FOREIGN EXCHANGE MARKET 3.

The purchase and sale of foreign currencies for hedging

Background and History of Foreign Exchange Markets
Foreign Exchange Markets -markets in which cash flows from the
sale of products or assets denominated in a foreign currency are
transacted
purposes to offset customer exposure in any given currency
4. The purchase and sale of foreign currencies for speculative
purposes through forecasting or anticipating future
movements in foreign exchange rates
Situations of a Financial Institution in Forex

Foreign Exchange Rates -the price at which one currency can be Net Exposure – An FI’s overall’s ForEx exposure in any given
exchanged for another currency currency

CHINESE YUAN (1 Chinese Yuan = 7.27 Php)
US DOLLAR (1 USD = 51.93 Php)
YEN (1 Japanese Yen = 0.49 php)
WON (1 South Korean Won = 0.043 php)
CANADIAN DOLLAR (1 Canadian Dollar = 39.30 php)
POUND STERLING (1 POUND STERLING = 63.45 php)
BAHT (1 Bath = 1.70 php)
Net Long in a Currency -A position of HOLDING MORE assets than
liabilities in a given currency
Net Short in a Currency -A position of HOLDING LESS assets than
liabilities in a given currency
Net Position = Assets – Liabilities + Forex Bought – Forex Sold

Major purposes of the foreign exchange markets

Foreign Exchange Risk -risk of cash flows will vary as the actual
To facilitate:
amount of US dollars received on a foreign investment changes
1. international trade and global payments systems.
due to a change in foreign exchange rates
2. global access to capital.
3. hedging currency risk.
Currency Depreciation -when a country’s currency falls in value
4. speculating on currency values.
relative to other countries, meaning the country’s goods become
cheaper for foreign buyers and foreign goods become more
Foreign Exchange Transactions
expensive for foreign sellers
Spot Foreign Exchange Transaction (immediate exchange)
Currency Appreciation -when a country’s currency rises in value
relative to other currencies, meaning that the country’s good are
Forward Foreign Exchange Transaction (specific rate at a specified
more expensive for foreign buyers and foreign goods are cheaper
date in the future); Typically, 1, 3, 6-month period
for foreign sellers
Investment: 3,000,000 Swiss Franc
Currency Depreciation -unofficial decrease in exchange rate
1. Convert investment to US Dollars
Currency Devaluation -official lowering of the value of the
3,000,000 x 1.0796 = 3,238,800 USD
country’s currency
2. Using Spot Rate, after 1 month, Sf is worth 1.0671 USD, what
Sequencing of Events
is the gain or loss on exchange.
 UK depletion of gold reserves
 Maastricht Treaty
ISF= 1.0671= 3,201,300 USD
 Gold System
 Law eliminating exchange rate boundaries
End: 3,201,300 USD
 Foreign Exchange Market had become among the largest of all
Beg: 3,238,800 USD
financial markets
37,500 USD (Loss)
 Bretton Woods Agreement
 Interbank Foreign Exchange Markets for spot and forward
3. What will you do to minimize loss if any?
ForEx transaction
 Europe ‘s sovereign debt crisis
Use the Forward Foreign Exchange (1 month, 3 months, 6 months)
 Law allowing countries to devalued dollars
 Establishment of Euro Notes and Euro Coins
1.0799 USD
 US increasing national debt
3,000,000 x 1.0799 USD = 3,239,700 USD
Roles of Financial Institutions in ForEx
Forward: 3,239,700 USD
4 FI positions in the ForEx markets
Spot Rate: 3,201,300 USD
38,400 USD (Gain)
1. The purchase and sale of foreign currency to allow customers
to partake in and complete international trade transactions
2. The purchase and sale of foreign currencies to allow
customers to take positions in foreign real and financial
investments
Hedging Foreign Exchange Risk The promised 1-year US CD rate is 4%, to be paid in dollars at the
end of the year; 1-year default risk-free loans in the US are yielding
On-Balance Sheet Hedging (changing the assets and liabilities in 6%, and default risk-free one-year loans are yielding 10% in
the balance sheet) Germany. The exchange rate of dollars for euros at THE
BEGINNING of the year is 1.25USD/Euro.
Off-Balance Sheet Hedging (no changes but rather takes position
in forward or other derivatives) Situation 1. (Spot Foreign Exchange rate has changed to
1.15USD/Euro)
Assets: 300M USD US loans
200M USD German Loans Calculate the:
a. Dollar proceeds from the German loan at the end of the year,
Liabilities: 500M USD CDs b. The return on the FI’s investment and
c. The net interest margin for the FIs
The promised 1-year US CD rate is 4%, to be paid in dollars at the
end of the year; 1-year default risk-free loans in the US are yielding Situation 2. (Spot Foreign Exchange rate has changed to
6%, and default risk-free one-year loans are yielding 10% in 1.35USD/Euro)
Germany. The exchange rate of dollars for euros at THE
BEGINNING of the year is 1.25USD/Euro. Calculate the:
a. Dollar proceeds from the German loan at the end of the year,
Situation 1. (Spot Foreign Exchange Rate has not changed) b. The return on the FI’s investment and
c. The net interest margin for the FIs
Beginning: 125 USD= 1 EURO
200,000,000 USD ÷ 1.25 USD = 160,000,000 USD Situation 3. (Spot Foreign Exchange rate has changed to
1.20USD/Euro)
Calculate the:
a. Dollar proceeds from the German loan at the end of the year, Calculate the:
a. Dollar proceeds from the German loan at the end of the year,
160,000,000 USD X 10% = 16,000,000 b. The return on the FI’s investment and
c. The net interest margin for the FIs
Investment: 160,000,000 Euro
Yield: 16,000,000 Euro
Total Amount: 176,000,000 Euro STOCK MARKET

