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Foreign Exchange (FX) Market

Foreign Exchange (FX) Market. Network of financial institutions and brokers in which individuals, businesses, banks, and governments buy and sell the currencies of different countries

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Foreign Exchange (FX) Market

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  1. Foreign Exchange (FX) Market • Network of financial institutions and brokers in which individuals, businesses, banks, and governments buy and sell the currencies of different countries • The liquidity of the market provides businesses with access to international markets for goods and services by providing foreign currency necessary for transactions worldwide

  2. Bid/Ask Price for a Currency • The bid price is the price at which the market is willing to buy a particular currency • The ask price is the price at which the market is willing to sell a particular currency

  3. Meaning of foreign exchange quote • Direct quote: $.6149/DM • Indirect quote (reciprocal rate): DM1.6263/$ = 1/.6149 • Bid rate = $.6149/DM (price bid by broker to purchase DM) Ask rate = $.6273/DM =1/1.594 (price asked by broker to sell DM) Spread = $.0124 = transaction cost

  4. International cash management • Objectives • Minimize cost of funds • Improve liquidity • Reduce risks • Improve return on investment • Cash inflows and outflows Beginning cash balance Collections Disbursements Ending cash balance Investing surplus cash Covering cash shortage Ending cash required

  5. Cross Rates • Compare direct rates to cross rates to identify attractive exchange opportunities: • Direct rate to convert £ to DM = DM2.607/£ • Cross rate DM/£ using $: Convert £ to $ ($1.665/£) and then convert $ to DM (DM1.594/$): ($1.665/£) * (DM1.594/$ )= DM2.654/£ • This particular cross rate of £ to $ to DM is more attractive than converting £ directly to DM.

  6. Comparing quotes from different traders Bilateral arbitrage opportunity: Assume you can convert your $ into € 0.7431 with a broker in New York and then convert each € with a broker in Frankfurt for $1.346: New York Frankfurt $1.3457 / € € 0.7429/$ € 0.7431 /$ $1.346/ € _____ $1 € 0.7431 * $1.346/ € $1.0002

  7. Trilateral arbitrage New York Frankfurt Zurich € 0.7431 /$ CHF1.326/€ $1.016/CHF $1 € 0.7431 * CHF1.326/€ CHF.9854 * $1.016/CHF $1.0011 • Foreign exchange market efficiency – • Foreign exchange rates reflect all publicly available information

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