FINANCE : 19 QUESTIONS MOSTLY ASKED IN EXAMINATIONS.

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21.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Project the annual free cash flows (FCF) of buying the chains.

The annual free cash flows for years 1 to 10 of buying the chains is $-482,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-485,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-486,940.

The annual free cash flows for years 1 to 10 of buying the chains is $-489,940.

22.The last four years of returns for a stock are as follows:

 

Year 1 Year 2 Year 3 Year 4
-3.9% +27.6% +11.5% +3.8%

 

Note: Notice that the average return and standard deviation must be entered in percentage format. The variance must be entered in decimal format. What is the standard deviation of the stock’s returns? (Round to two decimal places.)

The standard deviation is 13.99%.

The standard deviation is 14.79%.

The standard deviation is 14.99%.

The standard deviation is 13.79%.

23.You are considering a safe investment opportunity that requires a $920 investment today, and will pay $690 two years from now and another $640 five years from now. If you are choosing between this investment and putting your money in a safe bank account that pays an EAR of 5% per year for any horizon, can you make the decision by simply comparing this EAR with the IRR of the investment? Explain.

No, because the timing of the cashflows are different.

Yes, you can always compare IRRs of riskless projects, and an investment in the back is riskless.

No, this is like comparing the IRR of two projects.

Yes, because the EAR is the same at all horizons, so the two “projects” have the same riskiness, scale, and timing.

24.You are considering a safe investment opportunity that requires a $920 investment today, and will pay $690 two years from now and another $640 five years from now. What is the IRR of this investment?

The IRR of this investment is 8.65%.

The IRR of this investment is 6.92%.

The IRR of this investment is 22.29%.

The IRR of this investment is 11.74%.

25.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the FCF in years 1 through 9 of producing the chains.

The FCF in years 1 through 9 of producing the chains is $-338,950.

The FCF in years 1 through 9 of producing the chains is $-336,950.

The FCF in years 1 through 9 of producing the chains is $-342,950.

The FCF in years 1 through 9 of producing the chains is $-339,950.

26.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the NVP of producing the chains from the FCF.

The NVP of producing the chains from the FCF is $-3,007,692.

The NVP of producing the chains from the FCF is $-2,007,692.

The NVP of producing the chains from the FCF is $-4,007,692.

The NVP of producing the chains from the FCF is $-1,007,692.

27.IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business:

 

Debt outstanding (book value, AA-rated) $392.4 million
Number of shares of common stock 77.2 million
Stock price per share $14.67
Book value of equity per share $5.55
Beta of equity 1.32

 

What assumptions do you need to make? (Select all the choices that apply.)

Assume comparable assets have same risk as project.

Assume debt is risk-free and market value = book value.

Assume comparable assets have same cost.

Assume debt is risk-free and market value > book value.

28.IDX Tech is looking to expand its investment in advanced security systems. The project will be financed with equity. You are trying to assess the value of the investment, and must estimate its cost of capital. You find the following data for a publicly traded firm in the same line of business:

 

Debt outstanding (book value, AA-rated) $392.4 million
Number of shares of common stock 77.2 million
Stock price per share $14.67
Book value of equity per share $5.55
Beta of equity 1.32

 

What is your estimate of the project’s beta?

The project beta is 1.98.

The project beta is 0.98.

The project beta is 2.98.

The project beta is 1.48.

29.Your firm spends $473,000 per year in regular maintenance of its equipment. Due to the economic downturn, the firm considers forgoing these maintenance expenses for the next 3 years. If it does so, it expects it will need to spend $1.9 million in year 4 replacing failed equipment. For what costs of capital (COC) is forgoing maintenance a good idea?

For costs of capital that are less than the replacement costs.

For costs of capital that are greater than the NPV.

For costs of capital that are less than the IRR.

For costs of capital that are greater than the IRR.