Equity Financing -Stock market allows suppliers of funds to

b. The return on the FI’s investment (German Loan)
176,000,000 x 1.25 = 220,000,000 USD
New Amount - Original amount = Return Investment
Original Amount
220.000.000 – 200,000,000 = 0.10 or 10%
200,000,000
efficiently and cheaply get equity funds to public corporations
(user of funds)
COMMON STOCK VS. PREFERRED STOCK
DIVIDENDS
Common Stock
 Dividends are unlimited, with no specific amount
 If no dividends, company is not in default (no legal recourse)
 Dividends are taxable twice (Corporate tax and personal
tax)

Preferred Stock
 Dividends are fixed and paid quarterly

Preferred Stock Dividends

c. The net interest margin for the FIs (Return Investment)
Non-Participating Preferred Stock - dividends is fixed regardless
of increase or decrease in profit
Inflow Rate- Outflow Rate = Net Income Margin
7.6% - 4% = 3.6% Cumulative Preferred Stock – missed dividends go into arrears
and must be paid

Participating Preferred Stock – actual dividends paid may be

Assets: 300M USD US loans greater on what was agreed
200M USD German Loans
Non-cumulative Preferred Stock – dividends don’t go on arrears
Liabilities: 500M USD CDs and are never paid
RESIDUAL CLAIMS Red herring prospectus -the preliminary version of a security offer
Common Stock that is circulated to potential buyers before SEC approval
 In the event of liquidation, lowest priority in cash (registration) is obtained
distributions
Shelf registration- the firm preregisters with the SEC any
Preferred Stock securities it wishes to sell over the next two years.
 Paid after claims are paid but before common stock holders
are paid PROBLEM SOLVING
Suppose you own 50,000 shares of common stock in a firm with
LIMITED LIABILITY 2.5M total shares outstanding. The firm announces a plan to sell an
Common Stock additional 1M shares through a right offering. The market value of
 Has limited liability the stock is $35 before the rights offering and the new shares are
being offered to existing shareholders at a 5 USD discount
Preferred Stock
 Has limited liability 1. If you exercise your pre-emptive rights, how many of the new
shares can you purchase?
VOTING RIGHT
Common Stock 1,000,000 shares = 0.4 rights
 Has voting rights 2,500,000 shares

