Core Module

Core Module
INTERNATIONAL FINANCE
INTERNATIONAL FINANCE
Part 1
Part 1
Global
Global
Economics
Economics


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Bre
Lon
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Vale
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don
eille
cow
ncia
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AGENDA

Global Economics

International Accounting
Corporate Governance
International Investing
International Financing
Global Value Creating Management
Current Topics

Part 1

Part 2

Part 3

Part 4

Part 5

Part 6

Part 7
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AGENDA

Part 1

Chapter 1.1

Chapter 1.2

Chapter 1.3

Global Economics

Globalization Process
Foreign Exchange Theory Markets
Foreign Exchange Market
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THE GLOBALIZATION PROCESS:
THE GLOBALIZATION PROCESS:
Global Transition I
Global Transition I

Global Transition I - Global Transition I - Phase One: Domestic Operations Phase One: Domestic Operations
Trident Corporation Trident Corporation
(Los Angeles, USA) (Los Angeles, USA)
U.S. Suppliers U.S. Suppliers
(domestic) (domestic)
U.S. Buyers U.S. Buyers
(domestic) (domestic)
All payments in US $; All payments in US $;
All credit risk under U.S. law All credit risk under U.S. law

The globalization process is the structural and managerial The globalization process is the structural and managerial
changes and challenges experienced by a firm as it moves from changes and challenges experienced by a firm as it moves from
domestic to global in operations domestic to global in operations

Global Transition I Global Transition I = Trident moves from the domestic = Trident moves from the domestic
phase to the international trade phase phase to the international trade phase
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THE GLOBALIZATION PROCESS:
THE GLOBALIZATION PROCESS:
Global Transition I
Global Transition I

Canadian Buyers Canadian Buyers
Are Canadian buyers creditworthy? Are Canadian buyers creditworthy?
Will payment be made in US$ or C$? Will payment be made in US$ or C$?
Mexican Suppliers Mexican Suppliers
Are Mexican suppliers dependable? Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos? Will Trident pay US$ or Mexican pesos?
Trident Corporation Trident Corporation
(Los Angeles, USA) (Los Angeles, USA)
Global Transition I Global Transition I - - Phase Phase
Two: Expansion into Two: Expansion into
International Trade International Trade

Trident may not be global or international itself, yet its Trident may not be global or international itself, yet its
competitors, suppliers & buyers may be working across borders competitors, suppliers & buyers may be working across borders

This is often a key driver to push a firm like Trident into first This is often a key driver to push a firm like Trident into first
phase – international trade phase – international trade

The second half of this phase ( The second half of this phase (Global transition I Global transition I) is the ) is the
international trade phase international trade phase
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TRIDENT CORP: INITIATION OF GLOBALIZATION
TRIDENT CORP: INITIATION OF GLOBALIZATION
Global Transition I
Global Transition I

U.S. Suppliers U.S. Suppliers
(domestic) (domestic)
U.S. Buyers U.S. Buyers
(domestic) (domestic)
Phase One: Domestic Operations Phase One: Domestic Operations
All payments in US $; All payments in US $;
All credit risk under U.S. law All credit risk under U.S. law
Mexican Suppliers Mexican Suppliers Canadian Buyers Canadian Buyers
Phase Two: Expansion into International Trade Phase Two: Expansion into International Trade
Are Canadian buyers creditworthy? Are Canadian buyers creditworthy?
Will payment be made in US$ or C$? Will payment be made in US$ or C$?
Are Mexican suppliers dependable? Are Mexican suppliers dependable?
Will Trident pay US$ or Mexican pesos? Will Trident pay US$ or Mexican pesos?
Trident Corporation Trident Corporation
(Los Angeles, USA) (Los Angeles, USA)
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THE GLOBALIZATION PROCESS:
THE GLOBALIZATION PROCESS:
Global Transition I
Global Transition I

Trident responds to globalization factors by importing
Trident responds to globalization factors by importing
inputs from Mexican suppliers and making exports
inputs from Mexican suppliers and making exports
sales to Canadian buyers
sales to Canadian buyers

This stage is called the
This stage is called the
international trade phase
international trade phase

Exporting and importing products
Exporting and importing products
increases the
increases the
demands
demands
and
and
requirements
requirements
of a domestic only
of a domestic only
business
business
-
The first is direct
The first is direct
foreign exchange
foreign exchange
risks
risks
borne by Trident
borne by Trident


Trident may have
Trident may have
to quote prices and receive payments in
to quote prices and receive payments in
foreign currencies
foreign currencies
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THE GLOBALIZATION PROCESS
THE GLOBALIZATION PROCESS
Global Transition I: Risks
Global Transition I: Risks

Trident will now experience
Trident will now experience
significant
significant
risks
risks
from the
from the
daily
daily
volatility in exchange rates
volatility in exchange rates

Trident also faces
Trident also faces
risks
risks
associated with credit quality
associated with credit quality

and evaluation of international
and evaluation of international
counterparts:
counterparts:
-
This
This
credit risk
credit risk
management
management

task is much more difficult
task is much more difficult
in international business as
in international business as
buyers and suppliers are
buyers and suppliers are
new and subject to differing
new and subject to differing
business practices and legal
business practices and legal
systems
systems
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THE GLOBALIZATION PROCESS:
THE GLOBALIZATION PROCESS:
Global Transition II
Global Transition II

Is the move from the international trade phase to the
Is the move from the international trade phase to the
multinational phase
multinational phase

If Trident is successful in international trade then the
If Trident is successful in international trade then the
time will come for the next step in the globalization
time will come for the next step in the globalization
process
process
-
Trident will eventually need
Trident will eventually need
to establish foreign
to establish foreign

sales
sales
and
and
services
services
affiliates
affiliates
-
This step is followed by the establishment of
This step is followed by the establishment of
manufacturing operations
manufacturing operations
or licensing agreements
or licensing agreements
abroad
abroad
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THE GLOBALIZATION PROCESS
THE GLOBALIZATION PROCESS
Global Transition II
Global Transition II

Trident’s continued globalization will require it to
Trident’s continued globalization will require it to
identify the
identify the
sources of it competitive advantages
sources of it competitive advantages

This variety of strategic alternatives available to
This variety of strategic alternatives available to
Trident is called the
Trident is called the
foreign direct investment
foreign direct investment
sequence
sequence
-
These alternatives include the creation of foreign
These alternatives include the creation of foreign
sales offices, licensing agreements, manufacturing,
sales offices, licensing agreements, manufacturing,
etc.
etc.
Once Trident
Once Trident
owns
owns
assets and enterprises
assets and enterprises
in foreign
in foreign
countries
countries
it has entered the
it has entered the
multinational phase
multinational phase
of
of
globalization
globalization
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Trident and its Trident and its
Competitive Advantage Competitive Advantage
Exploit Existing Competit. Exploit Existing Competit.
Advantage Abroad Advantage Abroad
Change Change
Competitive Advantage Competitive Advantage
Licensing Licensing
Management Contract Management Contract
Control Assets Control Assets
Abroad Abroad
Acquisition of a Acquisition of a
Foreign Enterprise Foreign Enterprise
Greenfield Greenfield
Investment Investment
Production at Home: Production at Home:
Exporting Exporting
Production Abroad Production Abroad
Joint Venture Joint Venture
Wholly-Owned Wholly-Owned
Subsidiary Subsidiary
Greater Foreign Greater Foreign
Presence Presence
Greater Greater
Foreign Foreign
Investmen Investmen
t t
FOREIGN DIRECT INVESTMENT SEQUENCE
FOREIGN DIRECT INVESTMENT SEQUENCE
Global Transition II
Global Transition II
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FOREIGN EXCHANGE EXPOSURE
FOREIGN EXCHANGE EXPOSURE

Due to the fact that more cash flows (CF) are
Due to the fact that more cash flows (CF) are
denominated in foreign currencies, Trident and other
denominated in foreign currencies, Trident and other
corporations must manage these new exposures
corporations must manage these new exposures

There are three main
There are three main
foreign exchange exposures
foreign exchange exposures
that
that
must be managed by multinationals:
must be managed by multinationals:
-
Transaction Exposure
Transaction Exposure
comes from CF associated
comes from CF associated
from payments and receivables in foreign
from payments and receivables in foreign
currencies
currencies
-
Operating Exposure
Operating Exposure
comes from the changes in CF
comes from the changes in CF
caused by an unexpected change in exchange rates
caused by an unexpected change in exchange rates
-
Translation Exposure
Translation Exposure
is an accounting exposure
is an accounting exposure
associated with the restatement of foreign currency
associated with the restatement of foreign currency
denominated financial statements
denominated financial statements
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FOREIGN EXCHANGE EXPOSURE
FOREIGN EXCHANGE EXPOSURE
Moment in time when Moment in time when
exchange rate changes exchange rate changes
Time Time
Accounting exposure
Accounting exposure
Changes in reported owners’ equity Changes in reported owners’ equity
in consolidated financial statements in consolidated financial statements
caused by a change in exchange rates caused by a change in exchange rates
Transaction exposure
Transaction exposure
Impact of settling outstanding obligations entered into before change Impact of settling outstanding obligations entered into before change
in exchange rates but to be settled after change in exchange rates in exchange rates but to be settled after change in exchange rates
Operating exposure
Operating exposure
Changes in CF due to unexpected Changes in CF due to unexpected
changes in exchange rates changes in exchange rates
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FINANCING THE GLOBAL FIRM
FINANCING THE GLOBAL FIRM

As Trident prospers at home and abroad, it confronts
As Trident prospers at home and abroad, it confronts
a constraint on further growth – access to cheap and
a constraint on further growth – access to cheap and
plentiful capital can be difficult
plentiful capital can be difficult

This can be overcome by accessing global debt
This can be overcome by accessing global debt
and equity markets while maintaining an optimal
and equity markets while maintaining an optimal
financial structure
financial structure

