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UNIT 5: INTERNATIONAL FINANCIAL MANAGEMENT

5.1 INTRODUCTION

Exchange rate: Exchange rate is the price of one currency in terms of another currency.

Direct (or Normal) quote: quote in domestic currency (e.g., a US bank gives a direct quote for
the British pound, denoted as , as US$/one pound or US$/, whereas a British bank gives a
direct quote for the US dollar as /US$.)

Indirect (or Reciprocal) quote: the inverse of the direct quote. US (or American) Terms: direct
quote used in doing business in the US (e.g., US$/).

Spot (exchange) rate: bank rate (guaranteed) for up to 48 hours.

Forward rate: contractually agreed to rate for a future exchange.

Bid rate: buy rate

Offer rate: sell rate

Spread = bid rate - offer rate

Cross rate - exchange rate computed from two other rates.


For example assume that, the US exchange rates for Belgium and the UK are as follows:
US $ equiv.
(US Terms)
Currency per US $
(European Terms)
Belgium (Spot) 0.0321 ($/BF) 31.1150 (BF/$)
Britain (Spot) 1.5901 ($/) 0.6289 (/$)
Suppose you subscribe to a journal produced in the UK and the bill for a given year is 50 .
The proper payment, if they will accept a personal check, is $81, determined as follows:

From the table, the rate is 1.5901 US$/. Thus, the exact payment in US$ is
(1.5901 US$/) x (50 ) = 79.505 US$.

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One should include an extra amount, say $1.50, to cover inconvenience and any transactions
costs that the publisher might encounter.
5.2 CURRENCY MARKETS

The Eurocurrency markets and foreign exchange markets provide clearance and settlement
mechanisms for inter-bank transfers. Graphically, part of the system is as follows:

CURRENCY MARKETS
(Source: K. C. Butler, Multinational Finance, Cincinnati, OH: South-Western College
Publishing, p. 57.)
US customers
US credit market
UK customers
UK credit market
Eurodollars Euro pounds
Euro yen
Japanese credit mark
Japanese customer
Eurocurrencies
Forward Contracts
A forward contract is an agreement between two parties to buy or sell an asset at a certain
future time for a certain future price.
Forward contracts are normally not exchange traded.
The party that agrees to buy the asset in the future is said to have the long
position.
The party that agrees to sell the asset in the future is said to have the short
position.
The specified future date for the exchange is known as the delivery (maturity
(maturity))
date.
The specified price for the sale is known as the delivery price, we will denote this as K.
Note that K is set such that at initiation of the contract the value of the forward
contract is 0.

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As time progresses the delivery price doesnt change, but the current spot (market) rate does.
Thus, the contract gains (or loses) value over time.
Consider the situation at the maturity date of the contract. If the spot price is
higher than the delivery price, the long party can buy at K and immediately sell
at the spot price ST, making a profit of (ST-K), whereas the short position could
have sold the asset for ST, but is obligated to sell for K, earning a profit
(negative) of (K-ST).
Forward Contracts
Clearly the short position is just the mirror image of the long position, and, taken
together the two positions cancel each other out:
Futures Contracts
A futures contract is similar to a forward contract in that it is an agreement between
two parties to buy or sell an asset at a certain time for a certain price. Futures,
however, are usually exchange traded and, to facilitate trading, are usually
standardized contracts. This results in more institutional detail than is the case with
forwards.
The long and short party usually do not deal with each other directly or even know
each other for that matter. The exchange acts as a clearinghouse. As far as the two
sides are concerned they are entering into contracts with the exchange. In fact, the
exchange guarantees performance of the contract regardless of whether the other party
fails.
Options Contracts
The owner of an options has the OPTION to buy or sell something at a predetermined
price and is therefore more costly than a futures.
There are two basic types of options:
A Call option is the right, but not the obligation, to buy the underlying asset by
a certain date for a certain price.
A Put option is the right, but not the obligation, to sell the underlying asset by a
certain date for a certain price.

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Note that unlike a forward or futures contract, the holder of the
options contract does not have to do anything - they have the
option to do it or not.
Options Contracts
The date when the option expires is known as the exercise date,
date, the expiration
date, or the maturity date.
The price at which the asset can be purchased or sold is known as the strike
price.
If an option is said to be European, it means that the holder of the option can
buy or sell (depending on if it is a call or a put) only on the maturity date. If
the option is said to be an American style option, the holder can exercise on
any date up to and including the exercise date.
An options contract is always costly to enter as the long party. The short party
always is always paid to enter into the contract
Looking at the payoff diagrams you can see why
Traders frequently refer to an option as being in the money, out of the money or
at the money.
An in the money option means one where the price of the underlying is such
that if the option were exercised immediately, the option holder would receive
a payout.
For a call option this means that St>K
For a put option this means that St<K
An at the money option means one where the strike and exercise prices are
the same.
An out of the money option means one where the price of the underlying is
such that if the option were exercised immediately, the option holder would
NOT receive a payout.
For a call option this means that St<K
For a put option this means that St>K.

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