This chapter discusses the foreign exchange and international financial markets. It covers the economics of foreign exchange including how demand and supply determine currency prices. It also describes the structure of the foreign exchange market, including the roles of banks and the spot and forward markets. Finally, it discusses arbitrage in currency markets and the international capital market, including major international banks, the eurocurrency market, international bond market, and global equity markets.
It is very helpful for the students to describe the background and corporate use of the following international financial markets:
Foreign exchange market,
Eurocurrency market,
Euro credit market,
Eurobond market, and
International stock markets.
It is very helpful for the students to describe the background and corporate use of the following international financial markets:
Foreign exchange market,
Eurocurrency market,
Euro credit market,
Eurobond market, and
International stock markets.
MGMT 4710INTERNATIONAL BUSINESSUNIT 2 DISCUSSIONS Since DioneWang844
MGMT 4710
INTERNATIONAL BUSINESS
UNIT 2 DISCUSSIONS
Since the end of World War II, globalization of world markets has been increasing.
The main characteristics of globalization include free flow of goods and services
(International trade), and capital (foreign direct investments), less government intervention,
and regional and global integration. In addition, globalization is strengthened by cross-
national cooperation and institutions such as the World Trade Organization, the World
Bank and the International Monetary Fund. Globalization is supported by the argument
that international trade and foreign direct investments result in a better allocation of
resources.
In the last few years however, international trade and foreign direct investments
have been challenged as a growing number of governments have been questioning the
benefits of free flow of goods, services, and capital. In particular, the United Kingdom has
left the European Union (Brexit), the North American Free Trade Agreements (NAFTA)
has been revised, the United Stated is threatening to reduce or even eliminate its
contributions to international institutions. As a result, tariffs have started to rise, and
multinational enterprises are under increasing pressures to reduce their operations in
foreign countries and invest more in their home countries.
Question: Do you favor globalization of world markets?
Instructions:
-Your answer should be one single-spaced page or less (but at least 10 sentences). Also, cite inside your answer (e.g.: MacMillan, 2020) two recent articles (no older than 2018) from business periodicals such as Business Week, Forbes Magazine, Fortune Magazine, Wall Street Journal, Financial Times, or any other relevant popular press (no textbook, Wikipedia, or academic journal). At the end of your answer, provide complete references of both articles.
MGMK 4710
INTERNATIONAL BUSINESS
Chapter 9. GLOBAL FOREIGN EXCHANGE MARKETS
https://www.youtube.com/watch?v=jo4z26THnpo
I.
INTRODUCTION
Multinational enterprises (MNEs) do business in more than one country. Because countries
have different currencies (e.g. US dollar, Japanese Yen), MNEs will conduct transactions in
several currencies. This chapter (and the next chapter) will look at how companies handle the
complexities of dealing with multiple currencies.
II.
KEY CONCEPTS
- A currency is an instrument of payment in a country (e.g. US dollar) or grouping of countries
(e.g. Euro in most European Union countries).
- Foreign exchange is money denominated in the currency of another country (e.g. China has
more than US$2 trillion in reserve).
- Foreign exchange market is the place where currencies are traded. The foreign exchange
market is comprised of two segments:
+ The over-the-counter market (OTC) includes commercial banks, investment banks, and other financial institutions. The OTC is where most foreign exchange activity occurs
+ The exchange-traded market includes c ...
MGMT 4710INTERNATIONAL BUSINESSUNIT 2 DISCUSSIONS Since DioneWang844
MGMT 4710
INTERNATIONAL BUSINESS
UNIT 2 DISCUSSIONS
Since the end of World War II, globalization of world markets has been increasing.
The main characteristics of globalization include free flow of goods and services
(International trade), and capital (foreign direct investments), less government intervention,
and regional and global integration. In addition, globalization is strengthened by cross-
national cooperation and institutions such as the World Trade Organization, the World
Bank and the International Monetary Fund. Globalization is supported by the argument
that international trade and foreign direct investments result in a better allocation of
resources.
In the last few years however, international trade and foreign direct investments
have been challenged as a growing number of governments have been questioning the
benefits of free flow of goods, services, and capital. In particular, the United Kingdom has
left the European Union (Brexit), the North American Free Trade Agreements (NAFTA)
has been revised, the United Stated is threatening to reduce or even eliminate its
contributions to international institutions. As a result, tariffs have started to rise, and
multinational enterprises are under increasing pressures to reduce their operations in
foreign countries and invest more in their home countries.