The strategy of
The strategy of
globalizing the cost & availability
globalizing the cost & availability
of capital
of capital
is a critical one for firms wishing to
is a critical one for firms wishing to
reach true global competitiveness
reach true global competitiveness
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FOREIGN INVESTMENT DECISIONS
FOREIGN INVESTMENT DECISIONS

Foreign investment decisions combine both strategy
Foreign investment decisions combine both strategy
and finance
and finance

This strategy of expanding operations abroad leads to a
This strategy of expanding operations abroad leads to a
corporation’s transition into a multinational enterprise
corporation’s transition into a multinational enterprise

An MNE is defined as a firm that has operating
An MNE is defined as a firm that has operating
subsidiaries in countries outside of its home
subsidiaries in countries outside of its home
production & market
production & market

These firms also face evaluation of foreign located
These firms also face evaluation of foreign located
projects using a capital budgeting framework
projects using a capital budgeting framework

As Trident moves from a domestic operation towards a
As Trident moves from a domestic operation towards a
MNE, it faces new & considerable risks & returns
MNE, it faces new & considerable risks & returns
dependent upon the strategies employed for its
dependent upon the strategies employed for its
expansion
expansion
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FOREIGN INVESTMENT DECISIONS
FOREIGN INVESTMENT DECISIONS
Trident Europe Trident Europe
(Hamburg, Germany)
Greenfield Greenfield
Investment Investment
Trident Brazil Trident Brazil
(Sáo Paulo, Brazil) (Sáo Paulo, Brazil)
Cross-Border Cross-Border
Acquisition Investment Acquisition Investment
Trident China Trident China
(Shanghai, China) (Shanghai, China)
Joint Venture Joint Venture
Investment Investment
Trident Corporation Trident Corporation
(Los Angeles, USA) (Los Angeles, USA)
Greenfield Greenfield
Investment Investment
A long-term physical A long-term physical
investment in productive investment in productive
capability in that country capability in that country
Cross-Border Cross-Border
Acquisition Acquisition
Identification, valuation, Identification, valuation,
tender, and post-acquisition tender, and post-acquisition
management of an existing management of an existing
going-concern going-concern
Joint Venture Joint Venture
Investment Investment
Combining investment Combining investment
capital and managerial capital and managerial
know-how to reach know-how to reach
specific opportunities specific opportunities
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FOREIGN INVESTMENT ISSUES
FOREIGN INVESTMENT ISSUES

Other issues that firms face when expanding abroad
Other issues that firms face when expanding abroad
are
are

Corporate Governance
Corporate Governance
– the different corporate
– the different corporate
cultures encountered when dealing with firms
cultures encountered when dealing with firms
abroad
abroad

Global Portfolio Diversification
Global Portfolio Diversification
– the
– the
management of the risks and rewards needed to
management of the risks and rewards needed to
understand the various foreign operations and
understand the various foreign operations and
their effects on the domestic firm’s results
their effects on the domestic firm’s results
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MANAGING MULTINATIONAL OPERATIONS
MANAGING MULTINATIONAL OPERATIONS

Thus far the focus on Trident’s expansion into international Thus far the focus on Trident’s expansion into international
markets has been on operations and financing, but the markets has been on operations and financing, but the aim aim of of
management has not been addressed management has not been addressed

Trident must also address the objective of Trident must also address the objective of maximizing maximizing
shareholder value shareholder value. Then, . Then,

Trident must Trident must minimize minimize its its worldwide burden of taxation worldwide burden of taxation
-
Through transfer pricing (the prices charged on sales of Through transfer pricing (the prices charged on sales of
goods between units of Trident itself globally), Trident can goods between units of Trident itself globally), Trident can
reduce its global tax liabilities reduce its global tax liabilities
-
Trident can also assess charges from the parent (US) to the Trident can also assess charges from the parent (US) to the
subsidiaries (foreign) in the form of license fees and royalties subsidiaries (foreign) in the form of license fees and royalties
-
Trident must also consider the cash flow effects of blocked Trident must also consider the cash flow effects of blocked
funds (governmental regulations that hinder the movement of funds (governmental regulations that hinder the movement of
capital out of a country) capital out of a country)
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THE GOAL OF MANAGEMENT
THE GOAL OF MANAGEMENT

Two different points of view on the goal of
Two different points of view on the goal of
management
management

The Anglo-American markets believe that a
The Anglo-American markets believe that a
firm’s
firm’s
objective
objective
should be to
should be to
maximize shareholder
maximize shareholder
wealth
wealth
-
These countries include the US, Canada,
These countries include the US, Canada,
Australia, United Kingdom
Australia, United Kingdom

Shareholder believes that markets are efficient
Shareholder believes that markets are efficient
and that prices are correct
and that prices are correct
-
Follow financial theory about markets’
Follow financial theory about markets’
efficiency, systematic and unsystematic risk
efficiency, systematic and unsystematic risk
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THE GOAL OF MANAGEMENT
THE GOAL OF MANAGEMENT

The Continental European and Japanese markets
The Continental European and Japanese markets
believe that a
believe that a
firm’s objective
firm’s objective
should be to
should be to
maximize
maximize
corporate wealth
corporate wealth
-
These countries include the EU, Japan and Latin
These countries include the EU, Japan and Latin
American countries
American countries

Definition of corporate wealth is broader than Anglo-
Definition of corporate wealth is broader than Anglo-
American viewpoint that wealth is strictly financial
American viewpoint that wealth is strictly financial

A corporation’s role in wealth maximization includes
A corporation’s role in wealth maximization includes
the firm’s technical, market and human resources
the firm’s technical, market and human resources
-
Considerations as to the implications of strategic
Considerations as to the implications of strategic
moves affecting all parties, human resources,
moves affecting all parties, human resources,
towns, state, etc.
towns, state, etc.
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THE GOAL OF MANAGEMENT
THE GOAL OF MANAGEMENT
Shareholders Shareholders
Main Bank Main Bank
Firm Firm
(management) (management)
“ “Patient Capital” Patient Capital”
Shareholders Shareholders
Firm Firm
(management) (management)
Banks Banks Employees Employees
“ “Impatient Capital” Impatient Capital”
The Anglo-American Model has The Anglo-American Model has
been frequently criticized as been frequently criticized as
focusing on short-term profitability focusing on short-term profitability
rather than long-term growth. rather than long-term growth.
The Non-Anglo-American Model The Non-Anglo-American Model
has come under increasing criticism has come under increasing criticism
for its lack of accountability to equity for its lack of accountability to equity
investors – its shareholders – while investors – its shareholders – while
focusing on the demands of too focusing on the demands of too
diffuse a group of stakeholders. diffuse a group of stakeholders.
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CORPORATE GOVERNANCE
CORPORATE GOVERNANCE

These two approaches focus around the issue of
These two approaches focus around the issue of
corporate governance
corporate governance

Corporate Governance is the method by which an
Corporate Governance is the method by which an
organization establishes order among various
organization establishes order among various
stakeholders to ensure that decisions are made &
stakeholders to ensure that decisions are made &
interests are represented in line with the firm’s stated
interests are represented in line with the firm’s stated
objectives
objectives
-
These include failure’s (Enron), poor performance
These include failure’s (Enron), poor performance
(AT&T), and emerging markets (China)
(AT&T), and emerging markets (China)

As a result, companies are moving towards model of
As a result, companies are moving towards model of
“one share, one vote” in their corporate structures
“one share, one vote” in their corporate structures
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MINI - CASE
MINI - CASE

CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM
Individual Work
Individual Work
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

1. What do you believe a government expects to gain
1. What do you believe a government expects to gain
from privatizing major sectors like telecommunications?
from privatizing major sectors like telecommunications?

Privatization is often conducted in pursuit of both political and
Privatization is often conducted in pursuit of both political and
economic goals.
economic goals.

Politically, the recent trend globally has been toward market-
Politically, the recent trend globally has been toward market-
based economies, in which government ownership is to be
based economies, in which government ownership is to be
minimized.
minimized.

Economically, privatization is considered by many emerging
Economically, privatization is considered by many emerging
market countries as a significant way of raising capital and
market countries as a significant way of raising capital and
building globally competitive institutions and industries.
building globally competitive institutions and industries.
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

1. What do you believe a government expects to gain
1. What do you believe a government expects to gain
from privatizing major sectors like telecommunications?
from privatizing major sectors like telecommunications?

In the case of Brasil and the telecommunications sector, the
In the case of Brasil and the telecommunications sector, the
privatization auction
privatization auction
raised
raised
an
an
enormous amount of
enormous amount of
capital
capital
, as well as
, as well as
attracting foreign owners with world
attracting foreign owners with world
class experience in that specific industry
class experience in that specific industry
.
.

The hope was that
The hope was that
owners like Telecom Italia would
owners like Telecom Italia would
provide capital, technology, and managerial expertise
provide capital, technology, and managerial expertise
to
to
take the Brazilian telecom industry forward into the 21st
take the Brazilian telecom industry forward into the 21st
century.
century.
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

2. Why would two major investors like CVC/Opportunity and 2. Why would two major investors like CVC/Opportunity and
Telecom Italia create a partnership to gain control of a firm and Telecom Italia create a partnership to gain control of a firm and
then be unable to agree on the firm’s future strategy? then be unable to agree on the firm’s future strategy?

As is often the case with joint ventures and strategic alliances, As is often the case with joint ventures and strategic alliances,
the initial motivations for the partnership are not the same as the initial motivations for the partnership are not the same as
the long-term strategies of the individual players the long-term strategies of the individual players. .

Alone, either of the two parties could not have obtained the capital or Alone, either of the two parties could not have obtained the capital or
political links necessary to take control. political links necessary to take control.

