10. International Financial Environment – Fundamentals of International Business

CHAPTER 10

International Financial Environment

LEARNING OBJECTIVES

After reading this chapter, you should be able to:

  • Identify the characteristics of the international financial system
  • Explain the functioning of the foreign exchange market
  • Distinguish between foreign exchange risk and foreign exchange exposure
  • Discuss the structure and functions of the international capital market

VENEZUELA’S EXPERIMENTS WITH THE BOLIVAR

Venezuela is synonymous with economic crisis. The economy has shrunk by about a third in the past five years and the IMF expects GDP to contract by 15 per cent in the current year. Challenged by US sanctions and struggling to meet its obligations to international bondholders has led the country to continuous experiments with its exchange rate—the Sovereign Bolivar (code: VES).

The latest reform of the country’s foreign exchange system, is a policy move which has unified the formerly two-tiered exchange rate system that was established in March 2016. The dual exchange rate system was based on a highly subsidized ‘DIPRO’ rate operating alongside a quasi-liberalized ‘DICOM’ rate. The DIPRO rate had a current value of VES 10 to USD 1, and the DICOM rate, set at auction, stood at VES 3,345. The black-market rate, which is used by most people in Venezuela, had a rate of VES 235,782 bolivars to USD 1. The huge difference between these rates has fueled arbitrage and corruption, as the lucky few who had access to the official rates were able to buy dollars and import goods cheaply, to re-sell them at a handsome profit.

The new exchange rate regime has eliminated the preferential ‘DIPRO’ rate and mandated that all future foreign exchange transactions for the public and private sectors will be conducted at a renewed ‘DICOM’ rate. The reforms also include changes to the way the DICOM auctions are held, which could help push the new unified rate towards a more realistic level. The move is aimed at optimizing the foreign currency regime as a deep economic meltdown and a severe shortage of dollars has fuelled high inflation in the country.

Venezuela has had exchange controls in place since 2003. Since then, the country has devalued its official exchange rate four times and alternated between single and multiple exchange rate systems, including a four-tiered exchange system in 2015. As experienced in the past, the success of the latest reform depends on its ability to handle the official-parallel market rate mismatch and liquidity constraints in the system.

References: Bolívar rallies after Venezuela unifies exchange rates, https://www.ft.com; Venezuela, the Country With Four Exchange Rates, https://www.bloomberg.com, last accessed on15 October 2018.

INTRODUCTION

The international financial and monetary environment may be defined as the institutional framework within which international payments are made, national currencies are exchanged and cross currency exchange rates are determined. It is a complex system consisting of policies, institutions, practices, regulations and mechanisms. It includes the collective financial institutions that facilitate and regulate the flow of investment and capital funds worldwide. Its key players include national stock exchanges, commercial banks, central banks and finance ministries, in addition to specialized institutions such as the IMF and World Bank. The system has evolved over a period of time conditioned by both political and economic factors in the global economy. It has two broad components: the foreign exchange market and the international capital market.

INTERNATIONAL FINANCIAL SYSTEM

The international financial system consists of the activities of firms, banks and financial institutions engaged in different kinds of financial activities. Since the 1960s it has grown substantially in terms of volume and structure triggered by growth in world trade and investment activity, and aided by rapid developments in telecommunication and Internet technology. The large-scale liberalization of large parts of the developing world including India, the breakdown of the former Soviet Union and the opening up of China are among the factors responsible for the growth of global finance. The growing volume and changing structure of the international financial system can be attributed to the following factors:

  • The large-scale monetary and financial deregulation of the developing world.
  • The development of new technologies and payment systems and the use of the Internet in global financial activities.
  • Increased global and financial interdependence of financial markets.
  • The growing role of single-currency systems such as the euro.

The international financial system consists of two major components—foreign exchange markets and international capital markets.

These in turn consists of:

  • International money markets
  • International stock markets
  • International bond markets
  • International loan markets

Cross-border transactions of trade and investment occur through an exchange of currencies between buyers and sellers. A currency is a form of money and a unit of exchange. There are 175 currencies in the world today which are used for international trade and investment transactions between nations. This makes the world of international money somewhat complicated to understand. Therefore, we start with an overview of certain basic features of foreign exchange.

