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Accounting & Finance (ACC4004) Foreign Exchange Markets Week 9

Accounting & Finance (ACC4004) Foreign Exchange Markets Week 9. Learning Objectives:. Foreign Exchange Market Exchange Rates Spot and Forward rates Exchange rate systems Euro. The foreign exchange markets.

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Accounting & Finance (ACC4004) Foreign Exchange Markets Week 9

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  1. Accounting & Finance (ACC4004)Foreign Exchange MarketsWeek 9

  2. Learning Objectives: • Foreign Exchange Market • Exchange Rates • Spot and Forward rates • Exchange rate systems • Euro

  3. The foreign exchange markets • One currency is exchanged for another, at a rate usually determined by market supply and demand • FX trading takes place round the globe 24 hours a day • Largely OTC trading • Of the global $3.98 trillion estimated in 2010 over one-third is through London.

  4. Global daily FX turnover in April 2010Source:Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010. Bank for International Settlements, www.bis.org.

  5. Percentages of global foreign exchange market turnover by country, daily averages in April 2010Source:Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010. Bank for International Settlements, www.bis.org.

  6. Percentages of global foreign exchange market turnover by currency pair, daily averages in April 2010Source:Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010. Bank for International Settlements, www.bis.org.

  7. FX trading • Trading is carried out in numerous locations • Some of the trades are on regulated exchanges but most are not • Most trading occurs when both the European and New York markets are open • Most banks carry out proprietary trading • When a non-bank organisation needs an FX deal it mostly trades with a bank • Exchange trading tends to deal in standard amounts and maturities.

  8. The buyers and sellers of foreign currencies are: • Commercial companies with export or import interests • International banks and commercial banks carrying our proprietary trading • Dealers trading and acting as market makers in currency (usually the big banks) • Brokers buying and selling currencies on behalf of a client, e.g. a client bank or commercial firm • Governments needing foreign currency for overseas trade or to pay for activities abroad • Speculators or arbitrageurs taking advantage of perceived FX pricing anomalies • Tourists or investors (e.g. in property or shares) needing to pay in foreign currency • Fund managers investing abroad (pensions, insurance companies, etc.) • Central banks (smoothing out fluctuations or managing the rate to a desired level).

  9. Foreign exchange market turnover by execution method, 2010Source:Triennial Central Bank Survey: Report on global foreign exchange market activity in 2010. Bank for International Settlements, www.bis.org.

  10. Functions of the Foreign Exchange Market • It allows participants to transfer purchasing power between countries. This makes international trade possible since one party to any transaction is likely have to deal in a foreign currency. • Allows participants to obtain or provide credit for international trade transactions. Specialised instruments such as bankers’ acceptances and letters of credit finance international trade. • Helps participants to minimise their exposure to exchange rate risk by providing hedging facilities for transferring foreign exchange risk to someone else more willing to carry the risk.

  11. Exchange rates • An exchange rate is the price of one currency (the base currency) expressed in terms of another (the secondary, counter or quote currency) • If the exchange rate between the US dollar and the pound is US$1.60 = £1.00 this means that £1.00 will cost US$1.60 • US$1.00 will cost 62.50 pence • The standardised forms of expression are US$/£ : 1.60 or US$1.60/£ or USD1.60/£ • Exchange rates are expressed in terms of the number of units of the first currency per single unit of the second currency • A pip is one ten-thousandth of one unit of currency • The US$/£ exchange rate on 16 November 2010 US$1.5988/£.

  12. Exchange Rates • Direct Quote: The exchange rate that indicates the number of units of the home currency required to buy one unit of a foreign currency. • Indirect Quotes: The exchange rate that express the number of units of a foreign currency that can be bought for one unit of home currency. • Indirect quote = 1/direct quote Thus 1/1.5562 = £0.6426

  13. Asked Rate: The rate the bank or foreign exchange trader asks the customer to pay in home currency for foreign currency when the bank is selling and the customer is buying. Asked rate is also known as selling or offer rate. • Bid Rate: The rate at which the bank buys the foreign currency from the customer. The bid rate is also known as the buying rate.

  14. Arbitrage/Arbitrageur • Arbitrage is the practice of taking advantage of a price differential between two or more markets; the profit being the difference between the market prices; risk-free profit • As financial markets are well informed and highly competitive pricing anomalies are small and short-lived; Move large sums of money and quickly.

  15. Speculation/Speculator • Financial speculation can involve the buying, holding and selling of stocks, bonds, commodities, currencies etc to profit from fluctuations in its price. • Speculators: banks, firms and individuals who attempt to profit from outguessing the market; they may be wrong so they are taking a risk.

  16. Spot & Forward Rates In the ‘spot’ market, transactions take place which are settled quickly for ‘immediate delivery’ (actually takes 1 or 2 days) In the ‘forward market’ a deal is arranged to exchange currencies at some future date at a price agreed now Spot Transactions • The purchase of foreign exchange with delivery and payment between banks to take place, normally, on the second following business day. Forward Transactions • Forward transactions require delivery at a future date of a specified amount of one currency for a specified amount of another currency. • The exchange rate is established at the time of the agreement but payment and delivery are not required until maturity.