However, CVC/Opportunity is primarily interested in building the However, CVC/Opportunity is primarily interested in building the
profitability of BT itself over time, whereas Telecom Italia sees BT as profitability of BT itself over time, whereas Telecom Italia sees BT as
only one element of a much larger and complex strategy for only one element of a much larger and complex strategy for
telecommunications industry penetration in Latin America as a telecommunications industry penetration in Latin America as a
whole. whole.
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

3. If you were in management at Brasil Telecom, how
3. If you were in management at Brasil Telecom, how
would the fighting between your owners alter your ability
would the fighting between your owners alter your ability
to do your job? What could you do to ‘manage your
to do your job? What could you do to ‘manage your
owners’?
owners’?

The tendency among most larger firms is for management to
The tendency among most larger firms is for management to
either make all major decisions or guide ownership’s interest
either make all major decisions or guide ownership’s interest
in those decisions.
in those decisions.

BT’s management, if it were to focus its attention on a daily
BT’s management, if it were to focus its attention on a daily
basis on the disagreements among its owners, would find
basis on the disagreements among its owners, would find
itself standing still.
itself standing still.



Managing owners’ is a difficult and dangerous process of
Managing owners’ is a difficult and dangerous process of
management.
management.
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

3. If you were in management at Brasil Telecom, how
3. If you were in management at Brasil Telecom, how
would the fighting between your owners alter your ability
would the fighting between your owners alter your ability
to do your job? What could you do to ‘manage your
to do your job? What could you do to ‘manage your
owners’?
owners’?

In the case of Brasil Telecom, it appeared from the very
In the case of Brasil Telecom, it appeared from the very
beginning that Telecom Italia would not be a long-term
beginning that Telecom Italia would not be a long-term
owner, and most of management had therefore sided with
owner, and most of management had therefore sided with
CVC/Opportunity for expedient reasons.
CVC/Opportunity for expedient reasons.

Management will typically try to ignore it to whatever degree
Management will typically try to ignore it to whatever degree
possible, and prevent ownership’s divided input from
possible, and prevent ownership’s divided input from
entering daily management and leadership.
entering daily management and leadership.

Unfortunately, for major strategic and capital decisions such
Unfortunately, for major strategic and capital decisions such
as the rate at which BT is to fulfill infrastructure obligations,
as the rate at which BT is to fulfill infrastructure obligations,
the owners must be involved.
the owners must be involved.
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CORPORATE GOBERNANCE AT BRASIL
CORPORATE GOBERNANCE AT BRASIL
TELECOM
TELECOM

4. If you were a minority investor in Brasil Telecom, holding some 4. If you were a minority investor in Brasil Telecom, holding some
of the publicly-traded shares, what rights do you believe you of the publicly-traded shares, what rights do you believe you
should have in the ownership-control debate? should have in the ownership-control debate?

Minority shareholder rights is a very controversial subject in global Minority shareholder rights is a very controversial subject in global
business today. business today.

Many countries have enacted complex laws to protect minority Many countries have enacted complex laws to protect minority
shareholders. (For example, in many countries like France a corporate shareholders. (For example, in many countries like France a corporate
raider may not acquire more than 30% ownership of the publicly traded raider may not acquire more than 30% ownership of the publicly traded
shares without making a public tender offer to all remaining shares without making a public tender offer to all remaining
shareholders.) shareholders.)

Most minority shareholders will realize that they will not have any real Most minority shareholders will realize that they will not have any real
voice in the future direction of the firm. voice in the future direction of the firm.

In this case, minority investors are increasingly passive owners. The In this case, minority investors are increasingly passive owners. The
debate, can, however, become increasingly complex as foreign debate, can, however, become increasingly complex as foreign
ownership like Telecom Italia starts appearing to abuse the rights of ownership like Telecom Italia starts appearing to abuse the rights of
domestic investors – minority investors and major investors – adding domestic investors – minority investors and major investors – adding
fuel to the fire of public debate. fuel to the fire of public debate.
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AGENDA
AGENDA

Part Part 1 1

Chapter 1.1 Chapter 1.1

Chapter 1.2 Chapter 1.2

Chapter 1.3 Chapter 1.3

Global Economics Global Economics

Globalization Process Globalization Process
Foreign Exchange Theory Markets Foreign Exchange Theory Markets
Foreign Exchange Market Foreign Exchange Market
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CURRENCY TERMINOLOGY
CURRENCY TERMINOLOGY

A
A
foreign currency exchange rate
foreign currency exchange rate
, or
, or
exchange rate
exchange rate
,
,

is the price of one country’s currency in units of
is the price of one country’s currency in units of
another country’s currency
another country’s currency
-
The system, or
The system, or
regime
regime
, is classified as a
, is classified as a
fixed,
fixed,
floating,
floating,
or
or
managed
managed
exchange rate regime
exchange rate regime
-
The rate at which the currency is
The rate at which the currency is
fixed, or
fixed, or
pegged
pegged
, is frequently referred to as its
, is frequently referred to as its
par value
par value
-
If the government doesn’t interfere in the
If the government doesn’t interfere in the
valuation of its currency, the currency is
valuation of its currency, the currency is
classified as
classified as
floating
floating
or
or
flexible
flexible
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CURRENCY TERMINOLOGY
CURRENCY TERMINOLOGY

Spot exchange rate
Spot exchange rate
is the quoted price for the foreign
is the quoted price for the foreign
exchange (FX) to be delivered at once, or in 2 days for
exchange (FX) to be delivered at once, or in 2 days for
interbank transactions
interbank transactions
Example:
Example:
(1) (1)


¥114/$
¥114/$


$ 1 = ¥ 114: is quoted for 114 yen to
$ 1 = ¥ 114: is quoted for 114 yen to
buy one US $ for immediate delivery
buy one US $ for immediate delivery

Devaluation
Devaluation
(
(
≠ Depreciation)
≠ Depreciation)
of a currency refers to a
of a currency refers to a
drop in FX value of a currency that is pegged to gold or
drop in FX value of a currency that is pegged to gold or
to another currency. The par value is reduced, the
to another currency. The par value is reduced, the
opposite of devaluation is
opposite of devaluation is
revaluation
revaluation
(1) (1) Sources for currency quotations; Sources for currency quotations;
http:// http://www www. .bloomberg bloomberg. .com com/ /markets markets/ /currencies currencies/ /fxc fxc. .html html
http:// http://www www. .reuters reuters. .com com/ /financeCurrencies financeCurrencies. .jhtml jhtml
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CURRENCY TERMINOLOGY
CURRENCY TERMINOLOGY
Current Quotations
Current Quotations
Backup
U.S. $ ¥en Euro Can $ U.K. £ Aust $ SFranc
1 US $ = 1.000 109.250 0.8098 1.329 0.5497 1.348 1.269
1 ¥en = 0.009153 1.000 0.007405 0.0122 0.005029 0.0123 0.0116
1 Euro = 1.234 134.910 1.000 1.641 0.6786 1.664 1.567
1 Can $ = 0.7523 82.070 0.6080 1.000 0.4131 1.013 0.9542
1 UK £ = 1.819 198.750 1.472 2.418 1.000 2.452 2.309
1 Aust $ = 0.7414 80.980 0.6001 0.9860 0.4074 1.000 0.9406
1 SFranc = 0.7878 86.070 0.6375 1.046 0.4327 0.9406 1.000
Source: www.reuters.com/financeCurrencies.jhtml 16 March 2004
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CURRENCY TERMINOLOGY
CURRENCY TERMINOLOGY

Weakening, deteriorating
Weakening, deteriorating
,
,
or
or
depreciation
depreciation
of a currency
of a currency
refers to a drop in foreign exchange value a floating
refers to a drop in foreign exchange value a floating
currency. The
currency. The
opposite
opposite
of weakening is
of weakening is
strengthening
strengthening

or
or
appreciating
appreciating
, which refers to a gain in the exchange
, which refers to a gain in the exchange
value of a floating currency.
value of a floating currency.

Soft
Soft
or
or
weak
weak
describes a currency that we expect to
describes a currency that we expect to
devalue or depreciate relative to major currencies;
devalue or depreciate relative to major currencies;
hard
hard

or
or
strong
strong
is the opposite.
is the opposite.


Eurocurrencies
Eurocurrencies
are another type of money although in
are another type of money although in
reality they are domestic currencies of a country
reality they are domestic currencies of a country
deposited in another country.
deposited in another country.

Example: a
Example: a
Euro$
Euro$
is a US $ denominated deposit in a
is a US $ denominated deposit in a
bank outside of the United States
bank outside of the United States
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ATTRIBUTES OF THE “IDEAL” CURRENCY
ATTRIBUTES OF THE “IDEAL” CURRENCY

Exchange rate stability
Exchange rate stability
– the value of the currency would
– the value of the currency would
be fixed in relationship to other currencies so traders &
be fixed in relationship to other currencies so traders &
investors could be relatively certain of the FX value of
investors could be relatively certain of the FX value of
each currency in the present & near future
each currency in the present & near future

Full financial integration
Full financial integration
– complete freedom of
– complete freedom of
monetary flows would be allowed, so traders and
monetary flows would be allowed, so traders and
investors could willingly and easily move funds from
investors could willingly and easily move funds from
one country to another in response to perceived
one country to another in response to perceived
economic opportunities or risk
economic opportunities or risk

Monetary independence
Monetary independence
– domestic monetary & interest
– domestic monetary & interest
rate policies would be set by each individual country to
rate policies would be set by each individual country to
pursue desired national economic policies, especially as
pursue desired national economic policies, especially as
they might relate to limiting inflation, combating
they might relate to limiting inflation, combating
recessions and fostering prosperity & full employment
recessions and fostering prosperity & full employment
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ATTRIBUTES OF THE “IDEAL” CURRENCY
ATTRIBUTES OF THE “IDEAL” CURRENCY
Increased Increased
Capital Mobility Capital Mobility
Full Financial Full Financial
Integration Integration
Monetary Monetary
Independence Independence
Exchange Exchange
Rate Stability Rate Stability
Pure Float Pure Float Monetary Union Monetary Union
Full Capital Controls Full Capital Controls
A country is limited to only two-sides per system. For example, if A country is limited to only two-sides per system. For example, if
a nation wishes to pursue a nation wishes to pursue Monetary Independence Monetary Independence and and Full Full
Financial Integration Financial Integration, it cannot simultaneously attain , it cannot simultaneously attain Exchange Exchange
Rate Stability Rate Stability. .
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ATTRIBUTES OF THE “IDEAL” CURRENCY
ATTRIBUTES OF THE “IDEAL” CURRENCY

