INTERNATIONAL FINANCE

Importance of International Finance

 Specialization of nations and trade
 Opening of economies
 Globalization of firm
 Growth of world trade
 Forex- Basic concepts
 Foreign exchange market
 Exchange rate
 Cash market, spot market and forward market
 Quotation
 Types of quotes
 Spread/cost of transaction
 Determinants of spread
 Foreign Exchange risks
 Foreign exchange market
 The market where one currency is traded
for another.
 It exists in network of information system.
 Exchange rate: Price of one nation’s
currency in terms of another currency.
Ex : yen / dollar exchange rate is just the
number of yen that one dollar will buy.
 Major Forex markets
 New York
 London
 Paris
 Frankfurt
 Zurich
 Tokyo
 Singapore
 Hong Kong
 Size of forex market
 One of the largest financial markets in the world
$ 3.2 trillion average daily turnover, equivalent
to:

 More than 10 times the average daily turnover of

global equity markets
 More than 35 times the average daily turnover of the
NYSE
 Nearly $500 a day for every man, woman, and child
on earth
 An annual turnover more than 10 times world GDP
 Major Markets’ statistics

 The US & UK markets account for just over 50%

of turnover
 Major markets: London, New York, Tokyo
 Trading activity is heaviest when major markets
overlap
 Nearly two-thirds of NY activity occurs in the
morning hours while European markets are open
 The US dollar is involved in over 80% of all
foreign exchange transactions, equivalent to
over US$2.7 trillion per day
 Trading hours
 24 hour market
 Sunday 5pm EST through Friday 4pm EST.
 Trading begins in New Zealand, followed
by Australia, Asia, the Middle East,
Europe, and America

EST : Eastern Standard Time

 Average Daily Turnover by
Geographic Location
 UK 34.1%
 US 16.6%
 Switerzland 6.1%
 Japan 6.0%
 Singapore 5.8%
 Hongkong 4.4%
 Australia 4.3%
 France 3.0%
 Germany 2.5%
 Denmark 2.2%
 Other 15%
 Major currencies
 USD = US Dollar
EUR = Euro
JPY = Japanese Yen
GBP = British Pound
CHF = Swiss Franc
CAD = Canadian Dollar
AUD = Australian Dollar
NZD = New Zealand Dollar
FFR = French Franc
 FX Jargon

Every discipline has its own jargon, and the currency market is no different.
Here are some terms to know that will make you sound like a seasoned
currency trader

 Cable, sterling, pound - alternative names for the GBP

 Greenback, buck - nicknames for the U.S. dollar
 Swissie - nickname for the Swiss franc
 Aussie - nickname for the Australian dollar
 Kiwi - nickname for the New Zealand dollar
 Loonie, the little dollar - nicknames for the Canadian dollar
 Figure - FX term connoting a round number like 1.2000
 Yard - a billion units, as in "I sold a couple of yards of sterling."
 Spot market
 The market where the transactions are
conducted for the spot delivery of
currencies.
 Spot delivery means delivery after 2
business days.
 Spot rate determination: demand and
supply of currency.
 Quotations
 The amount of currency necessary to buy
or sell a unit of another currency.

 Bid Rate: the rate at which the exchange

dealer is ready to buy a currency.
 Ask rate: the rate at which the dealer is
ready to sell the currency
 Types of quotations
 Direct quote: A foreign exchange rate quoted as the domestic
currency per unit of the foreign currency ( or one unit of
foreign currency quoted in terms of domestic currency.)
Ex: Rs.43.50/$ (B) Rs.43.95/$ (A)
 Indirect quote: A foreign exchange rate quoted as the foreign
currency per unit of the domestic currency (one unit of
domestic currency is expressed in terms of foreign currency)
 For example, in the U.S., an indirect quote for the Canadian
dollar would be C$1.17 = US$1. Conversely, in Canada an
indirect quote for U.S. dollars would be US$0.85  = C$1.
 Spreads

 The amount by which the ask price exceeds the bid.

