Lecture 2

Foreign
Exchange
Multinational Business Finance
 Global Economy
 Corporate Ownership, Goal, and Governance
 International Monetary System
 Balance of Payments
 Foreign Exchange Market
 International Parity Conditions
 Foreign Exchange Forecasting
 Foreign Currency Derivatives and Swaps
 Transaction Exposure
 Translation Exposure
 Operating Exposure
 Global Cost of Capital
 Raising Capital Globally
 Multinational Tax Management
 International Trade Finance
 Foreign Direct Investments
 Multinational Capital Budgeting
 The Balance of Payments
• The measurement of all international economic
transactions between the residents of a country and
foreign residents is called the balance of payments
(BOP)
• A nation’s balance of payments interacts with
nearly all of its key macroeconomic variables
• Interacts means that the BOP affects and is affected
by such key macroeconomic factors as:
– Gross Domestic Product (GDP)
– The exchange rate
– Interest rates
– Inflation rates
Generic Balance of Payments
 The BOP and Exchange Rates

• Fixed Exchange Rate Countries

– Under a fixed exchange rate system, the government
bears the responsibility to ensure that the BOP is near zero

• Floating Exchange Rate Countries

– Under a floating exchange rate system, the government
has no responsibility to peg its foreign exchange rate

• Managed Floats
– Countries operating with a managed float often find it
necessary to take action to maintain their desired
exchange rate values
The Evolution of Capital Mobility
Multinational Business Finance
 Global Economy
 Corporate Ownership, Goal, and Governance
 International Monetary System
 Balance of Payments
 Foreign Exchange Market
 International Parity Conditions
 Foreign Exchange Forecasting
 Foreign Currency Derivatives and Swaps
 Transaction Exposure
 Translation Exposure
 Operating Exposure
 Global Cost of Capital
 Raising Capital Globally
 Multinational Tax Management
 International Trade Finance
 Foreign Direct Investments
 Multinational Capital Budgeting
 The Foreign Exchange Market
• Foreign exchange means the money of a foreign
country; that is, foreign currency bank balances,
banknotes, checks and drafts.
• A foreign exchange transaction is an agreement
between a buyer and a seller that a fixed amount of
one currency will be delivered for some other currency
at a specified date.
• The foreign exchange market spans the globe, with
prices moving and currencies trading somewhere
every hour of every business day.
 Transactions in the Interbank
Market
• Spot transaction - delivery and payment between
banks to take place, normally, on the second following
business day.
• An outright forward transaction (usually called just
forward) requires delivery at a future value date of a
specified amount of one currency for a specified
amount of another currency.
• A swap transaction in the interbank market is the
simultaneous purchase and sale of a given amount of
foreign exchange for different value (settlement)
dates.
 Foreign Currency Quotations
Note: no global standard
• Base currency – what’s being priced
• Price currency – currency that expresses value
• FX rate indicates the number of price currency units
per unit of base currency
• USD/EUR rate of 1.2735 means the euro (base
currency) costs 1.2735 U.S. dollars (price currency)
• EUR/USD rate = 1 / 1.2735 = 0.7852
• American terms: price currency is USD
• European terms: price currency is EUR
• Direct quotation: price currency is domestic
• Indirect quotation: price currency is foreign
• Other notation: EUR:USD or EURUSD means USD/EUR
 Cross rates

• Widely used for inactively traded currencies and

triangular arbitrage
• If we have two rate quotes, we can compute a
cross rate
• Quotes: JPY/USD = 76.73, MXN/USD = 13.6455
• Cross rate: JPY/MXN =
= JPY/USD ÷ MXN/USD
= 76.73/13.6455 = 5.6231
 Intermarket Arbitrage
• Citibank quote - $/€ $1.3297/€
• Barclays quote - $/£ $1.5585/£
• Dresdner quote - €/£ €1.1722/£
• Cross rate calculation:
$1.5585/£
Note = € 1.1721/£
$/£ ÷ $/€ = €/£
$1.3297/€
 Appreciation/Depreciation
vis-à-vis a given currency
• Direct quotation
• %Change = (Ending rate – Beginning rate) ÷
Beginning rate x 100%
• Indirect quotation
• %Change = (Beginning rate – Ending rate) ÷
Ending rate x 100%
• Idea: if appreciates %Change >0
if depreciates %Change <0
 Example
Direct, CAD/Currency Indirect, Currency/CAD

Currency 14/08/2014 20/08/2014 %Change 14/08/2014 20/08/2014 %Change

U.S. dollar 1.0903 1.0971 0.6237 0.9172 0.9115 0.6237

Australian dollar 1.0161 1.0189 0.2756 0.9842 0.9815 0.2756
European Euro 1.4577 1.4548 -0.1989 0.6860 0.6874 -0.1989
Japanese yen 0.01064 0.01057 -0.6579 93.9850 94.6074 -0.6579
Mexican peso 0.08331 0.08354 0.2761 12.0034 11.9703 0.2761
Swiss franc 1.2029 1.201 -0.1580 0.8313 0.8326 -0.1580

U.K. pound sterling 1.8196 1.8203 0.0385 0.5496 0.5494 0.0385

0.6860 = 1 / 1.4577
0.6874 = 1 / 1.4548
-0.1989 = (1.4548-1.4577)/1.4577*100 Source: Bank of Canada
-0.1989 = (0.6860 - 0.6874)/0.6874*100
 Forward Premium/Discount
vis-à-vis a given currency
• Direct quotation
• f% = (Forward – Spot)÷Spot x (360/days )x100%
• Indirect quotation
• f% = (Spot – Forward)÷Forward x (360/days)x100%
• Idea: per annum %, hence day conversion
if appreciates f% >0
if depreciates f% <0
 Example
0.659% = (1.3382-1.3360)/1.3360*(360/90)*100
0.659% = (0.748503-0.747272)/0.747272*360/90*100
Forward
  Days     Premium
Period Forward C$/Euro Euro/C$  on the C$/euro

spot   1.3360 0.748503  

1 month 30 1.3368 0.748055 0.722%

2 months 60 1.3376 0.747608 0.705%

3 months 90 1.3382 0.747272 0.659%

6 months 180 1.3406 0.745935 0.693%

12 months 360 1.3462 0.742832 0.765%

 Foreign Exchange Rates and
Quotations
• Interbank quotations are given as a bid and ask (also
referred to as offer).
• A bid is the price (i.e. exchange rate) in one currency
at which a dealer will buy another currency.
• An ask is the price (i.e. exchange rate) at which a
dealer will sell the currency.
• Dealers bid (buy) at one price and ask (sell) at a
slightly higher price, making their profit from the
spread between the buying and selling prices.
• A bid for one currency is also the offer for the
opposite currency.
Recent way to quote currencies
 Conclusion

• Price of any currency is called foreign

exchange rate, it depends on supply and
demand for that currency
• Currency trading is OTC
• Quotation can be direct (like other
goods/services) or indirect.
• Transactions may be spot (delivery within 2
business days) or forward