Capital market and its types

International Capital Market

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Learning Objectives

Wild, John J., Kenneth L. Wild & Jerry C.Y. Han. International Business: The Challenges of Globalization, 5th Edition. Pearson Learning Solutions

After studying this chapter, you should be able to

1 Discuss the purposes, development, and financial centers of the international capital market.

2 Describe the international bond, international equity, and Eurocurrency markets.

3 Discuss the four primary functions of the foreign exchange market.

4 Explain how currencies are quoted and the different rates given.

5 Identify the main instruments and institutions of the foreign exchange market.

6 Explain why and how governments restrict currency convertibility.

A LOOKBACK

Chapter 8 introduced the most prominent efforts at regional economic integration occurring around the world. We saw how international companies are responding to the challenges and opportunities that regional integration is creating.

A LOOK AT THIS CHAPTER

This chapter introduces us to the international financial system by describing the structure of international financial markets. We learn first about the international capital market and its main components. We then turn to the foreign exchange market, explaining how it works and outlining its structure.

A LOOK AHEAD

Chapter 10 concludes our study of the international financial system. We discuss the factors that influence exchange rates and explain why and how governments and other institutions try to manage exchange rates. We also present recent monetary problems in emerging markets worldwide.

Wii Is the Champion

Kyoto, Japan — Nintendo (www.nintendo.com) has been feeding the addiction of video gaming fans worldwide since 1989. More than 100 years earlier, in 1889, Fusajiro Yamauchi started Nintendo when he began manufacturing Hanafuda playing cards in Kyoto, Japan. Today, Nintendo produces and sells video game systems, including Wii, Nintendo DS, GameCube, and Game Boy Advance that feature global icons Mario, Donkey Kong, Pokémon, and others.

Nintendo took the global gaming industry by storm when it introduced the Wii game console. With wireless motion-sensitive remote controllers, built-in Wi-Fi capability, and other features, the Wii outdoes Sony’s Playstation and Microsoft’s Xbox game consoles. Nintendo’s game called Wii Fit cleverly forces player activity through 40 exercises consisting of yoga, strength training, cardio, and even doing the hula-hoop. Pictured at right, Nintendo employees perform a song together as they demonstrate the game “Wii Music.”

Yet Nintendo’s marketing and game-design talents are not all that affect its performance—so too do exchange rates between the Japanese yen (¥) and other currencies. The earnings of Nintendo’s subsidiaries and affiliates outside Japan must be integrated into consolidated financial statements at the end of each year. Translating subsidiaries’ earnings from other currencies into a strong yen decreases Nintendo’s stated earnings in yen.

Source: Fred Prouser/Reuters–CORBIS-NY.

Nintendo reported net income in 2008 of ¥ 257.3 billion ($2.6 billion), but also reported that its income included a foreign exchange loss of ¥ 92.3 billion ($923.5 million). A rise of the yen against foreign currencies prior to the translation of subsidiaries’ earnings into yen caused the loss. As you read this chapter, consider how shifting currency values affect financial performance and how managers can reduce their impact.1

Well-functioning financial markets are an essential element of the international business environment. They funnel money from organizations and economies with excess funds to those with shortages. International financial markets also allow companies to exchange one currency for another. The trading of currencies and the rates at which they are exchanged are crucial to international business.

Suppose you purchase an MP3 player imported from a company based in the Philippines. Whether you realize it or not, the price you paid for that MP3 player was affected by the exchange rate between your country’s currency and the Philippine peso. Ultimately, the Filipino company that sold you the MP3 player must convert the purchase made in your currency into Philippine pesos. Thus the profit earned by the Filipino company is also influenced by the exchange rate between your currency and the peso. Managers must understand how changes in currency values—and thus in exchange rates—affect the profitability of their international business activities. Among other things, our hypothetical company in the Philippines must know how much to charge you for its MP3 player.

In this chapter, we launch our study of the international financial system by exploring the structure of the international financial markets. The two interrelated systems that comprise the international financial markets are the international capital market and foreign exchange market. We start by examining the purposes of the international capital market and tracing its recent development. We then take a detailed look at the international bond, equity, and Eurocurrency markets, each of which helps companies to borrow and lend money internationally. Later, we take a look at the functioning of the foreign exchange market—an international market for currencies that facilitates international business transactions. We close this chapter by exploring how currency convertibility affects international transactions.

International Capital Market

A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism through which those who wish to borrow or invest money can do so efficiently. Individuals, companies, governments, mutual funds, pension funds, and all types of nonprofit organizations participate in capital markets. For example, an individual might want to buy her first home, a midsized company might want to add production capacity, and a government might want to develop a new wireless communications system. Sometimes these individuals and organizations have excess cash to lend and at other times they need funds.

capital market

System that allocates financial resources in the form of debt and equity according to their most efficient uses.

Purposes of National Capital Markets

There are two primary means by which companies obtain external financing: debt and equity . Capital markets function to help them obtain both types of financing. However, to understand the international capital market fully, we need to review the purposes of capital markets in domestic economies. Quite simply, national capital markets help individuals and institutions borrow the money that other individuals and institutions want to lend. Although in theory borrowers could search individually for various parties who are willing to lend or invest, this would be an extremely inefficient process.

