CHAPTER:3 oe Interactions between the Markets _ funds manager is to manage the cash flows in . the mosi efficient and profitable way. The manage- «5 .nvolves making sure that payments are made when eceived are invested at the highest possible return. ‘ng ‘c international markets, the funds manager also must eppropriate positions in various currencies. The desired positicas depend on the currencies of the cash flows involved as well as on thémanager's view of the currencies’ future values. Tne fends manager often has to operate within constraints imposed elsewhere in the organization, for example. a loan payment, while trying to reach a goalégf maximizing profits on excess funds or minimizing costs on borrowed fuhds. Ih this chapter we shall see-how funds manag- ets perform their duties by operating through the money and/or foreign exchange markets, To facilitate the initial presentation, we shall con- tinve to evoid getting involved in discussions involving bid and offer fates and talk only about “the rate" in each-market. This rate can be thought of as the midpoint between bid and offer rates. THE NATURE OF CASH FLOWS Cash flows are the raw material with which funds managers work. Cash is the stock in trade, whether its denomination is U.S. dollars, yen, Turkish liras, or some other currency. The major object of concern is the flow that is generated as cash balances increase or decrease. To define 4 cash flow properly, some of its characteristics must be specified. ‘Scanned with CamScannerEO §2 FORRICN RXCHANGE AND MONEY MARKETS ics include direction. currency. date, and location of . the given cash Tor jpjlows or ouffows. tis the nature of cash Rows ity rvkrae their direction through time. Ths, rate cash inflow eventually becomes an outflow. Specific examples of cash flows for a commercial bank and a nonfinancial business are presented below. The relationship between cash flows through time can be seen by comparing the entries under inflows and outflows (see lible below). ‘The currency. of a cush flow is another important characteristic of this flow. When dealing in one money market, the currency is obvious, the U.S. money market are denominated For example, all transactions in in U.S. dollars. However, in foreign exchange transactions there are always two currencies involved in the transaction—the currency being ‘These charact bought and the currency being sold. Cash Flows in-a Commercial Bank and a Nonfinancial Business prea Gommercial bank Nonfinancial business INFLOWS Receipt of proceeds from borrowings ‘Receipt of a deposit from a customer Receipt of repayment of a Coilection.of an account loan previously granted to receivable - inating eos : 5 of « deposit Termination of a deposit . nother bonk with a bank ~~ : ‘Scanned with CamScannerINTE RACTIONS BETWEEN THE MARKETS: 53 e identification of a cash i Tor ple, 03 a resull of ar gow Tequites the specification of dates. For : owings made, we will receive fund For niow) in Swiss francs in 2 business days, June 3 ne eayable (2 cash outflow) 30 days later, july 3 re Jane 9 They a describing these dates is the term value date. In nae arcs ee say that the Swiss franc inflow is the result of a iaecenead with ae gjote june 30, and maturing (producing an outflow) on ati July 20 ‘One more characteristic which identifies a cash flow is the lect where it is to occur. This place is usually identified in terms of the name ofan institution in a given country and city. For example, we can say that we will have a cash inflow in Swiss francs, value date Friday, to tive place in The Union Bank of Switzerland in Zurich. The bank and the city have probably been previously arranged with the pariy making the payment. The funds manager will want to verify that in each transaction the following characteristics of the given cash flow are well understood by all the parties to the transaction: 1. The name of the other party to the transaction 2. Whether the specific currency or money market instrament is being purchased or sold 3. The amount involved 4. The location where the funds or instrument purchased is wanted 5. The location where the other party wants the funds or instru- ment it purchased 6. The rate for this transaction 7. The value date ‘ifonly one of the above details is incorrect and the error is not discov- ered in time, it could be very costly to one or both of the parties to the transaction. . < a ‘Scanned with CamScannerINTERACTIONS BRTWEEN THE MARKETS: 55 Eligible Value Dates To be an eligible value date, a value date must be a business day in the home countries of the currencies involved in the transaction. In a money market transaction, only one currency and, therefore, one country are involved. However, in transactions in the foreign exchange market, two currencies are involved, the one bought and the one sold; therefore, to be an eligible date, the value date must be a business day in the coun- tries of both currencies being traded. In most countries business days are Monday through Friday, except when a holiday occurs on one of these days. However, in Moslem countries Friday is not part of the business week, but Saturday and Sunday are. : Let's first look at a normal business week without holidays in Europe and the United States. On Monday, the spot value date would be Wednesday, on Tuesday it would be Thursday, on Wednesday it would be Friday, on Thursday it would be Monday, and on Friday it would be Tuesday. Whenever there are ineligible days, such as weekends, we see that it is market practice to go forward to the next eligible business day. (See Exhibit 3.1.) Now, let's assume that Wednesday is a holiday in England. All inter- national money market transactions in sterling on Monday would be for value Thursday because Wednesday is a holiday. Likewise, exchange transactions for U.S. dollars against sterling on Monday would be for value Thursday. However, exchange transactions for U.S. dollars against continental European currencies, such as’ German marks or Swiss francs, on Monday would be for value Wednesday. It is important to note that it is quite possible for business in the country in which one or both parties of the transaction are located to be closed on a settlement date. This date is still eligible as a value date as long as businesses in those countries in which the payments have to be made are legally open. Thus, in our example, individuals in England can deal U.S. dollars against continental European currencies on Mon- day for value Wednesday. The fact that the English financial institutions are not open for business on that Wednesday does not interfere with the settlement of U.S. dollars and continental European currencies on that patine funds transfer to sce how the rule of - i - works. e ‘Scanned with CamScannerINTERACTIONS BETWEEN THR MARKETS’ OL , These