FIN 3380 - EXAM 2

Exchange Rate

is the price of one country’s currency in terms of another

Market for foreign exchange is the..

largest financial market in the world by virtually any standard

Foreign Exchange (FX) market

encompasses the conversion of purchasing power from one currency into another, bank deposits of foreign currency, the extension of credit denominated in a foreign currency, foreign trade financing, trading in foreign currency options and futures contracts, and currency swaps

Function of FX market

To assist clients in the conduct of international commerce

• Service that commercial banks provide to their clients

• International Banks provide the core

Over-the-counter markets (OTC)

meaning trading does not take place in a central marketplace where buyers and sellers congregate

• EX: Spot and Forward FX markets

Major Market Segments:

1. Australasia: Sydney, Tokyo, Hong Kong, Singapore, and Bahrain

2. Europe: Zurich, Frankfurt, Paris, Brussels, Amsterdam, and London

3. North America: New York, Montreal, Toronto, Chicago, San Francisco, and Los Angeles

FX market is a two-tier market with markets called

Interbank (wholesale), and Client (retail)

Interbank (wholesale) market

•About 100-200 banks worldwide stand ready to “make a market” in foreign exchange

•Nonbank dealers account for about 40% of the market

•There are FX brokers who match buy and sell orders but do not carry inventory and FX specialists

Bank Customers

international banks serve their retail clients in conducting foreign commerce or making international investment in financial assets that require foreign exchange

• include MNC, money managers, and private speculators

Nonbank Dealers

typically other financial institutions such as smaller commercial and investment banks, mutual funds, pension and hedge funds, who size and frequency of trades make it cost effective to establish their own dealing rooms

Market Participants include..

international banks, their customers, nonbank dealers, FX brokers, and central banks

Correspondent Banking Relationships

–Made up of a network of _________, with large commercial banks maintaining demand deposit accounts with one another

– their network facilitates the efficient functioning of the FX market

According to the BIS, the number of correspondent banks fell by about 20 percent in the last decade mainly due to…

• Shift in banks’ business strategies and risk appetites stemming from tightened regulations that followed the Global Financial Crisis.

• Additional cross-border payment options made available by technological advances

International commercial banks communicate with one another using:

–SWIFT: Society for Worldwide InterbankFinancial Telecommunications.

–CHIPS: Clearing House Interbank PaymentsSystem

–ECHO: Exchange Clearing House Limited

• First global clearinghouse for settling interbank FX transactions

Spot Market

• involves almost immediate purchase or sale of foreign exchange

• One can buy (take a long position) or sell (take a short position) foreign exchange

• Cash settlement is usually made in two business days after the transaction for trades between the US dollar and a non-North American currency

Direct Quotations

refer to the price of one unit of a foreign currency in terms of the domestic currency

Indirect quotation

is the price of one domestic currency in terms of a foreign currency

European terms

meaning the US dollar is priced in terms of the foreign currency (an indirect quote from the US perspective)

American Terms

price certain currencies in terms of the US dollar (a direct quote from the US perspective)

Cross-exchange rate

is an exchange rate between a currency pair where neither currency is the US dollar

Big figure vs small figure

–$1.31 is known as the bid quote______ and assumed to be known by all traders

–Last two digits (.53) is the _____

Bid ask spread

• Interbank FX traders buy currency for inventory at the bid price and sell from inventory at the higher offer or ask price

• Average of the bid and ask rates are called mid-rates

• Bid-ask spread allows dealers to earn a pro

Currency against currency trade

is when a customer wants to trade out a nondollar currency for another nondollar currency

• For example, a customer wants to trade out of British pounds into Swiss francs

• Typically handled by the bank selling British pounds for US dollars and then selling US dollars for Swiss francs

• Handled at the cross-rate desk of the bank

Triangular arbitrage

is the process of trading out of the US dollar into a second currency, then trading it for a third currency, which in turn is traded for US dollars

Purpose of a triangular arbitrage

to earn an arbitrage profit via trading from the second to the third currency when the direct cross-exchange rate between the two is not in alignment with the implied cross-exchange rate

Arbitrage

is a zero-risk, zero-investment strategy from which a profit is guaranteed

Forward Market

involves contracting today for the future purchase or sale of FX

• No money changes hands upon entering the contract today

• May be used to hedge FX exposure or to speculate in FX market

• Forward price is usually higher (at a premium) or lower (at a discount) than spot price (or equal)

