1. Foreign Exchange Market - The Foreign exchange market is a large,
growing and liquid financial market that operates 24 hours a day. It is not a market in the traditional sense because there is no central trading location or exchange". 2. Exchange Rate - The value of one currency expressed in terms of another. For example, if EUR/USD is 1.3200, 1 Euro is worth US$1.3200. 3. Currency Pair - The two currencies that make up an exchange rate. When one is bought, the other is sold, and vice versa. 4. Spot Market - The market for buying and selling currencies at the current market rate. 5. Base Currency - The first currency in the pair. Also the currency your account is denominated in. 6. Counter Currency - The second currency in the pair i.e the terms currency. 7. Currency Pair Terminology EUR/USD = "Euro" USD/JPY = "Dollar Yen" GBP/USD = "Cable" or "Sterling" USD/CHF = "Swissy" USD/CAD = "Dollar Canada AUD/USD = "Aussie Dollar" NZD/USD = "Kiwi" 8. Bid Price - The quote is displayed on the left and is the price at which you can buy one unit of the base currency. 9. Ask Price - The quote is displayed on the right and is the price at which you can sell one unit of the base currency. 10. Spread - The difference between the sell quote and the buy quote or the bid and offer price. 11. Pip - The smallest price increment a currency can make. Also known as points. 12. Direct Quote - A foreign exchange which represent a relationship between a fixed number of units of foreign currency against variable number of units of domestic currency. 1USD=INR 59.35 is a direct quote in India
13. Indirect Quote - A foreign exchange which represent a relationship between a fixed number of units of domestic currency against variable number of units of foreign currency. 1 INR = 0.0168481 USD is a direct quote in India 14. Cross Rate - The exchange rate between two currencies that are not the official currencies of the country that the exchange was quoted in. Cross rates usually do not involve the U.S. dollar. The cross rate is the exchange rate between currency A and currency C derived from actual exchange rate between currency A and currency B and between currency B and currency 15. Two-Way Quote - A type of quote that gives both the bid and the ask price of a security, informing would-be traders of the current price at which they could buy or sell the security. 16. Fiat money - Any money declared by a government to be legal tender 17. Vehicle Currency - The currency used to invoice an international trade transaction, especially when it is not the national currency of either the importer or the exporter. 18. Vostro Account - Account held by a foreign bank in a domestic bank is called Vostro account. A Vostro is our account of your money, held by us. For example Bank A(Barclays Bank of UK) opening an account in Bank B(ICICI Bank of India), this is Vostro account for Bank B(ICICI Bank of India).
19. Nostro Account Account held by a particular domestic bank in a foreign bank is called Nostro account. A Nostro is our account of our money, held by you. Here in the above example given in Vostro account the same account is a Nostro account for Bank A(Barclays Bank of UK), 20. Loro Account - An account held by a domestic bank in itself on behalf of a foreign A Loro is our account of their money, held by you. Loro account is a record of an account held by a second bank on behalf of a third party The Loro account is an account wherein a bank remits funds in foreign currency to another bank for credit to an account of a third bank.
Ch.1 Meaning of International Trade International business means carrying on business activities beyond national boundaries. The exchange of goods and services among individuals and businesses in multiple countries. A specific entity, such as a multinational corporation or international business company that engages in business among multiple countries.
Meaning of International Trade Capital Goods Services Technology Skilled labour Meaning of International Trade Production of physical goods Provision of services Banking Finance, Insurance, Construction, Trading Foreign investment, Foreign Direct Investment Objectives of International Trade Improved Sale and Profitability Risk Diversification Economy of Scope and Scale Competition and Survival Global Branding Multinational Companies An enterprise operating in several countries but managed from one (home) country. A corporation that has its facilities and other assets in at least one country other than its home country. Such companies have offices and/or factories in different countries. They have a centralized head office where they co-ordinate global management. Features of Multinational Companies Huge business enterprises operating in many countries. Large resources and Potential. Extend production, marketing and management to host countries. Centralized ownership and control. Multinational stock ownership. Reasons for growth of Multinational Companies Limited Scalability in domestic market. Cost Advantage. Indian Expertise. Government Policies. Social Environment. Examples of Multinational Companies Tata Motors. Infosys. Tata Consultancy Services. Ranbaxy Laboratories Ltd. Asian Paints. Dr. Reddys Laboratories Ltd. Bharat Forge. Theory of Comparative Advantage Assumptions There are no transport costs. Costs are constant and there are no economies of scale. There are only two economies producing two goods. The theory assumes that traded goods are homogeneous. Factors of production are assumed to be perfectly mobile within a country but no movement internationally. There are no tariffs or other trade barriers.
Theory of Comparative Advantage Comparative advantages and the mutually beneficiary exchanges between countries In one year, England requires labor of 100 men to produce cloth and 120 men to make wine. Whereas, Portugal requires only the labor of 80 men to produce cloth and 90 men to make wine. The two countries must acquire their respective benefit if they exchange production with each other on the basis of comparative advantage.
