INTERNATIONAL_FINANCIAL_MARKETS.pdf

Chapter 3: International Financial Markets
International Financial Management
BBA 8th Semester (Finance)
Department of Business Administration
Premier University

Due to growth in international business over the last 40 years,
various international financial markets have been developed.
Financial managers of MNCs must understand the various
international financial markets that are available so that they can use
those markets to facilitate their international business transactions.
Foreign Exchange Market:
Definition: The foreign exchange market or the ‘forex
market’ is a system which establishes an international
network allowing the buyers and sellers to carry out
trade or exchange of currencies of different countries. A
forex market can be stated as one of the most liquid
financial markets which facilitate ‘over-the-counter’
exchange of currencies.
Asst. Prof. Rajib Datta, Finance, PUC 2

Participants in the Foreign Exchange Market
The participant here refers to the people involved in the exchange or
trade of foreign currency. These can be the buyers, sellers or the
intermediaries. The participants in a forex market include the
following five parties:

 Central Bank: The central bank regulates the
exchange rates of the currency of their respective
country to ensure fluctuations within the desired
limit and keep control over the money supply in the
market.
 Commercial Banks: The commercial banks are the
medium of forex transactions, facilitating
international trade and exchange to its customers
along with other forex functions like making foreign
investments.

 Traditional Users: The traditional users involve foreign tourists,
companies carrying out business operations across the globe,
patients taking treatment in other country’s hospitals and students
studying abroad.
 Traders and Speculators: The traders and speculators are the
opportunity seekers and look forward to making a profit through
trading on short-term market trends.
 Brokers: They are considered to be financial experts who act as
an intermediary between the dealers and the investors by
providing the best quotations.

Characteristics of the Foreign Exchange Market
To understand what a forex market is, we must first go through its
essential features. Discussed below are the various characteristics
of the foreign exchange market which differentiates it from other
financial markets:
 Market Transparency: It is effortless to monitor the fluctuations
in the value of currencies of different countries in a forex market
easily through account tracking and real-time portfolio, without
the involvement of brokers.
 Dollar is Extensively Traded Currency: The USD, which is
paired with almost every country’s currency and listed on the
forex, is the most widely traded currency in the world.

 Most Dynamic Market: The value of the currencies in the forex
market keeps on changing every second and function twenty-four
hours a day. This makes it one of the most active markets in the
world.
 International Network of Dealers: The foreign exchange market
establishes a medium among the dealers and also with the
customers. There are dealer’s institutions located globally to carry
out the exchange and trading activities.
 “Over-The-Counter” Market: In different countries, the forex
market is the highly unregulated market initiating over the counter
trade by the banks through telex and telephone and social media.

 High Liquidity: The currency is considered to be the
most widely traded financial instrument across the globe,
making the forex market highly liquid.
 Twenty-Four Hour Market: The foreign exchange
market is operational for twenty-four hours of the day,
initiating the active trade and exchange of currencies at
any time.

Transactions in Foreign Exchange Market
A forex market performs three significant operations which
are explained in detail below:

❑ Spot Market Transactions
The forex transactions which are executed immediately, or usually
within two days, is known as the spot transaction. Such a forex
market is termed as a spot market, and the rate of exchange is
called a spot rate.
❑ Futures Market Transactions
The market in which the exchange of currencies involves a future
delivery and payment and the rate of exchange for the same is pre-
determined is called a futures forex market. Such exchange rate is
known as a future rate. It protects the buyer from the risk of a rise
in the value of the currency.

❑ Forward Market Transactions
A forward forex market is however very similar to the futures market, but here, the
terms of the contract are negotiable and can be amended by any of the parties
involved.
 Options: In an options contract, the holder is not bound to but have the right to
buy or sell the specified asset quantity at the pre-determined price on the
specific future.
 Futures: In a future contract, the quantity of an asset, date of execution and
price of the contract is fixed and standardized.
 Swap: Usually, commercial banks adopt swap contracts if they perform forward
exchange business operations. Here, they sell off a particular currency in the
spot market to buy that same currency in the forward market.
 Arbitrage: The rigorous buying and selling of different currencies in the forex
market to fetch gains out of such transactions are called arbitrage.