This is referred to as
This is referred to as
The Impossible Trinity
The Impossible Trinity
because
because
a country must give up one of the 3 goals described
a country must give up one of the 3 goals described
by the sides of the triangle, monetary independence,
by the sides of the triangle, monetary independence,
exchange rate stability, or full financial integration.
exchange rate stability, or full financial integration.
The forces of economics do not allow the
The forces of economics do not allow the
simultaneous achievement of all 3
simultaneous achievement of all 3
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INTERNATIONAL PARITY CONDITIONS
INTERNATIONAL PARITY CONDITIONS

The economic theories which link
The economic theories which link
exchange rates,
exchange rates,
price levels, and interest rates
price levels, and interest rates
together are called
together are called
international parity conditions
international parity conditions

These theories may not always work out to be “true”
These theories may not always work out to be “true”
when compared to what students and practitioners
when compared to what students and practitioners
observe in the real world, but they are central to any
observe in the real world, but they are central to any
understanding of how markets run & multinational
understanding of how markets run & multinational
business is conducted
business is conducted
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PRICES AND EXCHANGE RATES
PRICES AND EXCHANGE RATES

The Law of one price
The Law of one price
states that all else being equal
states that all else being equal
(no transaction costs) a product’s price should be the
(no transaction costs) a product’s price should be the
same in all markets
same in all markets

Even if prices for a particular product are in different
Even if prices for a particular product are in different
currencies, the law of one price states that
currencies, the law of one price states that
P
$
× S = P
¥

Where: Where:

The price of the product in US $ (P The price of the product in US $ (P
$ $
), multiplied by the spot ), multiplied by the spot
exchange rate (S, exchange rate (S, ¥ ¥ per $), equals the price of the product in per $), equals the price of the product in
Japanese Japanese ¥ ¥ (P (P
¥ ¥
) )
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PRICES AND EXCHANGE RATES
PRICES AND EXCHANGE RATES

Conversely, if the prices were stated in local
Conversely, if the prices were stated in local
currencies, and markets were efficient, the
currencies, and markets were efficient, the
exchange rate could be deduced from the relative
exchange rate could be deduced from the relative
local product prices
local product prices
$
P
P
S

Where:
Where:
γ
γ
=
=
¥
¥
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PURCHASING POWER PARITY (PPP) &
PURCHASING POWER PARITY (PPP) &
THE LAW OF ONE PRICE
THE LAW OF ONE PRICE

If the Law of One Price were true for all goods, the
If the Law of One Price were true for all goods, the
purchasing power parity (PPP)
purchasing power parity (PPP)
exchange rate could
exchange rate could
be found from any set of prices
be found from any set of prices

Through price comparison, prices of individual
Through price comparison, prices of individual
products can be determined through the PPP
products can be determined through the PPP
exchange rate
exchange rate

This is the
This is the
absolute theory of
absolute theory of
PPP
PPP

Absolute PPP states that the spot exchange rate
Absolute PPP states that the spot exchange rate
is determined by the relative prices of similar
is determined by the relative prices of similar
basket of goods
basket of goods
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THE BIG MAC HAMBURGER STANDARD
THE BIG MAC HAMBURGER STANDARD

The
The
Economist
Economist
developed the
developed the
Big Mac Standard to
Big Mac Standard to
track PPP
track PPP
:
:

Assuming that a Big Mac is identical in all countries,
Assuming that a Big Mac is identical in all countries,
it serves as a comparison point as to whether or not
it serves as a comparison point as to whether or not
currencies are trading at market prices
currencies are trading at market prices

Big Mac in Switzerland costs Sfr6.30 while the same
Big Mac in Switzerland costs Sfr6.30 while the same
Big Mac in the US costs $2.54
Big Mac in the US costs $2.54

The implied PPP of this exchange rate is
The implied PPP of this exchange rate is
$ Sfr2.4803/
$2.54
Sfr6.30
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THE BIG MAC HAMBURGER STANDARD
THE BIG MAC HAMBURGER STANDARD

However, on the date of the survey, the actual
However, on the date of the survey, the actual
exchange rate was Sfr1.73/$, therefore the Swiss
exchange rate was Sfr1.73/$, therefore the Swiss
franc ($) is overvalued (undervalued) by:
franc ($) is overvalued (undervalued) by:
43.37% or 1.4337
Sfr1.73
Sfr2.4803
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RELATIVE PURCHASING POWER PARITY
RELATIVE PURCHASING POWER PARITY

If the assumptions of absolute PPP theory are relaxed,
If the assumptions of absolute PPP theory are relaxed,
we observe
we observe
relative purchasing power parity
relative purchasing power parity

This idea is that PPP is not particularly helpful in
This idea is that PPP is not particularly helpful in
determining what the spot rate is today, but that
determining what the spot rate is today, but that
the
the
relative change in prices between countries over a
relative change in prices between countries over a
period of time determines the change in exchange
period of time determines the change in exchange
rates
rates

Moreover,
Moreover,
if the spot rate between 2 countries starts
if the spot rate between 2 countries starts
in equilibrium, any change in the differential rate of
in equilibrium, any change in the differential rate of
inflation between them tends to be offset over the
inflation between them tends to be offset over the
long run by an equal but opposite change in spot rate
long run by an equal but opposite change in spot rate

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INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES

Prices between countries are related by exchange
Prices between countries are related by exchange
rates and now we discuss how exchange rates are
rates and now we discuss how exchange rates are
linked to interest rates
linked to interest rates

The Fisher Effect
The Fisher Effect
states that
states that
nominal interest rates in
nominal interest rates in
each country are equal to the required real rate of
each country are equal to the required real rate of
return plus compensation for expected inflation.
return plus compensation for expected inflation.


As a
As a
formula, the Fisher Effect is:
formula, the Fisher Effect is:
i
i
= r +
= r +
π
π
+ r
+ r
π
π


Where Where i i is the nominal rate, is the nominal rate, r r is the real rate of interest, and is the real rate of interest, and
π
π is is
the expected rate of inflation over the period of time the expected rate of inflation over the period of time

The cross-product term, The cross-product term, r r
π
π, , is usually dropped due to its is usually dropped due to its
relatively minor value relatively minor value
(1 + i)
(1 + i)
= (1 + r) x (1 +
= (1 + r) x (1 +
π
π
)
)


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INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES

Applied to 2 different countries, like the US and Japan,
Applied to 2 different countries, like the US and Japan,
the Fisher Effect would be stated as
the Fisher Effect would be stated as
i i = r + = r +
π
π ; ; i i = r + = r +
π
π
$ $ $ ¥ ¥ ¥

It should be noted that this requires a forecast of the
It should be noted that this requires a forecast of the
future rate of inflation, not what inflation has been, and
future rate of inflation, not what inflation has been, and
predicting the future can be difficult!
predicting the future can be difficult!
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INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES

The
The
international Fisher effect
international Fisher effect
, or Fisher-open
, or Fisher-open
, states
, states
that the
that the
spot exchange rate should change in an
spot exchange rate should change in an
amount equal to, but in the opposite direction, of the
amount equal to, but in the opposite direction, of the
difference in interest rates between countries
difference in interest rates between countries

if we were to use the US $ and the Japanese
if we were to use the US $ and the Japanese
¥,
¥,
the
the
expected change in the spot exchange rate between
expected change in the spot exchange rate between
the $ and
the $ and
¥
¥
should be (in approximate form):
should be (in approximate form):
i i 100 x
S
S S
$
2
2 1
¥
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Justification for the international Fisher effect is that
Justification for the international Fisher effect is that
investors must be rewarded or penalized to offset the
investors must be rewarded or penalized to offset the
expected change in exchange rates
expected change in exchange rates

The international Fisher effect predicts that with
The international Fisher effect predicts that with
unrestricted capital flows, an investor should be
unrestricted capital flows, an investor should be
indifferent between investing in $ or
indifferent between investing in $ or
¥
¥
bonds, since
bonds, since
investors worldwide would see the same opportunity
investors worldwide would see the same opportunity
and compete it away
and compete it away
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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The Forward Rate
The Forward Rate

A
A
forward rate
forward rate
is an exchange rate quoted today
is an exchange rate quoted today
for settlement at some future date
for settlement at some future date

The forward exchange agreement between
The forward exchange agreement between
currencies states the rate of exchange at which
currencies states the rate of exchange at which
a foreign currency will be bought or sold
a foreign currency will be bought or sold
forward
forward
at a specific date in the future (typically
at a specific date in the future (typically
30, 60, 90, 180, 270 or 360 days)
30, 60, 90, 180, 270 or 360 days)

The forward rate is calculated by adjusting the
The forward rate is calculated by adjusting the
current spot rate by the ratio of euro currency
current spot rate by the ratio of euro currency
interest rates of the same maturity for the two
interest rates of the same maturity for the two
subject currencies
subject currencies
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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The Forward Rate
The Forward Rate
360
90
x i 1
360
90
x i 1
x S F
$
FC
FC/$ FC/$
90
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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The Forward Rate example with spot rate of Sfr1.4800/$,
The Forward Rate example with spot rate of Sfr1.4800/$,
a 90-day euro Swiss franc deposit rate of 4.00% p.a. (per
a 90-day euro Swiss franc deposit rate of 4.00% p.a. (per
annum) and a 90-day euro-$ deposit rate of 8.00% p.a.
annum) and a 90-day euro-$ deposit rate of 8.00% p.a.
$ Sfr1.4655/
1.02
1.01
x Sfr1.4800
360
90
x 0.800 1
360
90
x 0.400 1
x Sfr1.4800
Sfr/$
90
F · ·
+
+
·
]
]
]

