Chapter 3

International Financial Markets Lecture Outline

Motives for Using International Financial Markets
Motives for Investing in Foreign Markets Motives for Providing Credit in Foreign Markets Motives for Borrowing in Foreign Markets

Foreign Exchange Market

History of Foreign Exchange Foreign Exchange Transactions Interpreting Foreign Exchange Quotations Currency Futures and ptions Markets

International Money Market

rigins and !eve"op#ent $tandardi%ing &"o'a" Bank (egu"ations

International Credit Market

$yndicated )oans

International Bond Market

Euro'ond Market !eve"op#ent of ther Bond Markets

Comparing Interest Rates Among C rrencies International !tock Markets

Issuance of Foreign $tock in the *+$+ Issuance of $tock in Foreign Markets

Comparison of International Financial Markets "o# Financial Markets Affect an M$C%s &al e

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International Financial Management

Chapter Theme
This chapter identifies and discusses the various internationa" financia" #arkets used 'y M/Cs+ These #arkets faci"itate day0to0day operations of M/Cs1 inc"uding foreign exchange transactions1 investing in foreign #arkets1 and 'orrowing in foreign #arkets+

Topics to Stimulate Class Discussion

2+ 3hy do internationa" financia" #arkets exist4 ,+ How do 'anks serve internationa" financia" #arkets4 -+ 3hich internationa" financia" #arkets are #ost i#portant to a fir# that consistent"y needs short0ter# funds4 3hat a'out a fir# that needs "ong0ter# funds4

'(I$)*C(U$)ER+'(I$), !ho ld Firms )hat -o ' .lic Engage in International (fferings/

P I/T5 6es+ 3hen a *+$+ fir# issues stock to the pu'"ic for the first ti#e in an initia" pu'"ic offering 7IP 81 it is natura""y concerned a'out whether it can p"ace a"" of its shares at a reasona'"e price+ It wi"" 'e a'"e to issue its stock at a higher price 'y attracting #ore investors+ It wi"" increase its de#and 'y spreading the stock across countries+ The higher the price at which it can issue stock1 the "ower is its cost of using e9uity capita"+ It can a"so esta'"ish a g"o'a" na#e 'y spreading stock across countries+ C */TE(0P I/T5 /o+ If a *+$+ fir# spreads its stock across different countries at the ti#e of the IP 1 there wi"" 'e "ess pu'"ic"y0traded stock in the *+$+ Thus1 it wi"" not have as #uch "i9uidity in the secondary #arket+ Investors desire stocks that they can easi"y se"" in the secondary #arket1 which #eans that they re9uire that the stocks have "i9uidity+ To the extent that a fir# reduces its "i9uidity in the *+$+ 'y spreading its stock across countries1 it #ay not attract sufficient *+$+ de#and for the stock in the *+$+ Thus1 its efforts to create g"o'a" na#e recognition #ay reduce its na#e recognition in the *+$+ 3H I$ C ((ECT4 *se InfoTrac or so#e other search engine to "earn #ore a'out this issue+ 3hich argu#ent do you support4 ffer your own opinion on this issue+ :/$3E(5 The key is that students recogni%e the tradeoff invo"ved+ : fir# that engages in a re"ative"y s#a"" IP wi"" have "i#ited "i9uidity even when a"" of the stock is issued in the *+$+ Thus1 it shou"d not consider issuing stock internationa""y+ However1 fir#s with "arger stock offerings #ay 'e in a position to issue a portion of their shares outside the *+$+ They shou"d not spread the stocks across severa" countries1 'ut perhaps shou"d target one or two countries where they conduct su'stantia" 'usiness+ They want to ensure sufficient "i9uidity in each of the foreign countries where they se"" shares+

Chapter 3: International Financial Markets

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Answers to End of Chapter Questions

