Intl fin mkts chap iii

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Intl fin mkts chap iii

  1. 1. INTERNATIONAL FINANCIAL MANAGEMENT EUN / RESNICK Third Edition Chapter Objectives: This chapter serves to introduce the student to the institutional framework within which exchange rates are determined. This chapter lays the foundation for much of the discussion throughout the remainder of the text, thus it deserves your careful attention. 4Chapter Four The Market for Foreign Exchange www.StudsPlanet.com
  2. 2. Chapter Outline • Function and Structure of the FOREX Market • The Spot Market • The Forward Market www.StudsPlanet.com
  3. 3. Chapter Outline • Function and Structure of the FOREX Market – FX Market Participants – Correspondent Banking Relationships • The Spot Market • The Forward Market www.StudsPlanet.com
  4. 4. Chapter Outline • Function and Structure of the FOREX Market • The Spot Market – Spot Rate Quotations – The Bid-Ask Spread – Spot FX Trading – Cross Exchange Rate Quotations – Triangular Arbitrage – Spot Foreign Exchange Market Microstructurewww.StudsPlanet.com
  5. 5. Chapter Outline • Function and Structure of the FOREX Market • The Spot Market • The Forward Market – Forward Rate Quotations – Long and Short Forward Positions – Forward Cross-Exchange Rates – Swap Transactions – Forward Premium www.StudsPlanet.com
  6. 6. The Function and Structure of the FOREX Market • FOREX Market Participants • Correspondent Banking Relationships www.StudsPlanet.com
  7. 7. FOREX Market Participants • The FOREX market is a two-tiered market: – Interbank Market (Wholesale) • About 700 banks worldwide stand ready to make a market in Foreign exchange. • Nonbank dealers account for about 20% of the market. • There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists. – Client Market (Retail) • Market participants include international banks, their customers, nonbank dealers,www.StudsPlanet.com
  8. 8. Correspondent Banking Relationships • Large commercial banks maintain demand deposit accounts with one another which facilitates the efficient functioning of the forex market. • International commercial banks communicate with one another with: – SWIFT: The Society for Worldwide Interbank Financial Telecommunications. – CHIPS: Clearing House Interbank Payments System – ECHO Exchange Clearing House Limited, the first global clearinghouse for settling interbank FOREX transactions. www.StudsPlanet.com
  9. 9. The Spot Market • Spot Rate Quotations • The Bid-Ask Spread • Spot FX trading • Cross Rates www.StudsPlanet.com
  10. 10. Spot Rate Quotations • Direct quotation – the U.S. dollar equivalent – e.g. “a Japanese Yen is worth about a penny” • Indirect Quotation – the price of a U.S. dollar in the foreign currency – e.g. “you get 100 yen to the dollar” • See the insert card from your textbook. www.StudsPlanet.com
  11. 11. Spot Rate Quotations The direct quote for British pound is: £1 = $1.5627 Country USD equiv Friday USD equiv Thursday Currency per USD Friday Currency per USD Thursday Argentina (Peso) 0.3309 0.3292 3.0221 3.0377 Australia (Dollar) 0.5906 0.5934 1.6932 1.6852 Brazil (Real) 0.2939 0.2879 3.4025 3.4734 Britain (Pound) 1.5627 1.566 0.6399 0.6386 1 Month Forward 1.5596 1.5629 0.6412 0.6398 3 Months Forward 1.5535 1.5568 0.6437 0.6423 6 Months Forward 1.5445 1.5477 0.6475 0.6461 Canada (Dollar) 0.6692 0.6751 1.4943 1.4813 1 Month Forward 0.6681 0.6741 1.4968 1.4835 3 Months Forward 0.6658 0.6717 1.502 1.4888 www.StudsPlanet.com
  12. 12. Spot Rate Quotations The indirect quote for British pound is: £.6399 = $1 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry www.StudsPlanet.com
  13. 13. Spot Rate Quotations Note that the direct quote is the reciprocal of the indirect quote: 6399. 1 5627.1 = 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry www.StudsPlanet.com
