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Chapter 3

International Financial Markets Lecture Outline


Motives for Using International Financial Markets
Motives for Investing in Foreign Markets Motives for Providing Credit in Foreign Markets Motives for Borrowing in Foreign Markets

Foreign Exchange Market


History of Foreign Exchange Foreign Exchange Transactions Interpreting Foreign Exchange Quotations Currency Futures and Options Markets

International Money Market


Origins and Development Standardizing Global Bank Regulations

International Credit Market


Syndicated Loans

International Bond Market


Eurobond Market Development of Other Bond Markets

Comparing Interest Rates Among Currencies International Stock Markets


Issuance of Foreign Stock in the U.S. Issuance of Stock in Foreign Markets

Comparison of International Financial Markets How Financial Markets Affect an MNCs Value

Chapter Theme
This chapter identifies and discusses the various international financial markets used by MNCs. These markets facilitate day-to-day operations of MNCs, including foreign exchange transactions, investing in foreign markets, and borrowing in foreign markets.

Topics to Stimulate Class Discussion


1. Why do international financial markets exist? 2. How do banks serve international financial markets? 3. Which international financial markets are most important to a firm that consistently needs short-term funds? What about a firm that needs long-term funds?

Critical debate
Should firms that go public engage in international offerings? Proposition Yes. When a firm issues shares to the public for the first time in an initial public offering (IPO), it is naturally concerned about whether it can place all of its shares at a reasonable price. It will be able to issue its shares at a higher price by attracting more investors. It will increase its demand by spreading the shares across countries. The higher the price at which it can issue shares, the lower is its cost of using equity capital. It can also establish a global name by spreading shares across countries. Opposing view No. If a firm spreads its shares across different countries at the time of the IPO, there will be less publicly traded shares in the home country. Thus, it will not have as much liquidity in the secondary market. Investors desire shares that they can easily sell in the secondary market, which means that they require that the shares have liquidity. To the extent that a firm reduces its liquidity in the home country by spreading its share across countries, it may not attract sufficient home demand for the shares. Thus, its efforts to create global name recognition may reduce its name recognition in the home country. With whom do you agree? State your reasons. Use InfoTrac or some other search engine to learn more about this issue. Which argument do you support? Offer your own opinion on this issue. ANSWER: The key is that students recognize the tradeoff involved. A firm that engages in a relatively small IPO will have limited liquidity even when all of the stock is issued in the home country. Thus, it should not consider issuing stock internationally. However, firms with larger stock offerings may be in a position to issue a portion of their shares outside the home country. They should not spread the stocks across several countries, but perhaps should target one or two countries where they conduct substantial business. They want to ensure sufficient liquidity in each of the foreign countries where they sell shares. Stock Markets are inefficient Proposition I cannot believe that if the value of the euro in terms of, say, the British pound increases three days in a row, on the fourth day there is still a 50:50 chance that it will go up or down in value. I think that most investors will see a trend and will buy, therefore the price is more

likely to go up. Also, if the forward market predicts a rise in value, on average, surely it is going to rise in value. In other words, currency prices are predictable. And finally, if it were so unpredictable and therefore unprofitable to the speculator, how is it that there is such a vast sum of money being traded every day for speculative purposes there is no smoke without fire. Opposing view The simple answer is that if that is what you believe, buy currencies that have increased three days in a row and on average you should make a profit, buy currencies where the forward market shows an increase in value. The fact is that there are a lot of investors with just your sort of views. The market traders know all about such beliefs and will price the currency so that such easy profit (their loss) cannot be made. Look at past currency rates for yourself, check all fourth day changes after three days of rises, any difference is going to be not enough to cover transaction costs or trading expenses and the slight inaccuracy in your figures which are likely to be closing day mid point of the bid/ask spread. No, all currency movements are related to information and no-one knows if tomorrows news will be better or worse than expected. With whom do you agree? Could there be undiscovered patterns? Could some movements not be related to information? Could some private news be leaking out? ANSWER: Clearly there are no obvious patterns. Discussion on the impossibility of obvious patterns is worth emphasizing. However, does market inefficiency necessarily involve patterns, could market manipulation be occasional. There is worrying evidence from share price movements that there is unusual movement before announcements on many occasions, so the ideathat traders do not occasionally collude and move the price without supporting economic evidence is not an unreasonable view. Proof is however difficult as we have to separate anticipation from prior knowledge, the lucky speculator from the speculator who was in the know.