30.In mid-2009, Rite Ad had CCC-rated, 20-year bonds outstanding with a yield to maturity of 17.3%. At the time, similar maturity Treasuries had a yield of 3%. Suppose the mark risk premium is 5% and you believe Rite Aid’s bonds have a beta of 0.38. If the expected loss rate of these bonds in the event of default is 58%. In mid-2012, Rite Aid’s bonds a had a yield of 8.2%, while similar maturity Treasuries had a yield of 0.8%. What probability of default would you estimate now?

The probability of default will be 10.48%.

The probability of default will be 8.48%.

The probability of default will be 11.48%.

The probability of default will be 9.48%.

31.Bay Properties is considering starting a commercial real estate division. It has prepared the following four-year forecast of free cash flows for this division:

 

  Year 1 Year 2 Year 3 Year 4
Free cash flow $-122,000 $-9,000 $100,000 $219,000

 

Assume cash flows after year 4 will grow at 3% per year, forever. If the cost of capital for this division is 17%, what is the continuation value in year 4 for cash flows after year 4?

The continuation value is $1,611,214.

The continuation value is $1,601,214.

The continuation value is $611,214.

The continuation value is $1,621,214.

32.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000 but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the difference between the net present values of buying the chains and producing the chains.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $431,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $331,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $131,128.

The net present value of producing the chains in-house instead of purchasing them from the supplier is $231,128.

33.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Should you make the investment?

Yes, because the project will generate cash flows forever.

No, because the NVP is not greater than the initial costs.

Yes, because the NVP is positive.

No, because the NVP is less than zero.

34.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the FCF in year 10 of producing the chains.

The FCF in year 10 of producing the chains is $-182,613.

The FCF in year 10 of producing the chains is $-282,813.

The FCF in year 10 of producing the chains is $-182,813.

The FCF in year 10 of producing the chains is $-282,613.

35.A bicycle manufacturer currently produces 356,000 units a year and expects output levels to remain steady in the future. It buys chains from an outside supplier at a price of $2.10 a chain. The plant manager believes that it would be cheaper to make these chains rather than buy them. Direct in-house production costs are estimated to be only $1.50 per chain. The necessary machinery would cost $290,000 and would be obsolete after 10 years. This investment could be depreciated to zero for tax purposed using a 10-year straight-line depreciation schedule. The plant manager estimates that the operation would require additional working capital of $40,000, but argues that this sum can be ignored since it is recoverable at the end of the 10 years. Expected proceeds from scrapping the machinery after 10 years are $21,750. If the company pays tax at a rate of 35% and the opportunity cost of capital is 15%, what is the net present value of the decision to produce the chains in-house instead of purchasing them from the supplier?

Compute the initial FCF of producing the chains.

The initial FCF of producing the chains is $-335,000.

The initial FCF of producing the chains is $-339,000.

The initial FCF of producing the chains is $-340,000.

The initial FCF of producing the chains is $-330,000.

36.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Use the IRR to determine the maximum deviation allowable in the cost of capital estimate to make the investment.

The maximum deviation allowable in the cost of capital is 28.65%.

The maximum deviation allowable in the cost of capital is 21.60%.

The maximum deviation allowable in the cost of capital is 24.70%.

The maximum deviation allowable in the cost of capital is 18.45%.

37.The figure below shows the one-year return distribution of Startup, Inc.

 

Probability 40% 20% 20% 10% 10%
Return -100% -75% -50% -30% 1,000%

 

Calculate the expected return.

The expected return is 30.0%.

The expected return is 31.2%.

The expected return is 32.0%.

The expected return is 30.7%.

38.You are considering opening a new plant. The plant will cost $100.3 million upfront. After that, it is expected to produce profits of $31.9 million at the end of every year. The cash flows are expected to last forever. Calculate the IRR.

The IRR of the project is 30.60%.

The IRR of the project is 28.80%.

The IRR of the project is 33.70%.

The IRR of the project is 31.80%.

39.Pisa Pizza, a seller of frozen pizza, is considering introducing a healthier version of its pizza that will be low in cholesterol and contain no trans fats. The firm expects that sales of the new pizza will be $15 million per year. While many of these sales will be to new customers, Pisa Pizza estimates that 27% will come from customers who switch to the new, healthier pizza instead of buying the original version. Suppose that 39% of customers who switch from Pisa Pizza to its healthier pizza will switch to another brand if Pisa Pizza does not introduce a healthier pizza. What level of incremental sales is associated with introducing the new pizza in this case?