  14. 14. The Bid-Ask Spread • The bid price is the price a dealer is willing to pay you for something. • The ask price is the amount the dealer wants you to pay for the thing. • The bid-ask spread is the difference between the bid and ask prices. www.StudsPlanet.com
  15. 15. Spot FX trading • In the interbank market, the standard size trade is about U.S. $10 million. • A bank trading room is a noisy, active place. • The stakes are high. • The “long term” is about 10 minutes. www.StudsPlanet.com
  16. 16. Cross Rates • Suppose that S($/€) = .50 – i.e. $1 = 2 € • and that S(¥/€) = 50 – i.e. €1 = ¥50 • What must the $/¥ cross rate be? , ¥ € € $ ¥ $ since ×= ¥100$1or.01¥)/($ ¥100 1$ ¥50 1€ 2€ 1$ ==⇒=× S www.StudsPlanet.com
  17. 17. Triangular Arbitrage $ £¥ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 Suppose we observe these banks posting these exchange rates. First calculate the implied cross rates to see if an arbitrage exists. www.StudsPlanet.com
  18. 18. Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 80¥ 1£ 120¥ 1$ 1$ 50.1£ =× The implied S(¥/£) cross rate is S(¥/£) = 80 Credit Agricole has posted a quote of S(¥/£)=85 so there is an arbitrage opportunity. So, how can we make money? Buy the £ @ ¥80; sell @ ¥85. Then trade yen for dollars. ¥ £ www.StudsPlanet.com
  19. 19. Triangular Arbitrage $ Credit Lyonnais S(£/$)=1.50 Credit Agricole S(¥/£)=85 Barclays S(¥/$)=120 As easy as 1 – 2 – 3: 1. Sell our $ for £, 2. Sell our £ for ¥, 3. Sell those ¥ for $. ¥ £ 1 2 3 $ www.StudsPlanet.com
  20. 20. Triangular Arbitrage Sell $100,000 for £ at S(£/$) = 1.50 receive £150,000 Sell our £ 150,000 for ¥ at S(¥/£) = 85 receive ¥12,750,000 Sell ¥ 12,750,000 for $ at S(¥/$) = 120 receive $106,250 profit per round trip = $ 106,250- $100,000 = $6,250 www.StudsPlanet.com
  21. 21. Spot Foreign Exchange Microstructure • Market Microstructure refers to the mechanics of how a marketplace operates. • Bid-Ask spreads in the spot FX market: – increase with FX exchange rate volatility and – decrease with dealer competition. • Private information is an important determinant of spot exchange rates. www.StudsPlanet.com
  22. 22. The Forward Market • Forward Rate Quotations • Long and Short Forward Positions • Forward Cross Exchange Rates • Swap Transactions • Forward Premium www.StudsPlanet.com
  23. 23. The Forward Market • A forward contract is an agreement to buy or sell an asset in the future at prices agreed upon today. • If you have ever had to order an out-of- stock textbook, then you have entered into a forward contract. www.StudsPlanet.com
  24. 24. Forward Rate Quotations • The forward market for FOREX involves agreements to buy and sell foreign currencies in the future at prices agreed upon today. • Bank quotes for 1, 3, 6, 9, and 12 month maturities are readily available for forward contracts. • Longer-term swaps are available. www.StudsPlanet.com
  25. 25. Forward Rate Quotations • Consider the example from above: for Japanese yen, the spot rate is $1.5627 = £1.00 While the 180-day forward rate is $1.5445 = £1.00 • What’s up with that? www.StudsPlanet.com
  26. 26. Spot Rate Quotations Clearly the market participants expect that the pound will be worth less in dollars in six months. 1.49751.51060.66780.6626 Months Forward 1.48881.5020.67170.66583 Months Forward 1.48351.49680.67410.66811 Month Forward 1.48131.49430.67510.6692Canada (Dollar) 0.64610.64751.54771.54456 Months Forward 0.64230.64371.55681.55353 Months Forward 0.63980.64121.56291.55961 Month Forward 0.63860.63991.5661.5627Britain (Pound) 3.47343.40250.28790.2939Brazil (Real) 1.68521.69320.59340.5906Australia (Dollar) 3.03773.02210.32920.3309Argentina (Peso) Currency per USD Thursday Currency per USD Friday USD equiv Thursday USD equiv FridayCountry www.StudsPlanet.com
