Financial Context of Business II: International aspects

International money markets:

International markets are in broadly two groups:

• International capital markets
• the foreign exchange markets

International capital markets:

International capital markets have greatly expanded since the 1950s. This has
been the result of:

• the progressive abolition of exchange controls limiting the flow of capital

in and out of economies
• growth of multinational companies (MNCs) who often do not use capital
markets in the ‘home’ country; by borrowing abroad in different
currencies, MNCs can shop around for favourable terms and also avoid
any domestic government credit restraints.

The funds available on international capital markets fall into three broad
categories:

• short-term capital (Eurocurrency) borrowed mainly for the purposes of

working capital

• medium-term capital (Eurocredit) borrowed for working capital and

investment purposes

• long-term capital (Eurobonds) borrowed for investment purposes and

for financing mergers and acquisitions. Eurobonds are bonds issued by
very large companies, banks, governments and supranational
institutions, such as the European Commission, to raise long-term
finance (typically five years and over). These bonds are denominated in a
currency other than that of the borrower, although often US dollars are
used. The bonds are bought and traded by investment institutions and
banks.
The international capital market is useful not only for business borrowers. It is
also used for government borrowers (e.g. United Kingdom local government
authorities) and provides a market for lending funds for businesses with
surplus cash. Thus, the market performs a useful international element to the
financial asset management function of commercial enterprises.

Although these international markets operate in many financial centres, they

are dominated by Europe and the USA, and especially London.

The term ‘euromarket’ had its origins in the 1970s. International trading
expanded and this led to new foreign currency markets, such as the Eurodollar
market. In this market, dollar balances earned by European exporters (to the
USA) were held in European banks earning interest on favourable terms
because they are offshore (held outside the country of origin and not subject
to central bank control).

Foreign exchange markets:

Foreign exchange markets are concerned with the purchase and sale of foreign
exchange. This is primarily for four reasons:

• the finance of international trade

• companies holding and managing a portfolio of currencies as part of
their financial asset management function
• financial institutions dealing in foreign exchange to on behalf of their
customers and in order to benefit from changes in exchange rates
• to manage risks associated with exchange rate movements.

This market enables companies, fund managers, banks and others to buy and
sell foreign currencies. Capital flows arising from trade, investment, loans and
speculative dealing create a large demand for foreign currency, particularly
sterling, US dollars and euros and typically deals worth $2 trillion are traded
daily in London, the world’s largest foreign exchange centre.

London benefits from its geographical location, favourable time intervals (with
the United States and the Far East in particular) and the variety of business
generated there – insurance, commodities, banking, Eurobonds, etc.
Foreign exchange trading may be spot or forward.

• Spot: transactions are undertaken almost immediately and settled

within two days.

• However, forward buying involves a future delivery date from three

months onward. Banks and brokers, on behalf of their clients, operate in
the forward market to mitigate the risk of adverse exchange rate
movements occurring in the normal course of international trading
transactions.

This risk arises when the prices of imports or exports are fixed in foreign
currency terms and there is movement in the exchange rate between the date
when the price is agreed and the date when the cash is paid or received in
settlement.

The forward price of a currency is normally higher (at a premium) or lower (at
a discount) than the spot rate. Such premiums (or discounts) reflect interest
rate differentials between currencies and expectations of currency
depreciations and appreciations.

The price of currency (the exchange rate) is determined by the operation of

currency transactions undertaken in the foreign exchange markets, with high
demand or low supply of a currency leading to a rise in its exchange rate and
low demand or high supply leading to a fall in the rate.

Foreign exchange risks:

Firms dealing with more than one currency are exposed to risks due to
exchange rate movements. There are three main aspects of this.

a) Economic risk: Long-term movements in exchange rates can undermine

a firm’s competitive advantage. For example, a strengthening currency
will make an exporter’s products more expensive to overseas customers.
One way of managing this risk would be to set up production facilities in
the markets you wish to sell into.

