Download Lecture 3

Multinational Business Finance
6-1

Foreign exchange means the money of a foreign
country; that is, foreign currency, bank balances,
banknotes, checks and drafts.

A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount
of one currency will be delivered for some other
currency at a specified rate.
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The foreign exchange market spans the globe,
with currencies trading somewhere every hour
of every business day.
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
The Foreign Exchange Market provides:
 the physical and institutional structure through
which the money of one country is exchanged for
that of another country;
 the determination of rate of exchange between
currencies, and
 is where foreign exchange transactions are
physically completed.
6-5

The foreign exchange Market is the
mechanism by which participants:
 transfer purchasing power between countries;
 obtain or provide credit for international trade
transactions, and
 minimize exposure to the risks of exchange rate
changes.
6-6
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The foreign exchange market consists of two tiers:
 the interbank or wholesale market (multiples of $1 trillion US or
equivalent in transaction size), and
 the client or retail market (specific, smaller amounts).
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Four broad categories of participants:
bank and nonbank foreign exchange dealers, individuals and
firms conducting commercial or investment transactions,
speculators and arbitragers, and central banks and
treasuries.
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Banks and a few nonbank foreign exchange dealers operate in both the
interbank and client markets.

The profit from buying foreign exchange at a “bid” price and reselling it
at a slightly higher “offer” or “ask” price.
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Dealers in the foreign exchange department of large international banks
often function as “market makers.”

These dealers stand willing at all times to buy and sell those currencies in
which they specialize and thus maintain an “inventory” position in those
currencies.
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Individuals (such as tourists) and firms (such as importers,
exporters and MNEs) conduct commercial and investment
transactions in the foreign exchange market.

Their use of the foreign exchange market is necessary for
their underlying commercial or investment purpose.

Some of the participants use the market to “hedge” foreign
exchange risk.
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Speculators and arbitragers seek to profit from trading in the
market itself.

They operate in their own interest, without a need or
obligation to serve clients or ensure a continuous market.

While dealers seek the bid/ask spread, speculators seek all
the profit from exchange rate changes and arbitragers try to
profit from simultaneous exchange rate differences in
different markets.
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Central banks and treasuries use the market
to acquire or spend their country’s foreign
exchange reserves as well as to influence the
price at which their own currency is traded.

The motive is not to earn a profit

central banks and treasuries differ in motive
from all other market participants.
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
A spot transaction in the interbank market is
the purchase of foreign exchange, with
delivery and payment between banks to
take place on the second following business
day.

The date of settlement is referred to as the
value date.
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An outright forward transaction (or a forward)
requires delivery at a future value 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.

Forward exchange rates are usually quoted
for value dates of one, two, three, six and
twelve months.
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
A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates (settlement
date).

Both purchase and sale are conducted with the same
counterparty.

Some different types of swaps are:
 spot against forward,
 forward-forward,
 nondeliverable forwards (NDF).
6-14
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In April 2004, a survey conducted by the Bank
for International Settlements (BIS) estimated
the daily global net turnover in traditional
foreign exchange market activity to be $1.9
trillion.

This most recent period showed dramatic
growth in foreign exchange trading over that
seen in April 2001.
6-15
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A foreign exchange rate is the price of one
currency expressed in terms of another
currency.

A foreign exchange quotation (or quote) is a
statement of willingness to buy or sell at an
announced rate.
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Most foreign exchange transactions involve the
US dollar.

Professional dealers and brokers may state
foreign exchange quotations in one of two ways:
 the foreign currency price of one dollar, or
 the dollar price of a unit of foreign currency.

Most foreign currencies in the world are stated
in terms of the number of units of foreign
currency needed to buy one dollar.
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Foreign exchange quotes:
direct or indirect quote

the home country of the currencies being discussed is critical.
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A direct quote is a home currency price of a unit of foreign currency.
€/$

An indirect quote is a foreign currency price of a unit of home
currency. $/€
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The form of the quote depends on what the speaker regard as
“home.”
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For example, the exchange rate between US
dollars and the Swiss franc is normally stated:
 SF 1.6000/$ (European terms or direct quote)

However, this rate can also be stated as:
 $0.6250/SF (American terms or indirect quote)

most interbank quotations around the world
are stated in European terms.
6-22
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several exceptions exist to the use of
European terms quotes.

euro and U.K. pound sterling which are both
normally quoted in American terms. $/€, $/£

American terms are also utilized in quoting
rates for most foreign currency options and
futures, as well as in retail markets that deal
with tourists.
6-23

Interbank quotations are given as a bid and ask (also referred to as
offer).

A bid is the price (i.e. exchange rate) in one currency at which a dealer
will buy another currency.

An ask is the price (i.e. exchange rate) at which a dealer will sell the
other currency.

Dealers bid (buy) at one price and ask (sell) at a slightly higher price,
making their profit from the spread between the buying and selling
prices.

A bid for one currency is also the offer for the opposite currency.
6-24

Forward rates are typically quoted in terms of
points. 1 points typically corresponds to
0,0001 in value.

Rather, it is the difference between the
forward rate and the spot rate.
6-25
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Forward quotations may also be expressed as
the percent-per-annum deviation from the
spot rate.

This method of quotation makes it easier to
compare premiums or discounts in the
forward market

If a currency increases in value in the future, it
is traded at a premium, if decreases, it is at a
discount against the other currency.
6-26
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For quotations expressed in foreign currency
terms (Indirect quotations, $/€) the formula
becomes:
f ¥ = Spot – Forward x 360 x 100
Forward

n
For quotations expressed in home currency
terms (Direct quotations) the formula
becomes:
f ¥ = Forward – Spot x 360
Spot
n
x 100
6-27
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Some currency pairs are only inactively
traded, so their exchange rate is determined
through their relationship to a widely traded
third currency (cross rate).
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Cross rates can be used to check on
opportunities for intermarket arbitrage.

one bank’s (Dresdner) quotation on €/£ is not
the same as calculated cross rate between $/£
(Barclay’s) and $/€ (Citibank).
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Citibank quote - $/€
$1.2223/€
Barclays quote - $/£
$1.8410/£
Dresdner quote - €/£
€1.5100/£
=
Cross rate calculation:
$1.8410/£ = € 1.5062/£
$1.2223/€
Possible arbitrage using the rates difference?
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6-30

Measuring a change in the spot rate for quotations
expressed in home currency terms (direct quotations):
%∆ =
Ending rate – Beginning Rate
Beginning Rate
x 100
For the sake of simplicity, we use direct quotes. That is home
currency unit per foreign currency
6-31
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Why does a country like Venezuela impose
capital controls?
In the case of Venezuela, what is the
difference between the gray market and the
black market?
Create a financial analysis of Santiago’s
choices and use it to recommend a solution
to his problem.
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