Foreign Exchange Markets

The word ‘market’ means a place where goods are offered for sale; and it also refers to the business of buying and selling a specified commodity. The ‘foreign exchange market’ is the place for buying and selling of currencies—for example, the Indian rupee (INR) is bought for another currency such as the USD. Since international business activity is conducted in different parts of the world, it needs the use and conversion of different currencies. The foreign exchange market enables the business of converting from one currency to another as per need and requirement.

 

Under the fixed exchange rate system, the monetary authority or the central bank of the country determines the value of foreign exchange.

Let us examine some commonly used terms in this context and understand what they mean.

Foreign exchange is the money of a foreign country in the form of bank notes, drafts and checks.

 

The exchange rate is said to be floating if it is determined by the free forces of demand and supply of the foreign exchange market.

A foreign exchange transaction is an agreement between a buyer and a seller for the delivery of a certain amount of one currency at a specified rate in exchange for some other currency.

 

The devaluation of a currency refers to a decline in the domestic currency value in terms of the foreign currency under a fixed exchange rate system. Revaluation is the upward movement or increase in the value of the domestic currency in terms of the foreign currency.

Foreign exchange rate is the price of domestic currency in terms of a foreign currency. For instance, the value of the Indian rupee in terms of the US dollar is INR 63.17 on 20 September 2017; but it may be INR 62.17 the next day. Exchange rates are expressed as real exchange rates, if they have been adjusted for inflation and as nominal exchange rates, if they have not.

Functioning of the Foreign Exchange Market

The foreign exchange market is the place where prices of currencies are fixed and decided. Just as the price of a commodity is fixed in the market for goods and services, the price of the exchange rate is also determined in the market for foreign exchange. The demand for a foreign currency is linked to payments for imports or for making investments abroad, by residents of the home country. The supply of foreign currency comes from export earnings and from investments into the home country by residents of other countries. However, sometimes governments or their central banks intervene in the foreign exchange market in order to satisfy certain domestic economy requirements.

 

Under the floating exchange rate system a decline in the domestic currency value in terms of the foreign currency is called depreciation and an upward movement or increase in the value of the domestic currency in terms of the foreign currency is called appreciation.

The foreign exchange market exists at two levels—the wholesale or interbank market and the retail or client market. The participants in these markets consist of international banks, bank customers, nonbank dealers, foreign exchange brokers and central banks.

  • International banks are the core of the foreign exchange market. Their primary function is to buy and sell foreign currency as their own business. International banks function by servicing their retail bank customers and also carry out interbank trade.
  • Bank customers include TNCs, money managers and private speculators as the retail clients of international banks. International banks help their clients in all kinds of transactions which require foreign exchange such as conducting foreign commercial activities or making foreign investments in financial and other assets.
  • Non-bank dealers consist of non-banking financial institutions such as investment banks, mutual funds, pension funds and hedge funds. They are independent players in the interbank market for foreign exchange and make up almost one third of the interbank trading volume.
  • Foreign exchange brokers are dealers who help to buy and sell currencies but do not take a direct position themselves. There are very few specialized broking firms in existence at present since most trading activity is done using electronic trading platforms.
  • Central Bank is the national monetary authority which intervenes in the foreign exchange market to influence the domestic currency price in terms of foreign currency. This is known as fixing or ‘pegging’ of currency. Intervention by the central bank may be done to manage the supply of domestic currency, to manage its foreign exchange reserves or to manage its exports or imports and through them the country’s balance of trade.

The global foreign exchange business is concentrated in four centres, which account for about two-thirds of all reported turnover. These are called the major trading centres at London, New York, Singapore and Tokyo. Other important trading centres, known as the secondary trading centres, are at Zurich, Frankfurt, Paris, Hong Kong, San Francisco, Toronto, Brussels, Bahrain and Sydney. The US dollar is the major trading currency, followed by the Deutsche mark and the Japanese yen. Due to differences in the world’s time zones, there are only three hours out of every 24 that the major centres—London, New York and Tokyo—are all shut down.

Foreign Exchange Rate Quotations

Foreign Exchange rates may be quoted in different ways—as are discussed here:

Direct and indirect quote: The foreign exchange rate is the price of one currency expressed in terms of another foreign currency, for example the Indian rupee in terms of the US dollar - INR/USD. The exchange rate can be expressed as a direct quote, which is the home currency price of a foreign currency unit (INR/USD), or as an indirect quote, which is the foreign currency price of a home currency unit (USD/INR).