01 Motives for Investing in Foreign Money Markets1 Exp"ain why an M/C #ay invest funds in a financia" #arket outside its own country+ :/$3E(5 The M/C #ay 'e a'"e to earn a higher interest rate on funds invested in a financia" #arket outside of its own country+ In addition1 the exchange rate of the currency invo"ved #ay 'e expected to appreciate+ 21 Motives for 'roviding Credit in Foreign Markets1 Exp"ain why so#e financia" institutions prefer to provide credit in financia" #arkets outside their own country+ :/$3E(5 Financia" institutions #ay 'e"ieve that they can earn a higher return 'y providing credit in foreign financia" #arkets if interest rate "eve"s are higher and if the econo#ic conditions are strong so that the risk of defau"t on credit provided is "ow+ The institutions #ay a"so want to diversity their credit so that they are not too exposed to the econo#ic conditions in any sing"e country+ 31 Exchange Rate Effects on Investing1 Exp"ain how the appreciation of the :ustra"ian do""ar against the *+$+ do""ar wou"d affect the return to a *+$+ fir# that invested in an :ustra"ian #oney #arket security+ :/$3E(5 If the :ustra"ian do""ar appreciates over the invest#ent period1 this i#p"ies that the *+$+ fir# purchased the :ustra"ian do""ars to #ake its invest#ent at a "ower exchange rate than the rate at which it wi"" convert :< to *+$+ do""ars when the invest#ent period is over+ Thus1 it 'enefits fro# the appreciation+ Its return wi"" 'e higher as a resu"t of this appreciation+ 31 Exchange Rate Effects on Borro#ing1 Exp"ain how the appreciation of the =apanese yen against the *+$+ do""ar wou"d affect the return to a *+$+ fir# that 'orrowed =apanese yen and used the proceeds for a *+$+ pro>ect+ :/$3E(5 If the =apanese yen appreciates over the 'orrowing period1 this i#p"ies that the *+$+ fir# converted yen to *+$+ do""ars at a "ower exchange rate than the rate at which it paid for yen at the ti#e it wou"d repay the "oan+ Thus1 it is adverse"y affected 'y the appreciation+ Its cost of 'orrowing wi"" 'e higher as a resu"t of this appreciation+ 41 Bank !ervices1 )ist so#e of the i#portant characteristics of 'ank foreign exchange services that M/Cs shou"d consider+ :/$3E(5 The i#portant characteristics are 728 co#petitiveness of the 9uote1 7,8 the fir#?s re"ationship with the 'ank1 7-8 speed of execution1 7.8 advice a'out current #arket conditions1 and 7;8 forecasting advice+ 51 Bid*ask !pread1 *tah Bank?s 'id price for Canadian do""ars is <+@A-B and its ask price is <+B2+ 3hat is the 'idCask percentage spread4 :/$3E(5 7<+B2 D <+@A-B8C<+B2 E +F, or ,G 61 Bid*ask !pread1 Co#pute the 'idCask percentage spread for Mexican peso retai" transactions in which the ask rate is <+22 and the 'id rate is <+2F+ :/$3E(5 H7<+22 D <+2F8C<+22I E +FA21 or A+2G+

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International Financial Management

