Chapter 7 Foreign Exchange and the Global Capital Markets

What Are Currency and Foreign Exchange?

In order to understand the global financial environment, how capital markets work, and their impact on global business, we need to first understand how currencies and foreign exchange rates work.

Briefly, currencyAny form of money in general circulation in a country. is any form of money in general circulation in a country. What exactly is a foreign exchange? In essence, foreign exchangeMoney denominated in the currency of another country. Money can also be denominated in the currency of a group of countries, such as the euro. is money denominated in the currency of another country or—now with the euro—a group of countries. Simply put, an exchange rateThe rate at which the market converts one currency into another. is defined as the rate at which the market converts one currency into another.

Any company operating globally must deal in foreign currencies. It has to pay suppliers in other countries with a currency different from its home country’s currency. The home country is where a company is headquartered. The firm is likely to be paid or have profits in a different currency and will want to exchange it for its home currency. Even if a company expects to be paid in its own currency, it must assess the risk that the buyer may not be able to pay the full amount due to currency fluctuations.

If you have traveled outside of your home country, you may have experienced the currency market—for example, when you tried to determine your hotel bill or tried to determine if an item was cheaper in one country versus another. In fact, when you land at an airport in another country, you’re likely to see boards indicating the foreign exchange rates for major currencies. These rates include two numbers: the bid and the offer. The bid (or buy)The price at which a bank or financial service firm is willing to buy a specific currency. is the price at which a bank or financial services firm is willing to buy a specific currency. The ask (or the offer or sell)Quote that refers to the price at which a bank or financial services firm is willing to sell that currency., refers to the price at which a bank or financial services firm is willing to sell that currency. Typically, the bid or the buy is always cheaper than the sell; banks make a profit on the transaction from that difference. For example, imagine you’re on vacation in Thailand and the exchange rate board indicates that the Bangkok Bank is willing to exchange currencies at the following rates (see the following figure). GBP refers to the British pound; JPY refers to the Japanese yen; and HKD refers to the Hong Kong dollar, as shown in the following figure. Because there are several countries that use the dollar as part or whole of their name, this chapter clearly states “US dollar” or uses US$ or USD when referring to American currency.

This chart tells us that when you land in Thailand, you can use 1 US dollar to buy 31.67 Thai baht. However, when you leave Thailand and decide that you do not need to take all your baht back to the United States, you then convert baht back to US dollars. We then have to use more baht—32.32 according to the preceding figure—to buy 1 US dollar. The spreadThe difference between the bid and the ask. This is the profit made for each unit of currency bought and sold. between these numbers, 0.65 baht, is the profit that the bank makes for each US dollar bought and sold. The bank charges a fee because it performed a service—facilitating the currency exchange. When you walk through the airport, you’ll see more boards for different banks with different buy and sell rates. While the difference may be very small, around 0.1 baht, these numbers add up if you are a global company engaged in large foreign exchange transactions. Accordingly, global firms are likely to shop around for the best rates before they exchange any currencies.

What Is the Purpose of the Foreign Exchange Market?

The foreign exchange market (or FX market) is the mechanism in which currencies can be bought and sold. A key component of this mechanism is pricing or, more specifically, the rate at which a currency is bought or sold. We’ll cover the determination of exchange rates more closely in this section, but first let’s understand the purpose of the FX market. International businesses have four main uses of the foreign exchange markets.

Understand How to Determine Exchange Rates

What Are International Capital Markets?

A capital marketMarkets in which people, companies, and governments with more funds than they need transfer those funds to people, companies, or governments that have a shortage of funds. Capital markets promote economic efficiency by transferring money from those who do not have an immediate productive use for it to those who do. Capital markets provide forums and mechanisms for governments, companies, and people to borrow or invest (or both) across national boundaries. is basically a system in which people, companies, and governments with an excess of funds transfer those funds to people, companies, and governments that have a shortage of funds. This transfer mechanism provides an efficient way for those who wish to borrow or invest money to do so. For example, every time someone takes out a loan to buy a car or a house, they are accessing the capital markets. Capital markets carry out the desirable economic function of directing capital to productive uses.

