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2
Ch 9: International Financial Markets
Chapter 9
International Financial Markets
Learning Objectives:
9.1 Explain the importance of the international capital market
9.2 Describe the main components of the international capital market.
9.3 Outline the functions of the foreign exchange market.
9.4 Explain the different types of currency quotes and exchange rates.
9.5 Describe the instruments and institutions of the foreign exchange market.
Chapter Outline:
Introduction
Importance of the International Capital Market
Purposes of National Capital Markets
Role of Debt
Role of Equity
Purposes of the International Capital Market
Expands the Money Supply for Borrowers
Reduces the Cost of Money for Borrowers
Reduces Risk for Lenders
Forces Expanding the International Capital Market
World Financial Centers
Offshore Financial Centers
International Capital Market Components
International Bond Market
Types of International Bonds
Interest Rates: A Driving Force
International Equity Market
Spread of Privatization
Economic Growth in Emerging Markets
Activity of Investment Banks
Advent of Cybermarkets
Eurocurrency Market
Appeal of the Eurocurrency Market
The Foreign Exchange Market
Functions of the Foreign Exchange Market
Currency Conversion
Currency Hedging
Currency Arbitrage
Interest Arbitrage
Currency Speculation
Currency Quotes and Rates
Quoting Currencies
Direct and Indirect Rate Quotes
Cross Rates
Spot Rates
Buy and Sell Rates
Forward Rates
Forward Contracts
Swaps, Options, and Futures
Currency Swaps
Currency Options
Currency Futures Contracts
Market Instruments and Institutions
Trading Centers
Important Currencies
Interbank Market
Clearing Mechanisms
Securities Exchanges
Over-the-Counter Market
Currency Restriction
Instruments for Restricting Currencies
Bottom Line for Business
Appendix: Calculating Percent Change in Exchange Rates
A comprehensive set of specially designed PowerPoint slides is available for use with Chapter 9. These slides and the lecture outline below form a completely integrated package that simplifies the teaching of this chapter’s material.
Lecture Outline
I. INTRODUCTION
This chapter explores the two interrelated systems that comprise the international financial markets, which are the international capital market and the foreign exchange market.
II. IMPORTANCE OF THE INTERNATIONAL CAPITAL MARKET
A capital market is a system that allocates financial resources in the form of debt and equity according to their most efficient uses. Its main purpose is to provide a mechanism to borrow or invest money efficiently.
A. Purposes of National Capital Markets
Help individuals and institutions borrow money from lenders; intermediaries exist to facilitate financial exchanges.
1. Role of debt
a. Loans in which borrower repays borrowed amount (the principal) plus interest. Company debt normally takes the form of bonds—debt instruments specifying the timing of principal and interest payments.
b. Holder of a bond (the lender) can force the borrower into bankruptcy if payment is not made on a timely basis. Bonds to fund investments are issued by private-sector companies and by municipal, regional, and national governments.
2. Role of equity
a. Equity is part ownership of a company in which the equity holder participates with other part owners in the company’s financial gains and losses. Equity normally takes the form of stock—shares of ownership in a company’s assets that give shareholders a claim on the company’s future cash flows.
b. Shareholders may be rewarded with dividends or by increases in the value of their shares. They may also suffer losses through decreases in the value of their shares. Dividend payments are not guaranteed, but decided by the company’s board of directors and based on financial performance.
c. Shareholders can sell one stock and buy another or liquidate exchange stock for cash. Liquidity refers to the ease with which bondholders and shareholders convert investments into cash.
B. Purposes of the International Capital Market
The international capital market is a network of individuals, companies, financial institutions, and governments that invest and borrow across national boundaries. Large international banks gather excess cash of investors and savers around the world and then channel it to global borrowers.
1. Expands the money supply for borrowers
a. Companies unable to obtain funds from investors in the domestic market seek financing in the international capital market.
b. Essential for firms in countries with small or developing capital markets or emerging stock markets.
c. An expanded supply of money benefits small companies that might not get financing under intense competition for capital.