Let us take an example: In the Indian context if we need INR 70 to buy USD 1, this would be expressed as a direct quote INR 40/USD 1; and as an indirect quote it would be USD 1/INR 40. Under a direct quote, an increase of the exchange rate for example INR 75/USD 1 is a depreciation of the home currency or appreciation of the foreign currency.

Bid and ask: A bid is the exchange rate in one currency at which a dealer will buy another currency. An ask is the exchange rate at which a dealer will sell another currency. The difference between the bid and the ask rate is known as the bid–ask spread. For widely traded currencies such as the US dollar, the euro, yen or pound, the spread varies between 0.5 and 0.8 per cent.

Spot and forward A spot rate is the exchange rate for a transaction that requires immediate delivery of foreign exchange (usually on the second business day). Spot rate currency quotations may be stated as either direct quotes or indirect quotes.

Spot rates quotations may also be in the form of American or European quotes.

An American quote is the price of the American dollar quoted in terms of a foreign currency. This is a direct quote from the American view point and is the conventional method of making a spot quotation. For example, the American term quote for the British pound in terms in terms of the dollar is:

S(£/ $) = 1.9077

A European quote is the price of the US dollar in terms of a foreign currency (an indirect quote from the US point of view). The corresponding European term quote for the same relationship is:

S(£/ $) = 0.5242

A forward rate is the exchange rate for a transaction that requires delivery of transactions at a specified future date (for example—30, 90 or 120 days). The forward rate may be quoted higher or lower than the spot rate. If it is quoted at a higher price, it is said be at a premium; and if it is quoted lower, it is said to be at a discount, as compared to the spot price. The forward rate can be in the form of either a direct quote or indirect quote.

A forward transaction occurs between a bank and a customer and calls for delivery of a specified amount of foreign exchange at a fixed future date. The exchange rate is established at the time of entering into the deal, but the payment and delivery are made at the time of maturity. Customers may buy a foreign currency forward from a bank (for example, in an import business) or may sell a foreign currency forward (as in an export bank). If the initial transaction represents an asset or future ownership claim to foreign currency, it is known as a long position. If the market position represents a liability or future obligation, the position is called a short position. Forward transactions are a form of financial transactions which help TNCs to avoid foreign exchange risks.

The general form of a forward quote is: FN(j/k), where FN is the price of one unit of currency ‘k’ in terms of currency ‘j’ for delivery in ‘N’ months.

For example, F1($/ £) = 0.8470 is the forward rate of the US dollar in terms of the British pound.

A swap is a simultaneous spot and forward transaction. For example, an Australian firm might need British pounds for 30 days, so it makes a spot transaction to exchange dollars for pounds and a simultaneous forward transaction to exchange the pounds for dollars in 30 days when its need for British pounds has ended.

Cross Exchange Rate Quotation

A cross exchange rate is an exchange rate between a currency pair where neither of the two currencies is the US dollar. The cross exchange rate can be calculated from the US dollar exchange rates for the two currencies using either the European or American term quotations.

For example, if 1 pound(£) costs $1.9077 and one euro(€) costs $1.3112, then the euro/pound (€/£) cross rate as an American quote would be:

Arbitrage

The term arbitrage refers to the act of simultaneously buying and selling the same or equivalent assets or commodities for the purpose of making certain guaranteed profits. The existence of an arbitrage opportunity means that the market is not in a state of equilibrium. The market reaches a state of equilibrium only when there are no more opportunities for arbitrage. Two well known arbitrage equilibrium conditions arise out of interest rate parity and purchasing power parity.

Interbank trading between international banks is often speculative or arbitrage oriented. Market psychology is the key driver in currency trading and dealers can infer the intention of other participants by the market position. Arbitrage transactions are driven by the attempt to make a profit from temporary differences in currency prices between competing dealers.

Arbitrage equilibrium conditions are represented by interest rate parity and purchasing power parity. We look at these in the next chapter.

Speculation and Hedging

Speculative and hedging transactions are vital for the efficient functioning of the derivatives market. A speculator is a market participant who attempts to make a profit from a change in the price of futures. In order to do this, the speculator takes either a long or a short position in a futures contract depending on his expectation of future price movement.

