1. International Business Environments & Operations
15e, Global Edition
Daniels ● Radebaugh ● Sullivan
HSE International Business
Some contents copyright © 2015 Pearson Education Ltd.
International Business Environments and Operations 15e, Global Edition by Daniels, Radebaugh, and Sullivan

2. Markets for Foreign Exchange
Chapter 8
Markets for Foreign Exchange
Chapter 8: Markets for Foreign Exchange

3. Learning Objectives Learn the fundamentals of foreign exchange
Identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders
Describe how the foreign-exchange market works
Examine the different institutions that deal in foreign exchange
Understand why companies deal in foreign exchange
The Learning Objectives for this chapter are
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 describe how the foreign-exchange market works
To examine the different institutions that deal in foreign exchange
To understand why companies deal in foreign exchange

4. Introduction Learning Objective:
Learn the fundamentals of foreign exchange
Video: What is foreign exchange:1:47 min.
Video: How exchange rates work: 5 min.
Learning Objective : To learn the fundamentals of foreign exchange.

5. What Is Foreign Exchange?
money denominated in the currency of another nation or group of nations
Foreign exchange market
where foreign exchange transactions take place
Exchange rate
the price of a currency in another currency
What is foreign exchange? It’s money denominated in the currency of another nation or group of nations. It can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits, or other short-term claims.

6. Players On The Foreign Exchange Market

7. Players On The Foreign Exchange Market
Learning Objective:
Identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders
The foreign-exchange market: 2:52 min.
Learning Objective : To identify the major characteristics of the foreign-exchange market and how governments control the flow of currencies across national borders.

8. Players On The Foreign Exchange Market
The Bank for International Settlements (BIS) divides the market into
Reporting dealers
Financial institutions
Nonfinancial institutions
Reporting dealers, which are also called money center banks, actively participate in local and global foreign exchange and derivative markets. They include banks like Deutsche Bank, UBS, Barclays Capital, RBS, Citi, and JP Morgan. These banks are influential in setting prices and are the market makers.
The other financial institutions include commercial banks other than the money center banks (local and regional banks), hedge funds, pension funds, money market funds, currency funds, mutual funds, specialized foreign exchange trading companies, and so forth.
Nonfinancial institutions include corporations and governments that also play a role in the foreign exchange market.

9. Players On The Foreign Exchange Market
Foreign Exchange Markets: Turnover by Counterparty
This Figure shows the different parties involved in the foreign exchange market.

10. How To Trade Foreign Exchange
Learning Objective:
Describe how the foreign-exchange market works
Learning Objective : To describe how the foreign exchange market works.

11. How To Trade Foreign Exchange
Dealers can trade foreign exchange
Using electronic methods (41.3%)
Directly with customers (24.3%)
Through the interbank market (18.5%)
Through voice brokers (15.9%)
How are currencies traded? Dealers can trade currency by telephone or electronically through Reuters, EBS, or Bloomberg. In addition to currency trades, these companies also provide market data, news, quotes, and statistics about different markets.

12. Some Aspects Of The Foreign Exchange Market
The foreign exchange market has two segments
OTC commercial and investment banks
Securities exchanges
Today, the foreign exchange market has two major segments.

13. Global OTC Foreign Exchange Instruments
Global OTC foreign exchange instruments include
Spot transactions
Outright forward transactions
FX swap
Currency swaps
Options
Futures contracts
The spot rate is the exchange rate quoted for transactions that require delivery within two days.
Outright forwards involve the exchange of currency beyond three days at a fixed exchange rate, known as the forward rate.
An FX swap is a simultaneous spot and forward transaction - one currency is swapped for another on one date and then swapped back on a future date. Currency swaps deal more with interest-bearing financial instruments like bonds, and involve the exchange of principal and interest payments.
Options are the right, but not the obligation, to trade foreign currency in the future.
Finally, a futures contract is an agreement between two parties to buy or sell a particular currency at a particular price on a particular future date, as specified in a standardized contract to all participants in that currency futures exchange.

14. Global OTC Foreign Exchange Instruments
Foreign Exchange Markets: Turnover by Instrument
This Figure shows the turnover in foreign exchange by each of the instruments.