2. Reduces the cost of money for borrowers
a. An expanded money supply reduces the cost of borrowing. The “price” reflects supply and demand. Excess funds create a buyer’s market, forcing interest rates lower.
b. Projects regarded as infeasible because of low expected returns might be viable at a lower financing cost.
3. Reduces risk for lenders
a. The international capital market expands the available set of lending opportunities. Investors reduce portfolio risk by spreading their money over many debt and equity instruments.
b. Investors have a greater set of opportunities from which they can choose and investing in international securities benefits investors because some economies are growing while others are in decline.
C. Forces Expanding the International Capital Market
1. Information technology
Reduces time and money needed to communicate globally. Electronic trading after close of formal exchanges facilitates fast response times.
2. Deregulation
Increases competition, lowers cost of financial transactions, and opens many national markets to global investing and borrowing. Yet greater regulation flowing out of the credit crisis of 2008–2009 may curtail growth in this market.
3. Financial instruments
Increased competition is creating the need to develop innovative financial instruments. Securitization is the unbundling and repackaging of hard-to-trade financial assets into more liquid, negotiable, and marketable financial instruments, or securities. Here, too, regulation of securitization may curtail growth of this market.
D. World Financial Centers
The three most important financial centers are London, New York, and Tokyo.
1. Offshore financial centers
Country or territory where financial sector features few regulations and few, if any, taxes. They (1) are economically and politically stable; (2) are advanced in telecommunications; (3) offer large amounts of funding in many currencies; and (4) provide a less costly source of financing.
a. Operational centers see a great deal of financial activity (e.g., London for currencies; Switzerland for investment capital).
b. Booking centers are usually located on a small, island nation or territory with favorable tax or secrecy laws. Funds pass through on their way to large operational centers. Typically, are offshore branches of domestic banks used to record tax and currency exchange information.
III. INTERNATIONAL CAPITAL MARKET COMPONENTS
A. International Bond Market
Consists of all bonds sold by issuing companies, governments, and other organizations outside their own countries. Buyers include medium- to large-size banks, pension funds, mutual funds, and governments.
1. Types of international bonds
a. Eurobond
Issued outside the country in whose currency it is denominated (e.g., issued in Venezuela in U.S. dollars, and sold in Britain, France, and Germany). It accounts for 75 to 80 percent of all international bonds. Absence of regulation reduces the cost of issuing a bond but increases its risk.
b. Foreign bond
Sold outside borrower’s country and denominated in currency of country in which it is sold (e.g., yen-denominated bond issued by German carmaker BMW in Japan’s bond market). It accounts for 20 to 25 percent of all international bonds. Issuers must meet certain regulatory requirements and disclose details about company activities, owners, and upper management. Example: BMW’s samurai bonds (the name for foreign bonds issued in Japan) would need to meet the same disclosure and other regulatory requirements that Toyota’s bonds in Japan must meet. Foreign bonds in the United States are called yankee bonds, and those in the United Kingdom are called bulldog bonds. Foreign bonds issued and traded in Asia outside Japan (and normally denominated in dollars) are called dragon bonds.
2. Interest rates: a driving force
a. Borrowers from newly industrialized and developing countries borrow money from nations where interest rates are lower.
b. Investors in developed countries buy bonds in newly industrialized and developing nations to obtain a higher return.
c. Many emerging countries see the need to develop their own national markets. Volatility in currency market hurts projects that earn funds in those currencies and pay debts in dollars.
B. International Equity Market
Consists of all stocks bought and sold outside the issuer’s home country. Companies and governments issue equity and buyers include other companies, banks, mutual funds, pension funds, and individuals.
1. Spread of privatization
a. A single privatization often places billions of dollars of new equity on stock markets.
b. Increased privatization in Europe is expanding worldwide equity. European Union integration has made investors willing to invest in stocks from other European nations.
2. Economic growth in emerging markets
a. Growth in newly industrialized and developing countries contributes to growth in the international equity market.
b. Because of a limited supply of funds in emerging economies, the international equity market is a major source of funding.
