What are the functions and importance of 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.

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.

TABLE 9.2 Key Currency Cross Rates

Dollar

Euro

Pound

SFranc

Peso

Yen

CdnDlr

Canada

1.0108

1.5907

2.0029

0.9824

0.0981

0.0095

....

Japan

106.81

168.09

211.65

103.81

10.367

....

105.67

Mexico

10.303

16.214

20.415

10.013

....

0.0965

10.193

Switzerland

1.0289

1.6192

2.0388

....

0.0999

0.0096

1.0179

U.K.

0.5047

0.7942

....

0.4905

0.0490

0.0047

0.4993

Euro

0.6354

....

1.2591

0.6176

0.0617

0.0059

0.6286

U.S.

....

1.5737

1.9815

0.9719

0.0971

0.0094

0.9893

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

Naturally, the exchange rate between the euro and the yen is quite important to both the Japanese supplier and Dutch retailer we mentioned earlier. If the value of the euro falls relative to the yen, the Dutch company must pay more in euros for its Japanese products. This situation will force the Dutch company to take one of two steps: Either increase the price at which it resells the Japanese product (perhaps reducing sales), or keep prices at current levels (thus reducing its profit margin). Ironically, the Japanese supplier will suffer if the yen rises too much. Why? Under such circumstances, the Japanese supplier can do one of two things: Allow the exchange rate to force its euro prices higher (thus maintaining profits) or reduce its yen prices to offset the decline of the euro (thus reducing its profit margin). Both the Japanese supplier and the Dutch buyer can absorb exchange rate changes by squeezing profits—but only to a point. After that point is passed, they will no longer be able to trade. The Dutch buyer will be forced to look for a supplier in a country with a more favorable exchange rate or for a supplier in its own country (or another European country that uses the euro).

Spot Rates

All the exchange rates we’ve discussed so far are called spot rates —exchange rates that require delivery of the traded currency within two business days. Exchange of the two currencies is said to occur “on the spot,” and the spot market is the market for currency transactions at spot rates. The spot market assists companies in performing any one of three functions:

spot rate

Exchange rate requiring delivery of the traded currency within two business days.

spot market

Market for currency transactions at spot rates.

1. Converting income generated from sales abroad into their home-country currency

2. Converting funds into the currency of an international supplier

3. Converting funds into the currency of a country in which they wish to invest

Buy and Sell Rates

The spot rate is available only for trades worth millions of dollars. That is why it is available only to banks and foreign exchange brokers. If you are traveling to another country and want to exchange currencies at your bank before departing, you will not be quoted the spot rate. Rather, banks and other institutions will give you a buy rate (the exchange rate at which the bank will buy a currency) and an ask rate (the rate at which it will sell a currency). In other words, you will receive what we described when introducing the foreign exchange market as bid and ask quotes. These rates reflect the amounts that large currency traders are charging, plus a markup.

For example, suppose you are leaving Mexico for a business trip to Canada and need to buy some Canadian dollars (C$). The bank will quote you exchange rate terms, such as peso 10.088/98 per C$. In other words, the bank will buy Canadian dollars at the rate of peso 10.088/C$ and sell them at the rate of peso 10.098/C$.

Forward Rates

When a company knows that it will need a certain amount of foreign currency on a certain future date, it can exchange currencies using a forward rate —an exchange rate at which two parties agree to exchange currencies on a specified future date. Forward rates represent the expectations of currency traders and bankers regarding a currency’s future spot rate. Reflected in these expectations are a country’s present and future economic conditions (including inflation rate, national debt, taxes, trade balance, and economic growth rate) as well as its social and political situation. The forward market is the market for currency transactions at forward rates.

forward rate

Exchange rate at which two parties agree to exchange currencies on a specified future date.

forward market

Market for currency transactions at forward rates.

To insure themselves against unfavorable exchange-rate changes, companies commonly turn to the forward market. It can be used for all types of transactions that require future payment in other currencies, including credit sales or purchases, interest receipts or payments on investments or loans, and dividend payments to stockholders in other countries. But not all nations’ currencies trade in the forward market, such as countries experiencing high inflation or currencies not in demand on international financial markets.

