Financial Markets (2)
• Investors invest in foreign markets:
– to take advantage of favorable economic
conditions;
– when they expect foreign currencies to
appreciate against their own; and
– to reap the benefits of international
diversification.
 Motives for Using International
Financial Markets (3)
• Creditors provide credit in foreign markets:
– to capitalize on higher foreign interest rates
– when they expect foreign currencies to appreciate
against their own, and
– to reap the benefits of diversification.
• Borrowers borrow in foreign markets:
– to capitalize on lower foreign interest rates, and
– when they expect foreign currencies to depreciate
against their own.
 Some general points on Financial Markets
• Financial markets offer maturity transformation: short
term lending to long term borrowers. Because there is a
market, short term lenders can sell their investments at any time to
another lender (shares bonds etc)
• Risk Transformation: shares, bonds etc divide up the
investment and enables investors to take a small
investment (and hence risk) in a big investment (and hence
risk).
• Markets provide liquidity a gathering together of
people’s savings
• Markets also value investments on a daily /hourly
basis.

• Is this all good? See chapter 16 on Ethics

 Foreign Exchange Market
• The foreign exchange market allows
currencies to be exchanged in order to
facilitate international trade or financial
transactions.
• The system for exchanging foreign
currencies has evolved from the gold
standard, to agreements on fixed
exchange rates, to a floating rate system.
 Foreign Exchange Market
• The foreign exchange market when freely
floating the price depends of supply and
demand. What we will be
Lower demand for Higher supply of
Price of foreign currency, it is foreign currency in
foreign
currency
more expensive! exchange for more
home currency
finding out is
WHY there are
CHANGES in
demand and
supply and hence
Higher demand for
Lower supply of foreign
currency in exchange for
foreign currency, it is
cheaper!
WHY the
less home currency
exchange rate
Quantity of foreign
currency
changes
 Foreign Exchange
Transactions (1)
• The market for immediate exchange is
known as the spot market.
• Trading between banks occurs in the
interbank market. Within this market,
brokers sometimes act as
intermediaries.
 Foreign Exchange
Transactions (2)
• The forward market enables an MNC to lock
in the exchange rate at which it will buy or
sell a certain quantity of currency on a
specified future date.
• Customers in need of foreign exchange are
concerned with quote competitiveness,
special banking relationship, speed of
execution, advice about current market
conditions, and forecasting advice.
 Foreign Exchange
Transactions (3)
• Banks provide foreign exchange services for a
fee: a bank’s bid (buy) quote for a foreign
currency will be less than its ask (sell) quote.
bid/ask spread = ask rate – bid rate
ask rate
Example Suppose bid price for £ = $1.52,
ask price = $1.60.
Spread = (1.60 – 1.52) = .05 or 5%
1.60
 Foreign Exchange
Transactions (4)
• The spread on currency quotations is
positively influenced by order costs,
inventory costs, and currency risk, and
negatively influenced by competition, and
volume.
• The markets for heavily traded currencies
like the €, £, and ¥ are very liquid.
 Interpreting Foreign Exchange
Quotations (1)
• The exchange rate quotations published in
newspapers normally reflect the ask prices
for large transactions.
• Direct quotations represent the value of a
foreign currency in terms of the home
currency (e.g. 100R:£1 if £ is the home
currency), while indirect quotations
represent the number of units of a foreign
currency per unit of home currency (e.g.
£0.01:1R)
 Interpreting Foreign Exchange
Quotations (2)
• To recap: with the £ as the home currency
• £0.625:$1 is called a “direct quote” ie like
the price of any other “product”
• This is the same as …
• “$1.6 to the £1” or $1.6:£1 which is called
an “indirect quote”
• We use direct quotes because they are
simpler
• But why is £0.625:$1 = $1.6:£1 ?
 Interpreting Foreign Exchange
Quotations (2)
• Notation
“$1.6 to the £1”
can be written as:
$1.6/£ or $1.6:£1

and treated as $1.6 = £1

 Interpreting Foreign Exchange
Quotations (3)
Indirect quotation = 1
Direct quotation

So… with the £ as the home currency …

INDIRECT QUOTE OF $1.6 : £1 can be written as

£1 = $1.6
£ (1/1.6) = $1 (ie divide both sides by 1.6)
£0.625 = $1
i.e. DIRECT QUOTE OF £0.625 : $1
 Interpreting Foreign Exchange
Quotations (4)
• A cross-exchange rate is an IMPLIED exchange rate.
Example take two quotes with a common currency:
$1.5:£1, $.09:1¥
what is the implied rate of ¥ to the £ ?

Answer: TAKE THE TRIP!

