1. Market for, and management of, foreign exchange Day 2 Dr Michael Dowling

2. The market for foreign exchange Reading: Chapter 4 of Eun and Resnick: ‘The Foreign Exchange Market’

3. The market:  The conversion of purchasing power from one currency to another  Bank deposits of foreign currency  Extension of credit in a foreign currency  Foreign trade financing  Trading in foreign currency options and futures  Currency swaps

4. Today we’ll keep it quite limited Just looking at the Spot market : the immediate purchase or sale of foreign exchange (well, two day settlement period) In a future lecture we’ll be looking at the Forward market : contracting today for the future purchase or sale of foreign exchange

5. Major markets: London + NY

6. Modern FOREX trading … about 14% of trading is retail and bank client; remainder is speculation

7. … 24-hour trading

8. The Spot Market  Direct quotations (American terms) : the price of one unit of the foreign currency in home currency (e.g. EUR €1.1566 = STG £1)  Indirect quotations (European terms) : the price of one unit of home currency in foreign currency (e.g. EUR €1 = STG £0.8646)

9. Bid-ask spread

10. Question: What determines bid-ask spread?  Exchange rate volatility  Number of traders  Profitability expectation ?? [Huang and Masulis, 1999]

11. Assume spread = €0.0005 BidAsk S(€/£) 1.15611.1566 S(£/€) 0.86460.8650

12. Complete the table BidAsk S($/£) 1.5552 S(£/$) Assume bid-ask spread is $0.0007

13. Solution BidAsk S($/£) 1.55451.5552 S(£/$) 0.64300.6433 Assume bid-ask spread is $0.0007

14. Some trading language conventions… BidAsk S($/£)1.55451.5552.55 = ‘big figure’.45 = ‘small figure’ So quote would be given as ‘45-52’ Why might trader quote ‘46-53’ or ‘44-51’ if market equilibrium is currently at ‘45-52’?

15. Cross-exchange rates  Let’s say we have S(€/£) = €1.1566 and S(€/$) = €0.7475. We have sufficient information to calculate S($/£) and S(£/$) even if that quote isn’t published

16. An alternative and a formula we’ll use again… More generally: (where CC = common currency)

17. A quick adjustment for bid-ask

18. An Actual Cross-rate Transaction Bank QuotationsAmerican TermsEuropean Terms BidAskBidAsk British Pounds 1.90721.90770.52420.5243 Euros 1.31081.31120.76270.7629 [All above information quotes currencies in terms of USD$] Bank customer wants to sell £1,000,000 for euros Sell $ (i.e. buy £ from customer) at $1.9072 = $1,907,200 Buy $ (i.e. sell € to customer) at €0.7627 = €1,454,621 Effective exchange rate = €1,454,621/£1,000,000 = €1.4546/£1

19. A Triangular Arbitrage Opportunity

20. Profiting from this opportunity StepSelltoRateReceive 1 $5,000,000CL€3,813,500 2 CAG£2,631,815 3 BAR$5,019,398 Profit = $19,398

21. StepSelltoRateReceive 1 $5,000,000BAR£2,649,428 2 CAG€3,839,021 3 CL$5,033,461 Profit = $33,461

22. How do traders trade Forex?  Very quickly (Lyons; 1998 – 20 mins, now even quicker)  Very frequently (active currency pair trader might be generating 1,500 quotes and making 400 trades in a day)  Using private information? (Tokyo lunch breaks)  Using algorithms and other technical rules (see circulated)

23. Multinational Cash Management - how can we efficiently manage cash within a multinational company? - Reading: Chapter 18: ‘Multinational Cash Management’

24. Cash management  Transaction balances to cover scheduled outflows of funds  Precautionary cash balances in case the firm has underestimated the amount needed to cover transactions  Investing excess funds and borrowing in case of shortfalls at the most favourable rates  Main issues internationally are managing foreign exchange risk and whether to centralise cash management

25. US Parent Canadian Affiliate German Affiliate UK Affiliate $10 $35

26. US Parent Canadian Affiliate German Affiliate UK Affiliate $20 $30 $20 $10 $35 $60 $30 $40 $10 $25 $40

27. Basic: Summary  $350,000 interaffiliate flows between four affiliates in 12 foreign exchange transactions  Administration time  Assuming 0.5% cost then $1,750 fees  What if instead we engaged in bilateral netting, where each pair of affiliates determines the net amount due between them and only the net amount is transferred?

28. US Parent Canadian Affiliate German Affiliate UK Affiliate $10 $25 $20 $10 $15

29. Bilateral: Summary  $90,000 interaffiliate flows between four affiliates in 6 foreign exchange transactions  Assuming 0.5% cost then $450 fees; a saving of $1,300 ($1,750-$450) over no netting  What if instead we engaged in multilateral netting, where each affiliate nets all its interaffiliate receipts against all its disbursements?  The affiliate then transfers or receives the balance depending on whether it is a net payer or receiver

30. US Parent Canadian Affiliate German Affiliate UK Affiliate $15 $40

31. Multilateral: Summary  $55,000 interaffiliate flows between three affiliates in 2 foreign exchange transactions  Assuming 0.5% cost then $275 fees; a saving of $1,475 ($1,750-$275) over no netting  What if instead we added a centralised depository where all interaffiliate payments will flow?  This layer of bureaucracy will add some additional costs, but will provide other benefits

32. US Parent Canadian Affiliate German Affiliate UK Affiliate Central Depository $15 $55 $40

33. Centralised Depository: Summary  $110,000 flows to the central depository (an increase of $55,000 over multilateral netting without central depository)  However, flexibility over what currency transfers are denominated in  Main benefit of centralised depository is in external flows

34. Net cash receipts and disbursements from transactions with external parties AffiliateReceiptsDisbursementsNet US $140,000$120,000$20,000 Canada 135,000165,000(30,000) Germany 125,00050,00075,000 UK 130,000155,000(25,000) $40,000

35. US Parent Canadian Affiliate German Affiliate UK Affiliate Central Depository $30 $20 $25 $75

36. Centralised Depository: Benefits  Less chance of mislocated funds : i.e. funds denominated in the wrong currency  Allows for funds mobilisation : i.e. systemwide cash excesses can be invested at the most advantageous rates and cash shortages can be covered by borrowing at the most favourable rates  Reduces amount of precautionary cash balances needed. More on this 

37. Quick note: in practice we would net both internal and external cash flows AffiliateNet from Multilateral Netting Net from External Parties Net flow US $55,000$20,000$35,000 Canada (15,000)(30,000)15,000 Germany 075,000(75,000) UK (40,000)(25,000)(15,000) ($40,000)

38. US Parent Canadian Affiliate German Affiliate UK Affiliate Central Depository $15 $35 $15 $75

39. Precautionary Cash with each affiliate managing own cash: 3-SD AffiliateExpected Transactions Standard Deviation (SD) (assumed) Expected Needs plus Precautionary US $120,000$50,000$270,000 Canada 165,00070,000375,000 Germany 50,00020,000110,000 UK 155,00065,000350,000 $490,000$1,105,000

40. Precautionary Cash with Centralised Depository

41. A note cash management in practice  Banks such as HSBC, Standard Chartered, Citibank offer netting software as part of their banking package  Size helps determine cash holdings (obviously), but also culture  www.euronetting.com / Thomson Reuters’ Treasura www.euronetting.com