Chapter 02

International Financial
Markets: Structure and
Innovation
Learning Objectives
A. Describe foreign exchange (FX) markets,
structure and participants.
B. Use FX direct and indirect quotes,
compute transaction costs and calculate
cross rates.
C. Classify international banking
transactions.
D. Describe Euro-markets (short- and long-
term) and global equity markets.

2-2
A1. Foreign Exchange (FX): An
Overview
Focus on spot market (immediate
exchange of one currency for another)
rather than forward market
Large market with daily volume greater
than that of any other financial markets
Major players include:
MNCs and other entities have business related
needs to convert currency
Banks and other intermediaries service others
by converting currencies
Investment funds have portfolio-related needs
to convert currencies

2-3
A2. FX Markets: MNC
Participation
MNCs convert currencies to facilitate
transactions with subsidiaries, affiliates,
suppliers and customers
3 specific ways of participation:
MNCs purchase inputs/components from
foreign suppliers
MNCs sell goods and services in foreign
markets
MNCs make cross-border investments in real
assets
2-4
A3. FX: Banks & Other
Participants
Banks: most important players serve as
market makers/dealers, make up the
interbank market
Other financial institutions: investment
firms such as mutual funds, hedge funds
Governments: not the largest player, but
very influential with possible intervention
to manipulate the currency value
Individuals: tourism and investment needs
are met through currency transactions
2-5
A4. FX Markets: Size &
Structure
Overall size is USD 4 trillion a day, of which
37% is in the spot market and the rest are
future/forward contracts
Average transaction size is USD 4 million
Foreign exchange markets are fairly efficient
at price, allocation, and information
Major currencies are USD, EUR, JPY and
GBP with USD taking up 86% of all
transactions
Trades are done over-the-counter (OTC)
electronic markets
Settlement is electronically conducted within
two days after the transactions. Popular
systems include FedWire and CHIPS
2-6
B1. Foreign Exchange Quote
An exchange rate is the price of one currency in
terms of another currency
Given 3 = $5, dividing both sides by $5 gives
0.6/$ showing the number of GBP that one
dollar can buy. Its inverse 1/0.6 yields an
equivalent exchange rate at $1.6667/
A floating currency, whose value is determined
by market forces. Appreciate (depreciate) if it
gains (loses) value.
A pegged currency with its value set by the
government. Increase (decrease) in par value is
known as revaluation (devaluation)
B1. FX: Direct vs. Indirect Quote
Direct Quote
USD 1.25 per
EUR
Or
EURUSD=1.25
Indirect Quote
EUR 0.80 per
USD
Or
USDEUR=0.80
EUR 1
USD 1.25
USD 1
EUR 0.80
EQUALS
EQUALS
2-8
Equilibrium Exchange Rate
In a freely floating regime, exchange rate is
the market-clearing price that equilibrates
supplies and demands in the foreign exchange
market






Keep track of the currency units

S
D

$/
1.6667
Exchange Rate Changes:
Example
If GBP rises from $1.7188/ (e
0
) to $1.9586/
(e
1
) , then GBP has appreciated against the
dollar by (e
1
e
0
)/e
0
= (1.9586 1.7188) /
1.7188 = 13.95%
1 = $1.9586 translates into $1 = 0.51 = 1/e
1

(1/1.9586). 1 = $1.7188 is equivalent to $1 =
0.58 = 1/e
0
(1/1.7188). Dollar depreciates
against GBP by (1/e
1
1/e
0
)/(1/e
0
) = (0.51
0.58)/0.58 = -12.07%
The percentage change in currency value
differs because the base of which the change
is measured differs
Percentage Changes in
Foreign Exchange Rates
Percentage changes in direct and indirect FX
rates are related, as an appreciation in one
currency must be offset by a depreciation in
the other
Think of buying/selling the currency in the
denominator of an exchange rate
If the currency you would like to reference is
in the numerator, simply move it to the
denominator according to S
d/f
= 1/S
f/d

