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Foundations of Multinational Financial Management

Alan Shapiro

John Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton

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The Foreign Exchange Markets

Chapter 6

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CHAPTER OVERVIEW

6.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

6.2 THE SPOT MARKET

6.3 THE FORWARD MARKET

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PART I. INTRODUCTION

I. INTRODUCTION

A. The Market:

the place where money denominated in one currency is bought and sold with money denominated in another currency.

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INTRODUCTION

B. International Trade and Capital Transactions:

- facilitated with the ability

to transfer purchasing power

between countries

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INTRODUCTION

C. Location

1. OTC-type: no specific location

2. Most trades by phone,

telex, or SWIFT*

*SWIFT: Society for Worldwide Interbank

Financial Telecommunications

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PART II.ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

I . PARTICIPANTS IN THE FOREIGN EXCHANGE MARKET

A. Participants at 2 Levels

1. Wholesale Level (95%)

- major banks

2. Retail Level- banks deal with

business customers.

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

B. Two Types of Currency Markets

1. Spot Market:

- immediate transaction

- recorded by 2nd business day

2. Forward Market:

- transactions take place at a specified future date

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

C. Participants by Market

1. Spot Market

a. commercial banks

b. brokers

c. customers of commercial and central banks

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

2. Forward Market

a. arbitrageurs

b. traders

c. hedgers

d. speculators

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

II. CLEARING SYSTEMS

A. Clearing House Interbank Payments System ( CHIPS)

- used in U.S. for electronic

fund transfers.

B. FedWire- operated by the Fed- used for domestic transfers

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. ELECTRONIC TRADING

A. Automated Trading

- genuine screen-based market

B. Results:

1. Reduces cost of trading2. Threatens traders’

oligopoly of information 3. Provides liquidity

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ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

IV. SIZE OF THE MARKET

A. Largest in the world

1995: $1.2 trillion daily

B. Market Centers (1995):

London = $464 billion daily

New York= $244 billion daily

Tokyo = $161 billion daily

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PART III.THE SPOT MARKET

I. SPOT QUOTATIONS

A. Sources

1. All major newspapers

2. Major currencies have four different quotes:a. spot priceb. 30-dayc. 90-dayd. 180-day

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THE SPOT MARKET

B. Method of Quotation

1. For interbank dollar trades:

a. American terms

example: $.5838/dm

b. European terms

example: dm1.713/$

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THE SPOT MARKET

2. For nonbank customers:

Direct quote

gives the home currency price of one unit of foreign

currency.

EXAMPLE:dm0.25/FF

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THE SPOT MARKET

C. Transactions Costs

1. Bid-Ask Spreadused to calculate the feecharged by the bank

2. Bid = the price at which the bank is willing to buy

3. Ask = the price it will sellthe currency

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THE SPOT MARKET

4. Percent Spread Formula:

Percent Spread = (Ask-Bid)/Ask x 100

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THE SPOT MARKET

D. Cross Rates

1. The exchange rate between 2 non-US$ currencies.

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THE SPOT MARKET

2. Calculating Cross RatesWhen you want to know what the dm/pound cross rate is, and youknow dm2/US$ and .55pounds/US$,

then

dm/pounds =

*dm2/US$ ÷÷÷÷ .55 pounds/US$

= dm3.60/ pound

*Hint: Keep the denominators alike. Convert to indirect if necessary.

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THE SPOT MARKET

E. Currency Arbitrage

1. When cross rates differ from

one financial center to another,

profit opportunities exist.

2. Buy cheap in one int’l market,

Sell at a higher price in another

3. Role of Available Information

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THE SPOT MARKET

F. Settlement Date

Value Date:

1. Date monies are due

2. 2nd Working day after date of original transaction.

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THE SPOT MARKET

G. Exchange Risk

1. Bankers = middlemen

a. Incurring risk of adverse

exchange rate moves.

b. Increased uncertainty about future exchange rate requires

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THE SPOT MARKET

1.) Demand for higher risk

premium

2.) Bankers widen bid-ask spread

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PART II.MECHANICS OF SPOT

TRANSACTIONS

SPOT TRANSACTIONS: An Example

Step 1. Currency transaction: verbal agreement U.S. Importer specifies

a. Account to debit (his acct)b. Account to credit (exporter)

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MECHANICS OF SPOT TRANSACTIONS

Step 2. Bank sends importer contract note including:

- amount of foreigncurrency

- agreed exchange rate

- confirmation of Step 1.

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MECHANICS OF SPOT TRANSACTIONS

Step 3. Settlement

Correspondent bank in HongKong transfers HK$ fromnostro account to exporter’s.

Value Date.U.S. bank debits importer’saccount.

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PART III.THE FORWARD MARKET

I. INTRODUCTION

A. Definition of a Forward Contract

an agreement between a bank and a

customer to deliver a specified amount

of currency against another currency

at a specified future date and at a fixed

exchange rate.

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THE FORWARD MARKET

2. Purpose of a Forward:

Hedging

the act of reducing exchange

rate risk.

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THE FORWARD MARKET

B. Forward Rate Quotations

1. Two Methods:

a. Outright Rate: quoted to

commercial customers.

b. Swap Rate: quoted in the

interbank market as a discount or premium.

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THE FORWARD MARKET

CALCULATING THE FORWARDPREMIUM OR DISCOUNT

= F-S x 12 x 100S n

where F = the forward rate of exchangeS = the spot rate of exchangen = the number of months in the

forward contract

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THE FORWARD MARKET

C. Forward Contract Maturities

1. Contract Terms

a. 30-day

b. 90-day

c. 180-day

d. 360-day

2. Longer-term Contracts

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PART III.THE FORWARD MARKET

I. INTRODUCTION

A. Definition of a Forward Contract

an agreement between a bank and a

customer to deliver a specified amount

of currency against another currency

at a specified future date and at a fixed

exchange rate.

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THE FORWARD MARKET

B. Forward Rate Quotations

1. Two Methods:

a. Outright Rate:

Pound 1.4326 1.4330

1 m f 1.4302 1.4309

b. Swap Rate: in the interbank

market as a discount or premium.

Pound 26-30

1 m f 24-21

Rule if fb<fa --> premium, if fb>fa --> discount

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THE FORWARD MARKET

CALCULATING THE FORWARDPREMIUM OR DISCOUNT

= F-S x 12 x 100 S n

where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the

forward contract

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THE FORWARD MARKET

C. Forward Contract Maturities

1. a. 30-day (1m)

b. 90-day (3m)

c. 180-day (6m)

2. 360-day (1yr) or longer-term Contracts