International Financial Management

Foreign
Exchange Market
“FOREX” (part 1)
Learning Objectives:

You should understand:

 The organization of the Foreign Exchange

Market.
 The Foreign Exchange Market participants.
 The Foreign Exchange quotations.
 The Foreign Exchange transactions and
methods of international payments.
 The functions of the Foreign Exchange
Market.
 Arbitrage, Speculation & Hedging
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The Foreign Exchange Market
 The FOREX market is the market in
which currencies are traded.
 The FOREX is a financial market
where money denominated in
one currency is bought and sold
with money denominated in
another currency.
 The FOREX market is a global
worldwide decentralized financial
market for trading currencies. 3
The Foreign Exchange Market
 The Price of each currency is
determined in term of other
currencies.
 The Exchange rate is the rate at which

one currency is converted

(exchanged) into another.
 The FOREX assists international trade

and investment by enabling currency

conversion.
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FOREIGN EXCHANGE MARKET
 Two major features of the FOREX MARKET:

 The market never sleeps: The markets are

situated throughout different time zones of the
globe. If one is closing, the other is beginning its
operations.

 A global market that operates 24 hours a day (7/7).

 Forex Trading Schedule: A Forex Trading Day starts

every morning in Sydney and Tokyo... Hong Kong and
Singapore... Middle East... Frankfurt, Zurich and
London and finishes in NY, Chicago, San Francisco
and Los Angeles.

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 Higly integrated Market: There is
no significant difference between
exchange rates quotes in the different
trading centers;
 High speed computer linkages
between trading centers around the
world have effectively created a single
market.
 Most trades by phone, telex, or SWIFT

SWIFT: Society for Worldwide 6

 FOREX market is the more liquid market : It is
by far the largest financial market in
the world trading 3-4 trillion dollars
each day.

 The largest FOREX market is in London,

followed by New York, Tokyo, Zurich and
Frankfurt.
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FOREIGN EXCHANGE MARKET
 FOREX is described as an OTC (over the
counter) market as there is no physical
place where the participants meet to
execute the deals.

 FOREX is made up of Global network of

many participants : Banks, Central
Banks, FOREX Brokers, Companies,
Individuals.

 All the participants are connected by

electronic communications systems (telex,
telephone and internet) to buy and sell
foreign currencies. It is not located in any one
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place.
FOREIGN EXCHANGE MARKET
PARTICIPANTS
 BANKS (FOREX TRADERS)participate in foreign
exchange on behalf of their clients :
 COMPANIES : importers and exporters often trade fairly
small amounts compared to those of banks and their
trades often have a little short term impact on market
rate.
 FINANCIAL ENTITIES : investment and financial
transactions.
 INDIVIDUALS: tourists, travellers and migrants

 CENTRAL BANK participates in the FOREX market to

maintain the exchange rate at desired level by selling
and buying domestic currency or foreign currencies.

 FOREX BROKERS act as agents who inform and facilitate

trading currencies between FOREX traders.
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FOREIGN EXCHANGE MARKET
PARTICIPANTS
 WHOLESALE MARKET or INTERBANK MARKET:
BANKS, CENTRAL BANK, FOREX BROKERS

 The bank quoting the price is «

price maker » or
« market maker ».
 The bank asking for the price or the quote
is the
« price taker » or « user ».

 FOREX TRADERS: observe currency price movements

on Trading Platforms.

 RETAIL MARKET: Companies, Individuals and Financial

entities participate through INTERBANK MARKET or10
through FOREX Brokers.
 BANK 1
FOREX
TRADERS

CENTRAL BANK 2
BANK FOREX FOREX
FOREX BROKERS TRADERS
TRADERS

- Companie
- Govenme BANK 3
FOREX s
nt -Financi
Institutions TRADERS
al
- Individual
entities
- s - Individu
Economic FOREX MARKET als 1
role 1
 BANK 1
FOREX
TRADERS

CENTRAL BANK 2
BANK FOREX FOREX FOREX
TRADERS BROKERS TRADERS

BANK 3
FOREX
TRADERS

WHOLESALE MARKET 1
2
 CENTRAL BANK 2
BANK FOREX
FOREX TRADERS
TRADERS

- Companie
s
- Govenme -Financi
nt al
Institution entities
s - Individu
- Individual
s
RETAIL MARKET als 1
3
FOREIGN EXCHANGE TRANSACTIONS
 Network of CORRESPONDANT BANKS all over
the world: one bank can operates as an
agent for another bank in another place.