There are two main ways that someone accesses the capital markets—either as debt or equity. While there are many forms of each, very simply, debtMoney that’s borrowed and must be repaid. The bond is the most common example of a debt instrument. is money that’s borrowed and must be repaid, and equityMoney that is invested in return for a percentage of ownership but is not guaranteed in terms of repayment. is money that is invested in return for a percentage of ownership but is not guaranteed in terms of repayment.

In essence, governments, businesses, and people that save some portion of their income invest their money in capital markets such as stocks and bonds. The borrowers (governments, businesses, and people who spend more than their income) borrow the savers’ investments through the capital markets. When savers make investments, they convert risk-free assets such as cash or savings into risky assets with the hopes of receiving a future benefit. Since all investments are risky, the only reason a saver would put cash at risk is if returns on the investment are greater than returns on holding risk-free assets. Basically, a higher rate of return means a higher risk.

For example, let’s imagine a beverage company that makes $1 million in gross sales. If the company spends $900,000, including taxes and all expenses, then it has $100,000 in profits. The company can invest the $100,000 in a mutual fund (which are pools of money managed by an investment company), investing in stocks and bonds all over the world. Making such an investment is riskier than keeping the $100,000 in a savings account. The financial officer hopes that over the long term the investment will yield greater returns than cash holdings or interest on a savings account. This is an example of a form of direct financeA company borrows directly by issuing securities to investors in the capital markets.. In other words, the beverage company bought a security issued by another company through the capital markets. In contrast, indirect financeInvolves a financial intermediary between the borrower and the saver. For example, if the company deposited the money in a savings account at their bank, and then the bank lends the money to a company (or another person), the bank is an intermediary. involves a financial intermediary between the borrower and the saver. For example, if the company deposited the money in a savings account, and then the savings bank lends the money to a company (or a person), the bank is an intermediary. Financial intermediaries are very important in the capital marketplace. Banks lend money to many people, and in so doing create economies of scale. This is one of the primary purposes of the capital markets.

Capital markets promote economic efficiency. In the example, the beverage company wants to invest its $100,000 productively. There might be a number of firms around the world eager to borrow funds by issuing a debt security or an equity security so that it can implement a great business idea. Without issuing the security, the borrowing firm has no funds to implement its plans. By shifting the funds from the beverage company to other firms through the capital markets, the funds are employed to their maximum extent. If there were no capital markets, the beverage company might have kept its $100,000 in cash or in a low-yield savings account. The other firms would also have had to put off or cancel their business plans.

International capital marketsGlobal markets where people, companies, and governments with more funds than they need transfer those funds to people, companies, or governments that have a shortage of funds. International capital markets provide forums and mechanisms for governments, companies, and people to borrow or invest (or both) across national boundaries. are the same mechanism but in the global sphere, in which governments, companies, and people borrow and invest across national boundaries. In addition to the benefits and purposes of a domestic capital market, international capital markets provide the following benefits:

1. Higher returns and cheaper borrowing costs. These allow companies and governments to tap into foreign markets and access new sources of funds. Many domestic markets are too small or too costly for companies to borrow in. By using the international capital markets, companies, governments, and even individuals can borrow or invest in other countries for either higher rates of return or lower borrowing costs.
2. Diversifying risk. The international capital markets allow individuals, companies, and governments to access more opportunities in different countries to borrow or invest, which in turn reduces risk. The theory is that not all markets will experience contractions at the same time.

The structure of the capital markets falls into two components—primary and secondary. The primary marketWhere new securities (stocks and bonds are the most common) are issued. The company receives the funds from this issuance or sale. is where new securities (stocks and bonds are the most common) are issued. If a corporation or government agency needs funds, it issues (sells) securities to purchasers in the primary market. Big investment banks assist in this issuing process as intermediaries. Since the primary market is limited to issuing only new securities, it is valuable but less important than the secondary market.

The vast majority of capital transactions take place in the secondary marketThe secondary market includes stock exchanges (the New York Stock Exchange, the London Stock Exchange, and the Tokyo Nikkei), bond markets, and futures and options markets, among others. Secondary markets provide a mechanism for the risk of a security to be spread to more participants by enabling participants to buy and sell a security (debt or equity). Unlike the primary market, the company issuing the security does not receive any direct funds from the secondary market.. The secondary market includes stock exchanges (the New York Stock Exchange, the London Stock Exchange, and the Tokyo Nikkei), bond markets, and futures and options markets, among others. All these secondary markets deal in the trade of securities. The term securitiesIncludes a wide range of debt- and equity-based financial instruments. includes a wide range of financial instruments. You’re probably most familiar with stocks and bonds. Investors have essentially two broad categories of securities available to them: equity securities, which represent ownership of a part of a company, and debt securities, which represent a loan from the investor to a company or government entity.