The hedger is a market participant who has a completely opposite philosophy and wants to avoid price variation. She/he therefore, takes either a long position in a futures contract or a short position in a sales price to lock in the price and avoid variation in price. The hedger, thus, passes off the risk of price variation to the speculator who is both able and willing to suffer this risk.

Functions of the Foreign Exchange Market

The foreign exchange market performs three major functions:

  1. It is part of the international payments system and provides a mechanism for exchange or transfer of the national currency of one country into the national currency of another, thereby facilitating international business.
  2. It assists in supplying short-term credits through the eurocurrency markets and swap arrangements.
  3. It provides foreign exchange instruments of hedging against exchange rate risk. Although most commercial banks handle actions for their clients, many banks also act as market-makers, with each prepared to deal with other banks at any time. This activity constitutes the interbank market, where portfolio positions are adjusted and exchange rates determined.

Bird’s-eye View

The international financial system consists of firms, banks and financial institutions engaged either in foreign exchange markets or in the international capital markets. The foreign exchange market deals with the price determination and issue of currencies and money. The capital market, through its various components, deals with the inter-mediation of foreign exchange between different parties in the global economy.

FOREIGN EXCHANGE RISK AND EXPOSURE

Foreign exchange risk is a critical issue in international business. Any company that operates in more than one market or currency area or has cash flows across nations will face foreign exchange risk and foreign exchange exposure, which are different but related concepts.

Foreign exchange risk: Concerns the variance or change in the domestic-currency value of an asset, liability or operating income that takes place due to unanticipated changes in exchange rates. This means that foreign exchange risk is not the unpredictability of foreign exchange rates themselves, but rather the uncertainty of values of a firm’s assets, liabilities or operating incomes owing to uncertainty in exchange rates. Therefore, volatility or fluctuation in exchange rates is responsible for exchange-rate risk only if it translates into volatility in real values of assets, liabilities or operating incomes.

 

Foreign exchange exposure refers to the sensitivity of changes in the real domestic-currency value of assets, liabilities, or operating incomes to unanticipated changes in exchange rates.

Foreign exchange risk in turn depends on foreign exchange exposure. A firm may not face foreign exchange risks unless it is ‘exposed’ to foreign exchange fluctuations. For example, General Electric (GE) and Hitachi both invest and operate in Mexico. Unlike Hitachi, which imports many parts for its production plants in Mexico, GE has built up its own supply base within Mexico. In this case, GE faces lower foreign exchange risks than Hitachi because GE is not exposed to fluctuations of the Mexican peso in the process of supply procurement.

Foreign exchange exposure: Refers to the sensitivity of changes in the real domestic-currency value of assets, liabilities or operating incomes to unanticipated changes in exchange rates. This means that exposure involves the extent to which the home currency value of assets, liabilities or incomes is changed by variations in exchange rates. The ‘real’ domestic currency value means the value that has been adjusted by the nation’s inflation. Domestic currency-denominated assets can be exposed to exchange rates if, for example, unanticipated depreciation of the country’s currency causes its central bank to increase interest rates.

 

Foreign exchange risk concerns the variance or change in the domestic-currency value of an asset, liability or operating income that takes place due to unanticipated changes in exchange rates.

The difference between foreign exchange risk and foreign exchange exposure is as follows:

  • Foreign exchange risk is the variability in the domestic currency price of an asset, liability or operating income caused by exchange rate fluctuations. Foreign exchange exposure, on the other hand, is the degree to which an asset, liability or income is affected by changes in foreign exchange rates.
  • Variability in foreign exchange rates leads to foreign exchange risk only if there is foreign exchange exposure. Foreign exchange exposure leads to foreign exchange risk only when exchange rates are unpredictable and keep changing.
  • Foreign exchange risk is a positive function of both foreign exchange exposure and the variance of unanticipated changes in exchange rates. Uncertainty of exchange rates does not mean foreign exchange risk for items that are not exposed. Similarly, exposure on its own will not lead to foreign exchange risk if exchange rates are perfectly predictable.
  • The levels of foreign exchange risk and exposure often differ between asset/liability items and operating income. Because current asset and current liability items, especially accounts receivable and payable, have fixed face value and are short-term oriented, they are extremely sensitive to the uncertainty of foreign exchange rates. Unlike these asset or liability items, operating incomes do not have fixed face values. Exposure of operating incomes depends not only on unexpected changes of exchange rates but also on such factors as the elasticity of demand for imports or exports, and the flexibility of production to respond to changes in exchange rate movements.

