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CHAPTER        3

The Foreign Exchange Market (FOREX)     3

   The Spot Market                      4

      Quotations                        4

      Triangular (Currency) Arbitrage   4

  The Forward Market                    4

  The Options Market                    5

International Banking Services          5

   Capital Adequacy Standards           5

   International Money Markets          5

   International Capital Markets        6

International Stock Markets             7

  Valuation of Foreign Stocks           7

  Investing Internationally             8

  Exchange Rate Risks                   8
I C O N    K E Y

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Key Point

 International Financial Markets
 One trillion dollars a day is exchanged in the global exchange market

      nternational financial markets are comprised of currency markets, international debt
      instrument markets and international stock markets. These markets are places where
      currencies, debt, and equity are traded. These markets are not fully integrated due to the
      unique restrictions on trade by each country. These barriers create different economies and
 therefore different investing opportunities for different geographic areas.

 This chapter contains many new concepts. Most of these can be further researched on
 Wikipedia or a good online finance/economics dictionary, i.e. or

 The Foreign Exchange Market (FOREX)
 The foreign exchange market (FOREX) is where MNCs exchange their native currency for
 foreign currencies. An MNC may need to purchase foreign goods with foreign currency (imports)
 or may want to invest in a foreign country. There is no central place, called the FOREX, but
 rather it is a virtual trading place, which is conducted through communication channels such as
 the Internet or a similar telecommunications network.

 One popular online currency trader is Currenex. Currenex was founded in 1999 and has offices in
 London, New York, Chicago, California and Singapore. Currrenex is an online global currency
 exchange that links institutional buyers and sellers worldwide and is open to all Foreign Exchange
 and Money Market participants. It provides a low-cost and secure electronic channel to access the
 $1 trillion/day global foreign exchange market.

 There are three primary places where MNCs exchange their currency. They are the:

      1. Spot Market: where currencies are traded for an immediate delivery

    2. Forward and Future Market: where an arrangement for a future delivery is made and

    3. Options Market: where rights to buy (call options) and to sell (put options) are traded.

Participants in the currency markets are people buying and selling currency through currency
traders. They can be:

       Individual traders- people trading their home currency for foreign currencies because
        they are traveling abroad.
       Institutional traders- includes banks and security companies trading currency for
        business needs.
       Governments- trading currency for general needs.

Institutional traders can have several different strategies for trading. These include:

       Arbitrage- Trying to earn risk-free profits from differences in price due to market
       Hedging- Use of forward contracts to minimize the exchange rate risk of future cash
       Speculating- Guessing against the market to attempt to earn profit from exchange rate

Spot Market
In the Spot Market, currencies are traded for immediate delivery at the “spot rate”, which is the
current exchange rate between countries. Much of the trading is handled by banks in London,
New York, and Tokoyo. If a bank is short on a particular currency, it can purchase that currency
from another bank. This is called the interbank market. Traders use electronic trading boards that
can check rates at different banks around the world, and instantly receive the best price for the

Exchange Rate Quotations

   Exchange Rate quotations can either be in the American Term or the European Term. The
“Bid” is the price to buy the product, while the “Ask” is the price to sell the product (From the
dealers perspective). When you buy from the dealer you pay the Ask price, and when the dealer
buys currency back from you or you sell foreign currency to the dealer you receive the Bid price.

The spread is the difference between the asking price and the bid price and is the dealer’s profit
for handling the transaction, otherwise known as the transaction cost. Transaction cost is
determined by three factors:

    1. Trading Volume- Increased volume means a decrease in the spread.

    2. Trading Frequency- Increase in the frequency means a decrease in the spread

    3. Exchange Rate Volatility- Increase in volatility (risk) means an increase in the spread.

  When you want to travel to Europe, the Euro will be the currency in all the countries except a
few countries. As an example, lets say the Euro is valued at 1.08 and the asking price charged by
the bank is 1.13. If you had a $1,000 dollars you would get:

1,000/1.13 = 885 Euros

If you decided not to go to Europe, and converted the funds back into dollars you would have:

885 Euros X (1.08 banks bid) = 959 dollars.

The cost of converting the money goes to the bank and cost you 41 dollars. For this reason the
institution of the Euro has saved the MNCs billions of dollars in transaction cost. Because each
time a transaction is done, the bank gets paid.