Creditors, or debt holders, purchase debt securities and receive future income or assets in return for their investment. The most common example of a debt instrument is the bondA debt instrument. When investors buy bonds, they are lending the issuers of the bonds their money. In return, they typically receive interest at a fixed rate for a specified period of time.. When investors buy bonds, they are lending the issuers of the bonds their money. In return, they will receive interest payments usually at a fixed rate for the life of the bond and receive the principal when the bond expires. All types of organizations can issue bonds.

StocksA type of equity security that gives the holder an ownership (or a share) of a company’s assets and earnings. are the type of equity security with which most people are familiar. When investors buy stock, they become owners of a share of a company’s assets and earnings. If a company is successful, the price that investors are willing to pay for its stock will often rise; shareholders who bought stock at a lower price then stand to make a profit. If a company does not do well, however, its stock may decrease in value and shareholders can lose money. Stock prices are also subject to both general economic and industry-specific market factors.

The key to remember with either debt or equity securities is that the issuing entity, a company or government, only receives the cash in the primary market issuance. Once the security is issued, it is traded; but the company receives no more financial benefit from that security. Companies are motivated to maintain the value of their equity securities or to repay their bonds in a timely manner so that when they want to borrow funds from or sell more shares in the market, they have the credibility to do so.

For companies, the global financial, including the currency, markets (1) provide stability and predictability, (2) help reduce risk, and (3) provide access to more resources. One of the fundamental purposes of the capital markets, both domestic and international, is the concept of liquidityIn capital markets, this refers to the ease by which shareholders and bondholders can buy and sell their securities or convert their investments into cash., which basically means being able to convert a noncash asset into cash without losing any of the principal value. In the case of global capital markets, liquidity refers to the ease and speed by which shareholders and bondholders can buy and sell their securities and convert their investment into cash when necessary. Liquidity is also essential for foreign exchange, as companies don’t want their profits locked into an illiquid currency.

Major Components of the International Capital Markets

International Equity Markets

Companies sell their stock in the equity markets. International equity markets consists of all the stock traded outside the issuing company’s home country. Many large global companies seek to take advantage of the global financial centers and issue stock in major markets to support local and regional operations.

Figure 7.1 ArcelorMittal Global Headquarters

© ArcelorMittal, 2011.

For example, ArcelorMittal is a global steel company headquartered in Luxembourg; it is listed on the stock exchanges of New York, Amsterdam, Paris, Brussels, Luxembourg, Madrid, Barcelona, Bilbao, and Valencia. While the daily value of the global markets changes, in the past decade the international equity markets have expanded considerably, offering global firms increased options for financing their global operations. The key factors for the increased growth in the international equity markets are the following:

• Growth of developing markets. As developing countries experience growth, their domestic firms seek to expand into global markets and take advantage of cheaper and more flexible financial markets.
• Drive to privatize. In the past two decades, the general trend in developing and emerging markets has been to privatize formerly state-owned enterprises. These entities tend to be large, and when they sell some or all of their shares, it infuses billions of dollars of new equity into local and global markets. Domestic and global investors, eager to participate in the growth of the local economy, buy these shares.
• Investment banks. With the increased opportunities in new emerging markets and the need to simply expand their own businesses, investment banks often lead the way in the expansion of global equity markets. These specialized banks seek to be retained by large companies in developing countries or the governments pursuing privatization to issue and sell the stocks to investors with deep pockets outside the local country.
• Technology advancements. The expansion of technology into global finance has opened new opportunities to investors and companies around the world. Technology and the Internet have provided more efficient and cheaper means of trading stocks and, in some cases, issuing shares by smaller companies.

The Role of International Banks, Investment Banks, Securities Firms, and Global Financial Firms

The role of international banks, investment banks, and securities firms has evolved in the past few decades. Let’s take a look at the primary purpose of each of these institutions and how it has changed, as many have merged to become global financial powerhouses.