7+ For#ard Contract1 The 3o"fpack Corporation is a *+$+ exporter that invoices its exports to the *nited Kingdo# in British pounds+ If it expects that the pound wi"" appreciate against the do""ar in the future1 shou"d it hedge its exports with a forward contract4 Exp"ain+ :/$3E(5 The forward contract can hedge future receiva'"es or paya'"es in foreign currencies to insu"ate the fir# against exchange rate risk+ 6et1 in this case1 the 3o"fpack Corporation shou"d not hedge 'ecause it wou"d 'enefit fro# appreciation of the pound when it converts the pounds to do""ars+ 81 E ro1 Exp"ain the foreign exchange situation for countries that use the euro when they engage in internationa" trade a#ong the#se"ves+ :/$3E(5 There is no foreign exchange+ Euros are used as the #ediu# of exchange+ 091 Indirect Exchange Rate1 If the direct exchange rate of the euro is worth <2+,;1 what is the indirect rate of the euro4 That is1 what is the va"ue of a do""ar in euros4 :/$3E(5 2C2+,; E +B euros+ 001 Cross Exchange Rate1 :ssu#e Po"and?s currency 7the %"oty8 is worth <+2@ and the =apanese yen is worth <+FFB+ 3hat is the cross rate of the %"oty with respect to yen4 That is1 how #any yen e9ua" a %"oty4 :/$3E(5 <+2@C<+FFB E ,2+,; 2 %"oty E ,2+,; yen 021 !yndicated :oans1 Exp"ain how syndicated "oans are used in internationa" #arkets+ :/$3E(5 : "arge M/C #ay want to o'tain a "arge "oan that no sing"e 'ank wants to acco##odate 'y itse"f+ Thus1 a 'ank #ay create a syndicate where'y severa" other 'anks a"so participate in the "oan+ 031 :oan Rates1 Exp"ain the process used 'y 'anks in the Eurocredit #arket to deter#ine the rate to charge on "oans+ :/$3E(5 Banks set the "oan rate 'ased on the prevai"ing )IB (1 and a""ow the "oan rate to f"oat 7change every J #onths8 in accordance with changes in )IB (+ 031 International Markets1 3hat is the function of the internationa" #oney #arket4 Brief"y descri'e the reasons for the deve"op#ent and growth of the European #oney #arket+ Exp"ain how the internationa" #oney1 credit1 and 'ond #arkets differ fro# one another+ :/$3E(5 The function of the internationa" #oney #arket is to efficient"y faci"itate the f"ow of internationa" funds fro# fir#s or govern#ents with excess funds to those in need of funds+ &rowth of the European #oney #arket was "arge"y due to 728 regu"ations in the *+$+ that "i#ited foreign "ending 'y *+$+ 'anksL and 7,8 regu"ated cei"ings p"aced on interest rates of do""ar deposits in the *+$+ that encouraged deposits to 'e p"aced in the Eurocurrency #arket where cei"ings were nonexistent+

Chapter 3: International Financial Markets

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The internationa" #oney #arket focuses on short0ter# deposits and "oans1 whi"e the internationa" credit #arket is used to tap #ediu#0ter# "oans1 and the internationa" 'ond #arket is used to o'tain "ong0ter# funds 7'y issuing "ong0ter# 'onds8+ 041 Evol tion of Floating Rates1 Brief"y descri'e the historica" deve"op#ents that "ed to f"oating exchange rates as of 2A@-+ :/$3E(5 Country govern#ents had difficu"ty in #aintaining fixed exchange rates+ In 2A@21 the 'ands were widened+ 6et1 the difficu"ty of contro""ing exchange rates even within these wider 'ands continued+ :s of 2A@-1 the 'ands were e"i#inated so that rates cou"d respond to #arket forces without "i#its 7a"though govern#ents sti"" did intervene periodica""y8+ 051 International ;iversification1 Exp"ain how the :sian crisis wou"d have affected the returns to a *+$+ fir# investing in the :sian stock #arkets as a #eans of internationa" diversification+ H$ee the chapter appendix+I :/$3E(5 The returns to the *+$+ fir# wou"d have 'een reduced su'stantia""y as a resu"t of the :sian crisis 'ecause of 'oth dec"ines in the :sian stock #arkets and 'ecause of currency depreciation+ For exa#p"e1 the Indonesian stock #arket dec"ined 'y a'out ,@G fro# =une 2AA@ to =une 2AAB+ Further#ore1 the Indonesian rupiah dec"ined again the *+$+ do""ar 'y B.G+ 061 E rocredit :oans1 a+ 3ith regard to Eurocredit "oans1 who are the 'orrowers4 '+ 3hy wou"d a 'ank desire to participate in syndicated Eurocredit "oans4 c+ 3hat is )IB ( and how is it used in the Eurocredit #arket4 :/$3E(5 a+ )arge corporations and so#e govern#ent agencies co##on"y re9uest Eurocredit "oans+ '+ 3ith a Eurocredit "oan1 no sing"e 'ank wou"d 'e tota""y exposed to the risk that the 'orrower #ay fai" to repay the "oan+ The risk is spread a#ong a"" "ending 'anks within the syndicate+ c+ )IB ( 7)ondon inter'ank offer rate8 is the rate of interest at which 'anks in Europe "end to each other+ It is used as a 'ase fro# which "oan rates on other "oans are deter#ined in the Eurocredit #arket+ 071 Foreign Exchange1 6ou >ust ca#e 'ack fro# Canada1 where the Canadian do""ar was worth <+@F+ 6ou sti"" have C<,FF fro# your trip and cou"d exchange the# for do""ars at the airport1 'ut the airport foreign exchange desk wi"" on"y 'uy the# for <+JF+ /ext week1 you wi"" 'e going to Mexico and wi"" need pesos+ The airport foreign exchange desk wi"" se"" you pesos for <+2F per peso+ 6ou #et a tourist at the airport who is fro# Mexico and is on his way to Canada+ He is wi""ing to 'uy your C<,FF for 2-F pesos+ $hou"d you accept the offer or cash the Canadian do""ars in at the airport4 Exp"ain+ :/$3E(5 Exchange with the tourist+ If you exchange the C< for pesos at the foreign exchange desk1 the cross0rate is <+JFC<2F E J+ Thus1 the C<,FF wou"d 'e exchanged for 2,F pesos 7co#puted as ,FF M J8+ If you exchange Canadian do""ars for pesos with the tourist1 you wi"" receive 2-F pesos+

