Chapter Three:


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Chapter Three:

  1. 1. Table of Contents CHAPTE R 3 The Foreign Exchange Market (FOREX) 3 The Spot Market 4 Quotations 4 Triangular (Currency) Arbitrage 4 The Forward Market 4 The Options Market 5 International Banking Services 5 Capital Adequacy Standards 5 International Money Markets 5 International Capital Markets 6 International Stock Markets 7 Valuation of Foreign Stocks 7 Investing Internationally 8 Exchange Rate Risks 8
  2. 2. 3 Chapter I C O N K E Y Website Link Key Point Exercise International Financial Markets One trillion dollars a day is exchanged in the global exchange market I nternational financial markets are comprised of currency markets, international debt instrument markets and international stock markets. These markets are places where currencies, debt, and equity are traded. These markets are not fully integrated due to the unique restrictions on trade by each country. These barriers create different economies and therefore different investing opportunities for different geographic areas. Note: This chapter contains many new concepts. Most of these can be further researched on Wikipedia or a good online finance/economics dictionary, i.e. or The Foreign Exchange Market (FOREX) The foreign exchange market (FOREX) is where MNCs exchange their native currency for foreign currencies. An MNC may need to purchase foreign goods with foreign currency (imports) or may want to invest in a foreign country. There is no central place, called the FOREX, but rather it is a virtual trading place, which is conducted through communication channels such as the Internet or a similar telecommunications network. One popular online currency trader is Currenex. Currenex was founded in 1999 and has offices in London, New York, Chicago, California and Singapore. Currrenex is an online global currency exchange that links institutional buyers and sellers worldwide and is open to all Foreign Exchange and Money Market participants. It provides a low-cost and secure electronic channel to access the $1 trillion/day global foreign exchange market. There are three primary places where MNCs exchange their currency. They are the: 1. Spot Market: where currencies are traded for an immediate delivery 2. Forward and Future Market: where an arrangement for a future delivery is made and 2
  3. 3. 3. Options Market: where rights to buy (call options) and to sell (put options) are traded. Participants in the currency markets are people buying and selling currency through currency traders. They can be: • Individual traders- people trading their home currency for foreign currencies because they are traveling abroad. • Institutional traders- includes banks and security companies trading currency for business needs. • Governments- trading currency for general needs. Institutional traders can have several different strategies for trading. These include: • Arbitrage- Trying to earn risk-free profits from differences in price due to market inefficiencies. • Hedging- Use of forward contracts to minimize the exchange rate risk of future cash flows. • Speculating- Guessing against the market to attempt to earn profit from exchange rate movements. Spot Market In the Spot Market, currencies are traded for immediate delivery at the “spot rate”, which is the current exchange rate between countries. Much of the trading is handled by banks in London, New York, and Tokoyo. If a bank is short on a particular currency, it can purchase that currency from another bank. This is called the interbank market. Traders use electronic trading boards that can check rates at different banks around the world, and instantly receive the best price for the product. Exchange Rate Quotations Exchange Rate quotations can either be in the American Term or the European Term. The “Bid” is the price to buy the product, while the “Ask” is the price to sell the product (From the dealers perspective). When you buy from the dealer you pay the Ask price, and when the dealer buys currency back from you or you sell foreign currency to the dealer you receive the Bid price. The spread is the difference between the asking price and the bid price and is the dealer’s profit for handling the transaction, otherwise known as the transaction cost. Transaction cost is determined by three factors: 1. Trading Volume- Increased volume means a decrease in the spread. 2. Trading Frequency- Increase in the frequency means a decrease in the spread 3. Exchange Rate Volatility- Increase in volatility (risk) means an increase in the spread. 3