3. Activity of investment banks
a. Global banks facilitate the sale of stock worldwide by bringing together sellers and large potential buyers.
b. Becoming more common than listing a company’s shares on another country’s stock exchange.
4. Advent of cybermarkets
a. Stock markets consisting of online global trading activities that allow listing of stocks worldwide for electronic 24-hour trading.
C. Eurocurrency Market
1. All the world’s currencies banked outside their countries of origin are Eurocurrency and trade on the Eurocurrency market (e.g., Eurodollars, Europounds). It involves large transactions by the largest companies, banks, and governments.
2. Four sources of deposits:
Governments with excess funds from prolonged trade surplus
Commercial banks with excess currency
International companies with excess cash
Extremely wealthy individuals
3. Eurocurrency market is valued at around $6 trillion, with London accounting for about 20 percent of all deposits. Other important markets include Canada, the Caribbean, Hong Kong, and Singapore.
4. Appeal of the Eurocurrency market
a. Complete absence of regulation lowers costs. Banks charge borrowers less and pay investors more but still earn profit.
b. Low transaction costs because transactions are large.
c. Interbank interest rates are interest rates that the world’s largest banks charge one another for loans. London Interbank Offer Rate (LIBOR) is the interest rate charged by London banks to other large banks borrowing Eurocurrency. London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits.
5. An unappealing feature of the Eurocurrency market is greater risk due to a lack of government regulation. Still, Eurocurrency transactions are fairly safe because of the size of the banks involved.
IV. THE FOREIGN EXCHANGE MARKET
Market in which currencies are bought and sold and in which currency prices are determined. Exchange rates reflect the size of the transaction, the trader conducting it, general economic conditions, and sometimes, government mandate.
If the British pound is quoted in U.S. dollars at $1.5054, the bank may bid $1.5052 to buy British pounds and offer to sell them at $1.5056. The difference is the bid-ask spread; banks buy low and sell high, earning profits from the bid-ask spread.
A. Functions of the Foreign Exchange Market
1. Currency conversion
Companies use the foreign exchange market to convert one currency into another. They must convert to local currencies when they undertake foreign direct investment. When a firm’s international subsidiary earns a profit and the company wants to return some of it to the home country, it must convert the local money into the home currency.
2. Currency hedging
Insuring against potential losses that result from adverse changes in exchange rates. Companies use it to: (1) lessen the risk of international transfers; and (2) reduce exposure in transactions where a time lag exists between billing and receipt of payment.
3. Currency arbitrage
Instantaneous purchase and sale of a currency in different markets for profit. Common among experienced foreign exchange traders, large investors, and firms in arbitrage business.
a. Interest arbitrage is the profit-motivated purchase and sale of interest-paying securities denominated in different currencies. Companies use interest arbitrage to find higher interest rates abroad in government treasury bills, corporate and government bonds, and even bank deposits.
4. Currency speculation
Purchase or sale of a currency with the expectation that its value will change and generate a profit. Much riskier than arbitrage because the value, or price, of currencies is quite volatile.
V. CURRENCY QUOTES AND RATES
A. Quoting Currencies
Two components to every quoted exchange rate: the quoted currency and the base currency. In (¥/$), the yen is the quoted currency, the dollar is the base currency. The quoted currency is always the numerator, and the base currency is always the denominator.
1. Direct and indirect rate quotes (See Table 9.1)
In ¥ 84.3770 /$, the yen is the quoted currency; this is called a direct quote on the yen and an indirect quote on the dollar.
In $0.011852/¥, the dollar is the quoted currency; this is called a direct quote on the dollar and an indirect quote on the yen.
