© 2001 Prentice Hall9-1 International Business by Daniels and Radebaugh Chapter 9 The Foreign-Exchange Market

© 2001 Prentice Hall9-2 Objectives To learn the fundamentals of foreign exchange To identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders To understand why companies deal in foreign exchange To describe how the foreign-exchange market works To examine the different institutions that deal in foreign exchang e

© 2001 Prentice Hall9-3 Introduction Fundamental difference between payment transactions Domestic transaction—use only one curency Foreign transaction—use two or more currencies Foreign exchange— money denominated in the currency of another group of nations Foreign-exchange market—made up of: –over-the-counter (OTC) »commercial and investment banks »majority of foreign-exchange activity –security exchanges »trade certain types of foreign-exchange instruments Exchange rate—price of a currency Number of units of one currency that buys one unit of another currency Exchange rate can change daily

© 2001 Prentice Hall9-4 Foreign-Exchange Instruments Spot transactions —exchange rate quoted for transactions that require either immediate delivery or delivery within two days Spot rate— settlement rate for the transaction Outright forward—exchange currency beyond three days at a fixed exchange rate Single purchase or sale of a currency for future delivery Forward rate—settlement rate for transaction FX swap—a simultaneous spot and forward transaction Currency swaps—involve interest-bearing financial instruments Exchange of principal and interest payments Options—the right but not the obligation to trade foreign currency in the future Futures contract—agreement to buy or sell a currency in the future at a particular price

© 2001 Prentice Hall9-5 The Foreign-Exchange Market Size of foreign-exchange market $1.5 trillion daily in traditional instruments $110 billion daily in other OTC and exchange-traded instruments Spot transactions are only 40%t of total transactions U.S. dollar is the most important currency because it is: An investment currency in many capital markets A reserve currency held by many central banks A transaction currency in many international commodity markets An invoice currency in many contracts An intervention currency employed by monetary authorities to influence their exchange rates London—the biggest market for foreign exchange

© 2001 Prentice Hall9-6 1,190 1, U.S. dollars (billions) Average Daily Volume in World Foreign-Exchange Markets, 1989–1998 Years

© 2001 Prentice Hall9-7 $ $78.60 $81.70 $94.30 $ $ $139 $ United StatesHong KongSwitzerlandGermany JapanUnited KingdomSingaporeOthers Average Daily Volume of Foreign-Exchange Transactions

© 2001 Prentice Hall9-8 Hours Electronic conversations/hour Peak Average Circadian Rhythms of the FX Market

© 2001 Prentice Hall9-9 Key Foreign-Exchange Terms for the Spot Market Bid—price at which traders are willing to buy foreign currency Offer—price at which traders are willing to sell foreign currency Spread—difference between bid and offer price Profit margin for the trader Direct quote—the number of U.S. dollars per unit of foreign currency American terms—perspective of U.S. trader Indirect quote—the number of units of foreign currency per U.S. dollar European terms—perspective of European trader –base currency—U.S. dollar –terms currency—other currency in exchange Cross rate—exchange rate between non–U.S. dollar currencies

© 2001 Prentice Hall9-10 The Forward Market Most widely traded currencies British pound, Canadian dollar, French franc, German mark, Japanese yen, and U.S. dollar Many currencies do not have a forward market due to the small size and volume of transactions Forward rate—the rate quoted for transactions after two days Forward discount—the forward rate for foreign currency is less than the spot rate Forward premium—the forward rate for foreign currency is greater than the spot rate Options Option—the right but not the obligation to trade a foreign currency at a specific exchange rate Can be purchased OTC or from an exchange Forward contract is cheaper but less flexible than an option

© 2001 Prentice Hall9-11 Futures Futures contract—specifies in advance the exchange rate to be used in exchanging currency Tailored to the amount and time frame needed Not as flexible as a forward contract and, therefore, is less valuable Foreign-Exchange Convertibility Fully convertible currencies—government permits both residents and nonresidents to purchase in unlimited amounts Hard currency—currencies that are fully convertible Relatively stable and strong Soft currencies—currencies that are not fully convertible Typically currencies of developing countries Nonresident convertibility—foreigners can convert their currency into the local currency and can convert back into their currency

