FINM8007: Topics in International Finance

Answer Sketch to Problem Set 1 (Topics 0-1)

NOTE: The problem set is designed to provide you with practice questions. You are
encouraged to work through each problem, but you will not have to submit your
solutions.
Q1. [Conceptual, Topic 0] What are the factors that affect the decisions of
multinational enterprises to become multinational and operate in global markets?

The main factors for firms deciding to operate in a new market include (1) comparative
advantage, (2) market imperfections, and (3) expanded opportunity set.

For comparative advantage, countries and firms should specialize in the production of
its comparative advantage.

To better exploit market imperfections, firms should seek better production cost and
rate of productivity of factors of production, better regulations, lower taxation,
protectionist trade barriers, stable foreign exchange, and larger markets. And these
include
i). Acquisition of raw materials, not available elsewhere
ii). Achievement of greater efficiency, by producing in countries where one or more
of the factors of production are underpriced relative to other locations
iii). Acquisition of knowledge and expertise centred primarily in the foreign location
iv). Location of the firms’ foreign operations in countries deemed politically safe

Firms should also consider expanded opportunities on the international market as it

matures locally. It may be able to benefit from international financing and
investment opportunities. Entry into new markets, not currently served by the firm,
would allow the firm to grow and possibly to acquire economies of scale.

Q2. [Conceptual, Topic 1] How do liquidity seekers and profit seekers differ in the
context of FX market participants? How can these be used to categorise the five types
of market participants that we have defined and discussed in class?

Liquidity seekers trade currencies for commercial purposes. Profit seekers trade
currencies for profit. (1) Speculators and arbitragers seek to profit from trading within
the market itself, so they are classified as profit seekers. (2) Central banks and
treasuries acquire or draw down their country’s FX reserves to influence the price at
which their own currency is traded in a manner that will benefit the interests of their
citizens. Therefore, they are neither liquidity nor profit seekers, and they are even
willing to take losses in many instances. (3) Individuals and firms conducting
commercial or investment transactions, bank and non-bank FX dealers, and FX brokers
are both liquidity and profit seekers, depending on their motivations for a particular
currency trade.

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Q3. [Conceptual, Topic 1] What are the major functions of the foreign exchange
market?

1. To transfer purchasing power from one country and its currency to another.
Typical parties would be importers and exporters, investors in foreign securities, and
tourists.
2. A market place for the price of currencies to be determined.
3. To finance goods in transit. Typical parties would be importers and exporters.
4. To provide hedging facilities so FX risks could be transferred from those who do
not desire the risk to those who are more willing to assume the risks. Typical parties
would be importers, exporters, and creditors and debtors with short-term monetary
obligations.

Q4. [Conceptual, Topic 1] How is the global foreign exchange market structured?

The global FX market is an over-the-counter, decentralized market connected by a

network of telephones and computers. Participants in the market is organised into a
FX ladder or a two-tier market that include the interbank(wholesale) market and the
client(retail) market. The two-tier system differ in market access and the rates
available to participants. The rates in the interbank market is cheaper.

One of the biggest changes in the foreign exchange market in the past decade has
been a shift from a two-tier market to a single-tier market, wherein electronic
platforms and the development of sophisticated trading algorithms have facilitated
market access by traders of all kinds and sizes. However, participants with less
extensive relationships with market makers and with transactions of smaller sizes
are still subject to higher rates.

Participants in the foreign exchange market can be simplistically divided into two
major groups: those trading currency for commercial purposes, liquidity seekers, and
those trading for profit, profit seekers. Although the foreign exchange market began
as a market for liquidity purposes, facilitating the exchange of currency for the
conduct of commercial trade and investment purposes, the exceptional growth in
the market has been largely based on the expansion of profit-seeking agents. As
might be expected, the profit seekers are typically much better informed about the
market, looking to profit from its future movements, while liquidity seekers simply
wish to secure currency for transactions. As a result, the profit seekers generally
profit from the liquidity seekers.

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Q5. [Conceptual, Topic 1, Bid/Ask Quotation] Define and give an example of each of
(a) Bid rate quote (b) Ask rate quote.

