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-Gold Standard
From 1876 to 1913, each currency was convertible into gold
at a specified rate, as dictated by the gold standard. Thus
the exchange rate between two currencies was determined
by their relative convertibility rates per ounce of gold. Each
country used gold to back its currency.

When World War I began in 1914, the gold standard was

suspended. Some countries reverted to the gold standard in
the 1920s but abandoned it as a result of the U.S. and
European banking panic during the Great Depression. As a
result of instability in the foreign exchange market and the
severe restrictions on international transactions during this
period, the volume of international trade declined.

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Foreign Exchange Market-Agreements
on Fixed Exchange Rate
The 1944, Bretton Woods Agreement called for fixed
currency exchange rates.
An exchange rate was set for each pair of currencies,
and each country’s central bank was required to maintain its
respective local currency’s value within ±1% percent of the
agreed-upon exchange rates.

For example, when the U.S. demand for a specific foreign currency was
much stronger than the supply of that currency for sale, the commercial
banks that served the foreign exchange market would experience a
shortage of the foreign currency, and the exchange rate would start to
move outside the boundaries. Under these conditions, the Federal
Reserve was required to intervene to balance the exchange between the
two currencies The system established by the Bretton Woods Agreement
lasted until 1971.
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Foreign Exchange Market-Agreements on Fixed
Exchange Rate
By 1971 the U.S. dollar had apparently become overvalued, as
the U.S. demand for some foreign currencies was substantially
more than the supply of those currencies offered in exchange for
dollars.
Intervention by central banks could not effectively offset the large
imbalance between demand and supply. Representatives from the
major nations met to discuss this dilemma. This conference
resulted in the Smithsonian Agreement, whereby the U.S. dollar’s
value was devalued (reset downward) relative to the other major
currencies.
The degree to which the dollar was devalued varied with each
foreign currency. Not only was the dollar’s value reset, but
exchange rates were also allowed to fluctuate by 2.25 percent in
either direction from the newly set rates. These boundaries of 2.25
percent were wider than the previous boundaries (of 1 percent)
and thus enabled exchange rates to move within a wider range.
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Foreign Exchange Market-Floating Exchange
Rate System
Even with the wider bands allowed by the Smithsonian
Agreement, governments still had difficulty maintaining
exchange rates within the stated boundaries.

By March 1973, the official boundaries imposed by the

Smithsonian Agreement were eliminated, thereby allowing
exchange rates to move more freely.

Since that time, the currencies of most countries have been

allowed to fluctuate in accordance with market forces;
however, some countries’ central banks still periodically
intervene in the foreign exchange market to influence the
market-determined exchange rate or reduce the volatility in
their respective currency’s exchange rate movements.
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 Foreign Exchange
Transactions
• There is no specific building or location
where traders exchange currencies.
Trading also occurs around the clock.
• Foreign Exchange Dealers
• The spot market
• The Forward market

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 Foreign Exchange Dealers
Foreign Exchange Dealers serve as intermediaries in the
foreign exchange market by exchanging currencies desired by
MNCs or individuals. Foreign exchange dealers include large
commercial banks such as Citigroup, JPMorgan Chase & Co.,
Barclays (United Kingdom), UBS (Switzerland), and Deutsche
Bank (Germany).
In recent years, new trading platforms have been established that
allow some MNCs to engage in foreign exchange transactions
directly with other MNCs, thereby eliminating the need for a foreign
exchange dealer. An MNC that subscribes to such a platform can
indicate to the platform’s other users whether it wants to buy or sell
a particular currency as well as the volume desired. Some MNCs
continue to use a foreign exchange dealer, often because they
prefer personal attention or require more customized transactions
than can be handled via trading platforms.
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 Spot Market

The most common type of foreign exchange

transaction is for immediate exchange. The
market where these transactions occur is
known as the spot market.

The exchange rate at which one currency is

traded for another in the spot market is known
as the spot rate.

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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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 The Forward market
The forward market facilitates the trading of forward contracts on
currencies.
A forward contract is an agreement between a corporation and a financial
institution (such as a commercial bank) to exchange a specified amount of
a currency at a specified exchange rate (called the forward rate) on a
specified date in the future.
When MNCs anticipate a future need for or the future receipt of some
foreign currency, they can set up forward contracts to lock in the rate at
which they can purchase or sell that currency. Nearly all large MNCs use
forward contracts to some extent.
Some MNCs have forward contracts outstanding worth more than $100
million to hedge various positions.

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 The Forward market
Because forward contracts accommodate large corporations, the forward
transaction will often be valued at $1 million or more. Forward contracts
normally are not used by consumers or small firms. In cases where a
bank does not know a corporation well (or does not fully trust it), the bank
may request that the corporation make an initial deposit as assurance that
it intends to fulfill its obligation. Such a deposit is called a compensating
balance and typically does not pay interest. The most common forward
contracts are for 30, 60, 90, 180, and 360 days, although other periods
are available. Yet forward contracts can be customized to the specific
needs of the MNC. If an MNC wants a forward contract that allows it to
exchange dollars for 1.2 million euros in 53 days, a financial institution will
accommodate such a request. The forward rate of a given currency will
usually vary with the length (number of days) of the forward period.

