internation finance

8/12/2019 Internation Finance

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CONTENTS:

1. Foreign Exchange Market

2. International Money Market

3. International Credit Market

4. International Bond Market

5. International Stock Market

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INTERNATIONAL FINANCIAL MARKET

Financial Market:

A financial market is a market in which people andentities can trade financial securities (stocks and

bonds) at low transaction costs and at prices thatreflect supply and demand.

International Financial Market:

The international financial markets are financial marketswhere individuals buy and sell foreign assets such as stock,bonds, currencies at international level etc...

The foreign exchange markets would be an example of a

foreign financial market. 3


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1. FOREIGN EXCHANGE MARKET:

The foreign exchange market allows currencies to beexchanged in order to facilitate international trade or

financial transactions. The market in which participants are able to buy, sell and

exchange of currencies. Foreign exchange markets aremade up of banks, firms, central banks, investment

management firms.

Large commercial banks serve this market by holdinginventories of each currency, so that they can accommodaterequests by individuals or MNCs.

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The foreign exchange market assists international tradeand investments by enabling currency conversion.

For example, it permits a business in the United States to

import goods from the European Union member states,

especially Euro zone members, and pay Euros, even

though its income is in United States dollars.

It also supports direct speculation and evaluation relative

to the value of currencies, and the carry trade,

speculation based on the interest rate differential

between two currencies

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For one currency to be exchanged for another currency,there needs to be anexchange rate that specifies the rateat which one currency can be exchanged for another.

Systems used for Exchange Rate:

1. Gold Standard

2. Fixed Exchange Rate System

3. Floating Exchange Rate System

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1. Gold Standard:A monetary system in which a country's government allows its currencyunit to be freely converted into fixed amounts of gold and vice versa.The exchange rate under the gold standard monetary system isdetermined by the economic difference for an ounce of gold between

two currencies. Each currency was convertible into gold as a specifiedrate. Thus, the exchange rate between two currencies was determinedby their relative convertibility rates per ounce of gold.

2. Fixed Exchange Rate System:

A fixed exchange-rate system (also known as pegged exchange ratesystem) is a currency system in which governments try to keep thevalue of their currencies constant against one another. This makestrade and investments between the two currency areas easier andmore predictable, and is especially useful for small economies in whichexternal trade forms a large part of their GDP. It can also be used as a

means to control inflation 7
http://en.wikipedia.org/wiki/Inflationhttp://en.wikipedia.org/wiki/Inflation


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An international agreement (known as the BrettonWoods Agreement) called for fixed exchange ratesbetween currencies. Govt. would intervene to prevent

exchange rates from moving more than 1 percent aboveor below their initial established level.

3. Floating Exchange Rate System:

The more widely traded currencies were allowed tofluctuate in accordance with market forces, and theofficial boundaries were terminated. A currency that usesa floating exchange rate is known as a floating currency.Floating exchange rate started in 1971.

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Foreign Exchange Transactions:

The exchange of one currency for another, or the conversion of one

currency into another currency. Foreign exchange also refers to theglobal market where currencies are traded virtually around-the-clock. The

term foreign exchange is usually abbreviated as "forex" and occasionallyas "FX.

spot market.

The spot market or cash market is a public financialmarket in which financial instruments or commodities aretraded for immediate delivery

The immediate exchange rate is known as the spot rate.

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Spot Market Structure:

Hundreds of banks facilitate foreign exchange transactions,but the top 20 handle about 50 % of the transactions.

Deutsche Bank (Germany), Citibank (U.S) and J.P MorganChase are the largest traders of foreign exchange.

Some banks and other financial institutions have formedalliance (like FX Alliance) to offer currency transactions over

the internet.

Banks in London, New York, and Tokyo are the three largestforeign exchange trading centers, conduct mush of theforeign exchange trading.

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Banks in every major city all over the world facilitate foreignexchange transactions between MNCs.

Transactions between countries done electronically through statebank.

Trading between banks occurs in the interbank market. (It is thetop-level foreign exchange market where banks exchange differentcurrencies. The banks can either deal with one another directly, orthrough electronic brokering platforms.)

Many other financial institutions such as securities firm can providethe same exchange center.

Major airport around the world have foreign exchange center, where

individual can exchanged currencies.

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Attributes of Banks are Important to ForeignExchange Customers:

Competitiveness of quote

Special relationship between the bank and itscustomer

Speed of execution

Advice about current market conditions

Forecasting advice

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Foreign Exchange Transactions:

Banks provide foreign exchange services for afee: the banks bid (buy) quote for a foreigncurrency will be less than its ask (sell) quote.