Question: Do you favor globalization of world markets?
Instructions:
-Your answer should be one single-spaced page or less (but at least 10 sentences). Also, cite inside your answer (e.g.: MacMillan, 2020) two recent articles (no older than 2018) from business periodicals such as Business Week, Forbes Magazine, Fortune Magazine, Wall Street Journal, Financial Times, or any other relevant popular press (no textbook, Wikipedia, or academic journal). At the end of your answer, provide complete references of both articles.
MGMK 4710
INTERNATIONAL BUSINESS
Chapter 9. GLOBAL FOREIGN EXCHANGE MARKETS
https://www.youtube.com/watch?v=jo4z26THnpo
I.
INTRODUCTION
Multinational enterprises (MNEs) do business in more than one country. Because countries
have different currencies (e.g. US dollar, Japanese Yen), MNEs will conduct transactions in
several currencies. This chapter (and the next chapter) will look at how companies handle the
complexities of dealing with multiple currencies.
II.
KEY CONCEPTS
- A currency is an instrument of payment in a country (e.g. US dollar) or grouping of countries
(e.g. Euro in most European Union countries).
- Foreign exchange is money denominated in the currency of another country (e.g. China has
more than US$2 trillion in reserve).
- Foreign exchange market is the place where currencies are traded. The foreign exchange
market is comprised of two segments:
+ The over-the-counter market (OTC) includes commercial banks, investment banks, and other financial institutions. The OTC is where most foreign exchange activity occurs
+ The exchange-traded market includes c ...
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1. Chapter 8: The Foreign Exchange and
International Financial Markets
2. Chapter 8: The Foreign Exchange and International
Financial Markets
I. The Economics of Foreign Exchange
II. The Structure of the Foreign-Exchange Market
1) The Role of Banks
2) Spot and Forward Markets
3) Arbitrage and the Currency Market
a) Arbitrage of Goods-Purchasing Power Parity
b) Arbitrage of Money
III. The International Capital Market
1) Major International Banks
a) Commercial Banking Services
b) Investment Banking Services
2) The Eurocurrency Market
3) The International Bond Market
4) Global Equity Markets
5) Offshore Financial Centers
3. Learning Objectives
1. Describe how demand and supply determine the price of foreign exchange
2. Discuss the role of international banks in the foreign-exchange market
3. Assess the different ways firms can use the spot and forward markets to
settle international transactions
4. Summarize the role of arbitrage in the foreign –exchange market
5. Discuss the important aspects of the international capital market
4. Opening Case: The Loonie Takes Flight
The increasing value of the Canadian dollar in relation to the U.S. dollar
, and the effectthat increase has on U.S.
trade and investment with Canada.
The loonie: the nickname given for the Canadian one-dollar coin
Was sold atadiscount from the US dollar
.
2007
The Canadian dollar increased 24 percent against the U.S. dollar
.
The increasing value of the Canadian dollar resulted from concerns about the U.S.economy.
Canadian consumers are now paying lower prices for U.S.-madegoods and enjoyinglower costs when vacationing in the
U.S.
Since Canada’s economy is export oriented, the strengthening Canadian dollar has made their products more
expensive to U.S.consumers.
With the decline of export, Canadian economists are predicting asignificant loss in jobs.
Canadian retailers are also suffering as Canadians head south to the U.S.to take advantage of cheaperAmerican goods.
With the global recession of 2008-2009, commodity prices softened and the loonie fellin value against the US
Dollar.
This then brought about an increase in Canadian exports to the United States,and made Canadian retailers happyagain,as
Canadian customers stayedhome, andAmerican thought about heading north to take advantageof cheaper Canadian goods
with the increasing valueof the US Dollar.
