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Global Financial Markets and Institutions

Global Financial Markets and Institutions. FIN101 Supplement: Introduction to Finance, Financial Markets, and Institutions Chapter 1 Dr. K. G. Viswanathan. Introduction to Exchange Rates. Exchange Rate the conversion rate of one currency to another.

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Global Financial Markets and Institutions

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  1. Global Financial Markets and Institutions FIN101 Supplement: Introduction to Finance, Financial Markets, and Institutions Chapter 1 Dr. K. G. Viswanathan

  2. Introduction to Exchange Rates Exchange Rate the conversion rate of one currency to another. Exchange rates between currencies are quoted in direct and indirect terms. Viswanathan Ch. 1

  3. Introduction to Exchange Rates Direct Quote: indicates the units of home currencies that one unit of foreign currency buys at a specific point in time. [Home/(1)Foreign] Indirect Quote: indicates the units of foreign currency that one unit of home currency buys at a specific point in time. [Foreign/(1)Home] Viswanathan Ch. 1

  4. Introduction to Exchange Rates Currency Appreciation and Depreciation: Currency prices move up (appreciate) and down (depreciate) against other currencies. Viswanathan Ch. 1

  5. Home CCY Foreign CCY (US$1) Converting Currencies For Direct Quotes: Given: DM1.60/$ DM200,000 USD Equivalent: = DM200,000/DM1.60 = US$125,000 Viswanathan Ch. 1

  6. Foreign CCY Home CCY (DM1) Converting Currencies For Indirect Quotes: Given: US$0.6250/DM DM200,000 USD Equivalent: = DM200,000*US$0.6250 = US$125,000 Viswanathan Ch. 1

  7. Foreign Exchange Risk FX risk is the risk associated with the uncertainty of CF (Cash Flows) as a result of changes in exchange rates. Factors affecting exchange rates: • Macroeconomic Factors • Inflation • Interest Rates • Budget and Trade Deficits • Economic Growth • Money Supply • Political Factors • Government Stability • Market Regulations • Legal Environment These factors affect the supply and demand of currencies traded in FX markets, which in turn sets the price. Viswanathan Ch. 1

  8. Foreign Exchange Risk Example: GE à Lufthansa (DM25 payable in 1 year) Current Exchange Rate: $0.625/DM $15.625Mil Dollar Depreciates after 1 Year FX Rate: $0.610/DM $15.250Mil Loss Due to change in FX Rate ($375,000) Dollar Appreciates after 1 Year FX Rate: $0.650/DM $16.250Mil Gain Due to change in FX Rate $625,000 FX Risk can be managed by using derivatives. Viswanathan Ch. 1

  9. FX Settlement Risk (Herstatt Risk) June 26, 1974 Bankhaus Herstatt lost its banking license, and was ordered into liquidation during the banking day. German interbank payments system closes at 3:30 local time, during which time the bank was paid in DM counterparty payments were made. Herstatt’s NY correspondent bank suspends all USD payments at 10:30am. As a result the settlement fails. Similar examples include: Drexel Burnham Lambert BCCI (Bank of Credit and Commerce International) Barings Viswanathan Ch. 1

  10. FX Settlement Risk 5-6 hour lag DM USD DM200,000 AB US$125,000 Viswanathan Ch. 1

  11. Impact of Globalization on Financial Markets & Institutions Financial Integration: degree to which capital can flow between financial markets. Intermediaries obtain and disburse funds around the globe. Viswanathan Ch. 1

  12. International Bond Markets International Bond Markets are made up of two basic bond types: • Eurobonds • Foreign Bonds Viswanathan Ch. 1

  13. Eurobonds “A eurobond is an underwritten bond offered through an international syndicate of investment bank in countries other than the country in whose currency the issue is denominated.” Example: US based firm issuing USD bonds in Europe and Asia. Viswanathan Ch. 1

  14. Foreign Bonds “A foreign bond is an underwritten bond offered by a foreign issuer in a country, and denomination in the currency of that country.” Examples: Bulldogs – German firm issuing GBP bonds in the UK. Yankees – French firm issuing USD bonds in the US. Samurai Bonds – US firm issuing JPY bonds in Japan. Viswanathan Ch. 1

  15. International Equity Markets Euroequity Markets: “Equity issues specifically designed for distribution among foreign markets, underwritten by a group of investment banks and purchased mainly by institutional investors.” Issuing Equities: Firms can raise additional capital by listing its issues on foreign exchanges. Viswanathan Ch. 1

  16. Impact of Globalization on Investments Reasons to include foreign assets in a portfolio: • Diversification • Market Performance Ways to achieve international diversification: • Direct investment in stock traded on foreign exchanges • Investing in foreign securities traded on domestic exchanges • Investing in investment companies that invest in foreign securities. Changes in FX rates can dampen or amplify the impact of foreign investments. Viswanathan Ch. 1

  17. Impact of Globalization on Corporate Finance Risks associated with international business activity: • Political Risk • Social Risk • Economic Risk Forms of international business activity: • Exporting and Importing • Operating subsidiaries in foreign markets • Selling in foreign markets • Financing from foreign sources Viswanathan Ch. 1

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