Chapter 6 The Foreign Exchange Market Multinational Business

Chapter 6 The Foreign Exchange Market Multinational Business Finance 6 -1

The Foreign Exchange Market Foreign exchange means the money of a foreign country; that is, foreign currency, bank balances, banknotes, checks and drafts. A foreign exchange transaction is an agreement between a buyer and a seller that a fixed amount of one currency will be delivered for some other currency at a specified rate. 6 -2

Geography The foreign exchange market spans the globe, with currencies trading somewhere every hour of every business day. 6 -3

Exhibit 6. 1 Measuring Foreign Exchange Market Activity: Average Electronic Conversions Per Hour 6 -4

The Foreign Exchange Market provides: the physical and institutional structure through which the money of one country is exchanged for that of another country; the determination of rate of exchange between currencies, and is where foreign exchange transactions are physically completed. 6 -5

Functions of the Foreign Exchange Market The foreign exchange Market is the mechanism by which participants: transfer purchasing power between countries; obtain or provide credit for international trade transactions, and minimize exposure to the risks of exchange rate changes. 6 -6

Market Participants The foreign exchange market consists of two tiers: the interbank or wholesale market (multiples of $1 trillion US or equivalent in transaction size), and the client or retail market (specific, smaller amounts). Four broad categories of participants: bank and nonbank foreign exchange dealers, individuals and firms conducting commercial or investment transactions, speculators and arbitragers, and central banks and treasuries. 6 -7

Market Participants: Bank and Nonbank Foreign Exchange Dealers Banks and a few nonbank foreign exchange dealers operate in both the interbank and client markets. The profit from buying foreign exchange at a “bid” price and reselling it at a slightly higher “offer” or “ask” price. Dealers in the foreign exchange department of large international banks often function as “market makers. ” These dealers stand willing at all times to buy and sell those currencies in which they specialize and thus maintain an “inventory” position in those currencies. 6 -8

Market Participants: Individuals and Firms Individuals (such as tourists) and firms (such as importers, exporters and MNEs) conduct commercial and investment transactions in the foreign exchange market. Their use of the foreign exchange market is necessary for their underlying commercial or investment purpose. Some of the participants use the market to “hedge” foreign exchange risk. 6 -9

Market Participants: Speculators and Arbitragers Speculators and arbitragers seek to profit from trading in the market itself. They operate in their own interest, without a need or obligation to serve clients or ensure a continuous market. While dealers seek the bid/ask spread, speculators seek all the profit from exchange rate changes and arbitragers try to profit from simultaneous exchange rate differences in different markets. 6 -10

Market Participants: Central Banks and Treasuries Central banks and treasuries use the market to acquire or spend their country’s foreign exchange reserves as well as to influence the price at which their own currency is traded. The motive is not to earn a profit central banks and treasuries differ in motive from all other market participants. 6 -11

Transactions in the Interbank Market A spot transaction in the interbank market is the purchase of foreign exchange, with delivery and payment between banks to take place on the second following business day. The date of settlement is referred to as the value date. 6 -12

Transactions in the Interbank Market An outright forward transaction (or a forward) requires delivery at a future value date of a specified amount of one currency for a specified amount of another currency. The exchange rate is established at the time of the agreement, but payment and delivery are not required until maturity. Forward exchange rates are usually quoted for value dates of one, two, three, six and twelve months. 6 -13

Transactions in the Interbank Market A swap transaction in the interbank market is the simultaneous purchase and sale of a given amount of foreign exchange for two different value dates (settlement date). Both purchase and sale are conducted with the same counterparty. Some different types of swaps are: spot against forward, forward-forward, nondeliverable forwards (NDF). 6 -14

Market Size In April 2004, a survey conducted by the Bank for International Settlements (BIS) estimated the daily global net turnover in traditional foreign exchange market activity to be $1. 9 trillion. This most recent period showed dramatic growth in foreign exchange trading over that seen in April 2001. 6 -15

Foreign Exchange Rates and Quotations A foreign exchange rate is the price of one currency expressed in terms of another currency. A foreign exchange quotation (or quote) is a statement of willingness to buy or sell at an announced rate. 6 -16

Foreign Exchange Rates and Quotations Most foreign exchange transactions involve the US dollar. Professional dealers and brokers may state foreign exchange quotations in one of two ways: the foreign currency price of one dollar, or the dollar price of a unit of foreign currency. Most foreign currencies in the world are stated in terms of the number of units of foreign currency needed to buy one dollar. 6 -17