TNCs encounter three types of foreign exchange exposure:

  1. Transaction exposure
  2. Economic (or operating) exposure
  3. Translation (or accounting) exposure

Transaction exposure: Transaction exposure is the change in income levels as a result of changes in exchange rates for transactions that the business has already entered into, including the borrowing or lending of funds. It leads to a change in value of anticipated cash flows because commitments are subject to settlement at a later date. This essentially means that a business may realise a different amount than anticipated by it due to changes in the value of a currency for future settlements. Suppose for example an Indian exporter ships goods worth USD 2000 when the spot rate is USD 1 = INR 40. The settlement for this is equivalent to INR 80,000. On the day of settlement however, if the spot rate is USD 1 = INR 38, the exporter’s earnings are INR 76,000.

 

Transaction exposure is the change in income levels as a result of changes in exchange rates.

The exporter suffers a loss of INR 4,000 if he does not manage his exposure and risk properly.

Transaction exposure can arise on account of the following reasons:

  • Purchasing or selling goods and services on credit.
  • Borrowing or depositing funds denominated in foreign currencies.
  • Transacting a foreign-exchange contract.
  • Various transactions denominated in foreign exchange.

Economic exposure: Also called operating exposure, it refers to the change in the present value of the firm due to changes in the future operating cash flows caused by unexpected changes in exchange rates and macroeconomic factors. The change in value depends on the effect of the exchange rate change on future sales volume, prices or costs. In contrast to transaction exposure, which is concerned with pre-existing cash flows that will occur in the near future, economic exposure emphasizes expected future cash flows that are likely to be affected by unanticipated changes of exchange rates and macroeconomic conditions such as unexpected changes in interest rates and inflation rates. Some of the factors affecting economic exposure are:

 

Economic exposure, also called operating exposure, refers to the change in the present value of the firm due to changes in the future operating cash flows caused by unexpected changes in exchange rates and macroeconomic factors.

  • Export orientation: The higher an economy’s export orientation, the more it is likely to be affected by changes in exchange rate.
  • Pricing flexibility: This refers to the ability of the firm’s ability to raise its foreign currency selling price by a large enough margin to be able to preserve its profit margin in the case of foreign currency depreciation. This in turn depends on price elasticity of demand.
  • Production/outsourcing flexibility: This refers to the TNC’s ability to shift production and outsourcing of inputs among different nations. TNCs with worldwide production systems can cope with currency changes by shifting production to a low-cost locations.

Translation exposure: Translation exposure is associated with the accounting process followed by a TNC. Foreign financial statement translation is a two-step process. First, the accounts must be made consistent by being restated according to the same accounting principles (for example, Australian or American), such as those relating to the valuing of inventories and assets, and determining depreciation. After the basis of the accounts has been adjusted for consistency, the foreign currency amounts in the results are converted into the reporting or home currency.

Translation must not be confused with conversion. Translating is merely the restating of currencies, while conversion refers to the actual physical trade or exchange of units of one currency for another. There are four methods of translating statements to the reporting or home currency:

  1. The current rate method
  2. The temporal method
  3. The monetary-non-monetary method
  4. The current-non-current method

Bird’s-eye View

Foreign exchange transactions involve risk and exposure. Foreign exchange risk refers to the possibility of change in the value of assets or incomes due to the changes in the exchange rate. Foreign exchange exposure is the degree of change in asset or income values associated with changes in foreign exchange rates.

International Capital Market

A capital market is the place where investors and borrowers meet, generally with the assistance of brokers. Investors may be individuals, companies or institutions—such as insurance companies, superannuation funds and the like—who have money to invest. Borrowers may be individuals, companies or governments who need money to create goods and services needed by society. Brokers in the capital market may be financial institutions such as the short-term money market, life insurance offices, building societies, finance companies, credit unions, savings and trading banks, commercial banks (for example, National Australia, Westpac, Dresdner, Citibank) and investment banks (for example, Bankers Trust, Rothschild, Merrill Lynch).

 

A capital market is the place where investors and borrowers meet, generally with the assistance of brokers.