Forward Contracts

Suppose a Brazilian bicycle maker imports parts from a Japanese supplier. Under the terms of their contract, the Brazilian importer must pay 100 million Japanese yen in 90 days. The Brazilian firm can wait until one or two days before payment is due, buy yen in the spot market, and pay the Japanese supplier. But in the 90 days between the contract date and the due date, the exchange rate will likely change. What if the value of the Brazilian real goes down? In that case, the Brazilian importer will have to pay more reais (plural of real) to get the same 100 million Japanese yen. Therefore, our importer may want to pay off the debt before the 90-day term. But what if it does not have the cash on hand? What if it needs those 90 days to collect accounts receivable from its own customers?

To decrease its exchange-rate risk, our Brazilian importer can enter into a forward contract —a contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. Forward contracts are commonly signed for 30, 90, and 180 days into the future, but customized contracts (say, for 76 days) are possible. Note that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate: The bank must deliver the yen, and the Brazilian importer must buy them at the prearranged price. Forward contracts belong to a family of financial instruments called derivatives —instruments whose values derive from other commodities or financial instruments. These include not only forward contracts, but also currency swaps, options, and futures (presented later in this chapter).

forward contract

Contract that requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.

derivative

Financial instrument whose value derives from other commodities or financial instruments.

In our example, the Brazilian importer can use a forward contract to pay yen to its Japanese supplier in 90 days. It is always possible, of course, that in 90 days, the value of the real will be lower than its current value. But by locking in at the forward rate, the Brazilian firm protects itself against the less favorable spot rate at which it would have to buy yen in 90 days. In this case, the Brazilian company protects itself from paying more to the supplier at the end of 90 days than if it were to pay at the spot rate in 90 days. Thus it protects its profit from further erosion if the spot rate becomes even more unfavorable over the next three months. Remember, too, that such a contract prevents the Brazilian importer from taking advantage of any increase in the value of the real in 90 days that would reduce what the company owed its Japanese supplier.

PREMIUMS AND DISCOUNTS

As we have already seen, a currency’s forward exchange rate can be higher or lower than its current spot rate. If its forward rate is higher than its spot rate, the currency is trading at a premium. If its forward rate is lower than its spot rate, it is trading at a discount. Again, look at Table 9.1. Locate the row under “U.K. (pound)” labeled “1-mos forward.” This is the 30-day forward exchange rate for the British pound (GBP). Note that the rate of $1.9769/GBP is less than the spot rate of $1.9815/GBP (the spot rate quoted in the previous row of Table 9.1). The pound, therefore, is trading at a discount on the one-month forward contract. We know, then, that a contract to deliver British pounds in 30 days costs $0.0046 less per pound in 30 days than it does today. Likewise, the three- and six-month forward rates tell us that pounds cost $0.0140 and $0.0268 less in 90 and 180 days, respectively. Clearly, the pound is also trading at a discount on three- and six-month forward contracts.

Swaps, Options, and Futures

In addition to forward contracts, three other types of currency instruments are used in the forward market: currency swaps, options, and futures.

Currency Swaps

A currency swap is the simultaneous purchase and sale of foreign exchange for two different dates. Currency swaps are an increasingly important component of the foreign exchange market. Suppose a Swedish carmaker imports parts from a subsidiary in Turkey. The Swedish company must pay the Turkish subsidiary in Turkish lira for the parts when they are delivered tomorrow. It also expects to receive Turkish liras for cars sold in Turkey in 90 days. Our Swedish company exchanges kronor for lira in the spot market today to pay its subsidiary. At the same time, it agrees to a forward contract to sell Turkish lira (and buy Swedish kronor) in 90 days at the quoted 90-day forward rate for lira. In this way, the Swedish company uses a swap both to reduce its exchange-rate risk and to lock in the future exchange rate. In this sense, we can think of a currency swap as a more complex forward contract.

currency swap

Simultaneous purchase and sale of foreign exchange for two different dates.

Currency Options

Recall that a forward contract requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. In contrast, a currency option is a right, or option, to exchange a specific amount of a currency on a specific date at a specific rate. In other words, whereas forward contracts require parties to follow through on currency exchanges, currency options do not.

currency option

Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate.

