Topic 2 - Chapter 3

International Financial Management
12th Edition
by Jeff Madura
1 © 2015 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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3 International Financial Markets

Chapter Objectives
Describe the background and corporate use of the

following International Financial Markets:
n Foreign exchange market
n International money market
n International credit market
n International bond market
n International stock markets

International financial market
International
Financial market
International International
Capital market Money market
International International
Int Securities Foreign
long -term credit short-term credit
market market market exchange market market
Int Stock market Int Bond market
International financial market
Financial Market refers to

- the marketplace where the activities related to the creation
and trading of the different financial assets such as bonds,
shares, commodities, currencies, derivatives, etc takes
place
- and it provides the platform to sellers and buyers of the
financial assets to meet and trade with each other at a
price as determined by market forces.
Foreign Exchange Market
Allows for the exchange of one currency for

another.
Exchange rate specifies the rate at which one
currency can be exchanged for another.
History of Foreign Exchange

§ Gold Standard (1876 – 1913)
§ Each currency was convertible into gold at a specified
rate. When World War I began in 1914, the gold
standard was suspended.
§ Agreements on Fixed Exchange Rates
§ Bretton Woods Agreement 1944 - 1971
§ Smithsonian Agreement 1971 - 1973
§ Floating Exchange Rate System
§ Widely traded currencies were allowed to fluctuate in
accordance with market forces
Foreign Exchange Transactions

§ The over-the-counter market is the telecommunications
network where companies normally exchange one
currency for another.
§ Foreign exchange dealers serve as intermediaries in the
foreign exchange market
§ Spot Market: A foreign exchange transaction for
immediate exchange is said to trade in the spot market. The
exchange rate in the spot market is the spot rate.
§ Spot Market Structure: Trading between banks occurs in
the interbank market.
Foreign Exchange Transactions (cont.)

§ Use of the U.S. dollar in spot markets: The U.S. Dollar is
the commonly accepted medium of exchange in the spot
market.
§ Spot market time zones - Foreign exchange trading is
conducted only during normal business hours in a given
location. Thus, at any given time on a weekday, somewhere
around the world a bank is open and ready to accommodate
foreign exchange requests.
§ Spot market liquidity: More buyers and sellers means
more liquidity.
Foreign Exchange Transactions (cont.)

§ Attributes of Banks That Provide Foreign Exchange
§ Competitiveness of quote
§ Special relationship with the bank
§ Speed of execution
§ Advice about current market conditions
§ Forecasting advice
Foreign Exchange Quotations

§ The bid price is what the bank is willing to pay for a
currency, while the ask price is the rate at which a bank will
sell the same currency
§ At any given point in time, a bank’s bid (buy) quote for a
foreign currency will be less than its ask (sell) quote.
§ Bid/Ask spread of banks: The bid/ask spread covers the
bank’s cost of conducting foreign exchange transactions
§ Comparison of Bid/Ask spread among currencies
(Exhibit 3.1)
Ask rate - Bid rate
Bid / ask spread =
Ask rate
Foreign Exchange Quotations

- Ellen is an American traveler visiting Europe. The cost of purchasing
euros at the airport is as follows:
EUR 1 = USD 1.30 / USD 1.40
What is the cost to buy each euro? Ellen wants to buy EUR 5,000, so
she would have to pay the dealer ? USD
- The next traveler in line has just returned from her European
vacation and wants to sell the euros that she has left over.
Katelyn has EUR 5,000 to sell at the bid price of ?USD and would
receive ?USD.
- Because of the bid-ask spread, the kiosk dealer is able to make a profit
of ?USD from this transaction.
Exhibit 3.1 Computation of the Bid Ask Spread
Foreign Exchange Quotations (cont.)