This formula derives a direct quote from an indirect quote:
Direct Quote = ____1_____
Indirect Quote
And, for deriving an indirect quote from a direct quote, use:
Indirect Quote = ____1____
Direct Quote
In the example above, we were given an indirect quote on the U.S. dollar of ¥ 84.3770/$. To find the direct quote on the dollar we simply divide ¥ 84.3770 into $1: $1 ¥ 84.3770 = $0.011852/ ¥
This means that it costs $0.011852 to purchase one yen (¥)—slightly more than one U.S. cent. We state this exchange rate as $0.011852/¥. In this case, because the dollar is the quoted currency, we have a direct quote on the dollar and an indirect quote on the yen.
Looking at Table 9.1 you can see that the direct quote on the euro is € 0.7883/$. The direct quote on the Japanese yen is ¥ 84.3770/$. To find the cross rate between the euro and the yen, with the yen as the base currency, we simply divide € 0.7883/$ by ¥ 84.3770/$: € 0.7883/$ ¥ 84.3770/$ = € 0.0093/ ¥. See Table 9.2, it shows the Cross Rates for the major world currencies.
2. Cross rates
Used when no access to the exchange rate between two nation’s currencies, but have exchange rates for each nation’s currency with that of a third nation. Cross rates can be calculated using either currency’s indirect or direct exchange rates with another currency.
Spot Rates
Exchange rate that requires delivery of a traded currency within two business days. The spot market helps companies to:
Convert income from sales abroad into the home-country currency.
Convert funds into the currency of an international supplier.
Convert funds into the currency of a country in which it will invest.
1. Buy and sell rates
The spot rate is available only to banks and foreign exchange brokers. Small businesspeople exchanging currencies at their local bank receive a buy rate (the bank’s rate to buy a currency) and an ask rate (the bank’s rate to sell a currency). For example, if a bank quotes you an exchange rate between dollars and euros of $1.268/78 per euro (€), it will buy dollars at $1.268/€ and sell them at peso $1.278/€.
C. Forward Rates
Exchange rate at which two parties agree to exchange currencies on a specified future date. Represent traders’ and bankers’ expectations of a currency’s future spot rate. Used to insure against unfavorable changes in exchange rates.
1. Forward contract
a. Requires exchange of an agreed-upon amount of a currency on an agreed-upon date at a specific exchange rate. Belong to a family of financial instruments known as derivatives.
b. Commonly signed for 30, 90, and 180 days into the future, but customized contracts are also possible.
D. Swaps, Options, and Futures
Three other types of currency instruments are used in the forward market.
1. Currency swap
Simultaneous purchase and sale of foreign exchange for two different dates. Used to reduce exchange-rate risk and lock in a future exchange rate. Can be viewed as a complex forward contract.
2. Currency option
Right, or option, to exchange a specific amount of a currency on a specific date at a specific rate. Used to hedge against exchange-rate risk or obtain foreign currency at a favorable rate.
3. Currency futures contract
Contract requiring the exchange of a specific amount of currency on a specific date at a specific exchange rate, with all conditions fixed and not adjustable.
VI. MARKET INSTRUMENTS AND INSTITUTIONS
Electronic network of foreign exchange traders, currency trading banks, and investment firms among major financial centers. Single-day trading volume on the foreign exchange market (currency swaps and spot and forward contracts) is $4 trillion.
A. Trading Centers
The United Kingdom, United States, and Japan account for half of all global currency trading. London dominates the foreign exchange market for historic and geographic reasons.
B. Important Currencies
A vehicle currency is used as an intermediary to convert funds between two other currencies. Currencies most often involved in currency transactions are the U.S. dollar, British pound, Japanese yen, and European Union euro.
C. Interbank Market
Market where the world’s largest banks exchange currencies at spot and forward rates. Banks act as agents for clients and turn to foreign exchange brokers, who can obtain seldom traded currencies.
1. Clearing mechanisms aggregate currencies that one bank owes another and then carry out that transaction.
2. Today, clearing is a mostly digital, computerized affair, whereas in the past it meant physically delivering currencies from one bank to another.
D. Securities Exchanges
Specializes in currency futures and options transactions. Securities brokers facilitate currency transactions on securities exchanges. Transactions on securities exchanges are much smaller than those in the interbank market and vary with each currency.