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International Financial Management

081 Foreign !tock Markets1 Exp"ain why fir#s #ay issue stock in foreign #arkets+ 3hy #ight *+$+ fir#s issue #ore stock in Europe since the conversion to a sing"e currency in 2AAA4 :/$3E(5 Fir#s #ay issue stock in foreign #arkets when they are concerned that their ho#e #arket #ay 'e una'"e to a'sor' the entire issue+ In addition1 these fir#s #ay have foreign currency inf"ows in the foreign country that can 'e used to pay dividends on foreign0issued stock+ They #ay a"so desire to enhance their g"o'a" i#age+ $ince the euro can 'e used in severa" countries1 fir#s #ay need a "arge a#ount of euros if they are expanding across Europe+ 291 !tock Market Integration1 Bu""et1 Inc+1 a *+$+ fir#1 is p"anning to issue new stock in the *nited $tates during this #onth+ The on"y decision sti"" to 'e #ade is the specific day on which the stock wi"" 'e issued+ 3hy do you think Bu""et #onitors resu"ts of the Tokyo stock #arket every #orning4 :/$3E(5 The *+$+ stock #arket prices so#eti#es fo""ow =apanese #arket prices+ Thus1 the fir# wou"d possi'"y 'e a'"e to issue its stock at a "ower price in the *+$+ if it can use the =apanese #arket as an indicator of what wi"" happen in the *+$+ #arket+ However1 this indicator wi"" not a"ways 'e accurate+

Advanced Questions
201 Effects of !eptem.er 001 3hy do you think the terrorist attack on the *+$+ was expected to cause a dec"ine in *+$+ interest rates4 &iven the expectations for a potentia" dec"ine in *+$+ interest rates and stock prices1 how were capita" f"ows 'etween the *+$+ and other countries "ike"y affected4 :/$3E(5 The attack was expected to cause a weaker econo#y1 which wou"d resu"t in "ower *+$+ interest rates+ &iven the "ower interest rates1 and the weak stock prices1 the a#ount of funds invested 'y foreign investors in *+$+ securities wou"d 'e reduced+ 221 International Financial Markets1 (ecent"y1 3a"0Mart esta'"ished two retai" out"ets in the city of $han%en1 China1 which has a popu"ation of -+@ #i""ion+ These out"ets are #assive and contain products purchased "oca""y as we"" as i#ports+ :s 3a"0Mart generates earnings 'eyond what it needs in $han%en1 it #ay re#it those earnings 'ack to the *nited $tates+ 3a"0Mart is "ike"y to 'ui"d additiona" out"ets in $han%en or in other Chinese cities in the future+ a+ Exp"ain how the 3a"0Mart out"ets in China wou"d use the spot #arket in foreign exchange+