§ Factors That Affect the Spread
§ Order costs: Costs of processing orders, including clearing
costs and the costs of recording transactions.
§ Inventory costs: Costs of maintaining an inventory of a
particular currency.
§ Competition: The more intense the competition, the smaller
the spread quoted by intermediaries.
§ Volume: Currencies that have a large trading volume are more
liquid because there are numerous buyers and sellers at any
given time.
§ Currency risk: Economic or political conditions that cause the
demand for and supply of the currency to change abruptly.
Interpreting Foreign Exchange Quotations

§ Direct versus indirect quotations at one point in time (Exhibit
3.2)
§ Direct Quotation expresses the price of a unit of foreign
currency in terms of the domestic currency.
§ Example: for an American: $1.40 per Euro
§ Indirect quotation expresses the amount of foreign currency
per unit of domestic currency
§ Example: for an American: €0.7143 per Dollar
§ Indirect quotation = 1 / Direct quotation
§ The currency to the left of the slash is called the base
currency and the currency to the right of the slash is called,
the counter currency, or quoted currency
Exhibit 3.2 Direct and Indirect Exchange Rate Quotations
Interpreting Foreign Exchange Quotations (cont.)

§ Direct versus indirect exchange rate over time (Exhibit
3.3)
§ When the euro is appreciating against the dollar (based on
an upward movement of the direct exchange rate of the euro),
the indirect exchange rate of the euro is declining.
§ When the euro is depreciating (based on a downward

movement of the direct exchange rate) against the dollar, the
indirect exchange rate is rising.
Exhibit 3.3 Relationship Over Time between the
Euro’s Direct and Indirect Exchange Rates

§ Source of exchange rate quotations
§ Updated currency quotations are provided for several major
currencies on Yahoo’s website (finance.yahoo.com/currency).
§ Exchange rate quotations are also provided by many other

online sources, including oanda.com.

§ Cross Exchange Rates
§ Cross exchange rate is the amount of one foreign currency
per unit of another foreign currency
§ Example
Value of peso = $0.07
Value of Canadian dollar = $0.70
Value of peso in C$ = Value of peso in $
Value of C$ in $
= $0.07 = C$ 0.10
$0.70
§ Source of cross exchange rate quotations: Cross exchange
rates are provided for several major currencies on Yahoo’s
website (finance.yahoo.com/currency-investing).

§ Currency Derivatives: A contract with a price that is partially
derived from the value of the underlying currency that it
represents.
§ Forward Contracts: agreements between a foreign exchange
dealer and an MNC that specifies the currencies to be
exchanged, the exchange rate, and the date at which the
transaction will occur.
§ The forward rate is the exchange rate specified by the forward
contract.
§ The forward market is the over-the-counter market where
forward contracts are traded.

§ Currency futures contracts: similar to forward contracts but
sold on an exchange
§ Specifies a standard volume of a particular currency to be

exchanged on a specific settlement date.
§ The futures rate is the exchange rate at which one can purchase
or sell a specified currency on the specified settlement date.
§ The future spot rate is the spot rate that will exist at a future
point in time and is uncertain as of today.
Currency Derivatives

§ Currency Options Contracts
§ Currency Call Option: provides the right to buy currency at a
specified strike price within a specified period of time.
§ Currency Put Option: provides the right to sell currency at

specified strike price within a specified period of time.
International Money Market
§ Money Market is a type of financial market for lending or

borrowing short term loans with a maturity of less than 1 year.
§ The instruments dealt in the money market are Treasury Bills,

Commercial Papers, Certificate of Deposit, Bills of exchange,
etc.
§ Corporations or governments need short-term funds
denominated in a currency different from their home currency.
§ The international money market has grown because firms:
The international money market has grown because firms:
§ May need to borrow funds to pay for imports denominated in a

foreign currency.
§ May choose to borrow in a currency in which the interest rate

is lower.
§ May choose to borrow in a currency that is expected to

depreciate against their home currency
Origins and Development

§ European Money Market: Dollar deposits in banks in Europe
and other continents are called Eurodollars or Eurocurrency.
Origins of the European money market can be traced to the
Eurocurrency market that developed during the 1960s and
1970s.
§ Asian Money Market: Centered in Hong Kong and Singapore.

