International Finance Chapter 18. International Finance Total global trade (as measured by exports): – 1948: $58 billion – 2008: $16.1 trillion – From.

International Finance

Chapter 18

International Finance

• Total global trade (as measured by exports):– 1948: $58 billion– 2008: $16.1 trillion– From 1948 to 2008, increase of 27,805%, or

roughly 10% per year compounded• This trade is underpinned by an international

financial community consisting of multinational banks, global stock markets, and multinational corporations.

CurrenciesA Short History of Fixed Exchange Rates• “Gold standard”: (prior to the 1929 Stock Market

crash) a nation’s currency was directly convertible into gold at a fixed exchange rate– Gold flowed out of a country that ran a balance of

payments deficit– Gold flowed into a country that ran a balance of

payments surplus– This fixed exchange rate regime was seen as a form of

discipline on countries to maintain a balance of interest rates and trade, though it was subject to breakdown if a country ran low on gold

Currencies

A Short History of Fixed Exchange Rates

• Depression of 1929-1941• Countries went off the gold standard as

domestic needs took precedence over orderly international trade relations

• Protectionism curtailed trading between countries – Smoot-Hawley tariff of 1930

• World War II

Currencies

A Short History of Fixed Exchange Rates

• Bretton Woods: 1944 agreement which established a new fixed currency regime with the dollar as the anchor and in turn, the dollar was tied to gold at a fixed price of $35 per ounce– Led to the creation of the International Monetary

Fund, the World Bank, the General Agreement on Tariffs and Trade (today’s World Trade Organization)

Currencies

A Short History of Fixed Exchange Rates

• Inflation in the 1960’s and consequent escalating commodities prices led President Nixon to “close the gold window” in August 1971, effectively ending the Bretton Woods exchange rate regime.

Currencies

Floating Exchange Rates• Floating exchange rate: exchange rate

between two currencies can move in price each day– Value of currencies is determined by supply and

demand in marketplace.

Currencies

Floating Exchange Rates• Under the floating exchange rate regime,

international businesses must account for currency translation risk.– Currency translation risk: risk that value of

foreign currency changes in a way which makes business less profitable, absent an exchange rate “devaluation”

Currencies

Floating Exchange Rates• Exchange rate of a particular currency with U.S.

dollar is either:1. How many dollars it takes to buy one unit of

foreign currency2. How many units of foreign currency it takes to buy

one dollar• Cross rate (American perspective): exchange rate

between two foreign currencies because it can be calculated by multiplying their rates relative to the U.S. dollar

Futures, Options and Swaps

• Securities and other contractual mechanisms that help businesses hedge their currency translation risk:1. Forward contracts2. Future contracts3. Option contracts4. Swap Agreements

Future, Option and Swap

1. Forward contracts: privately negotiated agreements under which one party (often commercial bank) would agree to purchase another currency from counterparty at some fixed rate at some defined point forward in time– Terms negotiated between parties:• Type of currency• Rate• Time for forward delivery• Mechanism (physical delivery or cash settlement)

– Each contract is a “one-off” deal– Rarely secondary trading or securitization of contract

Futures, Option and Swap

2. Futures contracts: traded on an exchange– E.g. Chicago Mercantile Exchange– Standardized terms of contract:• Quantity of currency• Rate• Time of delivery• Mechanism for settlement (generally cash settlement)

– Merc facilitates liquidity in any particular contract, albeit at the expense of individual tailoring that a forward contract can provide.

Future, Option and Swap

3. Option contracts: one party pays a price (premium) to have the right to buy (for a call option) or sell (for a put option) a certain amount of currency at a defined price (called the strike price)– Priced based on elaborate financial models• Many are derived from Black-Scholes option pricing

model by Fisher Black and Myron Scholes in the early 1970’s.

Future, Option and Swap4. Swap agreements: privately negotiated agreements

between parties under which one party agrees to trade (or swap) a risk it bears with a counterparty in exchange for an instrument that does not have that risk– E.g. Interest rate swap: one party that is bearing interest

risk through a floating interest rate will agree to swap floating rate for a fixed rate from counterparty

– There may be explicit fee associated with swap– Fee may be embedded into terms of swap– Borrower benefits by locking in a fixed rate and

counterparty benefits from the fee income it generates for swap

Future, Option and Swap

4. Swap agreements (continued)– Swap agreements that hedge currency risk: one

party agrees to swap steam of cash flows in one currency for that same set of cash flows in a different currency

– Credit default swaps: one party swaps its credit default risk, an upfront fee and series of annual fees, until expiration of swap to counterparty in exchange for assurance of payment of notional value of swap contract in the event that the underlying company defaults on payments of its debt securities

Money Markets• International money market: international debt

securities with maturities of 12 months or less• Eurodollar market: debt securities denominated

in several different currencies with U.S. dollar being most prevalent

• Eurodollar: any dollar located outside the U.S., or currency borrowed in London money market at London Interbank Offered Rate (LIBOR)– 90 day LIBOR: benchmark short term rate, or proxy

for what it costs for one bank to borrow from another for a short period of time

Money Markets• Interest equalization tax (1963)– Made repatriating dollars more expensive than

keeping them abroad– Caused international banks to look for a way to

borrow and lend in dollars outside the U.S. – directly led to creation of Eurodollar market

• Eurodollar market today– Large, generally steady, liquid market– Banks lend to each other at the LIBOR– Banks use LIBOR as proxy for their cost of funds and

charge their best customers some spread over LIBOR

Money Markets

• Interest rate parity– Interest rates charged in international money

market are tied to exchange rates of underlying countries

– No-arbitrage condition that must hold, on average, over time

– Difference in forward exchange rate for two countries’ currencies must equal difference between interest rates in those countries

Money Markets

Interest Rate Parity• “Carry trade”: hedge funds borrowed money

in Japan at low interest rates on assumption that the Yen would not appreciate sufficiently to offset interest rate differential– From mid-2002 to July 2007, the Yen/Dollar

exchange rate was stable, but broke down in July 2007 - January 2009 time period

– Hedge funds which had borrowed in Yen were stuck with massive losses

Capital Markets

• In the immediate aftermath of World War II, American capital markets were dominant in the world finance.

• Over the past sixty plus years, New York has gradually decreased in importance as a global financial center.

• The result of this is that global capital raising is more dispersed with regional centers such as London and Hong Kong rising in importance

Capital Markets

• Trading occurs among major market centers around the world and across time zones!– Business managers face risks and opportunities– Company can list its shares on one of many different

financial markets– Financial firms need individuals in various locations in

order to meet global clients’ demands– Global risk managers need to be alert to changes in

market conditions, interest rates, and exchanges rates, and the consequent effects on business conditions