Multinational Financial

Management
Alan Shapiro

7th Edition

Power Points by
J.Wiley & Sons
Joseph F. Greco, Ph.D.
California State University, Fullerton
1

CHAPTER 7
THE FOREIGN
EXCHANGE
MARKET

CHAPTER OVERVIEW
I.
II.

INTRODUCTION
ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET
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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.

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

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

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

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.
12

ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET
B. FedWire
- operated by the Fed
- used for domestic
transfers
13

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

16

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.
b.
c.
d.

spot price
30-day
90-day
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
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
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THE SPOT MARKET

4. Percent Spread Formula
(PS):

Ask Bid
PS
x100
Ask
22

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.

25

THE SPOT MARKET

2. Buy cheap in one intl
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
28

THE SPOT MARKET

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

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)
30

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 exporters.
Value Date.
U.S. bank debits importers
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
b.

commercial customers.
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
36