Topic 8: Currency Market

The International Monetary System

 Every nation has a monetary system and a monetary authority. In the Philippines, the Bangko Sentral is the monetary
authority which is tasked by the law to promoting economic stability and growth as discussed in Topic 1.
 Countries trade with one another, hence they need a payments facility that connects these nations

International Monetary System

 The framework within which exchange rates are determined.
 Multinational companies also took advantages of these technology-advanced system

Multinational Companies (MNCs) or Global Firms / Transnational Corporations

 they international assets and operations in foreign markets and they earn part of their total revenue and profits
from those markets.

Primary reasons why companies go “global”:

A. To broaden markets.
 Based on economic product life-cycle theory, a
company must first produce in its domestic market, to
develop its product and satisfy local customers.
However, as the domestic market matures, the growth
of total demand slows, and competition becomes more
intense and stiffer. This is the time demand for the
product develops can be expand abroad, which creates
conditions favoring production in foreign countries.
geographically dispersed
E. Diversification
 companies can cushion the effect of adverse
economic conditions in a single country by establishing
worldwide production facilities and market
 companies investing overseas can benefit
from diversification in the same way that individuals
benefit from investing in a broad portfolio of stocks.

B. They seek efficiency in production. F. Retain customers

 assuming an adequate supply of labor and an
transportation infrastructure, companies based in high-
cost countries shift production to lower cost regions.
C. Avoid political, trade, and regulatory hurdles.
 To circumvent government restrictions, such as
but not limited to tariffs, quotas, and other restrictions
on imported goods and services, firms often develop
production facilities abroad.
D. Seek raw materials and new technology.
 companies must go where the materials are
found since supplies of many essential raw materials are
 Managing the relationship with customers
will be much easier and economies of scale and other
synergies will likely be achieved if the firm can obtain
what it needs from a supplier that also operates in
the same set of countries.
G. Protect processes and products.
 property rights involving intangible assets are
often difficult to protect particularly in foreign markets.
 In order to protect the secrecy of their
production processes, distribution systems, or the
product itself, firms often invest abroad rather than
license local foreign firms.

Five factors to consider when companies operate globally:

1. Political risk.
 constraints on the transfer or use of corporate
resources, including various regulations and tax
rules
 these must be addressed explicitly in any
financial analysis.
2. Economic and legal ramifications.
 Each country has its own economic and
legal systems. These differences should be
taken in to consideration since it may cause
significant problems when a firm tries to
coordinate its global operations
 Such differences can restrict global
corporations’ flexibility in deploying resources
3. Different currency denominations.
 exchange rates must be included in all
financial analysis of multinational companies
because cash flows in various parts within a
multinational corporate system will be
denominated in different currencies.
4. Language and cultural differences.
 Multinational companies find these matters
i.e. goals of the firm, performance evaluation,
attitudes toward risk, compensation systems,
interactions with employees, and the ability to
curtail unprofitable operations vary dramatically
 from one country to another.  Essentially, a political process in which the
terms under which companies compete, the
5. Role of governments. legal or illegal actions, and the terms of trade
 Traditional financial models have to include are determined not in the marketplace but by
political and other non-economic aspects in the negotiation between host governments of a
decision particular country and the multinational entities

Terminologies
 These words are frequently encountered when dealing with international markets

Exchange Rate  the supply and demand in the market determine

 it is the number of units of a particular the currency’s value
currency that can be purchased for one unit of
another currency. Devaluation of a currency
 the price of one country’s currency in terms of  refers to a decrease in the stated par value of a
another country’s currency currency whose value is fixed
 this decision is made by the government
Spot Exchange Rate
 quoted price for a unit of foreign currency to be Depreciation of a currency
delivered “on the spot” or within a short span oftime  a decrease in the foreign exchange value of a
floating currency
Forward Exchange Rate  this is caused by market forces
 quoted price for a unit of foreign currency to be
delivered in the future at a particular date Revaluation of a Currency
 refers to an increase in the stated par value of a
Fixed Exchange Rate currency whose value is fixed
 currency is set by the government and allowed to  this decision is made by the government
fluctuate slightly around the desired at set rate,
the parvalue Appreciation of a Currency
 an increase, respectively, in the foreign exchange
Floating or Flexible Exchange Rate value of a floating currency
 not regulated by the government  this is caused by market forces

Foreign Exchange Rate Quotations

Direct quote
 the number of units of domestic currency corresponding or in equivalent to 1 unit of foreign currency
 home or domestic currency price of one unit of the foreign currency.
 It is the norm in all countries, except in the Australia, UK, New-Zealand, Canada and the Eurozone
 Examples (for a Swiss Franc based investor):
o 0.99 CHF = 1 USD
o 1.08 CHF = 1 EUR

Indirect quote
 the number of units of foreign currency corresponding or in equivalent to 1 unit of domestic currency
 The foreign currency price of one unit of the home or domestic currency.
 this is the norm in UK, New-Zealand, Australia, Canada and theEurozone
 Examples:
 1 EUR = 1.09 USD
 1 AUD = 0.71 USD

CROSS RATES
 The exchange rate between any two currencies.
 Example:
 a German executive is flying to Tokyo for a business trip. The exchange rate in which he or she is interested is
not euros or yen per dollar, but the issue is how many yen can be purchased with a euro. Use this table:
Solution:
 For the German executive, the cross rates are determined:

 Cancelling the dollar signs will get the number of euros that 1 yen could buy:

 Finding the number of yen that 1 euro could buy:

 The two cross rates are reciprocals of each other.