The function of a capital market is of course to provide capital (that is, money) and the cost of this capital is called interest. However, money may be loaned in two forms, only one of which attracts interest. This form is a debt loan in which the borrower pays interest at some agreed rate at particular times (for example, monthly or annually). The interest must be paid regardless of whether or not the borrower has made a profit. Debt loans may be cash loans from banks or funds raised through the sale of corporate or government bonds. Interest is paid on the bonds until their maturity date.

The other way of raising money through the capital market is in the form of equity, which relates to the sale of a company’s shares. A share entitles the holder to a claim on the firm’s profits, which are known as dividends. Dividends are like interest paid on a debt loan, but they do not carry a guarantee. Dividends are subject to the dividend policy of the company: they may or may not be paid each year, and the rate is likely to vary according to the company’s profits. The international capital market has the following characteristic features:

  • The global capital market could not exist, nor could it have grown as it has, without modern communication technology. Technology has had several consequences in this respect:
    • Twenty-four-hour trading is possible.
    • All players have instant access to movements in the market.
    • An event in one place has the potential to cause a reaction around the world.
  • The world’s history and geography both have an impact on the location of major trading centres. London is the busiest trading centre because it was the economic hub of the former British Empire. It is still a hub for British companies with massive investments around the globe. London also is a convenient link between Europe to the east and America to the west. New York is a major centre because of the underlying strength of the US economy and because it is thebase for many US companies with overseas investments. Tokyo’s importance reflects the post-World War II growth of the Japanese economy and the strength of its currency.
  • The third and last point in this trio is the composition of the financial institutions in the global capital market. The major banks in the market are not just British, American and Japanese. Germany and France are also major players.

International Money Markets

International money markets are those in which foreign money is financed or invested. TNCs use international money markets to finance global operations at lower cost than is possible domestically. They borrow currencies that have low interest rates and are expected to depreciate against their own currency. They incur the risk that the currencies borrowed may appreciate, however, which will increase their cost of borrowing. Investors, on the other hand, may achieve substantially higher returns in foreign markets than in their domestic markets when investing in currencies that appreciate against their home currency.

 

The eurocurrency market is a short-term market for bank deposits and loans denominated in any currency except that of the country where the market is located.

Firms often conduct transactions in the money market through the eurocurrency market, which is a largely short-term market for bank deposits and loans denominated in any currency except that of the country where the market is located. In London, for example, the eurocurrency market is a market for bank deposits and loans denominated in dollars, marks, yen and any other currency except British pounds. In Paris, the market deals in dollars, marks, yen, pounds and every currency except the euro. The banks offering eurocurrency services are either local banks or foreign bank subsidiaries in a host country. Growing international trade and capital flows as well as cross-border differences in interest rates are the primary reasons for the growth of the eurocurrency market. Similarly, the eurobond market is a long-term market for bonds denominated in any currency except the currency of the country in which the market is located. The eurobond market is the long-term counterpart to the eurocurrency market.

International Bond Markets

Money is a financial claim on current goods; bonds are a financial claim on future goods. For example, if you hold USD 100 in cash for one year, at any time during the year you have only USD 100. However, if you forego the right to purchase goods during the year and hold USD 100 worth of bonds for one year, at the end of the year you receive USD 100 plus some nominal rate of interest. That will suffice for our purposes: to go further would involve the theory of open economies in which money, goods and bonds interact to produce equilibrium.

The bond is a traditional form of lending, and theoretically anyone may issue bonds. In most countries bonds are typically issued by governments and the term ‘government securities’ is a synonym for bonds. Bonds may carry varying interest rates, but the most common type of bond is the fixed-rate bond.

Two types of bonds are of interest to us in this chapter:

Foreign bonds are bonds sold outside the issuer’s country and are denominated in the currency of the country in which they are issued. Bonds issued in Britain are called bulldog bonds; bonds issued in Japan are called samurai bonds, bonds issued in the US are called Yankee bonds and bonds issued in Australia are called kangaroo bonds.

Eurobonds are a bond issued in countries other than the one in whose currency the bond is denominated. The eurobond market grew rapidly during the 1980s largely as a result of the deregulation of financial markets. Interest and principal on eurobonds has typically been payable in US dollars. However, the weakening of the dollar in 1985 caused a shift out of dollars toward euro–yen and euro–deutschemark issues.