Answers to End of Chapter Questions


1. Motives for Investing in Foreign Money Markets. Explain why an MNC may invest funds in a financial market outside its own country. ANSWER: The MNC may be able to earn a higher interest rate on funds invested in a financial market outside of its own country. In addition, the exchange rate of the currency involved may be expected to appreciate. 2. Motives for Providing Credit in Foreign Markets. Explain why some financial institutions prefer to provide credit in financial markets outside their own country. ANSWER: Financial institutions may believe that they can earn a higher return by providing credit in foreign financial markets if interest rate levels are higher and if the economic conditions are strong so that the risk of default on credit provided is low. The institutions may also want to diversity their credit so that they are not too exposed to the economic conditions in any single country. 3. Exchange Rate Effects on Investing. Explain how the appreciation of the Australian dollar against the euro would affect the return to a French firm that invested in an Australian money market security. ANSWER: If the Australian dollar appreciates over the investment period, this implies that the French firm purchased the Australian dollars to make its investment at a lower exchange rate than the rate at which it will convert A$ to euros when the investment period is over. Thus, it benefits from the appreciation. Its return will be higher as a result of this appreciation. 4. Exchange Rate Effects on Borrowing. Explain how the appreciation of the Japanese yen against the UK pound would affect the return to a UK firm that borrowed Japanese yen and used the proceeds for a UK project. ANSWER: If the Japanese yen appreciates over the borrowing period, this implies that the UK firm converted yen to pounds at a lower exchange rate than the rate at which it paid for yen at the time it would repay the loan. Thus, it is adversely affected by the appreciation. Its cost of borrowing will be higher as a result of this appreciation. 5. Bank Services. List some of the important characteristics of bank foreign exchange services that MNCs should consider. ANSWER: The important characteristics are (1) competitiveness of the quote, (2) the firms relationship with the bank, (3) speed of execution, (4) advice about current market conditions, and (5) forecasting advice. 6. Bid/ask Spread. Delay Banks bid price for US dollars is 0.53 and its ask price is 0.55. What is the bid/ask percentage spread? ANSWER: (0.55 0.53)/0.55 = .036 or 3.6%

7. Bid/ask Spread. Compute the bid/ask percentage spread for Mexican peso in which the ask rate is 20.6 New peso to the dollar and the bid rate is 21.5 New peso to the dollar. ANSWER: direct rates are 1/20.6 = $0.485:1 peso as the ask rate and 1/21.5 = $0.465:1 peso as the bid rate so the spread is [($0.485 $0.465)/$0.485] = .041, or 4.1%. Note that the spread is fro the Mexiccan peso not the dollar. 8. Forward Contract. The Wolfpack ltd is a UK exporter that invoices its exports to the United States in dollars. If it expects that the dollar will appreciate against the pound in the future, should it hedge its exports with a forward contract? Explain. . ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk. Yet, in this case, the Wolfpack Corporation should not hedge because it would benefit from appreciation of the dollar when it converts the dollars to pounds. 9. Euro. Explain the foreign exchange situation for countries that use the euro when they engage in international trade among themselves. ANSWER: There is no foreign exchange. Euros are used as the medium of exchange. 10. Indirect Exchange Rate. If the direct exchange rate of the euro is worth 0.685, what is the indirect rate of the euro? That is, what is the value of a pound in euros? ANSWER: 1/0.685 = 1.46 euros. 11. Cross Exchange Rate. Assume Polands currency (the zloty) is worth 0.17 and the Japanese yen is worth 0.005. What is the cross (implied) rate of the zloty with respect to yen? ANSWER: 0.17/0.005 = 34 zloty:1 yen

