LM Thapar School of Management

Master of Business Administration

Course: International Finance

Faculty: Dr. Shalu Bansal

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Foreign Exchange Markets &

Transactions

Foreign Exchange
Market
Foreign Exchange Market provides:
The physical and institutional structure
through which the money of one country
is exchanged for that of another country

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The determination rate of exchange

between currencies

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Foreign Exchange Market

Foreign exchange means the money
of a foreign country; that is, foreign
currency bank balances, banknotes,
checks and drafts.

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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.
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Functions of the
Foreign Exchange Market
The foreign exchange market is the
mechanism by which participants:
Transfer purchasing power between
countries
Obtain or provide credit for
international trade transactions

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Minimize exposure to the risks of

exchange rate changes
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Market Participants

Five broad categories of participants

operate within these two tiers; bank and
nonbank
foreign
exchange
dealers,
individuals and firms, speculators and
arbitragers, central 5banks and treasuries,2/2/16

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The foreign exchange market consists of

two tiers:
The interbank or wholesale market
(multiples of $1MM US or equivalent in
transaction size)
The client or retail market (specific,
smaller amounts)

 Banks and a few nonbank foreign

exchange dealers operate in both the
interbank and client markets.
The profit from buying foreign exchange
at a bid price and reselling it at a
slightly higher offer or ask price.
Dealers
in
the
foreign
exchange
department of large international banks
often function as market makers.
These dealers stand willing at all times to
buy and sell those currencies in which
they specialize and thus maintain an
inventory
position
in
those
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Bank and Nonbank Foreign

Exchange Dealers

Individuals and Firms

Their use of the foreign exchange market

is necessary but nevertheless incidental to
their underlying commercial or investment
purpose.
Some of the participants use the market to
hedge foreign exchange risk.
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Individuals (such as tourists) and firms

(such as importers, exporters and MNEs)
conduct commercial and investment
transactions in the foreign exchange
market.

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

Speculators seek all the profit from

exchange
rate
changes
and
arbitragers
try
to
profit
from
simultaneous
exchange
rate
differences in different markets.
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They operate in their own interest, without

a need or obligation to serve clients or
ensure a continuous market.

Central Banks and

Treasuries
Central banks and treasuries use the market to
acquire or spend their countrys foreign
exchange reserves as well as to influence the
price at which their own currency is traded.

The motive is not to earn a profit as such, but rather

to influence the foreign exchange value of their
currency in a manner that will benefit the interests
of their citicizens.
As willing loss takers, central banks and treasuries
differ in motive from all other market participants.
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They may act to support the value of their own

currency because of policies adopted at the
national level or because of commitments entered
into through membership in joint agreements such
as the European Monetary System.

 Foreign exchange brokers are agents who

facilitate trading between dealers without
themselves becoming principals in the
transaction.
For this service, they charge a commission.
It is a brokers business to know at any
moment exactly which dealers want to buy or
sell any currency.
Dealers use brokers for their speed, and
because they want to remain anonymous
since the identity of the participants may
influence short term quotes.
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Foreign Exchange
Brokers

Exchange Rate - Amount of one currency

needed to purchase one unit of another
currency. $
E/$ = 0.63
E$/ = 1.35
Spot Rate of Exchange the price of
currency for immediate delivery.
Forward Exchange Rate the price of
currency for delivery at sometime in the
future.
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Exchange Rates

International Prices

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The Big Mac Index The price of a

Big Mac in different countries (July 5,
2007)

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SPOT MARKET

Ask Bid
PS
x100
Ask
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Percent Spread Formula (PS):

Direct quote and indirect quote

Direct Exchange Rate:
The home currency price of one unit of
a foreign currency. sdomestic/foreign
formally: 1.00USD = 6.59026SEK (swedish

1.00EUR = 8.97835SEK
Indirect Exchange Rate:
The foreign currency price of one unit of
the
home currency.
1.00SEK = 0.151729USD
1.00SEK = 0.111379EUR
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Krona)

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Examples of Exchange Rate Quotations

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Cross exchange rate

The exchange rate between 2 currencies calculated
by the relationship to a third currency.

What is the exchange rate for British pound and Euro?

Cross exchange rate for /
E(/) = E($/) / E($/)
=1.58365/1.35973=1,16468
1.00USD = 0.630557GBP

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E($/) = 1.35973
E($/) = 1.58365

Foreign Exchange Rates

and Quotes

Citibank quote - $/ $0.9045/

Barclays quote - $/
$1.4443/
Dresdner quote - /
1.6200/
Cross rate calculation:
=
$1.4443/
= 1.5968/
$0.9045/

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Triangular Arbitrage
Citibank
Start with $1,000,000

Receive
(6)
$1,014,533

(1)

Sell $1,000,000 to
Barclays Bank at $1.4443/

Barclays Bank

Dresdner Bank
Sell
(5) 1,121,651 to
Citibank at $0.9045/

(2) Receive 692,377

(4)
Receive
1,121,651

(3) Sell 692,377 to Dresnder Bank

at 1.6200/
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End with $1,014,533

Exchange rate risk

Exchange rates fluctuate from minute to
minute,

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Participants at 2 Levels
1. Wholesale Level (95%)
- major banks
2. Retail Level
- business, customers.

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Foreign exchange
exposure

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Firms Assets and liabilities in

foreign currency vary according
to their exposure in that
particular currency, this is the
foreign exchange exposure.

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Example: appreciated
The value of 1 euro
Example: consider the exchange rate E$/

At t=0, E$/ = $1.06,

E$/ = $1.28

A euro buys E$/,1 - E$/,0 )/ E$/, 0 = 0.22/1.06

= 21% more U.S. dollars.
We would say the euro has appreciated by
(about) 21% against the U.S. dollar.
Or euro is traded at a premium to dollars
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At t=1,

Example: depreciated
The value of 1 dollar
Example: the exchange rate E/$
E/$,0 = 0.95, E/$,1 = 0.78

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A U.S. dollar buys E/$ / E/$,0 = 0.17/0.95 =

18% fewer euros.
The dollar has depreciated by (about) 18%
against the euro.
Or the dollar is traded at a discount to euro.

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Why Exchange Rate

Change?

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Purchasing power parity

Interest parity

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