(1 + s
d/f
) = 1/(1 + s
f/d
)
B2. FX: Bid and Ask
EURUSD ($/) is quoted at 1.5511-1.5514
The bank is willing to purchase one EUR by
paying USD 1.5511. That is the amount you
receive when you sell one EUR to the bank.
The bank is willing to sell EUR by receiving USD
1.5514. This is the cost to you of buying one
EUR from the bank.
With the logic of Buy low and Sell high, the
banks profit margin for the trades of EUR is



%. 01934 . 0
5514 . 1
5511 . 1 5514 . 1
EURUSD for ask - bid Percent =

=
2-12
Bid/Ask Quotation
Bid-ask spread for small retail
transaction is commonly in the range
of 3% - 7%
Bid-ask spread for wholesale
transaction is commonly in the range
of 0.01% - 0.03%
Factors affect the bid/ask spread:
Currency liquidity
Order costs
Credit quality
B3. FX: Transaction Costs
EXAMPLE: A Brazilian firm wishes to
purchase USD 400,000. It approaches
Unibanco bank for a quote. Unibanco
quotes USDBRL (R$/$) at 1.4015
1.4037. Also Unibanco imposes a
commission of Brazilian real (BRL) 200
on each transaction.
Since buying $1 costs R$1.4037, Firm Pays =

680 , 561 200 4037 . 1 000 , 400 BRL = +
2-14
B3. FX: Transaction Costs (cont.)
For a pure trade with no spread, firm pays



Cost saving =
Percentage cost for transaction =

Bid-ask spread for a particular currency
that the MNC is seeking to buy/sell is the
banks profit paid by the MNC
640 040 , 561 680 , 561 =
040 , 561
2
4037 . 1 4015 . 1
000 , 400 BRL =
+

% 114 . 0
040 , 561
640
=
2-15
B4. FX Cross Rates: Example
EUR is quoted directly and indirectly relative to
USD at 1.5514 ($/) and 0.64458 (/$)
respectively. The JPY is quoted directly and
indirectly relative to the USD at 0.0100 ($/)
and 100.00 (/$) respectively. Calculate the
cross rate between EUR and JPY using one of
the following two approaches.

Solution:
Value of EUR expressed in JPY = EURJPY (/)
= Direct quote of EUR / Direct quote of JPY
= ($/) / ($/) = 1.5514 / 0.0100 = 155.14
OR (/) = (/$) ($/) = 100 1.5514 = 155.14
2-16
C1. International Banking

Classification of Banking Positions
Residents Non-Residents
Domestic Currency A B
Foreign Currency D C
B+C = external or cross-border positions
C+D = foreign currency positions (also known as Eurocurrency)
B+C+D = international positions
A+B+C+D = global positions
Source: BIS, Guide to the International Banking Statistics, 2003

2-17
International transactions are transactions
dealt with non-residents (cross-border) or
transactions involve a foreign currency.
C2. Bank Deposit Classification:
Example
Consider the following transactions of a French
bank. It accepts two deposits from a French
citizen: EUR 5,000 and USD 10,000. It also
accepts two deposits from a Japanese citizen:
JPY 2,500,000 and EUR 8,000. Classify these
deposits.
Solution:
External positions = JPY 2,500,000 + EUR 8,000
Foreign currency positions = USD 10,000 + JPY
2,500,000
International positions = USD 10,000 + JPY
2,500,000 + EUR 8,000
Global positions = USD 10,000 + JPY 2,500,000 +
EUR 13,000

2-18
D1. Eurodollars & LIBOR
Eurocurrency is a freely convertible currency
deposited in a bank outside its country of
origin. USD on deposit in London become
Eurodollar
Deposits can be placed in a foreign bank or in
the foreign branch of a domestic US bank
The key indicator for the Eurocurrency market
is the London Inter Bank Offer Rate
(LIBOR), the rate offered by Eurobanks for
loans to other institutions
LIBOR rates are compiled by the British
Bankers Association, and disseminated at 11
am Greenwich Mean Time, reflect rates at
which banks are willing to lend to each other
2-19
Eurobanks
Banks in which Eurocurrencies are kept
are called Eurobanks
A bank, or bank department that accepts
deposits and makes loans in currencies
other than their domestic currencies where
the bank is located.
Eurobanks are major world banks that
conduct a Eurocurrency business in
addition to all other banking functions.
Loans to non-Eurobanks account for fewer
than half of all Eurocurrency loans