The incremental sales are $11 million.

The incremental sales are $8 million.

The incremental sales are $6 million.

The incremental sales are $13 million.

Wk 3 – Apply: Project Metrics

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Assignment Content

  1. Now that you’ve identified the organization’s SWOT, you need to determine the project and its objectives and metrics. This project should be based on an unmet opportunity for the organization, or to minimize a potential threat. What does the organization need to do to advance its goals and/or expand its competitive advantage? How will you measure their progress?

    Complete the following:

    • Explain why this opportunity/threat was selected, and how it is anticipated to benefit the organization.
    • Create at least 3 measurable project objectives based on your analyses. Determine timelines and responsibilities for each objective (e.g. with a RACI chart)
    • Explain why these objectives are appropriate for the project.
    • Develop at least 2 metrics to evaluate achievement of each of the project objectives. Provide a 1-page explanation for why these are appropriate metrics for each of the objectives.
    • Cite all sources following APA guidelines.

      Submit your assignment.BUS/475 v10

      Wk 1: Advanced Organizer

      BUS/475 v10

      Page 3 of 3

       

      C:\Users\djshirey\OneDrive - University of Phoenix\F_Drive\Style Guides\UPX Logos\Horizontal format\UOPX_Sig_Hor_Black_Medium.png

      Wk 1 Apply: Degree of Alignment

      Advanced Organizer

      Review the companies listed in the case studies portion of the textbook. Choose 1 of the companies to use for all weekly assessments. Complete the chart below with information provided in the textbook and other resources. Provide your analysis below the chart.

      Selected Organization:

      Describe the organization in the follow chart:

      Element

      		 Description
      Mission Apple Inc. mission is “To bringing the best user experience to its customers through its innovative hardware, software, and services (Piao & Kleiner, 2015).”
      Vision “We believe that we are on the face of the earth to make great products and that’s not changing.”
      Values “Values include Empathy for customers, team spirit, aggressiveness, positive social connection, innovation, individual performance team spirit, good management, excellence and individual reward (Tansim, 2018).”
      Structure “Apple Inc. has a hierarchical organizational structure, with notable divisional characteristics and a weak functional matrix. The hierarchy is a traditional structural feature in business organizations”
      Culture “The company’s cultural features focus on maintaining a high level of innovation that involves creativity and a mindset that challenges conventions and standards.”

      Analysis

      Based on your advanced organizer and further research, analyze the degree of alignment between what the organization is currently doing (actions) and their mission, vision, values, structure, and culture.

      The good thing with Apple Company is the fact that they embrace technology and change that focus on their vision and the mission statement of the organization. The values of this organization provide the employees with direction, customers and the management an overview of what is required from them (D O’Rourke, 2018). Apple has been successful in the high technology market which has been referred to as the inability of the organization on diversifying employees.as a high tech industry it faces a lot of challenges which are sometimes beyond control and still in the face of these challenges they have to make sure that they maintain the organization values and beliefs (Gruber et al., 2017). For Apple Inc. to become successful or for them to maintain their success, there is need for them to embrace diversity when it comes to employment, partnership, market as well as global interactions (Ng et al., 2018). Apple Inc has also failed to fulfil the need of culture in the organization and mostly they only focus on innovation and fail to focus on the peoples’ culture and the society need as well. Apple Inc should come up with a desirable culture that also include the society needs and satisfaction.

      Citations

      D O’Rourke, A. (2018). The world apple market. Routledge.

      Gruber, T. R., Sabatelli, A., Aybes, A., Pitschel, D. W., Voas, E. D., Anzures, F. A., & Marcos, P. D. (2017). U.S. Patent Application No. 15/193,971.

      Ng, E. H., Nepal, B., Schott, E., & Keathley, H. (2018). TOTAL QUALITY MANAGEMENT & APPLE SUCCESS.

