International Financial Management 2

7/31/2019 International Financial Management 2

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Chapter 2

Exchange Rates andInternational Financial Markets


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Objectives

This chapter provides a foundation forunderstanding how exchange rates are

determined, also identifies and discusses

the various international financial markets

used by MNCs. The specific objectives are:* to explain how the equilibrium exchange rate

is determined;

* to examine factors that affect theequilibrium exchange rate; and

* to describe the background and corporate

use of the international financial markets.


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Determination of EquilibriumExchange Rate

An exchange rate measures the valueof one currency in units of anothercurrency.

When a currency declines in value, it issaid to depreciate. When it increases invalue, it is said to appreciate.

The percentage change in the valueof a foreign currency is computed as(St St-1)/ St-1 ( where St denotes the

spot rate at time t.)


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Determination of EquilibriumExchange Rate

An exchange rate represents the price ofa currency, which is determined by the demandfor that currency relative to the supply of

that currency. The equilibrium exchange rate is the point

where the demand for one currency equates thesupply of that currency.

The equilibrium exchange rate will changeover time.


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Factors that InfluenceExchange Rates

Relative Inflation Rates

Relative Interest Rates

It is useful to consider real interest rates

Relative Income Levels Government Controls

* foreign exchange barriers;

* foreign trade barriers;* intervening in the foreign exchange market;

* affecting macro variables.


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Expectations

* Foreign exchange markets react to any news

that may have a future effect.

* Institutional investors often take a currency

positions based on anticipated interest

rate movements in various countries.

* Because of speculative transactions, foreign

exchange rates can be very volatile.


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Interaction of Factors* Traderelated factors (inflation differential,

income differential and governments

trade restrictions) and financial factors(interest rate differential, capital flow

restriction) sometimes interact. Exchange

rate movements may be simultaneously

affected by these factors.

* Over a particular period, different factors

may place opposing pressures on the

value of a foreign currency.


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The sensitivity of the exchange rateto these factors is dependent on thevolume of international transactions

between the two countries.

Summary of how factors can affectexchange rates: Exhibit 2.1.


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Inflation Differential

Income Differential

Govt Trade Restrictions

U.S. Demand for

Foreign Goods

Foreign Demand

for U.S. Goods

U.S Demand for

the Foreign

Currency

Supply of the

Foreign Currency

for sale

Interest Rate Differential

Capital Flow Restrictions

U.S. Demand for

Foreign Securities

Foreign Demand

for U.S. Securities

U.S. Demand for

the Foreign

Currency

Supply of the

Foreign Currency

for Sale

Exchange

Rate

Between

the

ForeignCurrency

and the

Dollar

Trade-Related Factors

Financial Factors

Exhibit 2.1 Summary of How Factors Can Affect

Exchange Rates


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Questions and Applications

Assume that the United States Investsheavily in government and corporate securitiesof Country K. In addition, residents of Country

K invest heavily in the United States.Approximately $10 billion worth of investmenttransactions occur between these twocountries each year. The total dollar value of

trade transactions per year is about $8 million.This information is expected to also hold in thefuture.


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Because your firm exports goods to Country K,

your job as international cash manager

requires you to forecast the value of country Ks

currency ( the krank) with respect to the dollar.

Explain how each of the following conditions

will affect the value of the krank, holding other

things equal. Then, aggregate all of these

impacts to develop an overall forecast of the

kranks movements against the dollar.


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Questions and Applicationsa. U. S. Inflation has suddenly increased

substantially, while Country Ks Inflation

remains low.

b. U. S. interest rates have increased

substantially, while Country Ks interest

rates remains low. Investors of both

countries are attracted to high interest rates.


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c. The U.S. Income level has increased

substantially, while Country Ks income

level has remained unchanged.

d. The United States is expected to impose a

small tariff on goods imported from

Country k.

e. Combine all expected impact to develop an

overall forecast.


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International Financial Markets

Topics for class discussion:

1. Where is the foreign exchange market?

2. Why does a foreign exchange market exist?

3. Which international financial markets

are most important to a firm that consistently

needs short-term funds? What about a firm

that needs long-term funds?


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Foreign Exchange Market

The foreign exchange market allowscurrencies to be exchanged in order to

facilitate international trade or financial

transactions.

The system for establishing exchange rates

has evolved over time:

* gold standard;

* period of instability;* Bretton Woods Agreement;

* Smithsonian Agreement;

* floating exchange rate system.


