International business 7e czinkota moffett ch07

Chapter 7
Financial Markets

1


Learning Objectives
To understand how currencies are traded and
quoted on world financial markets
To examine the links between interest rates
and exchange rates
To understand the similarities and differences
between domestic sources of capital and
international sources of capital
To examine how the needs of individual
borrowers have changed the nature of the
instruments traded on world financial markets
in the past decade
To understand how the debt crises of the 1980s
and 1990s are linked to the international
financial markets and exchange rates

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The Market for
Currencies
The price of any one
country’s currency in
terms of another country’s
currency is called a foreign

currency exchange rate
Every market, every
country, and every firm
may have its own set of
currency symbols
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Exchange Rate Quotations
and Terminology
Direct quotation:
when the subject
currency is stated
first
Indirect quotation:
when the subject
currency is stated
second

Spot rates: when
the exchange of
currencies takes
place immediately
Forward rates:
when the currency
exchange takes
place at a later
date and at an
agreed upon
exchange rate

4


Direct and Indirect
Quotations
Most currencies are quoted in direct
quotes versus the U.S. dollar
The major exceptions are currencies
associated with the British
Commonwealth and the European euro
When an exchange rate of a currency
is stated without using the U.S. dollar
as a reference, it is referred to as a
cross rate
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Foreign Currency Market
Structure
The market for foreign
currencies is a worldwide
market that is informal in
structure
The “market” is actually
the thousands of
telecommunications links
among financial
institutions around the
globe and it is open
nearly 24 hours a day

6


Market Size and
Composition

Until recently there was little data on the
actual volume of trading on world foreign
currency markets
In the spring of 1986, the Federal Reserve
Bank of New York along with others started
surveying the activity of currency trading
every three years
Growth of foreign currency trading has
been nothing less than astronomical
The majority of the world’s trading in
foreign currencies is still taking place in the
cities where international financial activity
is centered, London, New York, and Tokyo

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Market Size and
Composition

Three reasons typically given for the enormous growth in foreign currency trading
are:

Deregulation of international capital

flows
Gains in technology and transaction
cost efficiency
The world is a risky place

8


The Purpose of Exchange
Rates
If countries are to
trade, they must be
able to exchange
currencies
The exchange of one
country’s currency for
another should be
relatively simple, but
it’s not
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What is a Currency
Worth?
The exchange rate
between currencies
should equalize its
purchasing power
The theory of
purchasing power

parity (PPP) is
simply the rate that
equalizes the price
of the identical
product or service in
two different
currencies

The version of
purchasing power
parity that estimates
the exchange rate
between two
currencies using just
one good or service
as a measure of the
proper exchange for
all goods and
services is called the
Law of One Price

10


Monetary Systems of
the 20th Century
Mixed/fixed floating
exchange rate system is
in operation today
Prior to this, the Gold

Standard was in effect
Prior to that, the
Bretton Woods
Agreement was in effect
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The Gold Standard
The gold standard began sometime in
the 1880s
It was premised on three basic ideas:
A system of fixed rates of exchange
existed between participating countries
Money issued by member countries had
to be backed by gold reserves
Gold acted as an automatic adjustment

Under this standard, each country’s
currency would be set in value per
ounce of gold
12


The Bretton Woods
Agreement
The governments of 44 of the Allied
Powers gathered together in Bretton
Woods, New Hampshire in 1944 to plan for
the postwar international monetary system
This agreement called for the following:

Fixed exchange rates between member
countries
The establishment of a fund of gold and
currencies for stabilization of their
currencies, the International Monetary Fund
The establishment of a bank, the World
Bank, that would provide funding for longterm development projects

13


Floating Exchange
Rates
Since March 1973, the world’s
major currencies have floated
in value versus each other
The inability of a country to
control the value of its
currency on world markets
has been a harsh reality for
most
Direct intervention
Coordinated intervention

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The European Monetary
System and the Euro
In 1979 a formalized structure was put in place among

many of the major members of the European
Community
The European Monetary System (EMS) officially began
operation in March 1979 and once again established a
grid of fixed parity rates among member currencies
The EMS consisted of three elements:
First, all countries that were committing their
currencies and their efforts to the preservation of
fixed exchange rates entered the Exchange Rate
Mechanism (ERM)
Second, was the actual grid of bilateral exchange
rates with their specialized band limits
Third, was the creation of the European Currency
Unit (ECU)

15


The Maastricht Treaty
The members of the European Union concluded this treaty in December 1991
This treaty:

Laid out terms goals of harmonized
social and welfare policies
Specified a timetable for the adoption
of a single currency to replace all
individual currencies

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The Euro
On December 31,
1998, the final fixed
rates between the
11 currencies and
the euro were put
into place
On January 1,
1999,the euro was
officially launched
as a single currency
for the European
Union

The monetary policy
for the EMU will be
conducted by the
European Central
Bank (ECB) and has
a single
responsibility of
safeguarding the
stability of the euro
On January 4, 1999,
the euro began
trading on world
currency markets

17

International Money
Markets
International money
markets, often termed the
Eurocurrency markets,
constitute an enormous
financial market that is in
many ways outside the
jurisdiction and supervision
of world financial and
governmental authorities
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Eurocurrency Markets and
Eurocurrency Interest
Rates
A Eurocurrency
While there are
is any foreign
currency
denominated
deposit or
account at a
financial
institution
outside the
country of the

currency’s issue

hundreds of
different major
interest rates
around the
globe, the
international
financial markets
focus on the
interbank
interest rates

19


Defining International
Financing
The definition of what constitutes an international financial transaction is
dependent on two characteristics:

Whether the borrower is domestic or
foreign
Whether the borrower is raising capital
denominated in the domestic currency
or a foreign currency

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Defining International
Financing
The two characteristics that define an international financial transaction form four
categories:

Domestic borrower/domestic currency
Foreign borrower/domestic currency
Domestic borrower/foreign currency
Foreign borrower/foreign currency

21


Structure of International
Banking
Correspondent bank:
an unrelated bank
based in a foreign
country
Representative bank:
basically a sales office
for a bank
22


International Security
Markets
The international debt
securities markets have
experienced the

greatest growth in the
past decade
It includes:
Bonds
Equities
Private placements
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The International Bond
Market
The international bond market provides the bulk of financing

Foreign bonds
Eurobonds
Bearer bonds

24


Private Placements
One of the largest
and unpublicized
capital markets
A private placement
is the sale of debts
or equity to a large
investor

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