Role of Debt

Debt consists of loans, for which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest. Company debt normally takes the form of bonds —instruments that specify the timing of principal and interest payments. The holder of a bond (the lender) can force the borrower into bankruptcy if the borrower fails to pay on a timely basis. Bonds issued for the purpose of funding investments are commonly issued by private-sector companies and by municipal, regional, and national governments.

debt

Loan in which the borrower promises to repay the borrowed amount (the principal) plus a predetermined rate of interest.

bond

Debt instrument that specifies the timing of principal and interest payments.

Role of Equity

Equity is part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses. Equity normally takes the form of stock —shares of ownership in a company’s assets that give shareholders (stockholders) a claim on the company’s future cash flows. Shareholders may be rewarded with dividends—payments made out of surplus funds—or by increases in the value of their shares. Of course, they may also suffer losses due to poor company performance—and thus decreases in the value of their shares. Dividend payments are not guaranteed, but are determined by the company’s board of directors and based on financial performance. In capital markets, shareholders can sell one company’s stock for that of another or liquidate them—exchange them for cash. Liquidity , which is a feature of both debt and equity markets, refers to the ease with which bondholders and shareholders may convert their investments into cash.

equity

Part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses.

stock

Shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows.

liquidity

Ease with which bondholders and shareholders may convert their investments into cash.

Large financial institutions benefit borrowers and lenders worldwide in many ways. They underwrite securities and as asset managers they are caretakers of the personal financial savings of individuals. Pictured here, Citibank’s business director Weng Linnguo poses with lion dance troupes at the opening of a new Citibank branch in Beijing. Citibank has a truly global reach, with 200 million customer accounts in more than 100 countries.

Source: STR/AFP–Getty Images.

Purposes of the International Capital Market

The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. It consists of both formal exchanges (in which buyers and sellers meet to trade financial instruments) and electronic networks (in which trading occurs anonymously). This market makes use of unique and innovative financial instruments specially designed to fit the needs of investors and borrowers located in different countries that are doing business with one another. Large international banks play a central role in the international capital market. They gather the excess cash of investors and savers around the world and then channel this cash to borrowers across the globe.

international capital market

Network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries.

Expands the Money Supply for Borrowers

The international capital market is a conduit for joining borrowers and lenders in different national capital markets. A company that is unable to obtain funds from investors in its own nation can seek financing from investors elsewhere, making it possible for the company to undertake an otherwise impossible project. The option of going outside the home nation is particularly important to firms in countries with small or developing capital markets of their own. An expanded supply of money also benefits small but promising companies that might not otherwise get financing if there is intense competition for capital.

Reduces the Cost of Money for Borrowers

An expanded money supply reduces the cost of borrowing. Similar to the prices of potatoes, wheat, and other commodities, the “price” of money is determined by supply and demand. If its supply increases, its price— in the form of interest rates—falls. That is why excess supply creates a borrower’s market, forcing down interest rates and the cost of borrowing. Projects regarded as infeasible because of low expected returns might be viable at a lower cost of financing.

Reduces Risk for Lenders

The international capital market expands the available set of lending opportunities. In turn, an expanded set of opportunities helps reduce risk for lenders (investors) in two ways:

1. Investors enjoy a greater set of opportunities from which to choose. They can thus reduce overall portfolio risk by spreading their money over a greater number of debt and equity instruments. In other words, if one investment loses money, the loss can be offset by gains elsewhere.

2. Investing in international securities benefits investors because some economies are growing while others are in decline. For example, the prices of bonds in Thailand do not follow bond-price fluctuations in the United States, which are independent of prices in Hungary. In short, investors reduce risk by holding international securities whose prices move independently.

Small, would-be borrowers still face some serious problems in trying to secure loans. Interest rates are often high and many entrepreneurs have nothing to put up as collateral. For some unique methods of getting capital into the hands of small businesspeople (particularly in developing nations), see this chapter’s Entrepreneur’s Toolkit titled, “Microfinance Makes a Big Impression.”

ENTREPRENEUR’S TOOLKIT: Microfinance Makes a Big Impression

Wealthy nations are not the only places where entrepreneurs thrive. Developing nations are teeming with budding entrepreneurs who need just a bit of startup capital to get off the ground. Here are the key characteristics of microfinance.

■ Overcoming Obstacles. Obtaining capital challenges the entrepreneurial spirit in many developing countries. If a person is lucky enough to obtain a loan, it is typically from a loan shark, whose sky-high interest rates devour most of the entrepreneur’s profits. So microfinance is an increasingly popular way to lend money to low-income entrepreneurs at competitive interest rates (around 10 to 20 percent) without putting up collateral.

■ One for All, and All for One. Sometimes a loan is made to a group of entrepreneurs who sink or swim together. Members of the borrowing group are joined at the economic hip: If one member fails to pay off a loan, all in the group may lose future credit. Peer pressure and support often defend against defaults, however—support networks in developing countries often incorporate extended family ties. One bank in Bangladesh boasts 98 percent on-time repayment.

■ No Glass Ceiling Here. Although outreach to male borrowers is increasing, most microfinance borrowers are female. Women tend to be better at funneling profits into family nutrition, clothing, and education, as well as into business expansion. The successful use of microfinance in Bangladesh has increased wages, community income, and the status of women. The microfinance industry is estimated at around $8 billion worldwide.

