INTERNATIONAL FINANCE

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(AcFn 721)
1
 CHAPTER TWO

INTERNATIONAL
FINANCIAL MARKETS
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 CONTENTS:

2.1 Foreign Exchange Market

2.2 Foreign Exchange Exposure
2.3 Currency Futures, Options and SWAPs
2.4 International Bond Market
2.5 Major Financial Centers of the World

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 2.1
Foreign Exchange
Market

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Foreign Exchange Market
Foreign exchange means the money of a foreign
country.
Includes:
 foreign currency bank balances,
 banknotes,
 checks, &
 drafts.
A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount
of one currency will be delivered for some other
currency at a specified date.
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Foreign Exchange Market
The Foreign Exchange (forex) Market is:
◦ The physical & institutional structure through
which the money of one country is exchanged for
that of another country.
◦ The market where determination of rate of
exchange between currencies takes place.
◦ Where forex transactions are physically completed.
• The forex market is not an organized market,
trading is conducted over-the-counter (OTC).
• The forex market is the largest market in the
world & has grown dramatically in recent years.
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Foreign Exchange Market
• The three major foreign exchange centers are
located in the UK, the US, & Japan.
• Other important centers for forex trade include
Hong Kong, Paris, Singapore, Sydney, &
Zurich.
• Thanks to time-zone differences, there is not a
moment in the day when foreign exchange is not
being traded somewhere in the world.
• Most trades are conducted by phone, telex, or
SWIFT (Society for Worldwide Interbank
Financial Telecommunications).
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Market Participants
The forex market consists of two tiers:
 The interbank or wholesale market
 The client or retail market
Five broad categories of participants operate
within these two tiers:
 Bank & nonbank forex dealers
 Individuals & firms
 Speculators & arbitragers
 Central banks & treasuries
 Forex brokers

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1. Bank & Nonbank Forex Dealers
Banks & a few nonbank forex dealers operate in
both the interbank & client markets.
The profit is from buying forex at a “bid” price &
reselling it at a slightly higher “offer” or “ask”
price.
Dealers in the forex department of large
international banks often function as “market
makers”.
These dealers stand willing at all times to buy &
sell those currencies in which they specialize &
thus maintain an “inventory” of those currencies.
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2. Individuals and Firms
Individuals (such as tourists) & firms (such as
importers, exporters & MNCs) conduct
commercial & investment transactions in the
foreign exchange market.
Their use of the forex market is necessary but
incidental to their underlying commercial or
investment purpose.
Some of the participants use the market to
“hedge” foreign exchange risk.

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3. Speculators and Arbitragers
Speculators & arbitragers seek to profit from
trading in the market itself.
They operate in their own interest, without a
need or obligation to serve clients or ensure a
continuous market.
While dealers seek the bid/ask spread,
speculators seek all the profit from exchange
rate changes & arbitragers try to profit from
simultaneous exchange rate differences in
different markets.

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4. Central Banks and Treasuries
Use the market to acquire/spend their country’s
forex reserves as well as to influence the price at
which their own currency is traded.
They act to support the value of their own currency
because of policies adopted at the national level or
because of commitments entered into through
membership in joint agreements such as the EMS.
The motive is not to earn a profit as such, but rather
to influence the forex value of their currency to
benefit the interests of their citizens.
As willing loss takers, central banks & treasuries
differ in motive from all other market participants.
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5. Foreign Exchange Brokers
Forex brokers are agents who facilitate trading
between dealers without themselves becoming
principals in the transaction.
For this service, they charge a commission.
It is a brokers business to know at any moment
exactly which dealers want to buy or sell any
currency.
Dealers use brokers for their speed, and because
they want to remain anonymous since the identity
of the participants may influence short term
quotes.