If this risk is not managed then the value of the business could be
adversely (or favourably) affected.
b) Transaction risk: In the time period between an order being agreed and
payment received the exchange rate can move causing the final value of
the transaction to be more or less than originally envisaged. This affects
the business’s cash flows and therefore its ability to forecast and
manage its cash position. Transaction risk can be hedged (minimised) in
various ways.

Forward exchange contracts: enable the purchase and sale of currencies

at a fixed exchange rate for a specified time period. They are a
straightforward way to guarantee the value of future transactions.
Transaction risk can also be managed by using derivatives, such as

Futures and options:

Futures are like a forward contract in that: the company’s position is
fixed by the rate of exchange in the futures contract, it is a binding
contract.

A futures contract differs from a forward contract in the following ways:

Futures can be traded on futures exchanges. The contract which
guarantees the price (known as the futures contract) is separated from
the transaction itself, allowing the contracts to be easily traded.

Settlement takes place in three-monthly cycles (March, June, September

or December), i.e. a company can buy or sell September futures,
December futures and so on.

Futures are standardised contracts for standardised amounts. For

example, the Chicago Mercantile Exchange (CME) trades sterling futures
contracts with a standard size of £62,500. Only whole number multiples
of this amount can be bought or sold.

Because each contract is for a standard amount and with a fixed

maturity date, they rarely cover the exact foreign currency exposure.

Transaction risk can also be mitigated using currency options. Options

are similar to forward contracts but with one key difference.

They give the right but not the obligation to buy or sell currency at some
point in the future at a predetermined rate.
 A company can therefore: exercise the option if it is in its interests to
do so let it lapse if:
• the spot rate is more favourable
• there is no longer a need to exchange currency.

The downside risk is eliminated by exercising the option, but there is

still upside potential from letting the option lapse. Options are most
useful when there is uncertainty about the timing of the transaction
or when exchange rates are very volatile.

c) Translation risk: If a company has foreign assets (e.g. a factory) denoted

in another currency, then their value in its home currency will depend on
the exchange rate at the time. If its domestic currency strengthens, for
example, then foreign assets will appear to fall in value.

This risk, however, is not realised unless the asset is sold, so is of less
commercial importance.

However, if the local currency value of foreign currency denominated

assets and liabilities changes, the change in local value could lead to a
breach in a debt covenant or a change in the viewpoint of the
shareholders, which could then affect the share price. If asset values
increase, measures such as return on capital employed will decrease,
also potentially affecting the viewpoint of the investors

lustration 1 – Transaction risk:

Suppose a UK Company A contracts to sell a machine to a US Company B for

$300,000 payable in three months’ time. If the exchange rate now (the ‘spot’
rate) is £1 = $2, then the $300,000 is worth £150,000.

However, when the cash is received, suppose the exchange rate has moved to
£1 = $2.10. (Note: the $ has weakened compared to the £ so £1 buys more $)

The $300,000 will then be worth 300,000/2.10 = £142,857, a fall of £7,143.

Similarly, an exchange gain may arise if the exchange rate moves in Company
A's favour (here we would want the $ to strengthen compared to the £). The
key problem lies in being able to predict future exchange rates
 Illustration 2 – Economic risk:

A US exporter sells one product in the UK on a cost-plus basis and invoices in £

to remain competitive in the UK market. The selling price in £ is based on costs
of $100 plus a mark-up of 5% to give a sales value of $105.

If the current exchange rate is $1 = £0.85 and the exporter sets the £ price
now, the invoice price for the product will be $105 × 0.85 = £89.25.

If the exchange rate moves to $1 = $0.90 then a receipt of £89.25 for the
product from the exporter’s customers would mean that (£89.25/0.9) $99.17 is
received by the exporter once the £ have been converted to $.

This would mean that the exporter would no longer be able to make any profit
on this product in the UK market and is in fact not quite covering its costs. The
exporter would have to consider raising the price to remain profitable, but this
would lead to lower competitiveness.

