International Finance

International Finance
Chapter 18
International Finance
• Total global trade (as measured by exports):
– 1948: $58 billion
– 2008: $16.1 trillion
– From 1948 to 2008, increase of 27,805%, or
roughly 10% per year compounded
• This trade is underpinned by an international
financial community consisting of multinational
banks, global stock markets, and multinational
A Short History of Fixed Exchange Rates
• “Gold standard”: (prior to the 1929 Stock Market
crash) a nation’s currency was directly convertible
into gold at a fixed exchange rate
– Gold flowed out of a country that ran a balance of
payments deficit
– Gold flowed into a country that ran a balance of
payments surplus
– This fixed exchange rate regime was seen as a form of
discipline on countries to maintain a balance of
interest rates and trade, though it was subject to
breakdown if a country ran low on gold
A Short History of Fixed Exchange Rates
• Depression of 1929-1941
• Countries went off the gold standard as
domestic needs took precedence over orderly
international trade relations
• Protectionism curtailed trading between
countries – Smoot-Hawley tariff of 1930
• World War II
A Short History of Fixed Exchange Rates
• Bretton Woods: 1944 agreement which
established a new fixed currency regime with
the dollar as the anchor and in turn, the dollar
was tied to gold at a fixed price of $35 per
– Led to the creation of the International Monetary
Fund, the World Bank, the General Agreement on
Tariffs and Trade (today’s World Trade
A Short History of Fixed Exchange Rates
• Inflation in the 1960’s and consequent
escalating commodities prices led President
Nixon to “close the gold window” in August
1971, effectively ending the Bretton Woods
exchange rate regime.
Floating Exchange Rates
• Floating exchange rate: exchange rate
between two currencies can move in price
each day
– Value of currencies is determined by supply and
demand in marketplace.
Floating Exchange Rates
• Under the floating exchange rate regime,
international businesses must account for
currency translation risk.
– Currency translation risk: risk that value of foreign
currency changes in a way which makes business
less profitable, absent an exchange rate
Floating Exchange Rates
• Exchange rate of a particular currency with U.S.
dollar is either:
1. How many dollars it takes to buy one unit of
foreign currency
2. How many units of foreign currency it takes to buy
one dollar
• Cross rate (American perspective): exchange rate
between two foreign currencies because it can be
calculated by multiplying their rates relative to
the U.S. dollar
Futures, Options and Swaps
• Securities and other contractual mechanisms
that help businesses hedge their currency
translation risk:
Forward contracts
Future contracts
Option contracts
Swap Agreements
Future, Option and Swap
1. Forward contracts: privately negotiated
agreements under which one party (often
commercial bank) would agree to purchase
another currency from counterparty at some
fixed rate at some defined point forward in time
– Terms negotiated between parties:
Type of currency
Time for forward delivery
Mechanism (physical delivery or cash settlement)
– Each contract is a “one-off” deal
– Rarely secondary trading or securitization of contract
Futures, Option and Swap
2. Futures contracts: traded on an exchange
– E.g. Chicago Mercantile Exchange
– Standardized terms of contract:
Quantity of currency
Time of delivery
Mechanism for settlement (generally cash settlement)
– Merc facilitates liquidity in any particular
contract, albeit at the expense of individual
tailoring that a forward contract can provide.
Future, Option and Swap
3. Option contracts: one party pays a price
(premium) to have the right to buy (for a call
option) or sell (for a put option) a certain
amount of currency at a defined price (called
the strike price)
– Priced based on elaborate financial models
Many are derived from Black-Scholes option pricing
model by Fisher Black and Myron Scholes in the early
Future, Option and Swap
4. Swap agreements: privately negotiated agreements
between parties under which one party agrees to
trade (or swap) a risk it bears with a counterparty in
exchange for an instrument that does not have that
E.g. Interest rate swap: one party that is bearing interest
risk through a floating interest rate will agree to swap
floating rate for a fixed rate from counterparty
There may be explicit fee associated with swap
Fee may be embedded into terms of swap
Borrower benefits by locking in a fixed rate and
counterparty benefits from the fee income it generates
for swap
Future, Option and Swap
4. Swap agreements (continued)
– Swap agreements that hedge currency risk: one
party agrees to swap steam of cash flows in one
currency for that same set of cash flows in a different
– Credit default swaps: one party swaps its credit
default risk, an upfront fee and series of annual fees,
until expiration of swap to counterparty in exchange
for assurance of payment of notional value of swap
contract in the event that the underlying company
defaults on payments of its debt securities
Money Markets
• International money market: international debt
securities with maturities of 12 months or less
• Eurodollar market: debt securities denominated
in several different currencies with U.S. dollar
being most prevalent
• Eurodollar: any dollar located outside the U.S., or
currency borrowed in London money market at
London Interbank Offered Rate (LIBOR)
– 90 day LIBOR: benchmark short term rate, or proxy for
what it costs for one bank to borrow from another for
a short period of time
Money Markets
• Interest equalization tax (1963)
– Made repatriating dollars more expensive than
keeping them abroad
– Caused international banks to look for a way to
borrow and lend in dollars outside the U.S. – directly
led to creation of Eurodollar market
• Eurodollar market today
– Large, generally steady, liquid market
– Banks lend to each other at the LIBOR
– Banks use LIBOR as proxy for their cost of funds and
charge their best customers some spread over LIBOR
Money Markets
• Interest rate parity
– Interest rates charged in international money
market are tied to exchange rates of underlying
– No-arbitrage condition that must hold, on
average, over time
– Difference in forward exchange rate for two
countries’ currencies must equal difference
between interest rates in those countries
Money Markets
Interest Rate Parity
• “Carry trade”: hedge funds borrowed money
in Japan at low interest rates on assumption
that the Yen would not appreciate sufficiently
to offset interest rate differential
– From mid-2002 to July 2007, the Yen/Dollar
exchange rate was stable, but broke down in July
2007 - January 2009 time period
– Hedge funds which had borrowed in Yen were
stuck with massive losses
Capital Markets
• In the immediate aftermath of World War II,
American capital markets were dominant in
the world finance.
• Over the past sixty plus years, New York has
gradually decreased in importance as a global
financial center.
• The result of this is that global capital raising is
more dispersed with regional centers such as
London and Hong Kong rising in importance
Capital Markets
• Trading occurs among major market centers
around the world and across time zones!
– Business managers face risks and opportunities
– Company can list its shares on one of many different
financial markets
– Financial firms need individuals in various locations in
order to meet global clients’ demands
– Global risk managers need to be alert to changes in
market conditions, interest rates, and exchanges rates,
and the consequent effects on business conditions
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