12. Syndicated Loans. Explain how syndicated loans are used in international markets. ANSWER: A large MNC may want to obtain a large loan that no single bank wants to accommodate by itself. Thus, a bank may create a syndicate whereby several other banks also participate in the loan. 13. Loan Rates. Explain the process used by banks in the Eurocredit market to determine the rate to charge on loans. ANSWER: Banks set the loan rate based on the prevailing LIBOR, and allow the loan rate to float (change every 6 months) in accordance with changes in LIBOR. 14. International Markets. What is the function of the international money market? Briefly describe the reasons for the development and growth of the European money market. Explain how the international money, credit, and bond markets differ from one another.

ANSWER: The function of the international money market is to efficiently facilitate the flow of international funds from firms or governments with excess funds to those in need of funds. Growth of the European money market was largely due to (1) regulations in the U.S. that limited foreign lending by U.S. banks; and (2) regulated ceilings placed on interest rates of dollar deposits in the U.S. that encouraged deposits to be placed in the Eurocurrency market where ceilings were nonexistent. The international money market focuses on short-term deposits and loans, while the international credit market is used to tap medium-term loans, and the international bond market is used to obtain long-term funds (by issuing long-term bonds). 15. Evolution of Floating Rates. Briefly describe the historical developments that led to floating exchange rates as of 1973. ANSWER: Country governments had difficulty in maintaining fixed exchange rates. In 1971, the bands were widened. Yet, the difficulty of controlling exchange rates even within these wider bands continued. As of 1973, the bands were eliminated so that rates could respond to market forces without limits (although governments still did intervene periodically). 16. International Diversification. Explain how the Asian crisis would have affected the returns to a UK. firm investing in the Asian stock markets as a means of international diversification. [See the chapter appendix.] ANSWER: The returns to the UK firm would have been reduced substantially as a result of the Asian crisis because of both declines in the Asian stock markets and because of currency depreciation. For example, the Indonesian stock market declined by about 27% from June 1997 to June 1998. Furthermore, the Indonesian rupiah declined against the U.S. dollar by 84%. 17. Eurocredit Loans. a. With regard to Eurocredit loans, who are the borrowers? b. Why would a bank desire to participate in syndicated Eurocredit loans? c. What is LIBOR and how is it used in the Eurocredit market? ANSWER: a. Large corporations and some government agencies commonly request Eurocredit loans. b. With a Eurocredit loan, no single bank would be totally exposed to the risk that the borrower may fail to repay the loan. The risk is spread among all lending banks within the syndicate. c. LIBOR (London interbank offer rate) is the rate of interest at which banks in Europe lend to each other. It is used as a base from which loan rates on other loans are determined in the Eurocredit market.

18. Foreign Exchange. You just came back from Canada, where the Canadian dollar was worth 0.43. You still have C$200 from your trip and could exchange them for pounds at the airport, but the airport foreign exchange desk will only buy them for 0.40. Next week, you will be going to Mexico and will need pesos. The airport foreign exchange desk will sell you pesos for 0.055 per peso. You met a tourist at the airport who is from Mexico and is on his way to Canada. He is willing to buy your C$200 for 1500 New Pesos. Should you accept the offer or cash the Canadian dollars in at the airport? Explain. ANSWER: Exchange with the tourist. If you exchange the C$ for pesos at the foreign exchange desk, the C$200 is multiplied by 0.40 and then divided by 0.055 ie a ratio of 0.40/0.055 = 7.27 pesos to the C$. The total pesos would be 200 x 7.27 = 1454 pesos, a little less than is being offered by the tourist. 19. Foreign Stock Markets. Explain why firms may issue stock in foreign markets. Why might MNCs issue more stock in Europe since the conversion to a single currency in 1999? ANSWER: Firms may issue stock in foreign markets when they are concerned that their home market may be unable to absorb the entire issue. In addition, these firms may have foreign currency inflows in the foreign country that can be used to pay dividends on foreign-issued stock. They may also desire to enhance their global image. Since the euro can be used in several countries, firms may need a large amount of euros if they are expanding across Europe. 20. Stock Market Integration. Bullet plc a UK firm, is planning to issue new shares on the London Stock Exchange this month. The only decision still to be made is the specific day on which the shares will be issued. Why do you think Bullet monitors results of the Tokyo stock market every morning? ANSWER: The UK stock market prices sometimes follow Japanese market prices. Thus, the firm would possibly be able to issue its stock at a higher price in the UK if it can use the Japanese market as an indicator of what will happen in the UK market. However, this indicator will not always be accurate.