Preferred Stock 50,000 x 0.4 rights = 20,000 shares

 Has no voting rights
2. What is the market value of the stock after the rights offering?
Voting Right of Commons Stock
Before: 2,500,000 x 35$ = 87,500,000 USD
Voting Rights New: 1,000,000 x 30$ = 30,000,000 USD
3,500,000 shares 117,500,000 USD
 Cumulative Voting – candidates are elected at the same time ÷ 3,500,000 shares
33.57$ per share
 Straight Voting – elected one at a time
3. What is your total investment in the firm after the rights
Proxy Votes -vote through a representative offering? How is your investment split between original
shares and new shares?
Dual Class Firms -2 classes of common stock have different voting
rights each Before: 50,000 x 35$ = 1,750,000 USD
New: 20,000 x 30$ = 600,000 USD
PREFFERED STOCKS (Hybrid) 70,000 shares 3,350,000 USD
÷ 70,000 shares
Common Stock -Represents an ownership in the company 33.57$ per share

Bonds - Paid a fixed periodic payment 4. If you decide not to exercise your pre-emptive rights, what is
your investment in the firm the rights offering? How is this
split between old shares and rights?
PRIMARY STOCK MARKETS
50,000 x 33.57 USD = 1,678,500 USD
Raise funds through new shares of stocks done through IPO 20,000 x 3.57 USD = 71,400 USD
1,749,900 USD

Market Value (before): 1,750,000 USD

MV Shares of Stocks: (1,749,900 USD)
100 USD (Loss)
Gross Proceeds – Net Proceeds = Underwriter’s Spread
SECONDARY STOCK MARKETS
Syndicate -the process of distributing securities through of
investment banks
Markets in which stocks, once issued, are traded that is, bought
and sold by investors.
Originating House -the lead banks in the syndicate which will
negotiate with the issuing company on behalf of the syndicates
In secondary markets, funds are exchanged, usually with the help
of a securities broker or firm acting as an intermediary.
Seasoned Offering -the sale of additional securities by a firm
whose securities are publicly traded
2 Major Stock Markets
Pre-Emptive Right -a right of the existing stockholders in which
New York Stock Exchange Euronext (NYSE)
new shares must be offered to existing shareholders first to
 largest in volume trading
maintain their proportionate ownership in the corporation
 traditionally benefited a firm by improving the stock's price,
generating increased publicity for the firm, and providing
easier access to primary market capital
National Association of Securities Dealers Automated Quotation
(NASDAQ)
 largest in number of firms
 The NASDAQ automatic order execution system for individual
traders placing buy or sell orders of 1,000 or fewer shares is
called the SOE System)
 World’s first electronic stock market
 Inside quotes are highest bid and lowest ask
TRADING PROCESS
Value Weighted
NYSE Composite Index -index consists of all common stocks in
NYSE and 4 subgroups: industrial, transportation, utility, and
financial companies
Standard’s & Poor’s 500 Index -consisting of the stocks of the top
500 of the largest US Corporations
The NASDAQ Composite Index - consists of 3 categories of
NASDAQ companies: industrial, banks and insurance companies

Trading Post- a specific place on the floor of the exchange where Wilshire 5000 Index -broadest stock market index and possible
transaction on the NYSE occur the most accurate reflection of the overall stock market

Specialist – exchange members who have an obligation to keep the
market kept going, maintaining liquidity in their assigned stock at
all times.
Firm Specialist – due to large amount of capital
Banks/underwriters: rarely allowed by the Exchange to become
specialists.
PROBLEM SOLVING
PRICE WEIGHTED INDEX (PWI) vs. VALUE WEIGHTED INDEX (VWI)
1. Suppose a stock index contains of 4 firms: w, x, y, z. the stock
prices for the 4 companies are $50, $25, $60, and $5
respectively., and the firms have 100M, 400M, 200M, 50M
shares outstanding, respectively.