15. Size, Composition, and Location of the Foreign Exchange Market
Market size is $4 trillion daily
the U.S. dollar is the most important currency on the foreign-exchange market
London is the main foreign exchange market in the world
The most commonly traded currency pairs are EUR/USD and USD/JPY
Estimated daily foreign exchange turnover in 2010 was $4 trillion - up 20 percent from Almost 85 percent of all transaction involve the U.S. dollar.
In fact the dollar fill many roles: it’s 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, and an intervention currency employed by monetary authorities in market operations to influence their own exchange rates.
Because of the importance of the U.S. dollar as the currency through which most foreign exchange trades take place, the exchange rate between two currencies other than the U.S. dollar is known as a cross rate.

16. Size, Composition, and Location of the Foreign Exchange Market
Foreign Exchange Markets: Average Daily Volume
This Figure shows the average daily volume in the foreign exchange market from 1998 to 2010.

17. Size, Composition, and Location of the Foreign-Exchange Market
Global Foreign Exchange: Currency Distribution
This Table shows the currency distribution in global foreign exchange.

18. Size, Composition, and Location of the Foreign Exchange Market
Foreign Exchange Markets: Geographic Distribution
This Figure shows the geographical distribution of foreign exchange markets. Notice the dominance of the United Kingdom. More dollars are traded in London than in New York.

19. Major Foreign Exchange Markets
Foreign exchange dealers quote rates
Bid (buy) rate
the rate at which traders buy foreign exchange
Offer (sell) rate
the rate at which traders sell foreign exchange
Spread
the difference between bid and offer rates
Rates in the foreign exchange market are quoted by dealers.

20. Major Foreign Exchange Markets
American terms (direct quote)
the number of dollars per unit of foreign currency
European terms (indirect quote)
the number of units of foreign currency per dollar
Base currency
Terms currency
Currency quotes can be either direct or indirect. The numerator is called the terms currency and the denominator is called the base currency.

21. What is a 'Forward Market'
A forward market is an over-the-counter marketplace that sets the price of a financial instrument or asset for future delivery.
Forward markets are used for trading a range of instruments, but the term is primarily used with reference to the foreign exchange market.
It can also it can also apply to markets for securities and interest rates as well as commodities.

22. Forward Market Details
While forward contracts, like futures contracts, may be used for both hedging and speculation, there are some notable differences between the two.
Forward contracts can be customized to fit a customer's requirements, while futures contracts have standardized features in terms of their contract size and maturity.
Forwards are executed between banks or between a bank and a customer; futures are done on an exchange, which is a party to the transaction.
The flexibility of forwards contributes to their attractiveness in the foreign exchange market.

23. Details: 'Forward Market'
Pricing: Prices in the forward market are interest-rate based. In the foreign exchange market, the forward price is derived from the interest rate differential between the two currencies, which is applied over the period from the transaction date to the settlement date of the contract. In interest rate forwards, the price is based on the yield curve to maturity.

24. Details: 'Forward Market'
Foreign Exchange Forwards: Interbank forward foreign exchange markets are priced and executed as swaps. This means that currency A is purchased vs. currency B for delivery on the spot date at the at the spot rate in the market at the time the transaction is executed. At maturity, currency A is sold vs. currency B at the original spot rate plus or minus the forward points; this price is set when the swap is initiated.
The interbank market usually trades for straight dates, such as a week or a month from the spot date. Three- and six-month maturities are among the most common, while the market is less liquid beyond 12 months. Amounts are commonly $25 million or more and can range into the billions.

25. Details: 'Forward Market'
Customers, both corporations and financial institutions such as hedge funds and mutual funds, can execute forwards with a bank counter-party either as a swap or an outright transaction. In an outright forward, currency A is bought vs. currency B for delivery on the maturity date, which can be any business day beyond the spot date.
The price is again the spot rate plus or minus the forward points, but no money changes hands until the maturity date.
Outright forwards are often for odd dates and amounts; they can be for any size.

26. Details: 'Forward Market'
The most commonly traded currencies in the forward market are the same as on the spot market: EUR/USD, USD/JPY and GBP/USD.

27. The Forward Market Forward discounts Forward premiums Option Futures
when the forward rate is less than the spot rate
Forward premiums
when the forward rate is greater than the spot rate
Option
the right, but not the obligation, to trade a foreign currency at a specific exchange rate
Futures
specifies an exchange rate in advance of the actual exchange of currency
not as flexible as a forward contract
The spot market is for foreign exchange transactions that occur within two business days. Forward markets are used for transactions that call for delivery after two business days.
An option gives the right, but not the obligation to trade a foreign currency in the future. Options can be traded OTC or on an exchange.

