Financial Institutions 19

or doing business in a particular country. This risk depends on the countrys economic, political, and social environment. Countries with stable economic, social, political, and regulatory systems provide a safer climate for investment, and therefore have less country risk than less stable nations. Examples of country risk include the risk associated with changes in tax rates, regulations, currency conversion, and exchange rates. Country risk also includes the risk that property will be expropriated without adequate compensation, as well as new host country stipulations about local production, sourcing or hiring practices, and damage or destruction of facilities due to internal strife. International Exchange Rate Risk International securities usually are denominated in a currency other than the dollar, which means that the value of your investment depends on what happens to exchange rates. This is known as exchange rate risk. For example, if a U.S. investor purchases a Japanese bond, interest will probably be paid in Japanese yen, which must then be converted into dollars if the investor wants to spend his or her money in the United States. If the yen weakens relative to the dollar, then it will buy fewer dollars; hence the investor will receive fewer dollars when it comes time to convert. Alternatively, if the yen strengthens relative to the dollar, the investor will earn higher dollar returns. It therefore follows that the effective rate of return on a foreign investment will depend on both the performance of the foreign security and on what happens to exchange rates over the life of the investment. We will discuss exchange rates in detail in Chapter 26.

1.6 Financial Institutions

Direct funds transfers are more common among individuals and small businesses, and in economies where financial markets and institutions are less developed. While businesses in more developed economies do occasionally rely on direct transfers, they generally find it more efficient to enlist the services of one or more financial institutions when it comes time to raise capital. Here are the major categories of financial institutions: 1. Investment banking houses such as Merrill Lynch, Morgan Stanley, Goldman Sachs, or Credit Suisse Group provide a number of services to both investors and companies planning to raise capital. Such organizations (1) help corporations design securities with features that are currently attractive to investors, (2) then buy these securities from the corporation, and (3) resell them to savers. Although the securities are sold twice, this process is really one primary market transaction, with the investment banker acting as a facilitator to help transfer capital from savers to businesses. 2. Commercial banks, such as Bank of America, Wells Fargo, Wachovia, and JPMorgan Chase, are the traditional department stores of finance because
Transparency International provides a ranking of countries based on their levels of perceived corruption. See http://www .transparency.org/ policy_research/surveys_ indices/cpi/2005. The U.S. Department of State provides thorough descriptions of countries business climates at http://www.state.gov/ e/eb/ifd/2005/.

What four fundamental factors affect the cost of money? Name some economic conditions that influence interest rates, and explain their effects.

SELF-TEST