FIN 425 - Chapter 3

Eurocurrency Transactions Characteristics

- No withholding taxes - No reserve requirements - No interest rate regulation or caps - No regulations influencing credit allocation decisions - Less stringent disclosure requirements - No deposit insurance requirements

Rules For Dealing with Foreign Exchange

1) Keep track of your currency units 2) Think of buying or selling the currency in the denominator of a foreign exchange quote.

Rules for Determining the Currency Quoted

1) When the bid is lower than the offer quote, the bank is buying and selling the currency in the denominator of the quote. 2) When the bid quote is higher than the offer quote, the bank is buying and selling the currency in the numerator of the quote.

Dealers (Market Makers)

A dealer network composed of banks and financial institutions in an interbank wholesale market.

Financial Market

A market for financial (as opposed to real) assets and liabilities.

Direct or Non-Intermediated Market

A market in which borrowers such as government or a large corporation issue securities directly to the public.

Internal Market

A market in which financial contracts are issued in the currency of a host country, placed within that country, and regulated by authorities in that country. Ex: a US resident depositing dollars with US bank.

External Market

A market in which financial contracts are placed outside the borders of any single country and can be regulated by more than one country or by none at all. Ex: Eurocurrency market.

Intermediated Market

A market in which financial institution channels loanable fund from individual and corporate savers to borrowers.

Forward Market

A market in which trades are made for future delivery according to an agreed-upon delivery date, exchange rare, and amount.

Spot Market

A market in which trades are made for immediate delivery.

Foreign Exchange Market

A market that allows one currency to be exchanged for another. This market is largely an interbank market that deals in spot and forward currency transactions.

Net Position

A position in which banks can identify and manage their exposures to currency risks.

Risk Metrics

A system created to assist client in assessing and managing exposures to financial risks, including currency, interest rate, and commodity price risk.

Currency Swaps

In a forward market, it involves multiple future delivery dates, and are similar in form and function to portfolios of outright currency forward contracts.

SWIFT (Society for Worldwide Interbank Financial Telecommunication)

It is an industry-owned cooperative with thousands of members from commercial banking, asset management, securities, and insurance. It also ensure low-cost, secure transmission of electronic messages and fund transfers.

Foreign Exchange Risk (Currency Risk)

It is the risk of unexpected changes in exchange rates.

Operational Efficiency

It refers to how large influence transaction costs have on a market's operation.

Allocational Efficiency

It refers to how well a financial market channels capital toward its most productive uses.

Liquidity

It refers to the ease with with you can capture and asset's value.

Informational Efficiency

It refers to whether market prices reflect information, and thus the "true" or intrinsic value of the underlying asset.

Indirect Quote

It states the price of a unit of domestic currency in foreign currency term.

Direct Quote

It states the price of a unit of foreign currency in domestic currency terms.

Basis Point

Quotation in which interest rate spreads are measured, where one unity is 1/100th of one percent.

Currency of Reference (Referent Currency)

The currency that is being referred to.

Money Market

They are markets for financial assets and liabilities of short maturity, usually considered to be less than one year.

Capital Market

They are markets for long-term financial assets and liabilities, typically with maturity of one year or more.

Brokers

They serve as matchmakers and do not put their own money at risk. They monitor the quotes of major international banks through computerized quotation systems, and can quickly identify the banks offering the best rates.

Outright Forward

Transactions in a forward market that are involving a single delivery date.

Long Position

When a bank has purchased a currency in the spot or forward market.

Short Position

When a bank has sold a currency, and when by aggregating all of its expected future transactions at each forward date, the bank can identify its net position in each currency.

Term Premium

When borrowers that prefer long-term loans must pay a premium to attract funds. A structure in which interest rates or "yield curve" is typically upward sloping.

Random Walk

When exchange rate changes at a particular point in time are independent of previous changes and are equally likely to rise or fall.

Forward Premium

When the value of a currency in the forward market is higher than in the spot market.

Forward Discount

When the value of a currency in the forward market is lower than in the spot market.