Foundations of Multinational Financial Management Alan Shapiro John

Foundations of Multinational Financial Management Alan Shapiro John Wiley & Sons Power Points by Joseph F. Greco, Ph. D. California State University, Fullerton 1

The Foreign Exchange Markets Chapter 6 2

CHAPTER OVERVIEW 6. 1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 6. 2 THE SPOT MARKET 6. 3 THE FORWARD MARKET 3

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. 4

INTRODUCTION B. International Trade and Capital Transactions: - facilitated with the ability to transfer purchasing power between countries 5

INTRODUCTION C. Location 1. 2. OTC-type: no specific location Most trades by phone, telex, or SWIFT* *SWIFT: Society for Worldwide Interbank Financial Telecommunications 6

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. 7

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2 nd business day 2. Forward Market: - transactions take place at a specified future date 8

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. b. c. commercial banks brokers customers of commercial and central banks 9

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market a. arbitrageurs b. traders c. hedgers d. speculators 10

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. Fed. Wire - operated by the Fed - used for domestic transfers 11

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity 12

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 13

PART III. THE SPOT MARKET I. SPOT QUOTATIONS A. Sources 1. All major newspapers 2. Major currencies have four different quotes: a. b. c. d. spot price 30 -day 90 -day 180 -day 14

THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades: a. American terms example: $. 5838/dm b. European terms example: dm 1. 713/$ 15

THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price of one unit of foreign currency. EXAMPLE: dm 0. 25/FF 16

THE SPOT MARKET C. Transactions Costs 1. Bid-Ask Spread used to calculate the fee charged by the bank 2. Bid = the price at which the bank is willing to buy 3. Ask = the price it will sell the currency 17

THE SPOT MARKET 4. Percent Spread Formula: Percent Spread = (Ask-Bid)/Ask x 100 18

THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non-US$ currencies. 19

THE SPOT MARKET 2. Calculating Cross Rates When you want to know what the dm/pound cross rate is, and you know dm 2/US$ and. 55 pounds/US$, then dm/pounds = *dm 2/US$ . 55 pounds/US$ = dm 3. 60/ pound *Hint: Keep the denominators alike. Convert to indirect if necessary. 20

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 21

THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. 2 nd Working day after date of original transaction. 22

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 23

THE SPOT MARKET 1. ) Demand for higher risk premium 2. ) Bankers widen bid-ask spread 24

PART II. MECHANICS OF 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) 25

MECHANICS OF SPOT TRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1. 26

MECHANICS OF SPOT TRANSACTIONS Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ from nostro account to exporter’s. Value Date. U. S. bank debits importer’s account. 27

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. 28

THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk. 29

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. 30

THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM 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 31

THE FORWARD MARKET C. Forward Contract Maturities 1. Contract Terms 2. a. 30 -day b. 90 -day c. 180 -day d. 360 -day Longer-term Contracts 32

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