Chapter 3 (first lecture after mid-term) / Sunday 30, may.
A. foreign exchange market
1)it allows currencies to be exchanged from one currency to another.
2)MNC rely on FMC to exchange their home currency for a foreign currency that is
needed to purchase imports or to use for DFI
B. foreign exchange transactions:
1)Spot market: the most common type of foreign exchange transaction and is
used for immediate exchange, spot rate (immediate is interpreted as being within
2 days)
transactions are not just spot trades, it includes futures, forward options
and swaps which are knows as derivatives. (BANKS)
Spot market liquidity: the more willing buyer and sellers are the more the liquid
the market is. (more buyers and sellers=more market liquidity).
2) Over -the -counter: this type involves trading CURRENCIES without a middle
man. it is a process that is called disintermediation. ()مش الزم اروح البنك
OTC: telecommunication network where companies normally exchange one
currency for another.
OR it can be traded by private security dealers.
3)Interbank market: where trading between banks occurs. It usually occurs
/happens when and if a bank starts to experience a shortage in a particular
currency.
The US dollar is commonly accepted as a medium of exchange in countries where
home currencies are either weak or subject to foreign exchange restrictions.
C. Attributes(characteristics/features) of banks that provide foreign
exchange:
1) competitiveness of the quote (Exchange rate is better or not)/very tight
quote. (16.8 & 16.4, cents difference)
2) special relationship with the bank (loyal customer)
3) speed of execution (slowness in transaction/exchanging may take up to 3
hours), depends on clearing time, employees, and the presence of the
manager.
4) Advice about the current market condition.
5) Forecasting advice about upcoming changes in exchange rates for example.
D. Interpreting the exchange quotation:
Direct quote: the number of units of home currency for one unit of foreign
currency.
Ex: $1.40:1Euro (home $. foreign euro)
Indirect quote: the number of units of foreign currency for one unit of
home currency.
Ex:0.74(euro) per dollar, (0.74 euro:1$)
Indirect quote=q/direct quote
At any given point in time, a bank’s bid (buying price) السعر اللي البنك يشتري بيه
quote for a foreign currency will be (less-more) than its Ask (bank selling
price).
The bid-ask spread: the spread covers the bank’s cost of conducting foreign
exchange transaction اشتري" بالرخيص و ابيع بالغالي و الفرق استفيد بيه و اغطيcosts.
Bid-ask spread: (ask rate-bid rate)/ask rate.(profit)
Example :
Currency bid rate ask rate bid-ask spread
Dollar : str:0.54:1$ str.0.56:1$ (0.56-0.54/0.56)=0.035=3.5%
British pound :1.46 eu:1 str 1.48:1 str. (1.48-1.46/1.48)=0.013/1.35%
What is the bid ask spread? Bid-ask spread percentage
E. FACTORS AFFECRING THE BID-ASK SPREAD: (MONEY OF REVENUE THAT
BANK MAKES TO COVER THE COSTS)
1)ORDER COST: costs of processing orders including, clearing costs and the
cots of recording the transaction.
2)INVENTORY COSTS: costs of maintaining an inventory of a particular
currency.
3)COMPETITION: the more intense the competition is, the smaller the
spread quoted by the intermediaries. (To stay competitiveness)
4) VOLUME OF TRADING: currencies that have a large trading volume are
more liquid, because there are many buyers and sellers at a given time.
This means that the market has sufficient depth(deep) that a few large
transactions are unlikely to cause the currency price to change suddenly.
5)Currency RISK: Economic and political conditions that cause demand and
supply to change suddenly, affects the willingness of the intermediaries
(bank) to buy and sell (trade) in risky currencies that incur large losses due
to sudden change in the value of the currency.
Safe haven (stable and safe currency): Swiss franc, euro, and dollar.
Therefore, if the currency is a bit risky the bank will not be willing to keep a
huge stock of it.
F. Appreciating and depreciating of currencies (direct quote/indirect quote)
When the euro appreciates against the dollar, based on an upward
movement of the direct exchange rate of the euro. Therefore, the indirect
rate of the euro is declining.
Indirect quote=1/direct quote
When the euro depreciates against the dollar, based on a downward
movement of the direct exchange rate of the euro. Therefore, the indirect
rate of the euro is rising.
G. Cross Exchange rate:
H. Currency Derivatives: Future contracts, forward contracts, options, and
swap contracts.
Forward contracts: agreement between foreign exchange dealer and an
MNC that specifies (1) the currencies to be exchanged, (2) the exchange
rate, (3) and the date at which the transaction will occur.
(1) Forward rate: is the exchange rate specified by the forward contract.
Forward market: the OTC (over the counter) market where forward
contracts is traded.
Future contract: are similar to the forward contract except that they are
sold on an exchange whereas forward contracts are offered by commercial
banks.
Future contract: specifies the volume of particular currency to be traded
on a specific settlement date.
Future rate is the exchange rate at which one can purchase or sell a
specific currency on the settlement date.
Future spot rate: is the spot rate that will exist at the future point in time
and is uncertain as of today.
Currency put option contract: provides the right to buy currency at a
specified price within a specified period of time (strike price or exercise
price)
Currency call option: it is the right to sell a specific currency and a specific
price within a certain time.
Currency put and call option can be purchased on an exchange.
They are more flexible than the future and forward as you can the option
not to exercise the option
Questions on Direct versus Indirect:
Cross exchange rate: it is the amount of one foreign currency one unit of
another foreign currency.
Example (1):
Value of the peso=0.07
Value of Canadian dollar =0.07
Q: What is the cross exchange rate of peso in Canadian dollar?
value of peso in $ / value of Canadian $
A:=0.07/0.70=0.10 Canadian dollar
1 peso:0.10c$
…………………………………………………………………………………..endedhere
Example (2):
Australian $ to UK pound=2.30:1sterling
Mexican peso to UK pound=20 peso:1sterling
Q:what is the cross exchange rate of Australian to Mexican?
A:It is safe to assume Australian $ 2.30:20 peso (divide both side by 2.3)
Australian $ 2.30/2.30:20 peso/2.30
1 Australian $:8.7 peso
Q:What is the indirect rate =1/direct rate?
A:1/8.7=0.111 (1 peso:0.111 Australian $)
Example 3:
1Z:$0.17
1 yen:$0.008
0.17/0.008 {Z with respect to Jen (How many Jen equal to Z)}
Q:What is the cross rate of Yen with respect to Z?
A:0.008/0.17=0.47Z : 1Yen
Currency Derivitatives:Financial instruments used to hedge financial position of
the company against exchange rate [Link] contract,Future
contract,options&swaps
What are the financial markets?
a)International money markets:provide shortterm funds to
corporations/governments demominated in currency different from the home
[Link] of money market securities are Treasury bills,commercial
paper,certificate of deposits&federal funds(us),high liquidity securities&shortterm
maturity.
b) International capital market medium to longterm funds through loans from
local financial institution or issuance of notes (medium term debt obligation)
Syndicated loan:
1)loans of one year or longer. Loans one year or longer given to MNCs or
government agencies in Europe are called Euro Credit Loan.
2)To avoid interest rate risk, banks commonly use floating rate loans with rates
linked to the London interbank offer rate(libor)
Syndicated loan: when a single bank is unlikely or unable to lend an amount
needed by MNC or gov, a syndicate(group) of banks can be formed to underwrite
a loan asked for. The “lead bank” is the one responsible for it