INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

1
INBU 4200 INTERNATIONAL FINANCIAL MANAGEMENT

• Lecture 4
• The Foreign Exchange Market
• Quoting Currencies

2
Quiz 2 and Project 1 Information

• Quiz 2
• Date Change Reminder
• Quiz 2 will be given on Tuesday, March 21.
• There will be class on Thursday, March 23.
• Project 1
• Please identify a company you wish to investigate
  for this project.
• Check their web site for annual reports (You will
  need these).
• Look over the sample given in the course syllabus
  for format and specific topics to be covered.
• Make sure your written report covers all required
  topics.
• Due date for project is Thursday, February 23rd
  at the beginning of class LATE PROJECTS WILL NOT
  BE ACCEPTED.

3
Defining The Foreign Exchange Market

• The FOREX market Performs Three Important
  Functions
• Provides rates of exchange.
• The ratio of one currency to another.
• These determine the costs and returns to global
  businesses.
• Facilitates the conversion of one currency into
  another.
• Through the buying and selling of currencies.
• Allows global firms to move in and out of foreign
  currency as needed.
• Offers contracts to manage foreign exchange
  exposure.
• These hedging contracts allow global firms to
  offset foreign currency exposures.
• Thus, they can concentrate on their core business.

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Who Provides These Important FX Functions?

• Large global banks (e.g., HSBC, UBS, Citibank)
  Acting on behalf of
• Their clients (primarily global firms)
• Acting in a broker capacity (i.e., doing trades
  for clients)
• Meeting foreign currency business needs of their
  clients
• Global banks also trade for their own internal
  accounts and the profits of their banks.
• Acting in a dealer capacity
• Trading currencies to make a profit.
• Global banks establishing the tone of the
  market.
• Market maker function
• Setting prices and committed to buying and
  selling at quotes.

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Making the Market in FX

• The Market Maker Function Involves Two Primary
  Activities
• Willingness to provide market with on-going two
  way quotes upon request
• Price at which they will buy a currency
• Price at which they will sell a currency
• Provides the market with transparency
• Willingness to actually buy and/or sell at prices
  quoted
• Offers firm prices into the market!
• Provides the market with liquidity.

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How Do Market Makers Quote Currencies?

• We already know of two possible ways of quoting
  currencies these are
• European Terms
• Number of foreign currency units per 1 U.S.
  dollar.
• 119 yen to the dollar
• American Terms
• U.S. dollars and cents per 1 unit of the foreign
  currency
• 1.2100 to one Euro
• Which quote is used?
• Determine by convention (historically market use).

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ISO Currency Designations

• All currencies are assigned an International
  Standards Organization (ISO) abbreviation.
• E.g., USD JPY GBP EUR CNY HKD MXP AUD ZAR
• For individual countries please see
  http//www.oanda.com/site/help/iso_code.shtml
• Since the exchange rate is simply the ratio
  (value) of one currency against another, the
  market express this relationship using ISO
  designations.
• For Example
• USD/JPY
• EUR/USD

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Base and Quote Currency

• A complete currency quote as given by a market
  maker is always represented by the ratio of one
  currency to another and is always designated
  using ISO terms.
• Given that a complete quote has two ISO
  designations (e.g., EUR/USD or USD/JPY)
• The first ISO currency quoted is called the base
  currency
• The second ISO currency quoted is called the
  quote currency.
• For examples above
• EUR is the base currency and USD is the quote
  currency.
• USD is the base currency and JPY is the quote
  currency.

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Bid and Ask Quotes

• A currency quote as given by a market maker
  always provides two quoted numbers.
• One quoted number is what the market maker will
  buy a currency for (i.e., the bid).
• The other quoted number is what the market marker
  will sell a currency at (i.e., the ask, or
  offer).
• Also, recall that a complete quote provides two
  prices (a two way quote or both a buy and a
  sell price)
• The first number shown in the two way quote is
  called the bid.
• The second number shown in the two way quote is
  called the ask.
• Example EUR/USD 1.2102/1.2106
• The first number is the bid quote (or price) and
• The second number is the ask quote (or price)
• The bid number is always lower than the ask

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Interpreting a Currency Quote

• As one example of a complete ISO foreign exchange
  quotation
• EUR/USD 1.2102/1.2106
• What can we note about the quote?
• First ISO base currency/ISO quote currency
• AND
• Second Bid quote/ask quote
• So in the above example
• EUR the base currency is the Euro
• USD the quote currency is the U.S. dollar
• 1.2102 is the bid price
• 1.2106 is the ask price

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But What Do the Numbers Mean?

