This document provides an overview of Chapter 7 from the textbook "Multinational Financial Management" which discusses the foreign exchange market. It covers the organization of the foreign exchange market including participants at the wholesale and retail levels in both the spot and forward markets. It also describes the mechanics of spot transactions including quoting conventions, transaction costs, settlement dates, and exchange rate risk for banks. The document concludes with an introduction to the forward market, purposes of forward contracts for hedging exchange rate risk, and methods for quoting forward rates.

1. 1
Multinational Financial
Management
Alan Shapiro
7th Edition
J.Wiley & Sons
Power Points by
Joseph F. Greco, Ph.D.
California State University, Fullerton

2. 2
CHAPTER 7
THE FOREIGN
EXCHANGE MARKET

3. 3
CHAPTER OVERVIEW
I. INTRODUCTION
II. ORGANIZATION OF THE
FOREIGN EXCHANGE
MARKET
III. THE SPOT MARKET
IV. THE FORWARD MARKET

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

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

6. 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

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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
- 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 a
specified future date

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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

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ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
2. Forward Market
a. arbitrageurs
b. 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 in the world
1999: US$1.5 trillion daily
or
US$375 trillion a year
In 1999 the US GDP was US$9.1 trillion

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ORGANIZATION OF THE FOREIGN
EXCHANGE MARKET
B. Market Centers (1998):
#1: London = $637 billion
daily
#2: New York= $351 billion
daily
#3: Tokyo = $149 billion
daily

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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

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THE SPOT MARKET
B. Method of Quotation
1. For interbank dollar
trades:
a. American terms
example: $.5838/dm
b. European terms
example: Peso1.713/$

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

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

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THE SPOT MARKET
4. Percent Spread Formula (PS):
100
x
Ask
Bid
Ask
PS



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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
2. Calculating Cross Rates
When you want to know
what the dm/ff cross rate
is, and you know dm2/US$ and
ff.55/US$
then dm/ff = dm2/US$  ff.55/US$
= dm3.636/ ff

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THE SPOT MARKET
E. Currency Arbitrage
1. If cross rates differ from
one financial center to
another, and profit
opportunities exist.

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THE SPOT MARKET
2. Buy cheap in one int’l market,
sell at a higher price in
another
3. 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
original transaction.

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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

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

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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)

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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
Kong transfers HK$ from
nostro account to exporter’s.
Value Date.
U.S. bank debits importer’s
account.

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PART IV.
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.

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

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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.

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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