Power Point Slides for:
Financial Institutions, Markets, and
Money, 9th Edition
Authors: Kidwell, Blackwell, Whidbee &
Peterson
Prepared by: Babu G. Baradwaj, Towson University
and
Lanny R. Martindale, Texas A&M University
Copyright© 2006 John Wiley & Sons, Inc.
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CHAPTER 12
INTERNATIONAL
MARKETS
The Difficulties of International Trade
Information Asymmetry between Suppliers and
Customers.
Information about customers and suppliers is lacking or
incorrect.
Third party information gatherers are necessary and
expensive.
Differences in Legal & Business Systems
Foreign trade and funds flow involve different legal
systems and business procedures.
The Role of Currency Conversion
Foreign trade and funds flow must involve a conversion
from one currency to another.
Copyright© 2006 John Wiley & Sons, Inc.
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Foreign Exchange Rates
Foreign exchange rate - the price of a unit of one
currency in terms of another.
Foreign exchange rates are market determined.
The increased (decreased) cost of a unit of foreign
currency in terms of the U.S. dollar refers to the
depreciation (appreciation) of the dollar.
The U. S. dollar is considered to have depreciated
relative to the Euro (€) if more dollars are required to
purchase one €.
The U. S. dollar is said to have appreciated if fewer
dollars are required to buy one Euro.
The relative value of all currencies to one another
is maintained by continuous trading by arbitragers.
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Currency Quotation
Currency quotations are shown in Exhibit 12.3.
Typically, quotes are provided in two forms – direct &
indirect.
Direct Quote - U.S. $ / foreign currency unit.
Indirect Quote - Foreign currency unit / $.
In practice, bank dealers quote in either the American term
or European term. This is valid for deals between
themselves.
For non-bank customers, a direct quote is usually given.
For major currencies like the yen, Swiss Franc, British
pound, Canadian dollar, etc, not only is the spot rate
provided, but also forward quotes for one month, three
month and six month.
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The Euro (€)
The Euro (€) is the new common currency for
nations that are members of the European Union.
When first introduced in 1999, there were 11
original member nations who adopted this
currency – Austria, Belgium, Finland, France,
Germany, Ireland, Italy, Luxembourg,
Netherlands, Portugal, and Spain.
Along with EU member Greece, other non EU
members such as Monaco, the Vatican City and
San Marino have also switched to the Euro.
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Foreign Exchange Rates
Supply and demand for currencies depends on the
underlying demand and supply for goods and
services between countries caused by:
Relative costs of the factors of production in each
country.
Relative supply of factors between nations.
Consumer tastes for certain goods and services.
The ability of a country to supply its needs
domestically.
Barriers to trade such as import tariffs which affect the
flow of goods and services.
Copyright© 2006 John Wiley & Sons, Inc.
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Foreign Exchange Rates
Supply and demand for currencies depends on the
underlying demand and supply for goods and
services between countries caused by:
The rate of growth of national income of a country.
Trade flows will continue, with corresponding purchase
and sale of foreign exchange, until purchasing power
parity is achieved, or the cost of an item in one
country's currency is the same cost as in another
country's currency.
Copyright© 2006 John Wiley & Sons, Inc.
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International Trade and Exchange Rates
Factors that Influence Supply & Demand for a
Currency
Relative Prices – If one nation’s goods are
cheaper, demand for that nation’s goods and hence
its currency will increase, driving up the price of
that currency.
Barriers to Trade – Tariffs, taxes, quotas, and
other restrictions are barriers to trade that will
affect the demand for goods from a nation, the
demand for the currency, and hence its price with
respect to other currency.
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International Trade and Exchange Rates
Resource Endowment – Availability of resources
that determine the factors of production will
determine demand for a nation’s goods and hence
its currency price.
Tastes – Shifts in consumer preferences will
influence demand for goods from a country,
demand for its currency and hence, its price.
Productivity – The higher the productivity, the
greater the growth rate of an economy, greater the
demand for its goods, its currency, and hence, its
currency’s price.
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Capital Flows and Exchange Rates
Speculative capital flows - buying/selling of
foreign exchange based on future exchange rate
expectations.
Investment capital flows - investment in real or
financial assets (money or capital market) based
on prospects of real returns. Covered (forward
contract hedge) interest rate parity conditions are
achieved by arbitragers, eliminating the spot
conversion, interest rate, and forward exchange
differences between countries.
Political capital flows - transfer of wealth from
one country to another, also called capital flight.
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Government Intervention in the Forex Markets.
Support of a Nation’s Currency
(undervalued)
Government sells financial assets to foreigners
and acquires foreign currencies.
Government buys its currency with acquired
foreign currency, bidding up the price of its
own currency.
Increased demand for domestic currency
Promotes imports
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Government Intervention in the Forex Markets.
Depression of currency value (overvalued)
Buys assets for foreign currencies
More currency held by foreigners
Value of currency falls
Increased supply of domestic currency
Promotes exports
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Inflation and Exchange Rates
Inflation and Exchange Rates
Inflation increases prices of goods and services and the
higher level of inflation will mean imports would be
cheaper.
At the same time this country's exports will decline
because their products will be more expensive for other
nations.
More money owed on imports, and less money coming
in on exports will cause the trade deficit to worsen.
The increased supply of the country’s currency to pays
for its imports will drive down the value of the currency
with respect to other currencies.