Originated as a market involving mostly dollar-denominated
deposits, and was originally known as the Asian dollar market.
Money Market Interest Rates Among Currencies
§ The money market interest rates in any particular country are

dependent on the demand for short-term funds by borrowers,
relative to the supply of available short-term funds that are
provided by savers. (Exhibit 3.4)
§ Money market rates vary due to differences in the interaction of

the total supply of short-term funds available (bank deposits) in
a specific country versus the total demand for short-term funds
by borrowers in that country.
Exhibit 3.4 Comparison of 2011 International Money
Market Interest Rates
Money Market Interest Rates Among Currencies (cont.)

§ Global Integration of Money Market Interest Rates
§ Money market interest rates among countries tend to be highly
correlated over time.
§ When economic conditions weaken, the corporate need for
liquidity declines, and corporations reduce the amount of short
term funds they wish to borrow.
§ When economic conditions strengthen, there is an increase in
corporate expansion, and corporations need additional liquidity
to support their expansion.
Risk of International Money Market Securities
Money Market Interest Rates Among Currencies (cont.)

§ Risk of International Money Market Securities
§ International Money Market Securities are debt securities
issued by MNCs and government agencies with a short-term
maturity (1 year or less)
§ Normally, these securities are perceived to be very safe from the
risk of default.
§ Even if the international money market securities are not exposed
to credit risk, they are exposed to exchange rate risk when the
currency denominating the securities differs from the home
currency of the investors.
International Credit Market
MNCs sometimes obtain medium-term funds through term

loans from local financial institutions or through the
issuance of notes (medium-term debt obligations) in their
local markets.
Loans of 1 year or longer extended by banks to MNCs or
government agencies in Europe are commonly called
Eurocredits or Eurocredit loans.
To avoid interest rate risk, banks commonly use floating
rate loans with rates tied to the London Interbank Offer
Rate (LIBOR).
Syndicated Loans in the Credit Market
§ Sometimes a single bank is unwilling or unable to lend

the amount needed by an MNC or government agency.
§ A syndicate of banks can be formed to underwrite the

loans and the lead bank is responsible for negotiating
the terms with the borrower.
Regulations in the Credit Market

§ Single European Act
§ Capital can flow freely throughout Europe.
§ Banks can offer a wide variety of lending, leasing, and
securities activities in the EU.
§ Regulations regarding competition, mergers, and taxes are
similar throughout the EU.
§ A bank established in any one of the EU countries has the right
to expand into any or all of the other EU countries.
§ Basel Accord - Banks must maintain capital equal to at least

4 percent of their assets. For this purpose, banks’ assets are
weighted by risk.
Regulations in the Credit Market (Cont.)
§ Basel II Accord - Attempts to account for differences in

collateral among banks. In addition, this accord encourages
banks to improve their techniques for controlling operational
risk, which could reduce failures in the banking system. Also
plans to require banks to provide more information to
existing and prospective shareholders about their exposure to
different types of risk.
§ Basel III Accord - Called for new methods of estimating

risk-weighted assets that would increase the level of risk-
weighted assets, and therefore require banks to maintain
higher levels of capital.
Impact of the Credit Crisis on the Credit Market
§ The credit crisis of 2008 triggered by defaults in

subprime loans led to a halt in housing development,
which reduced income, spending, and jobs.
§ Financial institutions became cautious with their funds

and were less willing to lend funds to MNCs
International Bond Market
International bond market facilitates the flow of funds between

borrowers who need long-term funds and investors who are willing to
supply long-term funds.
Multinational corporations can obtain long-term debt by issuing bonds in
their local markets and in foreign markets. An MNC may choose to issue
bonds in the international bond markets for 3 reasons:
- First, to attract a stronger demand for their bonds.
- Second, MNCs may prefer to finance a specific foreign project in a
particular currency and thus 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 order to reduce its cost of financing,
although doing so would increase its exposure to exchange rate risk
International bonds are often classified as either foreign bonds or

