Ch. 3 International Financial Markets. Motives for Int l Financial Markets. Foreign Exchange Market

Transcription

1 Ch. 3 International Financial Markets Topics Motives for Int l Financial Markets Foreign Exchange Transactions Eurocurrency Market International Stock Markets Global Financial Markets & MNC s Value Motives for Int l Financial Markets The markets for real or financial assets are prevented from complete integration by barriers such as tax differentials, tariffs, quotas, labor immobility, communication costs, cultural differences, and financial reporting differences. Yet, these barriers can also create unique opportunities for specific geographic markets that will attract foreign investors. Foreign Exchange Market Allows for the exchange of one currency for another. Exchange rate specifies the rate at which one currency can be exchanged for another. Foreign Exchange Market The system for establishing exchange rates has evolved over time. From 1876 to 1913, each currency was convertible into gold at a specified rate, as dictated by the gold standard. This was followed by a period of instability, as World War I began and the Great Depression followed. The 1944 Bretton Woods Agreement called for fixed currency exchange rates. By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations from ±1% to ±2%. Even then, governments still had difficulties maintaining exchange rates within the stated boundaries. In 1973, the official boundaries for the more widely traded currencies were eliminated and the floating exchange rate system came into effect. 1

2 Foreign Exchange Transactions Over the counter market: There is no specific building or location where traders exchange currencies. Trading also occurs around the clock. Foreign exchange dealers serve as intermediaries. Spot market: Transaction for immediate exchange at the spot rate. Hundreds of banks facilitate foreign exchange transactions, though the top 20 handle about 50% of the transactions. Foreign Exchange Transactions The following attributes of banks are important to foreign exchange customers: Competitiveness of quote Special relationship between the bank and its customer Speed of execution Advice about current market conditions Forecasting advice Foreign Exchange Transactions Banks provide foreign exchange services for a fee: the bank s bid (buy) quote for a foreign currency will be less than its ask (sell) quote. This is the bid/ask spread. bid/ask spread (%) = ask rate bid rate ask rate Factors that affect the spread: Order costs, inventory costs, competition, volume, currency risk The bid/ask spread is normally larger for those currencies that are less frequently traded. The spread is also larger for retail transactions than for wholesale transactions between banks or large corporations. 2

3 Foreign Exchange Quotations Direct quotations represent the value of a foreign currency in dollars. Example (US residents): $1.40 per euro Indirect quotations represent the number of units of a foreign currency per dollar. Example (US residents): per dollar Cross exchange rate: Amount of one foreign currency per unit of another foreign currency. Value of 1 unit of currency A in units of currency B = value of currency A in $ value of currency B in $ Currency Futures and Options Market Currency forward contracts: Agreements between a foreign exchange dealer and an MNC that specifies the currencies to be exchanged, the exchange rate, and the date at which the transaction will occur. Currency futures contracts: Similar to forward contracts but sold on an exchange. Currency options contracts Currency Call Option: provides the right to buy currency at a specified strike price within a specified period of time. Currency Put Option: provides the right to sell currency at specified strike price within a specified period of time. They are traded on exchanges as well. International Money Market Corporations or governments in a particular country need for short-term funds denominated in a currency different from their home currency. Reasons for international money market: Need to borrow funds to pay for imports denominated in a foreign currency. Borrowing in a currency in which the interest rate is lower. 3

4 Risk of International Money Market Securities International Money Market Securities are debt securities issued by MNCs and government agencies with a shortterm maturity (1 year or less). Normally, these securities are perceived to be very safe from the risk of default. Even if the international money market securities are not exposed to credit risk, they are exposed to exchange rate risk when the currency denominating the securities differs from the home currency of the investors. Eurocurrency Market Eurodollars: U.S. dollar deposits placed in banks in Europe and other continents. Eurocurrency market: Eurocurrency grew to accommodate increasing international business and to bypass stricter U.S. regulations on banks in the U.S. Asian dollar market: The Eurocurrency market in Asia. The primary function of banks in the Asian dollar market is to channel funds from depositors to borrowers. Another function is interbank lending and borrowing. Eurocredit Market Loans of one year or longer are extended by Eurobanks to MNCs or government agencies in the Eurocredit market. These loans are known as Eurocredit loans. Typically, loans are denominated in dollars or other currencies with often maturities of 5 years. London Interbank Offer Rate (LIBOR): Rate charged for loans between banks. Floating rates are commonly used, since the banks asset and liability maturities may not match - Eurobanks accept short-term deposits but sometimes provide longer term loans. 4

5 Regulations in the Credit Market Single European Act Capital can flow freely throughout Europe. Banks can offer a wide variety of lending, leasing, and securities activities in the EU. Regulations regarding competition, mergers, and taxes are similar throughout the EU. A bank established in any one of the EU countries has the right to expand into any or all of the other EU countries. Basel Accord - Banks must maintain capital equal to at least 4 percent of their assets. For this purpose, banks assets are weighted by risk. Regulations in the Credit Market Basel II Accord - Attempts to account for differences in collateral among banks. In addition, this accord encourages banks to improve their techniques for controlling operational risk, which could reduce failures in the banking system. Also plans to require banks to provide more information to existing and prospective shareholders about their exposure to different types of risk. Basel III Accord - Called for new methods of estimating risk-weighted assets that would increase the level of riskweighted assets, and therefore require banks to maintain higher levels of capital. International Bonds Foreign bonds: Bonds denominated in the currency of the country where they are placed but issued by borrowers foreign to the country. Eurobonds: Bonds that are sold in countries other than the country represented by the currency denominating them. 5

6 Eurobond Market Eurobonds are underwritten by a multi-national syndicate of investment banks and simultaneously placed in many countries through second-stage, and in many cases, third-stage, underwriters. Eurobonds are usually issued in bearer form, pay annual coupons, may be convertible, may have variable rates, and typically have few protective covenants. Interest rates for each currency and credit conditions in the Eurobond market change constantly, causing the popularity of the market to vary among currencies. About 70% of the Eurobonds are denominated in the U.S. dollar. In the secondary market, the market makers are often the same underwriters who sell the primary issues. International Stock Markets In addition to issuing stock locally, MNCs can also obtain funds by issuing stock in international markets. This will enhance the firm s image and name recognition, and diversify the shareholder base. Stock issued in the U.S. by non-u.s. firms or governments are called Yankee stock offerings. Many of such recent stock offerings resulted from privatization programs in Latin America and Europe. Non-U.S. firms may also issue American depository receipts (ADRs), which are certificates representing bundles of stock. ADRs are less strictly regulated. Comparison of Stock Exchanges (as of 2013) 6

7 International Stock Markets The locations of the MNC s operations can influence the decision about where to place stock, in view of the cash flows needed to cover dividend payments. Market characteristics are important too. Stock markets may differ in size, trading activity level, regulatory requirements, taxation rate, and proportion of individual versus institutional share ownership. Global Financial Markets & MNC s Value Improved global image from issuing stock in global markets Cost of borrowing funds in global markets Value = [ ( ) ( )] m E CF n j, t E ER j, t j = 1 t t =1 ( 1 + k ) Cost of parent s equity in global markets Cost of parent s funds borrowed in global markets E (CF j,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t E (ER j,t ) = expected exchange rate at which currency j can be converted to dollars at the end of period t k = weighted average cost of capital of the parent 7