10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 1 Outline 3 3. Foreign Currency Markets: Spot and Forward Markets 3.1 Organization of the FX Market 3.2 Spot Rates and Spot Market 3.3 Forward Rates and Forward Market

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder Organization of the FX Market FX trading occurs to conduct trade in exports and imports of goods and for investment in assets denominated in different currencies (I.e. foreign investment) International trade ~ 10% of US GDP $ Volume of investment in any year is many times larger (95% of FX trading for international investment

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 3 Organization of the FX Market Look at the interbank spot and forward market ~ 20 large banks conduct the majority of FX transactions FX market transfers purchasing power from one currency to another –US importer of Beck’s beer needs to buy  ’s (euro’s) with $’s –US investor in FTSE Index needs £’s

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 4 Organization of the FX Market –Saudi investor in US Treasury bonds need to buy $ and sell riyals Interbank Market: conducts 95% of the volume of FX transactions –~ 20 major banks –SWIFT: Society for Worldwide Interbank Financial Telecommunication bank communication network

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 5 Organization of the FX Market Spot, Forward and Swap’s done in FX Interbank Market –Spot: transaction for immediate delivery in FX –Forward: agreed price and amount of FX for future delivery –Swap: simultaneous spot and forward transaction: E.g., buy ¥ (Japanese Yen) spot and sell same volume of ¥ 90 days forward at price agreed now

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 6 Organization of the FX Market FX market not a physical place, electronic network of banks Market trades 24 hours / day FX Participants include: –Large commercial banks –FX brokers in Interbank market –Commercial customers – mainly multinational corporations –Central banks (e.g.: US Federal Reserve, European Bank)

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 7 Organization of the FX Market Commercial Banks: –Few major banks buy/sell FX at bid-ask price spreads for a margin FX Brokers: –Match needs of banks demand/supply for FX –Receive small commission 1/32% on $1 million trade ($312) Commercial customers obtain FX through their banks that may be a Interbank member or buys FX from large commercial bank Central Bank: Intervene in the FX markets to reduce volatility of FX rates or keep FX rates within a specific target

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 8 Organization of the FX Market Forward FX Participants include: –Arbitrageur: earn spreads on interest rates across countries and use forward FX swaps to rid FX risk –Import/Export Trader: use forward contracts to avoid FX risk on import/export orders denominated in foreign currencies – Hedger: engage in FX transactions to protect domestic currency value of FX denominated assets –All of the above seek to avoid FX risk position by locking in future FX rates for currencies they do business in

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 9 Organization of the FX Market Forward FX Participants include: Who accepts the FX for these participants? Speculator: take FX risk positions for a risk premium; they buy/sell currencies forward for a profit from FX rate changes Their level of participation depends on profit opportunity: –current forward FX rate for a currency vis-à-vis their expectations of future FX spot rate

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 10 Organization of the FX Market FX Market Size: –Largest financial market in the world –2009 volume estimated at $4.5 trillion daily 40 times larger than NASDAQ daily $ volume This is because FX used to facilitate transactions in capital and money markets around the world plus FX trades for exports / imports –FX trading volume growing faster than export / import trading due to the hugely larger volume of international investment in world stock, bond, and money markets (of which NYSE is but one of many)

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 11 Organization of the FX Market Example FX speculative trade for profit: E = $ / £ = $ now E f = $ (90 day forward rate) E(E t+90 ) = $ (expected spot rate in 90 days) (prices as of 2/11/09 in WSJ 2/10/09) Bought 1 million £’s 90 days forward at $1.4501, immediately sold 1 million £’s in spot market 90 days from now for $1.4508; profit is:  margin = {($ $1.4501)/ $1.4501} = or %  = x $1,450,100 = $700.39

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder Spot Rates and Spot Market Spot market: transactions involving the trade of two currencies for delivery in two business days Spot rate quotes: usually expressed as a range depending upon whether buying or selling: –Bid (price you can sell FX at; bank’s buy price) –Ask (price that you can buy at; banks sell price) –Therefore Ask Rate > Bid Rate. –Bid-Ask Spread is the quote that you will receive on larger orders > $1 million or more –Ask-Bid difference is the profit for the bank for trading FX –Spot Rate quotes in financial papers are the mid-point of bid-ask prices > $1 million. Small retail rates will cost more for FX since you buy at “Ask” and rate higher w/ small volume.

