Outline 3 3 Foreign Currency Markets Spot and

Outline 3 3. Foreign Currency Markets: Spot and Forward Markets 3. 1 Organization of the FX Market 3. 2 Spot Rates and Spot Market 3. 3 Forward Rates and Forward Market 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 1

3. 1 Organization of the FX Market • FX trading occurs to conduct trade in exports and imports of goods and for investment in assets denominated in different currencies (I. e. foreign investment) • International trade ~ 10% of US GDP • $ Volume of investment in any year is many times larger (95% of FX trading for international investment 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 2

Organization of the FX Market • Look at the interbank spot and forward market ~ 20 large banks conduct the majority of FX transactions • FX market transfers purchasing power from one currency to another – US importer of Beck’s beer needs to buy ’s (euro’s) with $’s – US investor in FTSE Index needs £’s 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 3

Organization of the FX Market – Saudi investor in US Treasury bonds need to buy $ and sell riyals • Interbank Market: conducts 95% of the volume of FX transactions – ~ 20 major banks – SWIFT: Society for Worldwide Interbank Financial Telecommunication bank communication network 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 4

Organization of the FX Market • Spot, Forward and Swap’s done in FX Interbank Market – Spot: transaction for immediate delivery in FX – Forward: agreed price and amount of FX for future delivery – Swap: simultaneous spot and forward transaction: • E. g. , buy ¥ (Japanese Yen) spot and sell same volume of ¥ 90 days forward at price agreed now 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 5

Organization of the FX Market • FX market not a physical place, electronic network of banks • Market trades 24 hours / day • FX Participants include: – Large commercial banks – FX brokers in Interbank market – Commercial customers – mainly multinational corporations – Central banks (e. g. : US Federal Reserve, European Bank) 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 6

Organization of the FX Market • Commercial Banks: – Few major banks buy/sell FX at bid-ask price spreads for a margin • FX Brokers: – Match needs of banks demand/supply for FX – Receive small commission 1/32% on $1 million trade ($312) • Commercial customers obtain FX through their banks that may be a Interbank member or buys FX from large commercial bank • Central Bank: Intervene in the FX markets to reduce volatility of FX rates or keep FX rates within a specific target 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 7

Organization of the FX Market • Forward FX Participants include: – Arbitrageur: earn spreads on interest rates across countries and use forward FX swaps to rid FX risk – Import/Export Trader: use forward contracts to avoid FX risk on import/export orders denominated in foreign currencies – Hedger: engage in FX transactions to protect domestic currency value of FX denominated assets – All of the above seek to avoid FX risk position by locking in future FX rates for currencies they do business in 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 8

Organization of the FX Market • Forward FX Participants include: Who accepts the FX for these participants? Speculator: take FX risk positions for a risk premium; they buy/sell currencies forward for a profit from FX rate changes • Their level of participation depends on profit opportunity: – current forward FX rate for a currency vis-à-vis their expectations of future FX spot rate 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 9

Organization of the FX Market • FX Market Size: – Largest financial market in the world – 2009 volume estimated at $4. 5 trillion daily • 40 times larger than NASDAQ daily $ volume • This is because FX used to facilitate transactions in capital and money markets around the world plus FX trades for exports / imports – FX trading volume growing faster than export / import trading due to the hugely larger volume of international investment in world stock, bond, and money markets (of which NYSE is but one of many) 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 10

Organization of the FX Market • Example FX speculative trade for profit: E = $ / £ = $1. 4512 now Ef = $1. 4501 (90 day forward rate) E(Et+90) = $1. 4508 (expected spot rate in 90 days) (prices as of 2/11/09 in WSJ 2/10/09) Bought 1 million £’s 90 days forward at $1. 4501, immediately sold 1 million £’s in spot market 90 days from now for $1. 4508; profit is: margin = {($1. 4508 - $1. 4501)/ $1. 4501} = 0. 000483 or 0. 0483% = 0. 000483 x $1, 450, 100 = $700. 39 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 11

3. 2 Spot Rates and Spot Market • Spot market: transactions involving the trade of two currencies for delivery in two business days • Spot rate quotes: usually expressed as a range depending upon whether buying or selling: – – Bid (price you can sell FX at; bank’s buy price) Ask (price that you can buy at; banks sell price) Therefore Ask Rate > Bid Rate. Bid-Ask Spread is the quote that you will receive on larger orders > $1 million or more – Ask-Bid difference is the profit for the bank for trading FX – Spot Rate quotes in financial papers are the mid-point of bid-ask prices > $1 million. Small retail rates will cost more for FX since you buy at “Ask” and rate higher w/ small volume. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 12

