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Multinational Financial

Management
Alan Shapiro
9th Edition
J.Wiley & Sons

Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton

CHAPTER 7
The Foreign Exchange
Market

INTRODUCTION
I. INTRODUCTION
A. The Currency Market
Definition: a place where money denominated in
one currency is bought and sold with money
denominated in another currency

INTRODUCTION
B. International Trade and Capital
Transactions:
facilitated with the ability to transfer
purchasing power between countries

INTRODUCTION
C. Location
1.
OTC-type: no specific
location
2.
Most trades by phone,
telex, or SWIFT
SWIFT: Society for Worldwide Interbank Financial
Telecommunications

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
- business customers

ORGANIZATION OF THE FOREIGN


EXCHANGE MARKET
B.Two Types of Currency Markets
1.

Spot Market:
- immediate transaction
- recorded by 2nd business day

ORGANIZATION OF THE FOREIGN


EXCHANGE MARKET
2. Forward Market:
- transactions take place at a
specified future date

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

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)

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used in U.S. for electronic fund transfers.

ORGANIZATION OF THE FOREIGN


EXCHANGE MARKET
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

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ORGANIZATION OF THE FOREIGN


EXCHANGE MARKET
B. Results:
1. Reduces cost of trading

2. 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 financial market in the world

2007:

US$3.2 trillion daily


or
US$800 trillion a year

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ORGANIZATION OF THE FOREIGN


EXCHANGE MARKET
B. Market Centers by Size (2007):
-daily turnover:
#1: London = $1.359 trillion
#2: New York= $664 billion

#3: Zurich=$242 billion


#4: Tokyo = $238billion

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THE SPOT MARKET


I. SPOT QUOTATIONS
A. Sources
1. All major newspapers
2. Major currencies have four different quotes:
a. spot price
b. 30-day
c. 90-day
d. 180-day

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THE SPOT MARKET


B. Method of Quotation
1. For inter-bank dollar trades:
a. American terms
example: $1.21/

b. European terms
example: Peso1.713/$
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THE SPOT MARKET


2. For non-bank customers:
Direct quote gives the home currency price

(always in the numerator) of one unit of foreign


currency.
EXAMPLE:

$1.81/

Since this is a direct quote, we know that in


the U.S., one pound transacted at $1.81

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THE SPOT MARKET


C. Transactions Costs
1. Bid-Ask Spread
used to calculate the fee charged by the bank
Bid = the price at which the bank is willing to
buy
Ask = the price it will sell the currency

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THE SPOT MARKET


Percent Spread Formula (PS):

Ask Bid
PS
x100
Ask
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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


D. Cross Rates (cont)
2. Calculating Cross Rates (example)
Suppose you want to calculate the / cross
rate.
You know .5556/US$ and .8334/US$
then
/ = .5556/US$ .8334/US$

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= .6667/

THE SPOT MARKET


E. Currency Arbitrage
1. If cross rates differ from one financial center to
another, and profit opportunities exist.

2. Buy cheap in one intl market,sell at a higher


price in another
3. The Critical 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
1.) Demand for higher risk premium
2.) Bankers widen bid-ask spread

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MECHANICS OF SPOT
TRANSACTIONS
H. SPOT TRANSACTIONS: 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 foreign
currency
- agreed exchange rate

- confirmation of Step 1.

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MECHANICS OF SPOT
TRANSACTIONS
Step 3.

Settlement
Correspondent bank in Hong Kong
transfers HK$ from nostro account to
exporters.

Value Date.
U.S. bank debits importers account.

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THE FORWARD MARKET


I. INTRODUCTION
A. 3 Part 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. Purpose of a Forward:

Hedging
the act of reducing exchange
rate risk.

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THE FORWARD MARKET


C. Forward Rate Quotations
1. Two Methods:
a. Outright Rate: quoted to commercial
customers
b. Swap Rate: quoted in the inter-bank
market as a discount or premium

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THE FORWARD MARKET


CALCULATING THE FORWARD PREMIUM
OR DISCOUNT

= F-S x 12 x 100
S
n
where

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F=
S=
n=

the forward rate of exchange


the spot rate of exchange
the number of months in the
forward contract