Chapter 3: International Financial Markets

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:/$3E(5 The 3a"0Mart stores in China need other currencies to 'uy products fro# other countries1 and #ust convert the Chinese currency 7yuan8 into the other currencies in the spot #arket to purchase these products+ They a"so cou"d use the spot #arket to convert excess earnings deno#inated in yuan into do""ars1 which wou"d 'e re#itted to the *+$+ parent+ '+ Exp"ain how 3a"0Mart #ight uti"i%e the internationa" #oney #arket when it is esta'"ishing other 3a"0Mart stores in :sia+ :/$3E(5 3a"0Mart #ay need to #aintain so#e deposits in the Eurocurrency #arket that can 'e used 7when needed8 to support the growth of 3a"0Mart stores in various foreign #arkets+ 3hen so#e 3a"0Mart stores in foreign #arkets need funds1 they 'orrow fro# 'anks in the Eurocurrency #arket+ Thus1 the Eurocurrency #arket serves as a deposit or "ending source for 3a"0Mart and other M/Cs on a short0ter# 'asis+ c+ Exp"ain how 3a"0Mart cou"d use the internationa" 'ond #arket to finance the esta'"ish#ent of new out"ets in foreign #arkets+ :/$3E(5 3a"0Mart cou"d issue 'onds in the Euro'ond #arket to generate funds needed to esta'"ish new out"ets+ The 'onds #ay 'e deno#inated in the currency that is neededL then1 once the stores are esta'"ished1 so#e of the cash f"ows generated 'y those stores cou"d 'e used to pay interest on the 'onds+ 231 Interest Rates1 3hy do interest rates vary a#ong countries4 3hy are interest rates nor#a""y si#i"ar for those European countries that use the euro as their currency4 ffer a reason why the govern#ent interest rate of one country cou"d 'e s"ight"y higher than that of the govern#ent interest rate of another country1 even though the euro is the currency used in 'oth countries+ :/$3E(5 Interest rates in each country are 'ased on the supp"y of funds and de#and for funds for a given currency+ However1 the supp"y and de#and conditions for the euro are dictated 'y a"" participating countries in aggregate1 and do not vary a#ong participating countries+ 6et1 the govern#ent interest rate in one country that uses the euro cou"d 'e s"ight"y higher than others that use the euro if it is su'>ect to defau"t risk+ The higher interest rate wou"d ref"ect a risk pre#iu#+

Solution to Continuing Case Problem !lades" #nc$

2+ ne point of concern for you is that there is a tradeoff 'etween the higher interest rates in Thai"and and the de"ayed conversion of 'aht into do""ars+ Exp"ain what this #eans+ :/$3E(5 If the net 'aht0deno#inated cash f"ows are converted into do""ars today1 B"ades is not su'>ect to any future depreciation of the 'aht that wou"d resu"t in "ess do""ar cash f"ows+ ,+ If the net 'aht received fro# the Thai"and operation are invested in Thai"and1 how wi"" *+$+ operations 'e affected4 7:ssu#e that B"ades is current"y paying 2F percent on do""ars 'orrowed1 and needs #ore financing for its fir#+8 :/$3E(5 If the cash f"ows generated in Thai"and are a"" used to support *+$+ operations1 then B"ades wi"" have to 'orrow additiona" funds in the *+$+ 7or the internationa" #oney #arket8 at an interest rate of 2F percent+ For exa#p"e1 if the 'aht wi"" depreciate 'y 2F percent over the next year1 the Thai invest#ent wi"" render a yie"d of rough"y ; percent1 whi"e the co#pany pays 2F percent interest on funds 'orrowed in the *+$+ $ince the funds cou"d have 'een converted into do""ars i##ediate"y and used in the *+$+1 the 'aht shou"d pro'a'"y 'e converted into do""ars today to forgo the additiona" 7expected8 interest expenses that wou"d 'e incurred fro# this action+