·
`

'
|
]
]
]

·
`

'
|
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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The
The
forward premium
forward premium
or
or
discount
discount
is the percentage
is the percentage
difference between the spot and forward rates stated in
difference between the spot and forward rates stated in
annual percentage terms
annual percentage terms
100 x
days
360
x
Spot
Spot - Foward
f
FC
·

For direct
For direct
(indirect)
(indirect)
quotes ($/FC, home currency per foreign
quotes ($/FC, home currency per foreign
currency unit)
currency unit)
(FC/$, foreign currency per home currency
(FC/$, foreign currency per home currency
units)
units)


The valued or quoted Currency is FC (Foreign
The valued or quoted Currency is FC (Foreign
Currency)
Currency)
(Home currency = $)
(Home currency = $)
:
:

F > S
F > S


Premium Forward of quoted currency
Premium Forward of quoted currency

F < S
F < S


Discount Forward of quoted currency
Discount Forward of quoted currency
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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Using the previous Sfr example, the forward
Using the previous Sfr example, the forward
discount or premium would be as follows:
discount or premium would be as follows:
p.a. 3.96% 100 x
90
360
x
Sfr1.4655
Sfr1.4655 - Sfr1.4800
f
Sfr
+ · ·
100 x
days
360
x
Foward
Foward - Spot
f
FC
·
The positive sign indicates that the Swiss franc is selling
The positive sign indicates that the Swiss franc is selling
forward at a premium of 3.96% per annum (it takes 3.96%
forward at a premium of 3.96% per annum (it takes 3.96%
more $ to get a franc at the 90-day forward rate)
more $ to get a franc at the 90-day forward rate)
INTEREST RATES AND EXCHANGE RATES
INTEREST RATES AND EXCHANGE RATES
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INTEREST RATE PARITY (IRP)
INTEREST RATE PARITY (IRP)

IRP theory provides the linkage between foreign
IRP theory provides the linkage between foreign
exchange markets and international money markets
exchange markets and international money markets

The theory states that the difference in the national
The theory states that the difference in the national
interest rates for securities of similar risk and
interest rates for securities of similar risk and
maturity should be equal to, but opposite sign to, the
maturity should be equal to, but opposite sign to, the
forward rate discount or premium for the foreign
forward rate discount or premium for the foreign
currency, except for transaction costs
currency, except for transaction costs

In the diagram in the following slide, a US $-based
In the diagram in the following slide, a US $-based
investor with $1 million to invest, is shown
investor with $1 million to invest, is shown
indifferent between $-denominated securities for 90
indifferent between $-denominated securities for 90
days earning 8.00% per annum, or Swiss franc-
days earning 8.00% per annum, or Swiss franc-
denominated securities of similar risk and maturity
denominated securities of similar risk and maturity
earning 4.00% per annum, when “cover” against
earning 4.00% per annum, when “cover” against
currency risk is obtained with a forward contract
currency risk is obtained with a forward contract
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90 days 90 days
S = SF 1.4800/$ S = SF 1.4800/$
SF 1,480,000 SF 1,480,000
Dollar money market Dollar money market
$1,000,000 $1,000,000 $1,020,000 $1,020,000 × × 1.02 1.02
Start Start End End
i i
$ $
= 8.00 % per annum = 8.00 % per annum
(2.00 % per 90 days) (2.00 % per 90 days)
Swiss franc money market Swiss franc money market
SF 1,494,800 SF 1,494,800 × × 1.01 1.01
i i
SF SF
= 4.00 % per annum = 4.00 % per annum
(1.00 % per 90 days) (1.00 % per 90 days)

Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment. Note that the Swiss franc investment yields $1,019,993, $7 less on a $1 million investment.
F F
90 90
= SF 1.4655/$ = SF 1.4655/$
$1,019,993 $1,019,993
* *
INTEREST RATE PARITY (IRP)
INTEREST RATE PARITY (IRP)
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EXCHANGE RATE DETERMINATION (I)
EXCHANGE RATE DETERMINATION (I)

Three basic approaches
Three basic approaches

Parity conditions
Parity conditions

Balance of Payments
Balance of Payments

Asset market
Asset market

These theories are not competing theories but
These theories are not competing theories but
complimentary ones.
complimentary ones.

Along with an understanding of the theories, an
Along with an understanding of the theories, an
understanding of the
understanding of the
complexities of international
complexities of international
political economy, societal and economic
political economy, societal and economic
infrastructures, and random political and social events
infrastructures, and random political and social events
is needed when viewing the foreign exchange markets
is needed when viewing the foreign exchange markets
.
.
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EXCHANGE RATE DETERMINATION (II)
EXCHANGE RATE DETERMINATION (II)

Infrastructure weaknesses
Infrastructure weaknesses
were among the major
were among the major
causes of the exchange rate collapses
causes of the exchange rate collapses
in emerging
in emerging
markets in the late 1990s.
markets in the late 1990s.

Speculation
Speculation
contributed greatly to the emerging
contributed greatly to the emerging
market crises.
market crises.

Uncovered interest rate arbitrage
Uncovered interest rate arbitrage
caused by extremely
caused by extremely
low interest rates in Japan coupled with high real
low interest rates in Japan coupled with high real
interest rates in the US was a problem in the 1990s.
interest rates in the US was a problem in the 1990s.
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EXCHANGE RATE DETERMINATION (III)
EXCHANGE RATE DETERMINATION (III)

Cross-border foreign direct investment and
Cross-border foreign direct investment and
international portfolio investment into emerging
international portfolio investment into emerging
markets
markets
dried up during the recent crises.
dried up during the recent crises.

Foreign political risks
Foreign political risks
have been much reduced in
have been much reduced in
recent years as capital markets became less
recent years as capital markets became less
segmented from each other and more liquid.
segmented from each other and more liquid.

Finally, note that
Finally, note that
most determinants of spot exchange
most determinants of spot exchange
rates are also in turn affected by changes in the spot
rates are also in turn affected by changes in the spot
rate
rate
– in other words, they are not only linked but
– in other words, they are not only linked but
mutually determined.
mutually determined.
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EXCHANGE RATE DETERMINATION (IV)
EXCHANGE RATE DETERMINATION (IV)
Parity Conditions Parity Conditions
1. Relative inflation rates 1. Relative inflation rates
2. Relative interest rates 2. Relative interest rates
3. Forward exchange rates 3. Forward exchange rates
4. Interest rate parity 4. Interest rate parity
Balance of Payments Balance of Payments
1. Current account balances 1. Current account balances
2. Portfolio investment 2. Portfolio investment
3. Foreign direct investment 3. Foreign direct investment
4. Exchange rate regimes 4. Exchange rate regimes
5. Official monetary reserves 5. Official monetary reserves
Asset Approach Asset Approach
1. Relative interest rates 1. Relative interest rates
2. Prospects for economic growth 2. Prospects for economic growth
3. Supply & demand for assets 3. Supply & demand for assets
4. Outlook for political stability 4. Outlook for political stability
5. Speculation & liquidity 5. Speculation & liquidity
6. Political risks & controls 6. Political risks & controls
Spot
Exchange
Rate
Is there a well-developed Is there a well-developed
and liquid money and and liquid money and
capital market in that capital market in that
currency? currency?
Is there a sound and Is there a sound and
secure banking system secure banking system
in-place to support in-place to support
currency trading currency trading
activities? activities?
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FORECASTING IN PRACTICE (I)
FORECASTING IN PRACTICE (I)

Short-term forecasts are typically motivated by a
Short-term forecasts are typically motivated by a
desire to hedge
desire to hedge
a receivable, payable, or dividend for
a receivable, payable, or dividend for
perhaps a period of 3 months.
perhaps a period of 3 months.

Here,
Here,
long run economic fundamental
long run economic fundamental
analysis may not serve the purpose as
analysis may not serve the purpose as
well as
well as
technical factors in the
technical factors in the
marketplace, government
marketplace, government
intervention, news and passing
intervention, news and passing
whims of traders and investors
whims of traders and investors
.
.
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FORECASTING IN PRACTICE (II)
FORECASTING IN PRACTICE (II)
SHORT-RUN SHORT-RUN Fixed Rate Fixed Rate 1. Assume fixed rate is maintained 1. Assume fixed rate is maintained
2. Indications of stress on fixed rate? 2. Indications of stress on fixed rate?
3. Capital controls, black market rates 3. Capital controls, black market rates
4. Indicators of government's capability to maintain fixed rate? 4. Indicators of government's capability to maintain fixed rate?
5. Changes in official reserves 5. Changes in official reserves
SHORT-RUN SHORT-RUN Floating Rate Floating Rate 1.Technical methods which capture trend 1.Technical methods which capture trend
2. Forward rates as forecasts 2. Forward rates as forecasts
a. <30 days, assume random walk a. <30 days, assume random walk
b. 30-90 days, forward rates b. 30-90 days, forward rates
3. 90-360 days, combine trend with fundamental analysis 3. 90-360 days, combine trend with fundamental analysis
4. Fundamental analysis of inflationary concerns 4. Fundamental analysis of inflationary concerns
5. Government declarations and agreements regarding exchange rate goals 5. Government declarations and agreements regarding exchange rate goals
6. Cooperative agreements with other countries 6. Cooperative agreements with other countries
Forecast Period Forecast Period Regime Regime Recommended Forecast Methods: Variables to consider Recommended Forecast Methods: Variables to consider
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FORECASTING IN PRACTICE (III)
FORECASTING IN PRACTICE (III)
LONG-RUN LONG-RUN Fixed Rate Fixed Rate 1. Fundamental analysis 1. Fundamental analysis
2. BOP management 2. BOP management
3. Ability to control domestic inflation 3. Ability to control domestic inflation
4. Ability to generate hard currency reserves to use for intervention 4. Ability to generate hard currency reserves to use for intervention
5. Ability to run trade surpluses 5. Ability to run trade surpluses
LONG-RUN LONG-RUN Floating Rate Floating Rate 1.Focus on inflationary fundamentals and PPP 1.Focus on inflationary fundamentals and PPP
2. Indicators of general economic health such as economic growth and 2. Indicators of general economic health such as economic growth and
stability stability
3. Technical analysis of long-term trends; new research indicates possibility 3. Technical analysis of long-term trends; new research indicates possibility
of long-term technical “waves” of long-term technical “waves”
Forecast Period Forecast Period Regime Regime Recommended Forecast Methods: Variables to consider Recommended Forecast Methods: Variables to consider
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AGENDA
AGENDA

Part Part 1 1

Chapter 1.1 Chapter 1.1

Chapter 1.2 Chapter 1.2

Chapter 1.3 Chapter 1.3

Global Economics Global Economics

Globalization Process Globalization Process
Foreign Exchange Theory Markets Foreign Exchange Theory Markets
Foreign Exchange Market Foreign Exchange Market
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FOREIGN EXCHANGE MARKETS (I)
FOREIGN EXCHANGE MARKETS (I)

The FOREX market provides the physical and institutional The FOREX market provides the physical and institutional
structure through which the money of one country is exchanged structure through which the money of one country is exchanged
for that of another country. for that of another country.