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Currency Quotes & Prices
There are more than 150 countries having their
own currency in the world.
For ease of understanding, ISO currency
abbreviations are used which include two letters
from the country name and the name of the
currency.
The following two slides shows the name of
currencies, currency code and symbols of the
most active currencies in foreign exchange
market

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Currency Quotes & Prices
Country Currency Code Symbol
Ethiopia Birr ETB Br
Australia Dollar AUD $
E.U. Euro EUR €
Brazil Real BRL R$
Canada Dollar CAD $
China Yuan CNY ¥
Egypt Pound EGP £
Ghana Cedis GHC ¢
India Rupee INR Rs
Kenya Shilling KNS K Sh
Israel New Shekel ILS NIS
Russia Ruble RSR Rb
Japan Yen JPY ¥
Korea Won 24/08/21 KRW W 15
Currency Quotes & Prices
Country Currency Code Symbol
Mexico Peso MXN Mex$
Great Britain Pound GBP £
Turkey Lira TKL LT
Nigeria Naira NGN ₦
Norway Kroner NOK Nkr
U.A.E Dirham UAD Dh
Pakistan Rupee PKR P₨
Poland Zloty PLN zł
Qatar Riyal QAR QR
Somalia Shilling SOS So.Sh
Saudi Arabia Riyal SAR SRIs
Singapore Dollar SGD S$
South Africa Rand ZAR R
Sweden Krona SEK Skr
United States Dollar 24/08/21 USD $ 16
Foreign Exchange Rates & Quotations
A foreign exchange rate is the price of one
currency expressed in terms of another currency.
A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
 The foreign currency price of one unit of the
domestic currency.
 The domestic currency price of a unit of the
foreign currency.
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Foreign Exchange Rates & Quotations
A direct quote (European terms) is a home
currency price of a unit of foreign currency.
 Eg. ETB 30.064/1USD
An indirect quote (American terms) is a foreign
currency price of a unit of home currency.
 Eg. USD 0.0333/1ETB
The form of the quote depends on what the
speaker regard as “home.”
Indirectquote is the reciprocal of direct quote.
Most foreign currencies in the world are stated in
terms of Direct quote.
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Bid & Ask Price
Interbank quotations are given as a bid & ask (offer).
Dealers bid (buy) at one price and ask (sell) at a
slightly higher price, making their profit from the
spread between the buying and selling prices.
The profit for the dealer is the difference between Ask
and Bid prices.
Spread = Ask Rate – Bid Rate
Ask Rate
Eg. Suppose Bid price for £ = $1.52, & Ask price = $1.60.
Thus, Spread = (1.60 – 1.52)/1.60
= 5%
This implies the bank’s profit is 5% of the Ask price

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Vehicle Currency
Ifthere are N number of currencies issued, there
are N x (N - 1)/2 possible exchange rates.
Because of the transaction cost, a vehicle
currency is required.
Before 1900, British pound served as vehicle
currency.
Today, U.S. dollar is serving as a vehicle currency
as it is commonly used in international trade.
In the future, Euro is hoped to be the vehicle
currency.

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Most Traded Currencies in the World

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Cross Rate

• Cross rate is the indirect calculation of the

exchange rate of one currency from the
exchange rates of two other currency.
• Examples :
1) If 1 USD = 30.064 ETB & 1 USD = 0.6579
GBP then
1 ETB = ? GBP
2) If 1USD = 42 KNS & 1 USD = 21 NZD,
then
1 KNS = ? NZD

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Change in Exchange Rate
1. Devaluation & Revaluation
 If the monetary authorities increase the domestic
currency price of foreign exchange, they are
devaluing their money.
 Such actions increase the domestic currency
prices of foreign monies & are often the result of
a failure in government policy
 By devaluing their currency, the governments
induce more foreign demand for the domestic
goods produced in its country.

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Change in Exchange Rate
Ifthe authorities of a country decrease the
domestic currency price of foreign exchange, they
are said to be revaluing the country’s money
Ifa revaluation changes the relative prices across
countries, it benefits domestic consumers but
hurts domestic workers and producers.
This is because, the goods & services produced in
the country have to compete with imports that
have become cheaper after the revaluation.

