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C H A P T E R 3

C H A P T E R 3. International Financial Markets and Corporate Governance. Chapter 3 Objectives. This chapter will describe the: A. Foreign exchange market B. International money market C. International credit market D. International bond market E. International stock markets

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C H A P T E R 3

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  1. C H A P T E R 3 International Financial Markets and Corporate Governance

  2. Chapter 3 Objectives This chapter will describe the: A. Foreign exchange market B. International money market C. International credit market D. International bond market E. International stock markets F. Corporate Governance (added)

  3. A. Foreign Exchange Market 1. History of Foreign Exchange a. Gold Standard b. Agreements on Fixed Exchange Rates – after Bretton Woods Agreement in 1944 c. Floating Exchange Rate System Discussion (not in the text book): • Do you understand the US currency system? • Can you think of any shortcomings associated with the floating exchange rate system?

  4. A. Foreign Exchange Market 2. Foreign Exchange Transaction a. Spot Market: b. Spot Market Time Zones c. Spot Market Liquidity Discussion: • Go to www.forex.com and set up a practice account and you can trade with $50,000 virtue money. • Visit http://www.dailyfx.com/to get daily foreign exchange market news. • What is market liquidity? Is Thai Baht more liquid than US$? Why or why not?

  5. Spot Market Time Zone Example Distribution of the trading activity in the United States spot market in time: 1 - transactions volume between 12 p.m. and 4 p.m.; 2 - between 4 p.m. and 8 p.m.; 3 - between 8 a.m. and 12 p.m.

  6. Spot Market Time Zone • In an active global trading day (24 hours), the euro/dollar exchange rate may change its value 18,000 times. • An exchange rate may "fly" 200 pips in a matter of seconds if the market gets wind of a significant event. • The exchange rate may remain quite static for extended periods of time, even in excess of an hour, when one market is almost finished trading and waiting for the next market to take over. This is a common occurrence toward the end of the New York trading day.

  7. Foreign Exchange Market Players • The major traders in the spot market are the commercial banks and the investment banks, followed by hedge funds and corporate customers. • In the interbank market, the majority of the deals are international, reflecting worldwide exchange rate competition and advanced telecommunication systems. • Although the hedge funds' and corporate customers' business in foreign exchange has been growing, banks remain the predominant trading force.

  8. A. Foreign Exchange Market 3. Foreign Exchange Quotations a. Spot Market Interaction Among Banks b. Bid/Ask Spread of Banks 1. Ask price is always higher than bid prices 2. Buyers buy at ask prices and sellers sell at bid prices. c. Comparison of Bid/Ask Spread Among Currencies – Liquidity issue d. Factors that Affect the Spread: Spread = f(order costs, inventory cots, competitions, volume, currency risk) Example: Assume you have $1000 and bid rate is $1.52/£ and ask rate is $1.60 /£. Meanwhile, the bid rate is quoted as 0.625 £/$ and the ask rate is quoted as 0.6579 £/$. If you convert it to £ and then convert it back to $, what will happen ?

  9. B. Interpreting Foreign Exchange Quotations 1. Direct versus Indirect Quotes: a. The direct quote is the local currency price of one unit of foreign currency e.g. In New York City $1.38/€. • Indirect quote is the inverse of the direct quote. It is the quotations that represent the number of units of a foreign currency per dollar. e.g. In New York City €0.72/$. • Cross Exchange Rates: it is the quotations that represent the number of units of a foreign currency per another foreign currency. e.g. In New York City: €0.90/£. You can get the cross exchange rates at www.forex.com.

  10. B. Interpreting Foreign Exchange Quotations 3. Forward, Futures and Options Markets a. All are methods to hedge against negative exchange rate changes b. All three are contracts that: 1.) specify a fixed amount of currency 2.) to be bought or purchased at a fixed exchange rate 3.) at a specified time

  11. C. International Money Markets 1. Origins and Development a. European Money Market What is eurocurrency? e.g. eurodollar, euroyen. One key reference eurodollar rate is the three-month US dollar LIBOR (London Interbank Offered Rate) rate. b. Asian Money Market: Story of what has happened in South Korea during Asian financial crisis. 2. Money Market Interest Rates Among Currencies

  12. C. International Money Markets 3. Global Bank Regulations: Attempts at Standardization a. Single European Act, 1992 Story of attacks by Soros at GBP and Italy lira in 1992: Soros was betting on 10 billion worth of GBP and his profit was 1.1 billon dollars from its attack against GBP. He also bet on French Franc and Deutsche Mark but he lost this time. b. Basel Accord, December 1987 and Basel II Accord, at present – standardized requirements on banks, and Basel III accord in 2012 Banks must maintain capital equal to at least 4% of their capital.