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 13 Spot Rates and Spot Market Spot rate quotes: usually expressed as a range depending upon whether buying or selling: –Retail quotes will be one price (not bid-ask ranges and will be > ask price from interbank transactions If you call your bank, you get receive a one-number quote –Bid-Ask Spread: Smaller for widely traded, less volatile currencies and larger for less traded, highly volatile currencies EXAMPLES click on quotes and exotic currencies for real-time quotes

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 14 Spot Rates and Spot Market Spot rate quotes: –Bid-Ask Spread: Due to higher spreads and profits on emerging country currencies, large commercial banks have entered this business Emerging country FX trade volume is small but is expected to grow with greater interest in emerging country foreign investment activity. Cross spot rates: –FX rates not denominated in $ prices or foreign currency price of $ –Trade and investment occur across many different countries therefore need to know E’s among other currencies: Canadian dollar price of the Euro £/¥, or, the UK pound price of the Yen

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 15 Spot Rates and Spot Market Cross spot rates: 2/14/05 trading published in Wall Street Journal, 2/15/05: Given pound price of euro & pound price of dollar what is dollar price of a euro: e.g. £ /  = £0.6862, £ / $ = £ $ /  = (£ /  ) / ($ / £) = / = $1.2959

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 16 Spot Rates and Spot Market Exchange Risk: –Chance of a financial loss denominated in domestic currency due to unfavorable changes in the FX rate –Bankers and FX brokers take positions in foreign currencies as they buy and sell them in the FX market. If a US bank buys ¥ and then the $ price of the ¥ falls, ¥ is worth less in $ and bank may sell for a lower $ price –E.g., Citicorp buys ¥10,000,000,000 for at $ per ¥, paid $90,910,000. Suppose ¥ falls to $ within a few hours after the buy, the value of those ¥ fell to $90,800,000 for a loss of $110,000. –E.g.2 If E = $0.0091, then value of ¥ rose to $91,000,000 for a profit of $90,000. –The percent range between the low E and high E was 0.22%, a fairly typical daily fluctuation in the ¥/$ price.

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 17 Spot Rates and Spot Market Exchange Risk: –The chance of FX losses such as this example is what leads to Bid-Ask spreads: Bid-Ask spreads include the cost of a transaction, risk premium for FX exposure and profit for being in the business. The  the volatility (  ) of an FX rate and the chance of a loss from an FX position, the  will be the Bid-Ask due to larger risk premium.

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 18 Spot Rates and Spot Market Currency Arbitrage: –Exploiting difference in FX rates across markets for profit –Removes inconsistencies in FX rates across markets –Arbitrage opportunities are small and do not exist consistently due to access to information

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder Forward Rates and Fwrd. Market Forward rate: –FX rate agreed upon now for a specified amount of a foreign currency to be delivered at a fixed, future date Forward contract: –Agreement between speculator (bank) and customer for the delivery of a specified amount of foreign currency at a future fixed date at a given FX rate set when agreement is made Forward market exists only for highly traded currencies. –Forward contract eliminates uncertainty regarding the future value of a foreign currency relative to domestic currency, thereby eliminating FX risk

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 20 Forward Rates and Fwrd. Market Forward Discount: –Foreign currency selling at a discount if FX forward rate is lower than current spot rate Forward Premium: –Foreign currency selling at a premium if FX forward rate is greater than current spot rate Forward discount or premium –Where E f, E s, and # days are forward, spot, rates and number of days forward, respectively

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 21 Forward Rates and Fwrd. Market Forward discount or premium 2/10/09 Trading (published in Wall Street Journal 2/11/09): e.g.1: Swiss franc spot e = $0.8636; E t+180 = $ For. Prem.= ( )/ *2 = or % e.g.2: UK pound spot e = $1.4512; E t+180 = $ For. Disc. = ( )/ * 2 = or %

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 22 Forward Rates and Fwrd. Market Observations on forward contracts: 1.Gains or losses on forward contract has nothing to do with current spot rate - gains / losses are based on difference between forward rate and corresponding future spot rate 2.Forward contracts are not options - buyer must accept and seller must deliver FX at agreed price, volume, and future date - option gives the party to exercise the contract or not

10/8/2015Multinational Corporate Finance Prof. R.A. Michelfelder 23 Forward Rates and Fwrd. Market The bid-ask spread on forward rates depend upon: - volume of transactions in a currency - risk of a forward contract, based on the volatility of future spot rates - length of forward contract; longer contracts mean more uncertainty