Suppose a company buys an option to purchase Swiss francs at SF 1.02/$ in 30 days. If, at the end of the 30 days, the exchange rate is SF 1.05/$, the company would not exercise its currency option. Why? It could get SF 0.03 more for every dollar by exchanging at the spot rate in the currency market rather than at the stated rate of the option. Companies often use currency options to hedge against exchange-rate risk or to obtain foreign currency.

Currency Futures Contracts

Similar to a currency forward contract is a currency futures contract —a contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.

currency futures contract

Contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.

Quick Study

1. Explain how to calculate percent change in currency prices. Why is exchange-rate risk important to companies?

2. What is meant by the term cross rate ? Explain how it is useful to businesses.

3. Explain how a spot rate and forward rate are used in the foreign exchange market.

4. What are the main differences between currency swaps , options, and futures?

Foreign Exchange Market Today

The foreign exchange market is actually an electronic network that connects the world’s major financial centers. In turn, each of these centers is a network of foreign exchange traders, currency trading banks, and investment firms. On any given day, the volume of trading on the foreign exchange market (comprising currency swaps and spot and forward contracts) has grown to an unprecedented $3.2 trillion—an amount greater than the yearly gross domestic product of many small nations.6 Several major trading centers and several currencies dominate the foreign exchange market.

Trading Centers

Most of the world’s major cities participate in trading on the foreign exchange market. But in recent years, just three countries have come to account for more than half of all global currency trading: the United Kingdom, the United States, and Japan. Accordingly, most of this trading takes place in the financial capitals of London, New York, and Tokyo.

London dominates the foreign exchange market for historic and geographic reasons. The United Kingdom was once the world’s largest trading nation. British merchants needed to exchange currencies of different nations, and London naturally assumed the role of financial trading center. London quickly came to dominate the market and still does so because of its location halfway between North America and Asia. A key factor is its time zone. Because of differences in time zones, London is opening for business as markets in Asia close trading for the day. When New York opens for trading in the morning, trading is beginning to wind down in London.

Figure 9.1 shows why it is possible to trade foreign exchange 24 hours a day (except weekends and major holidays). Exchanges in at least one of the three major centers (London, New York, and Tokyo) keep the market open for 22 hours a day. Trading does not stop during the two hours these exchanges are closed because other trading centers (including San Francisco and Sydney, Australia) remain open. Also, most large banks active in foreign exchange employ overnight traders to ensure continuous trading.

Important Currencies

Although the United Kingdom is the major location of foreign exchange trading, the U.S. dollar is the currency that dominates the foreign exchange market. Because the U.S. dollar is so widely used in world trade, it is considered a vehicle currency —a currency used as an intermediary to convert funds between two other currencies. The currencies most often involved in currency transactions are the U.S. dollar, European Union euro, Japanese yen, and British pound.

vehicle currency

Currency used as an intermediary to convert funds between two other currencies.

One reason the U.S. dollar is a vehicle currency is because the United States is the world’s largest trading nation. The United States is so heavily involved in international trade that many companies and banks maintain dollar deposits, making it easy to exchange other currencies with dollars. Another reason is that following the Second World War, all of the world’s major currencies were tied indirectly to the dollar because it was the most stable currency. In turn, the dollar’s value was tied to a specific value of gold—a policy that held wild currency swings in check. Although world currencies are no longer linked to the value of gold (see Chapter 10), the stability of the dollar, along with its resistance to inflation, helps people and organizations maintain their purchasing power better than their own national currencies. Even today, people in many countries convert extra cash from national currencies into dollars.

FIGURE 9.1 Financial Trading Centers by Time Zone

Institutions of the Foreign Exchange Market

So far, we have discussed the foreign exchange market only in general terms. We now look at the three main components of the foreign exchange market: the interbank market , securities exchanges , and the over-the-counter market .

Interbank Market

It is in the interbank market that the world’s largest banks exchange currencies at spot and forward rates. Companies tend to obtain foreign exchange services from the bank where they do most of their business. Banks satisfy client requests for exchange quotes by obtaining quotes from other banks in the interbank market. For transactions that involve commonly exchanged currencies, the largest banks often have sufficient currency on hand. Yet rarely exchanged currencies are not typically kept on hand and may not even be easily obtainable from another bank. In such cases, banks turn to foreign exchange brokers, who maintain vast networks of banks through which they obtain seldom traded currencies.

interbank market

Market in which the world’s largest banks exchange currencies at spot and forward rates.

