The Foreign The Foreign Exchange MarketExchange Market

&&

The Global Capital The Global Capital MarketMarket

Chapter 9 & 11 - 2

Chapter PreviewChapter Preview

• Discuss the international capital market

• Describe the international bond, international equity and Eurocurrency markets

• Identify the foreign exchange market’s functions

• Explain currency quotes and the rates given

• Identify the instruments of foreign exchange

• Discuss government restrictions on currencies

Chapter 9 & 11 - 3

Capital MarketCapital Market

Debt: Repay principal plus interest Bond has timed principal & interest payments

Equity: Part ownership of a company Stock shares in financial gains or losses

System that allocates financial resourcesaccording to their most efficient uses

Chapter 9 & 11 - 4

International Capital MarketInternational Capital Market

Network of people, firms, financial institutions and governments borrowing and investing internationally

Borrowers

Expands money supply Reduces cost of money

Borrowers

Expands money supply Reduces cost of money

Lenders

Spread / reduce risk Offset gains / losses

Lenders

Spread / reduce risk Offset gains / losses

Chapter 9 & 11 - 5

International CapitalInternational CapitalMarket DriversMarket Drivers

Information technologyInformation technology

DeregulationDeregulation

Financial instrumentsFinancial instruments

Chapter 9 & 11 - 6

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Country or territorywhose financial sector

features few regulationsand few, if any, taxes

Operational centerExtensive financial activity

and currency trading

Operational centerExtensive financial activity

and currency trading

Booking centerMostly for bookkeeping

and tax purposes

Booking centerMostly for bookkeeping

and tax purposes

Offshore Financial CentersOffshore Financial Centers

Chapter 9 & 11 - 7

International Bond MarketInternational Bond Market

Foreign bond Interest ratesEurobond

Bond that is issued outside the country in whose currency the bond is denominated

Bond sold outside a borrower’s country and denominated in the currency of the country in which it is sold

Driving growth are differential interest rates between developed and developing nations

Market of bonds sold by issuing companies, governments and others outside their own countries

Chapter 9 & 11 - 8

International Equity MarketInternational Equity Market

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

Market of stocks bought and soldMarket of stocks bought and soldoutside the issuer’s home countryoutside the issuer’s home country

PrivatizationPrivatizationPrivatizationPrivatization

Investment banksInvestment banksInvestment banksInvestment banks

Developing nationsDeveloping nationsDeveloping nationsDeveloping nations

Electronic marketsElectronic marketsElectronic marketsElectronic markets

Chapter 9 & 11 - 9

Governments Commercial banks International companies Wealthy individuals

Eurocurrency MarketEurocurrency Market

Unregulated market of currencies banked outside

their countries of origin

Chapter 9 & 11 - 10

Foreign Exchange MarketForeign Exchange Market

Conversion: To facilitate sale or purchase, or invest directly abroad

Hedging: Insure against potential losses from adverse exchange-rate changes

Arbitrage: Instantaneous purchase and sale of a currency in different markets for profit

Speculation: Sequential purchase and sale (or vice-versa) of a currency for profit

Market in which currencies are bought and soldand their prices are determined

Chapter 9 & 11 - 11

Quoting CurrenciesQuoting Currencies

Quoted currency = numeratorBase currency = denominatorQuoted currency = numeratorBase currency = denominator

(¥/$) = Japanese yen needed to buy one U.S. dollar(¥/$) = Japanese yen needed to buy one U.S. dollar

Yen is quoted currency, dollar is base currencyYen is quoted currency, dollar is base currency

Chapter 9 & 11 - 12

Currency ValuesCurrency Values

Change in US dollar against Polish zloty

February 1: PLZ 5/$ March 1: PLZ 4/$

%change = [(4-5)/5] x 100 = -20%

US dollar fell 20%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Change in Polish zloty against US dollar

Make zloty base currency (1÷ PLZ/$) February 1: $.20/PLZ March 1: $.25/PLZ

%change = [(.25-.20)/.20] x 100 = 25%

Polish zloty rose 25%

Chapter 9 & 11 - 13

Cross RateCross Rate

Dollar Euro Pound SFranc Peso Yen CdnDlr

Canada 1.3931 1.6466 2.4561 1.0695 0.1198 0.0122 ....