• Since the market maker is the one quoting
  currency prices, we need to start by looking at
  the numbers from the standpoint of the market
  maker.
• The bid quote is the price at which the market
  maker will buy a currency (it is what they are
  biding for it).
• The ask quote is the price at which the market
  maker will sell a currency (it is what they are
  asking for it).
• But what currency is the market maker buying or
  buying?
• They are always quoting prices at which they will
  buy or sell the base currency (against the quote
  currency).

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FX Quote Example

• Assume a market maker provides the following
  EUR/USD quote
• 1.2102/1.2106
• Given this quote
• The market maker will buy EUR (euros) from the
  market at?
• 1.2102
• Or sell EUR (euros) to the market at?
• 1.2106
• Assume the following USD/JPY
• 110.12/110.20
• The market maker will buy dollars from the market
  at?
• 110.12
• Or sell dollars to the market at?
• 110.20
• Note The ask price is always higher than the
  bid.

13
A Quote from the Standpoint of Other than a
Market Maker

• Assume you are a corporate and you receive the
  following GBP/USD quote from a market maker bank
• 1.8020/1.8050
• If you wanted to buy pounds, what would you pay
  (in dollars) for each pound?
• 1.8050 (the ask price)
• Note this is the price to buy pounds or sell
  dollars.
• If you wanted to sell pounds, what would you get
  (in dollars) for each pound?
• 1.8020 (the bid price)
• Note this is the price to sell pounds or buy
  dollars.

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One More Example A Quote from the Standpoint of
Other than a Market Maker

• Assume you are a corporate and you receive the
  following USD/JPY quote from a market maker bank
• 112.50/112.75
• If you wanted to buy dollars, what would you pay
  in yen?
• 112.75 (the ask price)
• Note this is the price to buy dollars or sell
  yen.
• If you wanted to sell dollars, what would you get
  in yen?
• 112.50 (the bid price)
• Note this is the price to sell dollars or buy
  yen.
• Remember The market is always buying or selling
  the base currency (against the quote currency).

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Lets Look at Real Time Currency Quotes

• Go to the following web-site
• http//www.fxstreet.com/nou/graph/streamingchart.a
  sp
• At this site, go to
• Live Currency Rates (U.S. Dollar/Major
  currencies)
• Observe ISO quotes.
• Observe bid and ask quotes.
• Observe what currency and at what price the
  market maker is buying or selling (base
  currency).
• Observe what price you (a non-market maker) would
  buy or sell the base currency.
• Observe changes in bid and ask quotes.
• What do these mean?
• Another site http//www.forextrading.com/

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How are Some Currencies Quoted?

• Euro EUR/USD Swedish Krona USD/SEK
• British Pound GBP/USD Norwegian
  Kroner USD/KOR
• Australian Dollar AUD/USD Israeli
  Shekel USD/ILS
• New Zealand Dollar NZD/USD Danish
  Krone USD/DKK
• Russian Ruble USD/RUB
• Yen USD/JPY Malaysian Ringgit USD/MYR
• Swiss Franc USD/CHF Korean Won USD/KRW
• Canadian Dollar USD/CAD Indian Rupee USD/INR
• Mexican Peso USD/MXN Philippine Peso USD/PHP
• Hong Kong Dollar USD/HKD Argentina
  Peso USD/ARS
• Singapore Dollar USD/SGD
• Brazilian Real USD/BRL
• South African Rand USD/ZAR
• Thai Baht USD/THB
• Note American terms quoted currencies use the
  U.S. dollar as the quote currency and European
  terms quoted currencies use the U.S. dollar as
  the base currency.

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FX Spreads to Market Maker Banks

• All market makers give both a bid and an ask
  quote for a currency.
• Recall the ask is always higher.
• The difference between the bid and ask price is
  the spread to the market maker.
• This represents the profit from a round
  transaction.
• Assume the following GBP/USD quote 1.7921/1.7929
• Bid at 1.7921
• Ask at 1.7929
• What is the spread on a round transaction
  (assume 10 million pound transactions)
• Ask 1.7929 x 10,000,000 17,929,000
• Bid 1.7921 x 10,000,000 17,921,000
• Spread (Commission) 8,000

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Measuring the FX Bid Ask Spread

• Bid Ask Percentage Spread Formula
• (Ask price Bid price) / Ask price x 100
• Example assume the following quote
• GBP/USD 1.7921/1.7929
• Calculate the Percentage Spread
• (Ask price Bid price) / Ask price x 100
• (1.7929 1.7921) / 1.7929 x 100
• 0.045

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Notes About FX Bid Ask Spreads

• Bid ask spreads increase with exchange rate
  volatility.
• Bid ask spreads decrease with increases in market
  maker competition.
• Bid ask spreads larger in retail market than in
  wholesale (interbank) market.
• Wholesale market bank to bank
• Retail market bank to customer
• Profits for banks come primarily from their
  intermediary role (acting for clients) as opposed
  to speculative trades.
• Bid ask spreads critical here!
• Also banks adjust their bid and ask rates to
  adjust own positions.
• Making trades more or less attractive to others!