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Change in Exchange Rate
2. Currency Depreciation Vs. Appreciation
Depreciation (Weakening) of a currency is the
decrease in the purchasing power of a currency
relative to the other
ETB 29.47/USD → ETB 29.80/USD → ETB
30.06/USD
Appreciation (strengthening) of a currency is the
increase in the purchasing power of the currency
relative to the other
ETB 30.06/USD → ETB 29.95/USD → ETB
29.72/USD
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 Change in Exchange Rate

Change in U.S. dollar Change in Norwegian krone

against Norwegian krone against U.S. dollar
Make krone base currency (1÷ NOK/
$)
February 1: NOK 5/$ February 1: $.20/NOK
March 1: NOK 4/$ March 1: $.25/NOK

%change = [(4-5)/5] x 100 = -20% %change = [(.25-.20)/.20] x 100 = 25%

U.S. dollar fell 20% Norwegian krone rose 25%

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Spot and Forward Foreign Exchange Rates

Spot Exchange Rate - The rate today for

exchanging one currency for another for
immediate delivery.
delivery
Forward Exchange Rate - The rate today for
exchanging one currency for another at a specific
future date.
date
Currency risk can be thought of as the volatility
of the exchange rate of one currency for another
(say British pounds per U.S. dollar).

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Foreign Exchange Rates

Country Contract Us Dollar Equivalent

Britain Spot 1.6170
(pound) 30 – day forward 1.6153
90 – day forward 1.6130
180 – day forward 1.6200

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Premium or Discount in Exchange Rate
• The appreciation (premium) or depreciation
(discount) of domestic currency against foreign
currency is given using the following formula

Compute the premium or discount using the rate

given above for
1. 30 days forward rate
2. 90 days forward rate
3. 180 days forward rate
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Parity Conditions
Arbitrage is capitalizing on a discrepancy in quoted
prices. Often, the funds invested are not tied up & no
risk is involved.
In response to the imbalance in demand & supply
resulting from arbitrage activity, prices will realign
very quickly, such that no further risk-free profits can
be made.
Five Parity Conditions Result from Arbitrage
Activities
1. Purchasing Power Parity (PPP)
2. The Fisher Effect (FE)
3. The International Fisher Effect (IFE)
4. Interest Rate Parity (IRP)
5. Unbiased Forward 24/08/21
Rate (UFR) 30
Party Conditions

Inflation
PPP FE

Changes in IFE Changes in

Exchange Interest
rates rates

UFR IRP
Changes in
Forward
Rates
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1. Purchasing Power Parity (PPP)
PPP states that spot exchange rates between
currencies will change to the differential in
inflation rates between countries.
PPP says the currency with the higher inflation
rate is expected to depreciate relative to the
currency with the lower rate of inflation
In order to exist PPP we assume:
1. All goods and services are tradable
2. Transportation and other Trading costs are zero
3. Consumers in all countries consume the same
proportions of goods and services
4. The law of one price prevails
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1. Purchasing Power Parity (PPP)

In mathematical terms:

et

1  ih  t

e0 1  i  f
t

Where, et = future spot rate

e0 = current spot rate
ih = home inflation
if = foreign inflation
t= the time period

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Example
Projected inflation rates for the U.S. & Germany
for the next twelve months are 10% & 4%,
respectively. If the current exchange rate is
$.50/DM, what should the future spot rate be at
the end of next twelve months?

 1  ih 
t

et  e0 e1  .50(1.0577)
 1 i 
t
f

 1.10 
1

e1  .50
 1.04 
1 e1  $.529
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2. The Fisher Effect
 Interest rates reflect expectations of inflation
rates;
◦ high interest rates reflect high inflation
expectation
Fisher Effect: i = r + I
Where,
 i : “nominal” interest rate in a country
 r : “real” interest rate
 I : inflation over the period the funds are to
be lent

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3. The International Fisher Effect
For any two countries the spot exchange rate
should change in an equal amount but in the
opposite direction to the difference in nominal
interest rates between the two countries.
IFF: (S1-S2)/S2 X 100 = i$ - i¥
◦Where,
 S1 : spot rate at time 1,
 S2 : spot rate at time 2,
 i$, i¥ : nominal interest rates in the US & Japan

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4. Interest Rate Parity (IRP)
• The Theory states: the forward rate (F) differs
from the spot rate (S) at equilibrium by an
amount equal to the interest differential (rh -
rf) between two countries.
(1 + rh) = F
(1 + rf) e0
Where, rh = the home rate
rf = the foreign rate
F = the forward rate
e0 = the spot rate
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Example
If the Swiss franc is $.68/SF on the spot market &
the annualized interest rates in the U.S. &
Switzerland, respectively, are 7.94% & 2%, what is
the 180-day forward rate under parity conditions?