5. The Foreign Exchange and International Financial Markets
The difference between international business and domestic business
The use of more than one currency in commercial transactions
The foreign-exchange market exists;-
To facilitate conversion of currencies
Allowing firms to conduct trade more efficientlyacross nation
To facilitate international investment and capital flows
Firms can shop for low-cost financingin capitalmarkets around the world and then use the
foreign exchange market to convert the foreign funds they obtained
Changes in exchange rates affect
The prices thatconsumers pay
The markets in which consumers shop
The profits of firms
6. I. The Economics of Foreign Exchange
Foreign exchange
A commodity that consists of currencies issued by countries other than one’s own
The prices of foreign exchange (under floating exchange rate)
Set by demand and supply in the marketplace
7. The Economics of Foreign Exchange
Direct Quote
The price of the foreign currency in terms of home country
E.g.Say
,US is our homecountry,
Fig 8.4 (p.234) JapYen:$0.012978/ ¥1
IfSouth Korea is the home country? What would be our direct quote for US$?
KRW 1059.45 /$1
Indirect Quote
The price of home currency in terms of the foreign currency
E.g.Say
,US is our homecountry,
Fig 8.4(p.234) JapYen:¥77.06 /1$
IfSouth Korea is the home country? What would be our direct quote for US$?
$0.0009439/ 1 KRW
8. II. The Structure of the Foreign-Exchange Market
Anyone who owns money denominated in one currency and wants to convert that
money to asecondcurrency
Participating in the foreign exchange market
E.g.Pakistani tourists exchanging rupees for British pounds atLondon’s Heathrow Airport
When Toyota exports automobiles toCanada
The world wide volume of foreign exchange trading
$4.0 trillion per day
The largest foreign-exchange market
London,NewYork,Tokyo,and Singapore
Primary Transaction Currency for the foreign exchange market
US Dollar
Approximately 85% of the transactions involve the US dollar
The dollar is used to facilitate most currency exchange
9. II. The Structure of the Foreign-Exchange Market
The Role of Banks
Spot and Forward Markets
Arbitrage and the Currency Market
Arbitrage of Goods-Purchasing Power Parity
Arbitrage of Money
10. 1) The Role of Banks
Large international banks playadominant role in the foreign-exchange market
E.g.JPMorgan Chase, Barclays, and Deutsche Bank
Stand ready to buy or sell the major traded currencies
How do these banks make profits?
Spread between the bid and ask prices for foreign exchange
E.g.JPMorgan buys 10 million Swiss francs atSwFr 1.649/$1
And sells Swiss franc atSwFr 1.648/$1
Buy at$6,064,281.38 and sell at $6,067,961.16 $3,679.78 profit for JPMorgan
Act as speculators
A person or an institution who trades derivatives, commodities, bonds, equities or currencies with a
higher-than-average risk in return for a higher-than-average profit potential
betting that they can guess in which direction exchange rates are headed
Act as arbitrageurs
the simultaneous buying and selling of securities, currency, or commodities in different markets or in
derivative forms in order to takeadvantage of differing prices for the same asset.
11. 1) The Role of Banks
Key players in the wholesale market for foreign exchange
Dealing for their own accounts or on behalfof large commercial customers
Interbank transactions account for a majority of foreign-exchange transactions
Other key players in the foreign exchange market
Corporate treasurers, pension funds, hedge funds, and insurancecompanies
Online currency trading
Key players in the retail market for foreign exchange
Dealing with individual customers who want to buy or sell foreign currencies in large or small
amounts
The price paid by retail customers for foreign exchange
The prevailing wholesale exchange rate + a premium
The size of the premium: afunction of the size of the transaction & the importance of the customer to
the bank
e.g.GM converting to pay its investors < A Danish music store chain to buy new released CD < traveler’s
check
12. 1) The Role of Banks
The clients of the foreign exchange departments of banks
Commercial customers
Engage in foreign-exchange transactions as part of their normal commercial activities
E.g.exporting or importing goods and services, paying or receiving dividends and interest payments etc.