• Bank quotes for maturities of 1, 3, 6, 9, and 12 months are readily available

Forward Rate quotations

–Fn (j/k) is the notation used to refer to the price of one unit of currency k in terms of currency j for delivery in N months

–F notation is used to denote a forward exchange rate

–Like spot quotes, forward quotes are either direct or indirect with one being the reciprocal of the other

Forward Premium

Common to express the premium or discount of a forward rate as an annualized percentage deviation from the spot rate

• is useful for comparing against the interest rate differential between two countries

• can be calculated using American or European term quotations

Non-Deliverable Forward Contracts

Due to government-instituted capital controls, currencies of some emerging market countries are not freely traded

–Not possible to obtain these currencies offshore in the spot market to settle a forward position

–For many of these currencies, trading in (NDF) contracts exists

NDF vs DF

NDF is settled in cash at the difference between the spot exchange on the maturity date of the contract and the NDF rate times the notional amount of the contract

Exchange-Traded Fund (ETF)

• is a portfolio of financial assets in which shares representing fractional ownership of the fund trade on an organized exchange

• Allow small investors the opportunity to invest in portfolios of financial assets that they would find difficult to construct individually

FDI involves

the establishment of production facilities abroad.

• several developed nations are sources of outflow for ___

Greenfield investment

involves building new facilities from the ground up

Cross-border acquisition involves

partial (0-100%) purchase of an existing business

Why do firms invest overseas?

•Trade barriers

•Labor market imperfections

•Intangible assets

•Vertical integration

•Product life cycle

•Shareholder diversification

Trade Barriers

• Government action leads to market imperfections.

• Tariffs, quotas, and other restrictions on the free flow of goods, services, and people.

• arise naturally due to high transportation costs, particularly for low value-to-weight goods

Labor Market Imperfections

• is the least perfect.

• Recall that the factors of production are land, labor, capital, and entrepreneurial ability.

•If there exist restrictions on the flow of workers across borders, then labor services can be underpriced relative to productivity.

–The restrictions may be immigration barriers or simply social preferences.

Intangible Assets

• Coca-Cola has a very valuable asset in its closely guarded “secret formula.”

• To protect that proprietary information, Coca-Cola has chosen FDI over licensing.

• Since_____ are difficult to package and sell to foreigners, MNCs often enjoy a comparative advantage with FDI

Vertical Integration

MNCs may undertake FDI in countries where inputs are available in order to secure the supply of inputs at a stable accounting price.

International Vertical integration may be backward or forward as in domestic one:

• Backward: e.g., a furniture maker buying a foreign logging company.

• Forward: e.g., a U.S. auto maker buying a Japanese auto dealership.

Product Life Cycle

• U.S. firms develop new products in the developed world for the domestic market, and then markets expand overseas.

• FDI takes place when product maturity hits and cost becomes an increasingly important consideration for the MNC.

• It should be noted that the ____ theory was developed in the 1960s when the U.S. was the unquestioned leader in R&D and product innovation.

• located in multiple countries

Shareholder Diversification

•Firms may be able to provide indirect diversification to their shareholders if there exists significant barriers to the cross-border flow of capital.

•Capital market imperfections are of decreasing importance, however.

•Managers, therefore, probably cannot add value by diversifying for their shareholders, as the shareholders can do so themselves at lower cost.

Political risk

refers to the potential losses to the parent firm resulting from adverse political developments in the host country

• Range from the outright expropriation of foreign assets to unexpected changes in the tax laws that hurt the profitability of foreign projects

Macro Risk

where all foreign operations are affected by adverse political developments in the host country

Micro Risk

where only selected areas of foreign business operations or particular foreign firms are affected

Transfer Risk

which arises from uncertainty about cross-border flows of capital, payments, know-how, etc.

Operational Risk

which is associated with uncertainty about the host country’s policies affecting the local operations of MNCs

Control Risk

which arises from uncertainty about the host country’s policy regarding ownership and control of local operations

Political risk is not easy to measure, but experts evaluate a set of key factors, such as:

–The host country’s political and government system

–Track records of political parties and their relative strength

–Integration into the world system

–The host country’s ethnic and religious stability

–Regional security

–Key economic indicators

Corruption Perceptions Index (CPI)

provides a composite measure of perceived corruption in the public sector

Credit evaluating companies “Country Reports”

provides countries political and economic condition, outlook and forecast.

