Learning Objectives:

International Financial Management You should understand:

● The organization of the Foreign Exchange Market.

● The Foreign Exchange Market participants.
● The Foreign Exchange quotations.
Foreign ● The Foreign Exchange transactions and methods of
Exchange Market international payments.
“FOREX” (part 1) ● The functions of the Foreign Exchange Market.
● Arbitrage, Speculation & Hedging

The Foreign Exchange Market The Foreign Exchange Market

● The FOREX market is the market in which ● The Price of each currency is determined in
currencies are traded. term of other currencies.
● The FOREX is a financial market where ● The Exchange rate is the rate at which one
money denominated in one currency is currency is converted (exchanged) into
bought and sold with money denominated in another.
another currency. ● The FOREX assists international trade and
● The FOREX market is a global worldwide investment by enabling currency conversion.
decentralized financial market for trading
currencies.
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FOREIGN EXCHANGE MARKET
● Two major features of the FOREX MARKET: ● Higly integrated Market: There is no
significant difference between exchange rates
● The market never sleeps: The markets are situated quotes in the different trading centers;
throughout different time zones of the globe. If one is closing,
the other is beginning its operations. ● High speed computer linkages between
trading centers around the world have
● A global market that operates 24 hours a day (7/7).
effectively created a single market.
● Forex Trading Schedule: A Forex Trading Day starts every ● Most trades by phone, telex, or SWIFT
morning in Sydney and Tokyo... Hong Kong and
Singapore... Middle East... Frankfurt, Zurich and London and
finishes in NY, Chicago, San Francisco and Los Angeles.
SWIFT: Society for Worldwide Interbank
Financial Telecommunications
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FOREIGN EXCHANGE MARKET

● FOREX is described as an OTC (over the counter)

market as there is no physical place where the
● FOREX market is the more liquid market : It is by participants meet to execute the deals.
far the largest financial market in the world
● FOREX is made up of Global network of many
trading 3-4 trillion dollars each day. participants : Banks, Central Banks, FOREX
Brokers, Companies, Individuals.
● The largest FOREX market is in London, followed
● All the participants are connected by electronic
by New York, Tokyo, Zurich and Frankfurt. communications systems (telex, telephone and
internet) to buy and sell foreign currencies. It is not
located in any one place.
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FOREIGN EXCHANGE MARKET FOREIGN EXCHANGE MARKET
PARTICIPANTS PARTICIPANTS

❑ BANKS (FOREX TRADERS) participate in foreign exchange ● WHOLESALE MARKET or INTERBANK MARKET: BANKS,
on behalf of their clients : CENTRAL BANK, FOREX BROKERS
● COMPANIES : importers and exporters often trade fairly small
amounts compared to those of banks and their trades often have ● The bank quoting the price is « price maker»
a little short term impact on market rate.
● FINANCIAL ENTITIES : investment and financial transactions. or
● INDIVIDUALS: tourists, travellers and migrants « market maker ».
● The bank asking for the price or the quote is the
❑ CENTRAL BANK participates in the FOREX market to maintain the
exchange rate at desired level by selling and buying domestic « price taker » or « user ».
currency or foreign currencies.
● FOREX TRADERS: observe currency price movements on
❑ FOREX BROKERS act as agents who inform and facilitate trading Trading Platforms.
currencies between FOREX traders.
● RETAIL MARKET: Companies, Individuals and Financial entities
9 participate through INTERBANK MARKET or through 10
FOREX Brokers.

BANK 1 BANK 1
FOREX FOREX
TRADERS TRADERS

CENTRAL BANK 2 BANK 2

CENTRAL
BANK FOREX FOREX FOREX FOREX
BANK FOREX
FOREX BROKERS TRADERS BROKERS TRADERS
TRADERS
TRADERS

BANK 3 - Companies BANK 3

- Govenment - Financial
Institutions FOREX FOREX
TRADERS entities TRADERS
- Individuals - Individuals

