International finance multiple choice questions

International Finance Multiple Choice Questions

Multinational Financial Management

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CHAPTER 7
THE FOREIGN EXCHANGE MARKET

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CHAPTER OVERVIEW

I. INTRODUCTION

II. ORGANIZATION OF THE FOREIGN EXCHANGE MARKET

III. THE SPOT MARKET

IV. THE FORWARD MARKET

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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

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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):

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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

100

x

Ask

Bid

Ask

PS

-

=