E. Over-the-Counter (OTC) Market
Consists of a global computer network of foreign exchange traders and other market participants, but with no central trading location. Major players in the OTC market are large financial institutions and investment banks. The OTC market has grown because of several benefits:
Businesspeople search for the institution that provides the best (lowest) price for transactions.
It offers greater opportunities for designing customized transactions.
F. Currency Restriction
A convertible (hard) currency is one that trades freely in the foreign exchange market, with its price determined by the forces of supply and demand. Some countries do not permit the free convertibility of their currencies. Goals of currency restriction include:
1. Preserve nation’s hard currencies to repay debts owed to other nations.
2. Preserve hard currencies to pay for imports and finance trade deficits.
3. Protect a currency from speculators.
4. Keep individuals and businesses from investing in other nations.
G. Instruments for Restricting Currencies
Nation’s central bank must perform all foreign exchange transactions.
Government controls amount of foreign currency leaving the country by requiring importers to obtain import licenses.
Implement systems of multiple exchange rates that specify higher rates on the imports of certain goods or on the imports from certain nations.
Issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange holdings in special accounts before being granted import licenses.
Issue quantity restrictions that limit the amount of foreign currency that individuals can take out of the country when traveling abroad.
6. Countertrade
a. The exchange of goods or services between two parties without the use of money. International companies can circumvent currency convertibility restrictions and yet conduct business.
VII. INTERNATIONAL CAPITAL MARKETS AND BUSINESS
Continued growth in the international capital market is expected. It is crucial that managers understand the fundamentals of exchange rates and how the foreign exchange market is structured.
VIII. INTERNATIONAL FINANCIAL MARKETS AND BUSINESS
Key components of international financial markets are the international bond, equity, and Eurocurrency markets.
APPENDIX: Calculating Percent Change in Exchange Rates
1. Exchange rate risk can jeopardize profits from current and future international transactions. Managers minimize this risk by tracking percent changes in exchange rates.
2. Take Pn as the exchange rate at the end of a period (a currency’s new price), and Po as the exchange rate at the beginning of that period (a currency’s old price). Percent change in the value of the currency is calculated with the following formula:
Percent change (%) = Pn – Po x 100
Po
3. Suppose on February 1, the exchange rate between the Norwegian krone (NOK) and the U.S. dollar was NOK 5/$. On March 1, the exchange rate stood at NOK 4/$.
What is the change in the value of the base currency—the dollar? The value of the US Dollar has fallen 20 percent. In other words, one US Dollar buys 20 percent fewer Norwegian Krone pm March 1, than it did on February 1.
Percent change (%) = 4 – 5 x 100 = –20%
5
4 To calculate the change in the value of the Norwegian Krone, you must first calculate the indirect exchange rate on the krone. This step is necessary because you want to make the krone the base currency. Using the formula presented earlier, you obtain the exchange rate of $.20/NOK (1/NOK 5 = .20)
Percent change (%) = .25 – .20 x 100 = 25%
.20
In other words, the value of the Norwegian Krone has risen 25 percent.
Quick Study Questions
Quick Study 1
Q: What is the purpose of the international capital market?
A: First, it expands the money supply for borrowers. Companies unable to obtain funds from investors in the domestic market can seek financing in the international capital market. The option of going outside the home nation is particularly important to firms in countries with small or developing capital markets of their own, particularly those with emerging stock markets.
Second, it reduces the cost of money for borrowers. The “price” of money is determined by supply and demand—if its supply increases, price (in the form of interest rates) falls. Thus, excess supply creates a buyer’s market, forcing down interest rates and the cost of borrowing.
Third, it reduces risk for lenders. The international capital market expands the available set of lending opportunities. Investors enjoy a greater set of opportunities from which to choose. They can thus reduce overall portfolio risk by spreading their money over a greater number of debt and equity instruments. Investing in international securities also benefits investors because some economies grow while others decline.