      Piao, M., & Kleiner, B. (2015). Excellence in the Electronics Industry: The Comparison of the Organizational Culture among Apple Inc., Samsung Electronics and Google Inc. Conflict Resolution & Negotiation Journal, 2015(1).

      Tansim, M. (2018). An Organizational Analysis on Apple. European Journal of Business and Management, 10(11).

       

      Copyright 2019 by University of Phoenix. All rights reserved.

      Copyright 2019 by University of Phoenix. All rights reserved.

Develop an opportunity loss table.

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3.30

· 3.40

· 3.41

· 12.13

· 12.15

· 12.24

· 12.25

SHOW ALL WORK AND HIGLIGHT ANSWERS

Chapter 3 and 12 Problems

 

3-30 Even though independent gasoline stations have been having a difficult time, Susan Solomon has been thinking about starting her own independent gasoline station. Susan’s problem is to decide how large her station should be. The annual returns will depend on both the size of her station and a number of marketing factors related to the oil industry and demand for gasoline. After a careful analysis, Susan developed the following table:

SIZE OF FIRST STATION GOOD MARKET ($) FAIR MARKET ($) POOR MARKET ($)
Small 50,000 20,000 –10,000
Medium 80,000 30,000 –20,000
Large 100,000 30,000 –40,000
Very large 300,000 25,000 –160,000

For example, if Susan constructs a small station and the market is good, she will realize a profit of $50,000.

a. Develop a decision table for this decision.

b. What is the maximax decision?

c. What is the maximin decision?

d. What is the equally likely decision?

e. What is the criterion of realism decision? Use an α value of 0.8.

f. Develop an opportunity loss table.

g. What is the minimax regret decision?

 

 

 

 

 

 

3-40 Bill Holliday is not sure what he should do. He can build a quadplex (i.e., a building with four apartments), build a duplex, gather additional information, or simply do nothing. If he gathers additional information, the results could be either favorable or unfavorable, but it would cost him $3,000 to gather the information. Bill believes that there is a 50–50 chance that the information will be favorable. If the rental market is favorable, Bill will earn $15,000 with the quadplex or $5,000 with the duplex. Bill doesn’t have the financial resources to do both. With an unfavorable rental market, however, Bill could lose $20,000 with the quadplex or $10,000 with the duplex. Without gathering additional information, Bill estimates that the probability of a favorable rental market is 0.7. A favorable report from the study would increase the probability of a favorable rental market to 0.9. Furthermore, an unfavorable report from the additional information would decrease the probability of a favorable rental market to 0.4. Of course, Bill could forget all of these numbers and do nothing. What is your advice to Bill?

 

3-41 Peter Martin is going to help his brother who wants to open a food store. Peter initially believes that there is a 50–50 chance that his brother’s food store would be a success. Peter is considering doing a market research study. Based on historical data, there is a 0.8 probability that the marketing research will be favorable given a successful food store. Moreover, there is a 0.7 probability that the marketing research will be unfavorable given an unsuccessful food store.

a. If the marketing research is favorable, what is Peter’s revised probability of a successful food store for his brother?

b. If the marketing research is unfavorable, what is Peter’s revised probability of a successful food store for his brother?

c. If the initial probability of a successful food store is 0.60 (instead of 0.50), find the probabilities in parts (a) and (b).

 

12-13 Mike Dreskin manages a large Los Angeles movie theater complex called Cinema I, II, III, and IV. Each of the four auditoriums plays a different film; the schedule is set so that starting times are staggered to avoid the large crowds that would occur if all four movies started at the same time. The theater has a single ticket booth and a cashier who can maintain an average service rate of 280 movie patrons per hour. Service times are assumed to follow an exponential distribution. Arrivals on a typically active day are Poisson distributed and average 210 per hour.

To determine the efficiency of the current ticket operation, Mike wishes to examine several queue operating characteristics.

a. Find the average number of moviegoers waiting in line to purchase a ticket.

b. What percentage of the time is the cashier busy?

c. What is the average time that a customer spends in the system?

d. What is the average time spent waiting in line to get to the ticket window?

e. What is the probability that there are more than two people in the system? More than three people? More than four?