operations will make the net cash flows for each currency on every value date equal to zero, except for the interests, The funds manager can conduct these operations in either the money market or the foreign exchange market. Operating in the Money Market If the funds manager chooses to operate in the money market, the net cash flows on June 30 will have to be balanced within the markets where they occur. That is, the proceeds from the pounds deposit will be in- vested in pounds, and the payment of dollars will be met with borrow- ings made in dollars. The cash-flow effects of these transactions are shown in Exhibit 3.4 Exhibit 3.4 shows that the funds manager has balanced the cash flows for each value date by making inflows roughly equal to outflows for each currency. The initial inflow in pounds on June 30 was offset by investing (placing) these pounds in the pound sterling money market. The outflow in dollars was met by borrowing in the U.S. dollar money market. As to the flows for September 30, the maturity of the placement made on June 30 was designed to match the maturity of the deposit in pounds. Likewise, the maturity of the U.S. dollar borrowings was designed to coincide with the inflow resulting from the loan made earlier, on June 30. Therefore, all cash flows are properly matched. The funds manager has no risk of being unable to mect u required outflow or of having to leave acquired funds idle for any period of time. . The profitability of the transactions initiated by the funds manager can be measured by the interest differential between the return received on the placement of the pounds and the interest paid on the borrowing of US. dollars. Assuming that the interest rate received for pounds is 13 percent, and that the interest rate paid for U.S. dollars is 10 percent, the funds manager has achieved the two cash-flow objectives while — making a 3 percent positive spread.‘Scanned with CamScannerINTERACTIONS DETWEEN THE MARKETS: 65 What we have just done is convert an interest differential (3 percent Per annum) into an exchange rate differential ($0.0180/£). The formula for converting interest differentials into exchange rate differentials ts, in ‘general terms: ——— Spot rate x interest rate differential X effective time fraction 100 In terms of our example, it is: 240005653323. BEB» GiB 100 12 1200 We determined that the exchange rate differential between the spot rate an orward rate for the pound agains! 1c must be 0.0180. This figure, 0.0180, is cal ie swap rate, and we shall isuss it at some length in future chapters. To determine the actual rate for the three-month pound against the U.S. dollar, we subtract (the forward pound is selling at a discount) the swap rate from the spot rate: Spot rate .4000/£ Swap rate ‘Three-month forward rate 20/£ Thus, if the foreign exchange market approach to the funds manager's problems yiclds the same rate of profit as the money market approach, 3 percent, the forward transaction (three-month purchase of pounds against U.S. dollars or sale of U.S. dollars against pounds) will be done at the forward rate of $2.3820/£. : . a Let's make sure that if we deal at a forward rate of $2.3820/£ for three-month delivery, we are making a 3 percent spread. To do that, we hare to develop angie Jaco, tn ne to coe a every th change rate differential ($0.0180/£) into an interest rate Percent per annum). We know that we are making $0.0180 months. Since we are interested in a per annum ‘Scanned with CamScannerINTRRACTIONS BRTWFKN THE MARKETS: 69 repayment of the U.S. dollar borrowings (when following the money market approach) or the dollars sold forward (when following the for- eign exchange approach) for delivery on September 30: the proceeds from the repayment of a loan granted to a customer. That is, the rate ‘on the forward cash flows was locked in from the beginning on June 30. In the last example, where we are just taking advantage of the interest differential, we have to wait until September 30 to find out what the prevailing spot rate of the pound against the USS. dollar will be to determine whether the dollar proceeds from the sale of pounds are sufficient to repay the loan, The funds manager had a square position in each currency for each date. From the beginning, June 30, the manager had arranged outflows va'el every inflow in each currency on each date. In the last exam- ple, where we are trying to take advantage of a disparity between the money market and the foreign exchange market as of June 30, we have a net exchange position. We are /ong in pounds (net overbought) and short in dollars (net oversold) for September 30. We know that on that date there will be an inflow of pounds for which we have not yet contracted a matching outflow. We also know that we will have to repay dollar borrowings on September 30, and, as yct, we have not contracted a matching inflow of funds. Whenever a net exchange position exists, we are vulnerable to changes in the spot rate of the currencies involved. In this specific case, if the spot rate of the pound depreciates against the dollar (or the dollar appreciates against the pound), we shall lose money. On the other hand, were the pound to appreciate against the dollar, gains would materialize. We can say that a funds manager who allows net positions to develop has assessed, implicitly or explicitly, the future development of the spot rates. Any change in these rates will saffect the profitability of the operation. Now, can qne benefit from the situation of disequilibrium between the money market and the foreign exchange market without assuming a net exchange position, that is, without waiting until September 30 to find out what spot rates prevail on that date? Yes, by using the forward exchange market. That is, we use the same approach as the funds manager used when managing the cash flows: we arrange the precise — size and timing : f future cash flows beforehand so that the dil | in prices and interest rates will be profitable to us. The Interest rage.""$ Pilics ‘Scanned with CamScannerARKETS 72-FORFIGN FXCHANGE AND MONEY M iT 37 aria DIFFERENTIALS AND THE FOREIGN EXCHANGE MARKET livid HH FX Discount trade figures which could be very much better or worse than market participants had expected. If the British trade figures are interpreted i ice, the spot rate for sterling might rise. If the Bank of England were to reduce drastically the in sterling, which would probably also cause a reduction of ~~ ae ing interest rate, then the assumed Swap rate (discount on sterling) Fees toca aes ee SO 0 ONI00 A mubetenial deine ieee rates usually also puts Pressure on a currency’ which in our example might move from 2.4000, Ree stones Fats,2 ARI WdMhe. 20, Fart will be the the forward rate clearly did not foll n= oe Minus inact tees pr ca on “ci . rd Scanned with CamScanner