Chapter

3
International Financial Markets
 Chapter Objectives

• To describe the background and corporate

use of the following international financial
markets:
¤ Foreign exchange market,
¤ International Money Market,
¤ International Credit market,
¤ International bond market, and
¤ International stock markets.

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Foreign Exchange Market
When MNCs and individuals engage in international
transactions, they commonly need to exchange their local
currency for a foreign currency, or exchange a foreign
currency for their local currency.
The foreign exchange market allows for the exchange of one
currency for another. Large commercial banks serve this
market by holding inventories of each currency so that they
can accommodate requests by individuals or MNCs for
currency for various transactions.
Individuals rely on the foreign exchange market when they
travel to foreign countries. People from the United States
exchange dollars for Mexican pesos when they visit Mexico,
euros when they visit Italy, or Japanese yen when they
visit Japan.

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 Foreign Exchange Market

• The foreign exchange market allows

currencies to be exchanged in order to
facilitate international trade or financial
transactions.
• The system for establishing exchange rates
has evolved over time.
a) Gold Standard
b) Fixed Exchange Rate System
c) Floating Exchange Rate System
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Foreign Exchange Market
¤ 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%.
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 Foreign Exchange
Transactions
• There is no specific building or location
where traders exchange currencies.
Trading also occurs around the clock.
• The market for immediate exchange is
known as the spot market.
• The forward market enables an MNC to
lock in the exchange rate at which it will
buy or sell a certain quantity of currency
on a specified future date.
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 SPOT Market
• Indiana Co. purchases supplies priced at 100,000 euros (€) from Belgo, a
Belgian supplier, on the first day of every month. Indiana instructs its bank
to transfer funds from its account to Belgo’s account on the first day of
each month. It only has dollars in its account, whereas Belgo’s account
balance is denominated in euros.
• When payment was made last month, the euro was worth $1.08; hence
Indiana Co. needed $108,000 to pay for the supplies (€100,000 X $1.08)
=$108,000). The bank reduced Indiana’s account balance by $108,000,
which was exchanged at the bank for €100,000. The bank then sent the
€100,000 electronically to Belgo by increasing Belgo’s account balance by
€100,000.
• Today, a new payment needs to be made. The euro is currently valued at
$1.12, so the bank will reduce Indiana’s account balance by $112,000
(€100,000 X $1.12 = $112,000) and exchange it for €100,000, which will
be sent electronically to Belgo.

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 Forward market
Turz, Inc., is an MNC based in Chicago that will need 1 million
Singapore dollars in 90 days to purchase Singapore imports. It
can buy this currency for immediate delivery at the spot rate of
$.50 per Singapore dollar (S$). At this spot rate, the firm would
need $500,000 (calculated as S$1,000,000 X $.50 per
Singapore dollar). However, it does not now have the funds to
exchange for Singapore dollars. It could wait 90 days and then
exchange U.S. dollars for Singapore dollars at the spot rate
existing at that time, but Turz does not know what that rate will
be. If the rate rises to $.60 in those 90 days, then Turz will need
$600,000 (i.e., S$1,000,000 X $.60 per), or an additional outlay
of $100,000 due solely to the Singapore dollar’s appreciation.
To avoid exposure to such exchange rate risk, Turz can
negotiate a forward contract with a bank to purchase
S$1,000,000 90 days forward.
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 Foreign Exchange
Transactions
• Hundreds of banks facilitate foreign
exchange transactions, though the top 20
handle about 50% of the transactions.
• At any point in time, arbitrage ensures that
exchange rates are similar across banks.
• Trading between banks occurs in the
interbank market. Within this market,
foreign exchange brokerage firms
sometimes act as middlemen.
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 Foreign Exchange
Transactions
• The following attributes of banks are important
to foreign exchange customers in need of
foreign exchange:
¤ competitiveness of quote
¤ special relationship between the bank and its
customer
¤ speed of execution
¤ advice about current market conditions
¤ forecasting advice