Traditionally, international banks extended their domestic role to the global arena by servicing the needs of multinational corporations (MNC). These banks not only received deposits and made loans but also provided tools to finance exports and imports and offered sophisticated cash-management tools, including foreign exchange. For example, a company purchasing products from another country may need short-term financing of the purchase; electronic funds transfers (also called wires); and foreign exchange transactions. International banks provide all these services and more.

In broad strokes, there are different types of banks, and they may be divided into several groups on the basis of their activities. Retail banks deal directly with consumers and usually focus on mass-market products such as checking and savings accounts, mortgages and other loans, and credit cards. By contrast, private banks normally provide wealth-management services to families and individuals of high net worth. Business banks provide services to businesses and other organizations that are medium sized, whereas the clients of corporate banks are usually major business entities. Lastly, investment banks provide services related to financial markets, such as mergers and acquisitions. Investment banks also focused primarily on the creation and sale of securities (e.g., debt and equity) to help companies, governments, and large institutions achieve their financing objectives. Retail, private, business, corporate, and investment banks have traditionally been separate entities. All can operate on the global level. In many cases, these separate institutions have recently merged, or were acquired by another institution, to create global financial powerhouses that now have all types of banks under one giant, global corporate umbrella.

However the merger of all of these types of banking firms has created global economic challenges. In the United States, for example, these two types—retail and investment banks—were barred from being under the same corporate umbrella by the Glass-Steagall ActEnacted in 1932 during the Great Depression, the Glass-Steagall Act, officially called the Banking Reform Act of 1933, created the Federal Deposit Insurance Corporations (FDIC) and implemented bank reforms, beginning in 1932 and continuing through 1933. These reforms are credited with providing stability and reduced risk in the banking industry.. Enacted in 1932 during the Great Depression, the Glass-Steagall Act, officially called the Banking Reform Act of 1933, created the Federal Deposit Insurance Corporations (FDIC) and implemented bank reforms, beginning in 1932 and continuing through 1933. These reforms are credited with providing stability and reduced risk in the banking industry for decades. Among other things, it prohibited bank-holding companies from owning other financial companies. This served to ensure that investment banks and banks would remain separate—until 1999, when Glass-Steagall was repealed. Some analysts have criticized the repeal of Glass-Steagall as one cause of the 2007–8 financial crisis.

Because of the size, scope, and reach of US financial firms, this historical reference point is important in understanding the impact of US firms on global businesses. In 1999, once bank-holding companies were able to own other financial services firms, the trend toward creating global financial powerhouses increased, blurring the line between which services were conducted on behalf of clients and which business was being managed for the benefit of the financial company itself. Global businesses were also part of this trend, as they sought the largest and strongest financial players in multiple markets to service their global financial needs. If a company has operations in twenty countries, it prefers two or three large, global banking relationships for a more cost-effective and lower-risk approach. For example, one large bank can provide services more cheaply and better manage the company’s currency exposure across multiple markets. One large financial company can offer more sophisticated risk-management options and products. The challenge has become that in some cases, the party on the opposite side of the transaction from the global firm has turned out to be the global financial powerhouse itself, creating a conflict of interest that many feel would not exist if Glass-Steagall had not been repealed. The issue remains a point of ongoing discussion between companies, financial firms, and policymakers around the world. Meanwhile, global businesses have benefited from the expanded services and capabilities of the global financial powerhouses.

For example, US-based Citigroup is the world’s largest financial services network, with 16,000 offices in 160 countries and jurisdictions, holding 200 million customer accounts. It’s a financial powerhouse with operations in retail, private, business, and investment banking, as well as asset management. Citibank’s global reach make it a good banking partner for large global firms that want to be able to manage the financial needs of their employees and the company’s operations around the world.

Figure 7.2 Citibank Global Headquarters in New York City

Source: © Citigroup

In fact this strength is a core part of its marketing message to global companies and is even posted on its website (http://www.citigroup.com/citi/products/instinvest.htm): “Citi puts the world’s largest financial network to work for you and your organization.”

Dealing with Venture Capitalists

Young companies around the world now eagerly—and sometimes successfully—reach out to VCs in other countries. If you are a budding entrepreneur thinking about going the VC route to fund your business, it’s important to learn more about the industry and community. At the end of the day, money is what matters—it’s business for VCs. This is a harsh point of view for entrepreneurs, who are often quite emotional about their product or service. It can be hard to know just how to evaluate VCs. Here are some tips to follow no matter where in the world the entrepreneur or VCs are located.Sanjyot P. Dunung, Starting Your Business (New York: Business Expert Press, 2010).