Advanced Questions
21. Effects of September 11. Why do you think the terrorist attack on the U.S. was expected to cause a decline in U.S. interest rates? Given the expectations for a potential decline in U.S. interest rates and stock prices, how were capital flows between the U.S. and other countries likely affected? ANSWER: The attack was expected to cause a weaker economy, which would result in lower U.S. interest rates. Given the lower interest rates, and the weak stock prices, the amount of funds invested by foreign investors in U.S. securities would be reduced. 22. International Financial Markets. Carrefour the French Supermarket chain has established retail outlets worldwide. These outlets are massive and contain products purchased locally as well as imports. As Carrefour generates earnings beyond what it needs abroad, it may remit those earnings back to France. Carrefour is likely to build additional outlets especially in China. a. Explain how the Carrefour outlets in China would use the spot market in foreign exchange.

ANSWER: The Carrefour stores in China need other currencies to buy products from other countries, and must convert the Chinese currency (yuan) into the other currencies in the spot market to purchase these products. They also could use the spot market to convert excess earnings denominated in yuan into euros, which would be remitted to the French parent. b. Explain how Carrefour might utilize the international money markets when it is establishing other Carrefour stores in Asia. ANSWER: Carrefour may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Carrefour stores in various foreign markets. When some Carrefour stores in foreign markets need funds, they borrow from banks in the Eurocurrency market. Thus, the Eurocurrency market serves as a deposit or lending source for Carrefour and other MNCs on a short-term basis. (Eurocurrency refers to international currencies, most likely the dollar, not just the euro!) c. Explain how Carrefour could use the international bond market to finance the establishment of new outlets in foreign markets. ANSWER: Carrefour could issue bonds in the Eurobond market to generate funds needed to establish new outlets. The bonds may be denominated in the currency that is needed; then, once the stores are established, some of the cash flows generated by those stores could be used to pay interest on the bonds. 23. Interest Rates. Why do interest rates vary among countries? Why are interest rates normally similar for those European countries that use the euro as their currency? Offer a reason why the government interest rate of one country could be slightly higher than that of the government interest rate of another country, even though the euro is the currency used in both countries. ANSWER: Interest rates in each country are based on the supply of funds and demand for funds for a given currency. However, the supply and demand conditions for the euro are dictated by all participating countries in aggregate, and do not vary among participating countries. Yet, the government interest rate in one country that uses the euro could be slightly higher than others that use the euro if it is subject to default risk. The higher interest rate would reflect a risk premium.