Trading in Foreign Exchange

 The Foreign exchange rate or the so-called Forex market is the largest financial market.

Daily Trading Volume in Foreign Exchange Markets (in TrillionUSD): April 2007: 3.3
April 2010: 4.0
April 2013: 5.3

Source: Triennial Central Bank Survey conducted by the Bank for International Settlements – September 2013

SPOT RATES AND FORWARD RATES

Spot Rates
 rate paid for delivery of the currency “on the spot”
 in reality, no more than 2 days after the day of the trade

Forward Exchange Rate

 the buy or sell of currencies for delivery at an agreed-upon future date which is usually 30, 90, or 180 days from
the negotiated day of the transaction

Selling at: If: Description:

Discount spot rate < forward  obtain more of the foreign currency for a domestic or local currency
rate in the forward market than in the spot market
 forward currency is less valuable than the spot currency
 Premium spot rate > forward  obtain less of the foreign currency for a domestic or local currency
rate in the forward market than in the spot market
 forward currency is more valuable than the spot currency

Example:

Observe:
a. Selling at a discount: forward Australian dollars
• a dollar buys more Australian dollars in the forward market than in the spot market
b. Selling at premium: forward pounds, yen, and Swiss francs
• a dollar buys less pounds, yen, and Swiss francs in the forward market than in the spot market

Interest Rate Parity

 Specifies that investors should expect to earn the same return in all countries after adjusting for risk.
 Recognizes that when you invest in a country other than your home country, you are affected by two forces—returns on
the investment itself and changes in the exchange rate
 Equation:

Illustration:
The nominal annual interest rate on 6-month U.S. Treasuries is 1.5%. The spot rate of the British pound is $1.2881 (£0.7763
per U.S. dollar) and the 6-month forward rate of the British pound is $1.2960 (£0.7716 per U.S. dollar). If interest rate parity
holds, what is the nominal annual interest rate on default-free 6-month British bonds?
Step 1: Substitute the variables on the problem to the formula Step 2: Solve
• the semiannual return on 6-month U.S. Treasuries is 0.75%

• Hence, the nominal annual interest rate on a 6-month default-free British bond is: 2*0.135861% = 0.2717%. It is multiplied
by 2 to annualize the interest rate on default-free 6-month British bonds.

Purchasing Power Parity

 a theory stating that these two things should be equivalent:
 Buying a good in a given currency
 Using this money to exchange it into another currency and then buy the same good in the country of
this other currency
 sometimes referred to as the law of one price
 The relationship in which the same products cost roughly the same amount in different countries after taking
into account the exchange rate.
Equation:
ℎ � : ℎ= � 찀 ℎ ⿏ Ð ℎ ℎ 홰 䁙Ð � ;
찀= � 찀 ℎ ⿏ Ð ℎ 찀 � Ð 䁙Ð �

Illustration:
A U.S. customer observes that a tennis racket costs $200. 1 euro, in the spot market, can be exchanged for $1.1924. How
many euros is expected to be paid for the same tennis racket in Europe under the purchasing power parity theory?
Solution:

Analysis:
 If purchasing power parity holds, the price of the tennis racket in the European market should be €167.7290.
 The U.S. customer has $200 that either:
 could be used the $200 to buy the golf club in the U.S. market, or
 could be exchanged for €167.7290 and buy the tennis racket that cost €167.7290, when purchasing power parity
would hold.
 It would be better to buy the tennis racket in the United States if the tennis racket sold for more than €167.7290 in
Europe otherwise if the tennis racket sold for less than €167.7290 in the Eurozone, it would make sense to buy the
tennis racket in Europe.

International Credit Markets

Major types of international credit markets:
1. Eurocredits
 Floating-rate bank loans, available in most major trading currencies
 The oldest example of a eurocredit is a eurodollar deposit, which is a U.S. dollar deposited in a bank outside the United
States. Today eurocredits exist for most major trading currencies.

2. Eurobond market
 Eurobond
 An international bond underwritten by an international syndicate of banks and sold to investors in countries other
than the one in whose money unit the bond is denominated.

3. Foreign bond market

 Foreign Bonds
 A type of international bond issued in the domestic capital market of the country in whose currency the bond is
denominated and underwritten by investment banks from the same country
 the headquarters of the borrower is in a different country.

International Stock Markets

New issues of shares are sold in international markets for a various reason:
a. Create an equity market presence to accompany its operations in other country; and
b. Tap a much larger source of capital

Gold market
Gold, as a financial asset, has been used as: • Money (either as coins or as backing to Fiat
• Investment currency systems like the gold standard
• Store of value

Gold can be used to hedge against: • Stock market crashes

• A collapsing currency
• Political tensions
• Inflation
• The sudden loss of faith in a fiat currency system
The foreign exchange- https://www.youtube.com/watch?v=_tEbIzKbZhY
Purchasing Power Parity - https://www.youtube.com/watch?v=pbIhGTJe41k
https://www.youtube.com/watch?v=7lJxSMawhfI