1 Multinational Financial Management Alan Shapiro 10 th Edition John Wiley & Sons, Inc. PowerPoints by Joseph F. Greco, Ph.D. California State University, Fullerton

2 CHAPTER 7 The Foreign Exchange Market

3 INTRODUCTION I. INTRODUCTION A.The Currency Market Definition: a place where money denominated in one currency is bought and sold with money denominated i.n another currency 3

4 INTRODUCTION B.International Trade and Capital Transactions: facilitated with the ability to transfer purchasing power between countries 4

5 INTRODUCTION C. Location 1.OTC-type: no specific location 2.Most trades by phone, telex, or SWIFT SWIFT: Society for Worldwide Interbank Financial Telecommunications 5

6 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 6

7 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.Two Types of Currency Markets 1.Spot Market: - immediate transaction - recorded by 2nd business day 7

8 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET 2. Forward Market: - transactions take place at a specified future date 8

9 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 9

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

11 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET II.CLEARING SYSTEMS A. Clearing House Interbank Payments System (CHIPS) used in U.S. for electronic fund transfers. 11

12 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. FedWire - operated by the Fed - used for domestic transfers 12

13 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET III. ELECTRONIC TRADING A. Automated Trading - genuine screen-based market 13

14 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B.Results: 1.Reduces cost of trading 2.Threatens traders’ oligopoly of information 3.Provides liquidity 14

15 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET IV. SIZE OF THE CURRENCY MARKET A. Largest financial market in the world 2010: US$4 trillion daily or US$960 trillion a year 15

16 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET B. Market Centers by Size (2010): -daily turnover: #1: London = $1.854 trillion #2: New York= $904 billion #3: Tokyo = $312 billion 16

17 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 17

18 THE SPOT MARKET B.Method of Quotation 1.For inter-bank dollar trades: a. American terms example: $1.21/€ b. European terms example: Peso1.713/$ 18

19 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 $

20 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 20

21 THE SPOT MARKET Percent Spread Formula (PS): 21

22 THE SPOT MARKET D. Cross Rates 1.The exchange rate between 2 non - US$ currencies 22

23 THE SPOT MARKET D. Cross Rates (con’t) 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$ = £.6667/ € 23

24 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 int’l market, sell at a higher price in another 3.The Critical Role of Available Information 24

25 THE SPOT MARKET F. Settlement Date Value Date: 1.Date monies are due 2.2nd Working day after date of original transaction. 25

26 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 26

27 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) 27

28 MECHANICS OF SPOT TRANSACTIONS Step 2.Bank sends importer contract note including: - amount of foreign currency - agreed exchange rate - confirmation of Step 1. 28

29 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. 29

30 THE FORWARD MARKET I.INTRODUCTION A. 3 Part Definition of a Forward Contract: an agreement between a bank and a customer to deliver three things: a specified amount of currency against another currency at a specified future date and at a fixed exchange rate 30

31 THE FORWARD MARKET B. Purpose of a Forward : Hedging the act of reducing exchange rate risk 31

32 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 32

33 THE FORWARD MARKET CALCULATING THE FORWARDPREMIUM 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 33

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