■ Developed Country Agenda. The microfinance concept was pioneered in Bangladesh as a way for developing countries to create the foundation for a market economy. It now might be a way to spur economic growth in depressed areas of developed nations, such as in decaying city centers. But whereas microfinance loans in developing countries typically average about $350, those in developed nations would need to be significantly larger.

Source: Jennifer L. Schenker, “Taking Microfinance to the Next Level,” Business Week (www.businessweek.com), February 26, 2008; Steve Hamm, “Setting Standards for Microfinance,” Business Week (www.businessweek.com), July 28, 2008; Keith Epstein and Geri Smith, “Microlending: It’s No Cure-All,” Business Week (www.businessweek.com), December 13, 2007; Grameen Bank Web site (www.grameen-info.org), select reports.

Forces Expanding the International Capital Market

Around 40 years ago, national capital markets functioned largely as independent markets. But since that time, the amount of debt, equity, and currencies traded internationally has increased dramatically. This rapid growth can be traced to three main factors:

■ Information Technology. Information is the lifeblood of every nation’s capital market because investors need information about investment opportunities and their corresponding risk levels. Large investments in information technology over the past two decades have drastically reduced the costs, in both time and money, of communicating around the globe. Investors and borrowers can now respond in record time to events in the international capital market. The introduction of electronic trading after the daily close of formal exchanges also facilitates faster response times.

■ Deregulation. Deregulation of national capital markets has been instrumental in the expansion of the international capital market. The need for deregulation became apparent in the early 1970s, when heavily regulated markets in the largest countries were facing fierce competition from less regulated markets in smaller nations. Deregulation increased competition, lowered the cost of financial transactions, and opened many national markets to global investing and borrowing.

■ Financial Instruments. Greater competition in the financial industry is creating the need to develop innovative financial instruments. One result of the need for new types of financial instruments is securitization —the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or securities ). For example, a mortgage loan from a bank is not liquid or negotiable because it is a customized contract between the bank and the borrower. Thus banks cannot sell loans and raise capital for further investment because each loan differs from every other loan. But agencies of the U.S. government, such as the Federal National Mortgage Association (www.fanniemae.com), guarantee mortgages against default and accumulate them as pools of assets. They then sell securities in capital markets that are backed by these mortgage pools. When mortgage bankers participate in this process, they are able to raise capital for further investment.2

securitization

Unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments (or securities ).

World Financial Centers

The world’s three most important financial centers are London, New York, and Tokyo. Traditional exchanges may become obsolete unless they continue to modernize, cut costs, and provide new customer services. In fact, trading over the Internet and other systems might increase the popularity of offshore financial centers .

Offshore Financial Centers

An offshore financial center is a country or territory whose financial sector features very few regulations and few, if any, taxes. These centers tend to be economically and politically stable and provide access to the international capital market through an excellent telecommunications infrastructure. Most governments protect their own currencies by restricting the amount of activity that domestic companies can conduct in foreign currencies. So companies can find it hard to borrow funds in foreign currencies and thus turn to offshore centers, which offer large amounts of funding in many currencies. In short, offshore centers are sources of (usually cheaper) funding for companies with multinational operations.

offshore financial center

Country or territory whose financial sector features very few regulations and few, if any, taxes.

Offshore financial centers fall into two categories:

■ Operational centers see a great deal of financial activity. Prominent operational centers include London (which does a good deal of currency trading) and Switzerland (which supplies a great deal of investment capital to other nations).

■ Booking centers are usually located on small island nations or territories with favorable tax and/or secrecy laws. Little financial activity takes place here. Rather, funds simply pass through on their way to large operational centers. Booking centers are typically home to offshore branches of domestic banks that use them merely as bookkeeping facilities to record tax and currency-exchange information.3 Some important booking centers are the Cayman Islands and the Bahamas in the Caribbean; Gibraltar, Monaco, and the Channel Islands in Europe; Bahrain and Dubai in the Middle East; and Singapore in Southeast Asia.

Global banking giant HSBC recently added Dubai, United Arab Emirates, to its list of key offshore banking centers. The Dubai office will serve customers from the Middle East, North Africa, and Pakistan. HSBC also chose Dubai as its offshore center for Sharia-compliant products and services (those complying with Islamic law). HSBC Bank International is based in Jersey, Channel Islands, and has four other offshore centers in Jersey, Hong Kong, Miami, and Singapore.

Source: Ali Haider/epa–CORBIS-NY.

Quick Study

1. What are the three main purposes of the international capital market ? Explain each briefly.

2. Identify the factors expanding the international capital market. What is meant by the term securitization ?

3. What is an offshore financial center ? Explain its appeal to businesses.

Main Components of the International Capital Market

Now that we have covered the basic features of the international capital market, let’s take a closer look at its main components: the international bond, international equity, and Eurocurrency markets.

International Bond Market

The international bond market consists of all bonds sold by issuing companies, governments, or other organizations outside their own countries. Issuing bonds internationally is an increasingly popular way to obtain needed funding. Typical buyers include medium-sized to large banks, pension funds, mutual funds, and governments with excess financial reserves. Large international banks typically manage the sales of new international bond issues for corporate and government clients.

international bond market

Market consisting of all bonds sold by issuing companies, governments, or other organizations outside their own countries.