FX quotations are given as a bid and ask (also referred to as offer). A bid is the price
(i.e., exchange rate) in one currency at which a dealer will buy another currency. An
ask is the price (i.e., exchange rate) at which a dealer will sell the other currency.
Dealers bid (buy) at one price and ask (sell) at a slightly higher price, making their
profit from the spread between the buying and selling prices.

Bid and ask quotations in the foreign exchange markets are superficially complicated
by the fact that the bid for one currency is also the offer for the opposite currency. A
trader seeking to buy dollars with Swiss francs is simultaneously offering to sell Swiss
francs for dollars. For example, suppose a bank makes spot quotations for the
Japanese yen and US dollar pair as USD/JPY 118.27/37. The spot quotations indicate
that the bank’s foreign exchange trader will buy dollars (i.e., sell Japanese yen) at the
bid price of ¥118.27 per dollar. The trader will sell dollars (i.e., buy Japanese yen) at
the higher ask price of ¥118.37 per dollar. The bid/ask spread is the dealer’s profit
for market making.

Q6. [Conceptual/Numerical, Topic 1, Quotation] Suppose that Australia is the home

country. Determine whether the following quotes are direct or indirect, and convert
indirect (direct) quotes to direct (indirect) quotes:

a. Euro: AUD1.4462/EUR
b. Canada: CAD0.9812/AUD

A market quote would be written as Base currency/Price currency, which indicates

how much of the price currency is required to buy one unit of the base currency. There
are different quotation conventions (Topic 1 slide 33), the quotations in the question
can therefore be re-written to the following market quote.

Euro: EUR/AUD 1.4462 (or equivalently, EUR-AUD, EURAUD)

Canada: AUD/CAD 0.9812

A direct quote is the price of a foreign currency in domestic currency units, i.e., the
quote should show how much domestic currency is required to purchase one unit of
a foreign currency. An indirect quote is the price of the domestic currency in foreign
currency units, i.e., the quote should show how much foreign currency units is
required to purchase one unit of the domestic currency.

Therefore,
EUR/AUD 1.4462 is an indirect quote in the Eurozone (equivalently a direct quote in
Australia, the home country) and converting it to a direct quote in the Eurozone (and
equivalently an indirect quote in Australia) is to take the reciprocal (1/1.4462), i.e.,
AUD/EUR 0.6915 (quotations are usually quoted to 4 decimal places – slide 37,
unless otherwise indicated in the question).

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AUD/CAD 0.9812 is a direct quote in Canada (and an indirect quote in Australia, at
home). Converting it to an indirect quote in Canada (and equivalently a direct quote
in Australia) is to take the reciprocal (1/0.9812), i.e., CAD/AUD 1.0192.

Q7. [Numerical, Topic 1, FX risk] A foreign exchange trader with a U.S. bank took a
short position of £5,000,000 when the GBP/USD exchange rate was 1.55.
Subsequently, the exchange rate has changed to 1.61. Is this movement in the
exchange rate good from the point of view of the position taken by the trader? By how
much has the bank’s liability changed because of the change in the exchange rate?

Since the trader is short a currency (in a currency pair as we have with the GBP/USD
here, to short pound means the trader intends to sell pound to buy USD), the trader
expects the base currency would depreciate against the price currency. Therefore, the
trader’s action indicates she expects the pound to weaken against the USD, allowing
her to buy it back at a later date with less dollars (similar concept to shorting a stock,
you borrow stocks that you sell now, expecting the stock price to decrease so you
could buy it back at a lower price to unwind your original short position).

The increase in the GBP/USD exchange rate implies that the pound has appreciated
with respect to the dollar. This is unfavourable to the trader since the trader will have
to spend more USD to buy back the pound.

The bank’s liability in dollars initially was £5,000,000 x $1.55/£ = $7,750,000

The bank’s liability in dollars now is £5,000,000 x $1.61/£ = $8,050,000
Therefore, the bank’s liability increased by 8,050,000 - 7,750,000 = $300,000.

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