 

12-15 The wheat harvesting season in the American Midwest is short, and most farmers deliver their truckloads of wheat to a giant central storage bin within a 2-week span. Because of this, wheat-filled trucks waiting to unload and return to the fields have been known to back up for a block at the receiving bin. The central bin is owned cooperatively, and it is to every farmer’s benefit to make the unloading/storage process as efficient as possible. The cost of grain deterioration caused by unloading delays, the cost of truck rental, and idle driver time are significant concerns to the cooperative members. Although farmers have difficulty quantifying crop damage, it is easy to assign a waiting and unloading cost for truck and driver of $18 per hour. The storage bin is open and operated 16 hours per day, 7 days per week, during the harvest season and is capable of unloading 35 trucks per hour according to an exponential distribution. Full trucks arrive all day long (during the hours the bin is open) at a rate of about 30 per hour, following a Poisson pattern.

To help the cooperative get a handle on the problem of lost time while trucks are waiting in line or unloading at the bin, find the

a. average number of trucks in the unloading system.

b. average time per truck in the system.

c. utilization rate for the bin area.

d. probability that there are more than three trucks in the system at any given time.

e. total daily cost to the farmers of having their trucks tied up in the unloading process.

The cooperative, as mentioned, uses the storage bin only two weeks per year. Farmers estimate that enlarging the bin would cut unloading costs by 50% next year. It will cost $9,000 to do so during the off-season. Would it be worth the cooperative’s while to enlarge the storage area?

 

12-24 Billy’s Bank is the only bank in a small town in Arkansas. On a typical Friday, an average of 10 customers per hour arrives at the bank to transact business. There is one single teller at the bank, and the average time required to transact business is 4 minutes. It is assumed that service times can be described by the exponential distribution. Although this is the only bank in town, some people in the town have begun using the bank in a neighboring town about 20 miles away. If a single teller at Billy’s is used, find

a. the average time in the line.

b. the average number in the line.

c. the average time in the system.

d. the average number in the system.

e. the probability that the bank is empty.

 

12-25 Refer to the Billy’s Bank situation in  Problem 12-24 . Billy is considering adding a second teller (who would work at the same rate as the first) to reduce the waiting time for customers, and he assumes that this will cut the waiting time in half. A single line would be used, and the customer at the front of the line would go to the first available bank teller. If a second teller is added, find

a. the average time in the line.

b. the average number in the line.

c. the average time in the system.

d. the average number in the system.

e. the probability that the bank is empty.

Malaysian Futures Market

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Assignment 1Read the article “Open Your Market and Say “Ahh” , “Contagion Indicators” for an Ailing Global Economy.

http://www.rand.org/content/dam/rand/pubs/corporate_pubs/2007/RAND_CP22-1999-01.pdf

Write a critical review 2-3 page long addressing the following issues:.

  1. Identified the explanations for the financial crises affecting simultaneously few countries
  2. Identified and explain four models of financial contagion and their prospects for prediction and prevention
  3. Explain differences between financial crises in Argentina, South Africa and Southeast Asia

All written assignments and responses should follow APA rules for attributing sources.

 

Assignment 2 Discuss the advantages and disadvantages of futures contracts. Name two established exchanges where you would likely find future contracts traded.

Post your work by Sunday, September 23, 2012 to the Discussion Area. Comment on two other postings by the end of the module. Your work should be 3-5 paragraphs long.

All written assignments and responses should follow APA rules for attributing sources

CHAPTER 7 The Foreign Exchange Market

The Spaniards coming into the West Indies had many commodities of the country which they needed, brought unto them by the inhabitants, to who when they offered them money, goodly pieces of gold coin, the Indians, taking the money, would put it into their mouths, and spit it out to the Spaniards again, signifying that they could not eat it, or make use of it, and therefore would not part with their commodities for money, unless they had such other commodities as would serve their use.

