Slide 7.

Chapter 7

International financial markets

and institutions

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.2

International financial
markets and institutions
• Objectives
• Introduction
• Foreign exchange markets
• Determination of the exchange rate
• Protecting against exchange risk
• Foreign money and capital markets
• Regional money and capital markets
• The IMF system.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.3

Objectives
• Review the basic characteristics of all the
financial markets that may be available to a firm
in international business.
• Examine the foreign exchange market, its
operation, and the main participants.
• Explain the fundamental economic factors that
determine exchange rates.
• Show how firms can operate successfully in more
than one currency without facing unacceptable
levels of exchange risk.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.4

Objectives (Continued)
• Give insights into domestic money and capital
markets that exist around the world.
• Describe the functioning of the euromarkets, both
short term and long term.
• Explain how the international monetary system
functions and how it relates to both private-sector
firms and governments.
• Look at a country’s balance of payments and
show what lessons can be drawn from it.
• Show how firms can take advantage of the
opportunities available in all of these markets.
Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.5

Introduction
• International financial markets are relevant to
companies, whether or not they become directly
involved in international business through exports,
direct investment, and the like.
• Purchases of imported products or services,
borrowing and investment in other countries or
currency, all involve exchange risk.
• Exchange risk: The risk of financial loss or gain
due to an unexpected change in a currency’s
value.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.6

Introduction (Continued)
• Foreign exchange: any financial instrument that
carries out payment from one currency to
another.
• Exchange rate: the amount of one currency that
can be obtained for another currency.
– Spot rate is the rate quoted for current foreign
currency transactions.
– Forward rate is the rate quoted for the delivery of
foreign currency at a predetermined future date
such as 90 days from now.
– Cross rate is an exchange rate that is computed
from two other rates.
Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.7

Introduction (Continued)
• Foreign exchange: any financial instrument that
carries out payment from one currency to
another.
• Exchange rate: the amount of one currency that
can be obtained for another currency.
– Spot rate is the rate quoted for current foreign
currency transactions.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.8

Foreign exchange markets

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.9

The foreign exchange markets

• The foreign exchange market is a mechanism,
through which financial instruments (cash,
cheques or drafts, wire transfers telephone
transfers and contracts to sell or buy currency in
the future) that are denominated in different
currencies can be transacted.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.10

The foreign exchange markets

(Continued)
• There are four major ways of conducting foreign
exchange in the US:
– Between banks: the interbank market for foreign
exchange involves transactions between banks.
– Brokers: the brokers’ market consists of a small
group of foreign exchange brokerage companies
that make markets in foreign currencies. These
brokers do not take currency positions. They
simply match buyers and sellers and charge a
commission for their services.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.11

The foreign exchange markets

(Continued)
– Forward transactions: lets a customer “lock in” an
exchange rate and thus be protected against the risk
of an unfavourable change in the value of the
currency that is needed. This exchange market is
very important to firms that are doing business
overseas and dealing in foreign currency.
– Futures market: the futures market is very similar to
the forward foreign exchange market except in that
the amount of currency transacted is fixed to be
transferred at a future date at a fixed exchange rate.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.12

Figure 7.2 US foreign exchange markets

Source: Adapted from Robert Grosse, St. Louis Fed Review, March 1984, p. 91

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.13

Determination of the exchange rate

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.14

Figure 7.1 Foreign exchange market for euros in New York

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.15

Economic relationship
for exchange rate determination
• Exchange rates are determined by the activities
of the groups discussed above, as well as
through two fundamental economic relationships
that underlie exchange rate determination:
– Purchasing Power Parity
– The International Fisher Effect.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.16

Purchasing Power Parity

• PPP theory states

that the exchange
rate between two
currencies will be
determined by the
Infl = Inflation
relative purchasing XR = Exchange Rate
power of these = domestic $ / foreign $
currencies. t = time

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.17

The International Fisher Effect

– Fisher effect: describes
the relationship between
inflation and interest rates
in two countries and holds
that as inflation rises, so i = interest rate
will the nominal interest
XR = exchange rate
rate.
t = time
– The Fisher effect holds
that the interest rate
differential between two
countries is an unbiased
predictor of future
exchanges in the spot
market.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.18

Combined equilibrium
• The future exchange rate, XRt+1, will be partially
determined by both of the above factors (PPP
and IFE) in the absence of government
intervention.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.19

Figure 7.3 Exchange rate determination

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.20

Discussion
U.S. Senate Passes Chinese Currency Bill on Oct 11, 2011

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.21

End of 1 of 2

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.22

Protecting against exchange risk

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Slide 7.23

Protecting against exchange risk

• Alternatives to minimize exchange risk
– Risk avoidance: avoid foreign currency
transactions.
– Risk adaptation: this strategy includes all
methods of “hedging” against exchange rate
changes.
– Risk transfer: the use of an insurance contract or
guarantee that transfers the exchange risk to the
insurer or guarantor.
– Diversification: spreading assets and liabilities
across several currencies.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.24

Foreign money and capital markets

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Slide 7.25

Foreign money and capital markets

• The MNE will generally utilize local markets to
perform local financial transactions and often to
hedge its local asset exposure through local
borrowing (or its local liability exposure through
local deposits or investments).
• The MNE can also utilize local financial markets
to obtain additional funding (or place additional
funds) for its non-local activities.

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Slide 7.26

China Goes Global Survey

by Asia Pacific Foundation of Canada

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.27

Regional money and capital markets

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.28

Regional money and capital markets

• The eurocurrency market
– A eurodollar is a dollar-denominated bank deposit
located outside the United States.
– Eurobonds are financial instruments that are
typically underwritten by a syndicate of banks from
different countries and are sold in countries other
than the ones in which their currency is
denominated.
– Euroequities are shares of publicly traded stocks
traded on an exchange outside of the issuing firm’s
home country.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.29

The IMF system

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.30

The international monetary system

• International monetary system: The
arrangement between national
governments/central banks that oversee the
operation of official foreign exchange dealings
between countries.
• International Monetary Fund (IMF): The
international organization founded at Bretton
Woods, NH, in 1944 that offers balance of
payments support to countries in crisis along with
financial advising to central banks.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.31

The international monetary fund (IMF)

• The goals of the IMF include:
– to facilitate the balanced growth of international
trade;
– to promote exchange stability and orderly
exchange arrangements and to discourage
competitive currency depreciation;
– to seek the elimination of exchange restrictions
that hinder the growth of world trade;
– to make financial resources available to members,
on a temporary basis and with adequate
safeguards, to permit them to correct payment
imbalances without resorting to measures
destructive to national and international prosperity.

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009
Slide 7.32

IMF Employees talk about IMF

Alan M Rugman and Simon Collinson, International Business, 5th Edition, © Pearson Education Limited 2009