- Economic
role FOREX MARKET 11 WHOLESALE MARKET 12
 FOREIGN EXCHANGE TRANSACTIONS

● Network of CORRESPONDANT BANKS all over the

CENTRAL BANK 2
world: one bank can operates as an agent for
BANK FOREX another bank in another place.
FOREX TRADERS
TRADERS
● FOREX transactions are settled through
NOSTRO and VOSTRO accounts:
- Companies ▪ NOSTRO: our account with banks abroad. A domestic
- Financial bank maintains various nostro accounts in a number
- Govenment entities of countries.
Institutio - Individuals
ns ▪ VOSTRO: their account with us. Banks abroad
- Individuals maintain their nostro accounts at our domestic bank.
RETAIL MARKET 13 14

FOREIGN EXCHANGE TRANSACTIONS

Foreign Exchange Transactions
BANK IN TUNISIA ● The spot market: is the market for
immediate exchange.
VOSTRO VOSTRO VOSTRO
BANK IN U.S.A BANK IN BANK IN FRANCE ● The forward market: enables an MNC to
TND JAPAN TND
TND lock in the exchange rate at which it will buy
or sell a certain quantity of currency on a
BANK IN BANK IN
BANK IN JAPAN specified future date.
U.S.A FRANCE
NOSTRO NOSTRO NOSTRO
BANK IN TUNISIA BANK IN TUNISIA BANK IN TUNISIA
USD JPY EUR
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 Foreign Exchange Foreign Exchange Transactions
Transactions
● Trading between banks occurs in the ● Banks provide foreign exchange services for
interbank market. a fee: bid vs ask
● Within this market, foreign exchange ❖ The bid: is the price at which the bank buy a
brokerage firms act as middlemen. foreign currency.
❖ The ask: is the price at which a bank sell a
foreign currency.
● The bank’s bid (buy) quote fora
foreign currency will be less than its ask
(sell) quote.
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Foreign Exchange
Transactions
bid/ask spread
● The bid/ask spread is normally larger
● bid/ask spread % =
ask rate – bid
ask rate those currencies that are less
for
rate frequently
● Example: Suppose bid price for £ = traded.
● Exchange rate quotations for widely traded
$1.52, ask price = $1.60. currencies are frequently listed in the news
bid/ask spread %= (1.60–1.52)/1.60 = 5% media on a daily basis. Forward rates may
be quoted too.

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 The Exchange rate The Exchange rate
Examples:
● On FOREX, currencies are quoted against each other in the
form of parity. 1 CAD = 0.7612 USD: It takes 0.7612 US
● The exchange rate is the price at which the currency of one dollars to buy 1 Canadian dollar;
country is exchanged for the currency of another country.
● It is the amount of currency needed to buy a unit of currency 1 TND = 0.31 USD: It takes 0.31 US dollars to buy 1 Tunisian
from another country. dinar;
● On the markets, currency names are reduced to a three-letter 1 TND = 0.3 EUR: It takes 0.30euro to buy 1 Tunisian dinar;
code (CAD, USD, EUR, YEN, TND, etc.)
1 TND = 47.36 YEN: It takes 47.36 Japanese Yen to buy 1
TND

1 GBP = 1.6849 CAD: It takes 1.6849 CAD to buy 1 Pound

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Unit of exchange quotation

● ThePIP (Price Interest Point): Unit of exchange

● In general, exchange rates change rate quotation.
according to the economic/political/social
● 1 PIP is a unit of change in parity (the smallest
factors, etc. of the countries of the two
price change in the listed currency )
currencies concerned in parity (CAD/EUR
parity example)
● On the Dollar/Euro 1 PIP = 0.0001. When USD/EUR
goes from 1.3350 to 1.3360 there is an increase of 10
PIPs.
● On the Dollar/Yen (USD/YEN), 1 PIP = 0.01
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 The Exchange rate regimes The Exchange rate regimes
● Fixed (PEGGED) exchange rate: the central bank sets ● Flexible exchange rate (floating): fluctuate
the exchange rate and undertakes to maintain it over
prices according to market conditions.
time.
Constant against a reference currency (USD, EUR).
These regimes areadopted by developed
Can only be changed by a government reassessment or countries (US, Canada, UK…)
devaluation decision.
Independent and determined at each transaction by
the balance between supply and demand on the foreign
Fixed parity with USD (Bahrain, Cuba, Jordan, Oman, Panama, Qatar, United
Arab Emirates, Venezuela, etc.)
exchange markets.
Fixed parity with Euro (Bulgaria, Cameroon, Chad, Gabon, Senegal, etc.)