Example: LIBOR/LIBID
Technically, LIBID is the deposit rate and
LIBOR is the lending rate used in the
Eurocurrency markets
An MNC deposits $3 million for 60 days at a
LIBID rate of 5%.
With a daily rate of 5%/365, future value

Use compound interest


. 000 , 025 , 3
365
60
% 5 1 000 , 000 , 3 FV =
|
.
|

\
|
+ =
%. 178 . 5 1
000 , 000 , 3
000 , 025 , 3
return annual Effective
60 / 365
= |
.
|

\
|
=
D3. Eurocurrency Markets
Eurocurrency is a currency deposited in a
bank located in a country other than the
country issuing the currency.
The prefix Euro has nothing to do with euro
currency
Eurodollar, Euroyen, Europound and other
instruments make up the Eurocurrency
markets (move toward renaming to foreign
currency markets, because of confusion with
EUR)
Eurdollar origins:
Regulation Q (investors searched abroad for better
interest)
External holdings of USD (current account
deficits)
Innovation by Midland Bank in 1955, thwarting
regulation and creating this market
2-22
Euro-currency Markets
USD remains the dominant Eurocurrency
Euro-currency market involves a chain of deposits
and a chain of borrowers and lenders by
transferring control of deposits from one
Eurobank to another Eurobank.
No one buys or sells Eurocurrencies
Serve two valuable purposes:
Eurocurrency deposits are an efficient and convenient
money market device for holding excess corporate
liquidity
A major source of short-term bank loans to finance
corporate working capital needs, including the financing
of imports and exports
Eurocurrency Markets
Eurocurrency markets are unregulated
because the government issuing the
currency has no direct jurisdiction over the
deposit, the depositor or Eurobank
Eurocurrencies have short maturities and
floating rates
Two key financial instruments are Euro
commercial paper and Euro certificate of
deposit
Interest Rates in Domestic Credit
and Eurocurrency Markets
The interbank Eurocurrency market is very
competitive
Eurocurrencies trade in an external credit market
Eurocurrency market pays more interest on
deposits and accepts less interest on loans than on
comparable transactions in domestic credit
markets
MNCs with large enough borrowing needs and
good enough credit are able to find deals
Most Eurocurrency transactions are unsecured
transactions between private parties
Asia-currency Market
Located in Singapore because of the lack of
restrictive financial controls and taxes there
Asia-dollar markets was founded in 1968 as a
satellite market to channel to and from the
Eurodollar market the large pool of offshore
funds, mainly USD, circulating in Asia
The Asia-bond counterpart to the Asia-dollar
market is the dragon bond.
A dragon bond is long-term debt denominated
in a foreign currency (usually USD) but
launched, priced and traded in Asia
D4. Eurocurrency Loans:
Eurocredit Markets
Medium-term debt markets for 2-5 years
Main instrument is Floating Rate Note (FRN)
with interest specified as LIBOR + X
At any point in time, only the next period is
known, others depend on future values of
LIBOR. If margin is 75 bps, and current
LIBOR = 6%, the borrower will pay 6.75%
Term structure models or prices from futures
markets may be used to infer future values of
LIBOR. The reset period normally chosen is 6
months. LIBOR6 means a 6-month reset
period.
Fixed rate instruments known as Euronotes
sold in the Eurocurrency market
2-27
Example: Floating Rate Notes
A Filipino firm has arranged a 250m, 5-year
Euroeuro loan with a German bank.
With an up-front fee of 2%, net proceeds =
250m (1 0.02) = 245m
Interest is set at LIBOR + 1.75%, with LIBOR
reset every 6 months. The current LIBOR6 =
5.5%, the first semi-annual debt service
payment = 250m [(0.055+0.0175)/2] =
9.0625m
EAR = [1 + (9.0625/245)]
2
1= 7.53%
D5. Eurobonds
Mismatch between country of issue and currency
denomination (e.g., USD bonds issued outside of US)
A bond issued by a firm located in USA, denominated
in USD, but sold to investors in Europe and Japan
(not to investors in USA)
First Eurobond issued in 1963 by Autostrade
Traditionally, Eurobonds are bearer bonds
Main currencies: USD (75%), EUR, JPY, GBP
Median issue: USD 100 million
Most are fixed rate instruments
Issuers (i.e. borrowers) are typically well-known with
excellent credit ratings, e.g. GM
2-29
Eurobond Market
Issuers tend to be MNCs, large in size, and have wide
name recognition with high AAA bond quality ratings
Corporate issuers find the euro bond markets attractive
The choices of contract types (e.g. FRN, in bearer form,
in denomination of $5,000 and $10,000) ) and
denomination currencies are available to support
flexibility in the structure of the issue
Unregulated market implies disclosure requirements and
registration costs for Eurobond issues are much lower
than those for comparable domestic issues
Eurobond issues are cost-effective for raising long-term
debt capital because of the larger size of the market
compared to national markets.
Important also because of the potentially wider pool of
the investors that can be attracted
Eurobond Markets
Placement: A Eurobond is often underwritten by
an international syndicate of banks and other
securities firms, often with a 100+ underwriters
involved for an issue as small as $25 million
Being sold exclusively in countries other than
the country in whose currency the issue is
denominated, Eurobond market is fueled by
emergence of the swaps
Eurobond markets are free from regulatory
interference, less stringent disclosure rules and
favorable tax treatments for these bonds
Interest on Eurobonds is paid annually
Foreign Bonds
A bond issued by a foreigner for sale in the
domestic capital market of another country, and
denominated in the currency of that country.
A bond issued by a firm of resident in Sweden,
denominated in dollars, and sold in USA to US
investors by US investment banks and subject
to domestic regulatory agencies
Foreign bond market refers to the portion of
domestic bond market that represents issues
floated by foreign companies, with nicknames
such as Yankee bonds, Samurai bonds, and
Bulldogs

