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Joseph F. Greco, Ph.D. California State University, Fullerton. 2. CHAPTER 7. THE FOREIGN EXCHANGE ... E. Currency Arbitrage. 1. If cross rates differ from ... – PowerPoint PPT presentation

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Title: Multinational Financial Management Alan Shapiro 7th Edition J.Wiley


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

2
CHAPTER 7
  • THE FOREIGN EXCHANGE MARKET

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

4
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.

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

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

7
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

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

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

10
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

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

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

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

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

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

16
ORGANIZATION OF THE FOREIGN EXCHANGE MARKET
  • IV. SIZE OF THE MARKET
  • A. Largest in the world
  • 1999 US1.5 trillion daily
  • or
  • US375 trillion a year
  • In 1999 the US GDP was US9.1 trillion

17
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

18
PART III.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

19
THE SPOT MARKET
  • B. Method of Quotation
  • 1. For interbank dollar trades
  • a. American terms
  • example .5838/dm
  • b. European terms
  • example Peso1.713/

20
THE SPOT MARKET
  • 2. For nonbank customers
  • Direct quote
  • gives the home currency price of one unit of
    foreign currency.
  • EXAMPLE dm0.25/FF

21
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

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

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

24
THE SPOT MARKET
  • 2. Calculating Cross Rates
  • When you want to know what the dm/ff cross
    rate is, and you know dm2/US and ff.55/US
  • then dm/ff dm2/US ? ff.55/US
  • dm3.636/ ff

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

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

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

28
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

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

30
MECHANICS OF SPOT TRANSACTIONS
  • 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)

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

32
MECHANICS OF SPOT TRANSACTIONS
  • Step 3. Settlement
  • Correspondent bank in Hong
  • Kong transfers HK from
  • nostro account to exporters.
  • Value Date.
  • U.S. bank debits importers
  • account.

33
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.

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

35
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.

36
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
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