£1 converts to $1.5 which converts to 166.67¥.
The cross exchange rate is therefore:
166.67¥:£1
As this is a riskless market operation (arbitrage) the direct rate
must also be 166.67¥:£1 otherwise riskless profits would be
made. And we all know the market does NOT allow riskless
profits to be made (Google LTCM)
 Currency Futures and
Options Market
• Currency futures contracts specify a
standard volume of a particular currency to
be exchanged on a specific settlement date.
They are sold on exchanges, unlike forward
contracts.
• Currency call (put) options give the right to
buy (sell) a specific currency at a specific
price (called the strike or exercise price)
within a specific period of time.
• More on this later!
 International Money
Market (1)
• Financial institutions in this market serve
MNCs by accepting deposits and offering
loans in a variety of currencies.
 International Money
Market (2)
• Both the European and Asian money
markets originated as markets involving
mostly dollar-denominated deposits.
• The Eurocurrency market (market for
Eurodollars) developed during the 1960s
and 1970s, stimulated by regulatory
changes in the U.S. and the growing
importance of OPEC.
 International Money
Market (3)
• The growing standardization of global
banking regulations has contributed
towards the globalization of the industry.
– The Single European Act opened up the
European banking industry and increased its
efficiency.
– The Basel Accord outlined risk-weighted capital
adequacy requirements for banks.
– The proposed Basel II Accord attempts to
account for operational risk.
 International Credit Market (1)
• MNCs sometimes obtain medium-term funds
through banks located in foreign markets.
• Eurocredit loans refer to loans of one year or
longer extended by banks in Europe to
foreign MNCs or government agencies.
• Floating rate loans, such as those based on
the LIBOR, are common, since bank asset
and liability maturities may not match.
 International Credit Market (2)
• Sometimes a single bank is unwilling or
unable to lend the amount needed by a
particular MNC or government agency.
• A lead bank may then organize a syndicate
of banks to underwrite the loan.
• Borrowers that receive a syndicated loan
typically incur front-end management and
commitment fees, in addition to the interest
on the loan.
International Bond Market (1)
There are two types of international bonds:
1. Bonds denominated in the currency of the
country where they are placed but issued
by borrowers foreign to the country are
called foreign bonds or parallel bonds.
2. Bonds that are sold in countries other than
the country of the currency denominating
the bonds are called Eurobonds.
International Bond Market (2)
• The emergence of the Eurobond market
was partly due to the 1963 U.S. Interest
Equalization Tax (IET). They have become
very popular, perhaps in part because they
circumvent registration requirements.
• Usually, Eurobonds are issued in bearer
form, pay annual coupons, and have call
provisions. Some also carry convertibility
clauses, or have variable rate provisions.
International Bond Market (3)
• 70 to 75% of Eurobonds are denominated
in the U.S. dollar.
• Eurobonds are underwritten by a multi-
national syndicate of investment banks and
simultaneously placed in many countries.
• In the secondary market, the market
makers are often the same underwriters
who sell the primary issues.
 Comparing Interest Rates
Annualized Short-Term Interest Rates among Countries in 2001
 Why do these interest rates
differ?
• To say it is due to supply and demand is leaves us
understanding little about the issue.
• Let us see what Irving Fisher has to say about interest
rates:
• He wrote of 3 elements:
– Time Preference (reward for lending and not consuming now)
– Risk (reward for the chance that your investment loses value)
– Inflation (recompense for the decline in the purchasing of money)
– If TP = 1% R = 2% and Infl = 3% then interest = !% + 2% + 3% = 6%
• So what does the Fisher analysis mean at an international
level?
Country A Country B comment
Time 1½% 1½% No reason for there
to be a difference
preference
+ Risk 1% 1% We choose
investments in each
country that have
low risk
= Real rate 2½% 2½% Real rates should
be the same
+ inflation 4½% 2½% Different economic
policies are
inevitable
= interest rate 7% 5% The difference in
inflation rates
explains the
difference in
interest rates!
International Stock Markets (1)
• In addition to issuing stock locally, MNCs can
also obtain funds by issuing stock in
international markets.
• This will enhance the firms’ image and name
recognition, and diversify their shareholder
base.
• A stock offering may also be more easily
digested when it is issued in several markets.
International Stock Markets (2)
• Stock issued in the U.S. by non-U.S. firms
or governments are called Yankee stock
offerings. Many of such recent stock
offerings resulted from privatization
programs in Latin America and Europe.
• Non-U.S. firms may also issue American
depository receipts (ADRs), which are
certificates representing bundles of stock.
International Stock Markets (3)
• The locations of an MNC’s operations can
influence the decision about where to place
its stock, in view of the cash flows needed
to cover dividend payments.
• Market characteristics are important too.
Stock markets may differ in size, trading
activity level, and proportion of individual
versus institutional share ownership.
 Comparison of International
Financial Markets
• The foreign cash flow movements of a
typical MNC can be classified into:
1. Foreign trade—exports and imports
2. Direct foreign investment (DFI)—acquisition
of foreign real assets
3. Short-term investment or financing in foreign
securities
4. Longer-term financing in the international
bond or stock markets
 Foreign Cash Flow Chart of an MNC
Foreign
Exchange
MNC Parent Transactions

Export/Import
Dividend
Remittance Foreign
& Financing Exchange
Foreign Medium- & Markets
Business Long-Term
Short-Term
Clients Investment Financing
& Financing Long-Term
Financing
Export/
International
Import International Money Credit Markets International
Markets Stock Markets
Short-Term
Investment & Financing
Foreign
Subsidiaries Medium- & Long-Term Financing
Long-Term Financing
 How Financial Markets Affect
an MNC’s Value
• Since interest rates commonly vary among
countries, an MNC may use the
international financial markets to reduce its
cost of capital, thereby achieving a higher
valuation. In simple terms it lowers their
interest rate bill!