Hedgers
Reduce their risks due to potential unfavorable changes in foreign-exchange rates for moneys to be paid or
received in the future
Speculators
Deliberately assume exchange rate risks by acquiring positions in acurrency, hoping that they can
correctly predict changes in the currency’s market value
Arbitrageurs
Attempt to exploit small differences in the price of acurrency between markets
Seek to obtain riskless profit
Simultaneously buying the currency in the lower-priced market and selling it in the higher-priced
market
13. 1) The Role of Banks
The role of countries’ central banks and treasury departments
Required to intervene in the foreign-exchange market to ensure that the market value
of the country’s currency approximated the currency’s par value(ifthey are under the fixed-
exchange rate system)
Free to intervene the foreign-exchange market to influence the market values of their
currencies if they desire (ifthey are under floating-exchangerate system)
Domestic laws mayconstrain the ability to trade acurrency in the foreign-
exchange market
Convertible currencies (Hard currencies)
Currencies that are free tradable
E.g.the US dollar
, the British pond, the Euro, the Japaneseyen, the Swiss franc, the Canadiandollar
,
Inconvertible currencies (Soft currencies)
Currencies that are not freelytradable because of domestic laws or the unwillingness of
foreigners to hold them
14. 2) Spot and Forward Markets
International business transactions with payments to be made in the future
E.g.lending, buying on credit etc.
Risky: changes in currency value are common
Time dimensions of the foreign-exchange market
Currencies can be bought and sold
for immediate delivery (Spot) or
for delivery atsome point on the future (Forward)
Foreign Exchange Market
Spot Market
Consists of foreign-exchange transactions that are to be consummated immediately
Immediately: often means TWO days after the trade date
Due to time historically needed for payment to clear the international banking system
Forward Market
Consists of foreign-exchange transactions that are to occur sometime in the future
Prices are often published for foreign exchange that will be delivered one month, three months, and six months in
the future
E.g.T
ablefrom p. 239
15. 2) Spot and Forward Markets
Swap transaction
A transaction in which the same currency is bought and sold simultaneously
But delivery is made attwo differentpoints in time
E.g.“spot against forward” swap
A US manufacturer borrowing £10 million aBritish bank for one month
International Business International Banks
International Businesses (including MNCs) wants to buy or sell foreign exchange on
spot or forward basis Contract with International Banks
Prevailing wholesale rate for the currency + asmall premium for its services
16. 2) Spot and Forward Markets
Two other mechanisms of foreign-exchange market
To allow firms to obtain foreign exchange in the future
Currency future
Currency option
Currency future
A contract that resembles aforwardcontract
For a standard amount on a standard delivery date
A firm must complete the transaction by buying or selling the specified amount of foreign
currency atthe specified price and time
Firms can makean offsetting transaction
The difference between future and forward contracts
.
.
.
Forward Future
- Privately negotiated
- Traded over-the-counter
- Highly standardized
- Traded on an exchange
17. 2) Spot and Forward Markets
Currency option
Allows, but not require, afirm to buy or sell aspecified amount of aforeign
currency ataspecified price atanytime up to aspecified date
Grants the right
Publicly traded on organized exchanges worldwide
But international banks often are willing to write currency options customized as to amount and
time for their commercial clients due to the inflexibility of publicly traded options
Options
Call Option
Grants the right to buy the foreign currency in question
Put Option
Grants the right to sell the foreign currency in question
18. 2) Spot and Forward Markets
Instruments that facilitateinternational trade & investments and allow firms to
hedge or reduce the foreign-exchange risks
The forward market,currency options and currency futures
E.g.Best Buy purchases Sony PlayStation 3 gameconsoles for ¥ 800 million for delivery
three months in the future
Best Buy can go to its bank and contract to buy the ¥ 800 million in three months
Buy the yen based on the yen’scurrent price in the three-month forward wholesale market
The firm is able to protect itselffrom increases in the yen’sprice
The forward and spot price
Forward price < the spot price
The currency is sellingataforward discount
Forward price > the spot price
The currency is sellingataforward premium
19. 2) Spot and Forward Markets
Annualized forward premium or discount
Pƒ – Pc
Annualized forward premium or discount =
Pc
Where,
Pƒ= three-month forward price($1.6411)
Pc= spot price ($1.6426)
n = the number of periods in ayear (4 periods)
Annualized forward premium or discount = $1.6411–$1.6426 X 4
$1.6426
= -0.0037 = -0.37% (forwarddiscount)
20. 2) Spot and Forward Markets
Forward price
Represents themarketplace’saggregatepredictionof the spot price of the exchange rate in