2. Q: Unbundling and repacking hard-to-trade financial assets into more marketable financial instruments is called what?
A: Securitization is the unbundling and repacking of hard to trade financial assets into more liquid, negotiable, and marketable financial securities.
3. Q: What is the characteristic of an offshore financial center?
A: An offshore financial center is a country or territory whose financial sector features very few regulations and few, if any, taxes. Offshore financial centers offer large amounts of funding in many currencies and are a cheap source of financing for multinationals. They tend to be characterized by economic and political stability and typically have excellent telecommunications infrastructures. Some offshore centers are located on small, island nations or territories with favorable tax or secrecy laws.
Quick Study 2
1. Q: What type of financial instrument is traded in the international bond market?
A: The international bond market is the market consisting of all bonds sold by issuing companies, governments, or other organizations outside their own countries. The international bond market is growing at about 10 percent per year. The most important factor fueling the growth in the international bond market was the low interest rates (the cost of borrowing money). Low interest rates in developed nations meant low rates of return for investors in government and corporate bonds. Thus, investors turned to bonds issued by entities in developing and emerging markets where higher returns reflected their greater risk. Low interest rates in developed markets and high rates in developing and emerging markets caused growth in the international bond market.
2. Q: The market of all stocks bought and sold outside the issuer’s home country is called what?
A: The international equity market consists of all stocks bought and sold outside the issuer’s home country. Stock exchanges listing the greatest number of companies from outside their own borders are Frankfurt, London, and New York.
3. Q: What does the Eurocurrency market consist of?
A: All the world’s currencies that are banked outside their countries of origin are referred to as Eurocurrency and traded on the Eurocurrency market. For example, U.S. dollars deposited in Tokyo’s Sumitomo Bank are called Eurodollars, and British pounds deposited in New York’s Chase Manhattan are called Europounds. Deposits of Eurocurrency originate from governments with excess funds, commercial banks with excess currency, international companies with excess cash, and wealthy individuals.
Because the world’s largest financial institutions operate in the Eurocurrency market, individual transactions are worth very large sums of money. This allows the banks to lower transaction costs and charge one another what are called interbank interest rates—interest rates that the world’s largest banks charge one another for loans. The London Interbank Offer Rate (LIBOR) is the interest rate charged by London banks to other large banks borrowing Eurocurrency. The London Interbank Bid Rate (LIBID) is the interest rate offered by London banks to large investors for Eurocurrency deposits.
The main appeal of the Eurocurrency market is the complete absence of regulation—allowing it to operate at lower cost than traditional banking. This means that banks can charge borrowers less, pay investors more, and still earn healthy profits.
Quick Study 3
1. Q: What is the market in which currencies are bought and sold and their prices determined?
A: To exchange one currency for another in international transactions, companies rely on a mechanism called the foreign exchange market, a market in which currencies are bought and sold and their prices determined.
2. Q: Insuring against potential losses that may result from adverse changes in exchange rates is called what?
A: The practice of insuring against potential losses that result from adverse changes in exchange rates is called currency hedging.
3. Q: What do we call the instantaneous purchase and sale of a currency in different markets to make a profit?
A: Currency arbitrage is the instantaneous purchase and sale of a currency in different markets to make a profit.
Quick Study 4
1. Q: The numerator in a quoted exchange rate, or the currency with which another currency is to be purchased is called what?
A: When you designate any exchange rate, the quoted currency is always the numerator, and the base currency is the denominator.
2. Q: What is the name given to the risk of adverse changes in exchange rates?
A: Exchange rate risk is the risk of adverse changes in exchange rates.
3. Q: What do we call an exchange rate requiring delivery of a traded currency within two business days?
A: A spot rate is the exchange rate that requires delivery of the traded currency within two business days. The spot rate is available only to banks and foreign exchange brokers because their trades are worth many millions of dollars. The spot market assists companies in:
Converting income from sales abroad into the home-country currency.
Converting funds into the currency of an international supplier.
Converting funds into the currency of a country in which it will invest.
