International Financial

Markets
Chapter 3
Chapter Objectives
This chapter will describe the:
A. Foreign exchange market
B. International money market
C. International credit market
D. International bond market
E. International stock markets
Foreign Exchange Market
1. Allows for the exchange of one currency
for another
2. Exchange rate specifies the rate at which
one currency can be exchanged for another
History of Foreign Exchange
 The system used for exchanging foreign currencies has
evolved:
1. Gold Standard (1876 – 1913): each currency was
convertible into gold at a specified rate
2. Agreements on Fixed Exchange Rates: fixed exchange
rate between currencies. Governments would intervene
to prevent exchange rates from moving more than 1%
above or below the fixed rate
a. Bretton Woods Agreement 1944
b. Smithsonian Agreement 1971
3. Floating Exchange Rate System: boundaries were
removed and exchange rates were allowed to fluctuate
in accordance with market forces
Foreign Exchange Transactions
 The average daily transaction volume in the
foreign exchange market is about $4 trillion, with
the $US involved in about 40% of the transactions
 Historical data could be downloaded from :
http://www.oanda.com/currency/historical-rates
/

1. Over the counter market

2. Foreign exchange dealers serve as intermediaries
3. Spot Market: transaction for immediate exchange
at the spot rate
Spot Market
1. Spot market structure: electronic
2. Use of the Dollar in the spot market:
commonly accepted medium of exchange
in countries with weak currency
3. Spot market time zones
4. Spot market liquidity: more buyers and
sellers means more liquidity
Attributes of Banks That Provide
Foreign Exchange
1. Competitiveness of quote
2. Special relationship with the bank
3. Speed of execution
4. Advice about current market conditions
5. Forecasting advice
 Refer to p. 64
Foreign Exchange Quotations
 Spot market interaction among banks: the
exchange rate between two currencies should
be similar across various banks. Otherwise,
an arbitrage opportunity arises
 A bank’s bid (buy) is always lower than a

bank’s ask(sell). Refer to the example p. 65

(at the bottom)
 The bid-ask spread represents the difference

between the bid and the ask quotes

Foreign Exchange Quotations
 The differential between ask and bid quotes
could be standardized by measuring it as a
percentage of the spot rate:

Ask Rate  Bid Rate

Bid / ask spread in % 
Ask Rate

 Refer to Exhibit 3.1. p. 65

Factors That Affect the Spread
1. Order costs: costs of processing orders
(e.g., clearing costs and the costs of
recording transactions)
2. Inventory costs: costs of maintaining an
inventory of a particular currency
(opportunity costs)
3. Competition: the more intense the
competition, the narrower the spread
4. Volume: liquidity
5. Currency risk: exchange rate volatility
Interpreting Foreign Exchange
Quotations
 http://online.wsj.com/mdc/public/page/mdc_currencies.ht
ml?mod=mdc_topnav_2_3002_europe

1. Direct Quotation represents the value of a foreign currency

in dollars (number of dollars per currency)
Example: $1.031 per Euro
2. Indirect quotation represents the number of units of a
foreign currency per dollar
Example: €0.97 per Dollar
3. Cross Exchange Rates: exchange rate between two nondollar
currencies. If the peso is worth $ 0.1 and the C$ is worth
$0.7, what is the exchange rate between C$ and the peso?
 Refer to Exhibit 3.3 p. 69
 http://finance.yahoo.com/currency
Forward, Futures, and Option Markets
1. Forward Contracts: agreements between a foreign
exchange dealer and an MNC that specifies the
currencies to be exchanged, the exchange rate,
and the date at which the transaction will occur
2. Futures Contracts: similar to forward contracts but
sold on an exchange
3. Option Contracts
a. Currency Call Option: provides the right to buy currency
at a specified strike price within a specified period of time
(importers)
b. Currency Put Option: provides the right to sell currency at
specified strike price within a specified period of time
(exporters)
International Money Market
1. Corporations or governments in a particular
country need for short-term funds denominated in
a currency different from their home currency.
2. Reasons for international money market:
a. Need to borrow funds to pay for imports denominated in
a foreign currency
b. Borrowing in a currency in which the interest rate is lower
Origins and Development
1. European Money Market: Dollar deposits in
banks in Europe and other continents are
called Eurodollars or Eurocurrency.
2. Asian Money Market: centered in Hong
Kong and Singapore
Standardized Global Bank Regulations
1. Single European Act
2. Basel Accord: standardized capital
standards imposed on banks
3. Basel II Accord: correct some Basel I
accord’s inconsistencies (controlling
operational risk, providing more
information to shareholders, …)
International Credit Market
1. Eurocredit Market: loans denominated in
dollars or other currencies often maturities
of 5 years.
2. London Interbank Offer Rate (LIBOR): rate
charged for loans between banks
3. Syndicated Loans: one single bank is
unwilling or unable to lend the total
amount to a company or a government
International Bond Market
1. Foreign bonds: issued by borrower foreign
to the country where the bond is placed
2. Eurobonds: bonds sold in countries other
than the country of the currency
denominating the bond
Eurobonds
1. Features:
a. Bearer bonds
b. Annual coupon payments
c. Convertible or callable
2. Denominations
3. Underwriting Process
a. multinational syndicate of investment banks
4. Secondary Market
International Stock Markets
1. Issuance of Stock in Foreign Markets
2. Issuance of Foreign Stock in the U.S.
a. Yankee stock offerings ( stock issues by non-US firms on
US markets)
b. American Depository Receipts (ADR) (conversion ratio and
ADR price in $, refer to p. 82-86)
◦Why do US investors invest in foreign stocks?
◦What are the advantages in buying ADRs?
Exhibit 3.5 Comparison of Stock Exchanges
(as of 2008)
Exhibit 3.6 Impact of Governance on Stock
Market Participation and Trading Activity
Exhibit 3.7 Foreign Cash Flow Chart of an MNC