Types of International Bonds

One instrument used by companies to access the international bond market is called a Eurobond —a bond issued outside the country in whose currency it is denominated. In other words, a bond issued by a Venezuelan company, denominated in U.S. dollars, and sold in Britain, France, Germany, and the Netherlands (but not available in the United States or to its residents) is a Eurobond. Because this Eurobond is denominated in U.S. dollars, the Venezuelan borrower both receives the loan and makes its interest payments in dollars.

Eurobond

Bond issued outside the country in whose currency it is denominated.

Eurobonds are popular (accounting for 75 to 80 percent of all international bonds) because the governments of countries in which they are sold do not regulate them. The absence of regulation substantially reduces the cost of issuing a bond. Unfortunately, it increases its risk level—a fact that may discourage some potential investors. The traditional markets for Eurobonds are Europe and North America.

Companies also obtain financial resources by issuing so-called foreign bonds —bonds sold outside the borrower’s country and denominated in the currency of the country in which they are sold. For example, a yen-denominated bond issued by the German carmaker BMW in Japan’s domestic bond market is a foreign bond. Foreign bonds account for about 20 to 25 percent of all international bonds.

foreign bond

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

Foreign bonds are subject to the same rules and regulations as the domestic bonds of the country in which they are issued. Countries typically require issuers to meet certain regulatory requirements and to disclose details about company activities, owners, and upper management. Thus BMW’s samurai bonds (the name for foreign bonds issued in Japan) would need to meet the same disclosure and other regulatory requirements that Toyota’s bonds in Japan must meet. Foreign bonds in the United States are called yankee bonds and those in the United Kingdom are called bulldog bonds. Foreign bonds issued and traded in Asia outside Japan (and normally denominated in dollars) are called dragon bonds.

Interest Rates: A Driving Force

Today, low interest rates (the cost of borrowing) are fueling growth in the international bond market. Low interest rates in developed nations are resulting from low levels of inflation, but also mean that investors earn little interest on bonds issued by governments and companies in domestic markets. Thus banks, pension funds, and mutual funds are seeking higher returns in the newly industrialized and developing nations, where higher interest payments reflect the greater risk of the bonds. At the same time, corporate and government borrowers in developing countries badly need capital to invest in corporate expansion plans and public works projects.

This situation raises an interesting question: How can investors who are seeking higher returns and borrowers who are seeking to pay lower interest rates both come out ahead? The answer, at least in part, lies in the international bond market:

■ By issuing bonds in the international bond market, borrowers from newly industrialized and developing countries can borrow money from other nations where interest rates are lower.

■ By the same token, investors in developed countries buy bonds in newly industrialized and developing nations in order to obtain higher returns on their investments (although they also accept greater risk).

Despite the attraction of the international bond market, many emerging markets see the need to develop their own national markets because of volatility in the global currency market. A currency whose value is rapidly declining can wreak havoc on companies that earn profits in, say, Indonesian rupiahs but must pay off debts in dollars. Why? A drop in a country’s currency forces borrowers to shell out more local currency to pay off the interest owed on bonds denominated in an unaffected currency.

International Equity Market

The international equity market consists of all stocks bought and sold outside the issuer’s home country. Companies and governments frequently sell shares in the international equity market. Buyers include other companies, banks, mutual funds, pension funds, and individual investors. The stock exchanges that list the greatest number of companies from outside their own borders are Frankfurt, London, and New York. Large international companies frequently list their stocks on several national exchanges simultaneously and sometimes offer new stock issues only outside their country’s borders. Four factors are responsible for much of the past growth in the international equity market.

international equity market

Market consisting of all stocks bought and sold outside the issuer’s home country.

Spread of Privatization

As many countries abandoned central planning and socialist-style economics, the pace of privatization accelerated worldwide. A single privatization often places billions of dollars of new equity on stock markets. When the government of Peru sold its 26 percent share of the national telephone company, Telefonica del Peru (www.telefonica.com.pe), it raised $1.2 billion. Of the total value of the sale, 48 percent was sold in the United States, 26 percent to other international investors, and another 26 percent to domestic retail and institutional investors in Peru.

Increased privatization in Europe is also expanding worldwide equity. Although Europe is traditionally more devoted to debt as a means of financing, an “equity culture” is taking root. As the European Union becomes more thoroughly integrated, investors will become more willing to invest in the stocks of companies from other European nations.

Economic Growth in Emerging Markets

Continued economic growth in emerging markets is contributing to growth in the international equity market. Companies based in these economies require greater investment as they succeed and grow. The international equity market becomes a major source of funding because only a limited supply of funds is available in these nations.

Activity of Investment Banks

Global banks facilitate the sale of a company’s stock worldwide by bringing together sellers and large potential buyers. Increasingly, investment banks are searching for investors outside the national market in which a company is headquartered. In fact, this method of raising funds is becoming more common than listing a company’s shares on another country’s stock exchange.