 FOREX transactions are settled

through
NOSTRO and VOSTRO accounts:
 NOSTRO: our account with banks abroad. A
domestic bank maintains various nostro
accounts in a number of countries.
 VOSTRO: their account with us. Banks
abroad maintain their nostro accounts at14
our domestic bank.
 FOREIGN EXCHANGE TRANSACTIONS

BANK IN TUNISIA

VOSTRO VOSTRO VOSTRO

BANK IN U.S.A BANK IN JAPAN BANK IN FRANCE
TND TND TND

BANK BANK IN
BANK IN JAPAN
IN FRANCE
U.S.A
NOSTRO NOSTRO NOSTRO
BANK IN TUNISIA BANK IN TUNISIA BANK IN TUNISIA
USD JPY EUR
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 Foreign Exchange Transactions
 The spot market: is the market
for immediate exchange.
 The forward market: enables an MNC

to lock in the exchange rate at which it

will buy or sell a certain quantity of
currency on a specified future date.

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 Foreign Exchange
Transactions
 Trading between occurs in
banks the
 interbank
Within market.
this market, foreign
exchange brokerage firms act as
middlemen.

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Foreign Exchange Transactions
 Banks provide foreign exchange
services for a fee: bid vs ask
 The bid: is the price at which the bank

buy a foreign currency.

 The ask: is the price at which a bank

sell a foreign currency.

 The bank’s bid (buy) quote for a
foreign currency will be less than its ask
(sell) quote.
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bid/ask spread
bid/ask spread % = askask
rate –
rate
bid
 rate
Example: Suppose bid price for £ =
$1.52, ask price = $1.60.
bid/ask spread %= (1.60–1.52)/1.60
= 5%

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 Foreign Exchange
Transactions
The bid/ask spread is larger
normally those currencies for
that are less traded. frequent
 Exchange rate quotations forlywidely

traded currencies are frequently

listed in the news media on a
daily basis. Forward rates may be
quoted too.

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 The Exchange rate
 On FOREX, currencies are quoted against each other
in the
form of parity.
 The exchange rate is the price at which the currency
of one country is exchanged for the currency of
another country.
 It is the amount of currency needed to buy a unit of
currency from another country.
 On the markets, currency names are reduced to a
three-letter code (CAD, USD, EUR, YEN, TND, etc.)

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 The Exchange rate
 Examples:

 1 CAD = 0.7612USD: It takes 0.7612US dollarsto

buy 1 Canadian dollar;

 1 TND = 0.31 USD: It takes 0.31 US dollars to buy 1

Tunisian dinar;
 1 TND = 0.3 EUR: It takes 0.30 euro to buy 1 Tunisian
dinar;

 1 TND = 47.36 YEN: It takes 47.36 Japanese Yen to

buy 1 TND

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 1 GBP = 1.6849 CAD: It takes 1.6849 CAD to buy 1
 In general, exchange rates
change according to the
economic/political/social factors, etc.
of the countries of the two
currencies concerned in parity
(CAD/EUR parity example)

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 Unit of exchange quotation
 The PIP (Price Interest Point): Unit of exchange
rate quotation.
 1 PIP is a unit of change in parity (the smallest price
change in the listed currency )

 On the Dollar/Euro 1 PIP = 0.0001. When USD/EUR

goes from 1.3350 to 1.3360 there is an increase of 10
PIPs.
 On the Dollar/Yen (USD/YEN), 1 PIP = 0.01

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 The Exchange rate regimes
 Fixed (PEGGED) exchange rate: the central bank sets
the exchange rate and undertakes to maintain it
over time.
 Constant against a reference currency (USD, EUR).
 Can only be changed by a government reassessment or
devaluation decision.

