The document discusses motives for using international financial markets and the foreign exchange market. It describes how investors, creditors, and borrowers interact with foreign exchange markets. It also outlines how foreign exchange transactions occur between banks and dealers and discusses various types of currency derivatives.
The document discusses motives for using international financial markets and the foreign exchange market. It describes how investors, creditors, and borrowers interact with foreign exchange markets. It also outlines how foreign exchange transactions occur between banks and dealers and discusses various types of currency derivatives.
The document discusses motives for using international financial markets and the foreign exchange market. It describes how investors, creditors, and borrowers interact with foreign exchange markets. It also outlines how foreign exchange transactions occur between banks and dealers and discusses various types of currency derivatives.
The document discusses motives for using international financial markets and the foreign exchange market. It describes how investors, creditors, and borrowers interact with foreign exchange markets. It also outlines how foreign exchange transactions occur between banks and dealers and discusses various types of currency derivatives.
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Chapter: 03
C3 - 1 Motives for Using International Financial Markets • Investors invest in foreign markets: ¤ to take advantage of favorable economic conditions; ¤ when they expect foreign currencies to appreciate against their own; and ¤ to reap the benefits of international diversification.
C3 - 2 Motives for Using International Financial Markets • Creditors provide credit in foreign markets: ¤ to capitalize on higher foreign interest rates; ¤ when they expect foreign currencies to appreciate against their own; and ¤ to reap the benefits of international diversification.
C3 - 3 Motives for Using International Financial Markets • Borrowers borrow in foreign markets: ¤ to capitalize on lower foreign interest rates; and ¤ when they expect foreign currencies to depreciate against their own.
C3 - 4 Foreign Exchange Market • The foreign exchange market allows currencies to be exchanged in order to facilitate international trade/transactions or financial transactions. • E.g. when travel abroad, people need foreign currency; A Local MNC need foreign currency when purchasing raw materials from another country; or export oriented firms receive foreign currencies and they need to convert them into local currency .
C3 - 5 Foreign Exchange Market • There is no specific building or location where traders exchange currencies. The transactions are usually conducted through Foreign Exchange Dealers over electronic or telecommunication network, around the clock.
C3 - 6 Foreign Exchange Market • Foreign Exchange Dealers serve as intermediaries in the foreign exchange market by exchanging currencies desired by MNCs or individuals. Foreign exchange dealers include large commercial banks such as Citigroup, JPMorgan Chase & Co., Barclays (United Kingdom), UBS (Switzerland), and Deutsche Bank (Germany). Dealers such as these have branches in most major cities and also facilitate foreign exchange transactions with an online trading service.
C3 - 7 Foreign Exchange Market • Dealers that rely exclusively on online trading to facilitate such transactions include FX Connect (a subsidiary of State Street Corporation), OANDA (Canada), and XE.com (Canada). Customers establish an online account and can interact with the foreign exchange dealer’s website to transmit their foreign exchange order.
C3 - 8 Foreign Exchange Market • How Foreign Exchange service is provided? • Usually, banks hold various currencies and, when in need, they exchange their currencies. Bank maintains an inventory of various currencies. E.g. when export sector receives $/£, they exchange it for local currency from a bank; that increases $/£ balance in the bank. In contrast, when an import-base firm purchase goods from U.S./England, it will purchase $/£ from a bank; and that will reduce $/£ balance of that bank. C3 - 9 Foreign Exchange Transactions • The market for immediate exchange is known as the spot market. The rate is known as spot rate. • The forward market enables an MNC to lock in the exchange rate at which it will buy or sell a certain quantity of currency on a specified future date.
C3 - 10 Foreign Exchange Transactions • At any point in time, arbitrage ensures that exchange rates are similar across banks. • If a bank experience a shortage in a particular currency, it can purchase that currency from other banks. This trading between banks occurs in what is often referred to as the interbank market. Within this market, foreign exchange brokerage firms sometimes act as middlemen. C3 - 11 Foreign Exchange Transactions • Use of the U.S. Dollar in the spot market: many foreign transactions do not require an exchange of currencies but allow a given currency to cross country borders. E.g. U.S. dollar is commonly accepted as a medium of exchange by merchants in many countries.
