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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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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 aspecified future date
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ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
C. Participants by Market
1. Spot Marketa. 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. arbitrageursb. 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 financial market in the world
2007: US$3.2 trillion daily
or
US$800 trillion a year
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ORGANIZATION OF THE FOREIGN
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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