  4. 4. When you want to travel to Europe, the Euro will be the currency in all the countries except a few countries. As an example, lets say the Euro is valued at 1.08 and the asking price charged by the bank is 1.13. If you had a $1,000 dollars you would get: 1,000/1.13 = 885 Euros If you decided not to go to Europe, and converted the funds back into dollars you would have: 885 Euros X (1.08 banks bid) = 959 dollars. The cost of converting the money goes to the bank and cost you 41 dollars. For this reason the institution of the Euro has saved the MNCs billions of dollars in transaction cost. Because each time a transaction is done, the bank gets paid. You have a $1,000 and are going to the United Kingdom. The bank’s bid rate for the British pound is $1.52, and its ask rate is $1.60. You go to the bank and convert the funds to pounds. However at the last minute an emergency arises and you cannot go. How much will you lose if you convert the pounds back to dollars? Triangular Currency Arbitrage Arbitrage is the opportunity to make a certain profit, risk-free. It occurs when the market is temporarily imperfect, and there is a price disparity in violation of the “law of one price”. Triangular currency arbitrage occurs when the money in one’s home country (A) can be converted to another currency (B), in which a price disparity occurs between its currency (B) and another foreign currency (C). The result is a sure profit. 1) Simple Arbitrage Example The price of a twinkie at Store A is 40 cents, while the price of the same twinkie at Store B is 50 cents. Assuming that you can buy and sell twinkies at the same price (ignoring bid-asked price difference), can you make an arbitrage profits with $1,000 investment? Note that we must have the same products. We also need to have “prices or American terms” instead of “quantity or European terms.” Note also that the arbitrage opportunity or the price disparity would not last long if the market is perfect (meaning that the prices move as the demand and supply changes) 2) Triangular Arbitrage Example As an example, we will use the British pound (₤), the American dollar ($), and the Canadian dollar(C$). You have 1,000 U.S dollars. Current Spot Rate So = $1.60/₤ (Canadian dollar) So = $0.70/C$ 4
  5. 5. (British Pound) So = C$ 2.1/₤ First, convert your 1,000 U.S dollars to Canadian dollars. To do so we must use the inverse of the current spot rate between the US and Canada in order to be able to cross cancel the US dollars. Then multiply it by the amount of US dollars we are converting. C$/$= 1 C$/$0.70 = 1.43 C$/$1 * $1,000 = 1,430 C$ Canadian dollars Next we convert the 1,430 C$ for British Pounds at the rate of So = C$ 2.1/₤. However, the inverse exchange rate must be used in order to cross cancel out the C$. 1430 C$ * 1₤/ C$ 2.1 = 680.95 British Pounds Finally we convert the 680.95 British Pounds back to US Dollars to earn the arbitrage profit. 680.95₤ * $1.60 U.S dollars/₤ = $1089.52 = Profit of $ 89.52 NOTE: NEED TO SHOW HOW THIS OUGHT TO WORK! Forward Market The forward market, allows an MNC to lock in the exchange rate for a specific time period in the future. The MNC can then buy or sell currency at that rate during the specified period. A forward contract is a contract to buy or sell a predetermined amount of currency at a future time for a locked in exchange rate. MNCs use the forward market when they have a future transaction and want to be certain of the exchange rate. They “hedge” their future payments that they expect to make, assuring a guaranteed rate. For example the current exchange rate for the Euro is 1.10 Euros per dollar. A firm believes the Euro will rise in relation to the dollar, they can lock in the rate for a specific period of time, and so they will pay the current forward rate for the money. A forward contract is not an investment or an option, and the gain/loss on the forward contract is not directly related to current spot price Although the Wall Street Journal gives outright price quotes for forward contracts, most currency traders will quote the difference between the forward and spot rates. (F-So=0.02)  If F> So then forward rate is at a premium.  If F< So then forward rate is at a discount.  The percentage of forward rate premium/discount can be calculated as: F − So 12 * So # ContractMonths 5
  6. 6. Options Market The Options Market was established in 1982. The U.S. Securities and Exchange Commission regulates it. The Chicago Mercantile Exchange and the Chicago Board Options Exchange offer currency options. Currency options are available in many, but not all currencies. A currency option is a right to buy (put) or sell (call) with no obligation, over a specific period of time. This places the obligation on the seller while the buyer enjoys the right to use the option. When an option is used it is referred to as “exercising” the option. An option price is called a premium (pm). A rain check or call is an option that is free. It may be part of the marketing strategy to attract customers. International Banking Services Many banks want to establish multinational operations. Multinational banks are not subject to regulations of the country of the currency, and the arena is very competitive There are various types of international banking services: • Trade financing – L/C (Letter of