   You have a $1,000 and are going to the United Kingdom. The bank’s bid rate for the British
pound is $1.52, and its ask rate is $1.60. You go to the bank and convert the funds to pounds.
However at the last minute an emergency arises and you cannot go. How much will you lose if
you convert the pounds back to dollars?

Triangular Currency Arbitrage

Arbitrage is the opportunity to make a certain profit, risk-free. It occurs when the market is
temporarily imperfect, and there is a price disparity in violation of the “law of one price”.
Triangular currency arbitrage occurs when the money in one’s home country (A) can be
converted to another currency (B), in which a price disparity occurs between its currency (B) and
another foreign currency (C). The result is a sure profit.

1) Simple Arbitrage Example

The price of a twinkie at Store A is 40 cents, while the price of the same twinkie at Store B is 50
cents. Assuming that you can buy and sell twinkies at the same price (ignoring bid-asked price
difference), can you make an arbitrage profits with $1,000 investment?

Note that we must have the same products. We also need to have “prices or American terms”
instead of “quantity or European terms.” Note also that the arbitrage opportunity or the price
disparity would not last long if the market is perfect (meaning that the prices move as the demand
and supply changes)

2) Triangular Arbitrage Example

As an example, we will use the British pound (₤), the American dollar ($), and the Canadian
dollar(C$). You have 1,000 U.S dollars.

Current Spot Rate So = $1.60/₤

(Canadian dollar) So = $0.70/C$

(British Pound) So = C$ 2.1/₤

First, convert your 1,000 U.S dollars to Canadian dollars. To do so we must use the inverse of the
current spot rate between the US and Canada in order to be able to cross cancel the US dollars.
Then multiply it by the amount of US dollars we are converting.

        C$/$= 1 C$/$0.70 = 1.43 C$/$1 * $1,000 = 1,430 C$ Canadian dollars

Next we convert the 1,430 C$ for British Pounds at the rate of So = C$ 2.1/₤. However, the
inverse exchange rate must be used in order to cross cancel out the C$.

        1430 C$ * 1₤/ C$ 2.1 = 680.95 British Pounds

Finally we convert the 680.95 British Pounds back to US Dollars to earn the arbitrage profit.

        680.95₤ * $1.60 U.S dollars/₤ = $1089.52 = Profit of $ 89.52


Forward Market
The forward market, allows an MNC to lock in the exchange rate for a specific time period in the
future. The MNC can then buy or sell currency at that rate during the specified period. A forward
contract is a contract to buy or sell a predetermined amount of currency at a future time for a
locked in exchange rate.

MNCs use the forward market when they have a future transaction and want to be certain of the
exchange rate. They “hedge” their future payments that they expect to make, assuring a
guaranteed rate. For example the current exchange rate for the Euro is 1.10 Euros per dollar. A
firm believes the Euro will rise in relation to the dollar, they can lock in the rate for a specific
period of time, and so they will pay the current forward rate for the money.

   A forward contract is not an investment or an option, and the gain/loss on the forward
contract is not directly related to current spot price

   Although the Wall Street Journal gives outright price quotes for forward contracts, most
currency traders will quote the difference between the forward and spot rates. (F-So=0.02)

         If F> So then forward rate is at a premium.

         If F< So then forward rate is at a discount.

         The percentage of forward rate premium/discount can be calculated as:

                         F  So          12
                           So     # ContractMonths

Options Market
The Options Market was established in 1982. The U.S. Securities and Exchange Commission
regulates it. The Chicago Mercantile Exchange and the Chicago Board Options Exchange
offer currency options. Currency options are available in many, but not all currencies.

A currency option is a right to buy (put) or sell (call) with no obligation, over a specific
period of time. This places the obligation on the seller while the buyer enjoys the right to use
the option. When an option is used it is referred to as “exercising” the option. An option
price is called a premium (pm). A rain check or call is an option that is free. It may be part of
the marketing strategy to attract customers.

