30 Questions
Why do borrowers borrow in foreign markets?
To capitalize on lower foreign interest rates and when they expect foreign currencies to depreciate against their own.
How can MNCs reduce exchange rate risk when borrowing funds for their subsidiaries?
By having the subsidiary borrow funds locally.
What is the role of large commercial banks in the foreign exchange market?
They serve the market by holding inventories of each currency.
What is an exchange rate?
An exchange rate specifies the rate at which one currency can be exchanged for another.
What system did the exchange of foreign currencies evolve from?
The gold standard.
When did the gold standard era end?
The gold standard was suspended when World War I began in 1914.
What is the primary function of banks in the Asian dollar market?
Channeling funds from depositors to borrowers.
Explain the difference between a call option and a put option in the context of currency trading.
Call option gives the right to buy a specific currency at a specific price, while put option provides the right to sell a specific currency at a specific price.
What distinguishes options contracts from forward or futures contracts in terms of flexibility?
Options contracts do not require any obligation, allowing the firm to choose whether or not to exercise the option.
What are Eurodollars?
U.S. dollar deposits placed in banks in Europe and other continents.
How did the Eurocurrency market evolve in response to U.S. regulations on banks?
It grew to accommodate increasing international business and to bypass stricter U.S. regulations on banks.
What role does the Eurocurrency market play in recycling oil revenues from oil-exporting countries?
Historically, it has recycled oil revenues (petrodollars) from oil-exporting (OPEC) countries to other nations.
What are Eurocredit loans?
Loans of one year or longer extended by Eurobanks to MNCs or government agencies in the Eurocredit market.
How are international bonds classified?
International bonds are classified as foreign bonds or Eurobonds.
What distinguishes Eurobonds from Eurocurrency?
Eurobonds are any bonds denominated in a currency different from the country where they are issued, while Eurocurrency refers to any currency held on deposit outside its country of origin.
How are eurobonds categorized?
Eurobonds are categorized based on the currency in which they are denominated.
What types of bonds are included in the Eurobond market?
Bonds denominated in a currency other than that of the country in which they are issued.
Explain the use of floating rates in Eurocredit loans.
Floating rates are used in Eurocredit loans due to the mismatch in Eurobanks' asset and liability maturities.
What is a samurai bond?
A yen-denominated bond issued in Japan by a foreign entity, such as an American company.
What are the characteristics of a foreign bond?
- Issued by a foreign entity. 2. Traded on a foreign market. 3. Denominated in a foreign currency.
How do global bonds differ from eurobonds?
Global bonds can be offered in the country whose currency is used to denominate the bond, while eurobonds are issued and traded in a country other than the currency's denomination.
What is a eurobond?
A bond issued and traded in a country other than the one in which its currency is denominated.
What is a key risk associated with holding foreign bonds?
Currency risk due to fluctuations in exchange rates.
How does a global bond denominated in yen differ from a eurobond?
A global bond denominated in yen can be sold in Japan or any country through the Eurobond market, while a eurobond is issued and traded in a country different from the currency denomination.
What is the main difference between Eurobonds and foreign bonds in terms of underwriting and regulations?
Eurobonds are underwritten by an international syndicate and are not subject to any country's regulations, while foreign bonds are underwritten in the country of currency denomination and are subject to that country's regulations.
How did the 1963 Interest Equalization Tax in the U.S. contribute to the emergence of the Eurobond market?
The tax discouraged U.S. investors from investing in foreign securities, prompting non-U.S. borrowers to seek funds elsewhere.
What significant change in U.S. regulations in 1984 impacted the issuance of Eurobonds?
In 1984, U.S. corporations were allowed to issue bearer bonds directly to non-U.S. investors, and the withholding tax on bond purchases was abolished.
How are Eurobonds usually issued, and what features do they commonly have?
Eurobonds are usually issued in bearer form, pay annual coupons, may be convertible, and may have variable rates.
Why do interest rates in the Eurobond market vary among currencies?
Interest rates vary due to changing credit conditions and other market factors, influencing the popularity of the market for each currency.
What is the approximate percentage of Eurobonds denominated in U.S. dollars?
About 70% of Eurobonds are denominated in the U.S. dollar.
Study Notes
Motives for Using International Financial Markets
- Borrowers borrow in foreign markets to capitalize on lower foreign interest rates and when they expect foreign currencies to depreciate against their own.
- Multinational Corporations (MNCs) can reduce exchange rate risk by having the subsidiary borrow funds locally to support its business.
Foreign Exchange Market
- The foreign exchange market allows for the exchange of one currency for another.
- Large commercial banks serve this market by holding inventories of each currency.
- An exchange rate specifies the rate at which one currency can be exchanged for another.
History of Foreign Exchange
- From 1876 to 1913, exchange rates were dictated by the gold standard.
- Each currency was convertible into gold at a specified rate.
- The gold standard was suspended during World War I and abandoned in the 1920s due to the Great Depression.
Options Contracts
- Options contracts can be classified as calls or puts.
- Call option: the right to buy a specific currency at a specific price (strike price or exercise price) within a specific period of time.
- Put option: provides the right to sell a specific currency at a specific price within a specific period of time.
- Options contracts offer more flexibility than forward or futures contracts because they do not require any obligation.
International Money Markets
- The European Money Market, the Asian Money Market, and the Eurocurrency Market are key international money markets.
- The Eurocurrency market grew in the 1960s and 70s to accommodate increasing international business and bypass stricter U.S. regulations on banks.
- Eurocurrency market: U.S. dollar deposits placed in banks in Europe and other continents are called Eurodollars.
- Eurobanks accept deposits and provide loans in various currencies.
International Credit Market (Eurocredit Market)
- Loans of one year or longer are extended by Eurobanks to MNCs or government agencies in the Eurocredit market.
- These loans are known as Eurocredit loans.
- Floating rates are commonly used, since the banks' asset and liability maturities may not match.
International Bond Market (Eurobond Market)
- There are two types of international bonds:
- Foreign bonds or parallel bonds: denominated in the currency of the country where they are placed but issued by borrowers foreign to the country.
- Eurobonds: sold in countries other than the country represented by the currency denominating them.
- Global bonds: structured so that they can be offered in both foreign and eurobond markets.
Characteristics of Foreign Bonds
- Issued by a foreign entity (such as a government, municipality, or corporation).
- Traded on a foreign market.
- Denominated in a foreign currency.
- Subject to currency risks due to exchange fluctuations.
Characteristics of Eurobonds
- Issued and traded in a country other than the one in which its currency is denominated.
- Underwritten by an international syndicate and not subject to the rules and regulations of any country.
- Can be issued in bearer form, pay annual coupons, may be convertible, and may have variable rates.
Eurobond Market
- Emerged partially due to the 1963 Interest Equalization Tax imposed in the U.S.
- About 70% of the Eurobonds are denominated in the U.S. dollar.
- Interest rates for each currency and credit conditions in the Eurobond market change constantly.
Test your knowledge on motives for using international financial markets and the functioning of the foreign exchange market. Learn about borrowing in foreign markets to capitalize on lower interest rates and reduce exchange rate risk.
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