 

Eurobonds are a bond issued in countries other than the one in whose currency the bond is denominated.

International Stock Markets

A stock exchange is a facility for the trading of securities and other financial instruments. The traded securities include the shares issued by companies, trust funds and pension funds, as well as corporate and government bonds. Stock exchanges are a major source of funds for firms to engage in international business. Information technology has revolutionized the functioning of stock markets/equity markets, providing huge advances in speed and cost of transactions. Today, most stock exchanges are electronic networks not necessarily tied to a fixed location.

Each country sets its own rules for issuing and redeeming stock. Trade on a stock exchange is by members only. For example, the Tokyo Stock Exchange (TSE) is the home stock market to firms such as Toyota, Sony and Canon. The TSE is the major vehicle through which some 2,000 Japanese firms raise capital to fund their business activities. Several foreign companies, such as BP and Chrysler, are also listed on the TSE. Today, TNCs often list on a number of exchanges worldwide to maximise their ability to raise capital. The character of markets varies worldwide. For example, corporations hold the majority of the shares in the Japanese market, while in Britain and the US shares are held much more by individuals. Despite these differences, stock exchanges are being increasingly integrated into a global securities market.

CHAPTER SUMMARY
  • The international financial and monetary system consists of policies, institutions, practices, regulations and mechanisms that determine foreign exchange rates. Its key players include national stock exchanges, commercial banks, central banks and finance ministries in addition to specialized institutions.
  • Exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another.
  • Foreign exchange risk and exposure are two related yet distinct concepts. Foreign exchange risk is the change in domestic currency values of assets, liabilities and income caused by a sudden, unpredictable change in exchange rates. The extent of foreign exchange risk faced by a firm depends on its level of foreign exchange exposure. Foreign exchange exposure refers to the sensitivity of changes in the home-currency value of an asset, liability or income to unanticipated changes in exchange rates. Risk is an increasing function of exposure and the variance of unanticipated changes in exchange rates.
  • TNCs encounter three types of foreign exchange exposure—transaction exposure, translation (accounting) exposure, and economic (operating) exposure.
  • Transaction exposure can be hedged through financial instruments such as forward and options and production initiatives such as input sourcing.
  • Economic exposure refers to the change in the present value of the firm due to changes in the future operating cash flows caused by unexpected changes in exchange rates and macroeconomic factors.
  • In the case of translation exposure, there are four methods of translating statements to the reporting or home currency—current rate method, temporal method, monetary-non-monetary method, and current-non-current method.
KEY TERMS
  • Foreign exchange rate
  • Foreign exchange transaction
  • Bid
  • Spot rate
  • Forward rate
  • Swap fixed exchange rate system
  • Floating exchange rate system
  • Currency board arrangement
  • Crawling peg system
  • Managed float
  • Target-zone arrangement
  • Currency convertibility
  • Currency crisis
  • Capital market
  • Eurocurrency
  • Eurobond
DISCUSSION QUESTIONS
  1. List and explain the constituents of the international financial market. How do they affect the working of the global business environment?
  2. Distinguish between:
    1. Direct and indirect quote
    2. Bid and ask rate
    3. Spot and forward rate
  3. What is foreign exchange risk? How is it different from foreign exchange exposure?
  4. Explain the following concepts with clear calculations:
    1. Transaction exposure
    2. Economic exposure
    3. Translation exposure
EXAMINATION QUESTIONS
  1. Distinguish between: (7, 7)
    1. Fixed and flexible exchange rate systems
    2. Foreign exchange risk and foreign exchange exposure

      [B.Com (Hons.), 2010, 2012]

  2. What are the different functions of the foreign exchange market? Distinguish between foreign exchange risk and foreign exchange exposure. (7)

    [B.Com (Hons.), 2009, 2012, 2018]

  3. Write short note on ‘floating exchange rate system’. (5)

    [B. Com (Hons.), 2014]

  4. Write a short note on exchange rates. (7)

    [B.Com (Hons.), 2016]

  5. Give a brief account of foreign exchange risks. How are these risks managed? (7, 8)

    [B.Com (Hons.), 2015]

  6. Describe the important functions of the foreign exchange market. What are the different types of foreign exchange markets? (7)

    [B.Com (Hons.), 2017]