f t  e0
 1  rh 
 1 r  f

 .0794 
1  
 .68  
2
f180
 .02 
 1  
 2 

f180  $.70 / SF
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5. The Unbiased Forward Rate (UFR)
• The UFR states that if the forward rate is
unbiased, then it should reflect the
expected future spot rate.
• It is stated as
ft = e t

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 2.2
Foreign Exchange
Exposure

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Foreign Currency Exposures

Foreign exchange exposure is a measure of the

potential for a firm’s profitability, net cash flow,
& market value to change because of a change in
exchange rates.
An important task of the financial manager is to
measure foreign exchange exposure & to manage
it so as to maximize the profitability, net cash
flow, and market value of the firm.
The effect on a firm when foreign exchange rates
change can be measured in several ways.
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1. Transaction Exposure
Transaction exposure measures changes in the
value of outstanding financial obligations
incurred prior to a change in exchange rates but
not due to be settled until after the exchange rates
change.
Thus, this type of exposure deals with changes in
cash flows that result from existing contractual
obligations.

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2. Operating Exposure
Operating exposure, economic exposure, competitive
exposure, or strategic exposure, measures the
change in the present value of the firm resulting
from any change in future operating cash flows of
the firm caused by an unexpected change in
exchange rates.
Transaction exposure & operating exposure exist
because of unexpected changes in future cash flows.
The difference between the two is that transaction
exposure is concerned with future cash flows already
contracted for, while operating exposure focuses on
expected future cash flows that might change
because a change in exchange rates.
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3. Accounting Exposure

Accounting exposure, also called translation

exposure, is the potential for accounting-derived
changes in owner’s equity to occur because of the
need to “translate” foreign currency financial
statements of foreign subsidiaries into a single
reporting currency to prepare worldwide
consolidated financial statements.

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Hedging
Currency risk is defined roughly as the variance in
expected cash flows arising from unexpected
exchange rate changes
Many firms attempt to manage their currency
exposures through hedging.
Hedging is the act of offsetting an exposure to risk
Derivative instruments such as Forward, Futures,
Options and SWAPs are used in hedging
transaction & translation exposures.
Hedging is not useful for managing operating
exposure
Diversificationof the firm’s operation across a
range of currencies that are negatively correlated
is used for managing operating exposure.
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 2.3
Currency Futures,
Options, & SWAPs

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Currency Futures, Options and SWAPs
Derivatives, so named because their values are
derived from an underlying asset, are powerful
tools used for two distinct management
objectives:
◦ Speculation – the financial manager takes a
position in the expectation of profit
◦ Hedging – the financial manager uses the
instruments to reduce the risks of the firm’s
cash flow
The financial manager must first understand the
basics of the structure & pricing of these tools
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Derivative Market
Derivative instrument can be sold in either
standardized market or over the counter (OTC)
◦ Standardized markets:
 provide liquidity through large volume,
 have standardized contract & transparent
◦ Over-the-counter:
 instruments are tailored to individual
requirements

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 Derivative Market

Standardized Market Over the counter

Interest rate future Interest rate SWAP
Interest rate option Currency SWAP
Currency future Other SWAP related derivatives
Currency option
Stock future and options

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Derivative Market
The derivatives that will be discussed here
includes:
 Foreign Currency Futures
 Foreign Currency Options
 Foreign Currency Swaps
Financial derivatives are powerful tools in the
hands of careful and competent financial
managers.
They can also be very destructive devices when
used recklessly.

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1. Foreign Currency Futures
A foreign currency futures contract is an
alternative to a forward contract. It calls for
future delivery of a standard amount of currency
at a fixed time & price
Contract Specifications:

◦ Last trading day – contracts may be traded

through the second business day prior to
maturity date
◦ Collateral & maintenance margins – purchaser
or trader must deposit an initial margin or
collateral; (similar to a performance bond)
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1. Foreign Currency Futures…
At the end of each trading day, the account is
marked to market & the balance in the account is
either credited if value of contracts is greater or
debited if value of contracts is less than account
balance.
Size of contract – called the notional principal,
trading in each currency must be done in an even
multiple.
Method of stating exchange rates – “American
terms” are used; quotes are in the domestic
currency’s cost per unit of the foreign currency,
also known as direct quotes.
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1. Foreign Currency Futures…
Maturity date – contracts mature on the 3rd
Wednesday of January, March, April, June, July,
September, October or December.
Settlement – only 5% of futures contracts are
settled by physical delivery, most often buyers &
sellers offset their position prior to delivery date.
Commissions – customers pay a commission to
their broker to execute a round turn & only a
single price is quoted.
Use of a clearing house as a counterparty – All
contracts are agreements between the client & the
exchange clearing house.
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1. Foreign Currency Futures…
Any investor wishing to speculate on the
movement of a currency can pursue one of the
following strategies:
◦ Short position – selling a futures contract
based on view that currency will fall in value.
◦ Long position – buying a futures contract based
on view that currency will rise in value.

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Currency Futures and Forwards Compared

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2. Currency Options
A foreign currency option is a contract giving the
purchaser of the option the right to buy or sell a
given amount of currency at a fixed price per unit
for a specified time period.
The buyer of the option is the holder & the seller
of the option is termed the writer.
Two basic types of options, calls & puts
 Call – buyer has right to purchase currency
 Put – buyer has right to sell currency

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2. Currency Options
Every option has three different price elements
◦ The strike or exercise price is the exchange rate
at which the foreign currency can be purchased
or sold.
◦ The premium, the cost, price or value of the
option itself paid at time option is purchased
◦ The underlying or actual spot rate in the market

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2. Currency Options
Options may also be classified as per their
payouts
◦ At-the-money (ATM): options have an exercise
price equal to the spot rate of the underlying
currency
◦ In-the-money (ITM): options may be profitable,
excluding premium costs, if exercised
immediately
◦ Out-of-the-money (OTM): options would not be
profitable, excluding the premium costs, if
exercised

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3. Currency Swap
A currency swap is an exchange of asset or
liability in one currency for an asset or liability
in another currency.
In a currency swap two parties effectively trade
assets & liabilities denominated in different
currencies.
The simplest currency swap is an agreement to
sell a currency now at a given price & then
repurchase it at a stated price on a specified
future date.
The difference between the two prices is called
the swap rate.
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Example:

 A German bank might swap € for $ with a

Canadian bank by agreeing to sell €1 million at a
price of 1$ = € 0.60 & to repurchase €1 million
a year later at a price of 1$ = € 0.70.
 This currency swap allows the German bank to
borrow $ & the Canadian bank to borrow €.

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 2.4
International Bond
Market

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International Bond Market
Bond markets can be divided into two broad groups:
(1) the domestic bond market, &
(2) the international bond market.
(1) The domestic bond market is comprised of all
securities issued in each country by “domestic”
government & corporate entities.
◦ In this case, issuers are domiciled (i.e., headquartered)
in the country where those bonds are traded.
(2) The international bond market is comprised of
non-residents borrowing in another country’s bond
markets
◦ The international bond market consists of two groups:
 (1) Foreign Bonds, &
 (2) Eurobonds.

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Foreign Bonds: Characteristics
Foreign Bonds are bonds issued by a non-resident &
denominated in the currency of the country in which
it is being placed (i.e., issued).
◦ Example: Ford Motor Corporation issuing a yen
denominated bond in Japan
Foreign bonds are subject to the regulations of the
country in which the bond is being offered.
Historically, the most important foreign bond
markets have been in Zurich, New York, & Tokyo.
◦ Zurich & Tokyo because of low market interest rates; New
York because of its large market.
Foreign bonds are often swapped out for another
currency.
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Eurobonds
Eurobonds are bonds issued by a non-resident &
denominated in other than the currency of the
country in which it is being placed.
◦ The bond’s currency of denomination is referred to as an
offshore currency.
◦ Example: Coca Cola issuing a U.S. dollar denominated
bond in Europe.
They are generally issued & sold simultaneously in
more than one market & thus the advantage of the
Eurobond market is that issuers can raise large sums
of capital from investors all around the world.
Issuers include national governments, supranational
organizations (such as the WB),“AAA”
corporations & global banks.
The U.S. dollar is the dominant currency of
denomination for Eurobonds.
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The Main Features of a Eurobond
Eurobonds are not regulated by the country of
the currency in which they are denominated.
Eurobonds are “bearer bonds”, i.e., they are not
registered anywhere centrally, so whomever
holds (or bears) the bond is considered as the
owner. Bearer status also enables Eurobonds to
be held anonymously.
The Eurobond market is largely a wholesale (i.e.,
institutional market) with bonds held by large
institutions (Pension funds, insurance
companies, mutual funds).