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Bid And Ask Rate:

A two-way price quotation that indicates the best price at which a security

can be sold and bought at a given point in time. The bid price representsthe maximum price that a buyer or buyers are willing to pay for a security.The ask price represents the minimum price that a seller or sellers are

willing to receive for the security.

EXAMPLE:

A Canadian company will need to purchase 100,000 US dollars to pay forimported goods.

The USDCAD quoted rate is 1.0625 on the bid and 1.0675 on the offer, byconvention the USD is the unit currency and CAD is the terms currency.

The company will have to buy the USD on the dealer's offer, and will pay1.0675 for each dollar bought.

The importer pays 100,000 x 1.0675= 106,750 CAD.

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Currency Spread:

The difference between ask and bid rate is called spread.

Spread = Ask rate Bid rate

Bid/Ask Spread = ask rate bid rateask rate

Example:

Suppose bid price for = $1.52

ask price = $1.60.

bid/ask % spread = (1.601.52)/1.60 = 5%

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Factors Influencing the Size of Spreads:

1.Trading Volume- The higher the volume, or the moreactive a market, the lower the bid-ask spread.

2.Currency Rate Volatility- With higher volatility,

currency dealers are exposed to higher risk. Spreadswill increase with higher volatility.

3.Perceived Economic/Political Risks- Risks such aspolitical instability, higher inflation and changingeconomic conditions will affect the spreads associatedwith a particular currency. The higher the uncertainty,the greater the expected spread.

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4.Processing cost models claim that spread is the

compensation for dealers who offer immediacy whilebearing some fixed costs of market making. Such costsmay include subscriptions to electronic information,connection to the dealing system, and administrative

expense

5.Inventory risk models generally argue that spread isthe compensation for dealers who provide immediacy

and assume risk by holding inventory at the same time

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6.Information cost models:

Also known as asymmetric information or adverseselection models

Maintain that spread is the compensation for dealers whomight lose money when trading with better-informedagents. If some investors are better informed than others,the person who places a firm quote will lose to investors

with superior information. To cover the possible losscaused by trading with better-informed agents, dealersquote higher selling prices and lower buying prices

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Interpreting Foreign Exchange Quotations:

Quotation Systems

There are two systems of quoting a foreign exchange rate.

Direct Quote.A system under which the units of local currency are equated against oneunit of foreign currency. For instance, Rs / $ = 60 implies that Rs 60 is equalto $1.

Indirect Quote.A system under which the units of foreign currency are equated against oneunit of local currency. For instance, $ / = 1.45 implies that $ 1.45 is equal to1.

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Cross Exchange Rate:

A cross exchange rate reflects the amount of one foreigncurrency per unit of another foreign currency.

The currency exchange rate between two currencies, bothof which are not the official currencies of the country in

which the exchange rate quote is given in.

For example, if an exchange rate between the Euro and the

Japanese Yen was quoted in an American newspaper, thiswould be considered a cross rate in this context, becauseneither the euro or the yen is the standard currency of theU.S.

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Value of 1 unit of currency A in units of currency B

= value of currency A in $value of currency B in $

Example: If the Mexican peso is worth $.07 and theCanadian dollar is worth $.70, the value of the peso inCanadian dollars (C$) is calculated as follow:

Value of in C$ = value of peso in $ = $.07 = C$ .10value of C$ in $ $.70

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For example:

you can easily find, say, the eurodollar or the yendollar

exchange rates in financial media. However, the euroyenexchange rate may not be listed. Because the dollar is thecommon currency in this example, you can calculate the euro

yen (and also the yeneuro) exchange rate.

Section C4 of the WSJof Monday, September 10, 2012, listedthe yendollar and eurodollar rates as 78.56 and 0.7802,respectively. Suppose you want to know the euroyen exchangerate. In this case,

/$ = 78.56 and /$ 0.7801 and you want to know the / ?

= 0.7801

78.56 = 0.0099 23


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Forward Contract:A forward contract is an agreement between two parties

to exchange a specified amount of a currency at aspecified exchange rate, on a specified date in the future.An marketplace that sets the price of a financial

instrument or asset for future delivery is called forwardmarket.

The most common forward contracts are for 30, 60, 90,180 and 360 days. MNCs commonly used the forward market to hedge

future payments that they expect to make or receive in aforeign currency. In this way, do not have to worry about

fluctuation in the spot rate until the time of their futurepayment.

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Future Contract:

A currency futures contract specifies a standardvolume of a particular currency to be exchangedon a specific settlement date. Unlike forwardcontracts however, futures contracts are sold on

exchanges.A futures contract is a standardized contract,

traded on a futures exchange, to buy or sell a

certain underlying instrument at a certain date inthe future, at a specified price.