Edward Leigh (1671)

Learning Objectives

• To describe the organization of the foreign exchange market and distinguish between the spot and forward markets

• To distinguish between different methods of foreign exchange quotation and convert from one method of quotation to another

• To read and explain foreign currency quotations as they appear in the Wall Street Journal

• To identify profitable currency arbitrage opportunities and calculate the profits associated with these arbitrage opportunities

• To describe the mechanics of spot currency transactions

• To explain how forward contracts can be used to reduce currency risk

• To list the major users of forward contracts and describe their motives

• To calculate forward premiums and discounts

Key Terms

American terms

arbitrageurs

bid-ask spread

Clearing House Interbank Payments System (CHIPS)

contract note

cross rate

currency arbitrage

direct quotation

electronic trading

European terms

exchange risk

fed funds

FedWire

foreign exchange brokers

foreign exchange market

foreign exchange quotes

forward contract

forward discount

forward market

forward premium

forward price

hedgers

Herstatt risk

indirect quotation

interbank market

liquidity

long

no-arbitrage condition

nostro account

outright rate

position sheet

settlement risk

short

Society for Worldwide Interbank Financial

Telecommunications

speculators

spot market

spot price

swap

swap rate

traders

triangular currency

arbitrage

value date

The volume of international transactions has grown enormously over the past 60 years. Exports of goods and services by the United States now total more than 10% of gross domestic product. For both Canada and Great Britain, this figure exceeds 25%. Imports are about the same size. Similarly, annual capital flows involving hundreds of billions of dollars occur between the United States and other nations. International trade and investment of this magnitude would not be possible without the ability to buy and sell foreign currencies. Currencies must be bought and sold because the U.S. dollar is not the acceptable means of payment in most other countries. Investors, tourists, exporters, and importers must exchange dollars for foreign currencies, and vice versa.

The trading of currencies takes place in foreign exchange markets whose primary function is to facilitate international trade and investment. Knowledge of the operation and mechanics of these markets, therefore, is important for any fundamental understanding of international financial management. This chapter provides this information. It discusses the organization of the most important foreign exchange market—the interbank market—including the spot market, the market in which currencies are traded for immediate delivery, and the forward market, in which currencies are traded for future delivery. Chapter 8 examines the currency futures and options markets.

7.1 Organization of The Foreign Exchange Market

If there were a single international currency, there would be no need for a foreign exchange market. As it is, in any international transaction, at least one party is dealing in a foreign currency. The purpose of the foreign exchange market is to permit transfers of purchasing power denominated in one currency to another—that is, to trade one currency for another currency. For example, a Japanese exporter sells automobiles to a U.S. dealer for dollars, and a U.S. manufacturer sells machine tools to a Japanese company for yen. Ultimately, however, the U.S. company will likely be interested in receiving dollars, whereas the Japanese exporter will want yen. Similarly, an American investor in Swiss-franc-denominated bonds must convert dollars into francs, and Swiss purchasers of U.S. Treasury bills require dollars to complete these transactions. It would be inconvenient, to say the least, for individual buyers and sellers of foreign exchange to seek out one another, so a foreign exchange market has developed to act as an intermediary.

Most currency transactions are channeled through the worldwide interbank market, the wholesale market in which major banks trade with one another. This market, which accounts for about 95% of foreign exchange transactions, is normally referred to as the foreign exchange market. It is dominated by about 20 major banks. In the spot market, currencies are traded for immediate delivery, which is actually within two business days after the transaction has been concluded. In the forward market, contracts are made to buy or sell currencies for future delivery Spot transactions account for about 33% of the market, with forward transactions accounting for another 12%. The remaining 55% of the market consists of swap transactions, which involve a package of a spot and a forward contract.1

The foreign exchange market is not a physical place; rather, it is an electronically linked network of banks, foreign exchange brokers, and dealers whose function is to bring together buyers and sellers of foreign exchange. The foreign exchange market is not confined to any one country but is dispersed throughout the leading financial centers of the world: London, New York, Paris, Zurich, Amsterdam, Tokyo, Hong Kong, Toronto, Frankfurt, Milan, and other cities.