© 2001 Prentice Hall9-12 Governmental Restrictions on Foreign-Exchange Convertibility Restrictions used to conserve scarce foreign exchange Licensing—government regulates all foreign-exchange transactions –those who receive foreign currency required to sell it to its central bank at the official buying rate –central bank rations foreign currency Multiple exchange-rate system—different exchange rates set for different transactions Advance import deposit—requires importers to make a deposit with central bank covering price of goods they would purchase from abroad Quantity controls—limit the amount of currency that resident can purchase for foreign travel Currency controls increase the cost of international business and reduce overall international trade

© 2001 Prentice Hall9-13 How Companies Use Foreign Exchange Most foreign-exchange transactions involve international departments of commercial banks Banks buy and sell foreign currency; banks collect and pay money in transaction with foreign buyers and sellers Banks lend money in foreign currency Companies use foreign-exchange market for: Import and export transactions Financial transactions such as FDI Arbitrage—purchase of foreign currency on one market for immediate resale on another market Arbitragers hope to profit from price discrepancy Interest arbitrage—investing in debt instruments in different countries Speculation—buying or selling foreign currency has both risk and high profit potential

© 2001 Prentice Hall9-14 Foreign-Exchange Trading Process Companies work through their local banks to settle foreign-exchange balances Commercial banks in major money centers became intermediaries for small banks Most foreign-exchange activity takes place in traditional instruments Commercial and investment banks and other financial institutions handle spot, outright forward, and FX swaps Foreign-exchange market made up of about 2,000 dealer institutions worldwide Most foreign-exchange takes place in OTC market Dealers can trade foreign exchange: Directly with other dealers Through voice brokers Through electronic brokerage systems –Internet trades of currency are more popular

© 2001 Prentice Hall9-15 Foreign-Exchange Broker OTC Interbank Market Major Banks (spot and forward transactions) Securities Broker Securities Broker Securities Exchange Client buys marks with $ U.S. Client buys $ U.S. with marks CME (futures) PSE (options) Structure of Foreign-Exchange Markets

© 2001 Prentice Hall9-16 Voice Brokers Foreign-Exchange Dealers ReutersEBS MNE Internet Automated Brokers Direct to Interbank Counterparty Foreign-Exchange Transactions

© 2001 Prentice Hall9-17 Commercial and Investment Banks Greatest volume of foreign-exchange activity takes place with the big banks Top banks in the interbank market in foreign exchange are so ranked because of their ability to: –trade in specific market locations –engage in major currencies and cross-trades –deal in specific currencies –handle derivatives »forwards, options, future swaps –conduct key market research Banks may specialize in geographic areas, instruments, or currencies –exotic currency—currency of a developing country »often unstable, weak, and unpredictable

© 2001 Prentice Hall9-18 Bank 1. Citibank/Salomon Smith Barney 2. Deutsche Bank 3. Chase Manhattan Bank 4. Warburg Dillon Read 5. Goldman Sachs 6. Bank of America 7. JP Morgan 8. HSBC 9. ABN Amro 10. Merrill Lynch Estimated Market Share % Best In London = 10= 4 Best In New York = = Best In Trading Euro/Dollar Best In Trading Euro/Dollar Top OTC Commercial and Investment Banks in Foreign-Exchange Trades

© 2001 Prentice Hall9-19 Chicago Mercantile Exchange (CME) A not-for-proft corporation owned by its members Created the International Monetary Market (IMM) Deals primarily in futures contracts, CME futures contracts Ready market even with fixed maturity dates Tend to be for small amounts CME is losing business Struggling to find a niche in currency markets Philadelphia Stock Exchange (PHLX) The only exchange in the U.S. that trades foreign-currency options Offers standardized options and customized options Provide greater flexibility and convenience than futures PHLX growing faster than the CME