INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 4
• The Foreign Exchange Market
• Quoting Currencies

2
Defining The Foreign Exchange Market

• The FOREX market Performs Three Important
  Functions
• (1) Generates rates of exchange.
• The ratio of one currency to another.
• These determine costs and returns to global
  businesses.
• (2) Facilitates the conversion of one currency
  into another.
• Through the buying and selling of currencies.
• Allows global firms to move in and out of foreign
  currency as needed.
• (3) Offers contracts to manage foreign exchange
  exposure.
• These hedging contracts allow global firms to
  offset foreign currency exposures.
• Thus, they can concentrate on their core business.

3
Who Provides These Important FX Functions?

• Large global banks (e.g., HSBC, UBS, Citibank)
  acting on behalf of
• Their external clients (primarily global firms)
• Acting in a broker capacity at the request of
  their clients.
• Meeting foreign currency business needs of their
  clients.
• Exporters, importers, multinational firms, hedge
  funds, etc
• Global banks also trade for their own internal
  bank accounts to generate profits for their
  banks.
• Acting in a dealer (trader) capacity
• Taking positions in currencies to make a profit.
• In meeting the needs of their clients and their
  own internal trading, these global banks
  establish the tone of the market.
• This is through the market maker function,
  whereby they
• Quote prices to other parties and commit to
  buying and selling currencies at their quoted
  prices.

4
Making the Market in FX

• The Market Maker Function Involves Two Primary
  Activities
• (1) Willingness of the market maker to provide
  the market with on-going two way quotes upon
  request
• Price at which they will buy a currency
• Price at which they will sell a currency
• This function provides the market with
  transparency
• (2) Willingness of the market maker to actually
  buy and/or sell at the prices they quote
• Thus the market maker offers firm prices into
  the market!
• Thus function provides the market with liquidity.

5
How Do Market Makers Quote Currencies?

• We already know from a previous discussion of two
  possible ways of quoting currencies
• European Terms Quote
• Number of foreign currency units per 1 U.S.
  dollar.
• 119 yen to the dollar
• American Terms Quote
• U.S. dollars and cents per 1 unit of the foreign
  currency
• 1.2100 to one Euro
• Which quote is used?
• American terms quoted currencies historically
  related to non-decimal currencies (i.e., the
  pound, Australian and New Zealand dollar).
• Also by government decision, i.e., the Euro. ECB
  decided to quote the currency in American terms.
• The majority of the worlds currencies are quoted
  in European terms, while the majority of the
  worlds major currencies are quoted in American
  terms.

6
ISO Currency Designations

• All foreign currencies have been assigned an
  International Standards Organization (ISO)
  abbreviation.
• E.g., USD JPY GBP EUR CNY HKD MXP AUD ZAR
• For individual countries please see
  http//www.oanda.com/site/help/iso_code.shtml
• Since the exchange rate is simply the ratio
  (i.e., value) of one currency against another,
  the market makers express this relationship using
  the two currencies ISO designations.
• For Example
• USD/JPY
• USD/MXP
• EUR/USD
• GBP/USD

7
Base and Quote Currency

• Thus, a complete market maker currency quote is
  always represented by the ratio of one currency
  to another and is always designated using ISO
  terms.
• Since a complete quote must have two ISO
  designations (e.g., EUR/USD or USD/JPY)
• The first ISO currency quoted is called the base
  currency.
• The second ISO currency quoted is called the
  quote currency.
• For examples above
• EUR is the base currency and USD is the quote
  currency.
• USD is the base currency and JPY is the quote
  currency.

8
Bid and Ask Quotes

• Furthermore, a market maker currency quote always
  provides two quoted numbers.
• The first number quoted is what the market maker
  will buy a currency for (i.e., the bid quote).
• The second quoted number is what the market
  marker will sell a currency at (i.e., the ask
  quote, or offer quote).
• Recall that a complete quote provides two
  prices (i.e., a two way quote or both a buy and
  a sell price)
• Example EUR/USD 1.2102/1.2106
• The first number is the market makers bid quote
  (or buy price)
• The second number is the market makers ask quote
  (or sell price)
• Note The bid quote is always lower than the ask
  quote.

9
Interpreting a Currency Quote

• Example of a complete ISO foreign exchange
  quotation
• EUR/USD 1.2102/1.2106
• What can we note about the above quote?
• First ISO base currency/ISO quote currency
• AND
• Second Bid quote/ask quote
• So in the above example
• EUR the base currency is the Euro
• USD the quote currency is the U.S. dollar
• 1.2102 is the bid price
• 1.2106 is the ask price

10
But What Do the Numbers Mean?

• Since the market maker is the one quoting
  currency prices, we need to start by looking at
  the numbers from the standpoint of the market
  maker.
• The bid quote is the price at which the market
  maker will buy a currency (it is what they are
  biding for it).
• The ask quote is the price at which the market
  maker will sell a currency (it is what they are
  asking for it).
• But what currency is the market maker buying or
  selling?
• They are always quoting prices at which they will
  buy or sell the base currency (against the quote
  currency).