  27. 27. Long and Short Forward Positions • If you have agreed to sell anything (spot or forward), you are “short”. • If you have agreed to buy anything (forward or spot), you are “long”. • If you have agreed to sell forex forward, you are short. • If you have agreed to buy forex forward, you are long. www.StudsPlanet.com
  28. 28. Payoff Profiles 0 S180($/¥) F180($/¥) = .009524 Short positionloss profit If you agree to sell anything in the future at a set price and the spot price later falls then you gain. If you agree to sell anything in the future at a set price and the spot price later rises then you lose.www.StudsPlanet.com
  29. 29. Payoff Profiles loss 0 S180(¥/$) F180(¥/$) = 105 -F180(¥/$) profit Whether the payoff profile slopes up or down depends upon whether you use the direct or indirect quote: F180(¥/$) = 105 or F180($/¥) = . short position www.StudsPlanet.com
  30. 30. Payoff Profiles loss 0 S180(¥/$) F180(¥/$) = 105 -F180(¥/$) When the short entered into this forward contract, he agreed to sell ¥ in 180 days at F180(¥/$) = 105 profit short position www.StudsPlanet.com
  31. 31. Payoff Profiles loss 0 S180(¥/$) F180(¥/$) = 105 -F180(¥/$) 120 If, in 180 days, S180(¥/$) = 120, the short will make a profit by buying ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. 15¥ profit short position www.StudsPlanet.com
  32. 32. Payoff Profiles loss 0 S180(¥/$) F180(¥/$) = 105 Long position-F180(¥/$) F180(¥/$) short position profit Since this is a zero-sum game, the long position payoff is the opposite of the short. www.StudsPlanet.com
  33. 33. Payoff Profiles loss 0 S180(¥/$) F180(¥/$) = 105 Long position -F180(¥/$) profit The long in this forward contract agreed to BUY ¥ in 180 days at F180(¥/$) = 105 If, in 180 days, S180(¥/$) = 120, the long will lose by having to buy ¥ at S180(¥/$) = 120 and delivering ¥ at F180(¥/$) = 105. 120 –15¥ www.StudsPlanet.com
  34. 34. Forward Cross Exchange Rates • It’s just an “delayed” example of the spot cross rate discussed above. • In generic terms )/($ )/($ )/( and )/($ )/($ )/( kF jF jkF jF kF kjF N N N N N N = = www.StudsPlanet.com
  35. 35. SWAPS • A swap is an agreement to provide a counterparty with something he wants in exchange for something that you want. • Swap transactions account for approximately 56 percent of interbank FX trading, whereas outright trades are 11 percent. www.StudsPlanet.com
  36. 36. Forward Premium • It’s just the interest rate differential implied by forward premium or discount. • For example, suppose the € is appreciating from S($/€) = .5235 to F180($/€) = .5307 • The forward premium is given by: 01375. 5235. 5235.5307. 180 360 €)/($ €)/($€)/($180 $,€180 = − =× − = S SF f v www.StudsPlanet.com
  37. 37. Currency Market • Where currencies are bought and sold against each other. • OTC market. • Quite decentralized and operates through an electronic network that links various market participants. www.StudsPlanet.com
  38. 38. Typical Forex Transaction www.StudsPlanet.com
  39. 39. Global Currency Markets • A 24 hours market • Spreads geographically across all the time zones • No physical presence • Through dealing rooms of commercial banks • Sleek, being screen based • Deep, highly liquid, efficient and “fairest” • Highly volatile • High potential for profits/losswww.StudsPlanet.com
  40. 40. Forex Markets $351 bn $637 bn $149 bn www.StudsPlanet.com
  41. 41. Forex Markets • Domestic/Global • Euro markets • Offshore centers • Dealers/brokers • Spot/Forward • Inter-bank rates/Merchant rates www.StudsPlanet.com
  42. 42. Currency Market Participants • Commercial banks • Investment institutions • Currency brokers • Corporations • Individuals • Central banks www.StudsPlanet.com
  43. 43. Indian Currency Market Consists of • Authorized Dealers • Full-fledged Money Changers • Restricted Money Changers www.StudsPlanet.com