Trading has historically been done by telephone, telex, or the SWIFT system. SWIFT (Society for Worldwide Interbank Financial Telecommunications), an international bank-communications network, electronically links all brokers and traders. The SWIFT network connects more than 7,000 banks and broker-dealers in 192 countries and processes more than five million transactions a day, representing about $5 trillion in payments. Its mission is to transmit standard forms quickly to allow its member banks to process data automatically by computer. All types of customer and bank transfers are transmitted, as well as foreign exchange deals, bank account statements, and administrative messages. To use SWIFT, the corporate client must deal with domestic banks that are subscribers and with foreign banks that are highly automated. Like many other proprietary data networks, SWIFT is facing growing competition from Internet-based systems that allow both banks and nonfinancial companies to connect to a secure payments network.

Foreign exchange traders in each bank usually operate out of a separate foreign exchange trading room. Each trader has several telephones and is surrounded by terminals displaying up-to-the-minute information. It is a hectic existence, and many traders burn out by age 35. Most transactions are based on verbal communications; written confirmation occurs later. Hence, an informal code of moral conduct has evolved over time in which the foreign exchange dealers’ word is their bond. Today, however, much of the telephone-based trading has been replaced by electronic brokering.

Although one might think that most foreign exchange trading is derived from export and import activities, this turns out not to be the case. In fact, trade in goods and services accounts for less than 5% of foreign exchange trading. More than 95% of foreign exchange trading relates to cross-border purchases and sales of assets, that is, to international capital flows.

Currency trading takes place 24 hours a day, but the volume varies depending on the number of potential counterparties available. Exhibit 7.1 indicates how participation levels in the global foreign exchange market vary by tracking electronic trading conversations per hour.

The Participants

The major participants in the foreign exchange market are the large commercial banks; foreign exchange brokers in the interbank market; commercial customers, primarily multinational corporations; and central banks, which intervene in the market from time to time to smooth exchange rate fluctuations or to maintain target exchange rates. Central bank intervention involving buying or selling in the market is often indistinguishable from the foreign exchange dealings of commercial banks or of other private participants.

Exhibit 7.1 The Circadian Rhythms of the Foreign Exchange Market

Note: Time (0100-2400) hours, Greenwich Mean Time.

Source: Reuters Chart appears in Sam Y. Cross. “All About … the Foreign Exchange Market in the United States,” Federal Reserve Bank of New York, www.ny.frb.org/pihome/addpub.

Only the head offices or regional offices of the major commercial and investment banks are actually market makers—that is, they actively deal in foreign exchange for their own accounts. These banks stand ready to buy or sell any of the major currencies on a more or less continuous basis. Exhibit 7.2 lists some of the major financial institutions that are market makers and their estimated market shares.

A large fraction of the interbank transactions in the United States is conducted through foreign exchange brokers, specialists in matching net supplier and demander banks. These brokers receive a small commission on all trades (traditionally, 1/32 of 1% in the U.S. market, which translates into $312.50 on a $1 million trade). Some brokers tend to specialize in certain currencies, but they all handle major currencies such as the pound sterling, Canadian dollar, euro, Swiss franc, and yen. Brokers supply information (at which rates various banks will buy or sell a currency); they provide anonymity to the participants until a rate is agreed to (because knowing the identity of the other party may give dealers an insight into whether that party needs or has a surplus of a particular currency); and they help banks minimize their contacts with other traders (one call to a broker may substitute for half a dozen calls to traders at other banks). As in the stock market, the role of human brokers has declined as electronic brokers have significantly increased their share of the foreign exchange business.

Exhibit 7.2 Leading Foreign Exchange Traders in 2007

Source: EuroMoney Magazine. FX poll 2007: Winners and Losers in 2007.

Commercial and central bank customers buy and sell foreign exchange through their banks. However, most small banks and local offices of major banks do not deal directly in the interbank market. Rather, they typically will have a credit line with a large bank or with their home office. Thus, transactions with local banks will involve an extra step. The customer deals with a local bank that in turn deals with its head office or a major bank. The various linkages between banks and their customers are depicted in Exhibit 7.3. Note that the diagram includes linkages with currency futures and options markets, which we will examine in the next chapter.

