Types of international capital market

9 International Financial Markets

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.