notes

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

2. 2
CHAPTER 7
THE FOREIGN
EXCHANGE
MARKET

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

4. 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. 5
INTRODUCTION
B. International Trade and Capital
Transactions:
facilitated with the ability
to transfer purchasing power
between countries

6. 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

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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

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

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

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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

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

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

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

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

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

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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

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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

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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

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

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

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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

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THE SPOT MARKET
4. Percent Spread Formula (PS):
100x
Ask
BidAsk
PS
−
=

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

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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

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

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

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

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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

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

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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)

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

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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.

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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.

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

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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.

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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