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International Financial Management

-+ Construct a spreadsheet that co#pares the cash f"ows resu"ting fro# two p"ans+ *nder the first p"an1 net 'aht0deno#inated cash f"ows 7received today8 wi"" 'e invested in Thai"and at 2; percent for a one0year period1 after which the 'aht wi"" 'e converted to do""ars+ The expected spot rate for the 'aht in one year is a'out <F+F,, 7Ben Ho"t?s p"an8+ *nder the second p"an1 net 'aht0deno#inated cash f"ows are converted to do""ars i##ediate"y and invested in the *+$+ for one year at B percent+ For this 9uestion1 assu#e that a"" 'aht0deno#inated cash f"ows are due today+ !oes Ho"t?s p"an see# superior in ter#s of do""ar cash f"ows avai"a'"e after one year4 Co#pare the choice of investing the funds versus using the funds to provide needed financing to the fir#+ :/$3E(5 7$ee spreadsheet attached+8 If B"ades can 'orrow funds at an interest rate 'e"ow B percent1 it shou"d invest the excess funds generated in Thai"and at B percent and 'orrow funds at the "ower interest rate+ If1 however1 B"ades can 'orrow funds at an interest rate a'ove B percent 7as is current"y the case with an interest rate of 2F percent81 B"ades shou"d use the excess funds generated in Thai"and to support its operations rather than 'orrowing+

Plan %&!en 'olt(s Plan

Calculation of baht-denominated revenue: Price per pair of N$peedosN M Pairs of N$peedosN E Baht0deno#inated revenue Calculation of baht-denominated cost of goods sold: Cost of goods so"d per pair of N$peedosN M Pairs of N$peedosN E Baht0deno#inated expenses Calculation of dollar receipts due to conversion of baht into dollars: /et 'aht0deno#inated cash f"ows now 7B,J1A,F1FFF D ,FJ1@2,1FFF8 Interest earned on 'aht over a one0year period 72;G8 Baht to 'e converted in one year M Expected spot rate of 'aht in one year E Expected do""ar receipts in one year .1;A. 2BF1FFF B,J1A,F1FFF ,1B@2 @,1FFF ,FJ1@2,1FFF J,F1,FB1FFF A-1F-21,FF @2-1,-A1,FF < F+F,, < 2;1JA21,J,

Plan )*#mmediate Conversion

Calculation of baht-denominated revenue: Price per pair of N$peedosN M Pairs of N$peedosN E Baht0deno#inated revenue Calculation of baht-denominated cost of goods sold: Cost of goods so"d per pair of N$peedosN M Pairs of N$peedosN E Baht0deno#inated expenses .1;A. 2BF1FFF B,J1A,F1FFF ,1B@2 @,1FFF ,FJ1@2,1FFF

Chapter 3: International Financial Markets

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Calculation of dollar receipts due to conversion of baht into dollars: /et 'aht0deno#inated cash f"ows to 'e converted 7B,J1A,F1FFF D ,FJ1@2,1FFF8 M $pot rate of 'aht now E !o""ar receipts now Interest earned on do""ars over a one0year period 7BG8 E !o""ar receipts in one year

J,F1,FB1FFF < F+F,. < 2.1BB.1AA, 212AF1@AA < 2J1F@;1@A2 < 2;1JA21,J, 2J1F@;1@A2 < 7-B.1;,A8

Calculation of dollar difference between the two plans

P"an 2 P"an , !o""ar difference

Thus1 the cash f"ow generated in one year 'y P"an 2 exceed those generated 'y P"an , 'y approxi#ate"y <-B.1;,A+ Therefore1 Ben Ho"tOs p"an shou"d not 'e i#p"e#ented+