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http://en.wikipedia.org/wiki/Futures_markethttp://en.wikipedia.org/wiki/Futures_markethttp://en.wikipedia.org/wiki/Futures_markethttp://en.wikipedia.org/wiki/Futures_market


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INTERNATIONAL MONEY MARKET

In the most countries, local corporations

commonly need to borrow short term funds tosupport their operations. Country government may also need to borrow

short term funds to finance their budget deficits.

Individuals or local institutional investors in thosecountries provide funds through short termdeposits at commercial banks.

Corporations OR Govt. need short term

funds in a foreign currency:1.They may need to borrow funds to pay for

imports in a foreign currency.

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INTERNATIONAL MONEY MARKET2.If they need funds to support local operations,

they may consider borrowing in a currency inwhich the interest rate is lower.

3.They may consider borrowing in a currency thatwill less depreciate against their home currency.

Origins and Development:There are two important components ofinternational market.

1. European Money Market2. Asian Money Market

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INTERNATIONAL MONEY MARKET Eurocurrency Market: Origin of the European money market can be

traced to the Eurocurrency market thatdeveloped during the 1960 and 1970.

To conduct international trade with Europeancountries, United States corporations deposited

US dollars in European banks. The banks werewilling to accept the deposits because they couldlend the dollars to corporate customer.

These dollars deposited in banks in Europe

came to known as Eurodollars, and the marketfor Eurodollars came to be known as theEurocurrency Market.

Prof. Mohs in Raza 2529


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INTERNATIONAL MONEY MARKET The growth of the Eurocurrency market was

increased, when regulatory changes in the USA.

When the USA limited foreign lending by USbanks in 1968, than foreign MNCs could obtainthe US dollars from banks in Europe via theEurocurrency Market.

Organization of Petroleum Exporting Countries(OPEC) also contributed in the growth of theEurocurrency market. Because OPEC requirespayment for oil in dollars, the OPEC countries

deposited their portion of revenue in theEuropean banks that why some time calledPetrodollars.



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Asian Money Market:

Like European money market, in the some Asianbank involve most of deposit in dollars, that iscalled Asian Dollar Market.

That market to accommodate the needs of

businesses that were using the US dollar as amedium of exchange for international trade.

Asian Market centered in Hong Kong and

Singapore, where large banks accept depositsand makes loans in various foreign currencies.



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INTERNATIONAL MONEY MARKETStandardizing Global Bank Regulations:Three of the more significant regulatory eventsallowing for a more competitive global playingfield are

1. The Single European Act2. The Basel Accord

3. The Basel II Accord Single European Act: Single European Act has

opened up the European banking industry in1992 throughout the European Union (EU)

countries. Some provisions of Single European Act for the

banking industry.



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1. Capital can flow freely throughout Europe.2. Banks can offer a wide variety of lending,

leasing, and securities activities in the EU.3. Regulation regarding competition, merger

and taxes are similar throughout the EU.

4. A bank established in any one of the EUcountries has the right to expand into any orall of the other EU countries.

The Basel Accord:

in July 1988, in the Basel Accord signed bycentral banks governors of the 12 countriesagreed on standardized guidelines.



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Under these guidelines,1. Banks must maintain capital equal to al least

4% of their assets.2. For this banksassets weighted by risk.3. Off-balance sheet items are also accounted.4. Banks focusing on services.

The Basel II Accord:Banking regulators that form the so called BaselCommittee are completing a new accord tocorrect some inconsistencies that still exist.

The Basel II Accord is attempting to account forsuch differences among banks.



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1.To encourage banks to improve their techniquesfor controlling operational risk, which couldreduce failure in the banking system.

2.The Basel Committee also plans to requirebanks to provide more information to existing

and prospective shareholders about theirexposure to different types of bank.



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INTERNATIONAL CREDIT MARKET

MNCs and domestic firms sometimes obtain

medium term funds through term loans from localfinancial institutions or through the issuance ofnotes in their local markets.

MNCs also have access to medium term funds

through banks located in foreign markets. Loans of one year or longer extended by banks

to MNCs or Govt. agencies in Europe arecommonly called Eurocredits or Eurocredit

Loans. These loan are provided in the so called

Eurocredit Market.




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The loans have commonly 5 years maturityperiod.

To avoid risk banks commonly used floatingrates. The loan rate floats in accordance with themovement of some market interest rate, such asthe Landon InterBank Offer rate (LIBOR),which is the rate commonly charged for loansbetween banks.

A Eurocredit loan may have a loan rate that

adjusts every 6 months and is set at LIBORplus3 percent. The premium paid above LIBOR willdepend on credit risk of borrower.