A foreign exchange transaction is an agreement between a A foreign exchange transaction is an agreement between a
buyer and a seller that a fixed amount of one currency will be buyer and a seller that a fixed amount of one currency will be
delivered for some other currency at a specified rate. delivered for some other currency at a specified rate.

There are 6 main characteristics of the FOREX markets which There are 6 main characteristics of the FOREX markets which
will be discussed: will be discussed:

The geographic extent The geographic extent

The 3 main functions The 3 main functions

The market’s participants The market’s participants

Its daily transaction volume Its daily transaction volume

Types of transactions including spot, forward and swaps Types of transactions including spot, forward and swaps

Methods of stating exchange rates, quotations, and changes Methods of stating exchange rates, quotations, and changes
in exchange rates in exchange rates
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GEOGRAPHIC EXTENT OF THE MARKET (I)
GEOGRAPHIC EXTENT OF THE MARKET (I)

Geographically, the FOREX market spans the globe
Geographically, the FOREX market spans the globe
with prices moving and currencies trading on a 24
with prices moving and currencies trading on a 24
hour basis.
hour basis.

Major exchanges are located in Singapore, Hong
Major exchanges are located in Singapore, Hong
Kong and Tokyo in the East.
Kong and Tokyo in the East.

Then it moves to Bahrain, and London for the
Then it moves to Bahrain, and London for the
European area.
European area.

And on to New York, San Francisco and Sydney.
And on to New York, San Francisco and Sydney.
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GEOGRAPHIC EXTENT OF THE MARKET (II)
GEOGRAPHIC EXTENT OF THE MARKET (II)
0
5.000
10.000
15.000
20.000
25.000
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24
Measuring FOREX Market Activity: Average Electronic Conversations Per Hour
Greenwich Mean Time
Tokyo
opens
Asia
closing
10 AM
In Tokyo
Afternoon
in America
London
closing
6 pm
In NY
Americas
open
Europe
opening
Lunch
In Tokyo
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FUNCTIONS OF THE FOREX MARKET
FUNCTIONS OF THE FOREX MARKET

The FOREX market is the mechanism by which participants The FOREX market is the mechanism by which participants
transfer purchasing power between countries, obtains or transfer purchasing power between countries, obtains or
provides credit for international trade, and minimizes exposure provides credit for international trade, and minimizes exposure
to exchange rate risk. to exchange rate risk.

Transferring of purchasing power Transferring of purchasing power is necessary because is necessary because
international trade and capital transactions normally international trade and capital transactions normally
involve parties in countries with different currencies yet involve parties in countries with different currencies yet
each party wishes to transact in their own currency. each party wishes to transact in their own currency.

Because the movement of goods between countries takes Because the movement of goods between countries takes
time, inventory in transit must be financed. The FOREX time, inventory in transit must be financed. The FOREX
market provides a market provides a source of credit source of credit via specialized via specialized
instruments such as letters of credit. instruments such as letters of credit.

The FOREX market provides The FOREX market provides “hedging” “hedging” facilities for facilities for
transferring foreign exchange risk to someone else more transferring foreign exchange risk to someone else more
willing to carry that risk. willing to carry that risk.
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MARKET PARTICIPANTS
MARKET PARTICIPANTS

The FOREX market consists of 2 tiers, the interbank or
The FOREX market consists of 2 tiers, the interbank or
wholesale market, and the client or retail market.
wholesale market, and the client or retail market.

5 broad categories of participants operate within these
5 broad categories of participants operate within these
2 tiers:
2 tiers:

Bank and non bank foreign exchange dealers.
Bank and non bank foreign exchange dealers.

Individuals and firms conducting commercial or
Individuals and firms conducting commercial or
investment transactions.
investment transactions.

Speculators and arbitragers.
Speculators and arbitragers.

Central banks and treasuries.
Central banks and treasuries.

Foreign exchange brokers.
Foreign exchange brokers.
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BANK AND NON-BANK DEALERS (I)
BANK AND NON-BANK DEALERS (I)

These participants profit from buying currencies at a
These participants profit from buying currencies at a
bid price
bid price
and then reselling them at an
and then reselling them at an
offer or ask
offer or ask
price
price
.
.

Competition among dealers narrows the
Competition among dealers narrows the
spread
spread

between the bid and offer rate contributing to the
between the bid and offer rate contributing to the
market’s efficiency.
market’s efficiency.

Dealers on behalf of large international banks often act
Dealers on behalf of large international banks often act
as
as
market makers
market makers
, often willing to stand in and buy or
, often willing to stand in and buy or
sell these currencies without having a counterpart with
sell these currencies without having a counterpart with
which to unload the “inventory”.
which to unload the “inventory”.
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BANK AND NON-BANK DEALERS (II)
BANK AND NON-BANK DEALERS (II)

They trade amongst other banks and dealers in order
They trade amongst other banks and dealers in order
to keep their inventory levels at manageable levels.
to keep their inventory levels at manageable levels.

Currency trading is profitable and often contributes
Currency trading is profitable and often contributes
between 10% - 20% of a banks’ average net income.
between 10% - 20% of a banks’ average net income.

Small- to medium-sized banks rarely act as market
Small- to medium-sized banks rarely act as market
makers yet still participate in the interbank market.
makers yet still participate in the interbank market.
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INDIVIDUALS AND FIRMS CONDUCTING
INDIVIDUALS AND FIRMS CONDUCTING
COMMERCIAL/INVESTMENT TRANSACTIONS
COMMERCIAL/INVESTMENT TRANSACTIONS

Importers, exporters, portfolio investors, MNEs,
Importers, exporters, portfolio investors, MNEs,
tourists and others use the FOREX market to facilitate
tourists and others use the FOREX market to facilitate
execution of commercial or investment transactions.
execution of commercial or investment transactions.

Some of these participants use the market to
Some of these participants use the market to
hedge
hedge

foreign exchange rate risk.
foreign exchange rate risk.
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SPECULATORS AND ARBITRAGERS
SPECULATORS AND ARBITRAGERS

Speculators and arbitragers seek to profit from trading
Speculators and arbitragers seek to profit from trading
in the market itself.
in the market itself.

They operate for their own interest, without need or
They operate for their own interest, without need or
obligation to serve clients or ensure a continuous
obligation to serve clients or ensure a continuous
market.
market.

Speculators seek all their profit from exchange rate
Speculators seek all their profit from exchange rate
changes.
changes.

Arbitragers try to profit from simultaneous differences
Arbitragers try to profit from simultaneous differences
in exchange rates in different markets.
in exchange rates in different markets.

A large proportion of speculation and arbitrage is
A large proportion of speculation and arbitrage is
conducted on behalf of major banks by traders
conducted on behalf of major banks by traders
employed by those banks.
employed by those banks.
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CENTRAL BANKS AND TREASURIES
CENTRAL BANKS AND TREASURIES

Central banks and treasuries use the market to
Central banks and treasuries use the market to
acquire or spend their country’s currency reserves
acquire or spend their country’s currency reserves
as well as to influence the price at which their own
as well as to influence the price at which their own
currency trades.
currency trades.

They may act to support the value of their currency
They may act to support the value of their currency
because of their government’s policies or
because of their government’s policies or
obligations or because of commitments entered
obligations or because of commitments entered
through joint float agreements such as the European
through joint float agreements such as the European
Monetary System (EMS).
Monetary System (EMS).

Consequently their motive is not to profit but rather
Consequently their motive is not to profit but rather
influence the foreign exchange value of their
influence the foreign exchange value of their
currency in a manner that will benefit their interests.
currency in a manner that will benefit their interests.
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FOREIGN EXCHANGE BROKERS
FOREIGN EXCHANGE BROKERS

Foreign exchange brokers are agents who facilitate
Foreign exchange brokers are agents who facilitate
trading between dealers without themselves
trading between dealers without themselves
becoming principals in the transaction.
becoming principals in the transaction.

For this service they charge a small commission.
For this service they charge a small commission.