International Banking Services
Many banks want to establish multinational operations. Multinational banks are not subject to
regulations of the country of the currency, and the arena is very competitive

There are various types of international banking services:

       Trade financing – L/C (Letter of Credit). This is used because there is typically a lack of
        trust between the importer and exporter. The importer would prefer to receive the goods
        before sending payment, and exporter would rather have payment first. By using a bank
        as a third party, both the importer and exporter can trust the other will hold up their end
        of the deal because it is guaranteed by the bank.

       Currency exchange transactions

       Hedging transactions (Accounts Receivable (A/R) or Accounts Payable (A/P)
        denominated in a foreign currency using derivatives)

       Consulting services on international business/finance

International Capital Adequacy Standards

International Capital Adequacy standards refer to how many reserves (equity/retained
earnings and supplemental capital) a bank holds against risky assets. The larger the reserves
the safer the bank!

International Money Markets

International Money Markets refer to making a time deposit (CD) in a currency outside of
the country of the currency. For example, a German MNC could deposit a CD in a U.S.
bank in U.S. dollars.

International Capital Markets

Capital Markets refer to foreign banks that issue loans, or forward contract agreements, or bonds
from their foreign banks. These banks control interest rate risk using the floating rate Eurocredit
loans or Forward Rate Agreements. An Interbank contract allows the Eurobank to hedge the
interest rate risk in a mismatched (maturity deposits and loans by using the forward rate)

Examples are:

       Eurocredit (Euronotes) – medium-term funds

       Eurobonds – (long-term) Issued outside the country of the denominated currency. e.g.-
        Dollar denominated bonds issued in Great Britain.

       Foreign bonds: issued by a foreign company, in a country outside their home country;
        denominated in the currency of the country where issued. e.g - Yankee Bond=Dollar
        denominated bond issued in the U.S. by a Japanese company.

International Stock Markets
An MNC can diversify by investing in different countries’ stock markets. An MNC needs a
different currency in each country it invests in. With the introduction of the Euro, many U.S.
firms took advantage of the common currency, and issued stock in the European market. When
investing in foreign markets, firms need to be able to value the foreign stocks, understand the
different options available for investment, and minimize the risk involved due to exchange rate

Valuation of Foreign Stocks
There are three main methods used to determine the value of foreign stocks. Investors may
combine two or more of these methods to determine the quality of the foreign stock.

    1. Dividend Discount- The dividend of a foreign stock can normally be forecasted with
       more accuracy than the value of the foreign currency. An investor takes the dividend,
       converts it to their currency, and determines if it is a worthwhile investment.

    2. Price-Earnings Ratio- The expected earnings per share are multiplied by the expected
       price-earnings ratio for the firm to find the appropriate price for the stock.

    3. Macroeconomic Conditions- The strength of the economy is analyzed and companies
       that are positioned to benefit from the economy’s strengths are analyzed. This method is
       less focused on individual stocks and more focused on projected economic growth.

Investing Internationally
Direct Purchases of Foreign Stocks

When purchasing foreign stocks it is usually preferred to purchase those foreign stocks that are
trading in your local stock market. Of course its possible to use a foreign brokerage firm and
purchase stocks in foreign markets. However, inefficient information, transaction costs, and tax
differentials make these investments risky.

Investment in MNC Stocks

By offering stock in different countries, MNCs can effectively diversify sales and can achieve
stability by reducing risk. The stocks become an international stock portfolio.

American Depository Receipts (ADRs)

American Depository Receipts are certificates representing ownership of foreign stocks. There are
currently over 1,000 ADRs which are mainly traded over-the-counter (OTC). The prices are not
reported regularly and the transaction costs are high.

World Equity Benchmark Shares

World Equity Benchmarks Shares (WEBS), also referred to as iShares, represent indexes that
reflect composites of stocks for particular countries. Investors can invest directly in a stock index
representing different countries.

International Mutual Funds

International Mutual Funds are portfolios of stocks from different countries. They are popular

    1. Incurs a small initial investment

    2. Benefits of portfolio experts

    3. High degree of diversification and reduction of risk

Exchange Rate Risks
If a foreign investment appreciates, the investor makes money, if it depreciates they lose money.
Because exchange rates are volatile, foreign investments are also volatile. Investors can minimize
risk by diversifying between countries, continents, and stocks, and by buying short.


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