Foreign Exchange Quotations
Currencies are quoted in terms of other currencies means exchange
rate is a relative price. FE quotation is the amount of currency
that is exchanged for a unit of other currency.
At any given point in time, the exchange rate between two
currencies should be similar across the various banks that
provide foreign exchange services. If there is a large
discrepancy, customers or other banks will purchase large
amounts of a currency from whatever bank quotes a relatively
low price and immediately sell it to whatever bank quotes a
relatively high price. Such actions cause adjustments in the
exchange rate quotations that eliminate any discrepancy.

Bid/Ask Spread of Banks
Commercial banks charge fees for conducting foreign
exchange transactions; they buy currencies from
customers at a slightly lower price than the price at
which they sell the currencies. At any given point in
time, a bank’s bid (buy) quote for a foreign currency
will be less than it’s ask (sell) quote. The bid/ask =
spread represents the differential between the bid and
ask quotes and is intended to cover the costs involved in
accommodating requests to exchange currencies. The
bid/ ask spread is normally expressed as a percentage of
ask quote.

Comparison of Bid/Ask Spread among Currencies
The differential between a bid quote and an ask quote will
look much smaller for currencies that have a smaller
value. This differential can be standardized by measuring
it as a percentage of the currency’s spot rate.
A common way to compute the bid/ask spread in
percentage terms follows:
Bid/ask Spread = Ask rate - Bid rate/Ask rate

Direct versus Indirect Quotations
The quotations of exchange rates for currencies normally
reflect the ask prices for large transactions. Since
exchange rates change throughout the day, the exchange
rates quoted in a newspaper reflect only one specific
point in time during the day.
Quotations that represent the value of a foreign currency in
dollars (number of dollars per currency) are referred to
as direct quotations. Conversely, quotations that
represent the number of units of a foreign currency per
dollar are referred to as indirect quotations. The indirect
quotation is the reciprocal of the corresponding direct
quotation.

Example
 The spot rate of the euro is quoted this morning at $1.031. This is
a direct quotation, as it represents the value of the foreign currency
in dollars. The indirect quotation of the euro is the reciprocal of
the direct quotation:
Indirect quotation = 1/Direct quotation
=1/$1.031
=.97; which Means .97 eurors = $1
If you initially received the indirect quotation, you can take the
reciprocal of it to obtain the direct quote. Since the indirect
quotation for the euro is .97, the direct quotation is:
Direct quotation = 1/Indirect quotation
= 1/.97; = $1.031

Cross Exchange Rate
The cross rate refers to the exchange rate between two currencies,
each of which has an exchange rate quote against a common
currency. A cross rate is an exchange rate of two currencies
expressed in a third different currency.
Most tables of exchange rate quotations express currencies relative to
the dollar, but in some instances, a firm will 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
wants to know the Mexican peso value relative to the Canadian
dollar. The type of rate desired here is known as a cross exchange
rate, because it reflects the amount of one foreign currency per unit
of another foreign currency. Cross exchange rates can be easily
determined with the use of foreign exchange quotations. The value
of any non-dollar currency in terms of another is its value in dollars
divided by the other currency’s value in dollars.

Example
If the peso is worth $.07, and the Canadian dollar is worth $.70, the
value of the peso in Canadian dollars (C$) is calculated as
follows:
Value of peso in C$ = Value of peso in $/Value of C$ in $ =
$.07/$.70 =C$.10
Thus, a Mexican peso is worth C$.10. The exchange rate can also be
expressed as the number of pesos equal to one Canadian dollar.
This figure can be computed by taking the reciprocal: .70/.07 =
10.0, which indicates that a Canadian dollar is worth 10.0 pesos
according to the information provided.

Functions of Foreign Exchange Market
A foreign exchange market is the largest global financial market
which performs some crucial functions. The three of the primary
functions of a forex market are as follows:
Asst. Prof. Rajib Datta, Finance, PUC
19

 Hedging Function: The globally trading business entities can
hedge the risk of currency fluctuations by adopting means like a
letter of credit or forward contract. Here, the goods are to be
delivered on a pre-determined future date and at a mutually
agreed price.
 Transfer Function: The forex market majorly functions to
exchange the currency of one country into that of other, to
facilitate international trade activities.
 Credit Function: Providing the credit facility at the time of
making overseas payments through foreign bill of exchange to its
maturity or execution, is another significant function of the forex
market.
Functions of Foreign Exchange Market

Advantages of Foreign Exchange Market
As we know that ‘trade makes everyone better-off’ and so goes for the exchange or
trade of currencies. Let us now discuss the various benefits of the foreign
exchange market:
 High Leverage: A forex investor can avail the facility of leverage or loan of up
to 20 or 30 times of his/her capacity, for trading in the forex market.
 International Trade: Every country has its currency and therefore, to facilitate
trade activities between two countries, the forex market is essential.
 Trading Option: For the speculators or traders, foreign exchange market is just
like other financial markets where they can make money on short term
fluctuations in the currencies.
 Flexibility: We know that the forex market is a twenty-four-seven market, and
there is no minimum or maximum limit of the exchange amount. It provides the
flexibility of investment or exchange to the traders.