  44. 44. Dealing Room • A centralised establishment, usually of a commercial bank, which is willing to make/offer a two way dealing price for different currencies at all times even when they may not wish to deal, but all during prescribed business hours. www.StudsPlanet.com
  45. 45. Dealing Room www.StudsPlanet.com
  46. 46. Currency Dealers • Primary price makers or professional dealers make a two-way market to each other and to their clients • Foreign currency brokers act as middlemen between two market makers. • Corporations usually are price takers. www.StudsPlanet.com
  47. 47. Exchange Quotes • Direct Quote/Home Currency Quote: – Unit of foreign currency is kept constant against the amount of home currency to be exchanged for it. Example: US $ 1 = INR 43.60 • Indirect Quote/Foreign Currency Quote: – Indicates the number of units of foreign currency which will be exchanged for a fixed number of home currency units. Example: INR 100 = US $ 2.16 www.StudsPlanet.com
  48. 48. Exchange Rates Exchange of currencies on the very date of deal. Cash/Ready Rate Exchange of currencies on the next working day i.e. tomorrow Tom Rate Exchange of currencies on the second working day after the date of deal. Spot Rate Exchange of currencies after a period of spot date. Forward Rate Simultaneous purchase and sale of identical amounts of a currency for different value dates. Swap www.StudsPlanet.com
  49. 49. Spot Quotes • USD/CHF SPOT: 1.4575/1.4580 Bid Offer • Bank will buy 1 USD and give CHF 1.4575 • Bank will sell 1 USD and want to be paid CHF 1.4580. • Shortened to 1.4575/80 or even 75/80 between dealers. “1.45” is the “big figure”www.StudsPlanet.com
  50. 50. Spot Rates • A spot GBP/USD deal on Friday Dec 8 : Value date Tuesday Dec 11 • If Dec 11 holiday in NY/London, value date 12 Dec. • A 2-month forward deal USD/CHF on Monday Dec 11: Value date Feb 13 2001. If holiday in NY/Zurich, Feb 14. • A 2-month forward USD/JPY on Dec 26. Value date Feb 28. If holiday Tokyo/NY, push forward? NO. Pushing forward must not carry to next calendar month. Push back to Feb 27. • Spot deals in some currency pairs such as US dollar- Canadian dollar settled in one business day www.StudsPlanet.com
  51. 51. Spot Rates • Base Currency/Quoted Currency Bid Rate/Offer Rate – USD/CHF : USD base, CHF quoted – GBP/USD : GBP base, USD quoted • Most currencies quoted with USD as base. Exceptions are EUR, GBP, AUD, NZD • Quotation given as no. of units of quoted currency per unit of base currency, bid rate/offer rate. • Bid rate applies to market maker buying base currency. Offer rate applies to market maker selling base currency.www.StudsPlanet.com
  52. 52. Interbank Spot Dealing • Monday September 21, 10.45 am BANK A: "Bank A calling. DLR-FRF 25 please. • BANK B: "Forty -Fifty two” (Bank B is specifying a two-way price. Knowing that the caller is also a forex dealer, the dealer in Bank B quotes only the last two decimals of the full quotation. For instance the full quotation might be 4.1540/4.1552.) • BANK A: “Mine”www.StudsPlanet.com
  53. 53. Forward Rates Spot rate interest rate differential forward period 100 × No. of days in the year (usually 360) × × www.StudsPlanet.com
  54. 54. Forward Rates Where, F = Forward exchange rate S = Spot exchange rate iT = Interest rate in the country of the terms currency ic = Interest rate in the country of the commodity currency t = Time period ( ) ( ) 1 1 t T t c S i F i + = + www.StudsPlanet.com
  55. 55. Forward Quotes Spot EUR 1 = USD 0.8650/55 1 month Forward = 13 - 15 2 months Forward = 25 - 26 3 months Forward = 37 - 38 Forward premium www.StudsPlanet.com
  56. 56. Euro Markets • International money and capital markets on which currencies held outside their countries of origin are traded • Dollar is the predominant currency • Tokyo, Singapore, London, Frankfurt, Bahamas, Bermuda, Cayman Islands, Panama • Euro money market • Euro credit market • Euro capital market www.StudsPlanet.com

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