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The Main Features of a Eurobond…
Since they are denominated in an offshore
currency, investors in Eurobonds assume both
credit & foreign exchange risks (if the currency
of denomination is other than their home
currency).
Some publically offered Eurobonds trade on
stock exchanges, normally in London or
Luxembourg. Others are placed directly with
institutional investors without a listing (private
placement).

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Types of Eurobonds
Conventional or Straight Eurobonds have a fixed
coupon (usually paid on an annual basis) & maturity
date when all the principal is repaid.
Floating rate bond notes (FRN) are usually short to
medium term bond issues, with a coupon interest rate
that “floats,” i.e. goes up/down in relation to a
benchmark rate plus some additional “spread” of
basis points (each basis point being a hundredth of
1%).
◦ The reference benchmark rate is usually LIBOR
(London interbank offered rate) or EURIBOR (Euro
interbank offered rate).
◦ The “spread” added to that reference rate is a function of
the credit quality of the issuer.
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Types of Eurobonds…
Zero-coupon bonds do not have interest payments.
Convertible bonds can be exchanged for another
instrument, usually an ordinary share/shares (fixed
ahead with a predetermined price) of the issuer.
◦ The coupon payable is usually lower than it otherwise
would be. Because convertible bonds can be viewed
more as equity shares than bonds, the credit & interest
rate risks for investors are higher.
High-yield bonds a class of bonds (rather than a type
of bond) that individual investors may encounter.
◦ High-yield bonds are those that are rated to be “below
investment grade” by credit rating agencies (i.e. issuer has
a credit rating below BBB).
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Rise of the Euro-Bond Market
The Eurobond market offers several advantages
for borrowers that may account for its rising
popularity.
◦ (1) It gives borrowers access to a wider range of
lenders & debt instruments, enabling them to
diversify their sources of long-term funding.
◦ (2) In addition, the market provides a good
environment for internationally active companies
to hedge foreign currency exposures (through
offsetting liabilities)
◦ (3) Finally, through this market companies can
enhance their global profile.
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Bond Rating

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 2.5
Major Financial
Centers of the World

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Major Financial Centers of the World
Globalization of financial market started in the
1960s when world trade & MNCs started to
prosper.
Economic prosperity among industrial nations in
the 1980 & the rapid economic growth in
international capital flow transformed financial
markets.
The three most important financial centers in the
world at the moment include London, New york
and Tokyo.

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1. London
London is a financial center due to:
 Its leading position in Eurocurrency market
 The size of the foreign exchange market
 The international listing of foreign stock
 Excellent communication network
U.K. has adopted measures to strengthen
London's position in light of the emerging
European wide competition after 1992 &
European monitory union.

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2. New York
Based on the enormous size of the US company &
the participation of domestic & foreign financial
institutions, the New York financial market is the
largest in the world.
The adoption of SEC rule in 1990 has created
favorable environment for those offering
securities in New York market
This important step has helped the U.S. to
compete effectively with EuroBond Market.

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3. Tokyo
Tokyo become a major financial center in the
1990 as a result of:
 Strong Japanese economy
 High saving rate
 Continued trade surpluses
 Growth of direct & portfolio investment
worldwide
Recent competition has forced Japanese
government to readjust its policies toward the
market.

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Major Financial Centers of the World…
Other financial Centers include:
 Singapore
 Hong Kong
 Bahamas
Prerequisites to be a financial center
 Political stability
 Minimal government interventions
 Legal infrastructure
 Financial infrastructure

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Major Financial Crisis in the world…
The 1990 emerging countries crisis
 Mexico
 Brazil
The 1994 Asian countries crisis
 Thailand & other Asian countries
The 2008 Global financial crisis
 Totally destroyed Layman Brothers Bank
 Affected the world as a whole

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CHAPTER TWO

ENDS!
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