Portugal has its comparative advantages in the wine industry while England could be considered to be comparatively advantageous in the cloth industry. For the country enjoying overall advantages in the both industries, choose one in which it is comparatively more advantageous, while for the other country with overall disadvantages in the both industries, choose one in which it is comparatively less disadvantageous. A country enjoys a comparative advantage in the production of a good when that good can be produced at a lower cost in terms of other goods. For the country enjoying overall advantages in the both industries, choose one in which it is comparatively more advantageous, while for the other country with overall disadvantages in the both industries, choose one in which it is comparatively less disadvantageous. Gains from Comparative Advantage When countries specialize in producing the goods in which they have a comparative advantage, they maximize their combined output and allocate their resources more efficiently. Methods of International Business International Trade Licensing Franchising Joint Ventures Acquisitions Foreign Subsidiaries
Ch3 Foreign Exchange Dealings
Features of Forex market Decentralized interbank market Online Trading 24-Hour Market High liquidity Lower trading costs Geographical dispersion Market Participants of Forex market Banks Financial Institutions Central Bank Brokers Hedgers Investment Management Firms Consumers and Travellers Businessmen Types of Orders Market Order Limit Order Stop Order Once Cancel the Order (OCO) If Done Order Chpt.5 Forex Spot and Forward Types of Currency Markets Spot Market Forward Market Types of Currency Markets Spot Market: - immediate transaction - recorded by 2 nd business day Forward Market:- transactions take place at a specified future date FORWARD MARKET Definition of a Forward Contract: An agreement between a bank and a customer to deliver a specified amount of currency against another currency at a specified future date and at a fixed exchange rate.
Purpose of a Forward: Hedging: Act of reducing exchange rate risk. Forward Rate Quotations Two Methods: Outright Rate: quoted to commercial customers. Swap Rate: quoted in the interbank market as a discount or premium.
CALCULATING THE FORWARD PREMIUM OR DISCOUNT
= F-S x 12 x 100 S n
where F = the forward rate of exchange S = the spot rate of exchange n = the number of months in the forward contract Forward Contract Maturities 30-day 90-day 180-day 360-day
Arbitrageurs A forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of this disparity. Traders The act of buying and selling foreign currencies. Currency trading is most often engaged in by banks and other institutions, for the purposes of international trade. Individual investors may engage in currency trading as well, attempting to benefit from variations in exchange rates of the currencies. Hedgers Currency hedging is the act of entering into a financial contract in order to protect against unexpected, expected or anticipated changes in currency. It is used by financial investors and businesses to eliminate risks they encounter when conducting business internationally. Hedging limits the impact of foreign exchange rate risk. Speculators A person who trades derivatives, commodities, bonds, equities or currencies with a higher-than-average risk in return for a higher-than- average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains.
Chpt.6 Arbitrage in Forex markets Meaning of Arbitrage A forex strategy in which a currency trader takes advantage of different spreads offered by brokers for a particular currency pair by making trades. Different spreads for a currency pair imply disparities between the bid and ask prices. Currency arbitrage involves buying and selling currency pairs from different brokers to take advantage of this disparity. A trading strategy that is used by forex traders who attempt to make a profit on the inefficiency in the pricing of currency pairs.
Types of Arbitrage Geographical Triangular
Geographical Arbitrage Geographical arbitrage is possible when a banks buying price (bid price) is higher than another banks selling price (ask price) for the same currency. Example: Bid Ask Bank C NZ$ $.635 $.640 Bank D NZ$ $.645 $.650 Buy NZ$ from Bank C @ $.640, and sell it to Bank D @ $.645. Profit = $.005/NZ$.
Triangular arbitrage Triangular arbitrage is possible when a cross exchange rate quote differs from the rate calculated from spot rates. Example: Bid Ask /$ 1.60 1.61 MYR/$ 0.200 0.202 /MYR 8.1 8.2 Buy @ $1.61, convert @ MYR8.1/, then sell MYR @ $.200. Profit = $.01/. (8.1.2=1.62)
Chpt.11 Risk and Exposure
Foreign Exchange Risk Foreign exchange risk (also known as FX risk, exchange rate risk or currency risk) is a financial risk that exists when a financial transaction is denominated in a currency other than that of the base currency of the company. Foreign-exchange risk is the risk that an asset or investment denominated in a foreign currency looses value as a result of unfavourable exchange rate fluctuations between the investment's foreign currency and the investment holder's domestic currency.
Types of Foreign Exchange Risk Transaction risk Position Risk Credit Risk Liquidity/ Mismatch risk Operational Risk Sovereign/ Political/ Country Risk Cross Country Risk
Transaction risk Transaction risk is the risk that a company will incur losses in a transaction comprising multiple currencies due to exchange rate movements. The exchange rate risk associated with the time delay between entering into a contract and settling it. The greater the time differential between the entrance and settlement of the contract, the greater the transaction risk, because there is more time for the two exchange rates to fluctuate. Transaction risk creates difficulties for individuals and corporations dealing in different currencies, as exchange rates can fluctuate significantly over a short period of time. This volatility is usually reduced, or hedged, by entering into currency swaps and other similar securities.