Advent of Cybermarkets

The automation of stock exchanges is encouraging growth in the international equity market. The term cybermarkets denotes stock markets that have no central geographic locations. Rather, they consist of global trading activities conducted on the Internet. Cybermarkets (consisting of supercomputers, high-speed data lines, satellite uplinks, and individual personal computers) match buyers and sellers in nanoseconds. They allow companies to list their stocks worldwide through an electronic medium in which trading takes place 24 hours a day.

Eurocurrency Market

All the world’s currencies that are banked outside their countries of origin are referred to as Eurocurrency and trade on the Eurocurrency market . Thus U.S. dollars deposited in a bank in Tokyo are called Eurodollars and British pounds deposited in New York are called Europounds. Japanese yen deposited in Frankfurt are called Euroyen, and so forth.

Eurocurrency market

Market consisting of all the world’s currencies (referred to as “Eurocurrency”) that are banked outside their countries of origin.

Because the Eurocurrency market is characterized by very large transactions, only the very largest companies, banks, and governments are typically involved. Deposits originate primarily from four sources:

■ Governments with excess funds generated by a prolonged trade surplus

■ Commercial banks with large deposits of excess currency

■ International companies with large amounts of excess cash

■ Extremely wealthy individuals

Eurocurrency originated in Europe during the 1950s—hence the “Euro” prefix. Governments across Eastern Europe feared they might forfeit dollar deposits made in U.S. banks if U.S. citizens were to file claims against them. To protect their dollar reserves, they deposited them in banks across Europe. Banks in the United Kingdom began lending these dollars to finance international trade deals, and banks in other countries (including Canada and Japan) followed suit. The Eurocurrency market is valued at around $6 trillion, with London accounting for about 20 percent of all deposits. Other important markets include Canada, the Caribbean, Hong Kong, and Singapore.

Appeal of the Eurocurrency Market

Governments tend to strictly regulate commercial banking activities in their own currencies within their borders. For example, they often force banks to pay deposit insurance to a central bank, where they must keep a certain portion of all deposits “on reserve” in non-interest-bearing accounts. Although such restrictions protect investors, they add costs to banking operations. The main appeal of the Eurocurrency market is the complete absence of regulation, which lowers the cost of banking. The large size of transactions in this market further reduces transaction costs. Thus banks can charge borrowers less, pay investors more, and still earn healthy profits.

Interbank interest rates —rates that the world’s largest banks charge one another for loans—are determined in the free market. The most commonly quoted rate of this type in the Eurocurrency market is the London Interbank Offer Rate (LIBOR)—the interest rate that London banks charge other large banks that borrow Eurocurrency. The London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits.

interbank interest rates

Interest rates that the world’s largest banks charge one another for loans.

An unappealing feature of the Eurocurrency market is greater risk; government regulations that protect depositors in national markets are nonexistent here. Despite the greater risk of default, however, Eurocurrency transactions are fairly safe because the banks involved are large with well-established reputations.

Foreign Exchange Market

Unlike domestic transactions, international transactions involve the currencies of two or more nations. To exchange one currency for another in international transactions, companies rely on a mechanism called the foreign exchange market —a market in which currencies are bought and sold and their prices are determined. Financial institutions convert one currency into another at a specific exchange rate —the rate at which one currency is exchanged for another. Rates depend on the size of the transaction, the trader conducting it, general economic conditions, and sometimes government mandate.

foreign exchange market

Market in which currencies are bought and sold and their prices are determined.

exchange rate

Rate at which one currency is exchanged for another.

In many ways, the foreign exchange market is like the markets for commodities such as cotton, wheat, and copper. The forces of supply and demand determine currency prices, and transactions are conducted through a process of bid and ask quotes. If someone asks for the current exchange rate of a certain currency, the bank does not know whether it is dealing with a prospective buyer or seller. Thus it quotes two rates: The bid quote is the price at which it will buy, and the ask quote is the price at which it will sell. For example, say that the British pound is quoted in U.S. dollars at $1.9815. The bank may then bid $1.9813 to buy British pounds and offer to sell them at $1.9817. The difference between the two rates is the bid–ask spread. Naturally, banks will buy currencies at a lower price than they sell them and earn their profits from the bid–ask spread.

Functions of the Foreign Exchange Market

The foreign exchange market is not really a source of corporate finance. Rather, it facilitates corporate financial activities and international transactions. Investors use the foreign exchange market for four main reasons.

Currency Conversion

Companies use the foreign exchange market to convert one currency into another. Suppose a Malaysian company sells a large number of computers to a customer in France. The French customer wants to pay for the computers in euros, the European Union currency, whereas the Malaysian company wants to be paid in its own ringgit. How do the two parties resolve this dilemma? They turn to banks that will exchange the currencies for them.

Companies also must convert to local currencies when they undertake foreign direct investment. Later, when a firm’s international subsidiary earns a profit and the company wants to return some of it to the home country, it must convert the local money into the home currency.

Currency Hedging

The practice of insuring against potential losses that result from adverse changes in exchange rates is called currency hedging . International companies commonly use hedging for one of two purposes:

currency hedging

Practice of insuring against potential losses that result from adverse changes in exchange rates.