Conversely, if the exchange rate had moved in the opposite direction, the
exporter would be making higher profits on the product in the UK market and
could consider lowering the £ price to improve competitiveness.

Importers would feel the effects of exchange rate movements if they are
paying for goods and services in a foreign currency.

E.g., if the exporter invoiced in $ instead of £, pushing the exchange rate risk
onto the customer, then the UK importer is invoiced for $105. This makes a
payment of £89.25 when the exchange rate is $1 = £0.85 but this would rise to
£94.50 if the exchange rate moves to $1 = £0.90.

Illustration 3 – Translation risk:

A US company has debt denominated in US$ and its existing debt provider has
stipulated in a debt covenant agreement that the company will not take on
further debt above a level of US$1.5 million.

The company then takes out a loan in Euros with a value of €1,000,000. At the
time of the loan being taken out the exchange rate between US$ and € was € =
US$1.3, meaning that it has an effective US$ value of US$1.3 million. This
would not breach the debt covenant.
However, if the exchange rate moved above € = US$1.5 then the US$
value would rise to a higher value than is allowed by the covenant and
the company would be in breach of it.

Exchange rate systems:

Exchange rates: The exchange rate of a currency is a price. It is the external
value of a currency expressed in another currency, for example £1 = $1.25

The exchange of currencies is vital for trade in goods and services. British firms
selling abroad will require foreign buyers to exchange their currency into
sterling to facilitate payment. Similarly, British importers will need to pay out in
foreign currencies. Also, when funds are transferred between people in
different countries, foreign exchange is required.

Exchange rate systems – floating exchange rates:

Exchange rates that float is flexible and free to fluctuate in the light of changes
that take place in demand and supply. Such exchange rates are examples of
nearly perfect markets.

Demand:
Demand for a currency, sterling say, comes from a number of sources:

• It is required to pay for UK exports – for example, a French supermarket

buying English food priced in sterling will need to pay its suppliers in
sterling.

• Overseas investors making investments in the UK will need sterling – for

example, an American property company buying a factory building in the
UK will have to pay in sterling.

• Speculators may buy sterling if they feel it is about to increase

(appreciate) in value relative to other currencies.

• The government (strictly the central bank) may wish to buy sterling to
manipulate the exchange rate.

• For some currencies, there may be a demand for it to be held as an

international medium of exchange as is the case with the US dollar.
Supply:

Supply of sterling is also derived from a number of sources:

• UK purchasers wishing to buy imports priced in a foreign currency will

need to sell sterling and buy foreign currency.

• UK investors making overseas investments will need to sell sterling and

buy foreign currency.

• Speculators may sell sterling if they feel its value is about to decrease
(depreciate) relative to other currencies.

• The UK government (again, strictly the central bank) may sell currency
on the international markets to weaken the currency to improve export
performance. Today, the sale and purchase of currencies for trading
purposes is dwarfed by the lending and borrowing of funds.

Impact of different factors on the exchange rate:

Putting these issues together, we can comment on how various economic

factors affect exchange rates as follows:

• High inflation will weaken a currency as it makes goods more expensive

thus dampening export demand and reducing the demand for the
currency.

An increase in interest rates will have a two-fold effect. In the short run,
"hot money" will be attracted to UK deposits, increasing demand for
sterling and a corresponding rise in the exchange rate. In the long run,
high interest rates will erode the competitiveness of UK businesses
reducing the supply of and demand for UK goods. This will reduce the
demand for sterling, reducing the exchange rate.

• A trade deficit will result in the demand for sterling to buy exports being
lower than the supply of sterling to buy imports. This will result in
downward pressure on the exchange rate.
 • Speculation can influence the exchange rate up or down. This is usually a
short-term factor. In 2016, after the UK’s vote to leave the EU the pound
depreciated sharply. This was attributed by some as the effect of
speculation as to the future stability of the UK economy, with investors
switching their capital into traditionally secure currencies such as the
yen and the Swiss franc

In the diagram, suppose we have a factor that causes British goods to become
less competitive on world markets.