 Hedging Risk: The forex market provides for hedging the risk of
loss on currency fluctuations while carrying global business
operations and trading in foreign currency.
 Low Transaction Costs: Since brokers are not very much
entertained in the forex market, the transaction cost (called as
‘spread’) charged by the dealers is reasonably low if compared to
other financial markets.
 Inflation Control: To maintain the economic stability in the country
and control situations like inflation, the central bank maintains a
forex reserve which consists of currencies of different countries
around the world.
It adopts other means too, like decreasing bank lending rates and selling
out domestic currency for foreign currency.
Advantages of Foreign Exchange Market

Disadvantages of Foreign Exchange Market
A forex market is not always favorable and involves various kinds of risks.
These can be seen as its drawbacks and are elaborated below:
 Leverage Risks: Leverage refers to loan in other terms. Forex market
initiates the leverage of up to 20 to 30 times the investment capacity of
the traders or speculators, which may even lead the loss of the entire
amount of the investor.
 Counterparty Risks: The forex is highly unregulated with no central
authority for currency exchange or trading risk mitigation. Thus, it may
encounter the risk of non-fulfilment of the obligations by any of the
parties involved in such a contract.
 Operational Risks: Since forex is a twenty-four hours market, it is
difficult to manage its operations by humans. As a result, the traders and
MNCs rely on the algorithms, and trading desks spread, respectively, to
safeguard their investment in their absence.

Note
The countries which actively participate in the forex trading includes
US, UK, Australia, Germany, Switzerland, France, Italy, Japan,
Indonesia, Cyprus, Malta, Bulgaria, Romania and many Central
and Eastern Europe countries.
In countries like China, South Africa, Nigeria, Russia, Egypt and
Ukraine, forex trading is allowed but under the restrictions of the
central government.
However, in India, Bosnia Herzegovina, Israel, Belgium, Malaysia,
North Korea, France and Pakistan, forex trading is strictly
prohibited.

The International Money Market
The international money market is a market where international
currency transactions between numerous central banks of countries
are carried on. The transactions are mainly carried out using gold
or in US dollar as a base. The basic operations of the international
money market include the money borrowed or lent by the
governments or the large financial institutions.
The international money market is governed by the transnational
monetary transaction policies of various nations’ currencies. The
international money market’s major responsibility is to handle the
currency trading between the countries. This process of trading a
country’s currency with another one is also known as forex
trading.

Unlike share markets, the international money market sees
very large funds transfer. The players of the market are
not individuals; they are very big financial institutions.
The international money market investments are less
risky and consequently, the returns obtained from the
investments are less too. The best and most popular
investment method in the international money market is
via money market mutual funds or treasury bills.
The International Money Market

International Credit Market
A marketplace for the exchange of debt securities
and short-term commercial paper. Companies
and the government are able to raise funds by
allowing investors to purchase these debt
securities.

International Bond Market
International bonds are bonds issued by a country or
company that is not domestic for the investor. The
international bond market is quickly expanding as
companies continue to look for the cheapest way to
borrow money. By issuing debt on an international scale,
a company can reach more investors. It also potentially
helps decrease regulatory constraints.

Three Categories of International Bonds
 Domestic bonds: Issued, underwritten and then traded with the
currency and regulations of the borrower’s country.
 Eurobonds: Underwritten by an international company using
domestic currency and then traded outside of the country’s
domestic market.
 Foreign bonds: Issued in a domestic country by a foreign
company, using the regulations and currency of the domestic
country.

International Stock Market
Stocks are financial assets that indicate ownership in a
company. The international stock market refers to all
the international markets that negotiate stocks from
their domestic companies.

Foreign Cash Flow Chart of a Multinational Corporation (MNC)
Asst. Prof. Rajib Datta, Finance, PUC
31

Thank You All
To the Students:
To learn more regarding the contents of this chapter the students
are suggested to read the following book- International
Financial Management (13th Edition) by- Jeff Madura.

INTERNATIONAL_FINANCIAL_MARKETS.pdf

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