 Brokers trade on behalf of the customer’s at market price

(market order)
 Limit orders are left with a specialist to be executed
 Transact their own account

Two types of Vast Orders

Market Order – An order to transact at the best price available 2. If the next day, share prices change to $55, $24, $62, and $6,
when the order reaches the post
respectively
Limit Order – An order to transact at a specified price
 Order Book – record of unexecuted limit orders

PURCHASE OF STOCK IN NYSE

Commission Broker – representative from market marker

Floor Broker – working for the broker

Program Trading -simultaneous buying and selling of a portfolio 3. If, after the market closes, company W undergoes a 2-for-1
of at least 15 different stocks valued at more than 1M USD, using a split, its stock price falls to $55/2 = $27.50, and the number
computer program to initiate the trades of shares increases to 200M. The prices now sum to $119.50.
What is the divisor? What is the new PWI?
CONTROVERSIAL TRADING PRACTICES
1. Flash Trading: for a fee, traders are allowed to see incoming
buy or sell orders milliseconds earlier then general markets
2. Naked Access: allows some traders to rapidly buy and sell
stocks directly on exchanges using a broker’s computer code
without exchanges or regulators always knowing who is
making the trade
3. Dark Pools of liquidity: trading networks that provide
liquidity but do not display trades on order books.

STOCK MARKET INDEXES

Stock Market Indexes: composite value of a group of secondary Company W

market-traded stocks. Number of shares= 100,000,000 shares 200,000,000 shares
Stock Price= 55 27.50
DOW JONES INDUSTRIAL AVERAGE 5,500,000,000 shares 5,500,000,000 shares
 most widely reported stock market index
 price-weighted index of 30 stocks chosen to represent the
overall market. 27.50 + 24 + 62 + 6 = $119.50 (sum of prices)
Stock split
 the same total value but different number of shares and price
per share
 2 for 1; 1 stock is equals to 2 stocks
 ⬆ number of shares; ⬇ stock price
Dividend Yield - stock’s dividends as a % of the stock’s current
price
Earnings Per Share (EPS) -is the portion of the company’s profit
that is allocated to each outstanding share in common stock.
Price/ PE = EPS
Price Earnings Ratio (P/E) – the ratio of a company’s share price
to the company’s EPS.
Price / EPS = PE
Types of Contracts
Spot Contract
 agreement made between a buyer and a seller at time 0 for
the seller to deliver the asset immediately and the buyer to
pay for the asset immediately.
Forward Contract
 agreement between the buyer and a seller at time 0 to
exchange a nonstandardized asset for cash at some future
date.
 The details of the asset and the price to be paid at the forward
contract expiration date are set at time 0.
 The price of the forward contract is fixed over the life of
the contract
Futures Contract
 Agreement between a buyer and a seller at time 0 to exchange
a standardized asset for cash at some future date.
 Each contract has a standardized expiration and transactions
occur in a centralized market.
 The price of the futures contract changes daily as the
market value of the asset underlying the futures fluctuates.

Market to Market
 describes the prices on outstanding futures contract that are
adjusted each day to reflect current futures market conditions
 means that the contract price is adjusted each day as the price
a. What was the dividend yield? of the underlying asset underlying the futures contract
changes as the contract approaches expiration.
 process of realizing gains and losses each day as the futures
contract changes in price.

b. What was the most recent four quarters of earnings per Difference of Forward Contract and Future Contract
share?
Forward contracts are bilateral contracts subject to
counterparty default risk, but the default risk on futures is
significantly reduced by the futures exchange guaranteeing to
indemnify counterparties against credit or default risk.
c. Valued at the closing price, what was the total dollar volume
of shares traded? Example: A credit forward is a forward agreement that hedges against an
increase in default risk on a loan after the loan has been created by a
lender.

Another difference relates to the contract’s price, which in a

forward contract is fixed over the life of the contract, whereas a
d. What was the stock price at the beginning of the year?
futures contract is marked to market daily.

(This means that the contract’s price is adjusted each day as the price of
the asset underlying the futures contract changes and as the contract
approaches expiration. Therefore, actual daily cash settlements occur
between the buyer and seller in response to these price changes (this is
called marking to market).