In the interbank market, then, banks act as agents for client companies. In addition to locating and exchanging currencies, banks commonly offer advice on trading strategy, supply a variety of currency instruments, and provide other risk-management services. They also help clients manage exchange rate risk by supplying information on rules and regulations around the world.

But large banks in the interbank market use their influence in currency markets to get better rates for large clients. Small and medium-sized businesses often cannot get the best exchange rates because they deal only in small volumes of currencies and do so rather infrequently. A small company might get better exchange rate quotes from a discount international payment service.

CLEARING MECHANISMS

Clearing mechanisms are an important element of the interbank market. Foreign exchange transactions among banks and foreign exchange brokers happen continuously. The accounts are not settled after each individual trade, but are settled following a number of completed transactions. The process of aggregating the currencies that one bank owes another and then carrying out that transaction is called clearing . Years ago banks performed clearing every day or every two days, and physically exchanged currencies with other banks. Nowadays, clearing is performed more frequently and occurs digitally, which eliminates the need to physically trade currencies.

clearing

Process of aggregating the currencies that one bank owes another and then carrying out the transaction.

Securities Exchanges

Securities exchanges specialize in currency futures and options transactions. Buying and selling currencies on these exchanges entails the use of securities brokers, who facilitate transactions by transmitting and executing clients’ orders. Transactions on securities exchanges are much smaller than those in the interbank market and vary with each currency. The leading exchange that deals in most major asset classes of futures and options is the CME Group, Inc. (www.cmegroup.com). The CME Group merged the futures and options operations of the Chicago Board of Trade (www.cbt.com), the Chicago Mercantile Exchange (www.cme.com), and the New York Mercantile Exchange (www.nymex.com). The CME Group’s foreign exchange marketplace is the world’s second largest electronic foreign exchange marketplace with more than $80 billion in daily liquidity.7

securities exchange

Exchange specializing in currency futures and options transactions.

Another exchange is the London International Financial Futures Exchange (www.euronext.com), which trades futures and options for major currencies. In the United States, trading in currency options occurs only on the Philadelphia Stock Exchange (www.phlx.com). It deals in both standardized options and customized options, allowing investors flexibility in designing currency option contracts.8

Over-the-Counter Market

The over-the-counter (OTC) market is a decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants. All foreign exchange transactions can be performed in the OTC market where the major players are large financial institutions such as Goldman Sachs (www.gs.com).

over-the-counter (OTC) market

Decentralized exchange encompassing a global computer network of foreign exchange traders and other market participants.

GLOBAL MANAGER’S BRIEFCASE Managing Foreign Exchange

■ Match Needs to Providers. Analyze your foreign exchange needs and the range of service providers available. Find a provider that offers the transactions you undertake in the currencies you need and consolidate repetitive transfers. Many businesspeople naturally look to local bankers when they need to transfer funds abroad, but this may not be the cheapest or best choice. A mix of service providers sometimes offers the best solution.

■ Work with the Majors. Money-center banks (those located in financial centers) that participate directly in the foreign exchange market can have cost and service advantages over local banks. Dealing directly with a large trading institution is often more cost effective than dealing with a local bank because it avoids the additional markup that the local bank charges for its services.

■ Consolidate to Save. Save money by timing your international payments to consolidate multiple transfers into one large transaction. Open a local currency account abroad against which you can write drafts if your company makes multiple smaller payments in the same currency. Consider allowing foreign receivables to accumulate in an interest-bearing account locally until you repatriate them in a lump sum to reduce service fees.

■ Get the Best Deal Possible. If your foreign exchange activity is substantial, develop relationships with two or more money-center banks to get the best rates. Also, monitor the rates your company gets over time, as some banks raise rates if you’re not shopping around. Obtain real-time market rates provided by firms like Reuters and Bloomberg.

■ Embrace Information Technology. Every time an employee phones, e-mails, or faxes in a transaction, human error could delay getting funds where and when your company needs them. Embrace information technology in your business’s international wire transfers and drafts. Automated software programs available from specialized service providers reduce the potential for errors while speeding the execution of transfers.

