International Financial Market

Rashedul Hasan

Motives for investing in Foreign Market

• Economic Conditions

Investors may expect firms in a particular foreign country to achieve more favorable performance than those in the investor’s own country. For example, the loosening of restrictions in Eastern European Countries created favorable economic conditions there. Such condition attracted foreign investors and creditors.

Motives for investing in Foreign Market

• Exchange Rate Expectation Exchange Rate Expectation is another important motive for investing in Foreign Market.

• International DiversificationInvestors may achieve benefits from internationally diversifying their asset portfolio. When an investor’s entire portfolio does not depend solely on a single country’s economy, cross-border difference in economic condition can allow for risk reduction benefit.

Motives for investing in Foreign Market

firms across European countries is less risky than a stock portfolio representing firms in a single European country. More access to foreign markets allows investors to spread their funds across a more diverse group industries than may be available domestically. This is especially true for investors residing in countries where firms are concentrated in a relatively small number of industries.

Motives for providing credit in Foreign Market

• High foreign interest rate

Some countries experience a shortage of lonable fund, which can cause market interest rate to be relatively high. Foreign creditors may attempt to capitalize on the higher rate, thereby providing capital to overseas market.

• Exchange Rate Expectation

Creditors may consider supplying capital to countries whose currencies are expected to appreciate against their own. Whether the form of transactions is a bond or loan, the creditors benefit when the currency of denomination appreciate against the creditor’s home currency.

• International Diversification

Creditors can benefit from international diversification that may reduce the probability of simultaneous bankruptcy across borrower.

Foreign Exchange Market

By allowing currencies to be exchanged, the foreign exchange market facilitates international trade and financial transaction. MNC rely on foreign exchange market to exchange their home currency for a foreign currency that they need to purchase import or to use DFI.

History of Foreign Exchange

• Gold Standard

From 1876 to 1913, each currency was convertible into gold at a specified rate, as dictated by the gold standard. Thus the exchange rate between two currencies was determined by their relative convertibility rates per ounce of gold. Each country use gold to back its currency. When World War 1 began in 1914, the gold standard was suspended.

History of Foreign Exchange

• Fixed exchange rate: Bretton Woods Agreement

In 1944, an international agreement called Bretton woods agreement, called for fixed exchange rate between currencies. This agreement lasted until 1971.

Smithsonian Agreement By 1971, the U.S. dollar appeared to be overvalued. The Smithsonian Agreement devalued the U.S. dollar and widened the boundaries for exchange rate fluctuations from ±1% to ±2%.

History of Foreign Exchange

• Floating exchange rate

By March 1973, the more widely traded currencies were allowed to fluctuate in accordance with market forces and the official boundaries were eliminated.

Foreign exchange Market & Transactions

The foreign exchange market should not be treated as specific building or location where traders exchange currencies. Companies normally exchange one currency for another through a commercial Bank over a Telecommunication network. Trading also occurs around the clock. Trading between banks occurs in the inter bank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen.

The structure of Foreign Exchange Market

The Foreign Exchange Market is an electronically linked network of Banks, Foreign exchange brokers and dealers. The major participants of Foreign Exchange Market are as follows,

• Large commercial bank• Foreign exchange broker in the Inter Bank market

Commercial customers – MNC, Exporters, Importers

Central Bank

The structure of Foreign Exchange Market

• Commercial Bank

Commercial Bank deals in foreign exchange for their own account. They stand ready to buy or sell any of the major currencies on a more or less continuous basis.

• Foreign Exchange Broker

The large fraction of inter-bank transaction is conducted through foreign exchange brokers, specialists in matching suppliers and demander bank. They used to receive a small amount of commission on trades.

The structure of Foreign Exchange Market

• Commercial customers

Commercial customers buy and sell foreign exchange through their banks. In Bangladesh, customers request local banks for foreign exchanges. Local bank may deal in inter-bank market or may not. If local bank deals in directly then it facilitates buying or selling foreign exchange. If not, local bank can asks its home office for the foreign exchange transactions.

Foreign exchange Transactions• Spot Transaction

The market for immediate exchange is known as the spot market. In the spot market, currencies are traded for immediate delivery, which is actually within two business days after the transaction has been concluded.

• Forward TransactionIt means a particular currency will be purchased or sold at a pre-specified future date and at a pre-specified exchange rate. The market in which contracts are made for such transaction is referred to as the forward market. Commercial banks usually enter into forward contract with importer or exporter or MNCs.

Mechanics of Spot Transaction• Generally an Importer requires foreign currency for

payment of Import bills and accordingly requests his or her local bank. Then the dealing bank asks the importer to specify two accounts.

• 1. Account in the bank of importer in the home country• 2. Account in the bank of Exporter in his or her country• Upon completion of this, the trader will forward a

dealing slip containing the relevant information to the settlement section of his or her bank. The settlement section then makes contact with bank’s correspondent in the abroad, requesting transfer of foreign currency/local currency of exporting country to exporter account.

Foreign Exchange Quotations: Direct vs. Indirect Quotations

• Direct Quotations Quotation that represents the value of a foreign currency in dollars (number of dollar per currency) is known as direct Quotation. For example, $ 1 = 70.00 TK. 