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 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.
• To understand how a bid/ask spread could affect
you, assume you have $1,000 and plan to travel
from the United States to the United Kingdom.
Assume further that the bank’s bid rate for the British
pound is $1.52 and its ask rate is $1.60. Before
leaving on your trip, you go to this bank to exchange
dollars for pounds. Your $1,000 will be converted to
??? Pounds?
• Now if you want to convert the exchanged amount back into
U.S. dollars, then you will receive??? B3 - 11
 Bid/Ask spread

• bid/ask % spread = ask rate – bid rate

ask rate
• Example: Suppose bid price for £ = $1.52,
ask price = $1.60.
bid/ask % spread = (1.60–1.52)/1.60 = 5%

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 Practice

• Assume that a commercial bank’s prevailing

quote for wholesale transactions involving the
euro is $1.0876/78. The bid/ask spread in this
is???

• .0184%

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 Bid/Ask spread…….Cont.

• 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.

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Factors that affect the Spread
Factors Impact
Order costs +
Inventory costs +
Competition -
Volume -
Currency risk +

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 Factors that affect the Spread
a) Order costs: Order costs are the costs of processing orders;
these costs include clearing costs and the costs of recording
transactions.
b) Inventory costs: Inventory costs are the costs of maintaining
an inventory of a particular currency (Opportunity costs).
c) Competition: The more intense the competition, the smaller
the spread quoted by intermediaries.
d) Volume: Currencies that have a large trading volume are
more liquid and are less likely to experience a sudden change in
price.
e) Currency risk: Some currencies exhibit more volatility than
others because of economic or political conditions that cause
the demand for and supply of the currency to change abruptly.

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 Direct Vs Indirect Quotations
• Direct quotations represent the value of a foreign
currency in dollars, while indirect quotations
represent the number of units of a foreign
currency per dollar.
• The spot rate of the euro is quoted at $1.25. This is a
direct quotation. The indirect quotation of the euro is
the reciprocal of the direct quotation:

• So, indirect quotation = .80 Euro/$

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 Cross Exchange Rate

• A cross exchange rate reflects the 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 $

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 Example and Practice
• At the start of the period, the peso was worth $.12 and the
Canadian dollar was worth $.66. Under those conditions, the
value of the peso in Canadian dollars (C$) is calculated as
follows:
Values of pesos in C$ = Value of peso in $/ Value of C$ in $
= C$.182.

At the end of the period, the Mexican peso was worth $.11, while
the Canadian dollar was worth $.70. Under those conditions, the
value of the peso in Canadian dollars (C$) is?

Answer: C$ .157

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 Currency Derivatives
A currency derivative is a contract with a price that is
partially derived from the value of the underlying
currency that it represents. Three types of currency
derivatives that are often used by MNCs are

a) Forward contracts
b) Currency futures contracts
c) Currency options contracts.

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 a) Forward Contracts
• In some cases, an MNC may prefer to lock in an exchange
rate at which it can obtain a currency in the future.
• A forward contract is an agreement between an MNC and a
foreign exchange dealer that specifies the currencies to be
exchanged, the exchange rate, and the date at which the
transaction will occur.
• The forward rate is the exchange rate, specified in the
forward contract, at which the currencies will be exchanged.
Multinational corporations commonly request forward
contracts to hedge future payments that they expect to make
or receive in a foreign currency.
• In this way, they do not have to worry about fluctuations in the
spot rate until the time of their future payments.

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 Example
Today, MMZ Co. has ordered from European countries some supplies
whose prices are denominated in euros. It will receive the supplies in
90 days and will need to make payment at that time. It expects the euro
to increase in value over the next 90 days and therefore desires to
hedge its payables in euros. MMZ buys a 90-day forward contract on
euros to lock in the price that it will pay for euros at a future time.

Meanwhile, MMZ will receive Mexican pesos in 180 days because of an

order it received from a Mexican company today. It expects that the
peso will decrease in value over this period and wants to hedge these
receivables. MMZ sells a forward contract on pesos to lock in the
dollars that it will receive when it exchanges the pesos at a specified
time in the future.