Credit). This is used because there is typically a lack of trust between the importer and exporter. The importer would prefer to receive the goods before sending payment, and exporter would rather have payment first. By using a bank as a third party, both the importer and exporter can trust the other will hold up their end of the deal because it is guaranteed by the bank. • Currency exchange transactions • Hedging transactions (Accounts Receivable (A/R) or Accounts Payable (A/P) denominated in a foreign currency using derivatives) • Consulting services on international business/finance International Capital Adequacy Standards International Capital Adequacy standards refer to how many reserves (equity/retained earnings and supplemental capital) a bank holds against risky assets. The larger the reserves the safer the bank! International Money Markets International Money Markets refer to making a time deposit (CD) in a currency outside of the country of the currency. For example, a German MNC could deposit a CD in a U.S. bank in U.S. dollars. International Capital Markets 6
  7. 7. Capital Markets refer to foreign banks that issue loans, or forward contract agreements, or bonds from their foreign banks. These banks control interest rate risk using the floating rate Eurocredit loans or Forward Rate Agreements. An Interbank contract allows the Eurobank to hedge the interest rate risk in a mismatched (maturity deposits and loans by using the forward rate) Examples are: • Eurocredit (Euronotes) – medium-term funds • Eurobonds – (long-term) Issued outside the country of the denominated currency. e.g.- Dollar denominated bonds issued in Great Britain. • Foreign bonds: issued by a foreign company, in a country outside their home country; denominated in the currency of the country where issued. e.g - Yankee Bond=Dollar denominated bond issued in the U.S. by a Japanese company. International Stock Markets An MNC can diversify by investing in different countries’ stock markets. An MNC needs a different currency in each country it invests in. With the introduction of the Euro, many U.S. firms took advantage of the common currency, and issued stock in the European market. When investing in foreign markets, firms need to be able to value the foreign stocks, understand the different options available for investment, and minimize the risk involved due to exchange rate volatility. Valuation of Foreign Stocks There are three main methods used to determine the value of foreign stocks. Investors may combine two or more of these methods to determine the quality of the foreign stock. 1. Dividend Discount- The dividend of a foreign stock can normally be forecasted with more accuracy than the value of the foreign currency. An investor takes the dividend, converts it to their currency, and determines if it is a worthwhile investment. 2. Price-Earnings Ratio- The expected earnings per share are multiplied by the expected price-earnings ratio for the firm to find the appropriate price for the stock. 3. Macroeconomic Conditions- The strength of the economy is analyzed and companies that are positioned to benefit from the economy’s strengths are analyzed. This method is less focused on individual stocks and more focused on projected economic growth. 7
  8. 8. Investing Internationally Direct Purchases of Foreign Stocks When purchasing foreign stocks it is usually preferred to purchase those foreign stocks that are trading in your local stock market. Of course its possible to use a foreign brokerage firm and purchase stocks in foreign markets. However, inefficient information, transaction costs, and tax differentials make these investments risky. Investment in MNC Stocks By offering stock in different countries, MNCs can effectively diversify sales and can achieve stability by reducing risk. The stocks become an international stock portfolio. American Depository Receipts (ADRs) American Depository Receipts are certificates representing ownership of foreign stocks. There are currently over 1,000 ADRs which are mainly traded over-the-counter (OTC). The prices are not reported regularly and the transaction costs are high. World Equity Benchmark Shares World Equity Benchmarks Shares (WEBS), also referred to as iShares, represent indexes that reflect composites of stocks for particular countries. Investors can invest directly in a stock index representing different countries. International Mutual Funds International Mutual Funds are portfolios of stocks from different countries. They are popular because: 1. Incurs a small initial investment 2. Benefits of portfolio experts 3. High degree of diversification and reduction of risk Exchange Rate Risks If a foreign investment appreciates, the investor makes money, if it depreciates they lose money. Because exchange rates are volatile, foreign investments are also volatile. Investors can minimize risk by diversifying between countries, continents, and stocks, and by buying short. 8