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Multinational Financial Management Alan Shapiro th 7 Edition J. Wiley & Sons Power Points Multinational Financial Management Alan Shapiro th 7 Edition J. Wiley & Sons Power Points by Joseph F. Greco, Ph. D. California State University, Fullerton 1

CHAPTER 7 THE FOREIGN EXCHANGE MARKET 2 CHAPTER 7 THE FOREIGN EXCHANGE MARKET 2

CHAPTER OVERVIEW I. II. INTRODUCTION ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. THE SPOT CHAPTER OVERVIEW I. II. INTRODUCTION ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. THE SPOT MARKET IV. THE FORWARD MARKET 3

PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market: where money denominated in one PART I. INTRODUCTION I. INTRODUCTION A. The Currency Market: 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 INTRODUCTION B. International Trade and Capital Transactions: facilitated with the ability to transfer purchasing power between countries 5

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

PART II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET I. PARTICIPANTS IN THE FOREIGN EXCHANGE 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 - business customers 7

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Two Types of Currency Markets 1. Spot Market: - immediate transaction - recorded by 2 nd business day 8

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: - transactions take place at ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: - transactions take place at a specified future date 9

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET C. Participants by Market 1. Spot Market a. 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 10

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward a. b. c. d. Market arbitrageurs ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward a. b. c. d. Market arbitrageurs traders hedgers speculators 11

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II. CLEARING SYSTEMS A. Clearing House Interbank Payments ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II. CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) - used in U. S. for electronic fund transfers. 12

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Fed. Wire - operated by the Fed ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Fed. Wire - operated by the Fed - used for domestic transfers 13

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market 14

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Results: 1. Reduces cost of trading 2. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Results: 1. Reduces cost of trading 2. Threatens traders’ oligopoly of information 3. Provides liquidity 15

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET A. Largest in ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE MARKET A. Largest in the world 1999: US$1. 5 trillion daily or US$375 trillion a year In 1999 the US GDP was US$9. 1 trillion 16

ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers (1998): #1: London = $637 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers (1998): #1: London = $637 billion daily #2: New York= $351 billion daily #3: Tokyo = $149 billion daily 17

PART III. THE SPOT MARKET I. SPOT QUOTATIONS A. Sources 1. All major newspapers 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 18

THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades: a. American THE SPOT MARKET B. Method of Quotation 1. For interbank dollar trades: a. American terms example: $. 5838/dm b. European terms example: Peso 1. 713/$ 19

THE SPOT MARKET 2. For nonbank customers: Direct quote gives the home currency price 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 20

THE SPOT MARKET C. Transactions Costs 1. Bid-Ask Spread used to calculate the fee 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 21

THE SPOT MARKET 4. Percent Spread Formula (PS): 22 THE SPOT MARKET 4. Percent Spread Formula (PS): 22

THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non - THE SPOT MARKET D. Cross Rates 1. The exchange rate between 2 non - US$ currencies. 23

THE SPOT MARKET 2. Calculating Cross Rates When you want to know what the THE SPOT MARKET 2. Calculating Cross Rates When you want to know what the dm/ff cross rate is, and you know dm 2/US$ and ff. 55/US$ then dm/ff = dm 2/US$ ff. 55/US$ = dm 3. 636/ ff 24

THE SPOT MARKET E. Currency Arbitrage 1. If cross rates differ from one financial THE SPOT MARKET E. Currency Arbitrage 1. If cross rates differ from one financial center to another, and profit opportunities exist. 25

THE SPOT MARKET 2. Buy cheap in one int’l market, sell at a higher THE SPOT MARKET 2. Buy cheap in one int’l market, sell at a higher price in another 3. Role of Available Information 26

THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. THE SPOT MARKET F. Settlement Date Value Date: 1. Date monies are due 2. 2 nd Working day after date of original transaction. 27

THE SPOT MARKET G. Exchange Risk 1. Bankers = middlemen a. Incurring risk of 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 28

THE SPOT MARKET 1. ) Demand for higher risk premium 2. ) Bankers widen THE SPOT MARKET 1. ) Demand for higher risk premium 2. ) Bankers widen bid-ask spread 29

MECHANICS OF SPOT TRANSACTIONS: An Example Step 1. Currency transaction: verbal agreement, U. S. 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) 30

MECHANICS OF SPOT TRANSACTIONS Step 2. Bank sends importer contract note including: - amount MECHANICS OF SPOT TRANSACTIONS Step 2. Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1. 31

MECHANICS OF SPOT TRANSACTIONS Step 3. Settlement Correspondent bank in Hong Kong transfers HK$ 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. 32

PART IV. THE FORWARD MARKET I. INTRODUCTION A. Definition of a Forward Contract an PART IV. 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. 33

THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange THE FORWARD MARKET 2. Purpose of a Forward: Hedging the act of reducing exchange rate risk. 34

THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted THE FORWARD MARKET B. Forward Rate Quotations 1. Two Methods: a. Outright Rate: quoted to b. commercial customers. Swap Rate: quoted in the interbank market as a discount or premium. 35

THE FORWARD MARKET CALCULATING THE FORWARD PREMIUM OR DISCOUNT = F-S x 12 x 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 36