 Fixed parity with USD (Bahrain, Cuba, Jordan, Oman, Panama, Qatar, United
Arab Emirates, Venezuela, etc.)
 Fixed parity with Euro (Bulgaria, Cameroon, Chad, Gabon, Senegal, etc.)

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 The Exchange rate regimes
 Flexible exchange rate (floating): fluctuate
prices according to market conditions.

These regimes are adopted by

developed countries (US, Canada, UK…)
Independent and determined at each transaction by
the balance between supply and demand on the foreign
exchange markets.

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 Managed Floating Exchange rate is
neither
completely free nor fixed exchange rate

 It is officially fixed but alteredfrom time

to time by monetary authorities.

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 Fixed Exchange rate vs Floating
Advantages Disadvantages
Fixed :Provides a Rigid regime: The
stable framework for trade with central bank must be ready
a low level of risk with its reserves to intervene
(Costly)
Simplified management Fixed rate may not
of international trades (Rate reflect reality
known and fixed in advance).

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 Fixed Exchange rate vs Floating
Advantages Disadvantages
Floating :Consistent with Flexible regime:
the economic indicators the management MNCs
involved in international trade
is more difficult.

The government does A foreign exchange

not intervene in monetary policy risk to hedge (cost)

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TUNISIAN EXCHANGE RATE REGIME
 Managed Floating Exchange Rate Regime.
 Domestic currency is TND and it is not
totally convertible.
 Restrictions on the amount to convert

 Tunisian central bank :

 manages the exchange rate mechanism
 Keeps the exchange rate stable
 Regulates interbank FOREX transactions and
monitor the
FOREX exchange risk of the banks
 Manages and maintains the country’s
foreign exchange reserves
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 Exchange rate quotation
 Direct quotation: (Right quote)
 Expresses the value of the domestic currency against to foreign
currencies.
 In Canada, the 1.0061 CAD/USD is a direct quote for Canadians. (CAD
is the domestic currency (base currency or reference currency); USD
(Right side) is the foreign currency/ price currency or quote currency)
 In Great Britain, the 0.75 GBP/USD is a direct quote for the British.
(GBP is the domestic currency (base currency) and USD (Right side) is
the foreign currency (price currency or quote currency)).

 When the exchange rate is greater than 1, it means that the domestic
currency has less value than the foreign currency .
 When the exchange rate is less than 1, it means that the
domestic currency has more value than the foreign currency.

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 Indirect quotation: (left quote)
 Expresses the value of currencies against the domestic
foreign
 currency.of foreign currency for a unit of local currency.
Amount

 In Canada a quote of (1/1.0061) = 0.9939 USD/CAD is an indirect

quote for Canadians. (USD (left side) is the foreign currency and
CAD is the domestic currency).

 In Great Britain, a quote of (1/0.75) = 1.33 USD/GBP is an indirect

quote for the British. (USD (left side) is the foreign currency or quote
currency and GBP is the domestic currency or base currency).
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 Currency depreciation: the currency (TND)
becomes weaker.

TND/USD increase (3.18 TND/USD becomes 3.35

TND/USD)

 Currency appreciation: the currency (TND)

becomes more stonger.

TND/USD decrease (3.18 TND/USD becomes 3.05

TND/USD)
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Example: (Appreciation /Depreciation)
 Spott rate : 2.5445 CAD/GBP
 Spott+1 rate: 2.3079 CAD/GBP
 Has the pound depreciated or appreciated?
 The Spott+1 rate is lower than the Spott rate, so the pound
has
depreciated.

 What is the change in the value of the pound sterling?

(end – beginning) / beginning = (2.3079 - 2.5445) / 2.5445 = -

9.3%
What happened to the dollar? 3

So, the pound depreciated by 9.3% against the Canadian dollar. 5

 If the pound has depreciated and the dollar?

 Since the reference has become the dollar, the rates must
be
expressed inversely. The dollar has therefore gone from:

0.3930 GBP/CAD (1/ 2.5445) to 0.4333 GBP/CAD (1/2.3079)

 0.4333GBP/CAD is higher than

0.3930GBP/CAD , so the CAD is appreciated.
 Variation:
(end – beginning) / beginning =
(0.4333-0.3930) / 0.3930 =
10.25%
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 Eurocurrencies
 Eurocurrencies: are domestic deposited in
currencies foreign banks.
 A Eurodollar is a deposit denominated in dollars in a
bank outside the United States.
 A Euroyen is a deposit denominated in yen in a
bank outside Japan.