Hedging Political Risk

• Geographic diversification

• Minimize exposure

  • Form joint ventures with local companies.

  • Join a consortium of international companies to undertake FDI.

  • Finance projects with local borrowing

• Insurance

The Overseas Private Investment Corporation (OPIC), a U.S. government federally-owned organization, offers insurance against:

1.The inconvertibility of foreign currencies.

2.Expropriation of U.S.-owned assets.

3.Destruction of U.S.-owned physical properties due to war, revolution, and other violent political events in foreign countries.

4.Loss of business income due to political violence.

Typical Foreign Exchange Transactios

Consider a U.S. importer, who is an automobile dealer, and who desires to purchase automobiles from a Japanese exporter, the manufacturer. The two do not know one another and are obviously separated by a great distance.

• If the Japanese manufacturer could have his way, he would have the U.S. importer pay cash in advance for the shipment.

• If the auto dealer could have his way, he ideally would prefer to receive the cars on consignment from the auto manufacturer. Second best would be to receive the car shipment on credit and then to make payment.

Letter of Credit

is a guarantee from the importer’s bank that it will act on behalf of the importer and pay the exporter for the merchandise if all relevant documents specified in the ___ are presented according to terms

Time draft

instructs the importer, or his agent, to pay the amount specified on its face on a certain date

Bill of Lading (B/L)

a document issued by the common carrier specifying that it has received the goods for shipment; it can serve as title to the goods

Bankers Acceptance (B/A)

• a negotiable money market instrument for which a secondary market exists

• can be held to maturity by the exporter

A typical foreign trade transaction requires three basic documents to issue B/A:

letter of credit, time draft, and bill of lading

Forfaiting

• a type of medium-term financing used to finance the sale of capital goods

• Involves the sale of promissory notes signed by the importer in favor of the exporter

• The bank buys the notes at a discount from face value from the exporter

• Exporter receives payment and does not have to carry the financing

• denominated in Swiss francs, euros, and dollars

Government Assistance in Exporting

•For political reasons (having to do with mercantilism), most developed countries offer competitive assistance to domestic exporters.

•This assistance often takes the form of subsidized credit that can be extended to exporters.

-Also, credit insurance programs that guarantee financing extended by private financial institutions are common

Export-Import Bank (Ex-Im Bank) of the United States

was founded in 1934 and subsequently chartered in 1945, as an independent government agency to facilitate and finance U.S. export trade

Eximbank purpose

to provide financing in situations where private financial institutions are unable or unwilling to because:

–The loan maturity is too long.

–The amount of the loan is too large.

–The loan risk is too great.

–The importing firm has difficulty in obtaining hard currency.

Working Capital Guarantee Program

encourages commercial lenders to make short-term working capital loans to U.S. exporters

Direct Loan Program

facilitates direct credit to foreign buyers of U.S. exports

Loan Guarantee Program

guarantees the loans made by private FIs to foreign importers

Export Credit Insurance Program

protects U.S. exporters against loss should a foreign buyer or other foreign debtor default for political or commercial reasons

Countertrade

• an umbrella term used to describe many different types of transactions in “which the seller provides a buyer with goods or services and promises in return to purchase goods or services from the buyer.”

• may or may not involve the use of currency, as in barter.

Barter

is the direct exchange of goods between traders and requires a double coincidence of wants.

Clearing Arrangement

form of barter in which the traders agree to buy a certain amount of goods from each other.

• They set up accounts with each other that are debited and credited as needed. At the maturity of the arrangement, the parties settle up in cash or merchandise.

Switch trade

the purchase by a third party of one country’s clearing agreement balance for hard currency.

Buy-back transaction

involves a technology transfer via the sale of a manufacturing plant.

–The seller of the plant agrees to buy back some of the output of the plant once it is constructed.

Counter-purchase trade agreement

similar to a buy-back transaction, but differs in that the output that the seller of the plant agrees to buy is unrelated to the plant.

Offset transaction

be viewed as a counterpurchase trade agreement involving the aerospace/defense industry.

Negative incentives for a country to be in favor of countertrade:

Conservation of cash and hard currency, improvement of trade imbalances, and the maintenance of export prices

Positive reasons, from both the country and corporate perspectives:

Enhanced economic development, increased employment, technology transfer, market expansion, increased profitability, less costly sourcing of supply, reduction of surplus goods from