the future
Helps international businesspeople forecast future changes in exchange rates
These changes can affect
The price of imported components
The competitiveness and profitability of the firm’sexports
If,
Forward discount (forward price < spot price)
The foreign exchange market believes that the currency will depreciate over time
Firms maywant to;-
Reduce their holdings of assets
Increase their liabilities denominated in the currency
Often with the countries experiencing-
Balance of paymentdeficits
High inflation rate
Signals the market’s
expectations regarding
that country’s economic
policies and prospects
21. 3) Arbitrage and the Currency Market
Arbitrage
The riskless purchase of aproduct in one market for immediate resale in asecond
market
In order to profit from aprice discrepancy
Two types ofArbitrage
Arbitrage of Goods-Purchasing Power Parity
Arbitrage of Money
22. a) Arbitrage of Goods-Purchasing Power Parity
The arbitrage of goods
If the price of agood differs between two markets
Buy the good in the “cheap”market (that offers the lower price)
Resell it in the “expensive” market (that offers the higher price)
Thelawofoneprice
The arbitrage activities will continue until the price of good is identical in both markets
The theory of purchasing power parity (PPP)
The prices of tradable goods will tend to equalizeacross countries as aresult of
exchange rate changes
PPP occurs because the process of buying goods in the cheapmarket and reselling
them in the expensive market affects the demand for
,and the price of,the foreign
currency &the market price of the good itself
23. a) Arbitrage of Goods-Purchasing Power Parity
The theory of purchasing power parity (PPP)
E.g.Assume the exchange rate between US &Canadian dollars
Levi’s jeans US $48 in the US; Can $60 inCanada
US$ 0.80 = Can$1
US $0.80
× Can $60 = US$48 the Levi’sjeans are the same price in both markets
Can $1
Canadian firms decide to increase their investments in Mexico
Canadians sell their currency (to buy Mexican pesos) ↑↑ Supply of Canadian dollar in foreign exchange
↓↓ Valueof Canadian dollar
New exchange rate between US &Canadian dollars US$ 0.60 = Can $1
PPP no longer exists
US residents could cross the border
, exchange US$ 36 for Can $60 buy Levi’sin Canada
Saving US $12
24. a) Arbitrage of Goods-Purchasing Power Parity
The arbitrage process affects three markets
The foreign-exchange market (Forex) between US and Canadian dollars
US residents increase the supply of US dollars in the Forex
Rising the value of the Canadian dollar relative to the US dollar
The market for Levi’sin the US
The behavior of the US residents reduces the demand for Levi’sin the US
the US
The market for Levi’sin Canada
The behavior of the US residents increase the demand for Levi’sin Canada
Canada
The PPP theory
Prices of tradable goods will tend to equalize
lowering the price in
lowering the price in
IfPPP does not exist in the two countries for jeans,people will buy the good in the cheap
market and transport it to the expensive market
Affect prices in the two product markets & supply and demand in the Forex
25. a) Arbitrage of Goods-Purchasing Power Parity
International economists use PPP to help them compare standard of living across countries
E.g.Comparing France and Canada
Seems that averageFrench enjoys higher income level
BUT fails to take into account “differences in price levelsbetween the two countries”
MUST consider whether the report on International income dataare reported with or without PPP
adjustments
France Canada
Per Capita Income in 2009 US$ 42,680
(Originally measured in €, but when converted into US$ with
average foreign exchange rate between € and US$ in 2009)
US$ 42,170
France Canada
Per Capita Income in 2009
after adjusting for
purchasing power
US$ 33,980
(Originally measured in €, but when converted into US$ with
average foreign exchange rate between € and US$ in 2009)
US$ 37,590
26. a) Arbitrage of Goods-Purchasing Power Parity
International economists use the PPP theory to forecast long-term changes
in exchange rates
Purchasing power imbalances between countries signal possible changes in exchange
rates
E.g.McDonald’s Big Mac Index (published in TheEconomist)– p.242
Provides helpful signals showing whether acurrency is overvalued or undervalued in
the foreign-exchange market
NOTE: Big Mac Index is not the perfect indicator because the price of aBig Mac is
affectedby taxes and nontraded inputs like local rents
27. b) Arbitrage of Money
Arbitrage of money short-term gaining
Much of the $4.0 trillion in daily trading of Forex stems from financialarbitrage
Whenever the Forex is not in equilibrium, professional traders canprofit through
arbitraging money
Three common forms of foreign-exchange arbitrage
Two-point arbitrage (geographic arbitrage)
Three-point arbitrage
Covered interest arbitrage
28. Two-point arbitrage (geographic arbitrage)
Two-point arbitrage
Profiting from price differences in two geographically distinct markets
E.g.currency price differences
Arbitrage Opportunity
- JPMorganChase
TakeUS$ 1.80 and buy 1 £ in London Forex, and resell it in New YorkForex
No Risk!
