FOREIGN EXCHANGE AND INTERNATIONAL FINANCIAL MARKETS

CHAPTER 4: FOREIGN EXCHANGE AND ITNERNATIONAL FINACIAL MARKETS LEARNING OBJECTIVES To become literate on Foreign Exchange terminology To understand the way foreign exchange markets operate (Place, participants, tools) To discuss the important aspects of the international capital market

The Question: You go to your local bank You want to buy Sterling (English businessman wants to get paid in Sterling) The banker looks at the exchange rate of Euro to Sterling He figures out (calculates according to the rate) the amount that you have to pay in euro for the Sterling the English businessman is asking. The banker debits your deposit with the amount plus transaction costs and gives you a check payable in Sterling, made out to the exporter You then send the check to English businessman who would deposit it in his bank in London. His account in London will then be credited. What do you have to do when you have to pay a business man from UK for the goods that you bought from him?

Foreign Exchange Literacy Direct Code or in American terms: The number of units of domestic currency needed to buy one unit of foreign currency (€/$) – euro price of a dollar - the price of foreign in terms of home Indirect Code or in European terms The number of units of foreign currency needed to buy one unit of the domestic currency (1$//€) – dollar price of a euro - the price of home in terms of foreign. Foreign Exchange: The currency of another country (Cash, checks, with transfers, contracts…) Foreign Exchange Rate: the number of units of one currency that must be given to acquire one unit of a currency of another country. The Exchange rate can be expressed in two different ways:

Literacy … continued Spot Rates The spot rate is the exchange rate between two currencies for their immediate trade for delivery within two days Forward Rates The forward rate is the cost today for a commitment by one party to deliver to or take from another party an agreed amount of a currency at a fixed, future date. Cross Rates Rate between two countries currency, after we relate them to a third currency.

Foreign Exchange Markets The Interbank Market Majority of Foreign Exchange transactions are through a network between banks. If a bank doesn´t have the currency, then it will enter the interbank network (CHIPS in USA) (SWIFT in Cyprus) to buy from other banks The clients of foreign-exchange departments of banks are: Commercial Customers (for their exporting or importing or when receiving interest and dividends from abroad. Something they might hedge – use of forwards to reduce the risk of an unfavorable change in rates) Speculators (individuals, companies, banks, governments may buy without having a seller in an attempt to make gains in the future (risky) Arbitrageurs (simultaneously contracting (buying and selling) in two or more foreign exchange markets to profit from exchange rate differences)

A Note on Arbitrage The buying or selling of foreign currencies at a profit due to price discrepancies A Note on Forwards The use of forwards eliminates risk and helps the Multinational Manager in planning.

The forward Foreign Exchange Market A company other than contracting in the spot (immediate) market at the bank can also deal in the future through a forward contract (price determined through telecommunication means between banks) A company can also (sell) a future (a future contract of a fixed amount – size – and of a smaller value than forwards). Futures are traded in physical locations, are not available in many currencies and have preestablished dates (on the third Wednesday of January, March, April, June, July, September, October, or December). They are usually traded before maturity Foreign Currency Options are also an alternative for the company. They offer the participant the right to buy or sell in the future rather than the obligation to do so. It can be exercised at any time between its issuance and maturity date. Traded in organized physical locations.

A note on SWAPS Forward transactions account for 8 to 10% of foreign exchange volume. Most trading is done through SWAPSs (account for 40%) A SWAP is a transaction that involves the exchange of currencies in the spot market accompanied by an agreement to reverse the transaction in the future. Example A A US manufacturer has located a bank in England which is willing to give a loan of 10 million pounds at a low interest rate. The loan will be repaid in 30 days. (keep in mind the exchange rate, 30 days from now might be different) The US manufacturer sells the 10 million pounds in the spot market in order to get dollars (use them for manufacturing) At the same time, the manufacturer buys 10 million pounds in the forward market (30- day forward with his US bank) Why? To lock in an exchange rate which will guarantee that he will pay almost the same number of dollars 30 days from today when he will have to repay his million British pounds loan.

Example (B) on SWAPs An American parent company wants to lend euro to its Italian subsidiary. It also wants to eliminate currency exchange risk when the Italian subsidiary will be repaying its loan to the parent 90 day from now in euro. How will this be achieved? 1.The American parent company will buy euro in the spot market and lend them to the Italian subsidiary 2.At the same time, the parent will buy US dollars for forward delivery (90-day forward, the period of the loan). Risk was eliminated. How? When the Italian subsidiary will give euros to the parent company 90 days from now, the parent has secured that those euros are worth the dollars it has paid 90 days ago. How? Remember it has locked almost the same exchange rate by entering into a 90-day forward contract to buy dollars.

The International Money Market Is there any other market where the MNE can make deposits or get loans in foreign currency?.... The International Market In an attempt to satisfy their domestic customers (not lose them to other banks) and compete for sources abroad, major banks have gone international. They have developed branches (not separately incorporated) abroad, subsidiaries (separately incorporated under the umbrella of a corporation) and affiliated banks (an overseas operation established in conjunction – part ownership – with a foreign partner. International banks also utilize eurocurrencies (a currency on deposit outside of its country of issue… Eurodollar, Euroyen, Europound…). It can be used for financing operations abroad.