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Adjusting Bid Ask Quotes to Adjust Foreign
Exchange Holdings

• Market makers (banks) adjust their bid and ask
  quotes to adjust their own books.
• Assume competition is quoting the GBP/USD as
• Bid 1.7921
• Ask 1.7929
• If your bank wanted to increase its holdings of
  pounds (or decrease its holding of dollars) it
  will quote
• More than 1.7921 (raise its bid quote) and
  attract more pounds!
• If your bank wanted to decrease its holdings of
  pounds (or increase its holdings of dollars) it
  will quote
• Less than 1.7929 (lower its ask quote) and sell
  more pounds!

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Quotes According to Delivery Time Period

• Spot Quote Quote for immediate transactions.
• Actually, delivery will take place at the end of
  2 business days.
• Saturday and Sunday are not business days
• Perhaps a one day delivery depending upon the
  location (e.g., between Canada and the U.S., or
  within Europe).
• Two way quotes are given in the spot markets by
  market makers.
• Forward Quote Quote for more than 3 business
  day transactions.
• Delivery to take place at the end of 3 business
  days or more from now.
• Two way quotes are given in the forward market by
  market makers.

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Examples of Spot FX Quotes

• September 8, 2004 Feb 6, 2006
• American Terms
• U.K. (pound) 1.7867 1.7471
• Eurozone (euro) 1.2186 1.1960
• Australia (dollar) .6964 .7421
• European Terms
• Japan (yen) 109.30 119.02
• Mexico (peso) 11.584 10.458
• China (RMB) 8.2781 8.0572
• Sources
• http//online.wsj.com/public/us and
  http//fx.sauder.ubc.ca/today.html

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What Moves a Floating Spot Rate

• Anything that affects the demand for or supply of
  the currency on foreign exchange markets,
  including
• Relevant economic data ,such as
• trade data,
• Inflation data,
• unemployment date, GDP data and
• Central bank key interest rates (e.g., Federal
  Funds rate or comparable rates in foreign
  countries) and changes in these rates.
• Announcements by key officials (e.g., central
  bankers)
• What is important?
• The actual data itself
• And the markets expectation for this data.
• Was the reported data in line with market
  expectations?
• Also important are political/military events.

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Forward FX Rates

• Involves contracting today for the future
  purchase or sale of foreign exchange.
• Forward rate is quoted today by market makers.
• As with spot rates, forward rates are two way
  quotes, or bid and ask prices.
• Bid at which they will buy the base currency in
  the future.
• Ask at which they will sell the base currency in
  the future.
• Forward rates can be
• Worth more than spot (premium)
• Worth less than spot (discount)
• Equal to spot (flat)

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Examples of Forward FX Rates

• September 8, 2004 February 6, 2006
• American Terms
• U.K. (Pound) 1.7867 1.7471
• 1 month forward 1.7818 1.7472
• European Terms
• Japan (Yen) 109.30 119.02
• 1 month forward 109.13 118.60
• Sources
• http//online.wsj.com/public/us and
  http//fx.sauder.ubc.ca/today.html

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Determining Forward Discounts and Forward Premiums

• Question On September 8, 2004, was the pound
  selling at a forward discount or forward premium?
• U.K. (Pound) 1.7867
• 1 month forward 1.7818
• Answer
• Discount 1 month forward is less than the spot
  by .0049 (1.7818 1.7867 -.0049).
• Note the dollar is selling at a premium (less
  dollars to buy a pound forward than to buy a
  pound spot).

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Determining Forward Discounts and Forward Premiums

• Question On February 6, 2006, was the pound
  selling at a forward discount or forward premium?
• U.K. (Pound) 1.7471
• 1 month forward 1.7472
• Answer
• Premium 1 month forward is more than the spot
  by .0001 (1.7472 1.7471 .0001).
• Note the dollar is selling at a discount (more
  dollars to buy a pound forward than to buy a
  pound spot).
• However, the pound forward is very close to
  flat.

28
Determining Forward Discounts and Forward Premiums

• Question On February 6, 2006, was the Japanese
  yen selling at a forward premium or forward
  discount?
• Japan (yen) 119.02
• 1 month forward 118.60
• Answer
• First, convert to American terms (119.02
  .008402 118.60 .008432).
• Yen 1 month forward is worth more than the spot
  by .00003 (.008432 - .008402 .00003).
• Premium Yen is selling at a premium (.00003).
• Note Dollar is selling at a discount (more
  dollars to buy a yen forward than a yen spot)