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INTERNATIONAL CREDIT MARKET Syndicated Loans: Sometime a single bank is unwilling to lend

amount needed by a particular corporation. Inthis case, a syndicate of banks may beorganized. Each bank within the syndicateparticipants in the lending. A lead bank is

responsible for managing terms with theborrower. Then the lead bank organizes a groupof banks to underwrite the loans.

Borrowers that receive a syndicated loan incur

various fees besides the interest on the loan.Front-end management fees are paid to coverthe costs of organizing the syndicate loan.



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In addition a commitment fee of about .25 or .50percent is charged annually on the unused

portion of the available credit extended by thesyndicate.

The interest rate on loan depends on the

currency in which loan obtained, creditworthinessof the borrower, maturity of the loan. interest rate on loan adjust normally every 6

month.

Syndicated loan not only reduce the default riskof large loan but they can also add an extraincentive for the borrower to repay the loan.



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INTERNATIONAL BOND MARKET

MNCs like domestic firms, can obtain long termdebt by issuing bonds in their local markets.

MNCs can also access long term funds in foreignmarket. MNCs may choose to issue in theinternational bond markets for three reasons.

1.Issuer recognize that they may be able to attracta stronger demand by issuing their bonds in aparticular foreign country rather than in theirhome country.

2.MNCs may prefer to finance a specific foreignproject in a particular currency and therefore mayattempt to obtain funds where that currency iswidely used.



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3.Financing in a foreign currency with a lowerinterest rate may enable an MNC to reduce its

cost of financing.Major Participants in the International Bond Market:

1. Commercial banks2. Mutual Funds3. Insurance Companies4. Pension Funds

International bonds are typically classified as

either Foreign Bonds or Eurobonds.



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EuroBond Market: Eurobonds are bonds that are sold in country of

the currency denominating the bonds. The US Govt. was imposed Interest

Equalization Tax (IET) to discourage US

investors from investing in foreign securities.Thus, non US borrowers that historically had soldforeign securities to US investors.

Then in 1984, U.S. corporations were allowed to

issue bearer bonds directly to non-U.S.investors, and the withholding tax on bondpurchases was abolished.




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Eurobands have become very popular as meansof attracting funds. US based MNC such asMcDonaldsissue Eurobonds. Non US firms suchas Nestle use the Eurobond market as sourcesof funds.

Features of Eurobonds:1.Eurobonds are usually issued in bearer form.2.Pay Annual Coupons.3.May be convertible.4.May have floating rates.

Underwriting Process:Eurobonds are underwritten by Multinationalsyndicate of investment banks in many countries,providing a wide spectrum of funds.




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Secondary market of Bonds: Eurobonds also have a secondary market. The

market makers are in many cases the sameunderwriters who sell the primary issues.

A technological advance called Euro-clear helps

to inform all traders about outstanding issues forsales, thus allowing a more active secondarymarket.

The major intermediaries in the secondary

markets are based in 10 different countries, withthose in the banks of UK, Bank of AmericaInternational, Smith Barney, and CiticorpInternational.



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INTERN TION L STOCK M RKETS In addition to issuing stock locally, MNCs can

also obtain funds by issuing stock in internationalmarkets.

This will enhance the firms image and namerecognition, and diversify the shareholder base.

The stocks may also be more easily digested. Note that market competition should increase the

efficiency of new issues.



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INTERN TION L STOCK M RKETS Non-U.S. firms may also issue American

depository receipts (ADRs), which arecertificates representing bundles of stock. ADRsare less strictly regulated.



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INTERN TION L STOCK M RKETS The locations of the MNCs operations can

influence the decision about where to placestock, in view of the cash flows needed to coverdividend payments.

Market characteristics are important too. Stock

markets may differ in size, trading activity level,regulatory requirements, taxation rate, andproportion of individual versus institutional shareownership.

Stock issued in the U.S. by non-U.S. firms arecalled Yankee stock offerings. Many of suchrecent stock offerings resulted from privatizationprograms in Latin America and Europe.



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INTERN TION L STOCK M RKETS Electronic communications networks (ECNs)

have been created to match orders between

buyers and sellers in recent years.As ECNs become more popular over time, they

may ultimately be merged with one another or

with other exchanges to create a single globalstock exchange. The foreign cash flow movements of a typical

MNC can be classified into four corporate

functions, all of which generally require the useof the foreign exchange markets.Foreign trade. Exports generate foreign cash

inflows while imports require cash outflows.Prof. Mohs in Raza 4448


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INTERN TION L STOCK M RKETSDirect foreign investment (DFI). Cash outflows to

acquire foreign assets generate future inflows.

Short-term investment or financing in foreignsecurities, usually in the Eurocurrency market.

Longer-term financing in the Eurocredit,

Eurobond, or international stock markets.

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