C3 - 12 Foreign Exchange Transactions • Spot Market Liquidity: The more willing buyers and sellers there are, the more liquid a market is. The spot markets for heavily traded currencies are the U.S. dollar, the Euro, the GBP, and the Japanese Yen.
C3 - 13 Foreign Exchange Transactions • The following attributes of banks are important to foreign exchange customers: ¤ competitiveness of quote ¤ special relationship between the bank and its customer ¤ speed of execution ¤ advice about current market conditions ¤ forecasting advice
C3 - 14 Foreign Exchange Quotations
• Banks provide foreign exchange services
for a fee: the bank’s bid (buy) quote for a foreign currency will be less than its ask (sell) quote. This is the bid/ask spread.
• bid/ask % spread = ask rate – bid rate
ask rate
C3 - 15 Foreign Exchange Quotations
C3 - 16 Foreign Exchange Transactions • The bid/ask spread is normally larger for those currencies that are less frequently traded. • The spread is also larger for “retail” transactions than for “wholesale” transactions between banks or large corporations.
NOTE: For our following discussions we will ignore the bid/ask
differences in order to understand various complex concepts at ease. C3 - 17 Factors that affect the spread
C3 - 18 Factors that affect the spread • Order Cost: overall cost associated with an order to complete • Inventory cost: opportunity cost • Competition: higher competition results in narrow spread • Volume (trading volume): Quantity Discount • Currency risk: e.g. economic and political volatility/instability C3 - 19 Interpreting Foreign Exchange Quotations • Direct quotations represent the value of a foreign currency in dollars (number of dollars per foreign currency) • Indirect quotations represent the number of units of a foreign currency per dollar.
C3 - 20 Foreign Exchange Quotations • The spot rate of the euro is quoted this morning at $1.031. This is a direct quotation, as it represents the value of the foreign currency in dollars. The indirect quotation of the euro is the reciprocal of the direct quotation:
C3 - 21 Foreign Exchange Quotations
C3 - 22 Foreign Exchange Quotations
C3 - 23 Interpreting Foreign Exchange Quotations • A cross exchange rate reflects the amount of one foreign currency per unit of another foreign currency.
C3 - 25 Derivative Contracts in the Foreign Exchange Market Forward, Futures and Options Market
• In addition to the spot market, a forward
market for currencies enables an MNC to lock in the exchange rate (called a forward rate) at which it will buy or sell a currency. • A forward contract specifies the amount of a particular currency that will be purchased or sold by the MNC at a specified future point in time and at a specified exchange rate. C3 - 26 Forward, Futures and Options Market
• Commercial banks accommodate the MNCs
that desire forward contracts. MNCs commonly use the forward market to hedge future payments that they expect to make or receive in a foreign currency. In this way, they do not have to worry about fluctuations in the spot rate until the time of their future payments.
C3 - 27 Forward, Futures and Options Market
• Example: Memphis Co. has ordered supplies
from European countries that are denominated in euros. It expects the euro to increase in value over time and therefore desires to hedge its payables in euros. Memphis buys forward contracts on euros to lock in the price that it will pay for euros at a future point in time.
C3 - 28 Forward, Futures and Options Market
• A currency futures contract specifies a
standard volume of a particular currency to be exchanged on a specific settlement date. • Currency options contracts give the right to buy or sell a specific currency at a specific price within a specific period of time. They are sold on exchanges too.
C3 - 29 Forward Vs Futures Forward Contract Futures Customized to customer Standardized needs Used for Hedging Used for Speculation No initial payment Initial payment required required Negotiated directly by the Quoted and traded on the buyer and seller exchange Only contracting parties Clearing house involved are involved in the process High counter-party risk Low counter-party risk C3 - 30
