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International Business Study Notes for Exam

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Ryerson University
Global Management Studies
GMS 724
Howard Lin

***Chapter 9: Global Foreign-Exchange Markets*** Foreign Exchange Foreign exchange : money dominated in the currency of another nation or group of nations Can be form of cash, funds available on credit and debit cards, travelers checks, bank deposits, or other short-term claims Foreign exchange market: market in which these transactions take place Exchange rate: price of a currency Players on the Foreign Exchange Market Types of Foreign Exchange Market Traditional Foreign Exchange Instruments 1. Spot Transactions: immediate exchange currency, generally made on second business day after the date on which two foreign-exchange dealers agree to transaction Spot rate: rate at which transaction is settled 1. Outright Forward Transactions: exchange of currency on future date, forward transaction will be settled at forward rate no matter what actual spot rate is at time of settlement Forward rate: rate at which transaction is settled and contract rate between two parties 1. FX swap: simultaneous spot and forward transaction, currency is swapped for another on one date and then swapped back on future date 2. Currency Swaps: deal more with interest-bearing financial instruments and involve exchange of principal and interest payments 3. Options: the right, but no obligation, to trade foreign currency in future 4. Futures Contract: agreement between two parties to buy or sell particular currency at particular price on particular date Hedge funds: funds typically used by wealthy individuals and institutions that are allowed to use aggressive strategies unavailable to mutual funds Five Major Reasons Why the Dollar is so widely traded 1. Its an investment currency in many capital markets 2. Its a reserve currency held by many central banks 3. Its a transaction currency in many international commodity markets 4. Its an invoice currency in many contracts 5. Its an intervention currency employed by monetary authorities in market operations to influence their own exchange rates Important Currency and Pairs The U.S dollar is the most important currency on the foreign-exchange market Top two pairs include EUR/USD and UUSD/JPY Cross rate: exchange rate between two currencies other than US dollar Geographical Distribution of Foreign Exchange Markets Four largest centers for foreign exchange trading (UK, US, Japan, Singapore) account for 62.5% of total average daily turnover UK market is so dominant that more dollars are traded in London than in New York MAJOR FOREIGN EXCHANGE MARKETS The Spot Market Bid: price at which dealer is willing to buy foreign currency Offer: price at which dealer is willing to sell foreign currency Spread: difference between the bid and offer rates, and it is the dealers profit margin Direct and Indirect Quote American terms (aka. Direct quote): number of dollars per unit of foreign currency European terms (aka. Indirect quote): number of units of foreign currency per dollar Always quote base currency (denominator) first and then terms currency (numerator) Direct and indirect quotes (for UK pound: $1.64 and 0.6072) Inter-bank Transactions: transactions between banks Retail transactions( those between banks and companies or individuals) provide fewer foreign currency units per dollar than interbank transactions The Forward Market Forward rate: rate quoted for transactions that call for delivery after two business days Forward discounts: exist when the forward rate is less than the spot rate Forward premium: exist when the forward rate is greater than the spot rate Premium percentage is calculated by multiplying the difference between spot and forward rates by 12 months divided by number of months forward Eg. 0.9329 0.9303/0.9303 X 12/6 = 0.0055894 or 0.56% Therefore, it is selling at premium in forward market because forward rate is greater than the spot rate Option the right, but no the obligation to trade a foreign currency at a specific exchange rate Options Option: right, but not the obligation, to trade a foreign currency specific exchange rate Option provides company flexibility because it can walk away from option if strike price is not a good price Forward contract is cheaper but less flexible than option Futures A future contract specifies an exchange rate in advance f actual exchange of currency, but it is not as flexible as forward contract Future Contract Similarities Forward Contract Traded on exchange not OTC specifies an exchange rate companies work with Companies work with exchange some time in advance of banks brokers when purchasing future actual exchange of tailored to amount and contracts currency time frame company Tailored for specific amount and needs specific maturity date ore valuable to company Less valuable to company May be more useful to speculators and small companies that cannot enter into forward contract THE FOREIGN EXCHANGE TRADIGN PROCESS When a company sells goods or services to a foreign customer and receives foreign currency, it needs to convert the foreign currency into the domestic currency When importing, the company needs to convert domestic to foreign currency to pay the foreign supplier This conversion usually takes place between the company and its bank Large MNEs go through their money center banks to settle foreign-exchange balances but other firms use local banks or other financial institutions The Foreign Exchange Trading Policy Banks and Exchanges The top banks in the inter-bank market in foreign exchange are so ranked because of their ability to Trade in specific market locations. Engage in major currencies and cross-trades. Deal in specific currencies. Handle derivatives (forwards, options, futures, swaps). Conduct key market research Large companies may use several banks to deal in foreign exchange, selecting those that specialize in specific geographic areas, instruments, or currencies Top Exchanges for Trading Foreign Exchange Three of the best known exchanges are: 1. Chicago Mercantile Exchange (CME) Group Merger between CME and Chicago Board of Trade Traders stand in a pit and call out prices and quantities Platform is linked to an electronic trading platform, which is increasing in popularity CME trades many different foreign exchanges 2007, CME and Reuters teamed p and launched worlds first centrally cleared global foreign exchange platform called FXMarketSpace establish centrally cleared global platform that allowed customers to buy and sell currencies anonymously 1. NASDAQ OMX Pioneers in trading currency options 2008, merged with PHLX and created third largest options market in US Formed new hybrid of trading (involves traditional floor trading and online trading) 1. NYSE Liffe (London International Financial Futures and Options Exchanges) 2002, bought by Euronext 2007, merged with New York Stock Exchange Worlds second largest derivatives exchanges by value of transacted business HOW COMPANIES USE FOREIGN EXCHANGE Business Purposes #1 Cash flow Aspects of Imports and Exports Commercial Bills of Exchange Draft (aka commercial bill of exchange): instrument in which one party (the drawer) directs another party (the drawee) to make payment Drawee either company or bank In letter case (below, draw would be considered a bank draft) Documentary drafts and documentary letters of credit are often used to protect both buyer and seller Sight draft: exporter requests payment to be made immediately Time draft: payment to be made later (eg 30 days after delivery) Letters of Credit Letter of credit: obligates the buyers bank in importing country to honor a draft presented to it and assume payment; credit relationship exists between importer and importers bank Confirmed letter of credit: exporter has guarantee of an additional bank Business Purposes #2 Other Financial Flows Companies also deal in foreign exchange for other transitions such as the receipt or payment of dividends or the receipt or payment of loans and interest Speculation speculation buying or selling of a commodity, in this case foreign currency, that has both an element of risk and the chance of great profit arbitrage: purchase of foreign currency on one market for immediate resale on another market (in different country) to profit from price discrepancy interest arbitrage: investing in interest-bearing instruments in foreign exchange in an effort to earn a profit due to interest rate differentials ***Chapter 10: The Determination of Exchange Rate*** INTERNATIONAL MONETARY FUND (IMF) Origin and Objectives Mission of IMF: Ensure stability in international monetary system Promote international monetary cooperation and exchange-rate stability Facilitate balanced growth of international trade Provide resources to help members in balance of payments difficulties or to assist with poverty reduction Through a process of surveillance, the IMF monitors the global economy as well as the economies of individual countries and advises on needed policy adjustments IMF also provides technical assistancemainly to low- and middle-income countriesand lending to countries that have balance-of
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