4. Q: What instruments are used in the forward market?
A: A forward contract is a contract in which two parties agree to exchange currencies on a specified future date. Forward rates are helpful to a company that knows it will need a certain amount of currency on a certain future date. Companies often use the forward market to insure against unfavorable changes in exchange rates. In addition, a currency swap is the simultaneous purchase and sale of foreign exchange for two different dates. A currency option is a right, or option, to exchange a specified amount of a currency on a specified date at a specified rate. A currency futures contract is a contract requiring the exchange of a specified amount of currency on a specified date at a specified exchange rate, with all conditions fixed and not adjustable.
Quick Study 5
1. Q: Where does more than half of all global currency trading take place?
A: The world’s main foreign exchange trading centers are located in the United Kingdom (London), the United States (New York), and Japan (Tokyo)—together accounting for slightly more than one-half of all global currency trading. London dominates the foreign exchange market for historic and geographic reasons. The U.S. dollar, the British pound, the Japanese yen, and the European euro are the currencies most used in the foreign exchange market.
2. Q: A currency used as an intermediary to convert funds between two other currencies is called what?
A: A vehicle currency is used as an intermediary to convert funds between two other currencies.
3. Q: What is another name for a freely convertible currency?
A: A hard currency is another name for a freely convertible currency, one that is accepted by both residents and non-residents of the country for payment of goods and services.
4. Q: Why do governments sometimes engage in currency restrictions?
A: Reasons nations restrict currency conversion:
1. Preserve a country’s reserve of hard currencies with which to repay debts owned to other nations.
2. Preserve hard currencies to pay for imports and finance trade deficits.
3. Protect a currency from speculators.
4. Keep resident individuals and businesses from investing in other nations.
Policies nations use to restrict currency conversion:
1. Require all foreign exchange transactions to go through the nation’s central bank.
2. Require importers to obtain import licenses—allowing governments to control the amount of foreign currency leaving the country.
3. Implement systems of multiple exchange rates that specify higher rates on the imports of certain goods or on the imports from certain nations.
4. Issue import deposit requirements that require businesses to deposit certain percentages of their foreign exchange holdings in special accounts before being granted import licenses.
5. Issue quantity restrictions that limit the amount of foreign currency that individuals can take out of the country when traveling abroad.
Ethical Challenge
The goal of government regulation of financial-services industries is to maintain the integrity and stability of financial systems, thereby protecting both depositors and investors. Regulations include prohibitions against insider trading, against lending by management to itself or to closely related entities (called “self-dealing”), and against other transactions in which there is a conflict of interest. In less than two decades, deregulation transformed the world’s financial markets. It drove competition and growth in financial sectors and boosted the economies of developed and emerging countries alike. It also helped bring the international financial system to the brink of a complete collapse. Although it is also true that intervention in financial markets by government officials helped fuel the financial bubble that eventually burst.
9-5 Q: What do you see as the “dark side” of deregulation, in terms of business ethics?
A: The dark side of deregulation is the potential for the occurrence of those very things that are mentioned in the question itself. However, deregulation does not mean the total dismantling of all regulations, but a reduction in those that are overly burdensome and that create market inefficiencies. Countries retain the most important regulatory aspects of their legal systems and continue to support their agencies responsible for oversight of financial services industries. The “colluding producers” argument may apply today to the recent surge in merger and acquisition activity. However, as long as regulators scrutinize proposed mergers and acquisitions for anticompetitive consequences, it is likely that the trend toward greater concentration will continue in many industries.
9-6 Q: Do you think the recent increase in regulation is effective in helping prevent another global financial meltdown?
A: This is a good opportunity to discuss extraterritoriality. On the one hand, should the U.S. government have the right to control and legislate U.S. business activity abroad? And on the other hand, should U.S. firms be allowed to exploit a loophole and avoid paying their fair share of taxes? Students supporting the use of an OFC to avoid taxation in national markets must explain why it is okay for some (usually large) companies to evade national taxation but not others (usually small companies with fewer resources). They must also justify letting a company using an OFC off the hook in terms of contributing to the national infrastructure, health care, education, and general welfare of the people of that nation. Students supporting a clampdown on the OFC system must explain why it is unethical to use an OFC to shelter income and avoid regulations.
