Slide Ch 7 Multinational Financial Management

8/10/2019 Slide Ch 7 Multinational Financial Management

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Multinational Financial

ManagementAlan Shapiro9thEdition

J.Wiley & Sons

Power Points by

Joseph F. Greco, Ph.D.

California State University, Fullerton


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CHAPTER 7

The Foreign ExchangeMarket


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INTRODUCTION

I. INTRODUCTION

A. The Currency MarketDefinition: a place where money denominated inone currency is bought and sold with moneydenominated in another currency

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INTRODUCTION

B. International Trade and Capital

Transactions:facilitated with the ability to transferpurchasing power between countries

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INTRODUCTION

C. Location

1. OTC-type: no specific

location2. Most trades by phone,

telex, or SWIFT

SWIFT: Society for Worldwide Interbank FinancialTelecommunications

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ORGANIZATION OF THE FOREIGN

EXCHANGE MARKET

I. PARTICIPANTS IN THE FOREIGN EXCHANGEMARKET

A. Participants at 2 Levels

1. Wholesale Level (95%)

- major banks

2. Retail Level- business customers

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EXCHANGE MARKET

B. Two Types of Currency Markets

1. Spot Market:

- immediate transaction

- recorded by 2nd business day

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EXCHANGE MARKET

2. Forward Market:

- transactions take place at aspecified future date

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EXCHANGE MARKET

C. Participants by Market

1. Spot Marketa. commercial banks

b. brokers

c. customers of commercial and central banks

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EXCHANGE MARKET

2. Forward Market

a. arbitrageursb. traders

c. hedgers

d. speculators

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EXCHANGE MARKET

II. CLEARING SYSTEMS

A. Clearing House Interbank Payments System(CHIPS)

used in U.S. for electronic fund transfers.

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EXCHANGE MARKET

B. FedWire

- operated by the Fed

- used for domestic transfers

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EXCHANGE MARKET

III. ELECTRONIC TRADING

A. Automated Trading- genuine screen-based market

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EXCHANGE MARKET

B. Results:

1. Reduces cost of trading

2. Threatens traders oligopoly of information

3. Provides liquidity

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EXCHANGE MARKET

IV. SIZE OF THE MARKET

A. Largest financial market in the world

2007: US$3.2 trillion daily

or

US$800 trillion a year

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EXCHANGE MARKET

B. Market Centers by Size (2007):

-daily turnover:#1: London = $1.359 trillion

#2: New York= $664 billion

#3: Zurich=$242 billion

#4: Tokyo = $238billion

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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/$

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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 $1.81

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THE SPOT MARKET

C. Transactions Costs

1. Bid-Ask Spreadused to calculate the fee charged by the bank

Bid = the price at which the bank is willing tobuy

Ask = the price it will sell the currency

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THE SPOT MARKET

Percent Spread Formula (PS):

100x

Ask

BidAskPS

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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

D. Cross Rates (cont)

2. Calculating Cross Rates (example)Suppose you want to calculate the /crossrate.

You know .5556/US$ and.8334/US$then

/= .5556/US$ .8334/US$

= .6667/23


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THE SPOT MARKET

E. Currency Arbitrage1. If cross rates differ from one financial center to

another, and profit opportunities exist.

2. Buy cheap in one intl market,sell at a higherprice in another

3. The Critical 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 originaltransaction.

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THE SPOT MARKET

G. Exchange Risk

1. Bankers = middlemena. Incurring risk of adverse exchange rate moves.

b. Increased uncertainty about future exchangerate requires

1.) Demand for higher risk premium2.) Bankers widen bid-ask spread

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MECHANICS OF SPOT

TRANSACTIONS

H. SPOT TRANSACTIONS: Example

Step 1. Currency transaction:verbal agreement, U.S. importerspecifies:

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 Kongtransfers HK$ from nostro account toexporters.

Value Date.

U.S. bank debits importers account.

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THE FORWARD MARKET

I. INTRODUCTION

A. 3 Part Definition of a Forward Contract:

an agreement between a bank and a customer todeliver a

specified amount of currency againstanother currency

at a specified future date and

at a fixed exchange rate

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THE FORWARD MARKET

B. Purpose of a Forward:

Hedgingthe act of reducing exchange

rate risk.

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THE FORWARD MARKET

C. Forward Rate Quotations

1. Two Methods:a. Outright Rate: quoted to commercial

customers

b. Swap Rate: quoted in the inter-bankmarket as a discount or premium

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THE FORWARD MARKET

CALCULATING THE FORWARD PREMIUMOR DISCOUNT

= F-S x 12 x 100S n

where F = the forward rate of exchangeS = the spot rate of exchange

n = the number of months in the

forward contract

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Slide Ch 7 Multinational Financial Management

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