28. The Foreign Exchange Trading Process
This Figure shows the process for trading foreign currencies.
Companies selling goods or services to foreign customers in exchange for foreign currency, need to convert the foreign currency into the domestic currency.
Similarly, companies that import goods or services need to convert their domestic currency in order to pay the foreign supplier.
These conversions usually takes place between the company and its bank following the outline in the Figure.
Large MNEs go through their money center banks to settle foreign-exchange balances, but other firms use local banks or other financial institutions.

29. Banks And Exchanges
The top banks in the inter-bank market in foreign exchange can
trade in specific market locations
engage in major currencies and cross-trades
deal in specific currencies
handle derivatives
forwards, options, futures, swaps
conduct key market research
The largest volume of foreign exchange activity takes place with the big money center banks. While these banks all typically have the ability to trade in specific market locations, engage in major currencies and cross-trades, deal in specific currencies, handle derivatives like forwards, options, futures, and swaps, and also conduct key market research, most large companies usually use several banks.

30. Banks And Exchanges
Foreign Exchange Trades: Top Commercial Banks, 2012
Ranked by Overall Market Share
This Table shows the top banks in the world in terms of foreign exchange trading.

31. Top Exchanges For Trading Foreign Exchange
Three of the best-known exchanges are
the Chicago Mercantile Exchange (CME) Group
the NASDAQ OMX
the NYSE Liffe
Foreign exchange is traded OTC, and also on commodities exchanges.
The CME Group for example, trades a variety of futures and options contracts in numerous currencies against the dollar as well as in cross rates—such as the euro against the Australian dollar.
Similarly, the NASDAQ OMX is involved in a new hybrid of trading, which involves traditional floor trading and online trading as well. Options are offered in the Australian dollar, the British pound, the Canadian dollar, the euro, the Japanese yen, and the Swiss franc, while futures are offered in British pounds and the euro.
NYSE Liffe is the world’s second-largest derivatives exchange by value of transacted business.

32. How Companies Use Foreign Exchange
Learning Objective:
Understand why companies deal in foreign exchange
Learning Objective : To understand why companies deal in foreign exchange.

33. How Companies Use Foreign Exchange
Import and export cash flow options
Commercial bills of exchange
sight draft
time draft
Letters of credit
confirmed letter of credit
How do companies use the foreign exchange market? They use it to facilitate their regular business transactions, and/or to speculate. Companies have a variety of options when it comes to moving money for transactions.
The most common is the commercial bill of exchange which is also known as a draft. Commercial bills of exchange are used to direct another party to make payment. A sight draft requires payment to be made when it’s presented, while a time draft allows payment to be made after the date when it’s presented.
A letter of credit provides an additional layer of security to a transaction. It obligates the buyer’s bank to honor a draft presented to it and assume payment. A credit relationship will exist between the importer and the importer’s bank. With a confirmed letter of credit, the exporter has the guarantee of an additional bank in the home country or a third country.

34. How Companies Use Foreign Exchange
Other financial flows for business
Speculation
buying or selling of a foreign currency that has an element of risk and a chance of great profits
Arbitrage
the buying and selling of foreign currencies at a profit due to price discrepancies
interest arbitrage
Companies also deal in foreign exchange for other transactions. For example, a company might receive or pay dividends, loans and/or interest.
Companies that speculate in foreign exchange take positions in foreign exchange markets and other capital markets in the hopes of earning a profit.
Companies also engage in arbitrage with the goal of making a profit. Interest arbitrage involves investing in interest-bearing instruments in foreign exchange in an effort to earn a profit due to interest rate differentials.

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39. BMW foreign exchange management
FT case study.

40. Where Are Foreign Exchange Markets Headed?
More efficient markets
create more opportunities for foreign exchange trading
lower costs
Frequent financial crises in Europe
future of the euro
Rise of the Chinese yuan and Brazilian real
Technology developments
more electronic trades
What is likely to happen to foreign exchange markets in the future? Well, they will almost certainly be more efficient which should not only create more opportunities for foreign exchange trading, it should also lower the cost of transactions for companies. Similarly, developments in technology will prompt more electronic trades rather than traditional phone trades.
The financial crisis in Europe will also have an impact on the future of foreign exchange markets. If the situation stabilizes, the euro could take on a dominant role. However, if the crisis deepens, the very existence of the euro could be in jeopardy. In either case, both the Chinese yuan and the Brazilian real are likely to become bigger players.