11
FX Quote Example

• Assume a market maker provides the following
  EUR/USD quote
• 1.2102/1.2106
• Given this quote
• The market maker will buy euros from the market
  at?
• 1.2102
• Or sell euros to the market at?
• 1.2106
• Assume the following USD/JPY
• 110.12/110.20
• The market maker will buy dollars from the market
  at?
• 110.12
• Or sell dollars to the market at?
• 110.20
• Note Again Regardless of the type of quote, the
  ask price is always higher than the bid.

12
A Quote from the Standpoint of Other than a
Market Maker

• Assume you are a corporate and you receive the
  following GBP/USD quote from a market maker bank
• 1.8020/1.8050
• If you wanted to buy pounds from the market
  maker, what would you pay (in dollars) for each
  pound?
• You would pay the ask price, or 1.8050 for each
  pound
• Note this is your price to buy pounds or sell
  dollars.
• If you wanted to sell pounds to the market maker,
  what would you get (in dollars) for each pound
  sold?
• You would get the bid price, or 1.8020
• Note this is your price to sell pounds or buy
  dollars.

13
One More Example

• Assume you are a corporate and you receive the
  following USD/JPY quote from a market maker bank
• 112.50/112.75
• Note, now the base currency is the dollar.
• If you wanted to buy dollars from the market
  maker, what would you pay in yen?
• You would pay the ask price, or 112.75 for each
  dollar.
• Note this is your price to buy dollars or sell
  yen.
• If you wanted to sell dollars to the market
  maker, what would you get in yen for each dollar?
• You would get the bid price, or 112.50 for each
  dollar.
• Note this is your price to sell dollars or buy
  yen.
• Remember The market maker is always buying or
  selling the base currency (against the quote
  currency).

14
Lets Look at Real Time Currency Quotes

• Go to the following web-site
• http//www.fxstreet.com/nou/graph/streamingchart.a
  sp
• At this site, go to
• Live Currency Rates (U.S. Dollar/Major
  currencies)
• Observe ISO quotes.
• Observe bid and ask quotes.
• Observe what currency and at what price the
  market maker is buying or selling (base
  currency).
• Observe what price you (a non-market maker) would
  buy or sell the base currency to the market
  maker.
• Observe changes in bid and ask quotes.
• What do these mean?
• Another site http//www.forextrading.com/

15
How are Some Currencies Quoted?

• Euro EUR/USD Swedish
  Krona USD/SEK
• British Pound GBP/USD Norwegian
  Kroner USD/KOR
• Australian Dollar AUD/USD Israeli
  Shekel USD/ILS
• New Zealand Dollar NZD/USD Danish
  Krone USD/DKK
• Russian Ruble USD/RUB
• Yen USD/JPY Malaysian
  Ringgit USD/MYR
• Swiss Franc USD/CHF Korean
  Won USD/KRW
• Canadian Dollar USD/CAD Indian
  Rupee USD/INR
• Mexican Peso USD/MXN Philippine
  Peso USD/PHP
• Hong Kong Dollar USD/HKD Argentina
  Peso USD/ARS
• Singapore Dollar USD/SGD
• Brazilian Real USD/BRL
• South African Rand USD/ZAR
• Thai Baht USD/THB
• Note American terms quoted currencies use the
  foreign currency as the base currency and
  European terms quoted currencies use the U.S.
  dollar as the base currency.

16
FX Spreads to Market Maker Banks

• Recall, that all market makers provide both a bid
  (i.e., buy) and an ask (i.e., sell) quote for a
  currency.
• Recall the ask is always higher.
• The difference between the bid and ask price is
  the spread to the market maker.
• This represents the market makers profit from
  executing a round transaction (i.e., an equal
  buy and sell for a currency).
• Assume the following GBP/USD quote 1.7921/1.7929
• Bid at 1.7921
• Ask at 1.7929
• What is the spread to the market maker on a
  round transaction (assume 10 million pound
  transactions)
• Ask 1.7929 x 10,000,000 17,929,000 (price
  to sell pounds)
• Bid 1.7921 x 10,000,000 17,921,000 (price
  to buy pounds)
• Spread (Commission) 8,000 (on
  round transaction)

17
Measuring the FX Bid Ask Spread

• Bid Ask Percentage Spread Formula
• (Ask price Bid price) / Ask price x 100
• Example assume the following quote
• GBP/USD 1.7921/1.7929
• Calculate the Percentage Spread
• (Ask price Bid price) / Ask price x 100
• (1.7929 1.7921) / 1.7929 x 100
• 0.045

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Observations About Bid/Ask Spreads

• Bid/ask spreads increase with exchange rate
  volatility.
• Bid/ask spreads decrease with increases in market
  maker competition.
• Bid/ask spreads larger in retail market than in
  wholesale (i.e., interbank) market.
• Wholesale market global bank to global bank
• Retail market bank to customer (client of bank)
• Profits for banks come primarily from their
  intermediary role (acting for clients) as opposed
  to speculative trades.
• Bid ask spreads critical here!
• Also banks adjust their bid and ask rates to
  adjust own positions.
• Making trades more or less attractive to others!