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Fixed Exchange rate vs Floating

● Managed Floating Exchange rate is neither
Advantages Disadvantages
completely free nor fixed exchange rate
✔ Fixed :Provides a stable ✔ Rigid regime: The central
framework for trade with a bank must be ready with
● It is officiallyfixed but altered from time low level of risk its reserves to intervene
to time by monetary authorities. (Costly)
✔ Simplified management of ✔ Fixed rate may not reflect
international trades (Rate reality
known and fixed in advance).

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 Fixed Exchange ratevs Floating TUNISIAN EXCHANGE RATE REGIME
Advantages Disadvantages ● Managed Floating Exchange Rate Regime.
✔ Floating :Consistent with the ✔ Flexible regime: the ● Domestic currency is TND and it is not
economic indicators management MNCs involved totally convertible.
in international trade is ● Restrictions on the amount to convert
more difficult.
● Tunisian central bank :
✔ The government does not ✔ A foreign exchange risk to ▪ manages the exchange rate mechanism
intervene in monetary policy ▪ Keeps the exchange rate stable
hedge (cost)
▪ Regulates interbank FOREX transactions and monitor the
FOREX exchange risk of the banks
▪ Manages and maintains the country’s foreign
exchange reserves
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Exchange rate quotation

Direct quotation: (Right quote) Indirect quotation: (left quote)
✔ Expresses the value of the domestic currency against to foreign
currencies. ✔ Expresses the value of foreign currencies against the domestic
✔ In Canada, the 1.0061 CAD/USD is a direct quote for Canadians. (CAD currency.
is the domestic currency (base currency or reference currency); USD ✔ Amount of foreign currency for a unit of local currency.
(Right side) is the foreign currency/ price currency or quote currency)
✔ In Great Britain, the 0.75 GBP/USD is a direct quote for the British. ● In Canada a quote of (1/1.0061) = 0.9939 USD/CAD is an indirect
(GBP is the domestic currency (base currency) and USD (Right side) is quote for Canadians. (USD (left side) is the foreign currency and
the foreign currency (price currency or quote currency)).
CAD is the domestic currency).
● When the exchange rate is greater than 1, it means that the domestic
currency has less value than the foreign currency . ● In Great Britain, a quote of (1/0.75) = 1.33 USD/GBP is an indirect
● When the exchange rate is less than 1, it means that the domestic quote for the British. (USD (left side) is the foreign currency or quote
currency has more value than the foreign currency. currency and GBP is the domestic currency or base currency).
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● Currency depreciation: thecurrency (TND) Example: (Appreciation /Depreciation)
● Spott rate : 2.5445 CAD/GBP
becomes weaker.
● Spott+1 rate: 2.3079 CAD/GBP
Has the pound depreciated or appreciated?
TND/USD increase (3.18 TND/USD becomes 3.35 TND/USD) The Spott+1rate is lower than the Spott rate, so the pound
has
● Currencyappreciation: thecurrency (TND) becomes depreciated.

more stonger. What is the change in the value of the pound sterling?

(end – beginning) / beginning = (2.3079 - 2.5445) / 2.5445 = - 9.3%

TND/USDdecrease (3.18 TND/USD becomes 3.05 TND/USD)

33
So, thehappened
What pound depreciated by 9.3% against the Canadian dollar.
to the dollar? 35

Eurocurrencies
● If the pound has depreciated and the dollar?
● Eurocurrencies: aredomestic currencies
● Since the reference hasbecome the dollar, the rates must deposited
be foreign banks. in
expressed inversely. The dollar has therefore gone from:
A Eurodollar is a deposit denominated in dollars in a bank
0.3930 GBP/CAD (1/ 2.5445) to 0.4333 GBP/CAD (1/2.3079) outside the United States.
0.4333GBP/CAD is higher than 0.3930GBP/CAD , so the CAD is A Euroyen is a deposit denominated in yen in a
appreciated.
Variation: bank outside Japan.
(end – beginning) / beginning = (0.4333-0.3930) /
0.3930 =
35 36
10.25%
 FOREIGN EXCHANGE MARKET
FUNCTIONS TRADING/ FINANCIAL TRANSACTIONS