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 Futures contracts
• Futures contracts are similar to forward contracts but are sold
on an exchange instead of over the counter.
• A currency futures contract specifies a standard volume of a
particular currency to be exchanged on a specific settlement
date.
• Some MNCs involved in international trade use the currency
futures markets to hedge their positions. The futures rate is
the exchange rate at which one can purchase or sell a
specified currency on the settlement date in accordance with
the futures contract.
• Thus the futures rate’s role in a futures contract is similar to
the forward rate’s role in a forward contract.

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 Currency options contracts
• Currency options contracts give the right to buy
or sell a specific currency at a specific price
within a specific period of time.
• A currency call option provides the right to buy a
specific currency at a specific price (called the strike
price or exercise price) within a specific period of
time. It is used to hedge future payables.
• A currency put option provides the right to sell a
specific currency at a specific price within a specific
period of time. It is used to hedge future
receivables.

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 Currency Call and Put Option
A currency call option grants the right to buy a
specific currency at a designated price within a specific
period of time. The price at which the owner is allowed
to buy that currency is known as the exercise price or
strike price, and there are monthly expiration dates for
each option.
The owner of a currency put option has the right to sell
a currency at a specified price (the strike price) within a
specified period of time. As with currency call options,
the owner of a put option is not obligated to exercise
the option. Therefore, the maximum potential loss to
the owner of the put option is the price (or premium)
paid for the option contract.
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 Factors Affecting Currency Call Option Premiums
a) Spot Price Relative to Strike Price: The higher
the spot rate relative to the strike price, the higher
the option price will be.
b) Length of Time before the Expiration Date: It is
typically assumed that the spot rate is more likely
to rise high above the strike price if it has a longer
period of time to do so.
c) Volatility of the Currency: The greater the
variability in the currency’s price, the greater the
likelihood of the spot rate rising above the strike
price.

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 Example
Jim is a speculator who buys a British pound call option with a
strike price of $1.40 and a December settlement date. The
current spot price as of that date is about $1.39. Jim pays a
premium of $.012 per unit for the call option. Assume there are
no brokerage fees. Just before the expiration date, the spot rate
of the British pound reaches $1.41. At this time, Jim exercises
the call option and then immediately sells the pounds (to a bank)
at the spot rate.
Determine Jim’s profit or loss assume that one option contract
specifies 31,250 units.

Whats about seller?

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 Example
A put option contract on British pounds specifies the following
information.
■ Put option premium on British pound (£) = $.04 per unit.
■ Strike price = $1.40.
■ One option contract represents £31,250.
A speculator who had purchased this put option decided to
exercise the option shortly before the expiration date, when the
spot rate of the pound was $1.30. The speculator purchased the
pounds in the spot market at that time.

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C P
A U
L T
L
O
O P
P T
T I
I O
O N
N

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 International Financing Sources

• A) Money Market (Euro Dollar, Petro Dollar

and LIBOR)
• B) Credit market
• C) Bond Market
• D) Stock Market

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 Practice
a) Explain how the appreciation/depreciation of the
Australian dollar against the U.S. dollar would
affect the return to a U.S. firm that invested in an
Australian money market security.
b) Utah Bank’s bid price for Canadian dollars is
$.7938 and its ask price is $.8100. What is the
bid/ask percentage spread?
c) If the direct exchange rate of the euro is $1.25,
what is the euro’s indirect exchange rate? That is,
what is the value of a dollar in euros?

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 Practice
d) Assume Poland’s currency (the zloty) is worth $.17
and the Japanese yen is worth $.008. What is the
cross rate of the zloty with respect to yen? That is, how
many yen equal a zloty?
e) You just came back from Canada, where the Canadian dollar
was worth $.70. You still have C$200 from your trip and could
exchange them for dollars at the airport, but the airport foreign
exchange desk will only buy them for $.60. Next week, you will
be going to Mexico and will need pesos. The airport foreign
exchange desk will sell you pesos for $.10 per peso. You met a
tourist at the airport who is from Mexico and is on his way to
Canada. He is willing to buy your C$200 for 1,300 pesos. Should
you accept the offer or cash the Canadian dollars in at the
airport? Explain.
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 Assignment

• Write an essay on Derivatives Market of

Bangladesh
• What are the major differences between
Forward Contract and Future Contract?

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 Chapter-5

Q&A- 13 & 14.

AQ- 35, 31, 42.

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