The over-the-counter market has grown rapidly because it offers distinct benefits for business. It allows businesspeople to search freely for the institution that provides the best (lowest) price for conducting a transaction. It also offers opportunities for designing customized transactions. For additional ways companies can become more adept in their foreign exchange activities, see this chapter’s Global Manager’s Briefcase titled, “Managing Foreign Exchange.”

Currency Convertibility

Our discussion of the foreign exchange market so far assumes that all currencies can be readily converted to another in the foreign exchange market. A convertible (hard) currency is traded freely in the foreign exchange market, with its price determined by the forces of supply and demand. Countries that allow full convertibility are those that are in strong financial positions and have adequate reserves of foreign currencies. Such countries have no reason to fear that people will sell their own currency for that of another. Still, many newly industrialized and developing countries do not permit the free convertibility of their currencies. Let’s now take a look at why governments place restrictions on the convertibility of currencies and how they do it.

convertible (hard) currency

Currency that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand.

Goals of Currency Restriction

Governments impose currency restrictions to achieve several goals. One goal is to preserve a country’s reserve of hard currencies with which to repay debts owed to other nations. Developed nations, emerging markets, and some countries that export natural resources tend to have the greatest amounts of foreign exchange. Without sufficient reserves (liquidity), a country could default on its loans and thereby discourage future investment flows. This is precisely what happened to Argentina several years ago when the country defaulted on its international public debt.

A second goal of currency restriction is to preserve hard currencies to pay for imports and to finance trade deficits. Recall from Chapter 5 that a country runs a trade deficit when the value of its imports exceeds the value of its exports. Currency restrictions help governments maintain inventories of foreign currencies with which to pay for such trade imbalances. They also make importing more difficult because local companies cannot obtain foreign currency to pay for imports. The resulting reduction in imports directly improves the country’s trade balance.

A third goal is to protect a currency from speculators. For example, in the wake of the Asian financial crisis years ago, some Southeast Asian nations considered controlling their currencies to limit the damage done by economic downturns. Malaysia stemmed the outflow of foreign money by preventing local investors from converting their Malaysian holdings into other currencies. Although the move also curtailed currency speculation, it effectively cut off Malaysia from investors elsewhere in the world.

A fourth (less common) goal is to keep resident individuals and businesses from investing in other nations. These policies can generate more rapid economic growth in a country by forcing investment to remain at home. Unfortunately, although this might work in the short term, it normally slows long-term economic growth. The reason is that there is no guarantee that domestic funds held in the home country will be invested there. Instead, they might be saved or even spent on consumption. Ironically, increased consumption can mean further increases in imports, making the balance-of-trade deficit even worse.

Policies for Restricting Currencies

Certain government policies are frequently used to restrict currency convertibility. Governments can require that all foreign exchange transactions be performed at or approved by the country’s central bank. They can also require import licenses for some or all import transactions. These licenses help the government control the amount of foreign currency leaving the country.

Some governments implement systems of multiple exchange rates, specifying a higher exchange rate on the importation of certain goods or on imports from certain countries. The government can thus reduce importation while ensuring that important goods still enter the country. It also can use such a policy to target the goods of countries with which it is running a trade deficit.

Other governments issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange funds in special accounts before being granted import licenses. In addition, quantity restrictions limit the amount of foreign currency that residents can take out of the home country when traveling to other countries as tourists, students, or medical patients.

Countertrade

Finally, one way to get around national restrictions on currency convertibility is countertrade —the practice of selling goods or services that are paid for, in whole or in part, with other goods or services. One simple form of countertrade is a barter transaction, in which goods are exchanged for others of equal value. Parties exchange goods and then sell them in world markets for hard currency. For example, Cuba once exchanged $60 million worth of sugar for cereals, pasta, and vegetable oils from the Italian firm Italgrani. And Boeing (www.boeing.com) has sold aircraft to Saudi Arabia in return for oil. We detail the many different forms of countertrade in Chapter 13.

countertrade

Practice of selling goods or services that are paid for, in whole or in part, with other goods or services.

Quick Study

1. What are the world’s main foreign exchange trading centers? Identify the currencies most used in the foreign exchange market.

2. Describe the three main institutions of the foreign exchange market.

3. What are the reasons for restrictions on currency conversion? Identify policies governments use to restrict currency conversion.