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 FOREIGN EXCHANGE MARKET
FUNCTIONS
 Two functions:

 Converting currencies:

 Trading/Financial

Transactions
 Arbitrage
 Speculation

 Reducing Risk (Hedging)

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TRADING/ FINANCIAL TRANSACTIONS

 Companies that receive payments in

foreign currencies need to convert
theses payments to their home
currency (exporting)

 Companies paying foreign

businesses of goods or services
(importing)

 Companies investing cash for short

terms in money market accounts.
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 ARBITRAGE
 If Exchange Rates quoted in different
markets were not essentially the same,
there would be an opportunity for
arbitrage.

 The process of buying a currency at a lower

price in a FOREX Market and selling it at a
higher price in another FOREX Market at the
same time.

 Profit seeking from variations in rates in

different markets but at the same time. 39

 No risk: positive profit in a certain way.

 ARBITRAGE
 On October 24th, at 10 a.m:
Paris FOREX: 1 EUR = 3.36 TND
Tunis FOREX: 1 EUR = 3.41 TND

 Two different markets and two

different Exchange Rates at the
same time.

 ARBITRAGE: we have to buy the EUR at the low rate

on a market
and sell it at the high rate on another market at the
same time.

 We buy 1 EUR at 3.36 TND in Paris FOREX Market and

sell
FOREXit at
Markets at the same
3.41 TND in Tunis FOREX Market at the same time.
 Types of Arbitrage
 There are two types of
arbitrage:

 Geographic

arbitrage

 Triangular

arbitrage
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 Geographic Arbitrage
 The geographic arbitrage consists in
taking advantage without risk of a
difference between quoted prices at the
same time on two different financial
markets.

 This arbitrage may be made by a trader

when, at the same time, the bid price of
a currency on a given financial centre
is higher than the bid price of that
same currency on another centre. 42
 Geographic Arbitrage : Example
1 London Frankfurt
Bid 0.2074 GBP/EUR 0.2126 GBP/EUR
Ask 0.2080 GBP/EUR 0.2127 GBP/EUR

 A rational arbitrator who holds EUR 50,000: What does he do?

 He will compare bid and ask prices in both financial markets
 To have an opportunity for arbitrage :
Bid 1 > Ask 2
 The bid price of EUR in Frankfurt > the ask price of EUR in London.
Arbitrage opportunity
 Sell the euro on the market where the price is higher (bid price is higher)
 Buy the euros on the market where the price is low (ask price is weak)
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Example 1 (Cont’d)
London Frankfurt
Bid 0.2074 GBP/EUR 0.2126 GBP/EUR
Ask 0.2080 GBP/EUR 0.2127 GBP/EUR

 Sell the euros at the bid price 0.2126 GBP/EUR in Frankfurt

 50 000* 0.2126 GBP/EUR = 10 630 GBP
 The arbitrator have more GBP selling the euros
 Buy the euros from London with the ask price 0.2080
GBP/EUR
10 630 / 0.2080 GBP/EUR = 51105.7692 EUR
 The arbitrator pays less GBP for 1 EUR
Sell EUR 10 630 GBP
Buy EUR 51105.7692 EUR
Profit 51105.7692 EUR – 50 000 EUR = 1105.76 EUR
4
5
Example 2

Montreal New York

Bid 1.0580 CAD/USD 1.0620 CAD/USD
Ask 1.0600 CAD/USD 1.0650 CAD/USD

 A rational arbitrator with 1000 000 $US: What he can

do?

45
Cross-rates


46
 Example 1: A Mexican importer
needs Korean Won.

 Korean won: 1200.00 KRW/USD

 Mexican Peso: 9.3750 MXN/USD

 Calculate the KRW/MXN cross rate?