• This will result in a fall in the demand for British exports and hence
causes a shift in the demand curve for sterling to D1.

• This shift causes a fall in the exchange rate to P1, assuming that the
demand for British imports (and hence the supply curve) remains
unchanged.

• P1- Q1 would be a new equilibrium position at which the demand for

pounds and the supply of pounds are equal.

Note: since the demand and supply of a currency for trade purposes is a tiny
fraction of all demand and supply for a currency, current account
deficits/surpluses are unlikely to have much effect on the exchange rate.
Exchange rate systems – dirty floating:

Governments often intervene in the foreign exchange markets (either by

creating demand or supply of their currency as required) in order to maintain
or achieve an exchange rate target. The purpose of this normally is to make a
country’s exports more competitive, by lowering the exchange rate, or to assist
in the control of inflation.

The central bank will be instructed to:

• Buy or sell the currency to raise or lower the exchange rate.

• Alter interest rates to encourage the buying or selling of the currency.
• For example, raising interest rates should encourage speculators to
deposit more funds in that country. The subsequent rise in demand for
the currency should cause a rise in the exchange rate.

For example, China operates a managed floating exchange rate system

for the Yuan and international leaders have criticized the Chinese
government for keeping the value of the Yuan artificially low, to boost
exports.

'Hot' money: Deposits of money can be transferred from one currency

to another at short notice. This clearly affects the demand for, and
supply of, currencies. The main factors influencing such transfers of
what has been called ‘hot money’ are:
o relative interest rates – if the differential between nations
changes,
o then capital tends to move towards the nation whose interest rate
offers the most lucrative return
o expectations – if the holders of ‘hot money’ expect a currency to
appreciate, they will deposit money in that country, as the
appreciation will raise the exchange value of the deposits
o inflation – countries with relatively high rates will find their
currency less attractive to depositors because its value is
depreciating more than that of other countries.
Exchange rate systems – fixed:

Some governments will have a policy of fixing the value of their currency
against the value of another currency or to another measure of value, such as
gold. Known as a fixed exchange rate system, this can operate to stabilise the
value of their currency, making international trade easier.

Currency substitution:
Some countries even allow the use of a foreign currency in addition to the
domestic currency (known as currency substitution, or dollarisation when the
foreign currency used is US dollars). They may choose to do this in a period of
economic uncertainty where the home currency may be subject to significant
fluctuation. The use of a stable foreign currency stabilises the value of day to
day transactions.

Single currency zones:

One way of avoiding exchange rate risk is for each country to use the same
currency. The best-known example of such an arrangement is the plan for
Economic and Monetary Union (EMU), which seeks to establish a single
currency and monetary authority within the European Union.

Two major components of this integration are:

o A single European currency – the Euro
o The European Central bank.

The Euro:

The Euro was launched on 1 January 1999, with 11 of the then 15 members
agreeing to participate. National currencies were retained until 2002 to be
replaced with Euro notes and coins.

Performance of the Euro against other major world currencies has been
patchy.

In its first year, the Euro depreciated from $1.19 a Euro to $0.80 per Euro,
though it since recovered some of this value.
The European Central Bank (ECB):

The European Central Bank (ECB) began operations in May 1998 as the single
body with the power to issue currency, draft monetary policy, and set interest
rates in the Euro-zone. The Maastricht Treaty envisaged the ECB as an
independent body free from day-to-day political interference, with a principal
duty of price stability.

The ECB is the central bank for the Euro currency area and is based in
Frankfurt.

It is the sole issuer of the Euro. Its main objective, as defined by the Maastricht
Treaty, is price stability. It therefore has the power to set short-term interest
rates.

The main focus of its activities has been on interest rate policy rather than
exchange rate policy. Like the Monetary Policy Committee of the Bank of
England, the ECB pursues a policy of controlling interest rates as a means of
achieving influence over the long-term rate of inflation.