Bottom LineFOR BUSINESS

Well-functioning financial markets are essential to conducting international business. International financial markets supply companies with the mechanism they require to exchange currencies, and more. Here we focus only on the main implications of these markets for international companies.

International Capital Market and Businesses

The international capital market joins borrowers and lenders in different national capital markets. A company unable to obtain funds in its own nation may use the international capital market to obtain financing elsewhere and allow the firm to undertake an otherwise impossible project. This option can be especially important for firms in countries with small or emerging capital markets.

Similar to the prices of any other commodity, the “price” of money is determined by supply and demand. If its supply increases, its price (in the form of interest rates) falls. The international capital market opens up additional sources of financing for companies, possibly financing projects previously regarded as not feasible. The international capital market also expands lending opportunities, which reduces risk for lenders by allowing them to spread their money over a greater number of debt and equity instruments and benefiting from the fact that securities markets do not move up and down in tandem.

International Financial Market and Businesses

Companies must convert to local currencies when they undertake foreign direct investment. Later, when a firm’s international subsidiary earns a profit and the company wishes to return profits to the home country, it must convert the local money into the home currency. The prevailing exchange rate at the time profits are exchanged influences the amount of the ultimate profit or loss.

This raises an important aspect of international financial markets—fluctuation. International companies can use hedging in foreign exchange markets to lessen the risk associated with international transfers of funds and to protect themselves in credit transactions in which there is a time lag between billing and receipt of payment. Some firms also take part in currency arbitrage if there are times during which they have very large sums of cash on hand. Companies can also use interest arbitrage to find better interest rates abroad than those available in their home countries.

Businesspeople are also interested in tracking currency values over time because changes in currency values affect their international transactions. Profits earned by companies that import products for resale are influenced by the exchange rate between their currency and that of the nation from which they import. Managers who understand that changes in these currencies’ values affect the profitability of their international business activities can develop strategies to minimize risk.

In the next chapter, we extend our coverage of the international financial system to see how market forces (including interest rates and inflation) have an impact on exchange rates. We also conclude our study of the international financial system by looking at the roles of government and international institutions in managing movements in exchange rates.

Chapter Summary

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

■ The international capital market is meant to: (1) expand the supply of capital for borrowers, (2) lower interest rates for borrowers, and (3) lower risk for lenders.

■ Growth in the international capital market is due mainly to: (1) advances in information technology, deregulation of capital markets, and innovation in financial instruments.

■ London (U.K.), New York (U.S.), and Tokyo (Japan) are the world’s most important financial centers.

■ Offshore financial centers handle less business but have few regulations and few if any taxes.

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

■ The international bond market consists of all bonds sold by issuers outside their own countries.

■ It is growing as investors in developed markets search for higher rates from borrowers in emerging markets, and vice versa.

■ The international equity market consists of all stocks bought and sold outside the home country of the issuing company.

■ Four factors driving growth in international equity are: (1) privatization, (2) greater issuance of stock by companies in emerging and developing nations, (3) greater international reach of investment banks, and (4) global electronic trading.

■ The Eurocurrency market consists of all the world’s currencies banked outside their countries of origin; its appeal is the lack of government regulation and lower cost of borrowing.

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

■ The foreign exchange market is the market in which currencies are bought and sold and in which currency prices are determined.

■ One function of the foreign exchange market is that individuals, companies, and governments use it, directly or indirectly, to convert one currency into another.

■ Second, it is used as a hedging device to insure against adverse changes in exchange rates.

■ Third, it is used to earn a profit from the instantaneous purchase and sale of a currency (arbitrage) or other interest-paying security in different markets.

■ Fourth, it is used to speculate about a change in the value of a currency and thereby earn a profit.

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

■ An exchange-rate quote between currency A and currency B (A/B) of 10/1 means that it takes 10 units of currency A to buy 1 unit of currency B (this is a direct quote of currency A and an indirect quote of currency B).

■ Exchange rates between two currencies can also be found using their respective exchange rates with a common currency; the resulting rate is called a cross rate .

■ An exchange rate that requires delivery of the traded currency within two business days is called a spot rate .

■ The forward rate is the rate at which two parties agree to exchange currencies on a specified future date; it represents the market’s expectation of a currency’s future value.

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

■ A forward contract requires the exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate.

■ A currency swap is the simultaneous purchase and sale of foreign exchange for two different dates.

