International financial markets and institutions

International financial markets and institutions• Objectives • Introduction • Foreign exchange markets • Determination of the exchange rate • Protecting against exchange risk • Foreign m

International financial markets

and institutions

Chapter 7

International financial markets and institutions

• Objectives

• Introduction

• Foreign exchange markets

• Determination of the exchange rate

• Protecting against exchange risk

• Foreign money and capital markets

• Regional money and capital markets

• The IMF system.

• Review the basic characteristics of all the financial

markets that may be available to a firm in

international business.

• Examine the foreign exchange market, its

operation, and the main participants.

• Explain the fundamental economic factors that

determine exchange rates

• Show how firms can operate successfully in more

than one currency without facing unacceptable

• Give insights into domestic money and capital

markets that exist around the world.

• Describe the functioning of the euromarkets, both

short term and long term.

• Explain how the international monetary system

functions and how it relates to both private-sector firms and governments.

• Look at a country’s balance of payments and show

what lessons can be drawn from it.

• Show how firms can take advantage of the

opportunities available in all of these markets.

Objectives (Continued)

• International financial markets are relevant to

companies, whether or not they become directly involved in international business through exports, direct investment, and the like

• Purchases of imported products or services,

borrowing and investment in other countries or

currency, all involve exchange risk

• Exchange risk: The risk of financial loss or gain

due to an unexpected change in a currency’s

• Foreign exchange: any financial instrument that

carries out payment from one currency to another.

• Exchange rate: the amount of one currency that

can be obtained for another currency.

– Spot rate is the rate quoted for current foreign

currency transactions.

– Forward rate is the rate quoted for the delivery of

foreign currency at a predetermined future date such as 90 days from now.

– Cross rate is an exchange rate that is computed

from two other rates

Introduction (Continued)

• Foreign exchange: any financial instrument that

carries out payment from one currency to

another.

• Exchange rate: the amount of one currency that

can be obtained for another currency.

– Spot rate is the rate quoted for current foreign

currency transactions.

Introduction (Continued)

Foreign exchange markets

The foreign exchange markets

• The foreign exchange market is a mechanism,

through which financial instruments (cash,

cheques or drafts, wire transfers telephone

transfers and contracts to sell or buy currency in the future) that are denominated in different

currencies can be transacted

• There are four major ways of conducting foreign exchange in the US:

– Between banks: the interbank market for foreign

exchange involves transactions between banks

– Brokers: the brokers’ market consists of a small

group of foreign exchange brokerage companies that make markets in foreign currencies These brokers do not take currency positions They simply match buyers and sellers and charge a commission for their services

The foreign exchange markets

(Continued)

– Forward transactions: lets a customer “lock in” an

exchange rate and thus be protected against the risk

of an unfavourable change in the value of the

currency that is needed This exchange market is

very important to firms that are doing business

overseas and dealing in foreign currency

– Futures market: the futures market is very similar to

the forward foreign exchange market except in that the amount of currency transacted is fixed to be

transferred at a future date at a fixed exchange rate.

The foreign exchange markets

(Continued)

Figure 7.2 US foreign exchange markets

Source: Adapted from Robert Grosse, St Louis Fed Review, March 1984, p 91

Determination of the exchange rate

Figure 7.1 Foreign exchange market for euros in New York

Economic relationship for exchange rate determination

• Exchange rates are determined by the activities of the groups discussed above, as well as through two fundamental economic relationships that

underlie exchange rate determination:

– Purchasing Power Parity

– The International Fisher Effect.

Purchasing Power Parity

• PPP theory states

that the exchange

rate between two

The International Fisher Effect

– Fisher effect: describes

the relationship between

inflation and interest rates

in two countries and holds

that as inflation rises, so

will the nominal interest

rate.

– The Fisher effect holds

that the interest rate

differential between two

Combined equilibrium

determined by both of the above factors (PPP

and IFE) in the absence of government

intervention.

Discussion U.S Senate Passes Chinese Currency Bill on Oct 11, 2011

End of 1 of 2

Protecting against exchange risk

Protecting against exchange risk

• Alternatives to minimize exchange risk

– Risk avoidance: avoid foreign currency

transactions.

– Risk adaptation: this strategy includes all

methods of “hedging” against exchange rate changes.

– Risk transfer: the use of an insurance contract or

guarantee that transfers the exchange risk to the insurer or guarantor

– Diversification: spreading assets and liabilities

Foreign money and capital markets

Foreign money and capital markets

• The MNE will generally utilize local markets to

perform local financial transactions and often to hedge its local asset exposure through local

borrowing (or its local liability exposure through local deposits or investments)

• The MNE can also utilize local financial markets

to obtain additional funding (or place additional funds) for its non-local activities

by Asia Pacific Foundation of Canada

Regional money and capital markets

Regional money and capital markets

• The eurocurrency market

– A eurodollar is a dollar-denominated bank deposit

located outside the United States

– Eurobonds are financial instruments that are

typically underwritten by a syndicate of banks from different countries and are sold in countries other than the ones in which their currency is

denominated

– Euroequities are shares of publicly traded stocks

traded on an exchange outside of the issuing firm’s home country.

The IMF system

The international monetary system

• International monetary system: The

arrangement between national

governments/central banks that oversee the

operation of official foreign exchange dealings

between countries.

• International Monetary Fund (IMF): The

international organization founded at Bretton

Woods, NH, in 1944 that offers balance of

payments support to countries in crisis along with financial advising to central banks.

The international monetary fund (IMF)

• The goals of the IMF include:

– to facilitate the balanced growth of international

trade;

– to promote exchange stability and orderly

exchange arrangements and to discourage competitive currency depreciation;

– to seek the elimination of exchange restrictions

that hinder the growth of world trade;

– to make financial resources available to members,

on a temporary basis and with adequate safeguards, to permit them to correct payment

IMF Employees talk about IMF