9-7 Q: Do you think the warning of Adam Smith, one of the first philosophers of capitalism against the dangers of “colluding producers,” applies to the financial-services sector today?
A: Countries retain the most important regulatory aspects of their legal systems and continue to support their agencies responsible for oversight of financial services industries. The “colluding producers” argument may apply today to the recent surge in merger and acquisition activity. However, as long as regulators scrutinize proposed mergers and acquisitions for anticompetitive consequences, it is likely that the trend toward greater concentration will continue in many industries.
Teaming Up
Research Project. Suppose your team works for a firm that has $10 million in excess cash to invest for one month. Your team’s task is to invest this money in the foreign exchange market to earn a profit—holding dollars is not an option. Select the currencies you wish to buy at today’s spot rate, but do not buy less than $2.5 million of any single currency. Track the spot rate for each of your currencies over the next month in the business press. On the last day of the month, exchange your currencies at the day’s spot rate. Calculate your team’s gain or loss over the one-month period. (Your instructor will determine whether, and how often, currencies may be traded throughout the month.)
A: This project is excellent for instructors who want their students to acquire a better grasp of the foreign exchange market and the reasons for currency fluctuations. Students should be asked to research each of the currencies they purchase and pass these reasons on to the instructor at the time of their initial purchase. Students should also follow the business press to learn the reasons for daily fluctuations in the value of each currency.
Practicing International Management Case
Should We Cry for Argentina?
9-16 Q: Argentina’s peso was linked to the U.S. dollar through a currency board for ten years before it was cut loose. Why did Argentina peg its currency to the dollar in the first place?
A: Students can consult business and financial Web sites to update the situation and get background information on the peso’s link to the dollar. The peso–dollar link contributed to Argentina’s problems. For 10 years the Argentine peso was fixed at parity to the dollar through a currency board. Argentina initially pegged the peso to the dollar to reduce inflation. Early on, the currency board worked and stabilized the peso and eliminated the inflation problem. But the peg caused problems after Brazil devalued its currency, raising the relative price of Argentina’s goods on global markets.
9-17 Q: Companies encounter many difficulties in adapting their strategies to deal with the effects of a currency crisis that becomes an economic crash. How did local and international companies adapt to the business environment at the height of Argentina’s crisis?
A: The Argentine units of U.S. companies, which collect revenues in pesos, had a difficult time repaying dollar-denominated debts as the peso’s value fell. Parent firms did not rescue their ailing subsidiaries in Argentina because most were independent entities. AES Corp., of Arlington, VA reported that most of its Argentine businesses were in default on their project-financing arrangements but that AES was not required to support the potential cash flow or debt service obligations of the businesses.
Local companies blamed their defaults on the need to get authorization from the central bank to send money abroad. Stiff restrictions on foreign-currency exchange forced importers to wait several months or more while the government authorized payments in dollars. Companies also struggled with new rules that raised taxes on exporters and other cash-rich firms to help the government pay for social services. Local firms also had a hard time obtaining funds to pay their debts to foreign suppliers. (Students could be asked to research the experiences of several Argentine companies to learn how they endured the economic crisis, loss of markets abroad, and so on.)
9-18 Q: What has been the impact on the savings and purchasing power of ordinary citizens?
A: Strapped for cash, the government seized the savings accounts of its citizens and restricted how much they could withdraw at a time. When street protesters turned violent, they beat up several politicians and attacked dozens of banks. Many citizens have lost everything because of the value of the currency and chose to leave Argentina. For example, the World Jewish Congress financially assisted Argentine Jews to relocate to Israel. Students should locate recent articles in the business press for reports on how international aid is perceived by the Argentines themselves (paying attention to the people’s differing economic status) and the international community. There will no doubt be disparity in their views.
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