1. To lessen the risk associated with international transfers of funds

2. To protect themselves in credit transactions in which there is a time lag between billing and receipt of payment.

Suppose a South Korean carmaker has a subsidiary in Britain. The parent company in Korea knows that in 30 days—say, on February 1—its British subsidiary will be sending it a payment in British pounds. Because the parent company is concerned about the value of that payment in South Korean won a month in the future, it wants to insure against the possibility that the pound’s value will fall over that period—meaning, of course, that it will receive less money. Therefore, on January 2 the parent company contracts with a financial institution, such as a bank, to exchange the payment in one month at an agreed-upon exchange rate specified on January 2. In this way, as of January 2 the Korean company knows exactly how many won the payment will be worth on February 1.

Currency Arbitrage

Currency arbitrage is the instantaneous purchase and sale of a currency in different markets for profit. Suppose a currency trader in New York notices that the value of the European Union euro is lower in Tokyo than it is in New York. The trader can buy euros in Tokyo, sell them in New York, and earn a profit on the difference. Hightech communication and trading systems allow the entire transaction to occur within seconds. But note that if the difference between the value of the euro in Tokyo and the value of the euro in New York is not greater than the cost of conducting the transaction, the trade is not worth making.

currency arbitrage

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

Currency arbitrage is a common activity among experienced traders of foreign exchange, very large investors, and companies in the arbitrage business. Firms whose profits are generated primarily by another economic activity, such as retailing or manufacturing, take part in currency arbitrage only if they have very large sums of cash on hand.

INTEREST ARBITRAGE

Interest arbitrage is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find better interest rates abroad than those that are available in their home countries. The securities involved in such transactions include government treasury bills, corporate and government bonds, and even bank deposits. Suppose a trader notices that the interest rates paid on bank deposits in Mexico are higher than those paid in Sydney, Australia (after adjusting for exchange rates). He can convert Australian dollars to Mexican pesos and deposit the money in a Mexican bank account for, say, one year. At the end of the year, he converts the pesos back into Australian dollars and earns more in interest than the same money would have earned had it remained on deposit in an Australian bank.

interest arbitrage

Profit-motivated purchase and sale of interest-paying securities denominated in different currencies.

Currency Speculation

Currency speculation is the purchase or sale of a currency with the expectation that its value will change and generate a profit. The shift in value might be expected to occur suddenly or over a longer period. The foreign exchange trader may bet that a currency’s price will go either up or down in the future. Suppose a trader in London believes that the value of the Japanese yen will increase over the next three months. She buys yen with pounds at today’s current price, intending to sell them in 90 days. If the price of yen rises in that time, she earns a profit; if it falls, she takes a loss. Speculation is much riskier than arbitrage because the value, or price, of currencies is quite volatile and is affected by many factors. Similar to arbitrage, currency speculation is commonly the realm of foreign exchange specialists rather than the managers of firms engaged in other endeavors.

currency speculation

Purchase or sale of a currency with the expectation that its value will change and generate a profit.

A classic example of currency speculation unfolded in Southeast Asia in 1997. After news emerged in May about Thailand’s slowing economy and political instability, currency traders sprang into action. They responded to poor economic growth prospects and an overvalued currency, the Thai baht, by dumping the baht on the foreign exchange market. When the supply glutted the market, the value of the baht plunged. Meanwhile, traders began speculating that other Asian economies were also vulnerable. From the time the crisis first hit until the end of 1997, the value of the Indonesian rupiah fell by 87 percent, the South Korean won by 85 percent, the Thai baht by 63 percent, the Philippine peso by 34 percent, and the Malaysian ringgit by 32 percent.4 Although many currency speculators made a great deal of money, the resulting hardship experienced by these nations’ citizens caused some to question the ethics of currency speculation on such a scale. (We cover the Asian crisis and currency speculation in detail in Chapter 10.)

Foreign exchange brokerage workers in Tokyo, Japan, dress in traditional Japanese kimonos for the first trading day of the year. Average daily turnover on Tokyo’s foreign exchange market is about $240 billion. Yet this is still significantly lower than trading volume in the U.K. market ($1.33 trillion) and the U.S. market ($618 billion). Around $3.2 trillion worth of currency is traded on global foreign exchange markets every day.

Source: Eriko Sugita/Reuters–CORBIS-NY.

Quick Study

1. Describe the international bond market . What single factor is most responsible for fueling its growth?

2. What is the international equity market ? Identify the factors responsible for its expansion.

3. Describe the Eurocurrency market . What is its main appeal?

4. For what four reasons do investors use the foreign exchange market?

How the Foreign Exchange Market Works

Because of the importance of foreign exchange to trade and investment, businesspeople must understand how currencies are quoted in the foreign exchange market. Managers must know what financial instruments are available to help them protect the profits earned by their international business activities. They must also be aware of government restrictions that may be imposed on the convertibility of currencies and know how to work around these and other obstacles.

Quoting Currencies

There are two components to every quoted exchange rate: the quoted currency and the base currency. If an exchange rate quotes the number of Japanese yen needed to buy one U.S. dollar (¥/$), the yen is the quoted currency and the dollar is the base currency . When you designate any exchange rate, the quoted currency is always the numerator and the base currency is the denominator. For example, if you were given a yen/dollar exchange rate quote of 110/1 (meaning that 110 yen are needed to buy one dollar), the numerator is 110 and the denominator is 1. We can also designate this rate as ¥ 110/$.

quoted currency

The numerator in a quoted exchange rate, or the currency with which another currency is to be purchased.

base currency

The denominator in a quoted exchange rate, or the currency that is to be purchased with another currency.