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Government Intervention in the Forex Markets.
Politics & Exchange rates
Strong Dollar Scenario
• This scenario would attract capital to the U. S. and
increase the demand for the dollar as investors seek
to invest in a strong currency.
• A strong dollar would make imports cheaper, and
force domestic producers of goods with import
substitutes to lower prices.
• This lowers domestic cost of living and inflation.
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Government Intervention in the Forex Markets.
Politics & Exchange rates
Weak Dollar Scenario
• U. S. products would be more price-competitive
globally and exports would increase.
• To meet the increased demand for U. S. made
products both at home and abroad, production will
go up, increase employment, and stimulate
economic growth.
• However, one has to watch out for an increase in
inflation, as domestic firms increase prices on goods
facing weak foreign competition.
Copyright© 2006 John Wiley & Sons, Inc.
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Structure of the Foreign Exchange Markets
Characteristics of the market
No single marketplace
An OTC market
Dealers
Twenty-four hour trading
Efficient communications systems
Traditional code of ethics
Major Participants
Large multinational commercial banks
Foreign exchange departments of investment banking
firms
Foreign central banks
Business and individuals
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Trading Foreign Exchange
Commercial banks are the major traders of currencies.
Rapid pace of transaction
Maintain inventory of currencies to meet customer needs.
Must avoid large currency losses with changes in exchange
rates.
Regulation prohibits U. S. banks from making speculative
currency trades.
Trading is generally done by telephone, telex, or the Swift
(Society for Worldwide Inter-bank Financial
Telecommunications) system
Inter-bank clearing system through correspondent
relationships
Trading by small group of traders
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Spot and Forward Transactions
Foreign exchange traded for immediate delivery
takes place in the spot market.
Spot trading for immediate delivery (within two
business days) - spot rate.
Foreign exchange traded for delivery at some
future point in time takes place in the forward
market.
Futures market – structured and trades on
exchanges.
Standard maturity terms - 30, 60, 90 or 180
days
Standard contract sizes
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Spot and Forward Transactions
Forward market - does not trade on exchange.
Term tailored to business needs
Two-party agreement
Importer buys foreign exchange; exporter may
sell if exporter is to be paid in the future in a
foreign currency.
Foreign exchange risk is hedged; so is
opportunity to gain.
Currency options may also be used to buy or sell a
foreign currency at a future date.
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Three International Trade Problems
Exporters lack information about importer's
credit rating, and importers lack information
about exporter’s reliability.
Exact amounts of the trade and date of
payment must be known before one party
can hedge foreign exchange risk.
Bank wants a clean deal without disputes
and delay of funds flow.
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Specialized Financial Trade Instruments
Letter of credit - guarantees payment upon
submission of correct documents.
Draft - a request for payment submitted to
the guaranteeing bank by the exporter
Sight draft - payable on demand.
Time draft - payable on a particular date.
Bill of lading - a receipt issued by the
exporter to the shipping company.
Copyright© 2006 John Wiley & Sons, Inc.
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Euromarkets
Eurocurrency - any currency held in timedeposit outside its country of origin.
Large, unregulated short-term market with
centers in Europe, the Middle East and Asia.
A Eurocurrency is any currency held in a shortterm time deposit outside the country of origin
– yen held outside of Japan.
A Eurodollar is a short-term dollar time
denominated deposit held outside of the U. S.
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Functions of the Eurocurrency Market
Source of attractively priced working
capital loans for multinational firms.
Serve as a place to store excess liquidity for
multinational corporations, countries and
individuals.
The market facilitates international trade by
providing reasonably priced credit.
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Eurocurrency markets
Highly liquid assets that can be used to
conduct international transactions.
LIBOR - the rate international banks charge
other banks.
Used globally as a benchmark or base rate just
like the prime rate in the U. S.
LIBOR tends to be closely related to the Fed
funds rate. (See Exhibit 12.11).
LIBOR is higher that the fed funds rate by an
average of 10 to 12 basis points.
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LIBOR vs. Fed Funds rate
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The Eurobond Market - Medium Term
Eurobonds are bonds sold in countries other than the
country whose currency is the one in which the bond is
denominated.
They are underwritten by a multinational syndicate of
investment banks.
Eurobonds are bearer bonds and do not have to be registered
which makes them more marketable.
Interest or coupon payments are annual and are calculated on
a 360-day year.
Minimum denominations are $5,000 and $10,000.
U.S. firms issue dollar-denominated bonds in Europe
because of cost savings ranging from 50 to 100 basis points
(0.5% - 1%).
Today, the market is dominated by institutional investors
such as mutual funds and pension funds.
Copyright© 2006 John Wiley & Sons, Inc.
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The Internationalization of Financial Markets
Factors affecting the globalization of financial markets.
The demise of fixed exchange rates and the movement
towards a floating, market determined exchange rate system
in the developing nations.
The change in trading patterns and the concentration of
wealth in the OPEC nations since the petroleum crises of
1974 and 1979-1980.
The extraordinary budget and trade deficits of the United
States since 1981.
The global economic expansion which began in 1982
leading to the rise of the multinational corporations.
Improved telecommunications and computer technology.
A strong dollar has become the new gold standard in a world
where many currencies are rather volatile.
Copyright© 2006 John Wiley & Sons, Inc.
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