1. Understand the nature of a VC. They are basically fund managers looking for high returns for their investors. Understand the VC’s portfolio’s mission and goals. Most have multiple funds in their portfolio each with different investment parameters based in part on the various investors. VC is an industry, and the VCs are your “customer.” You need to understand how the industry operates, how to get your “product” (i.e., your company) noticed, and how to close the sale (i.e., get your funding). While there are certainly nuances, treat it like a sales process from start to finish. Remember that VCs run a business, one that they are held accountable to by their investors. More often than not, the people you meet at a VC firm are not the actual investors (although the senior principals may have some of their own money in the fund); they just work for the VC firm.

   VCs focus on market trends, whether it’s green technology, social networking websites, or the current perceived “hot” industry. While it’s still possible to get funding if you are not in a current trend, it’s certainly harder. VCs typically look at groups of investments and generally like to have funds with three or four companies out of ten providing exceptional returns. They expect the rest of the businesses in the portfolio to either be weak performers or to fail. Sounds harsh, perhaps, but this is purely statistical to the VC industry. It’s important to ask VCs about their expected returns. When VCs market their funds to potential global institutional and wealthy investors, they have to indicate a vision, strategy, and target range for returns to these potential “buyers”—that is, investors. If you’re beginning to think that a VC sounds suspiciously like an entrepreneur, you’re correct. You need to realize that in the same way you’re raising money from a VC, the VC is raising money from someone else.

2. Control the interview. Ask the VC about their mission and goals. Additionally, learn about the VC’s investment style. Do they prefer to be heavily involved? Or are they hands-off? Is their investment style consistent with both your operating style and stage of business? Experienced and well-connected VCs can be very useful for an early-stage company. If the VC is a strategic investor, understand the motivations for their interest in your product, service, or market.

3. Act the part. Be prepared. Conduct yourself professionally at all times. Dress and act like you’re going to a job interview—it’s quite similar. Don’t drop names or promise too much. Don’t make claims about your product or service that can’t be substantiated.

   Again, your credibility will suffer even if you actually have a solid product or service. Go to any VC meeting with a clear presentation and detailed business plan. If you can’t answer a specific question, say so and promise to get back to them within a specified time frame with further information. Even if you don’t have an answer, be sure to get back to them later with a follow-up that indicates you are still researching the answer. Don’t act like you’re entitled to funding for any reason. You may think your idea is great, but VCs see many “great” ideas. Support your request for funding with clear business rationale and facts. Lose any attitude.