  13. D. International Bond Market Eurobond Market a. Features of Eurobonds: bonds sold in countries other than the country of the currency denominating the bonds. e.g. McDonald Co. issued Eurobond. b. Secondary Market: Eurobonds can be traded in the secondary market.

  14. F. International Stock Markets 1. Issuance of US Stock in Foreign Markets e.g. Marsh and McLennan Companies is traded in LSE (ticker: MHM). IT is also traded in NYSE (ticker: MMC). • Issuance of Stock by Non-U.S. Firms in the U.S. Story of Sohu.com. • Issuance of Foreign Stocks in the US: American Depository Receipts (ADRs) Example: China southwest airline (ZNH), Toyota Motor Corp (TM). Website for Depository Receipts information: http://www.adrbnymellon.com/home_dr.jsp “over 735 New Depositary Receipt Programs were introduced between 10/1/08 and 8/17/09. Some of the well-known companies include: Credit Aricole(CRARY) and Careefour (CRERY) of France, Linde (LNAGY) of Germany, Konica Minolta(KNCAY) of Japan, Standard Bank(DBGOY) of South Africa. The 735 ADRs have very thin daily trading volumes since they are new and mostly traded OTC (over the counter).”

  15. F. International Stock Markets - More discussion about ADR • ADRs trade just like stocks but represent shares of a foreign company trading on a foreign stock exchange. • ADR shares float on supply and demand, just like a regular stock. • How ADR is generated: Suppose the prospects for China airline industry is positive. South China Airline wants to list shares on the NYSE to gain exposure to the U.S. market. South China Airline already trades on the Chinese Stock Exchange at 40 Yuan, which is equivalent to US$5.8. Let's say that a U.S. bank purchases 30 million shares and issues them in the U.S. at a ratio of 5:1. This means each ADR share you purchase is worth 5 shares on the Chinese Stock Exchange. So, the new ADR should have an issue price of around US$29 each (5 times $5.8). What will happy if the price is more than $29? • ADR Risk: Political risk, exchange rate risk and inflation risk.

  16. Foreign Cash Flow Chart of an MNC Insert Exhibit 3.5 page 71

  17. Corporate Governance - The Agency Problem • Arises because of the separation of decision-making and risk-bearing functions • Why the managers are hired in the first place? • Examples of Agency Problem • Few shareholders have strong enough incentive to incur the costs of monitoring management themselves. 4-17

  18. Remedies for the Agency Problem • Governance mechanisms: • 1. Board of directors • 2. Incentive contracts • 3. Concentrated ownership • 4. Accounting transparency • 5. Debt • 6. Overseas stock listings • 7. Market for corporate control 4-18

  19. Law and Corporate Governance • Commercial legal systems of most countries derive from a relatively few legal origins. • The content of law protecting investors’ rights and the quality of law enforcement vary across countries. 4-19

  20. Ownership and Control pattern • Concentrated ownership may create a different agency conflict • Mechanisms to acquire control rights

  21. Daimler-Benz AG Exhibit of Ownership Structure 14% 28.3% 25.23% 32.37% Deutsche Bank Kuwait government Mercedes-Automobil Holding AG Widely Held 25% 25% 50% Widely Held Stella Automobil Beteiligungsges mbH Stern Automobil Beteiligungsges mbH Widely Held 25% 25% 25% 25% Bayerische Landesbank Robert Bosch GmbH Kornet Automobil Beteiligungsges mbH Dresdner Bank 4-21

  22. Capital Markets and Valuation • Investor protection promotes the development of external capital markets. • When investors are assured of receiving fair returns on their funds, they will be willing to pay more for securities. • Thus strong investor protection will be conducive to large capital markets. • Weak investor protection can be a factor in sharp market declines during a financial crisis. 4-22

  23. Corporate Governance Reform • Asian financial crisis and scandals of major companies • Companies’ internal governance mechanisms, auditors, regulators, banks, and institutional investors failed. • Damage investor confidence , stunt the development of capital markets, raise the cost of capital, distort capital allocation, etc. 4-23

  24. The Sarbanes-Oxley Act • Major components: • Accounting regulation • Audit committee • Internal control assessment • Executive responsibility • Compliance is costly 4-24

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