CHAPTER 32. INTERNATIONAL CORPORATE FINANCE. ADR [American Depository Receipt] Eurocurrency : Money deposited outside of the country whose currency is involved. [e.g., eurodollars] Definition of Foreign Exchange [FX] Market : A network of banks, foreign exchange brokers, and dealers whose function is to bring buyers (demanders) and sellers (suppliers) of foreign exchange together. Interbank Market An informal arrangement of the larger commercial banks and a number of FX brokers for buying and selling foreign currencies. Interbank Market n The spot market and the forward market Size of FX market n Daily volume approximately $1 Trillion or $250 Trillion per year. n Daily trading volume on the NYSE is about $7 Billion [0.7%] Participants of FX markets n Typically larger commercial banks. n Stand ready to buy or sell currencies on a continuous basis. n Compensated for making a market by ‘Bid-Ask Spread’ n FX brokers n Maintain lists of demanders and suppliers of currencies n Connect two parties [i.e., demanders and suppliers] n Approx. 60% of FX transactions occur through brokers. n Commercial customers : Large multinational corporation. n Central Banks : Intervention. I. The Spot Market. Definition n In the spot market, currencies are traded for immediate delivery. n Prices are quoted in pairs. n Bid : The price at which bank will buy the currencies. n Ask : The price at which bank will sell the currencies. n Bank Profit = Ask - Bid = Bid-ask spread PAGE 1 Example quotes shown in WSJ. EXCHANGE RATES Thursday, November 13, 1997 The New York foreign exchange selling rates below apply to trading among banks in amounts of $1 million and more, as quoted as 4 p.m. Eastern time by Dow Jones Telerate Inc. and other sources. Retail transaction provide few units of foreign currency per dollar. U.S. $ equiv. Currency per U.S. $ Country Thu Wed Thu Wed Japan (Yen) .007957 .007903 125.68 126.54 Direct Quotation n Home currency price per unit of foreign currency. n $ / Yen in U.S. Indirect Quotation n Foreign currency price per unit of home currency. n Yen / $ in U.S. Cross Rates - Many currency pairs are only inactively traded, so their exchange rate is determined through their relationship to a widely traded third currency. EXAMPLE : An Australian tourist wants to purchase Danish currency to pay for a visit to Copenhagen. The Australian dollar (symbol A$) is not actively traded with the Danish Krone(symbol DK). However, both currencies are actively traded with the U.S. dollar. Given the following quotes, what is the exchange rates between A$ and DK? [A$0.21345 / DK] Australian dollar : A$1.3806/US$ Danish krone : DK6.4680/US$ PAGE 2 Intermarket Triangular Aribitrage - Cross rates can be used to check on opportunities for intermarket arbitrage. EXAMPLE : Suppose the following exchange rates are available. Assume that there is no transaction costs. Dutch guilders (DG) per US $ : DG2.00/US$ Canadian dollars(C$) per US $ : C$ 1.25/US$ Then the cross rate between Dutch guilders and Canadian $ is DG1.60 / C$ However, the cross rate is not the same as the actual quotation of DG1.70 / C$ Is there any arbitrage opportunity ? ..Netherlands.. DG 1,062.5 DG 1,000 Multiplied by Divided by DG 1.70 / C$ DG 2.00 / US$ C$625 Multiplied by US$500,000 ..Canada.. C$1.25 /US$ ..United States.. PAGE 3 II. The Forward Market. Definition n In the forward market, currencies are traded for future delivery. n The exchange rate is established at the time the contract is agreed on, but payment and delivery are not required until maturity [1,2,3,6,12 months] Terminology n One can speak of "buying forward" or "selling forward" to describe the same transaction. n A contract to deliver $ for Yen in 6 months might be referred to as "buying Yen forward for $" or selling $ forward for Yen. Why 'forward'? n To lock in the price of a currency needed in the future n To eliminate the uncertainty of future exchange rate movements. Example : A U.S company buys machines from Japan with payment of Yen 1 Million due in 90 days. During the next 90 days, the Japanese Yen can appreciate against the US$ [If this happens, the importer's cost will ????] The importer can hedge this risk by buying the Yen in the forward market. ® We say the importer took a long position in the forward contract to offset a short position in the spot market. Note : A forward contract is an obligation not an option. n Bank is required to sell the Yen n Importer is required to buy the Yen. Forward premium or discount Interest Rate Parity [IRP] n The difference in the national interest rates for securities of similar risk and maturity should be equal to the difference between the forward and spot exchange rates. F (1+ iY ) = S (1+i $ ) n Example on Page 820. The law of one price [ or purchasing power parity ] n Example on Page 820. III. Assigned problems from the textbook. Q1 – Q3 PAGE 4 .