Chapter 3: International Financial Markets1

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

Foreign Exchange Transactions

Interpreting Foreign Exchange Quotations

Currency Futures and Options Markets

Eurocurrency Market

Development of the Eurocurrency Market

Composition of the Eurocurrency Market

Syndicated Eurocurrency Loans

Standardizing Bank Regulations within the Eurocurrency Market

Asian Dollar Market

Eurocredit Market

Eurobond Market

Development of the Eurobond Market

Comparing Interest Rates Among Currencies

Global Integration of Interest Rates

International Stock Markets

Use of International Financial Markets

How Financial Markets Affect an MNC’s 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.Where is the foreign exchange market?

2.Why does a foreign exchange market exist?

3.Which international financial markets are most important to a firm that consistently needs shortterm funds? What about a firm that needs longterm funds?

Answer to Nike Problem

Discussion Question: Why do you think that Nike’s foreign subsidiaries do not just rely on a large bank in the U.S. to provide all of its foreign exchange services and its deposit or loan services?

ANSWER: Nike’s foreign subsidiaries can benefit from having a local bank facilitate some of its operations, because the local bank is open during similar hours of the day, and is easily accessible during business hours. Also, it is convenient to work with a bank that is close by, in case specific issues require that managers meet with bank employees.

Answers to End of Chapter Questions

1.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 firm’s relationship with the bank, (3) speed of execution, (4) advice about current market conditions, and (5) forecasting advice.

2.Assume that a bank’s bid price for Canadian dollars is $.7938 while its ask price is $.81. What is the bid/ask percentage spread?

ANSWER: ($.81 – &.7938)/$.81 = .02 or 2%

3.Compute the forward discount or premium for the Mexican peso whose 90day forward rate is $.102 and spot rate is $.10. State whether your answer is a discount or premium.

ANSWER: [($.102 – $.10)/$.10] × 360 = .08 or 8% (premium)

  1. Of what use is a forward contract to an MNC?

ANSWER: The forward contract can hedge future receivables or payables in foreign currencies to insulate the firm against exchange rate risk.

5.How can a forward contract backfire?

ANSWER: A forward contract can backfire when the forward rate at the time a forward contract is negotiated is (1) less than the spot rate that exists when receivables arrive, or (2) more than the spot rate that exists when payables are due.

6.If a U.S. dollar is worth .8 euros, what is the U.S. dollar value of a euro?

ANSWER: (1/.8) = $1.25.

7.Assume Poland’s currency (zlotty) is worth $.17 and a Japanese yen is worth $.008. What is the cross rate of the zlotty with respect to yen? That is, how many yen equal a zlotty?

ANSWER: ($.17/$.008) = 21.25

1 zlotty = 21.25 yen

8.Explain how the Eurocurrency, Eurocredit, and Eurobond markets differ from one another.

ANSWER: The Eurocurrency market focuses on shortterm deposits and loans, while the Eurocredit market is used to tap mediumterm loans, and the Eurobond market is used to obtain longterm funds (by issuing longterm bonds).

9.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).

10.What is the function of the Eurocurrency market?

ANSWER: The function of the Eurocurrency market is to efficiently facilitate the flow of international funds from firms or governments with excess funds to those in need of funds.

11.Briefly describe the reasons for growth in the Eurocurrency market during the last twenty years.

ANSWER: Growth was largely due to (1) regulations in the U.S. that limited foreign lending by U.S. banks; (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; and (3) zero reserve requirements of dollars deposited in Eurobanks which allowed Eurobanks to offer attractive rates on deposits and on loans.

  1. Why do interest rates vary among countries? Why are interest rates now the same for those European countries that use the euro as their currency?

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 does not vary among participating countries.

13.With regard to Eurocredit loans, who are the common borrowers?

ANSWER: Large corporations and some government agencies commonly request Eurocredit loans.

14.What is LIBOR and how is it used in the Eurocredit market?

ANSWER: LIBOR (London interbank offer rate) is the rate of interest at which Eurobanks lend to each other. It is used as a base from which loan rates on other loans are determined in the Eurocredit market.

15.Why would a bank desire to participate in syndicated Eurocredit loans?

ANSWER: 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.

16.Discuss some reasons for the popularity of the Eurobond market.

ANSWER: This market can sometimes avoid regulations required for domestic bonds and may allow borrowers to obtain funds at lower interest rates.

17.Compute the forward discount or premium for the British pound whose 180day forward rate is $1.75 and spot rate is $1.78. State whether your answer is a discount or premium.

ANSWER: Forward = 1.75–1.78 ×360 = –3.37% (minus sign implies

Discount 1.78 180 discount)

18.The Wolfpack Corporation is a U.S. exporter that invoices its exports to the United Kingdom in British pounds. If it expects that the pound will appreciate against the dollar in the future, should it hedge its exports with a forward contract? Explain.

ANSWER: Wolfpack Corporation should not hedge because it would benefit from appreciation of the pound when it converts the pounds to dollars.

19.Explain why firms may consider issuing stock in foreign markets. Why might U.S. firms 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 foreignissued 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.Bullet Inc., a U.S. firm, is planning to issue new stock in the United States during this month. The only decision it has left is the specific day in which the stock should be issued. Why do you think this firm monitors results of the Tokyo stock market every morning?

ANSWER: The U.S. stock market prices sometimes follow Japanese market prices. Thus, the firm would possibly be able to issue its stock at a lower price in the U.S. if it can use the Japanese market as an indicator of what will happen in the U.S. market. However, this indicator will not always be accurate.

21. Recently, Wal-Mart established two retail outlets in the city of Shanzen, China, which has a population of 3.7 million. These outlets are massive and contain products purchased locally as well as imports. As Wal-Mart generates earnings beyond what it needs in Shanzen, it may remit those earnings back to the United States. Wal-Mart is likely to build additional outlets in Shanzen or in other cities in the future.

a) Explain how the Wal-Mart outlets in China would use the spot market in foreign exchange.

ANSWER:The Wal-Mart 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 dollars, which would be remitted to the U.S. parent.

b)Explain how Wal-Mart’s parent may utilize the Eurocurrency market when it is establishing other Wal-Mart stores in Asia.

ANSWER: Wal-Mart may need to maintain some deposits in the Eurocurrency market that can be used (when needed) to support the growth of Wal-Mart stores in various foreign markets. When some Wal-Mart 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 Wal-Mart and other MNCs on a short-term basis.

c)Explain how Wal-Mart could use the Eurobond market to finance the establishment of new outlets in foreign markets.

ANSWER: Wal-Mart 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.

22. Explain how the Asian crisis would have affected the returns to a U.S. firm investing in the Asian stock markets as a means of international diversification. [See the appendix.]

ANSWER: The returns to the U.S. 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 again the U.S. dollar by 84%.

Small Business Dilemma

Use of the Foreign Exchange Markets by the Sports Exports Company

Each month, the Sports Exports Company (a U.S. firm) receives an order for footballs from a British sporting goods distributor. The monthly payment for the footballs is denominated in British pounds, as was requested by the British distributor. Jim Logan, owner of the Sports Exports Company, must convert the pounds received into dollars.

1.Explain how the Sports Exports Company could utilize the spot market in order 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 dollars 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 dollars.

The Sports Exports Company could engage in a forward contract in which it would sell pounds forward in exchange for dollars. 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 dollars at a specific forward rate. This would lock in the forward rate at which the pounds would be converted into dollars in 30 days, thereby removing any concern that the pound could depreciate against the dollar 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.