International Business: A Managerial Perspective PDF

International Business: A Managerial Perspective Ninth Edition, Global Edition Chapter 8 Foreign Exchange and International Financial...

International Business: A Managerial Perspective Ninth Edition, Global Edition Chapter 8 Foreign Exchange and International Financial Markets Slides in this presentation contain hyperlinks. JAWS users should be able to get a list of links by using INSERT+F7 Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Learning Objectives 8.1 Understand what is the exchange rate 8.2 Understand the basics on the Evolution of the international monetary system 8.3 Identify and understand the Factors that determine foreign exchange rate 8.4 recognize the world Capital markets 8.5 Understand strategic responses to foreign exchange Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Economics of Foreign Exchange Foreign exchange: a commodity that consists of currencies issued by countries other than one’s own. Price of foreign exchange: set by demand and supply in the marketplace. (given a flexible exchange rate system) Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Gold Standard (1870–1914) The gold standard was a system in place between 1870 and 1914, when the value of most major currencies was maintained by fixing their prices in terms of gold. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Bretton Toward the end of Woods World WarSystem (1944–1973) II, at an allied conference in Bretton Woods, New Hampshire, a new system—known simply as the Bretton Woods system—was agreed upon by 44 countries. The Bretton Woods system was centered on: - US dollar as the new common denominator. - All currencies were pegged at a fixed rate to the dollar. - Only the dollar, as the official reserve currency, was convertible into gold at $35 per ounce. Other currencies were not required to be gold convertible. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Post–Bretton Woods System (1973–present) ▪ In August 1971, in order to stop such hemorrhaging of gold , President Richard Nixon unilaterally announced that the dollar was no longer convertible into gold. ▪ Major countries collectively agreed to hammer the coffin nails of the Bretton Woods system by allowing their currencies to float in 1973 Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Economics of Foreign Exchange: Foreign Exchange Rate Quotes Direct Exchange Rate (or Direct Quote) is the price of the foreign currency in terms of the home currency. US$/KD = 0.3 KD Indirect Exchange Rate (or Indirect Quote) is the price of the home currency in terms of the foreign currency. KD/US$= 3.3 US$ Copyright © 2020 Pearson Education Ltd. All Rights Reserved.  Determinants of Foreign Exchange Rates ❑Basic supply & demand ❑Relative price differences & PPP ❑Interest rates & money supply ❑Productivity and BoP ❑Exchange rate policies – Floating – Fixed (politically & Economically) ❑Investor Psychology Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Economics of Foreign Exchange: Demand for Yen Figure 8.1 The Demand for Japanese Yen is Derived from Foreigners’ Demand for Japanese Products. As the price of the yen falls, the quantity of yen demanded increases Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Economics of Foreign Exchange: Supply of Yen Figure 8.2 The Supply of Yen is Derived from Japanese Demand for Foreign Products. As the price of the yen rises, the quantity supplied also rises Copyright © 2020 Pearson Education Ltd. All Rights Reserved. The Economics of Foreign Exchange: The Market for Yen Figure 8.3 The Market for Yen Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market (1 of 2) Volume of foreign-exchange trading is estimated at $5.1 trillion per day The largest foreign-exchange market: London, followed by New York, Singapore, Hong Kong, and Tokyo Approximately 88% of the transactions involve the U.S. dollar U.S. dollar is the primary transaction currency for the foreign-exchange market Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market (2 of 2) Figure 8.5 Currencies Involved in Foreign-Exchange Market Transactions Source: Based on data from Bank for International Settlements, Triennial Central Bank Survey: Foreign exchange turnover in April 2016. (N.B. These numbers add up to 200 percent— there are two currencies in each transaction.) Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market: The Role of Banks (1 of 3) Major Players International Banks – International Banks – Spread between the Bid – Corporate Treasurers and Ask Prices – Pension Funds – Wholesale Market – Hedge Funds – Retail Market – Insurance Companies – Interbank Transactions – Central Banks – Treasury Departments Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market: The Role of Banks (2 of 3) Clients – Commercial Customers: engage in foreign-exchange transactions as part of their normal business activities – Exchange-Rate Speculators: assume exchange rate risks by acquiring positions in a currency, hoping that they can correctly predict changes in the currency’s market value – Currency Arbitrageurs: attempt to exploit small differences in the price of a currency between markets Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market: The Role of Banks (3 of 3) Types of Currencies – Convertible/Hard: freely tradable these include the euro, the British pound, the Swedish krona, the Canadian dollar, the Swiss franc, the Japanese yen, and the U.S. dollar – Inconvertible/Soft: not freely tradable Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Structure of the Foreign Exchange Market: Spot and Forward Markets (1 of 2) I. Spot Market: foreign-exchange transactions that are to be consummated immediately (normally defined as two days after the trade date II. Forward Market : hedge foreign currency exchange risk. future delivery in 30, 90, or 180 days III. Swap Transaction: A swap transaction is a transaction in which the same currency is bought and sold simultaneously, but delivery is made at two different points in time. Example: EU Company A borrows $150 million from U.S. Company B; concurrently, EU Company A lends 100 million euros to U.S. Company B with an exchange rate of $1.2/1Euro spot rate Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Other mechanisms to allow firms to obtain foreign exchange in the future ❑Currency Futures: a contract that resembles a forward contract for a standard amount on a standard delivery date ❑Currency Options: allows, but does not require, a firm to buy or sell a specified amount of a foreign currency at a specified price on a specified date – Call Option: grants the right to buy the foreign currency in question; – Put Option: grants the right to sell the foreign currency Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Forward premium and forward Discount Premium: A currency is trading at a premium if its forward rate is higher than its current spot rate. This implies that the currency is expected to appreciate against the other currency in the future. Example: Spot rate: 1 USD = 100 JPY 6-month forward rate: 1 USD = 98 JPY o The USD is trading at a premium because fewer JPY are required to buy 1 USD in the future. This suggests the JPY is expected to appreciate, or the USD is expected to weaken. Discount: A currency is trading at a discount if its forward rate is lower than its current spot rate. This indicates that the currency is expected to depreciate against the other currency in the future. Example: Spot rate: 1 GBP = 1.40 USD, 3-month forward rate: 1 GBP = 1.35 USD The GBP is trading at a discount because fewer USD are expected to buy 1 GBP in the future. This suggests the GBP is expected to depreciate, or the USD is expected to strengthen. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Example of forward market Assume that Company A in the United States wants to contract for a future purchase of machine parts from Company B, which is located in France. Therefore, changes in the exchange rate between the US dollar and the euro may affect the actual price of the purchase – either up or down. The exporter in France and the importer in the US agree upon an exchange rate of 1.30 US dollars for 1 euro that will govern the transaction that is to take place six months from the date the currency forward contract is made between them. At the time of the agreement, the current exchange rate is 1.28 US dollars per 1 euro. If, in the interim and by the time of the actual transaction date, the market exchange rate is 1.33 US dollars per 1 euro, then the buyer will have benefited by locking in the rate of 1.3. On the other hand, if the prevailing currency exchange rate at that time is 1.22 US dollars for 1 euro, then the seller will benefit from the currency forward contract. However, both parties have benefited from locking down the purchase price so that the seller knows his cost in his own currency, and the buyer knows exactly how much they will receive in their currency. Source: https://corporatefinanceinstitute.com/resources/knowledge/finance/currency-forward/ Copyright © 2020 Pearson Education Ltd. All Rights Reserved. How Do Currency Swap Contracts Work? In order to understand the mechanism behind currency swap contracts, let’s consider the following example. Company A is a US- based company that is planning to expand its operations in Europe. Company A requires €850,000 to finance its European expansion. On the other hand, Company B is a German company that operates in the United States. Company B wants to acquire a company in the United States to diversify its business. The acquisition deal requires US$1 million in financing. Neither Company A nor Company B holds enough cash to finance their respective projects. Thus, both companies will seek to obtain the necessary funds through debt financing. Company A and Company B will prefer to borrow in their domestic currencies (that can be borrowed at a lower interest rate) and then enter into the currency swap agreement with each other. Copyright © 2020 Pearson Education Ltd. All Rights Reserved.  The currency swap between Company A and Company B can be designed in the following manner. Company A obtains a credit line of $1 million from Bank A with a fixed interest rate of 3.5%. At the same time, Company B borrows €850,000 from Bank B with the floating interest rate of 6-month LIBOR. The companies decide to create a swap agreement with each other. According to the agreement, Company A and Company B must exchange the principal amounts ($1 million and €850,000) at the beginning of the transaction. In addition, the parties must exchange the interest payments semi-annually. Company A must pay Company B the floating rate interest payments denominated in euros, while Company B will pay Company A the fixed interest rate payments in US dollars. On the maturity date, the companies will exchange back the principal amounts at the same rate ($1 = €0.85). Source: https://corporatefinanceinstitute.com/resources/knowledge/finance/currency-swap-contract/ Copyright © 2020 Pearson Education Ltd. All Rights Reserved. International Capital Market: Major International Banks (1 of 3) Table 8.1 The World’s 20 Largest Banks, 2017 Revenues ($ Billions Rank Company Country of US dollars) 1 Industrial & Commercial Bank of China China 153.0 2 China Construction Bank China 138.6 3 Agricultural Bank of China China 122.4 4 BNP Paribas France 117.4 5 Bank of China China 115.4 6 JP Morgan Chase & Co. United States 113.9 7 Bank of America United States 100.3 8 Wells Fargo United States 97.7 9 Citigroup United States 88.0 10 Banco Santander Spain 87.4 11 Crédit Agricole France 84.2 12 HSBC Holdings United Kingdom 79.6 Copyright © 2020 Pearson Education Ltd. All Rights Reserved. International Capital Market: Major International Banks (2 of 3) Table 8.1 [Continued] Revenues ($ Billions Rank Company Country of US dollars) 13 Société Générale France 69.9 14 Itau Unibanco Holding Brazil 66.3 15 Groupe BPCE France 61.1 16 Banco Bradesco Brazil 58.1 17 Bank of Communications China 57.7 18 ING Group Netherlands 56.3 19 Banco do Brasil Brazil 55.3 20 Mitsubishi UFJ Financial Group Japan 54.8 Source: Based on www.fortune.com, accessed August 7, 2018; various corporate websites. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Review Questions (1 of 2) What determines the demand for any given currency in the foreign-exchange market? What determines the supply of any given currency in the foreign-exchange market? Briefly explain the determinants of foreign exchange rate. How are prices established in the foreign-exchange market? Explain the different techniques that firms can use to protect themselves from future changes in exchange rates. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Review Questions (2 of 2) Discuss the major types of arbitrage activities that affect the foreign-exchange market. What is hedging? Why is it commonly used by companies in international business? What is arbitrage? Give examples. Explain the function of Eurocurrency and its use in international transactions. Copyright © 2020 Pearson Education Ltd. All Rights Reserved. Copyright This work is protected by United States copyright laws and is provided solely for the use of instructors in teaching their courses and assessing student learning. Dissemination or sale of any part of this work (including on the World Wide Web) will destroy the integrity of the work and is not permitted. The work and materials from it should never be made available to students except by instructors using the accompanying text in their classes. All recipients of this work are expected to abide by these restrictions and to honor the intended pedagogical purposes and the needs of other instructors who rely on these materials. Copyright © 2020 Pearson Education Ltd. All Rights Reserved.