  17. Worked example Covering in the forward market On 12 November 2010 a UK exporter sells goods to a customer in France invoiced at €5,000,000. Payment is due three months later. Spot rate of exchange at €1.1787/£ If the pound strengthens against the euro and the rate is then €1.40/£ €5,000,000 = £4,241,961 1.1787 £4,241,961 €5,000,000 –£3,571,429 = £3,571,429 causing a loss of 1.40 £670,532

  18. Worked example Covering in the forward market (Continued) If sterling weakens to €1.10/£ a currency gain is made Rather than run the risk of a possible loss on the currency side of the deal the exporter may decide to cover in the forward market. Under this arrangement the exporter promises to sell €5m against the pound in three months (the agreement is made on 1 2 November for delivery of currency in February). The forward rate available (ignoring any market makers’ spreads and transaction costs) on 1 2 November is €1 .1 791 /£. This forward contract means that the exporter will receive £4,240,522 in February Cover in the forward market. The forward rate available is €1.1791/£ £4,545,455 €5,000,000 –£4,241,961 = £4,545,455 and the currency gain will be 1.10 £303,494 €5,000,000 = £4,240,522 1.1791

  19. Question Answer the following questions on the basis that the euro/US$ (EUR/USD) exchange rate is 1 .3605–1 .3609, that is, US$1 .3605/€ or US$1 .3609/€ depending on whether you are buying or selling euros. 1 What is the cost of buying €200,000? 2 How much would it cost to purchase US$4m? 3 How many dollars would be received from selling €800,000? 4 How many euros would be received from selling US$240,000?

  20. Answer

  21. Cross exchange rates • A cross rate is the exchange rate between two foreign currencies neither of which is the currency of the domestic currency. • The Philippines peso and the United Arab Emirates dirham would see little trade. The traditional way of dealing with this was to exchange the dirhams into one of the major currencies, usually the US dollar, and then to exchange the dollars for pesos

  22. Exchange Rate Systems • The international monetary system is the set of policies, institutions, practices, regulations and mechanisms that determine exchange rates. • Nations prefer economic stability and often link this with a stable exchange rate. • But fixing exchange rates often leads to currency crises if the nations’ monetary policy is inconsistent with the fixed rate. • Economic shocks can be absorbed more easily when exchange rates float free. • Freely floating exchange rates may exhibit excessive volatility which hurt trade and stifle economic growth.

  23. EXCHANGE RATE SYSTEMS FOR THE UK SINCE 1944 • 1944-72: Fixed Exchange Rates ( Dollar/Gold) • 1972-87: Managed Floating • 1987-88: Shadowing the Deutsche Mark (Under Chancellor Nigel Lawson) • 1988-90: Managed Floating • 1990-92: Semi-Fixed Exchange Rates • 1992- : Floating Exchange Rate

  24. Meanwhile • The euro was established by the provisions in the 1992 Maastricht Treaty by the European union. To participate in the currency, member states are meant to meet strict criteria. • 1st January 1999 currency was officially introduced. • 18 of the 27 EU countries of Europe now use Euro

  25. Euro: The Single Currency Countries in • Belgium, Germany, Ireland, Spain, France, Italy, Luxembourg, the Netherlands, Austria, Portugal and Finland (1999), Greece(2001), Slovenia (2007), Cyprus, Malta (2008), Slovakia (2009), Estonia (2011), Latvia (2014) Countries not in • UK, Denmark and Sweden

  26. Impact on European Monetary Policy • Single money supply rather than one for each country • EU monetary policy is consolidated • May lead to more political unification European Central Bank • Based in Frankfurt • Sets monetary policy for all participating countries • Objective is to control inflation and stabilize, within reasonable boundaries, the value of the Euro.

  27. Implications of European Monetary Policy • More consistent economic conditions across countries. • Any policy at a given time is likely to enhance some countries and adversely affect others. • Each countries will still make its own fiscal policy (tax and government spending)

  28. Impact on Business in Europe • Eliminate currency risk • Cheaper transaction costs, exchange rate certainty, transparent price differences • Will encourage long-term business arrangements between firms in different countries • Inter country business should increase therefore increasing trade flows • Should increase price comparability • All this should lead to economies becoming more integrated.

  29. Impact on Financial Flows • Share prices more comparable • Investors can invest in other countries without exchange risk • More cross border investment than in the past • If economies become more highly correlated then share prices should be more highly correlated too. • Diversification may be more difficult for investors • Stock markets may consolidate over time • Bond investors will also find cross border investment easier but find it harder to become diversified.

  30. Impact on UK businesses • Will be significant especially for importers and exporters. • Some will have to undertake many transactions in Euros. • Some multinationals will use Euros for all their transactions and will want UK subsidiaries to do so too. • Some retailers use the Euro • Wholesale financial markets are using the Euro.

  31. The benefits of the Euro • Europe is better able to absorb shocks such as the 9/11 attacks • Eliminates exchange rate risk within the Euro zone • Helps to create deeper capital markets, making bigger deals possible • The Euro is becoming a popular reserve currency.

  32. The disadvantages of the Euro • The strong Euro makes it difficult for exporters who face competition from China. • There is a risk that a financial crisis in one nation will infect the whole zone. • The unified monetary policy limits action that can be taken to support slow growth countries and may spur inflation in high growth countries.

  33. Bibliography Howells, P. and Bain, K., (2007) Financial Markets and Institutions.5th ed. England: Pearson Howells, P. and Bain, K., (2005) The Economics of money, banking and Finance: A European text.3rd ed. England: Pearson Mishkin, F.S. and Eakins, S.G., (2009) Financial Markets and Institutions. 6th ed. Boston: Pearson Arnold, Glen. (2013) Corporate Financial Management. 5th ed. Pearson Arnold, Glen. (2012) Modern Financial Markets and Institutions.. Pearson McLaney, Eddie. (2012)Business Finance : Theory & Practice, 9th Edition, Pearson Education Limited Pike, R. and Neale, B. (2009) Corporate Finance and investment, 6th edition, FT Prentice Hall. [ebook is available] Valdez (2010); Introduction to Global Financial Markets 6e; Palgrave • http://en.wikipedia.org/wiki/Foreign_exchange_market • http://markets.ft.com/research/markets/currencies

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