Spot Rates and Spot Market • Spot rate quotes: usually expressed as a range depending upon whether buying or selling: – Retail quotes will be one price (not bid-ask ranges and will be > ask price from interbank transactions • If you call your bank, you get receive a one-number quote – Bid-Ask Spread: • Smaller for widely traded, less volatile currencies and larger for less traded, highly volatile currencies • EXAMPLES http: //wwwforex-markets. com/quotes_composite. htm click on quotes and exotic currencies for real-time quotes 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 13

Spot Rates and Spot Market • Spot rate quotes: – Bid-Ask Spread: • Due to higher spreads and profits on emerging country currencies, large commercial banks have entered this business • Emerging country FX trade volume is small but is expected to grow with greater interest in emerging country foreign investment activity. • Cross spot rates: – FX rates not denominated in $ prices or foreign currency price of $ – Trade and investment occur across many different countries therefore need to know E’s among other currencies: • Canadian dollar price of the Euro • £/¥, or, the UK pound price of the Yen 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 14

Spot Rates and Spot Market Cross spot rates: 2/14/05 trading published in Wall Street Journal, 2/15/05: Given pound price of euro & pound price of dollar what is dollar price of a euro: e. g. £ / = £ 0. 6862, £ / $ = £ 0. 5295 $ / = (£ / ) / ($ / £) = 0. 6862/0. 5295 = $1. 2959 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 15

Spot Rates and Spot Market • Exchange Risk: – Chance of a financial loss denominated in domestic currency due to unfavorable changes in the FX rate – Bankers and FX brokers take positions in foreign currencies as they buy and sell them in the FX market. • If a US bank buys ¥ and then the $ price of the ¥ falls, ¥ is worth less in $ and bank may sell for a lower $ price – E. g. , Citicorp buys ¥ 10, 000, 000 for at $0. 009091 per ¥, paid $90, 910, 000. Suppose ¥ falls to $0. 00908 within a few hours after the buy, the value of those ¥ fell to $90, 800, 000 for a loss of $110, 000. – E. g. 2 If E = $0. 0091, then value of ¥ rose to $91, 000 for a profit of $90, 000. – The percent range between the low E and high E was 0. 22%, a fairly typical daily fluctuation in the ¥/$ price. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 16

Spot Rates and Spot Market • Exchange Risk: – The chance of FX losses such as this example is what leads to Bid-Ask spreads: • Bid-Ask spreads include the cost of a transaction, risk premium for FX exposure and profit for being in the business. • The the volatility ( ) of an FX rate and the chance of a loss from an FX position, the will be the Bid-Ask due to larger risk premium. 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 17

Spot Rates and Spot Market • Currency Arbitrage: – Exploiting difference in FX rates across markets for profit – Removes inconsistencies in FX rates across markets – Arbitrage opportunities are small and do not exist consistently due to access to information 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 18

3. 3 Forward Rates and Fwrd. Market • Forward rate: – FX rate agreed upon now for a specified amount of a foreign currency to be delivered at a fixed, future date • Forward contract: – Agreement between speculator (bank) and customer for the delivery of a specified amount of foreign currency at a future fixed date at a given FX rate set when agreement is made • Forward market exists only for highly traded currencies. – Forward contract eliminates uncertainty regarding the future value of a foreign currency relative to domestic currency, thereby eliminating FX risk 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 19

Forward Rates and Fwrd. Market • Forward Discount: – Foreign currency selling at a discount if FX forward rate is lower than current spot rate • Forward Premium: – Foreign currency selling at a premium if FX forward rate is greater than current spot rate • Forward discount or premium – Where Ef, Es, and # days are forward, spot, rates and number of days forward, respectively 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 20

Forward Rates and Fwrd. Market Forward discount or premium 2/10/09 Trading (published in Wall Street Journal 2/11/09): e. g. 1: Swiss franc spot e = $0. 8636; Et+180 = $0. 8673 For. Prem. = (0. 8673 - 0. 8636)/0. 8636 *2 =+0. 008569 or 0. 8569% e. g. 2: UK pound spot e = $1. 4512; Et+180 = $1. 4496 For. Disc. = (1. 4496 -1. 4512)/1. 4512 * 2 = -0. 00221 or -0. 221% 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 21

Forward Rates and Fwrd. Market Observations on forward contracts: 1. Gains or losses on forward contract has nothing to do with current spot rate - gains / losses are based on difference between forward rate and corresponding future spot rate 2. Forward contracts are not options - buyer must accept and seller must deliver FX at agreed price, volume, and future date - option gives the party to exercise the contract or not 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 22

Forward Rates and Fwrd. Market The bid-ask spread on forward rates depend upon: - volume of transactions in a currency - risk of a forward contract, based on the volatility of future spot rates - length of forward contract; longer contracts mean more uncertainty 3/19/2018 Multinational Corporate Finance Prof. R. A. Michelfelder 23