Other banks will also note for the opportunity for quick profits
US$ value in London will fall;£ value in New York will rise until there will be no opportunity to
arbitrage
The same price for both markets and the Forex will be in equilibrium
Arbitrage transaction costs
Cost of arbitrage ↑↑ the differences in exchange rates in the two markets
New York Foreign-exchangeMarket London Foreign-exchange Market
1 £ = US$ 2.00 1 £ = US$ 1.80
29. Three-point arbitrage
Three-point arbitrage
The buying and selling of the three differentcurrencies to make ariskless profit
E.g.New York,Tokyo, and London Forex market (same exchange rates for all market)
£ 1 = US$ 2.00; US$ 1= ¥ 120; £ 1 = ¥ 200
No opportunity of two-point arbitrage (all the markets sell atthe same price)
Opportunity for three-point arbitrage
Riskless profit of £ 0.20
30. Three-point arbitrage
£ 1
£ 1 US$ 1 £ 1
Able to make profits through three-point arbitrage
whenever the cost of buying acurrency directly differs from the cross rate of exchange
Cross rate
An exchange rate between two currencies calculated through the use of athird currency
Usually the US $ is the primary third currency used in calculatingcross rates
E.g.Direct quote between ponds and yen = ¥ 200
Cross rate between ponds and yen = US$ 2 × ¥ 120 = ¥240
The differencebetween the exchange rate &cross rate
The market for the three currencies will be in equilibrium
Links together individual foreign exchange markets
Opportunity for arbitrage
No arbitrageprofit
Changes in direct quote of one currency market affects the other
31. Covered interest arbitrage
Covered interest arbitrage
Arbitrage thatoccurs when the difference between two countries’interest ratesis
not equalto the forward discount/premium on their currencies
The most important form of arbitrage in Forex
Occurs because international bankers, insurance companies, and corporate treasurers are
continually scanning money markets worldwide to obtain
the best returns on their short-term excess cash balances&the lowest rates on short-term loans
They are trying to cover themselves from exchange rate risks
32. Covered interest arbitrage example
New York investors would want to earn higher returns availablein London
They must convert their dollars to pound to invest in London
They will get the return on investment in three-month BUT exchange rate risk
What ifthe pound’s value were to fallduring that three-month period?
Possibility of wiping out the gains earned by higher interest rate
NY investors can avoid exchange rate risk by using the forward market
If an investor has;-
Investment money = $ 1,000,000
Spot exchange rate of 1 pound = US$ 2
Three-month forward rate of 1 pound = US$ 1.99
London NewYork
Annual interest rate for three-month deposits 12% 8%
33. Covered interest arbitrage example
Choices that NY investor has;-
1. Invest their money in NY @ 8% p.a.interest rate (2% for three months)
$1, 000,000× 1.02= $1,020,000 $20,000 return
2. Exchange their currency to pound, invest in London @ 12 % interest today
,&in three months
liquidate their London investment &convert it back to dollars
Convert $1 million to British pounds @ spotrate of $2.00/ £1 £ 500,000
Invest the money- @ 12 % p.a.interest rate (3% for three months) in three monthperiod
£ 500,000 × 1.03 = £ 515,000
[To avoid currency risk] Sell the £ 515,000 today in the three-month forward market atthe current
three-month forward rate of $1.99/ £1
£ 515,000 × $1.99/£1 = $ 1,024,850 $24,850 return
The NY investor can earn more money by investing in London
Covered-interest arbitrage allows to capture higher interest rate in London while covering
exchange rate risk by using the forward market
∴Short-term investment money will flow from NY London (seeking higher covered return)
34. Covered interest arbitrage example
What happens in the two lending markets (NY & London) and the Forex when
such arbitrage occurs?