Direct and Indirect Rate Quotes

Table 9.1 lists exchange rates between the U.S. dollar and a number of other currencies as reported by the Wall Street Journal.5 There is one important note to make about this table. As we learned in Chapter 8, the currencies of nations participating in the single currency (euro) of the European Union are already out of circulation. To look up exchange rates for these nations, see the line reading “Euro area euro” in Table 9.1.

The second column of numbers in Table 9.1, under the heading “Currency per U.S. $,” tells us how many units of each listed currency can be purchased with one U.S. dollar. For example, find the row labeled “Japan (Yen).” The number 106.81 in the second column tells us that 106.81 Japanese yen can be bought with one U.S. dollar. We state this exchange rate as ¥ 106.81/$. Because the yen is the quoted currency, we say that this is a direct quote on the yen and an indirect quote on the dollar. This method of quoting exchange rates is called European terms because it is typically used outside the United States.

TABLE 9.1 Exchange Rates of Major Currencies

Country/Currency

U.S. $ Equivalent

Currency per U.S. $

Argentina (peso)

0.3319

3.0130

Australian (dollar)

0.9556

1.0465

Bahrain (dinar)

2.6525

0.3770

Brazil (real)

0.6211

1.6100

Canada (dollar)

0.9893

1.0108

1-mos forward

0.9888

1.0113

3-mos forward

0.9882

1.0119

6-mos forward

0.9873

1.0129

Chile (peso)

0.001989

502.77

China (yuan)

0.1458

6.8599

Colombia (peso)

0.0005782

1729.51

Czech Rep. (koruna)

0.06724

14.872

Denmark (krone)

0.2109

4.7416

Ecuador U.S. (dollar)

1

1

Eqypt (pound)

0.1870

5.3476

Euro area (euro)

1.5737

0.6354

Hong Kong (dollar)

0.1282

7.8021

Hungary (forint)

0.006794

147.19

India (rupee)

0.02325

43.0108

Indonesia (rupiah)

0.0001090

9174

Israel (shekel)

0.3109

3.2165

Japan (yen)

0.009362

106.81

1-mos forward

0.009379

106.62

3-mos forward

0.009412

106.25

6-mos forward

0.009465

105.65

Jordan (dinar)

1.4139

0.7073

Kenya (shilling)

0.01505

66.450

Kuwait (dinar)

3.7702

0.2652

Lebanon (pound)

0.0006634

1507.39

Malaysia (ringgit)

0.3082

3.2446

Mexico (peso)

0.0971

10.3029

New Zealand (dollar)

0.7577

1.3198

Norway (krone)

0.1955

5.1151

Pakistan (rupee)

0.01403

71.276

Peru (new sol)

0.3566

2.8043

Philippines (peso)

0.0220

45.475

Poland (zloty)

0.4804

2.0816

Romania (leu)

0.4442

2.2511

Russia (ruble)

0.04267

23.436

Saudi Arabia (riyal)

0.2666

3.7509

Singapore (dollar)

0.7360

1.3587

Slovak Rep (koruna)

0.05196

19.246

South Africa (rand)

0.1291

7.7459

South Korea (won)

0.0010008

999.20

Sweden (krona)

0.1664

6.0096

Switzerland (franc)

0.9719

1.0289

1-mos forward

0.9722

1.0286

3-mos forward

0.9727

1.0281

6-mos forward

0.9735

1.0272

Taiwan (dollar)

0.03290

30.395

Thailand (baht)

0.02975

33.613

Turkey (lira)

0.8166

1.2245

U.A.E. (dirham)

0.2723

3.6724

U.K. (pound)

1.9815

0.5047

1-mos forward

1.9769

0.5058

3-mos forward

1.9675

0.5083

6-mos forward

1.9547

0.5116

Uruguay (peso)

0.05190

19.27

Venezuela (b. fuerte)

0.46628742

2.1446

Vietnam (dong)

0.00006

16850

Source: Wall Street Journal (www.wsj.com), July 9, 2008.

The first column of numbers in Table 9.1, under the heading “U.S. $ Equivalent,” tells us how many U.S. dollars it costs to buy one unit of each listed currency. The first column following the words “Japan (Yen),” tells us that it costs $0.009362 to purchase one yen (¥)—less than one U.S. cent. We state this exchange rate as $0.009362/¥. In this case, because the dollar is the quoted currency, we have a direct quote on the dollar and an indirect quote on the yen. The practice of quoting the U.S. dollar in direct terms is called U.S. terms because it is used mainly in the United States.

Whether we use a direct or an indirect quote, it is easy to find the other: simply divide the quote into the numeral 1. The following formula is used to derive a direct quote from an indirect quote: And for deriving an indirect quote from a direct quote:

And for deriving an indirect quote from a direct quote:

For example, suppose we are given an indirect quote on the U.S. dollar of ¥ 106.81/$. To find the direct quote, we simply divide ¥ 106.81 into $1:

$1 ÷ ¥ 106.81 = $0.009362/¥

Note that our solution matches the number in the first column of numbers in Table 9.1 following the words “Japan (Yen).” Conversely, to find the indirect quote, we divide the direct quote into 1. In our example, we divide $0.009362 into ¥ 1:

¥ 1 ÷ $0.009362 = ¥ 106.81/$

This solution matches the number in the second column of numbers in Table 9.1 following the words “Japan (Yen).”