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Foreign Exchange Market

Foreign Exchange Transactions* spot market& forward market(read the

related materials about those markets);

* bid/ask spreadof banks;

(examples)

* foreign exchange quotations

direct quotations ( number of local

currency per foreign currency)indirect quotations

cross exchange rate(how to compute)

* Currency futures& optionsmarkets


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Eurocurrency Market

U.S. dollar deposits placed in banks in Europeand other continents are called Eurodollars.

In the 1960s and 70s, the Eurodollar market,

or what is now referred to as the

Eurocurrency market, grew to accommodate

increasing international business and to

bypass stricter U.S. regulations on banks in theU.S.


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Eurocurrency Market

The Eurocurrency market is made up ofseveral large banks called Eurobanks thataccept deposits and provide loans in various

currencies. Although the Eurocurrency market focuseson large-volume transactions, there are timeswhen no single bank is willing to lend

the needed amount. A syndicate ofEurobanks may then be composed tounderwrite the loans.


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Eurocurrency Market

The Eurocurrency market in Asia issometimes referred to separately asthe Asian dollar market.

* The primary function of banks in theAsian dollar market is to channel funds

from depositors to borrowers.

* Another function is interbank lending andborrowing.


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Eurocredit Market

Loans of one year or longer are extended

by Eurobanks to MNCs or government

agencies in the Eurocredit market.These loans are known as Eurocredit

loans. Floating rates are commonly used,

since the banks assets and liabilitymaturities may not match.


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Eurobond Market

There are two types of international bonds.

* Bonds denominated in the currency of the

country where they are placed but issued

by borrowers foreign to the country are

called foreign bondsor parallel bonds.

* Bonds that are sold in countries other than

the country represented by the currency

denominating them are called Eurobonds.


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Eurobond Market

Eurobonds are underwritten by a

multinational syndicate of investment

banks and simultaneously placed inmany countries.

Eurobonds are usually issued in bearer

form, pay annual coupons, may beconvertible, may have variable rates, andtypically have few protective covenants.


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International Stock Markets

In addition to issuing stock locally, MNCs can

also obtain funds by issuing stock in international

markets. This will enhance the firms image

and name recognition, and diversify the

shareholder base. The stocks may also be more

easily digested.

Stock issued in the U.S. by non-U.S. firms

or governments are called Yankee stock

offerings. Non-U.S. Firms may also issueAmerican depository receipts (ADRs),

which are certificates representing bundles

of stock. ADRs are less strictly regulated.


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International Stock Markets

Electronic communications networks(ECNs) have been created to match

orders between buyers and sellers in

recent years. As ECNs become more popular over

time, they may ultimately be merged

with one another or with other exchangesto create a single global stock exchange.


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Comparison of InternationalFinancial Markets

The foreign cash flow movements of a typical

MNC can be classified into four corporate

functions: foreign trade; direct foreign

investment; short-term investment or

financing; longer-term financing. All of

which generally require the use of the foreign

exchange markets.

* Foreign trade. Exports generate foreign

cash inflows while imports require cash

outflows.


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Comparison of InternationalFinancial Markets

Direct foreign investment (DFI).

Cash outflows to acquire foreign assets but

generate future inflows.

Short-term investment or financing

in foreign securities, usually inEurocurrency

market.

* Longer-term financingin theEurocredit,

Eurobond , or international stock

markets.


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Summary of the Corporate Use ofInternational Financial Markets

MNCs can use

spot market to exchange currencies

for immediate delivery; forward market or currency futures

market to lock in the exchange rate

at which currencies will be exchangedat a future point in time;


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Summary of the Corporate Use ofInternational Financial Markets

currency options market to lock in themaximum (minimum) amount to be paid(received ) in a future currency transaction but

maintain flexibility in the event of favorableexchange rate movements; Eurocurrency market for short-term investing

or financing;

Eurocredit marketfor medium-term financing; Eurobond market or international stock

marketfor long-term financing.


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Recently, Wal-Mart established two retail outletsin the city of Shanzen, China, which has apopulation of 3.7 million. These outlets are

massive and contain products purchasedlocally as well as imports. As Wal-Martgenerates earnings beyond what it needs inShanzen, it may remit those earnings back to

the United States. Wal-Mart is likely to buildadditional outlets in Shanzen or in other cities inthe future.


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a. Explain how the Wal-Mart outlets in China

would use the spot market in foreign

exchange .

b. Explain how Wal-Mart might utilize the

Eurocurrency market when it is establishing

other Wal-Mart stores in Asia.

c. Explain how Wal-Mart could use the Eurobondmarket to finance the establishment of new

outlets in foreign markets.

Documents

International Financial Management 2