Solution to Supplemental Case +ret, Tool Compana+ Citicorp cou"d faci"itate the fo""owing financia" transactions5 2+ Foreign Exchange+ Citicorp cou"d provide whatever currency was needed 'y &ret% in the foreign exchange #arket+ ,+ $hort0Ter# Financing+ Citicorp cou"d provide short0ter# "oans to &ret% in whatever currency is desired through the internationa" #oney #arket+ 7Citicorp wou"d 'e the creditor here+8 Citicorp cou"d a"so accept short0ter# deposits in various currencies through the internationa" #oney #arket+ -+ Mediu#0Ter# Financing+ Citicorp cou"d provide #ediu#0ter# "oans to &ret% in whatever currency is desired through the internationa" credit #arket 7Citicorp wou"d 'e the creditor here8+ .+ )ong0Ter# Financing+ Citicorp cou"d p"ace 'onds issued 'y &ret% in the internationa" 'ond #arket 7Citicorp wou"d nor#a""y serve as an inter#ediary rather than the creditor here8+ Citicorp cou"d a"so he"p &ret% p"ace new"y issued stock in foreign stock #arkets+

'+ /or#a""y1 a su'sidiary wou"d prefer to 'orrow the currency that it uses to invoice its products+ Thus1 the future cash inf"ows wou"d 'e in the sa#e currency that is needed to pay 'ack the "oan1 and exchange rate risk is avoided+ $ince the British su'sidiary pro'a'"y invoices its products in British pounds1 this is the "ogica" currency to 'orrow+ However1 the high interest rate on the British pound #ay cause the su'sidiary to consider 'orrowing a different currency+ 6et1 it #ust recogni%e the risk invo"ved+ The currency 'orrowed wou"d initia""y 'e converted to pounds+ :t a future point in ti#e1 pounds wi"" 'e converted to that currency to repay the "oan+ Thus1 the risk is that the currency 'orrowed appreciates against the franc over the period of concern+ This concept is covered in detai" in "ater chapters+ :t this point1 the o'>ective is to si#p"y #ake the student aware of the possi'"e a"ternatives and the risk0return tradeoff invo"ved+

Small !usiness Dilemma

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International Financial Management

Use of the Foreign Exchange Markets .y the !ports Exports Company

2+ Exp"ain how the $ports Exports Co#pany cou"d uti"i%e the spot #arket to faci"itate the exchange of currencies+ Be specific+ :/$3E(5 The $ports Exports Co#pany wou"d have an account with a co##ercia" 'ank+ :s it receives pay#ent in pounds each #onth1 it wou"d deposit the check at a 'ank that provides foreign exchange services+ Each #onth1 the 'ank wou"d cash the check1 and then convert the British pounds received into do""ars for the $ports Exports Co#pany at the prevai"ing spot rate+ ,+ Exp"ain how the $ports Exports Co#pany is exposed to exchange rate risk and how it cou"d use the forward #arket to hedge this risk+ :/$3E(5 The $ports Exports Co#pany is exposed to exchange rate risk1 'ecause the va"ue of the British pound wi"" change over ti#e+ If the pound depreciates over ti#e1 the pay#ent in pounds wi"" convert to fewer do""ars+ The $ports Exports Co#pany cou"d engage in a forward contract in which it wou"d se"" pounds forward in exchange for do""ars+ For exa#p"e1 if it anticipated receiving a pay#ent in pounds -F days fro# now1 it cou"d negotiate a forward contract in which it wou"d se"" pounds in exchange for do""ars at a specific forward rate+ This wou"d "ock in the forward rate at which the pounds wou"d 'e converted into do""ars in -F days1 there'y re#oving any concern that the pound cou"d depreciate against the do""ar over that -F0day period+ This hedges exchange rate risk over the short run1 'ut does not effective"y hedge against exchange rate risk over the "ong run+