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 To calculate the KRW/MXN cross
rate, a simple rule of three is then
used:

 1USD = 1200.0000 KRW

 1USD = 9.3750 MXN

Cross rate: KRW/MXN : 128.0000 KRW/MXN (1200/9.3750)

Cross rate: MXN/KRW : 0.0078 MXN/KRW (9.3750/1200)

48
 Example 2:
 You have the following rates
1 Euro = 36.9040 THB (36.9040 THB/EUR)
1 Euro = 3.36 TND (3.36 TND/EUR)

What is the cross rate : THB / TND?

What is the cross rate : TND/ THB?

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 When the implicit cross rate differs from the direct exchange rate
of the two currencies, there is a possibility of triangular
arbitrage.
 Triangular arbitrage involves 3 currencies.
 Arbitrage :

 Buy on the market where the price is low (the currency is

undervalued).
 Sell on the market where the price is high (the currency is
overvalued).

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Triangular Arbitrage: Example 1

Exchange rate
NY 1.2440 USD/EUR

Londres 140 YEN/EUR

Tokyo .0092 USD/YEN

•Determine the profit from this

arbitrage. You have 1 000 000 USD.

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 Example 1
 Cross rate (NY-London): (1.2440 USD/EUR)/(140 YEN/EUR)
= .0089 USD/YEN
.0089USD/YEN (cross quotation ) ≠ .0092 USD/YEN in Tokyo

ARBITRAGE OPPORTUNITY

Market Rate Overvalued versus undervalued

NY 1.2240 USD/EUR USD is overvalued
EUR is undervalued
London 140 YEN/EUR EUR is overvalued
YEN is undervalued
Tokyo 0.0092 USD/YEN YEN is overvalued
USD is undervalued
Implicit rate 0.0089 USD/YEN

5
3
 Steps of the Arbitrage :
 Sell the USD in NY :
1000000 USD /1.2440 USD/EUR = 803858.52 EUR
 Sell the EUR in London:
803 858.52 EUR * 140 YEN/EUR = 112 540 192.9
YEN
 Sell YEN in Tokyo :
112540192.9 YEN * .0092 USD/YEN = 1 035 369.78 USD
 Profit = 1 035 369.78 – 1 000 000 = 35 369.78 USD

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 SPECULATION
 The process of buying, now, a currency
which exchange rate is expected to
rise in the future and selling it when
expectation is realized.

 A form of Gambling, taking very though

risk.

 Speculators are « Risk Lovers »

 Profit seeking from anticipated exchange

rates movements. 54
 SPECULATION
 On October 24th:
Paris FOREX: 1 EUR = 3.36 TND
 We predict that on November 24th:
Tunis FOREX: 1 EUR = 3.45 TND
 SPECULATION : we buy the EUR at the low observed
rate now,
hold it and sell it, possibly, at the high predicted rate in
the future
 On October 24th: we buy 1 EUR at 3.36 TND in Paris
FOREX Market
 On November 24th ifprediction is:
 realized : Tunis FOREX: 1 EUR = 3.45 TND , we sell

1 EURO at
3.45 TND and the profit will be 0.09 TND per 1 EUR
bought and sold at different time.
 Not realized: Tunis FOREX: 1 EUR = 3.2 TND, we sell 1
 It is a uncertain profit 5
6
EUR at
FOREIGN EXCHANGE RISK EXPOSURE

 Most important characteristic of

FOREX
transaction is that involves FOREX RISK

 FOREX RISK: the risk that arises

from changes in EXCHANGE RATES.

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FOREIGN EXCHANGE RISK
EXPOSURE
 Tunisian Company exporting bags
 Domestic price 10 TND/Bag
 On October 24th
 order of 1.000 Bags from a French Company
 Tunis FOREX: 1 EUR = 3.36 TND
 Invoice 2.976 EUR = 10.000 TND
 On december 15th,
 Transfer of 2.976 EUR
 Tunis FOREX: 1 EUR = 3 TND
 Converted income 2.976 EUR = 8928 TND <
10.000 TND

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 HEDGING

A firm that insures itself against

FOREX RISK is hedging.

 The FOREX MARKET can be used

to provide insurance to protect
against FOREX RISK.

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