Global Bonds
Global bonds are bonds traded in the
Eurobond markets as well as in one
or more national bond markets
Both foreign bond and Eurobond
represent the flexibility that issuers
have in targeting their markets and in
taking advantage of the relative
strengths/weakness of various
currencies
International Debt Markets
B + D = external (cross-border) bond
market
B + C + D = international bond market
C + D = euro bonds are traded in a more
global market

Issue by Residents Issued by Non-
residents
Domestic Currency (A) Domestic Bond (B) Foreign Bond
Foreign Currency (C) Eurobond (D) Eurobond
Impact of Global Financial Crisis
on Bond Markets
Like money markets, bond markets also
experienced a flight to quality in 2007-2009.
Issuers with lower credit ratings find it
expensive and at times difficult to sell new
bonds
Secondary market yields on lower-rated issues
also increase relative to Treasury bonds (i.e. the
widening of bond market credit spreads)
After markets have returned to normal in 2009
and 2010, corporations around the world issue
large amounts of debt to take advantage of low
interest rates
Toronto Stock Exchange is the eighth-
largest stock exchange in the world
Many different equity markets exist
NYSE is the largest exchange owing to the fact that (a)
the US equity markets are the largest in the world, (b)
NYSE has engaged in many acquisitions worldwide.
Emerging markets
Generally less regulation and standardization
of trading activity
Risks: Illiquidity, lack of information,
political uncertainty
International Equity Markets
Cross-Listing Process
Advantages of listing

Prestige and goodwill
Established value in
mergers and acquisitions
Excellent market visibility
More available
information
Facilitates valuation for
tax purposes
Increased marketability
and attention of investors
Disadvantages of listing
Additional controls on
management
Additional costs to the
company
Market indifference (i.e.
trading volumes turn out
to be very low)
Additional disclosure
required
The need to keep market
participants informed