Eurobonds.
Foreign bonds are issued by borrower foreign to the country where the
bond is placed.
Eg: a U.S. corporation may issue a bond denominated in Japanese yen
that is sold to investors in Japan.
In some cases, a firm may issue a variety of bonds in various countries.
The currency denominating each type of bond is determined by the
country where it is sold. The foreign bonds in these cases are
sometimes referred to as parallel bonds.
Eurobonds
§ An international bond denominated in a currency other than the
home currency of the country or market in which it is issued.
§ An issuer sells its eurobonds in a number of international markets
§ Eg: A bond issued by a Russian corporation in the European market
that pays interest and principal in U.S. dollars.
§ US’s Company XYZ issue bonds denominated in Canadian dollars in
Australia market, Japan market…
§ Denominations of Eurobonds
§ commonly denominated in a number of currencies; US dollar,
JPY
§ Eurobonds are frequently grouped together by the currency in
which they are denominated, such as eurodollar or Euro-yen
37 bonds.
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Development of Other Bond Markets

§ Bond markets have developed in Asia and South America
§ Bond market yields among countries tend to be highly
correlated over time.
§ When economic conditions weaken, aggregate demand for
funds declines with the decline in corporate expansion.
§ When economic conditions strengthen, aggregate demand
for funds increases with the increase in corporate
expansion.
Risk of International Bonds

§ Interest Rate Risk - potential for the value of bonds to
decline in response to rising long-term interest rates.
§ Exchange Rate Risk - represents the potential for the value
of bonds to decline (from the investor’s perspective)
because the currency denominating the bond depreciates
against the home currency.
§ Liquidity Risk - represents the potential for the value of
bonds to decline because there is not a consistently active
market for the bonds.
§ Credit Risk - represents the potential for default.
Impact of the Greek Crisis on Bonds

§ Spring 2010: Greece experienced weak economic conditions
and large increase in the government budget deficit.
§ Concern spread to other European countries such as Spain,
Portugal, and Ireland that had large budget deficits.
§ May 2010: many European countries and the IMF agreed to
provide Greece with new loans.
§ Contagion Effects:
§ Weakened some other European countries
§ Forced creditors to recognize that government debt is not always
risk free.
International Stock Markets
Issuance of Stock in Foreign Markets - Some U.S. firms

issue stock in foreign markets to enhance their global image.
§ Impact of the Euro: resulted in more stock offerings in
Europe by U.S. and European based MNCs.
Issuance of Foreign Stock in the U.S.
§ Yankee stock offerings - Non-U.S. corporations that need
large amounts of funds sometimes issue stock in the United
States
§ American Depository Receipts (ADR) - Certificates
representing bundles of stock. ADR shares can be traded
just like shares of a stock.
Non-U.S. Firms Listing on U.S. Exchanges
§ Non-U.S. firms have their shares listed on the New York

Stock Exchange or the Nasdaq market so that the shares can
easily be traded in the secondary market.
§ Effect of Sarbanes-Oxley Act on Foreign Stock Listings -

Many non-U.S. firms decided to place new issues of their
stock in the United Kingdom instead of in the United States
so that they would not have to comply with the law.
Investing in Foreign Stock Markets

§ Many investors purchase stocks outside of the home
country.
§ Recently, firms outside the U.S. have been issuing
stock more frequently.
§ Comparing the size of stock markets (Exhibit 3.5)
Exhibit 3.5 Comparison of Stock Exchanges (2013)
How Market Characteristics Vary among Countries

(Exhibit 3.6)
§ Stock market participation and trading activity are higher in
countries where managers are encouraged to make decisions
that serve shareholder interests, and where there is greater
transparency.
§ Factors that influence trading activity:
§ Rights - vary by country
§ Legal protection of shareholders
§ Government enforcement of securities laws
§ Accounting laws
Exhibit 3.6 Impact of Governance on Stock Market

Participation and Trading Activity
Integration of Stock Markets

§ Stock market conditions reflect the host country’s conditions. If
the country is integrated, the stock market will be also.
Integration of International Stock Markets and Credit

Markets
§ The key link is the risk premium, which affects the rate of
return required by financial institutions.
How Financial Markets Serve MNCs (Exhibit 3.7)
Corporate functions that require foreign exchange markets.