■ A currency option is the right to exchange a specific amount of a currency on a specific date at a specific rate; it is sometimes used to acquire a needed currency.

■ A currency futures contract requires the exchange of a specific amount of currency on a specific date at a specific exchange rate (no terms are negotiable).

■ The interbank market is where the world’s largest banks locate and exchange currencies for companies.

■ Securities exchanges are physical locations at which currency futures and options are bought and sold (in smaller amounts than those traded in the interbank market).

■ The over-the-counter (OTC) market is an exchange that exists as a global computer network linking traders to one another.

6. Explain why and how governments restrict currency convertibility.

■ One main goal of currency restriction is that a government may be attempting to preserve the country’s hard currency reserves for repaying debts owed to other nations.

■ Second, convertibility might be restricted to preserve hard currency to pay for needed imports or to finance a trade deficit.

■ Third, restrictions might be used to protect a currency from speculators.

■ Fourth, restrictions can be an attempt to keep badly needed currency from being invested abroad.

■ Policies used to enforce currency restrictions include: (1) government approval for currency exchange, (2) imposed import licenses, (3) a system of multiple exchange rates, and (4) imposed quantity restrictions.

Talk It Over

1. What factors do you think are holding back the creation of a truly global capital market? How might a global capital market function differently from the present-day international market? (Hint: Some factors to consider are interest rates, currencies, regulations, and financial crises for some countries.)

2. The use of different national currencies creates a barrier to further growth in international business activity. What are the pros and cons, among companies and governments, of replacing national currencies with regional currencies? Do you think a global currency would be possible someday? Why or why not?

3. Governments dislike the fact that offshore financial centers facilitate money laundering. Do you think that electronic commerce makes it easier or harder to launder money and camouflage other illegal activities? Do you think offshore financial centers should be allowed to operate as freely as they do now, or do you favor regulation? Explain your answers.

Teaming Up

1. Research Project. Form a team with several of your classmates. Suppose you work for a firm that has $10 million in excess cash to invest for one month. Your group’s task is to invest this money in the foreign exchange market to earn a profit—holding dollars is not an option. Select the currencies you wish to buy at today’s spot rate, but do not buy less than $2.5 million of any single currency. Track the spot rate for each currency over the next month in the business press. On the last day of the month, exchange your currencies at the day’s spot rate. Calculate your team’s gain or loss over the one-month period. (Your instructor will determine whether, and how often, currencies may be traded throughout the month.)

2. Market Entry Strategy Project. This exercise corresponds to the MESP online simulation. For the country your team is researching, does it have a city that is an important financial center? What volume of bonds is traded on the country’s bond market? How has its stock market(s) performed over the past year? What is the exchange rate between its currency and that of your own country? What factors are responsible for the stability or volatility in that exchange rate? Are there any restrictions on the exchange of the nation’s currency? How is the forecast for the country’s currency likely to influence business activity in its major industries? Integrate your findings into your completed MESP report. (Hint: Good sources are the monthly International Financial Statistics and the annual Exchange Arrangements and Exchange Restrictions, both published by the IMF.)

Key Terms

base currency (p. 255)

bond (p. 246)

capital market (p. 246)

clearing (p. 263)

convertible (hard) currency (p. 264)

countertrade (p. 265)

cross rate (p. 258)

currency arbitrage (p. 254)

currency futures contract (p. 261)

currency hedging (p. 253)

currency option (p. 261)

currency speculation (p. 254)

currency swap (p. 261)

debt (p. 246)

derivative (p. 260)

equity (p. 246)

Eurobond (p. 250)

Eurocurrency market (p. 252)

exchange rate (p. 253)

exchange-rate risk (foreign exchange risk) (p. 257)

foreign bond (p. 251)

foreign exchange market (p. 253)

forward contract (p. 260)

forward market (p. 260)

forward rate (p. 259)

interbank interest rates (p. 253)

interbank market (p. 263)

interest arbitrage (p. 254)

international bond market (p. 250)

international capital market (p. 247)

international equity market (p. 251)

liquidity (p. 247)

offshore financial center (p. 249)

over-the-counter (OTC) market (p. 263)

quoted currency (p. 255)

securities exchange (p. 263)

securitization (p. 249)

spot market (p. 259)

spot rate (p. 259)

stock (p. 246)

vehicle currency (p. 262)

Take It to the Web

1. Video Report. Visit this book’s channel on YouTube (YouTube.com/MyIBvideos). Click on “Playlists” near the top of the page and click on the set of videos labeled “Ch 09: International Financial Markets.” Watch one video from the list and summarize it in a half-page report. Reflecting on the contents of this chapter, which aspects of international financial markets can you identify in the video? How might a company engaged in international business act on the information contained in the video?