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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 (P-67)
• 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??? 625+950 B3 - 18
 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 (P-69)
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 units.
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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 Exercise-1
A call option on Canadian dollars with a strike price of
$.60 is purchased by a speculator for a premium of
$.06 per unit. Assume there are 50,000 units in this
option contract.
If the Canadian dollar’s spot rate is $.65 at the time the
option is exercised, what is the net profit per unit and
for one contract to the speculator? What would the
spot rate need to be at the time the option is exercised
for the speculator to break even? What is the net profit
per unit to the seller of this option?

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 Exercise-2
A put option on Australian dollars with a strike price of
$.80 is purchased by a speculator for a premium of
$.02. If the Australian dollar’s spot rate is $.74 on the
expiration date, should the speculator exercise
the option on this date or let the option expire? What is
the net profit per unit to the speculator? What is the
net profit per unit to the seller of this put option?

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 Answer
1. The net profit to the buyer is -$.01 per unit.
The net profit to the buyer for one contract is -$500
(computed as -$.01 X 50,000 units).
The spot rate would need to be $.66 for the speculator to
break even.
The net profit to the seller of the call option is $.01 per unit.

2. The speculator should exercise the option.

The net profit to the speculator is $.04 per unit.
The net profit to the seller of the put option is -$.04 per unit.

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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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 The Money Market
Each country has a money market whereby surplus units (individuals or
institutions with available short-term funds) can transfer funds to deficit
units (institutions or individuals in need of funds). Financial institutions
such as commercial banks accept short-term deposits from surplus units
and redirect the funds toward deficit units. The international money
market developed to accommodate the needs of MNCs.
First, many MNCs borrow short-term funds in different currencies to pay
for imports denominated in those currencies.
Second, MNCs that need funds to support local operations may consider
borrowing in a nonlocal currency that exhibits lower interest rates. This
strategy is especially appropriate for firms expecting future receivables
denominated in that currency.
Third, MNCs may consider borrowing in a currency that they anticipate
will depreciate against their home currency, as this would enable them to
repay the short-term loan at a more favorable exchange rate. In this
case, the actual cost of borrowing would be less than the interest rate
quoted for that currency
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 The Money Market
At the same time, some MNCs and institutional investors have incentives
to invest shortterm funds in a foreign currency. First, the interest rate on a
short-term investment denominated in a foreign currency might exceed
the interest rate on a short-term investment denominated in their home
currency.
Second, they may consider investing in a currency that they expect will
appreciate against their home currency so that the return on their
investment would be greater than the interest rate quoted for the foreign
investment.
Financial institutions such as commercial banks serve this market by
accepting deposits and providing loans in various currencies. These
intermediaries typically also serve as dealers in the foreign exchange
market.

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 International Credit market
Multinational corporations and domestic firms sometimes obtain medium-
term funds via term loans from local financial institutions or by issuing
notes (medium-term debt obligations) in their local markets. However,
MNCs also have access to medium-term funds through banks located in
foreign markets.
Loans of one year or longer that are extended by banks to MNCs or
government agencies in Europe are commonly called Eurocredits or
Eurocredit loans, which are transacted in the Eurocredit market.
These loans can be denominated in dollars or in one of many other
currencies, and their typical maturity is five years.

**Syndicated Loan

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 International Bond Market and Share market
The international bond market facilitates the flow of funds between
borrowers who need long-term funds and investors who are willing to
supply long-term funds.
Major investors in the international bond market include institutional
investors such as commercial banks, mutual funds, insurance companies,
and pension funds from many countries.

Institutional investors may prefer to invest in international bond markets,

rather than in their respective local markets, when they can earn a higher
return on bonds denominated in foreign currencies. Borrowers in the
international bond market include both national governments and MNCs.

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 International Bond Market and Share market
Multinational corporations can obtain long-term debt by issuing bonds in
their local markets, and they can also access long-term funds in foreign
markets. They may choose to issue bonds in the international bond
markets for three reasons.
First, MNCs may be able to attract a stronger demand by issuing their
bonds in a particular foreign country rather than in their home country.
Some countries have a limited investor base, so MNCs in those countries
naturally seek financing elsewhere.
Second, MNCs may prefer to finance a specific foreign project in a
particular currency and thus may seek funds where that currency is widely
used.
Third, an MNC might attempt to finance projects in a foreign currency with
a lower interest rate in order to reduce its cost of financing, although doing
so would increase its exposure to exchange rate risk.

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 International Share market
Some MNCs issue stock outside their home country, many investors
purchase stocks outside their home country.
There are several reasons for such a strategy.
First, these investors may expect favorable economic conditions in a
particular country and therefore invest in stocks of the firms in that country.
Second, investors may wish to acquire stocks denominated in currencies
that they expect to strengthen over time, because that would enhance the
return on their investment.
Third, some investors invest in stocks of other countries as a means of
diversifying their portfolio. Thus their investment is less sensitive to
possible adverse stock market conditions in their home country.

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 International Bond Market and Share market
MNCs may issue stock in foreign markets for various reasons. MNCs may
more readily attract funds from foreign investors by issuing stock in
international markets. They have their stock listed on an exchange in any
country where they issue shares, because investors in a foreign country
are only willing to purchase stock if they can later easily sell their holdings
locally in the secondary market. The stock is denominated in the currency
of the country where it is placed.

An MNC’s stock offering may be more easily digested when it is issued in

several markets. The stocks of some U.S.-based MNCs are widely traded
on numerous stock exchanges around the world, which gives non-U.S.
investors easy access to those stocks and also gives the MNCs global
name recognition. Many MNCs issue stock in a country where they will
generate enough future cash flows to cover dividend payments.

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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- 31, 35, 42.

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