They maintain instant access to hundreds of dealers
They maintain instant access to hundreds of dealers
worldwide via open lines and at times may maintain
worldwide via open lines and at times may maintain
such lines with several banks, with separate lines for
such lines with several banks, with separate lines for
differing currencies, spot and forward rates.
differing currencies, spot and forward rates.
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TRANSACTIONS IN THE INTERBANK MARKET
TRANSACTIONS IN THE INTERBANK MARKET

Transactions within this market can be executed on
Transactions within this market can be executed on
a spot, forward, or swap basis
a spot, forward, or swap basis

A spot transaction requires almost immediate
A spot transaction requires almost immediate
delivery of foreign exchange
delivery of foreign exchange

A forward transaction requires delivery of
A forward transaction requires delivery of
foreign exchange at some future date
foreign exchange at some future date

A swap transaction is the simultaneous
A swap transaction is the simultaneous
exchange of one foreign currency for another
exchange of one foreign currency for another
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SPOT TRANSACTIONS
SPOT TRANSACTIONS

A spot transaction in the interbank market is the
A spot transaction in the interbank market is the
purchase of foreign exchange, with delivery
purchase of foreign exchange, with delivery
and payment between banks to take place,
and payment between banks to take place,
normally, on the second following business day
normally, on the second following business day

The settlement date is often referred to as
The settlement date is often referred to as
the value date.
the value date.

This is the date when most dollar
This is the date when most dollar
transactions are settled through the
transactions are settled through the
computerized Clearing House Interbank
computerized Clearing House Interbank
Payment Systems (CHIPS) in New York.
Payment Systems (CHIPS) in New York.
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OUTRIGHT FORWARD TRANSACTIONS
OUTRIGHT FORWARD TRANSACTIONS

This transaction requires delivery at a future value date
This transaction requires delivery at a future value date
of a specified amount of one currency for another.
of a specified amount of one currency for another.

The exchange rate is agreed upon at the time of the
The exchange rate is agreed upon at the time of the
transaction, but payment and delivery are delayed.
transaction, but payment and delivery are delayed.

Forward rates are contracts quoted for value dates of
Forward rates are contracts quoted for value dates of
one, two, three, six, nine and twelve months
one, two, three, six, nine and twelve months

Terminology typically used is buying or selling
Terminology typically used is buying or selling
forward.
forward.

A contract to deliver $ for € in 6 months is both
A contract to deliver $ for € in 6 months is both
buying € forward for $ and selling $ forward for €.
buying € forward for $ and selling $ forward for €.
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SWAP TRANSACTIONS (I)
SWAP TRANSACTIONS (I)

A
A
swap transaction in the interbank market
swap transaction in the interbank market
is the
is the
simultaneous purchase and sale of a given amount of
simultaneous purchase and sale of a given amount of
foreign exchange for two different value dates.
foreign exchange for two different value dates.

Both purchase and sale are conducted with the same
Both purchase and sale are conducted with the same
counterpart.
counterpart.

A common type of swap is a
A common type of swap is a
spot against forward
spot against forward

The dealer buys a currency in the spot market
The dealer buys a currency in the spot market
and simultaneously sells the same amount back
and simultaneously sells the same amount back
to the same bank in the forward market.
to the same bank in the forward market.

Since this transaction occurs at the same time
Since this transaction occurs at the same time
and with the same counterpart, the dealer incurs
and with the same counterpart, the dealer incurs
no exchange rate exposure.
no exchange rate exposure.
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SWAP TRANSACTIONS (II)
SWAP TRANSACTIONS (II)

Forward-forward swaps:
Forward-forward swaps:

A dealer sells
A dealer sells
£20,000 forward for $ for delivery in 2
£20,000 forward for $ for delivery in 2
months at $1.6870/£ and simultaneously buys
months at $1.6870/£ and simultaneously buys
£20,000 forward for delivery in 3 months at $1.6820/£
£20,000 forward for delivery in 3 months at $1.6820/£

The difference between the buying and selling
The difference between the buying and selling
price (0.0050) is equivalent to the interest rate
price (0.0050) is equivalent to the interest rate
differential.
differential.

Thus a swap can be viewed as a technique for
Thus a swap can be viewed as a technique for
borrowing another currency on a fully
borrowing another currency on a fully
collateralized basis.
collateralized basis.
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SWAP TRANSACTIONS (III)
SWAP TRANSACTIONS (III)

Non-deliverable forwards (NDFs)
Non-deliverable forwards (NDFs)
:
:

NDFs possess the same characteristics as traditional
NDFs possess the same characteristics as traditional
forward contracts except that they are settled only in
forward contracts except that they are settled only in
US $ and the foreign currency being sold or bought
US $ and the foreign currency being sold or bought
forward is not delivered
forward is not delivered

The dollar-settlement feature reflects the fact
The dollar-settlement feature reflects the fact
that NDFs are contracted offshore and are
that NDFs are contracted offshore and are
beyond the reach and regulatory frameworks of
beyond the reach and regulatory frameworks of
the home country governments.
the home country governments.

Pricing of NDFs reflects basic interest rate
Pricing of NDFs reflects basic interest rate
differentials.
differentials.
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SIZE OF THE FOREX MARKET (I)
SIZE OF THE FOREX MARKET (I)

The Bank for International Settlements (BIS)
The Bank for International Settlements (BIS)
estimates that daily global net turnover in traditional
estimates that daily global net turnover in traditional
FOREX market activity to be US$ 1,210 billion in April
FOREX market activity to be US$ 1,210 billion in April
2001.
2001.
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SIZE OF THE FOREX MARKET (II)
SIZE OF THE FOREX MARKET (II)
0
100
200
300
400
500
600
700
800
1989 1992 1995 1998 2001
Spot
Forwards
Swaps
Global Foreign Exchange Market Turnover Global Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars) (daily averages in April, billions of US dollars)
Source: Bank for International Settlements Source: Bank for International Settlements, “Central Bank Survey of Foreign , “Central Bank Survey of Foreign
Exchange and Derivatives Market Activity in April 2001,” Exchange and Derivatives Market Activity in April 2001,” October 2001, www.bis.org. October 2001, www.bis.org.
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SIZE OF THE FOREX MARKET (III)
SIZE OF THE FOREX MARKET (III)

Two of the three categories fell between 1998 and 2001
Two of the three categories fell between 1998 and 2001
with spot market daily turnover falling the most, from
with spot market daily turnover falling the most, from
$568 billion in 1998 to $387 billion in 2001.
$568 billion in 1998 to $387 billion in 2001.

Forward transactions increased slightly from $128
Forward transactions increased slightly from $128
billion in 1998 to $131 billion in 2001.
billion in 1998 to $131 billion in 2001.

Swaps fell to $656 billion in 2001 from $734 billion in
Swaps fell to $656 billion in 2001 from $734 billion in
1998
1998

BIS attributes the introduction of the €, the
BIS attributes the introduction of the €, the
growing share of electronic broking in the spot
growing share of electronic broking in the spot
market and consolidation in banking as
market and consolidation in banking as
explanations for the reduction.
explanations for the reduction.
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SIZE OF THE FOREX MARKET (IV)
SIZE OF THE FOREX MARKET (IV)
0
100
200
300
400
500
600
700
1989 1992 1995 1998 2001
United States
United Kingdom
Japan
Singapore
Germany
Geographic Distribution of Foreign Exchange Market Turnover Geographic Distribution of Foreign Exchange Market Turnover
(daily averages in April, billions of US dollars) (daily averages in April, billions of US dollars)
Source: Bank for International Settlements, Source: Bank for International Settlements, “Central Bank Survey of Foreign “Central Bank Survey of Foreign
Exchange and Derivatives. Market Activity in April 2001,” Exchange and Derivatives. Market Activity in April 2001,” October 2001, www.bis.org. October 2001, www.bis.org.
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SIZE OF THE FOREX MARKET (V)
SIZE OF THE FOREX MARKET (V)
0
10
20
30
40
50
60
70
80
90
1989 1992 1995 1998 2001
US dollar
EURO
Deutsche Mark
French franc
EMS currencies
Japanese yen
Pound sterling
Swiss franc
Currency Distribution of Global Foreign Exchange Market Turnover Currency Distribution of Global Foreign Exchange Market Turnover
(percentage shares of average daily turnover in April) (percentage shares of average daily turnover in April)
Source: Bank for International Settlements, “Central Bank Survey of Foreign Source: Bank for International Settlements, “Central Bank Survey of Foreign
Exchange and Derivatives. Market Activity in April 2001,” October 2001, www.bis.org. Exchange and Derivatives. Market Activity in April 2001,” October 2001, www.bis.org.
86 IMBA International Finance (E) Part 1 Lecture Part 1 Global Economics

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FOREIGN EXCHANGE RATES & QUOTATIONS (I)
FOREIGN EXCHANGE RATES & QUOTATIONS (I)

A foreign exchange quote is a statement of willingness
A foreign exchange quote is a statement of willingness
to buy or sell at an announced rate
to buy or sell at an announced rate

In the retail market (newspapers and exchange
In the retail market (newspapers and exchange
booths), quotes are often given as the home currency
booths), quotes are often given as the home currency
price of the foreign currency.
price of the foreign currency.

Interbank quotes – professionals state forex quotes
Interbank quotes – professionals state forex quotes
in one of two ways
in one of two ways
-
The foreign currency price of one $
The foreign currency price of one $
·
Sfr1.6000/$, read as 1.600 Swiss francs per $.
Sfr1.6000/$, read as 1.600 Swiss francs per $.
-
The $ price of a unit of foreign currency
The $ price of a unit of foreign currency
·
$0.6250/Sfr, read as 0.625 $ per Swiss franc.
$0.6250/Sfr, read as 0.625 $ per Swiss franc.
$ 1 = Sfr 1.6000 $ 1 = Sfr 1.6000
Sfr 1 = $ 0.625 Sfr 1 = $ 0.625
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FOREIGN EXCHANGE RATES & QUOTATIONS (II)
FOREIGN EXCHANGE RATES & QUOTATIONS (II)

The former quote
The former quote
(Foreign currency price of one $)
(Foreign currency price of one $)
is
is
considered the “
considered the “
European quote
European quote
” and the latter
” and the latter
($ price
($ price
of a unit of foreign currency)
of a unit of foreign currency)
is the “
is the “
American quote
American quote
”.
”.

Almost all European currencies, except two, are quoted
Almost all European currencies, except two, are quoted
the European way
the European way

The Sterling Pound and the € are the exceptions.
The Sterling Pound and the € are the exceptions.