2. Web Site Report. Visit the Web site of a financial institution or business periodical that publishes exchange rates among the world’s currencies. Compare the performance of the U.S. dollar against the European Union euro since July 9, 2008—the date of the information contained in Table 9.1.

Between that date and now, has the dollar fallen or risen in value against the euro? What is the exchange rate between the dollar and euro using: a) an indirect quote on the dollar, and b) a direct quote on the dollar? What percentage change has occurred in the value of the dollar against the euro? (Remember to mind your quoted and base currencies!)

Conducting Web-based research, what reasons lie behind the exchange-rate movement between the dollar and euro? Is the shift in the exchange rate due more to movement in the value of the dollar or the euro? Explain your answer. How has the exchange-rate change affected international business activity between the U.S. and European nations using the euro? Be specific.

Ethical Challenges

1. You are a U.S. senator serving on a subcommittee with the task of developing new regulations for U.S. firms doing business through offshore financial centers (OFCs). Bank deposits in offshore financial centers grew from the tens of billions of dollars a few decades ago to more than $1 trillion today. “Dirty money” obtained through drug trafficking, gambling, and other illicit activities use offshore financial centers to escape the same thing as respectable “clean capital”: national taxation and government regulations. Some experts argue that institutions such as international currency markets and offshore tax havens reduce stability and are hostile to the public interest. They say that people use such institutions to get beyond the reach of the law and undermine what they consider to be inefficient and bureaucratic attempts to impose a certain morality on people. As senator, what type of regulations do you support? What rationale do you give business leaders in your constituency who do business with OFCs? Do you think corporate use of OFCs to avoid home-country bureaucracies and taxes is ethical? Why or why not?

2. You are a member of the board of directors for one of the nation’s largest banks. Although recent banking deregulation is fostering greater competition in the industry, you are concerned about the direction in which banking is headed. The top management team of your bank is to meet soon with government officials to discuss the situation. The goal of government regulation of financial-services industries is to maintain the integrity and stability of financial systems, thereby protecting both depositors and investors. Regulations include prohibitions against insider trading, against lending by management to itself or to closely related entities (a practice called “self-dealing”), and against other transactions in which there is a conflict of interest. Yet in less than two decades deregulation has transformed the world’s financial markets. It spurred competition and growth in financial sectors and allowed capital to flow freely across borders, which boosted the economies of developing countries. What advice do you give your bank’s executives prior to meeting with the government? What do you see as the “dark side” of deregulation, in terms of business ethics? What do you think Adam Smith, one of the first philosophers of capitalism, meant when he warned against the dangers of “colluding producers”? Do you think this warning applies to the financial-services sector today?

PRACTICING INTERNATIONAL MANAGEMENT CASE Argentina Into the Abyss, Then Out, and Now Back In?

Argentina’s past President, Eduardo Duhalde, had summed it up perfectly. “Argentina is bust. It’s bankrupt. Business is halted, the chain of payments is broken, there is no currency to get the economy moving and we don’t have a peso to pay Christmas bonuses, wages, or pensions,” he said in a speech to Argentina’s Congress.

Although it was the star of Latin America in the 1990s, Argentina defaulted on its $155 billion of public debt in early 2002, the largest default by any country ever. After taking office in January 2002, President Duhalde implemented many measures to keep the country’s fragile economy from complete collapse after four years of recession. For 10 years the Argentine peso was fixed at parity to the dollar through a currency board. The president cut those strings immediately. But when it was allowed to float freely on currency markets, Argentina’s peso quickly lost two-thirds of its value and was trading at 3 pesos to the dollar. Then, strapped for cash, the government seized the savings accounts of its citizens and restricted how much they could withdraw at one time. Street protesters turned violent, beating up several politicians and attacking dozens of banks.