The major participants in the forward market can be categorized as arbitrageurs, traders, hedgers, and speculators. Arbitrageurs seek to earn risk-free profits by taking advantage of differences in interest rates among countries. They use forward contracts to eliminate the exchange risk involved in transferring their funds from one nation to another.

Traders use forward contracts to eliminate or cover the risk of loss on export or import orders that are denominated in foreign currencies. More generally, a forward-covering transaction is related to a specific payment or receipt expected at a specified point in time.

Hedgers, mostly multinational firms, engage in forward contracts to protect the home currency value of various foreign currency-denominated assets and liabilities on their balance sheets that are not to be realized over the life of the contracts.

Arbitrageurs, traders, and hedgers seek to reduce (or eliminate, if possible) their exchange risks by “locking in” the exchange rate on future trade or financial operations.

In contrast to these three types of forward market participants, speculators actively expose themselves to currency risk by buying or selling currencies forward in order to profit from exchange rate fluctuations. Their degree of participation does not depend on their business transactions in other currencies; instead, it is based on prevailing forward rates and their expectations for spot exchange rates in the future.

Exhibit 7.3 Structure of Foreign Exchange Markets

Note: The International Money Market (IMM) Chicago trades foreign exchange futures and euro futures options. The London International Financial Futures Exchange (LIFFE) trades foreign exchange futures. The Philadelphia Stock Exchange (PSE) trades foreign currency options.

Source: Federal Reserve Bank of St. Louis, Review, March 1984, p. 9, revised.

The Clearing System.

Technology has standardized and sped up the international transfers of funds, which is at the heart of clearing, or settling, foreign exchange transactions. In the United States, where all foreign exchange transactions involving dollars are cleared, electronic funds transfers take place through the Clearing House Interbank Payments System (CHIPS). CHIPS is a computerized network developed by the New York Clearing House Association for transfer of international dollar payments, currently linking 46 major depository institutions that have offices or affiliates in New York City. Currently, CHIPS handles more than 360,000 interbank transfers daily valued at more than $2 trillion. The transfers represent more than 95% of all interbank transfers relating to international dollar payments.

The New York Fed (Federal Reserve Bank) has established a settlement account for member banks into which debit settlement payments are sent and from which credit settlement payments are disbursed. Transfers between member banks are netted out and settled at the close of each business day by sending or receiving FedWire transfers of fed funds through the settlement account. Fed funds are deposits held by member banks at Federal Reserve branches.

The FedWire system is operated by the Federal Reserve and is used for domestic money transfers. FedWire allows almost instant movement of balances between institutions that have accounts at the Federal Reserve Banks. A transfer takes place when an order to pay is transmitted from an originating office to a Federal Reserve Bank. The account of the paying bank is charged, and the receiving bank’s account is credited with fed funds.

To illustrate the workings of CHIPS, suppose Mizuho Corporate Bank has sold U.S.$15 million to Citibank in return for ¥1.5 billion to be paid in Tokyo. In order for Mizuho to complete its end of the transaction, it must transfer $15 million to Citibank. To do this, Mizuho enters the transaction into its CHIPS terminal, providing the identifying codes for the sending and receiving banks. The message—the equivalent of an electronic check—is then stored in the CHIPS central computer.

As soon as Mizuho approves and releases the “stored” transaction, the message is transmitted from the CHIPS computer to Citibank. The CHIPS computer also makes a permanent record of the transaction and makes appropriate debits and credits in the CHIPS accounts of Mizuho Corporate Bank and Citibank, as both banks are members of CHIPS. Immediately after the closing of the CHIPS network at 4:30 p.m. (eastern time), the CHIPS computer produces a settlement report showing the net debit or credit position of each member bank.

Member banks with debit positions have until 5:45 P.M. (eastern time) to transfer their debit amounts through FedWire to the CHIPS settlement account on the books of the New York Fed. The Clearing House then transfers those fed funds via FedWire out of the settlement account to those member banks with net creditor positions. The process usually is completed by 6:00 P.M. (eastern time).