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.
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.
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.)