Additionally, Australian and New Zealand $ are
Additionally, Australian and New Zealand $ are
also quoted in American terms.
also quoted in American terms.
$ 1 = Sfr 1.6000 $ 1 = Sfr 1.6000
Sfr 1 = $ 0.625 Sfr 1 = $ 0.625
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(III)
(III)

Direct and Indirect Quotes
Direct and Indirect Quotes

A
A
direct
direct
quote is a home currency price of a
quote is a home currency price of a
unit of a foreign currency
unit of a foreign currency
-
Sfr1.6000/$ is a direct quote in Switzerland.
Sfr1.6000/$ is a direct quote in Switzerland.

An
An
indirect
indirect
quote is a foreign currency price in
quote is a foreign currency price in
a unit of the home currency
a unit of the home currency
-
Sfr1.600/$ is an indirect quote in the US,
Sfr1.600/$ is an indirect quote in the US,
-
$0.625/Sfr is a direct quote in the US and an
$0.625/Sfr is a direct quote in the US and an
indirect quote in Switzerland.
indirect quote in Switzerland.
$ 1 = Sfr 1.6000 $ 1 = Sfr 1.6000
Sfr 1 = $ 0.625 Sfr 1 = $ 0.625
$ 1 = Sfr 1.6000 $ 1 = Sfr 1.6000
Sfr 1 = $ 0.625 is the Sfr 1 = $ 0.625 is the
reciprocal of $ 1 = Sfr 1.6000 reciprocal of $ 1 = Sfr 1.6000
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(IV)
(IV)

Bid and Ask Quotations
Bid and Ask Quotations

Interbank quotes are given as a bid and ask
Interbank quotes are given as a bid and ask
-
The
The
bid
bid
is the price at which a dealer will buy a
is the price at which a dealer will buy a
currency
currency
-
The
The
ask or offer
ask or offer
is the price at which a dealer will
is the price at which a dealer will
sell a currency
sell a currency
·
Example:
Example:
¥118.27 - ¥118.37/$ is the
¥118.27 - ¥118.37/$ is the
bid/ask
bid/ask
for
for
Japanese yen
Japanese yen
·
The bank will buy $ (sell ¥) at ¥118.27 per $
The bank will buy $ (sell ¥) at ¥118.27 per $
and sell $ (buy ¥) at ¥118.37 per $ making
and sell $ (buy ¥) at ¥118.37 per $ making
profit on the spread
profit on the spread
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(V)
(V)

Expressing
Expressing
Forward Quotations on a Points Basis
Forward Quotations on a Points Basis

The previously mentioned rates for yen were
The previously mentioned rates for yen were
considered
considered
outright quotes
outright quotes
.
.

Forward quotes are different and typically
Forward quotes are different and typically
quoted in terms of points.
quoted in terms of points.

A point is the
A point is the
last digit of a quotation
last digit of a quotation
, with
, with
convention dictating the number of digits
convention dictating the number of digits
to
to
the right of the decimal.
the right of the decimal.
-
Hence a point is equal to 0.0001 of most
Hence a point is equal to 0.0001 of most
currencies.
currencies.
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(VI)
(VI)

Expressing Forward Quotations on a Points Basis
Expressing Forward Quotations on a Points Basis

The yen is quoted only to two decimal points.
The yen is quoted only to two decimal points.

A forward
A forward
point basis
point basis
quotation
quotation
is
is
not a foreign
not a foreign
exchange rate, rather
exchange rate, rather
the difference between
the difference between
the spot and forward rates
the spot and forward rates
.
.

Example:
Example:
Bid Bid Ask Ask
Outright spot: Outright spot: ¥118.27 ¥118.27 ¥118.37 ¥118.37
Outright forward: Outright forward: ¥116.84 ¥116.84 ¥116.97 ¥116.97
Plus points (3 months) -1.43 -1.40 Plus points (3 months) -1.43 -1.40
It’s possible: It’s possible: + + or or – –


Premium Premium or or discount discount
of the quoted currency of the quoted currency
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(VII)
(VII)

Forward Quotations in Percentage Terms
Forward Quotations in Percentage Terms

Forward quotations may also be expressed as the
Forward quotations may also be expressed as the
percent-per-annum deviation from the spot rate.
percent-per-annum deviation from the spot rate.
-
This is similar to the forward discount or
This is similar to the forward discount or
premium calculated earlier.
premium calculated earlier.

The important thing to remember is which currency
The important thing to remember is which currency
is being used as the home or base currency: the
is being used as the home or base currency: the
quoted currency.
quoted currency.
-
For direct quotes (i.e. quote expressed in home
For direct quotes (i.e. quote expressed in home
currency terms = The
currency terms = The
foreign currency is quoted
foreign currency is quoted
),
),
the formula is:
the formula is:
100 x
days
360
x
Spot
Spot - Forward
f
H
·
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(VIII)
(VIII)

Forward Quotations in Percentage Terms
Forward Quotations in Percentage Terms

Example: Indirect quote
Example: Indirect quote

Example: Direct quote
Example: Direct quote
p.a. 2.32% 100 x
90
360
x
105.04
105.04 - 105.65
f + · ·
¥
p.a. 2.32% 100 x
90
360
x
5 0.00946521
5 0.00946521 - 3 0.00952018
f
$
+ · ·
Spot: $ 1 =
Spot: $ 1 =
¥
¥
105.65
105.65
Forw: $ 1 =
Forw: $ 1 =
¥
¥
105.04
105.04
Spot:
Spot:
¥
¥
1 =
1 =
$
$
0.009465215
0.009465215
Forw:
Forw:
¥
¥
1 =
1 =
$
$
0.009520183
0.009520183
Reciprocals
Reciprocals
2.32% = ¥’s
2.32% = ¥’s
premium = $’s discount
premium = $’s discount forward (3 months)
forward (3 months)
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(IX)
(IX)

Cross Rates
Cross Rates

Many currencies pairs are inactively traded, so their
Many currencies pairs are inactively traded, so their
exchange rate is determined through their
exchange rate is determined through their
relationship to a widely traded third currency.
relationship to a widely traded third currency.

Example: A Mexican importer needs Japanese yen
Example: A Mexican importer needs Japanese yen
(¥) to pay for purchases in Tokyo. Both the Mexican
(¥) to pay for purchases in Tokyo. Both the Mexican
peso (P
peso (P
s s
) and ¥ are quoted in US $.
) and ¥ are quoted in US $.
-
Assume the following quotes:
Assume the following quotes:
Japanese yen
Japanese yen
¥ 121.13/$
¥ 121.13/$


$ 1 = ¥ 121.13
$ 1 = ¥ 121.13
Mexican peso
Mexican peso
P
P
s s
9.190/$
9.190/$


$ 1 = P
$ 1 = P
s s
9.190
9.190
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(X)
(X)

Cross Rates Cross Rates
• The Mexican importer can buy one US dollar for P The Mexican importer can buy one US dollar for P
s s
9.190 9.190
and with that dollar buy and with that dollar buy ¥121.13; the cross rate would be: ¥121.13; the cross rate would be:
S
S
13.1806/P
9.190/$ P
121.13/$

dollar pesos/US Mexican
dollar yen/US Japanes
· ·
¥
¥
$ 1 = ¥ 121.13 & $ 1 = P
$ 1 = ¥ 121.13 & $ 1 = P
s s
9.190
9.190


¥ 121.13 = P
¥ 121.13 = P
s s
9.190
9.190


¥ 1 = 9.190 / 121.13 P
¥ 1 = 9.190 / 121.13 P
s s
= 0.075868901 P
= 0.075868901 Ps s


or
or

P
Ps s
1 = 121.13/ 9.190 ¥ = 13.18063112 ¥/P
1 = 121.13/ 9.190 ¥ = 13.18063112 ¥/Ps s
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(XI)
(XI)

Intermarket Arbitrage
Intermarket Arbitrage

Cross rates can be used to check on
Cross rates can be used to check on
opportunities for intermarket arbitrage.
opportunities for intermarket arbitrage.

Example: Assume the following exchange rates
Example: Assume the following exchange rates
are quoted.
are quoted.
Citibank Citibank $0.9045/ $0.9045/€ €
Barclays Bank Barclays Bank $1.4443/£ $1.4443/£
Dresdner Bank Dresdner Bank €1.6200/£ €1.6200/£
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FOREIGN EXCHANGE RATES & QUOTATIONS
FOREIGN EXCHANGE RATES & QUOTATIONS
(XII)
(XII)

Intermarket Arbitrage Intermarket Arbitrage

The cross rate between Citibank and Barclays is The cross rate between Citibank and Barclays is

This cross rate is not the same as Dresdner’s rate This cross rate is not the same as Dresdner’s rate
quote of quote of €1.6200/£, so an opportunity exists for risk- €1.6200/£, so an opportunity exists for risk-
less profit less profit
1.5968/
$0.9045/
$1.4443/
·
£
£


Citibank $0.9045/ Citibank $0.9045/€ €

⇒ $ 1 = 1 / 0.9045€ $ 1 = 1 / 0.9045€
Barclays Bank $1.4443/£ Barclays Bank $1.4443/£

⇒ £ 1 = $ 1.4443 then, £ 1 = £ 1 = $ 1.4443 then, £ 1 =
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FOREIGN EXCHANGE RATES & QUOTATIONS (XIII)
FOREIGN EXCHANGE RATES & QUOTATIONS (XIII)
Citibank
Dresdner Bank Barclays Bank
End with $1,014,533
Start with $1,000,000
(1) Sell £692,377 to Dresdner Bank
at €1.6200/£
(4) Receive €1,121,651
(1) Sell $1,000,000 to Barclays
Bank at $1.4443/£
(2) Receive £692,377 (1) Sell €1,121,651 to Citibank
at $0.9045/€
(6) Receive $1,014,533

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