Foundations of Multinational Financial Management Alan Shapiro John Wiley & Sons

1. Foundations of Multinational Financial ManagementAlan ShapiroJohn Wiley & Sons Power Points by Joseph F. Greco, Ph.D. California State University, Fullerton

2. The Foreign Exchange Markets Chapter 6

3. CHAPTER OVERVIEW • 6.1 ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • 6.2 THE SPOT MARKET • 6.3 THE FORWARD MARKET

4. PART I. INTRODUCTION • I. INTRODUCTION • A. The Market: • the place where money denominated in one currency is bought and sold with money denominated in another currency.

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

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

7. 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 • - banks deal with business customers.

8. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • B. Two Types of Currency Markets • 1. Spot Market: • - immediate transaction • - recorded by 2nd business day • 2. Forward Market: • - transactions take place at a specified future date

9. 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

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

11. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • II. CLEARING SYSTEMS • A. Clearing House Interbank Payments System ( CHIPS) • - used in U.S. for electronic • fund transfers. • B. FedWire • - operated by the Fed • - used for domestic transfers

12. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • III. ELECTRONIC TRADING • A. Automated Trading • - genuine screen-based market • B. Results: • 1. Reduces cost of trading • 2. Threatens traders’ oligopoly of information • 3. Provides liquidity

13. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET • IV. SIZE OF THE MARKET • A. Largest in the world • 1995: $1.2 trillion daily • B. Market Centers (1995): • London = $464 billion daily • New York= $244 billion daily • Tokyo = $161 billion daily

14. 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

15. THE SPOT MARKET • B. Method of Quotation • 1. For interbank dollar trades: • a. American terms • example: $.5838/dm • b. European terms • example: dm1.713/$

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

17. THE SPOT MARKET • C. Transactions Costs • 1. Bid-Ask Spread • used to calculate the fee • charged by the bank • 2. Bid = the price at which the bank is willing to buy 3. Ask = the price it will sell the currency

18. THE SPOT MARKET • 4. Percent Spread Formula: • Percent Spread = (Ask-Bid)/Ask x 100

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

20. THE SPOT MARKET • 2. Calculating Cross Rates • When you want to know what the dm/pound cross rate is, and you • know dm2/US$ and .55pounds/US$, • then • dm/pounds = • *dm2/US$  .55 pounds/US$ • = dm3.60/ pound • *Hint: Keep the denominators alike. Convert to indirect if necessary.

21. THE SPOT MARKET • E. Currency Arbitrage • 1. When cross rates differ from • one financial center to another, • profit opportunities exist. • 2. Buy cheap in one int’l market, • Sell at a higher price in another • 3. Role of Available Information

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

23. 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

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

25. PART II.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)

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

27. 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.

28. PART III.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.

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

30. 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.

31. 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

32. THE FORWARD MARKET • C. Forward Contract Maturities • 1. Contract Terms • a. 30-day • b. 90-day • c. 180-day • d. 360-day • 2. Longer-term Contracts