multinational business finance 6-1. foreign exchange means the money of a foreign country; that is,...

Multinational Business Finance

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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.

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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.

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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).

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.

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 profitcentral 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).

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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.

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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.

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. $/€

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.

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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.

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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.

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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.

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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.

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For quotations expressed in foreign currency terms (Indirect quotations, $/€) the formula becomes:

f ¥ = Spot – Forward 360

For quotations expressed in home currency terms (Direct quotations) the formula becomes:

f ¥ = Forward – Spot 360

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100

nForward

xx

100n Spot

x x

Some currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency (cross rate).

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/£

Possible arbitrage using the rates difference?

$1.2223/€= € 1.5062/£

=

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Measuring a change in the spot rate for quotations expressed in home currency terms (direct quotations):

%∆ = Ending rate – Beginning Rate

For the sake of simplicity, we use direct quotes. That is home currency unit per foreign currency

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Beginning Ratex 100

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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