Funds are transferred from NY London
The supply of lendablemoney in NY ↓
The supply of lendablemoney in London ↑
Interest rates in NY ↑
Interest rates in London ↓
[The spot market] the demand for pounds ↑ Spot price of pounds ↑
[The three-month forward market] the supply of pounds ↑ Forward price of pounds ↓
Lendable funds will continue to flow from NY
London untilthe return on the covered investment is the same in London and NY
The short-term interest rate differentialbetween two countries determines the
forward discount or premium on their currencies IMPORTANT to Forex
35. International Fisher Effect
Why should interest rates vary among countries in the first place?
The question was answered byYaleeconomist, Irving Fisher in 1930
Country’s nominal interest rate = the real interest rate + expected inflation in that country
∴National differences in expected inflation rates yield differencesin nominal interest rates among
countries
International Fisher Effect
International Fisher effect &covered-interest arbitrage
A country’s expected inflation rate ↑
higher ↑ interest rate in the country
A shrinking ↓ of the forward premium /awidening ↑ of the forward discount of acountry’s currency in
the Forex
∴IBers carefully monitor countries’inflation trends
Influence on international monetary system
E.g.a fixed exchangeratesystemfunctions poorly ifinflation rates vary widely among countries
36. Importance of arbitrage activities
1. Constitutes amajor portion of the $4.0 trillion in currencies traded globally
each working day
2. Affects the supply and demand for each of the major trading currencies
3. Ties together the foreign exchange markets
Overcoming differences in geography (two-point arbitrage)
Overcoming currency type (three-point arbitrage)
Time (covered-interest arbitrage)
37. Carry Trade
CarryTrade
Tries to exploit differences in the interest rates between countries
Japan lowest interest rates among the major trading nations
JapaneseYen:A favorite currency of the carry trade
Borrow yen ata low interest rate use the borrowed yen to buy bonds, notes, or
certificates of deposit denominated in currencies thatare payinghigher interest rates
(e.g.NZ$ orAU$)
Risky
If the yen raises in value relative to the second currency the carry trader will lose a lot
E.g.2007 – Japaneseprivate investors (non-professionals) carry trade; subprime crisis in 2007
Japaneseyen rose 4% against US$; 9% againstAU$;
increase in volatility of currency market
11% against NZ$
A lot of carry trader lost
38. III. The International Capital Market
Important role of International Banks
The functioning of the foreign-exchange market (Forex) &arbitrage transactions
Playacritical role in financingthe operations of international businesses
Acting as commercial bankers &investment bankers
As commercial bankers,
Finance exports & imports, accept deposits, provide working capitalloans, and offer sophisticated cash m
anagement services for their clients
As investment bankers,
Underwrite or syndicate local, foreign or multinational loans and broker
Facilitate or finance mergers and JVbetween foreign and domestic firms
39. III. The International Capital Market
Major International Banks
Commercial Banking Services
Investment Banking Services
The Eurocurrency Market
The International Bond Market
Global Equity Markets
Offshore Financial Centers
40. 1) Major International Banks
International Banking
Correspondent relationship
An agentrelationship whereby one bank act as acorrespondent or agentfor another bank in the
first bank’shome country
E.g.US bank could be the correspondent for aDanish bank in the US (vice versa)
Paying or collecting foreign funds, providing credit information, honoring letters to credit
Each bank maintains accounts at the other bank denominated in the local currency
Internationalization of its own operations (owning its foreign operations)
Larger international banks increasingly provides their own overseas operations
To improve their ability to compete internationally
Better access to new sources of deposits and profitable lending opportunities
Banks can better meet its clients’international banking needs
Retains the international business of its domestic clients and reduces the risk thatsome other
international bank has
41. 1) Major International Banks
International Banks’ overseas banking operations
Subsidiary bank:
ifit is separately incorporated from the parent
Branch bank:
ifit is not separately incorporated from the parent
Affiliated bank:
an overseas operation in which it takes part ownership in conjunction with alocal or foreign partner
Types of international banking services
Commercial Banking Services
The physical exchange of one country’s paper currency for another’s
Financing and facilitatingeveryday commercial transactions
Short-term financing of the purchase; international electronic funds transfer; forward purchase of currency; advice about paper
documentation for importing and paying for the goods
Investment Banking Services
Corporate clients higher investment bankers;-
To package and locate long-term debt and equity funding
To arrange mergers and acquisitions of domestic and foreign firms
42. 2) The Eurocurrency Market
Originated in the early 1950s (called the Eurodollar market)
When the communist-controlled governments of Central Europe and Eastern Europe
needed dollars to finance their international trade
Feared that the US government would confiscate or block their holdings of dollars in US banks
for political reasons
The communist governments solved the problem by
using European banks that were willing to maintaindollar accounts for them
Eurodollars
US dollars deposited in European bank accounts
Other banks worldwide began offering dollar-denominated deposit accounts
US dollars deposited in any bank account outside the US
Other currencies became stronger in the post-WWII era
like Euroyen, Europounds etc.