Blades plc Case Study

As a financial analyst for Blades plc you are reasonably satisfied with Blades current setup of exporting Speedos (roller blades) to Thailand. Due to the unique arrangement with Blades primary customer in Thailand, forecasting the revenue to be generated there is a relatively easy task. Specifically, your customer has agreed to purchase 180,000 pairs of Speedos annually, for a period of three years, at a price of THB4,594 (THB = Thai baht) per pair. The current direct quotation of the dollar-baht exchange rate is 0.016. The cost of goods sold incurred in Thailand (due to imports of the rubber and plastic components from Thailand) runs at approximately THB2,871 per pair of Speedos, but Blades currently only imports materials sufficient to manufacture about 72,000 pairs of Speedos. Blades primary reasons for using a Thai supplier are the high quality of the components and the low cost, which has been facilitated by a continuing depreciation of the Thai baht against the pound. If the pound cost of buying components becomes more expensive in Thailand than in the United Kingdom, Blades is contemplating providing its UK supplier with the additional business. Your plan is quite simple; Blades is currently using its Thai-denominated revenues to cover the cost of goods sold incurred there. During the last year, excess revenue was converted to pounds at the prevailing exchange rate. Although your cost of goods sold is not fixed contractually as the Thai revenues are, you expect them to remain relatively constant in the near future. Consequently, the baht-denominated cash inflows are fairly predictable each year because the Thai customer has committed to the purchase of 180,000 pairs of Speedos at a fixed price. The excess pound revenue resulting from the conversion of baht is used either to support the UK production of Speedos if needed or to invest in the United Kingdom. Specifically, the revenues are used to cover cost of goods sold in the UK manufacturing plant. Ben Holt, Blades finance director, notices that Thailands interest rates are approximately 15 percent (versus 8 percent in the United Kingdom). You interpret the high interest rates in Thailand as an indication of the uncertainty resulting from Thailands unstable economy. Holt asks you to assess the feasibility of investing Blades excess funds from Thailand operations in Thailand at an interest rate of 15 percent. After you express your opposition to his plan, Holt asks you to detail the reasons in a detailed report. 1. One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand and the delayed conversion of baht into dollars. Explain what this means. 2. If the net baht received from the Thailand operation are invested in Thailand, how will UK operations be affected? (Assume that Blades is currently paying 10 percent on dollars borrowed and needs more financing for its firm.) 3. Construct a spreadsheet to compare the cash flows resulting from two plans. Under the first plan, net baht-denominated cash flows (received today) will be invested in Thailand at 15 percent for a one-year period, after which the baht will be converted to dollars. The expected spot rate for the baht in one year is about 0.0147 (Ben Holts plan). Under the second plan, net baht-denominated cash flows are converted to pounds immediately and invested in the United Kingdom for one year at 8 percent. For this question, assume that all baht-denominated cash flows are due today. Does Holts plan seem superior in terms of pound cash flows available after one year? Compare the choice of investing the funds versus using the funds to provide needed financing to the firm.

Solution to Continuing Case Problem: Blades


1. One point of concern for you is that there is a tradeoff between the higher interest rates in Thailand and the delayed conversion of baht into dollars. Explain what this means. ANSWER: If the net baht-denominated cash flows are converted into pounds today, Blades is not subject to any future depreciation of the baht that would result in less pound cash flows.

2. If the net baht received from the Thailand operation are invested in Thailand, how will UK operations be affected? (Assume that Blades is currently paying 10 percent on dollars borrowed, and needs more financing for its firm.) ANSWER: If the cash flows generated in Thailand are all used to support UK operations, then Blades will have to borrow additional funds in the UK (or the international money market) at an interest rate of 10 percent. For example, if the baht will depreciate by 10 percent over the next year, the Thai investment will render a yield of roughly 5 percent, while the company pays 10 percent interest on funds borrowed in the UK Since the funds could have been converted into pounds immediately and used in the UK, the baht should probably be converted into pounds today to forgo the additional (expected) interest expenses that would be incurred from this action. 3. Construct a spreadsheet to compare the cash flows resulting from two plans. Under the first plan, net baht-denominated cash flows (received today) will be invested in Thailand at 15 percent for a one-year period, after which the baht will be converted to dollars. The expected spot rate for the baht in one year is about 0.0147 (Ben Holts plan). Under the second plan, net baht-denominated cash flows are converted to pounds immediately and invested in the United Kingdom for one year at 8 percent. For this question, assume that all baht-denominated cash flows are due today. Does Holts plan seem superior in terms of pound cash flows available after one year? Compare the choice of investing the funds versus using the funds to provide needed financing to the firm. ANSWER: (See spreadsheet attached.) If Blades can borrow funds at an interest rate below 8 percent, it should invest the excess funds generated in Thailand at 8 percent and borrow funds at the lower interest rate. If, however, Blades can borrow funds at an interest rate above 8 percent (as is currently the case with an interest rate of 10 percent), Blades should use the excess funds generated in Thailand to support its operations rather than borrowing.