Position Risk In investing, any trade that has been established, or entered, that has yet to be closed with an opposing trade involves position risk. An open position can exist following a buy (long) position, or a sell (short) position. In either case, the position will remain open until an opposing trade has taken place. Probability of loss associated with a particular trading (long or short) position due to price changes. Any investment that has been entered into but not closed. For example, an investor who is long 100 shares of INTC has an open position until an order to sell those 100 shares has been placed and filled.
Credit Risk Credit risk refers to the risk that a borrower will default on any type of debt by failing to make required payments. The risk is primarily that of the lender and includes lost principal and interest, disruption to cash flows, and increased collection costs. The risk of loss of principal or loss of a financial reward stemming from a borrower's failure to repay a loan or otherwise meet a contractual obligation. Investors are compensated for assuming credit risk by way of interest payments from the borrower or issuer of a debt obligation.
Liquidity/ Mismatch risk Liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit). A category of risk that refers to the possibility that a swap dealer will be unable to find a suitable counterparty for a swap transaction for which it is acting as an intermediary.
Operational Risk Operational risk is defined as the risk of loss resulting from inadequate or failed processes, people and systems or from external events. A form of risk that summarizes the risks a company or firm undertakes when it attempts to operate within a given field or industry. It is the risk remaining after determining financing and systematic risk, and includes risks resulting from breakdowns in internal procedures, people and systems.
Sovereign / Political/ Country Risk The risk that a government will either default on its obligations or will impose regulations restricting the ability of issuers in that country to meet their obligations, such as foreign currency restrictions. The risk that a foreign central bank will alter its foreign-exchange regulations thereby significantly reducing or completely nulling the value of foreign-exchange contracts. The risk that an investment's returns could suffer as a result of political changes or instability in a country. Instability affecting investment returns could stem from a change in government, legislative bodies, other foreign policy makers, or military control.
Cross Country Risk A collection of risks associated with investing in a foreign country. These risks include political risk, exchange rate risk, economic risk, sovereign risk and transfer risk, which is the risk of capital being locked up or frozen by government action. Country risk varies from one country to the next. Some countries have high enough risk to discourage much foreign investment.
Foreign Exchange Exposure Foreign exchange exposure is the possibility that a firm will gain or lose because of changes in exchange rates. Foreign exchange risk is the risk of loss due to changes in the relative value of world currencies. There are three types of Foreign Exchange Exposures: A Translation Exposure B Economic Exposure C Transaction Exposure
Types of foreign exchange exposure Transaction Exposure measures changes in the value of outstanding financial obligations due to exchange rate changes. Translation Exposure also called Accounting Exposure, is the changes in owners equity because of the need to translate financial statements of foreign subsidiaries into a single reporting currency for consolidated financial statements. Economic Exposure also called Operating Exposure, measures the change in the present value of the firm resulting from any change in expected future operating cash flows caused by an unexpected change in exchange rates.
Conceptual Comparison of Foreign Exchange Exposure
Transaction Exposure Transaction exposure measures changes in the value of outstanding financial obligations incurred prior to a change in exchange rates but not due to be settled until after the exchange rates change. Thus, this type of exposure deals with changes in cash flows the result from existing contractual obligations. Transactions exposure results from particular transactions such as an export where a known cash flow in a given currency will take place at a certain date
Transaction Exposure Transactions exposure arises when a company must pay or receive a foreign currency at an unknown future exchange rate It is contractual It affects the income statement It can often be hedged directly using forwards, futures or currency options. Translation Exposure Translation exposure, also called Accounting exposure, is the potential for changes in owners equity to occur because of the need to translate foreign currency financial statements of foreign subsidiaries into a single reporting currency to prepare worldwide consolidated financial statements. Results from the need of a global firm to consolidated its financial statements to include results from foreign operations. o Consolidation involves translating subsidiary financial statements from local currencies (in the foreign markets where the firm is located) to the home currency of the firm (i.e., the parent). o Consolidation can result in either translation gains or translation losses. Translation Exposure Translation or accounting exposure results from the way accounting conventions dictate that a companys foreign assets and liabilities should be booked.
Economic Exposure Economic Exposure, also called Operating Exposure, measures the change in the present value of the firm resulting from any change in future operating cash flows of the firm caused by an unexpected change in exchange rates. This is a long term foreign exchange exposure resulting from a previous FDI location decision. Over time, the firm will acquire foreign currency denominated assets and liabilities in the foreign country. The firm will also have operating income and operating costs in the foreign country. Economic exposure impacts the firm through contracts and transactions which have yet to occur, but will, in the future, because of the firms location. Economic exposure can have impacts on a global firms competitive position and on the market value of that firm.
Economic Exposure o Change in the economic value of the firm resulting from unanticipated exchange rate changes. Booked vs. anticipated transactions Expected vs. unexpected changes; the "cost of hedging" Exposure and the parity assumptions: "We are not exposed in the long run" Currency of denomination vs currency of determination;