Japan 114.50 135.32 201.85 87.898 9.8420 .... 82.185

Mexico 11.633 13.749 20.510 8.9309 .... 0.1016 8.3504

Switzerland 1.3026 1.5395 2.2965 .... 0.1120 0.0114 0.9350

United Kingdom 0.5672 0.6704 .... 0.4355 0.0488 0.0050 0.4071

Euro 0.8461 .... 1.4917 0.6495 0.0727 0.0074 0.6073

United States .... 1.1819 1.7630 0.7677 0.0860 0.0087 0.7178

• Exchange rate calculated using two other exchange rates• Use direct or indirect exchange rates against a third currency

Cross Rate ExampleCross Rate Example

Direct quote method

1) Quote on euro = € 0.8461/$2) Quote on yen = ¥ 114.50/$3) € 0.8461/$ ÷ ¥ 114.50/$ = € 0.0074/¥4) Costs 0.0074 euros to buy 1 yen

Indirect quote method

1) Quote on euro = $ 1.1819/€2) Quote on yen = $ 0.008734/¥

3) $ 1.1819/€ ÷ $ 0.008734/¥ = ¥ 135.32/€4) Final step: 1 ÷ € 135.32/¥ = € 0.0074/¥5) Costs 0.0074 euros to buy 1 yen

Chapter 9 & 11 - 15

Spot RateSpot Rate

Exchange rate requiring deliveryExchange rate requiring deliveryof traded currency within two business daysof traded currency within two business days

Repatriate incomeRepatriate incomefrom sales abroadfrom sales abroad

Invest in anotherInvest in anothernational marketnational market

Pay supplier inPay supplier inits own currencyits own currency

Chapter 9 & 11 - 16

Forward RateForward Rate

Rate at which two parties will exchangecurrencies on a specified future date

Forward Contract

Derivative

Premium vs. Discount

Chapter 9 & 11 - 17

Currency swapCurrency swapSimultaneous purchase and sale of foreign exchange

for two different dates

Currency swapCurrency swapSimultaneous purchase and sale of foreign exchange

for two different dates

Currency optionCurrency optionOption to exchange a specific amount of a currency on a

specific date at a specific rate

Currency optionCurrency optionOption to exchange a specific amount of a currency on a

specific date at a specific rate

Currency futures contractCurrency futures contractContract requiring the exchange of a specific amount of a currency

on a specific date at a specific rate, with all conditionsfixed and not adjustable

Currency futures contractCurrency futures contractContract requiring the exchange of a specific amount of a currency

on a specific date at a specific rate, with all conditionsfixed and not adjustable

Swaps, Options and FuturesSwaps, Options and Futures

Chapter 9 & 11 - 18

24 Hour Trading24 Hour Trading

Chapter 9 & 11 - 19

Key Market InstitutionsKey Market Institutions

Interbankmarket

Securitiesexchange

Market in whichthe world’s largestbanks exchangecurrencies at spotand forward rates

Market in whichthe world’s largestbanks exchangecurrencies at spotand forward rates

Exchange that specializes in currency futures and options transactions

Exchange that specializes in currency futures and options transactions

Global computer network of foreignexchange tradersand other marketparticipants

Global computer network of foreignexchange tradersand other marketparticipants

Over-the-Counter(OTC) market

Chapter 9 & 11 - 20

Goals of Currency RestrictionGoals of Currency RestrictionGoals of Currency RestrictionGoals of Currency Restriction

Protect a currencyfrom speculators

Protect a currencyfrom speculators

Constrain individualsand companies from

investing abroad

Constrain individualsand companies from

investing abroad

Preserve hard currencyto repay debts owed

to other nations

Preserve hard currencyto repay debts owed

to other nations

Preserve hard currencyto pay for imports andfinance trade deficits

Preserve hard currencyto pay for imports andfinance trade deficits

Chapter 9 & 11 - 21

Currency Restriction PoliciesCurrency Restriction Policies

Multiple exchange rate system

Import deposit requirementsImport deposit requirements

What’s a firm to do??

“Countertrade”

Quantity restrictionsQuantity restrictions

Chapter 9 & 11 - 22

Chapter SummaryChapter Summary

• This chapter presents two systems that comprise international financial markets: the international capital market and the foreign exchange market. The international capital market offers advantages over domestic capital markets because it: (1) increases the supply of funds available to borrowers and lowers the cost of capital; and (2) provides a wider range of investment opportunities that allows investors to diversify their risk. The international capital market has grown dramatically because of information technology, deregulation by governments, and innovations in financial instruments. There are three main components of the international capital market: the international bond market; the international equity market; and the Eurocurrency market. The foreign exchange market is the market in which currencies are bought and sold and in which currency prices are determined. The foreign exchange market is not a place, but a network of banks, brokers, and dealers that exchange currencies 24 hours a day. The foreign exchange market is used for: (1) currency conversion, (2) currency hedging, (3) currency arbitrage, and (4) currency speculation.

International International Financial MarketsFinancial Markets