• Indirect Quotations On the other hand, Indirect Quotation refers to as the number of unit of foreign currency per dollar. For example, 70.00 TK. = $ 1

• Indirect Quotation = 1/direct quotation

Assume that, the spot rate of Euro is quoted this morning at $ 1.031. Calculate the Indirect Quotation.

Indirect Quotation = 1/direct quotation

• = 1/ 1.031

= .97 which mean .97 euros = $ 1.

Cross Exchange Rate

• A cross exchange rate reflects the amount of one foreign currency per unit of another foreign currency.

Value of 1 unit of currency A in units of currency B = value of currency A in $

Value of currency B in $

Cross Exchange Rate

Most tables of exchange rate quotation table express currencies against dollar. But in some instance, the firms may be concerned about the exchange rate between two non-dollar currencies. For example, if a Canadian firm needs Mexican Pesos to buy Mexican goods, it want to know the Mexican peso value relative to Canadian dollar.

Cross Exchange Rate

• Assume that, if the peso is worth $ .07 and the Canadian dollar is worth $ .70. calculate the cross exchange rate.

• Value of Peso = value of Peso in $

Value of C$ in $

= .07 / .70

= C$ .10

Bid/Ask Spread of bank

Commercial Banks charge fees for conducting foreign exchange transaction. At any given point in time the bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) price. The bid/ask spread represent the difference between bid and ask quote.

Bid/Ask Spread Effect • Assume, You have $ 1000 and plan to travel from US to

UK. The Bank’s bid rate for British Pound is $ 1.53 and asks rate is 1.60. Before leaving on your trip, you go to this bank to exchange dollar for pounds. Your dollar $ 1000 will be converted to the pound in the following manner,

Amount of US $ to be converted Price charged by bank per pound

= 1000 / 1.60

= 625 British Pound.

Bid/Ask Spread Effect

• Now suppose that, because of an emergency, you cannot take the trip and you want to reconvert the British Pound 625 back to US $. If the exchange rate has not changed, you will receive,£ 625 * (bank’s bid rate of $ 1.52 per pound) = $ 950. Due to the bid/ask spread, you have $ 50 (5%) less than your initial $1000.

 

Bid/Ask Spread in terms of %

• bid/ask % spread = Ask rate – Bid rate

Ask rate

= (1.60–1.52)/1.60 = 5%

Factors that Affect the Spread

Order cost: it includes cost of processing order, clearing cost and cost of recording transactionsInventory cost: it includes the cost of maintaining an inventory of particular currency. Holding an inventory involves an opportunity cost because the funds could have been used for some other purpose.If interest rate were relatively high, the opportunity cost of holding an inventory would be relatively high. Therefore, the higher the inventory cost, the larger the spread.

Factors that Affect the Spread

Competition: the more intense the competition, the smaller the spread quoted by intermediaries.

Volume: more liquid currencies are less likely to experience sudden change in price. Currencies that have a large trading volume are more liquid because there are many buyers and sellers for them.

Factors that Affect the Spread

Currency Risk: some currencies exhibit more volatility than others due to economic or political conditions that cause the demand for and supply of the currency to change abruptly. Intermediaries may suffer from losses due to an abrupt change in the value of these currencies.

Terminologies

• Currency arbitrage

Now a days, exchange rates are quoted not only against dollars, but also quoted against other important currencies like Euro, pound, DM, Lira, Yen, Rupee etc. This facilitates arbitrageur to buy foreign currency at a lower rate from one market and sell at higher rate in another market, as there is exchange rate inconsistency exists in different money center,

TerminologiesAsian Money market

Asian money market originated as a market involving mostly dollar dominated deposits. The market emerged to accommodate the needs of businesses that were using US $ and some other foreign currency as a medium of exchange for international trade. These businesses could not rely on banks in Europe because of the distance and different time zone. Asian money market is centered in Hong Kong and Singapore, where large banks accept deposits and make loans in various foreign currencies.

Terminologies

Basel AccordIn July 1998, 12 Central Bank Governor of 12 major industrialized nations, agreed on standardized guideline for Bank operation management. Under this guideline, bank must maintain capital equal to at least 4% of their assets. For this purpose, bank’s assets are weighted by risk. This result in a higher capital ratio for riskier assets.

Terminologies

Basel 2 Accord

Basel 2 Accord had corrected some of inconsistency those exist after Basel Accord. For example, banks in some countries have required better collateral to back their loan. The Basel 2 accord had attempted to account for such differences among banks. The Basel Committee encourage banks to improve their techniques for controlling operational risks.

TerminologiesLondon Inter Bank Offer Rate [ LIBOR]As bank accept short-term deposit and make long-term loan, their assets and liabilities maturity do not match. This can adversely affect a bank’s performance during period of rising interest rate, since the bank may have locked in a rate on its longer term loans while the rate its pays on short term deposit is rising over time. To avoid this risk the banks commonly use floating rate loan. The loan rate floats in accordance with the movement of some market interest rate such as London Inter Bank Offer Rate [LIBOR]. It is a rate commonly charged for loans between banks. For example, a Euro credit loan may have a loan rate that adjusts every six month and is set at “LIBOR plus 3%”