 Spread = Ask – Bid
 This is essentially the difference in price between the highest price
that a buyer is willing to pay for an asset and the lowest price for
which a seller is willing to sell it.
 ( IMP )The size of the spread from one asset to another will differ
mainly because of the difference in liquidity of each asset. For
example, currency is considered the most liquid asset in the world
and the bid-ask spread in the currency market is one of the smallest
(one-hundredth of a percent). On the other hand, less liquid assets
such as a small-cap stock may have spreads that are equivalent to a
percent or two of the asset's value
 Understanding forex trading terms
 Position: The "position" is the netted sum
commitment in a particular currency
 Position square/flat : when there's no
exposure
 Going long : It's long if more currency is
being bought than sold
 Going short : The position is short if more
currency is being sold than bought
Forward market :( It is the market where forward contracts
are bought and sold at forward exchange rates )

 Forward exchange rate : the exchange

rates for delivery and payment at specified
future dates.
Present contract for future delivery.
 Forward exchange rate determination:
forward demand and forward supply of
currencies.
 Premium and Discount
 Premium: a foreign currency is said to be
at premium where forward price exceeds
the present/spot price in terms of
domestic currency.
 Discount: a foreign currency is said to be
at discount where forward price is lesser
than the present/spot price in terms of
domestic currency.
 Problem 1: calculate the annualized bid
and ask premiums for 1 month and 3
months fwd from the following.
Spot Rs./$ 45.6300(B)
Rs./$ 45.6325(A)
Forward Rate Rs./$ 45.6320(B)
Rs./$ 45.6350(A)
 Forex market - India
 Average monthly turnover 2003-2004 :
175 billion dollars
 Average monthly turnover 2005-06 :
359 billion dollars (over 10 times higher
than daily turnover of BSE)
Since 1991 changed from fixed exchange
rate to floating rate
 70% of forex transactions in inter-bank
market.
 Trading regulated by FEDAI: Foreign
Exchange Dealers Association of India
 Clearing and settlement of trades done by
CCIL (Clearing corporation of India Ltd)
 India is a member of ACU (Asian Clearing
Union)
 Asian Clearing Union
 Established - December 9, 1974
 With initiative of United Nations Economic
and Social Commission for Asia and Pacific
(ESCAP)
 Head quarters at Tehran, Iran
 The ACU is a system for clearing payments
among the member countries on a
multilateral basis
 Members of ACU
 The central banks and monetary authorities of
 Iran
 India
 Bangladesh
 Bhutan
 Nepal
 Pakistan
 Sri Lanka
 Myanmar
Fundamental Equilibrium
Relationships
 Topics covered
 Purchasing Power Parity (PPP)
 Interest Rate Parity (IRP)
 Fisher Open Theorem (FOT)
 International Fisher Effect (IFE)
 Purchasing power parity
 Gustav Cassel (Swedish Economist)
 What is purchasing power?
 The idea of PPP
 The law of one price
 Absolute PPP
 Relative PPP
 Purchasing power
 Purchasing power of a currency is
determined by the amount of goods and
services that can be purchased with one
unit of currency.
 Purchasing power
 Purchasing power of a currency is
determined by the amount of goods and
services that can be purchased with one
unit of currency.
 Idea of PPP
 PPP states that if arbitrage across national
borders is unhindered, the price of a good
or service in one nation should be the
same as the “exchange rate adjusted
price” of the same good or service in
another nation.
 Law of one price
 law of one price is the basis for interpreting this
theory. It says :

 Identical goods should trade at the same relative

prices regardless of where they are sold.
 Assumption : consumers in all countries have
the same consumption basket and that all
goods are equally tradable.
 Absolute PPP
 Absolute PPP states that the domestic
price level should equal the foreign price
level times the spot exchange rate.
P = EP*
P = price of a G/S in domestic country
E = Exchange rate
P* = Price of G/S in foreign country
Big Mac hamburger
Big Mac Index
 Relative PPP
 Relative PPP states that the change in an
exchange rate is equal to the difference in the
inflation rates between two economies.
 % change in ER = Inflation rate differential
 Et = (1+Ih)t
Eo (1+If)t
Et: Forward rate, Eo: Spot rate
Ih: Inflation rate of home country
Ih: Inflation rate of foreign country
t: time period