Foreign Exchange Rates and Quotations Foreign exchange quotes: direct or indirect quote the home country of the currencies being discussed is critical. A direct quote is a home currency price of a unit of foreign currency. €/$ An indirect quote is a foreign currency price of a unit of home currency. $/€ The form of the quote depends on what the speaker regard as “home. ” 6 -18

Exhibit 6. 2 Global Foreign Exchange Market Turnover, 19892007 (daily averages in April, billions of US$) 6 -19

Exhibit 6. 3 Top 10 Geographic Trading Centers in the Foreign Exchange Market, 1992– 2007 (daily averages in April, billions of U. S. dollars) 6 -20

Exhibit 6. 4 Foreign Exchange Market Turnover by Currency Pair (Daily averages in April) 6 -21

Foreign Exchange Rates and Quotations For example, the exchange rate between US dollars and the Swiss franc is normally stated: SF 1. 6000/$ (European terms or direct quote) However, this rate can also be stated as: $0. 6250/SF (American terms or indirect quote) most interbank quotations around the world are stated in European terms. 6 -22

Foreign Exchange Rates and Quotations several exceptions exist to the use of European terms quotes. euro and U. K. pound sterling which are both normally quoted in American terms. $/€, $/£ American terms are also utilized in quoting rates for most foreign currency options and futures, as well as in retail markets that deal with tourists. 6 -23

Foreign Exchange Rates and Quotations Interbank quotations are given as a bid and ask (also referred to as offer). A bid is the price (i. e. exchange rate) in one currency at which a dealer will buy another currency. An ask is the price (i. e. exchange rate) at which a dealer will sell the other currency. Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their profit from the spread between the buying and selling prices. A bid for one currency is also the offer for the opposite currency. 6 -24

Foreign Exchange Rates and Quotes Forward rates are typically quoted in terms of points. 1 points typically corresponds to 0, 0001 in value. Rather, it is the difference between the forward rate and the spot rate. 6 -25

Foreign Exchange Rates and Quotes Forward quotations may also be expressed as the percent-per-annum deviation from the spot rate. This method of quotation makes it easier to compare premiums or discounts in the forward market If a currency increases in value in the future, it is traded at a premium, if decreases, it is at a discount against the other currency. 6 -26

percent-per-annum For quotations expressed in foreign currency terms (Indirect quotations, $/€) the formula becomes: f ¥ = Spot – Forward x 360 x 100 Forward n For quotations expressed in home currency terms (Direct quotations) the formula becomes: f ¥ = Forward – Spot x 360 Spot n x 100 6 -27

Foreign Exchange Rates and Quotes Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate). Cross rates can be used to check on opportunities for intermarket arbitrage. one bank’s (Dresdner) quotation on €/£ is not the same as calculated cross rate between $/£ (Barclay’s) and $/€ (Citibank). 6 -28

Ex: Foreign Exchange Rates and Quotes Citibank quote - $/€ $1. 2223/€ Barclays quote - $/£ $1. 8410/£ Dresdner quote - €/£ € 1. 5100/£ = Cross rate calculation: $1. 8410/£ = € 1. 5062/£ $1. 2223/€ Possible arbitrage using the rates difference? 6 -29

Exhibit 6. 8 A Triangular Arbitrage 6 -30

Foreign Exchange Rates and Quotes Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations): %∆ = Ending rate – Beginning Rate x 100 For the sake of simplicity, we use direct quotes. That is home currency unit per foreign currency 6 -31

Mini-Case Questions: The Venezuelan Bolivar Black Market Why does a country like Venezuela impose capital controls? In the case of Venezuela, what is the difference between the gray market and the black market? Create a financial analysis of Santiago’s choices and use it to recommend a solution to his problem. 6 -32

Exhibit 6. 5 Spot and Forward Quotations for the Euro and Japanese Yen 6 -33

Exhibit 6. 6 Foreign Exchange Rate Quotations on the U. S. Dollar/British Pound in the Financial Press 6 -34

Exhibit 6. 7 Key Currency Cross Rates 6 -35

Exhibit 6. 8 B Triangular Arbitrage 6 -36

Exhibit 1 Venezuelan Official and Gray Market Exchange Rates, Venezuelan Bolivar/U. S. Dollar (January 2002–March 2004) 6 -37