Calculating Percent Change

Businesspeople and foreign exchange traders track currency values over time as measured by exchange rates because changes in currency values can benefit or harm current and future international transactions. Exchange-rate risk (foreign exchange risk) is the risk of adverse changes in exchange rates. Managers develop strategies to minimize this risk by tracking percent changes in exchange rates. For example, take PN as the exchange rate at the end of a period (the currency’s new price) and PO as the exchange rate at the beginning of that period (the currency’s old price). We now can calculate percent change in the value of a currency with the following formula:

exchange-rate risk (foreign exchange risk)

Risk of adverse changes in exchange rates.

Note: This equation yields the percent change in the base currency, not in the quoted currency.

Let’s illustrate the usefulness of this calculation with a simple example. Suppose that on February 1 of the current year, the exchange rate between the Norwegian krone (NOK) and the U.S. dollar was NOK 5/$. On March 1 of the current year, suppose the exchange rate stood at NOK 4/$. What is the change in the value of the base currency, the dollar? If we plug these numbers into our formula, we arrive at the following change in the value of the dollar:

Thus the value of the dollar has fallen 20 percent. In other words, one U.S. dollar buys 20 percent fewer Norwegian kroner on March 1 than it did on February 1.

To calculate the change in the value of the Norwegian krone, we must first calculate the indirect exchange rate on the krone. This step is necessary because we want to make the krone our base currency. Using the formula presented earlier, we obtain an exchange rate of $.20/NOK (1 ÷ NOK 5) on February 1 and an exchange rate of $.25/NOK (1 ÷ NOK 4) on March 1. Plugging these rates into our percent-change formula, we get:

Thus the value of the Norwegian krone has risen 25 percent. One Norwegian krone buys 25 percent more U.S. dollars on March 1 than it did on February 1.

How important is this difference to businesspeople and exchange traders? Consider that the typical trading unit in the foreign exchange market (called a round lot) is $5 million. Therefore, a $5 million purchase of kroner on February 1 would yield NOK 25 million. But because the dollar has lost 20 percent of its buying power by March 1, a $5 million purchase would fetch only NOK 20 million—5 million fewer kroner than a month earlier.

Cross Rates

International transactions between two currencies other than the U.S. dollar often use the dollar as a vehicle currency. For example, a retail buyer of merchandise in the Netherlands might convert its euros (recall that the Netherlands uses the European Union currency) to U.S. dollars and then pay its Japanese supplier in U.S. dollars. The Japanese supplier may then take those U.S. dollars and convert them to Japanese yen. This process was more common years ago, when fewer currencies were freely convertible and when the United States greatly dominated world trade. Today, a Japanese supplier may want payment in euros. In this case, both the Japanese and the Dutch companies need to know the exchange rate between their respective currencies. To find this rate using their respective exchange rates with the U.S. dollar, we calculate what is called a cross rate —an exchange rate calculated using two other exchange rates.

cross rate

Exchange rate calculated using two other exchange rates.

Cross rates between two currencies can be calculated using either currency’s indirect or direct exchange rates with another currency. For example, suppose we want to know the cross rate between the currencies of the Netherlands and Japan. Looking at Table 9.1 again, we see that the direct quote on the euro is € 0.6354/$. The direct quote on the Japanese yen is ¥ 106.81/$. To find the cross rate between the euro and the yen, with the yen as the base currency, we simply divide € 0.6354/$ by ¥ 106.81/$:

€ 0.6354/$ ÷ ¥ 106.81/$ = € 0.0059/¥

Thus it costs 0.0059 euros to buy 1 yen.

We can also calculate the cross rate between the euro and the yen by using the indirect quotes for each currency against the U.S. dollar. Again, we see in Table 9.1 that the indirect quote on the euro to the dollar is $1.5737/€. The indirect quote on the yen to the dollar is $0.009362/¥. To find the cross rate between the euro and the yen, again with the yen as the base currency, we divide $1.5737/€ by $0.009362/¥:

$1.5737/€ ÷ $0.009362/¥ = € 168.09/¥

We must then perform an additional step to arrive at the same answer as we did earlier. Because indirect quotes were used in our calculation, we must divide our answer into 1:

1 ÷ € 168.09/¥ = € 0.0059/¥

Again (as in our earlier solution), we see that it costs 0.0059 euros to buy 1 yen.

Table 9.2 shows the cross rates for major world currencies. When finding cross rates using direct quotes, currencies down the left-hand side represent quoted currencies; those across the top represent base currencies. Conversely, when finding cross rates using indirect quotes, currencies down the left side represent base currencies; those across the top represent quoted currencies. Look at the intersection of the “Euro” row (the quoted currency in our example) and the “Yen” column (our base currency). Note that our solutions for the cross rate between euro and yen match the listed rate of 0.0059 euros to the yen.