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BBK3273 | International Finance Prepared by Dr Khairul Anuar

L1: Foreign Exchange Market

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Contents

1. Foreign Exchange Market

2. History of Foreign Exchange

3. Size of the Foreign Exchange Market

4. Foreign Exchange Transactions

5. Spot Market

6. Attributes of Banks That Provide Foreign Exchange

7. Foreign Exchange Quotations

8. Computation of the Bid Ask Spread

9. Factors That Affect the Spread

10. Interpreting Foreign Exchange Quotations

11. Interpreting Changes in Exchange Rates

12. Rates Over Time

13. Cross Exchange Rates

14. Currency Derivatives

15. How Financial Markets Serve MNCs

16. Summary

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1. Foreign Exchange Market

• Allows for the exchange of one currency for another.

• Exchange rate specifies the rate at which one currency can be exchanged for another.

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2. History of Foreign Exchange

• Gold Standard (1876 – 1913)

Each currency was convertible into gold at a specified rate. When

World War I began in 1914, the gold standard was suspended.

• Agreements on Fixed Exchange Rates

Bretton Woods Agreement 1944 -1971

Smithsonian Agreement 1971 - 1973

• Floating Exchange Rate System

Widely traded currencies were allowed to fluctuate in accordance

with market forces

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• The Bank for International Settlements (BIS) estimates that daily

global net turnover in traditional FOREX market activity to be USD

3.7 trillion in April 2010

Spot transactions at $1,495 billion/day

Outright forward transactions at $475 billion/day

Swap transactions at $1,765 billion/day

• Refer to Figure 1 shows the Global Foreign Exchange Market

Turnover, 1989-2010.

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Figure 1: Global Foreign Exchange Market Turnover, 1989-2010

(average daily turnover in April, billions of US dollars)

4. Foreign Exchange Transactions

• The over-the-counter market is the telecommunications network

where companies normally exchange one currency for another.

• Foreign exchange dealers serve as intermediaries in the foreign

exchange market

• A foreign exchange transaction for immediate exchange is said to

trade in the spot market. The exchange rate in the spot market is the

spot rate.

• Trading between banks occurs in the interbank market.

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5. Spot Market

• The U.S. Dollar is the commonly accepted medium of exchange in

the spot market.

• Spot market time zones - Foreign exchange trading is conducted

only during normal business hours in a given location. Thus, at any

given time on a weekday, somewhere around the world a bank is

open and ready to accommodate foreign exchange requests.

• Spot market liquidity: The spot market for each currency can be

described by its liquidity, ie. the level of trading activity.

More buyers and sellers means more liquidity.

The spot market for heavily traded currencies such as the euro,

the British pound and the Japanese yen are very liquid.

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6. Attributes of Banks That Provide Foreign Exchange

• The following characteristics of banks are important to customers in need of foreign exchange. 1. Competitiveness of quote – a savings of 1cents per unit on an order

of one million of currency is worth $10,000.

2. Special relationship with the bank – the bank may offer cash management services or be willing to make a special effort to obtain even hard-to-find foreign currencies for the corporation.

3. Speed of execution – banks may vary in the efficiency with which they handle an order.

4. Advice about current market conditions – some banks may provide assessments of foreign economies and relevant activities in the international financial environment that relates to corporate customers.

5. Forecasting advice – some banks may provide forecasts of the future state of foreign economies and the future value of exchange rates.

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7. Foreign Exchange Quotations

rateAsk

rate Bid rateAsk spreadask / Bid

• At any given point in time, the exchange rate between two

currencies should be similar across the various banks that provide

foreign exchange services.

Hence, at any given point in time, a bank’s bid (buy) quote for a

foreign currency will be less than its ask (sell) quote.

• The bid/ask spread covers the bank’s cost of conducting foreign

exchange transactions

• Using the formula above, the bid-ask spreads are computed I Figure

1 for both British pound an the Japanese yen

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8. Computation of the Bid Ask Spread

• ABC bank quotes a bid price for yen of $.007 and asks price

of $.0074. In this case, the nominal bid/ask spread is $.0074,

or just four-hundredths of a penny.

Figure 1: Computation of the Bid/Ask Spread

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9. Factors That Affect the Spread

• Order costs: Costs of processing orders, including clearing costs and

the costs of recording transactions.

• Inventory costs: Costs of maintaining an inventory of a particular

currency.

• Competition: The more intense the competition, the smaller the

spread quoted by intermediaries.

• Volume: Currencies that have a large trading volume are more

liquid because there are numerous buyers and sellers at any given

time.

• Currency risk: Economic or political conditions that cause the

demand for and supply of the currency to change abruptly.

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Direct vs Indirect Quotations

1. Direct Quotation represents the value of a foreign currency

in dollars (number of dollars per currency).

Example: $1.40 per Euro

2. Indirect quotation represents the number of units of a foreign

currency per dollar.

Example: €0.7143 per Dollar

Indirect quotation = 1 / Direct quotation

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Figure 2: Direct and Indirect Exchange rate Quotations


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11. Interpreting Changes in Exchange Rates

• When the euro is appreciating against the dollar (based on an

upward movement of the direct exchange rate of the euro), the

indirect exchange rate of the euro is declining.

• When the euro is depreciating (based on a downward movement of

the direct exchange rate) against the dollar, the indirect exchange

rate is rising.

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Exhibit 3.3 Relationship Between the Direct and Indirect

12. Rates Over Time

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13. Cross Exchange Rates

• Cross exchange rate is the amount of one foreign currency per unit

of another foreign currency

• Example

Value of peso = $0.07

Value of Canadian dollar = $0.70

Value of peso in C$ = Value of peso in $

Value of C$ in $

= $0.07 = C$ 0.10

$0.70

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• Forward Contracts: agreements between a foreign exchange

dealer and an MNC that specifies the currencies to be exchanged,

the exchange rate, and the date at which the transaction will

occur.

The forward rate is the exchange rate specified by the forward

contract.

The forward market is the over-the-counter market where

forward contracts are traded.

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• Futures Contracts: similar to forward contracts but sold on an

exchange

Specifies a standard volume of a particular currency to be

exchanged on a specific settlement date.

The futures rate is the exchange rate at which one can purchase

or sell a specified currency on the specified settlement date.

The future spot rate is the spot rate that will exist at a future point

in time and is uncertain as of today.

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• Currency Options Contracts

Currency Call Option: provides the right to buy currency at a

specified strike price within a specified period of time.

Currency Put Option: provides the right to sell currency at

specified strike price within a specified period of time.

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• The following are some of the corporate functions that require

foreign exchange markets.

Foreign trade with business clients.

Direct foreign investment, or the acquisition of foreign real

assets.

Short-term investment or financing in foreign securities.

Longer-term financing in the international bond or stock

markets.

Exhibit 3.7 Foreign Cash Flow Chart of an MNC


Summary

• The foreign exchange market allows currencies to be exchanged in order to facilitate international trade or financial transactions. Commercial banks serve as financial intermediaries in this market.

• The international money markets are composed of several large banks that accept deposits and provide short-term loans in various currencies. This market is used primarily by governments and large corporations.

• The international credit markets are composed of the same commercial banks that serve the international money market. These banks convert some of the deposits received into loans (for medium-term periods) to governments and large corporations.

• The international bond markets facilitate international transfers of long-term credit, thereby enabling governments and large corporations to borrow funds from various countries. The international bond market is facilitated by multinational syndicates of investment banks that help to place the bonds.

• International stock markets enable firms to obtain equity financing in foreign countries. Thus, these markets help MNCs finance their international expansion.

16. Summary

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