● Two functions: ● Companies that receive payments in foreign

currencies need to convert theses payments
● Converting currencies: to their home currency (exporting)

● Trading/Financial Transactions
● Arbitrage ● Companies paying foreign businesses of
● Speculation goods or services (importing)

● Reducing Risk (Hedging) ● Companies investing cash for short terms in

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money market accounts. 38

ARBITRAGE ARBITRAGE
● On October 24th, at 10 a.m:
● If Exchange Rates quoted in different markets were Paris FOREX: 1 EUR = 3.36 TND
Tunis FOREX: 1 EUR = 3.41 TND
not essentially the same, there would be an
opportunity for arbitrage.
● Two different marketsand two different Exchange Rates at
the
● The process of buying a currency at a lower price in same time.
a FOREX Market and selling it at a higher price in
another FOREX Market at the same time. ● ARBITRAGE: we have to buy the EUR at the low rate on a market
and sell it at the high rate on another market at the same time.

● Profit seeking from variations in rates in different ● We buy 1 EUR at 3.36 TND in Paris FOREX Market and sell it at
markets but at the same time. 3.41 TND in Tunis FOREX Market at the same time.

● No risk: positive profit in a certain way. 39

● FOREX Markets
Profit of 0.05at the same per
TND time.1 EUR bought and sold on
 Types of Arbitrage Geographic Arbitrage
● There are two types of arbitrage: ● The geographic arbitrage consists in taking
advantage without risk of a difference between
quoted prices at the same time on two different
financial markets.
● Geographic arbitrage
● This arbitrage may be made by a trader when, at
● Triangular arbitrage the same time, the bid price of a currency on a
given financial centre is higher than the bid price
of that same currency on another centre.
● It is necessary that Bid1 > Ask2
41 42

Geographic Arbitrage : Example 1 Example 1 (Cont’d)

London Frankfurt London Frankfurt
Bid 0.2074 GBP/EUR 0.2126 GBP/EUR Bid 0.2074 GBP/EUR 0.2126 GBP/EUR
Ask 0.2080 GBP/EUR 0.2127 GBP/EUR Ask 0.2080 GBP/EUR 0.2127 GBP/EUR

● Sell the euros at the bid price 0.2126 GBP/EUR in Frankfurt

A rational arbitrator who holds EUR 50,000: What does he do? ● 50 000* 0.2126 GBP/EUR = 10 630 GBP
He will compare bid and ask prices in both financial markets ● The arbitrator have more GBP selling the euros
To have an opportunity for arbitrage : ● Buy the euros from London with the ask price 0.2080 GBP/EUR
Bid 1 > Ask 2 ● 10 630 / 0.2080 GBP/EUR = 51105.7692 EUR
The bid price of EUR in Frankfurt > the ask price of EUR in London. ● The arbitrator pays less GBP for 1 EUR

Arbitrage opportunity Sell EUR 10 630 GBP

Sell the euro on the market where the price is higher (bid price is higher) Buy EUR 51105.7692 EUR
Buy the euros on the market where the price is low (ask price is weak) Profit 51105.7692 EUR – 50 000 EUR = 1105.76 EUR
43 4
5
Example 2

Montreal New York

Cross-rates
Bid 1.0580 CAD/USD 1.0620 CAD/USD ●
Ask 1.0600 CAD/USD 1.0650 CAD/USD

● A rational arbitrator with 1000 000 $US: What he can do?