Futures Market

Open-outcry Auction -method of futures trading where traders

DERIVATIVES SECURITIES MARKETS face each other and “cry out” their offer to buy or sell a stated
number of futures contracts at a stated price
Derivative Securities Market -the markets in which derivatives
securities trade Open Interest -the total number of futures or options contract
outstanding at the beginning of the day.
Derivative Securities -an agreement between two parties to
exchange a standard quantity of an asset at a pre-determined price People involved in Future Market
at a specified date in the future
Floor Broker: exchange members who place trades from the public
Of the following, the most recent derivative security innovations
are, CREDIT DERIVATIVES
Professional Traders: Exchange members who trade for their own When to Buy or Write…
account
Call Option Put Option
Position Traders: Exchange members who take a position in the Buy when the underlying when the underlying
futures market based on their expectations about the future asset's price is expected asset's price is expected
direction of the prices of the underlying assets to rise to fall

Write (sell) when the underlying when the underlying

Day Traders: Exchange members who take position within a day asset's price is expected asset's price is expected
and liquidate it before day’s end to fall to rise

Scalpers: Exchange members who take position for very short

periods of time. Writing a put option results in a potentially limited gain and a
potentially unlimited loss.
Transaction in Future Contracts
Option Values
Long Position -a purchase of a futures contract The model most commonly used by traders to price and value
options is the BLACK-SCHOLES PRICING MODEL, which
Short Position -a sale of futures Contract examines five factors;
1. The spot price of the underlying asset
Clearinghouse -the unit that oversees trading on the exchange and 2. The exercise price of the option
guarantees all trades made by the exchange traders 3. The option’s exercise date
4. Price volatility of the underlying asset
Margin Requirements on Future Contracts 5. The risk-free rate of interest.

Initial Margin: a deposit required on futures trades to ensure that Intrinsic Value of an option -the difference between an options
the terms of any futures contract will be met. exercise price and the underlying asset

Maintenance Margin: the margin a futures trader must maintain
once a futures is taken, usually 75% of the initial margin. If losses
on the customer’s future position occur and the level of the funds
in the margin account drop below the maintenance margin, the
customer is required to deposit additional funds into his or her
margin account.
Margin Call
Leveraged Investment: An investment in which traders post and
maintain only a small portion of the value of their futures position
in their accounts. The vast majority of investment is borrowed
from the investor’s broker
OPTION
-a contract that gives the holder the right, but not the obligation to
buy or sell the underlying asset at a specified price within a
specified period of time
Call Options
- Gives the purchaser (buyer) the right to buy an underlying
security at a pre-specified price called the exercise or strike
price.
- In return, buyer must pay the seller an up-front fee called
“premium”
- Premium: negative cash flow for the buyer
- The following increases the price of call option:
i. Stock price
ii. Stock price volatility
iii. Interest rates
Time Value of an option -the difference between and option price
(premium) and its intrinsic value
Option Markets
The trading process for options is similar to that for the futures
contract.
Stock Option -the underlying asset on a stock option contract is the
stock of a publicly traded company. One option generally involves
100 shares of the underlying company’s stock.
Stock Index Options -the underlying asset on a stock index option
is the value of a major stock market index
Difference: at expiration, the stock index option holder cannot
settle the option contract with the actual purchase or sale of the
underlying stock index, rather it is settled in cash.
PROBLEM SOLVING
Calculating Profits and Losses on a Stock Option
You have purchased a put-on Micron Tech common stock. The has
an exercise price of $14 and Micron Tech’s stock currently trades
at $14.35. The option premium is $0.17 per contract.
1. Calculate your net profit on the option if Micron Tech’s stock
price falls to $13.25 and your exercise your option.

Put Options
- Gives the option buyer the right to sell an underlying
security at a specified price to the writer of the put option.
- American Option: can be exercised at any time before and on
expiration date. 2. Calculate your net profit on the option if Micron Tech’s stock
- European Option: exercised only on the expiration date. price does not change over the life of the option. Should you
- put option on common stock more valuable when there is a exercise option or not?
high level of
- Stock price volatility
- Exercise price