University of Economics Prague

Department of International Trade

Josef Tauer
Associate Professor
Office Hours: See ISIS
Email: tauser@vse.cz
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Financial Management in IB
Content:
1. Foreign Exchange Markets
Exchange Rate Quotations, Cross Rates. Locational Arbitrage,
Triangular Arbitrage, Currency Speculations

2. Currency Derivatives
FX forwards, Currency Futures, FX Swaps and Currency Swaps,
Currency Options.

3. Exchange Rate Exposure

Transaction, Economic and Translation Exposure; Exchange
Rate Risk Measurement and Management

4. International Investement Decisions

Time Value of Money, Stock Valuation, Interest Rates and Bond
Valuation, Security Market Line, Investment Criteria
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Literature
Eiteman, D. K., Stonehill, A. I., Moffet, M. H.:
Multinational Business Finance, Pearson Addison
Wesley, 2004
ROSS, S A., WESTERFIELD, R., JAFFE, J F.:
Fundamtentals of Corporate finance, McGraw-Hill, 2005
Madura, Jeff: International Financial Management,
Thomson South-Western, 8th Edition, 2006

Financial Management in IB

Foreign Exchange Markets

Foreign Exchange Markets

Exchange Rate
Exchange rate is the price of one currency in units of another
currency.
Quotations that represent the value of a foreign currency in
domestic currency are referred to as direct quotations.
For example: 1 $ = 0.8000 (USD, CHF, CAD)

Foreign Exchange Markets

Exchange Rate
Exchange rate is the price of one currency in units of another
currency.
Quotations that represent the number of units of a foreign currency
per domestic currency are referred to as indirect quotations.
for example: 1 = 1.25 $ or EUR/ USD 1.25 (EUR, GBP)

Foreign Exchange Markets

Exchange Rate - Quotations
Foreign Currency
(USD) appreciates

Foreign Currency
(USD) depreciates

Indirect Quotation
(EUR/USD)

Exchange Rate falls

Exchange Rate rises

Direct Quotation
(1 USD = x EUR)

Exchange Rate rises

Exchange Rate falls

Foreign Exchange Markets

Foreign exchange market
The foreign exchange market allows currencies to be exchanged to
facilitate international trade or financial transactions.
There is no specific building or location where traders exchange
currencies.
The currencies are traded directly from the offices and dealing
centers of the banks over telecommunication systems.

Foreign Exchange Markets

Interbank Market
The market for immediate exchange is known as the spot market.

Delivery takes places normally on the second following

business day.

Trading between banks makes up what is often referred to as the

interbank market.

The banks often function as market makers.

Individual transactions in the interbank market are usually

for larger sums that are multiplies of a million Euros, US
Dollars etc.

On the client market the transactions are typically for

smaller
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Foreign Exchange Markets

Exchange Rate (Bid Ask rate)
Banks provide foreign exchange transactions for a fee (spread).
Direct Quotation: the bid (buy) quote for a foreign currency will be
less than its as (sell) quote.

bid/ask spread

ask rate - bid rate

=
ask rate

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Foreign Exchange Markets

Exchange Rate (Bid Ask rate)
Banks provide foreign exchange transactions for a fee (spread).
Indirect Quotation: the bid (buy) quote for a domestic currency will
be less than its ask (sell) quote.

The bid/ask spread is normally greater for those currencies

that are less frequently traded.

The bid/ask spread is normally smaller if there is a strong

competition on the market.

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Foreign Exchange Markets

Exchange Rate Quotations /USD (on 31.12.2000)
Bid Rate

1.2013

Ask Rate
1.2332 1.2333 1.2334
1.2295

1.2361

Cash
Transactions
(Bid Rate)

Client
(Bid Rate)

1.2611

Euro
Interbank Fixing Interbank
(Bid Rate)

(Ask Rate)

Client
(Ask Rate)

Cash
Transactions
(Ask Rate)

Source: Stocker, K. (2001): WechselExchange Ratemanagement auf Euro-Basis, pp.11

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Foreign Exchange Markets

Exchange Rate Quotations
Inverse value of bid rate in direct quotation equals ask rate
in indirect quotation.
Example:
Direct quotation: EUR/USD: 1.3292/1.3304
In indirect quotation:

0.7517

= BID (indirect quotation)

0.7523

= ASK (indirect quotation)

USD/EUR: 0.7517/0.7523
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Foreign Exchange Markets

Cross Rates

/1

For currencies that Euro is not directly traded with.

All currencies are quoted against US Dollar

Dollar may be used as a Vehicle-Currency

Euro is traded only with the most important currencies.

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Foreign Exchange Markets

Cross Rates

/2

Example:
How can we calculate the EUR /AZM (Azerbaijan Manat)
exchange rate using US Dollar as an intermediate currency?
Solution
1 EUR = ? AZM
EUR/USD 1.2388 and 2.0354 USD/AZM
EUR/AZM 2.5215
Indirect Quotation x Direct Quotation

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Foreign Exchange Markets

Cross Rates

/3

International Arbitrage /1

All spot rates shall agree with relevant cross rates, otherwise the
arbitrage opportunities do exist!

Arbitrage can be defined as capitalizing on the differences in

quoted prices by making risk-less profit.

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Foreign Exchange Markets

International Arbitrage/2
3 types of arbitrages on foreign exchange markets

Locational Arbitrage

Triangular Arbitrage

Covered Interest Arbitrage

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Foreign Exchange Markets

Locational Arbitrage
Locational arbitrage is a process of buying a currency on
the market where it is relatively cheap and immediately selling
it on another market where it is priced higher.
Example:
Paris Interbank market:

EUR/USD 1.3277/1.3285

London Interbank market:

EUR/USD 1.3287/1.3295

Solution:
Arbitrageur buys Euros in Paris for 1.3285 USD and
immediately sell Euros in London for 1.3287 USD.

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Foreign Exchange Markets

Locational Arbitrage

Locational arbitrage is possible when the bid price of one bank

is higher than the ask price of another bank for the same
currency.

In response to the imbalance in demand and supply resulting

from such arbitrage activity, the prices will adjust very quickly.

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Foreign Exchange Markets

Triangular Arbitrage
Triangular arbitrage is a process of capitalizing on the
differences between the spot rates and cross rates.
Example:
EUR/USD 1.2900
EUR/CZK 27.850
USD/CZK 21.900
Solution:
Arbitrageur sells Euros for 1.2900 USD; then he sells USD for
21.900 CZK and buys again Euros for 27.850 CZK.

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Foreign Exchange Markets

Triangular Arbitrage

Triangular arbitrage is possible when a quoted cross exchange

rate differs from that calculated using the appropriate spot rates.

In response to the imbalance in demand and supply resulting

from such arbitrage activity, the prices will adjust very quickly.

Spreads reduce the arbitrage profits.

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Foreign Exchange Markets

International Arbitrage

Locational arbitrage ensures that quoted exchange rates are

similar across banks in different locations.

Triangular arbitrage ensures that cross exchange rates are set

properly.

Any discrepancy will trigger arbitrage, which will then eliminate

the discrepancy. Arbitrage thus makes the foreign exchange
market more orderly.

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Foreign Exchange Markets

Currency Speculations

Speculators seek to profit from the exchange rate movements.

To achieve a high leverage effect the speculators open short

positions in weak currencies.

Example:
Assume you expect Euro to depreciate from EUR/USD 1.40 to 1.33
in 30 days. What is your expected profit from the speculation if your
borrowing capacity is 10 MEUR or 14 MUSD and annualized
interest rates are as follows:
EUR

2.00% - 2.10%

USD

4.00% - 4.35%
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