19
Adjusting Bid Ask Quotes to Adjust Foreign
Exchange Holdings

• Market makers adjust their bid and ask quotes to
  adjust their own holdings of currencies.
• Assume the competition is quoting the GBP/USD as
• Bid 1.7921 (price at which the competition
  will buy pounds)
• Ask 1.7929 (price at which the competition will
  sell pounds)
• If your bank wanted to increase its holdings of
  pounds (or decrease its holding of dollars) it
  will quote
• More than 1.7921 (raise its bid quote) and
  attract more pounds!
• If your bank wanted to decrease its holdings of
  pounds (or increase its holdings of dollars) it
  will quote
• Less than 1.7929 (lower its ask quote) and sell
  more pounds!
• This is why you need to shop around for the best
  deal.

20
Quotes According to Delivery Time Period

• Spot Quote Quote for immediate transactions.
• Actual delivery will take place at the end of 2
  business days.
• Saturday and Sunday are not business days
• There may be a one day delivery depending upon
  the location (e.g., between Canada and the U.S.,
  or within Europe).
• Two way spot quotes are provided by market
  makers.
• Forward Quote Quote for more than 3 business
  day transactions.
• Actual delivery to take place at the end of 3
  business days or more from now.
• Two way forward quotes are provided by market
  makers.

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Examples of Spot FX Quotes

• September 8, 2004 Feb 6, 2006
• American Terms
• U.K. (pound) 1.7867 1.7471
• Eurozone (euro) 1.2186 1.1960
• Australia (dollar) .6964 .7421
• European Terms
• Japan (yen) 109.30 119.02
• Mexico (peso) 11.584 10.458
• China (RMB) 8.2781 8.0572
• Sources
• http//online.wsj.com/public/us and
  http//fx.sauder.ubc.ca/today.html

22
What Moves a Floating Spot Rate

• Anything that affects the demand for or supply of
  the currency on foreign exchange markets,
  including
• Relevant economic data ,such as
• trade data,
• Inflation data,
• unemployment date, GDP data and
• Central bank key interest rates (e.g., Federal
  Funds rate or comparable rates in foreign
  countries) and changes in these rates.
• Announcements by key officials (e.g., central
  bankers)
• What is important?
• The actual data itself
• And the markets expectation for this data.
• Was the reported data in line with market
  expectations?
• Also important are political/military events.

23
Forward FX Rates

• Involves contracting today for the future
  purchase or sale of foreign exchange.
• Forward rates are quoted today by market makers.
• As with spot rates, forward rates are two way
  quotes, or bid and ask prices.
• Bid at which they will buy the base currency in
  the future.
• Ask at which they will sell the base currency in
  the future.
• Forward rates can be
• Worth more than spot (premium)
• Worth less than spot (discount)
• Equal to spot (flat)

24
Examples of Forward FX Rates

• September 8, 2004 February 6, 2006
• American Terms
• U.K. (Pound) 1.7867 1.7471
• 1 month forward 1.7818 1.7472
• European Terms
• Japan (Yen) 109.30 119.02
• 1 month forward 109.13 118.60
• Sources
• http//online.wsj.com/public/us and
  http//fx.sauder.ubc.ca/today.html

25
Determining Forward Discounts and Forward Premiums

• Question On September 8, 2004, was the pound
  selling at a forward discount or forward premium?
• U.K. (Pound) 1.7867
• 1 month forward 1.7818
• Answer
• Use the formula Forward rate spot rate.
• Discount 1 month forward is less than the spot
  by .0049 (1.7818 1.7867 -.0049).
• Note the dollar was selling at a premium (less
  dollars to buy a pound forward than to buy a
  pound spot).

26
Determining Forward Discounts and Forward Premiums

• Question On February 6, 2006, was the pound
  selling at a forward discount or forward premium?
• U.K. (Pound) 1.7471
• 1 month forward 1.7474
• Answer
• Use the formula Forward rate spot rate.
• Premium 1 month forward is more than the spot
  by .0003 (1.7474 1.7471 .0003).
• Note the dollar was selling at a discount (more
  dollars to buy a pound forward than to buy a
  pound spot).

27
Determining Forward Discounts and Forward Premiums

• Question On February 6, 2006, was the Japanese
  yen selling at a forward premium or forward
  discount?
• Japan (yen) 119.02
• 1 month forward 118.60
• Answer
• First, convert to American terms (119.02
  .008402 118.60 .008432).
• Use the formula Forward rate spot rate.
• Yen 1 month forward is worth more than the spot
  by .00003 (.008432 - .008402 .00003).
• Premium Yen is selling at a premium (.00003).
• Note Dollar is selling at a discount (more
  dollars to buy a yen forward than a yen spot)