Eurocurrency
the term included other currencies
43. The Euroloan Market
Euroloan market
Extremely competitive, andlenders operate on razor-thin margins
Often quoted on the basis of LIBOR
London Interbank Offer Rate (LIBOR)
The interest rate that London banks charge each other for short-term Eurocurrency loans
Euroloan market is the low-cost source of loans for large,creditworthy
borrowers (such as Governments &large MNEs)
Why?
1. Free of costly government banking regulations
2. Large transactions
The averagecost of making the loans is lower
3. Lower risk premium
Only the most creditworthy borrowers use the Euroloan market
44. International Banking Facility (IBF)
An entity of aUS bank that is legally distinct from the bank’sdomestic
operations that mayoffer only international banking services
Created in response to complaints of US banks about reserve requirements and
regulations imposed by the Federal Reserve Board
Which caused suffering from competition with European andAsian banks in issuing dollar-
denominated international loans
Do not need to observe the numerous US domestic banking regulations
45. 3) The International Bond Market
The International Bond Market
Represents amajor source of debt financingfor the world’s governments, international
organizations and larger firms
Two types of international bonds
Foreign bonds
Bonds issued by aresident of country A but sold to residents of country B & denominated in the
currency of country B
E.g.the Nestle Corporation, aSwiss resident: issue aforeign bond denominated in yen &sold primarily
to residents of Japan
Eurobond
A bond issued in the currency of country A but sold to residents of other countries
E.g.American Airlines borrow $500 million to finance new aircraft purchases by selling Eurobonds
denominated in dollars to residents of Denmark & Germany
Dominant currencies in the international bond market
The euro &the US dollar
46. 3) The International Bond Market
Syndicates
of international banks, securities firms,and commercial banks
put together complex packages of international bonds
to serve the borrowing needs of large,creditworthy borrowers
Global bond
A large,liquid financialasset that can be traded anywhere atany time
Pioneered by the World Bank
Sold $1.5 billion of US dollar-denominated global bonds in North America, Europe and Japan
Succeed in lowering its interest costs on the bond issue by 0.225 percentage point
the bank reduced its annual financialcosts by $3,375,000
0.225 percentage point X $1.5billion
International bond market
Highly competitive
Borrowers are often ableto obtain funds on very favorable terms
47. 4) Global Equity Markets
Globalization of equity markets
The growing importance of multinational operations
Improvements in telecommunications technology
Facilitated by the globalization of the financial services industry
Start-up companies:
No longer restricted to raising new equity solely from domestic sources
E.g.Swiss pharmaceutical firms major source of equity capitalfor new US biotech firms
Established firms:
When expanding into aforeign market,afirm maychoose to raise capitalfor its foreign subsidiary in the
foreign market
E.g.The Walt Disney Company – initiallysold 51% of its Disneyland Paris project to Frenchinvestors
Country Funds
A mutual fund that specializes in investing in agiven country’s firm
48. 5) Offshore Financial Centers
Offshore Financial Centers
Focus on offering banking and other financialservices to nonresident customers
Its financialcenters mostly located on island states
E.g.Bahamas,Bahrain,the Cayman Island,Bermuda, the NetherlandsAntilles and Singapore
Luxembourg & Switzerland not island states but important “offshore” financial centers
MNEs canobtain low-cost Eurocurrency loans
Benefits of offshore financial centers
Political stability
,
A regulatory climatethat facilitates international capital transactions,
Excellent communications links to other major financial centers,
Availability of legal,accounting,financialand other expertise needed to package large loans
Efficiency in attracting deposits &lending these funds to customers worldwide
Important factor in the growing globalization of the capital market