Plan 1Ben Holt's Plan


Calculation of baht-denominated revenue: Price per pair of "Speedos" Pairs of "Speedos" = Baht-denominated revenue Calculation of baht-denominated cost of goods sold: Cost of goods sold per pair of "Speedos" Pairs of "Speedos" = Baht-denominated expenses Calculation of dollar receipts due to conversion of baht into dollars: Net baht-denominated cash flows now (826,920,000 206,712,000) Interest earned on baht over a one-year period (15%) Baht to be converted in one year Expected spot rate of baht in one year = Expected dollar receipts in one year 4,594 180,000 826,920,000

2,871 72,000 206,712,000

620,208,000 93,031,200 713,239,200 0.0147 10,484,616

Plan 2Immediate Conversion


Calculation of baht-denominated revenue: Price per pair of "Speedos" Pairs of "Speedos" 4,594 180,000

= Baht-denominated revenue Calculation of baht-denominated cost of goods sold: Cost of goods sold per pair of "Speedos" Pairs of "Speedos" = Baht-denominated expenses

826,920,000

2,871 72,000 206,712,000

Calculation of dollar receipts due to conversion of baht into dollars: Net baht-denominated cash flows to be converted (826,920,000 206,712,000) Spot rate of baht now = Dollar receipts now Interest earned on pounds over a one-year period (8%) = Dollar receipts in one year

620,208,000 0.016 9,923,328 793,866 10,717,194

Calculation of pound difference between the two plans:


Plan 1 Plan 2 Dollar difference 10,484,616 10,717,194 (232,578)

Thus, the cash flow generated in one year by Plan 1 is very close to Plan 2, Plan 2 is slightly better.

Small Business Dilemma


Use of the Foreign Exchange Markets by the Sports Exports Company Each month, the Sports Exports Company (n Irish firm) receives an order for basketballs from a British sporting goods distributor. The monthly payment for the basketballs is denominated in British pounds, as requested by the British distributor. Jim Logan, owner of the Sports Exports Company, must convert the pounds received into euros. 1. Explain how the Sports Exports Company could utilize the spot market to facilitate the exchange of currencies. Be specific. 2. Explain how the Sports Exports Company is exposed to exchange rate risk and how it could use the forward market to hedge this risk.

1. Explain how the Sports Exports Company could utilize the spot market to facilitate the exchange of currencies. Be specific. ANSWER: The Sports Exports Company would have an account with a commercial bank. As it receives payment in pounds each month, it would deposit the check at a bank that provides foreign exchange services. Each month, the bank would cash the check, and then convert the British pounds received into euros for the Sports Exports Company at the prevailing spot rate. 2. Explain how the Sports Exports Company is exposed to exchange rate risk and how it could use the forward market to hedge this risk.

ANSWER: The Sports Exports Company is exposed to exchange rate risk, because the value of the British pound will change over time. If the pound depreciates over time, the payment in pounds will convert to fewer euros. The Sports Exports Company could engage in a forward contract in which it would sell pounds forward in exchange for euros. For example, if it anticipated receiving a payment in pounds 30 days from now, it could negotiate a forward contract in which it would sell pounds in exchange for euros at a specific forward rate. This would lock in the forward rate at which the pounds would be converted into euros in 30 days, thereby removing any concern that the pound could depreciate against the euro over that 30-day period. This hedges exchange rate risk over the short run, but does not effectively hedge against exchange rate risk over the long run.