§ Foreign trade with business clients.
§ Direct foreign investment, or the acquisition of foreign real
assets.
§ Short-term investment or financing in foreign securities.
§ Longer-term financing in the international bond or stock
markets.
Exhibit 3.7 Foreign Cash Flow Chart of a
Multinational Corporation (MNC)
Summary
§ The foreign exchange market allows currencies to be

exchanged in order to facilitate international trade or
financial transactions. Commercial banks serve as financial
intermediaries in this market.
§ The international money markets are composed of several
large banks that accept deposits and provide short-term
loans in various currencies. This market is used primarily by
governments and large corporations.
§ The international credit markets are composed of the same
commercial banks that serve the international money
market. These banks convert some of the deposits received
into loans (for medium-term periods) to governments and
large corporations.
Summary (Cont.)
§ The international bond markets facilitate international

transfers of long-term credit, thereby enabling governments
and large corporations to borrow funds from various
countries. The international bond market is facilitated by
multinational syndicates of investment banks that help to
place the bonds.
§ International stock markets enable firms to obtain equity
financing in foreign countries. Thus, these markets help
MNCs finance their international expansion.

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International Financial Management

3 International Financial Markets

Describe the background and corporate use of the

n International money market

n International credit market

n International bond market

n International stock markets

Int Stock market Int Bond market

International financial market

Financial Market refers to

Allows for the exchange of one currency for

Foreign Exchange Market

History of Foreign Exchange

Foreign Exchange Transactions

Foreign Exchange Market

Foreign Exchange Transactions (cont.)

Foreign Exchange Transactions (cont.)

Foreign Exchange Market

Foreign Exchange Quotations

Foreign Exchange Quotations

Exhibit 3.1 Computation of the Bid Ask Spread

Foreign Exchange Quotations (cont.)

Foreign Exchange Market

Interpreting Foreign Exchange Quotations

Foreign Exchange Market

Interpreting Foreign Exchange Quotations (cont.)

§ When the euro is depreciating (based on a downward

Foreign Exchange Market

Interpreting Foreign Exchange Quotations (cont.)

§ Exchange rate quotations are also provided by many other

Interpreting Foreign Exchange Quotations (cont.)

Foreign Exchange Market

Interpreting Foreign Exchange Quotations (cont.)

Interpreting Foreign Exchange Quotations (cont.)

§ Specifies a standard volume of a particular currency to be

Interpreting Foreign Exchange Quotations (cont.)

§ Currency Put Option: provides the right to sell currency at

§ Money Market is a type of financial market for lending or

§ The instruments dealt in the money market are Treasury Bills,

International Money Market

The international money market has grown because firms:

§ May need to borrow funds to pay for imports denominated in a

§ May choose to borrow in a currency in which the interest rate

§ May choose to borrow in a currency that is expected to

Origins and Development

§ Asian Money Market: Centered in Hong Kong and Singapore.

International Money Market

Money Market Interest Rates Among Currencies

§ The money market interest rates in any particular country are

§ Money market rates vary due to differences in the interaction of

International Money Market

Money Market Interest Rates Among Currencies (cont.)

Money Market Interest Rates Among Currencies (cont.)

International Credit Market

MNCs sometimes obtain medium-term funds through term

Syndicated Loans in the Credit Market

§ Sometimes a single bank is unwilling or unable to lend

§ A syndicate of banks can be formed to underwrite the

International Credit Market