45 46

● Example 1: A Mexican importer needs ● To calculate the KRW/MXN cross rate, a

Korean Won. simple rule of three is then used:

● Korean won: 1200.00 KRW/USD

● Mexican Peso: 9.3750 MXN/USD ● 1USD = 1200.0000 KRW
● 1USD = 9.3750 MXN

Cross rate: KRW/MXN : 128.0000 KRW/MXN (1200/9.3750)

● Calculate the KRW/MXN cross rate? Cross rate: MXN/KRW : 0.0078 MXN/KRW (9.3750/1200)

47 48
 Example 2:
● You have the following rates ● When the implicit cross rate differs from the direct exchange rate
1 Euro = 36.9040 THB (36.9040 THB/EUR) of the two currencies, there is a possibility of triangular
arbitrage.
1 Euro = 3.36 TND (3.36 TND/EUR)
● Triangular arbitrage involves 3 currencies.
● Arbitrage :

Buy on the market where the price is low (the currency is

What is the cross rate : THB / TND?
undervalued).
What is the cross rate : TND/ THB?
Sell on the market where the price is high (the currency is
overvalued).

49 50

Triangular Arbitrage: Example 1 Example 1

● Cross rate (NY-London): (1.2440 USD/EUR)/(140 YEN/EUR)
= .0089 USD/YEN
Exchange rate .0089USD/YEN (cross quotation ) ≠ .0092 USD/YEN in Tokyo

NY 1.2440 USD/EUR ARBITRAGE OPPORTUNITY

Londres 140 YEN/EUR
Market Rate Overvalued versus undervalued
Tokyo .0092 USD/YEN
NY 1.2240 USD/EUR USD is overvalued
EUR is undervalued
London 140 YEN/EUR EUR is overvalued
YEN is undervalued
Tokyo 0.0092 USD/YEN YEN is overvalued
• Determine the profit from this arbitrage. USD is undervalued

You have 1 000 000 USD. Implicit rate 0.0089 USD/YEN

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5
3
● Steps of the Arbitrage : SPECULATION
✔ Sell the USD in NY :
1000000 USD /1.2440 USD/EUR= 803858.52 EUR ● The process of buying, now, a currency which
✔ Sell the EUR in London: exchange rate is expected to rise in the future
and selling it when expectation is realized.
803 858.52 EUR * 140 YEN/EUR = 112 540 192.9 YEN
✔ Sell YEN in Tokyo :
● A form of Gambling, taking very though risk.
112540192.9 YEN * .0092 USD/YEN = 1 035 369.78 USD

● Profit = 1 035 369.78 – 1 000 000 = 35 369.78 USD ● Speculators are « Risk Lovers »

● Profit seeking from anticipated exchange rates

movements.
53 54

SPECULATION
● On October 24th: FOREIGN EXCHANGE RISK EXPOSURE
Paris FOREX: 1 EUR = 3.36 TND
● We predict that on November 24th:
Tunis FOREX: 1 EUR = 3.45 TND
● SPECULATION : we buy the EUR at the low observed rate now,
● Most important characteristic of FOREX
hold it and sell it, possibly, at the high predicted rate in the future transaction is that involves FOREX RISK
● On October 24th: we buy 1 EUR at 3.36 TND in Paris FOREX
Market
● On November 24th if prediction is: ● FOREX RISK: the risk that arises
● realized : Tunis FOREX: 1 EUR = 3.45 TND , we sell 1 EURO at
3.45 TND and the profit will be 0.09 TND per 1 EUR bought and from changes in EXCHANGE RATES.
sold at different time.
● Not realized: Tunis FOREX: 1 EUR = 3.2 TND, we sell 1 EUR at
3.2 TND and the loss will be 0.16 TND per 1 EUR bought and
sold at different time.
● It is a uncertain profit 56 56
FOREIGN EXCHANGE RISK
EXPOSURE HEDGING
● Tunisian Company exporting bags
● Domestic price 10 TND/Bag
● A firm that insures itself against FOREX
● On October 24th
● order of 1.000 Bags from a French Company RISK is hedging.
● Tunis FOREX: 1 EUR = 3.36 TND
● Invoice 2.976 EUR = 10.000 TND
● The FOREX MARKET can be used to
● On december 15th,
provide insurance to protect against FOREX
● Transfer of 2.976 EUR
● Tunis FOREX: 1 EUR = 3 TND RISK.
● Converted income 2.976 EUR = 8928 TND < 10.000
TND
57 58