4. Examine the VCs network/expertise. What is the VC’s network? Is the VC or their network in your industry? Does the VC know both clients and partners, and at what decision-making level are these contacts? Is the VC willing to actively assist you with global networking? Look at the companies in the VC’s portfolio to see if there’s a synergy across the portfolio. It’s helpful if the VC is willing to facilitate interaction with key strategic investors in the fund as well as other complementary portfolio companies.
5. Does the VC have an ability to guide the company to a suitable exit strategy? An important issue for most investors and VCs is the exit strategy. It’s great if a company does well, but the VC wants to know how and when they’re going to get their money out. Experienced VCs usually have a time horizon of three to seven years. The entire life of their fund may be only ten to thirteen years, after which time their investors expect to receive their original investments back with all the returns. While an initial public offering (IPO) is certainly a sexy exit strategy, it’s not for every company. If you do business with the companies that are likely to buy your firm, then be sure to highlight this early on. Many VCs also like to see a list of possible strategic acquirers. As noted earlier in this section, access to global markets benefits many global VCs and entrepreneurs, both of whom now have more options to find investors or companies to invest in as well as more exit strategies.
6. Check-writing ability. Can the VC make an initial investment? What is their process for obtaining more funding? Venture capitalists fund companies from one of their portfolio funds. If monies in those funds run out, there’s limited ability to find more funding. Most experienced VCs save a portion of each fund for follow-on funding for their portfolio companies (which are companies they have already invested in). Remember that VCs have an interest in your company’s success, so long as the business parameters warrant it. They are not likely to keep funding a venture with minimal life left in it.
7. Beware when a VC has no real management experience. Find a VC with experience in running a company, not just banking. Venture capitalists still tend to come from the worlds of consulting and investment banking. Most have never worked for a company. As a result, their knowledge base of a corporation tends to be academic and theoretical and doesn’t stem from any tangible experiences. They tend to be unfamiliar with corporate operating practices as well as general line management. Despite some efforts to hire entrepreneurs on their teams, most VCs still hire people who are just like themselves, a practice that drastically limits the range of experiences and perspectives of their team. Look at the individual backgrounds to assess any diversity of experience and perspective. If you are targeting key markets globally, make sure your VC has direct experience in those markets.
8. Avoid unreasonable terms and demands. Manage return expectations; ensure you and the VC are on the same page as far as expectations. Make sure that you and the VC are both motivated by a mutual win. Don’t agree to terms that are potentially dangerous to the long-term health of your company. For example, the VC may try to extract personal terms from you, such as a deferred salary or personal guarantees. Even if you are independently wealthy, terms that may make your personal financial survival more difficult only distract you and make you less focused on the business, which should be your and the VC’s priority. In such cases, the VC is less interested in your well-being: after all, everyone needs to pay their bills. These terms are never in anyone’s best interest, let alone the company, and will undoubtedly come back to haunt both you and the VC. The entrepreneur should also be careful not to have unreasonably high compensation demands for themselves.
9. Level of involvement and fit. How involved do the VCs want to be? Are they helpful or intrusive? Are your professional and cultural styles compatible? If you’re from different cultures, be sure that you understand effective ways to communicate and manage differences and expectations. Negotiating a VC’s level of involvement can be really challenging, as expectations may change over time. Some VCs who take a hands-off approach in the beginning may increase their involvement at the first hint of difficulties or problems. Overall, most VCs oversee investments in multiple companies, so they don’t always want to be heavily involved. Just be sure that the level of involvement meets the needs and expectations of both you and the VC.

10. Look for mutual respect. Sure, you need money, but the VC needs to also be aware that they need good companies with solid ideas in order to be successful and profitable.

    Is there a mutual acknowledgment of respect and that you both need each other to succeed? Many VCs appear to operate as if this isn’t the case. Just as you will likely turn to your VC for creative financing and exit strategies, the VC should respect your industry and management experiences. Success can only be achieved if there’s mutual respect and a focus on creating a win for all involved.

11. Watch for questionable integrity, greed, ego, and power trips. Be wary of the VC who shows interest in doing your deal and suggests he or she receive a personal fee for doing so or wants to go on your payroll as an “advisor.” Kickbacks are not legally standard in the VC world, although they occur in varied forms more often than not. The only persons who may be entitled to fees are those you have retained as investment bankers, advisors, or intermediaries. Additionally, a VC who operates this way is likely to have a pattern of doing so and is not likely to provide the kind of professional support needed during challenging periods. If your VC is from a country outside your base country, be sure to understand your VC’s culture and his or her country’s rules. It’s not worth engaging in unscrupulous business practices. Even if in the short term it helps to fund your company, the long-term repercussions could be disastrous. Find another source. Above all, strive to keep your integrity in all your business dealings.

VCs who are undeservedly full of themselves may be more interested in satisfying their egos than partnering to grow strong companies. Some VCs will show such characteristics by playing mind games at early meetings. Others may try to intimidate you or be unconstructively condescending—for example, creating a hostile environment by aggressively and rudely demanding that you close your PowerPoint presentation and answer obtuse questions. You may find yourself the target of a barrage of foul language. While every industry has its share of egomaniacs, what you really need to focus on is how you can build a level of professional trust that will enable you and the VC to work together during challenging periods. Some VCs can forget that it’s a partnership and that the entrepreneur is likely to have an equity interest in the company as well. The VC may seek to treat the entrepreneur as a subordinate or an employee—and not a co-owner as well. Without a sense of cooperative teamwork, you may not have the VC and board support you need at critical junctures. Interestingly enough, the code of conduct that most professionals are expected to follow in the corporate world is not always standard in the VC world. Stay above any questionable behavior and stay professional. Despite the allure of money, you probably wouldn’t want to do business with these types of people in any circumstance.Sanjyot P. Dunung, Starting Your Business (New York: Business Expert Press, 2010).