1. International Business Environments and Operations Global Edition
Part 4
World Financial Environment
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2. Copyright © 2011 Pearson Education
Chapter 9
Global Foreign
Exchange Markets
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3. Copyright © 2011 Pearson Education
Chapter 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 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
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4. What is Foreign Exchange?
Money denominated in the currency of another nation or group of nations
Can be in the form of cash, funds available on credit and debit cards, traveler’s checks, bank deposits, or other short-term claims
An exchange rate is the price of a currency
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5. Players on the Foreign Exchange Market
The Bank for International Settlements
divides the foreign-exchange market into
reporting dealers (also known as dealer
banks or money center banks), other
financial institutions, and non-financial
institutions.
Who are the players?
Reporting dealers, also known as money center banks, are widely assumed to include the 10 largest banks in terms of overall market share in foreign exchange trading: Deutsche Bank, UBS, Barclays Capital, RBS, Citi, JP Morgan, HSBC, Goldman Sachs, Credit Suisse, and Bank of America. Because of the volume of transactions that the money center banks engage in, they 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.
Dealers can trade foreign exchange:
• Directly with other dealers
• Through voice brokers
• Through electronic brokerage systems
Electronic Services Dealers, whether in the money center banks or other financial institutions, use one or a combination of electronic services to trade currencies. Three of the most widely used are Reuters, EBS, and Bloomberg. Reuters, EBS, and Bloomberg facilitate foreign-exchange trades on automated trading systems.
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6. Aspects of the Foreign Exchange Market
Over-the-counter (OTC) commercial and investment banks.
• Securities exchanges
CME, NASDAQ OMX, NYSE Liffe
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7. Traditional Foreign Exchange Instruments
Spot Transactions
Outright Forward Transactions
FX Swap
Currency Swaps
Options
Futures Contract
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.
In an FX swap, one currency is swapped for another on one date and then swapped back on a future date. Most often, the first leg of an FX swap is a spot transaction, with the second leg of the swap a forward transaction.
Currency swaps deal more with interest-bearing financial instruments (such as a bond), and they involve the exchange of principal and interest payments.
Options are the right, but not the obligation, to trade foreign currency in the future.
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.
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8. Size, Composition, and Location of the Foreign Exchange Market
Size of the foreign-exchange market—$3.2 trillion daily
The U.S. dollar is the most important currency on the foreign-exchange market
Frequently Traded Currency Pairs
Top two pairs include EUR/USD and USD/JPY
Foreign-exchange activity increased substantially in 2007 by 71 percent compared with the 2004 survey. This increase more than reversed the fall in global foreign exchange activity from 1998 to Some of the reasons for the increase are the growing importance of foreign exchange as an alternative asset and a larger emphasis on hedge funds—funds typically used by wealthy individuals and institutions that are allowed to use aggressive strategies unavailable to mutual funds.
The dollar is the most widely traded currency in the world:
• 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 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.
The euro is also in four of the top 10 currency pairs. Although the dollar is still more popular in most emerging markets, the euro is gaining ground, particularly in Eastern European countries like the Czech Republic and Hungary.
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9. Global Foreign Exchange: Currency Distribution
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10. Geographical Distribution of Foreign Exchange Markets
The four largest centers for foreign-exchange trading (the United Kingdom, the United States, Japan, and Singapore) account for 62.5 percent of the total average daily turnover. The U.K. market is so dominant that more dollars are traded in London than in New York.
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The Spot Market
Direct and Indirect Quotas
Base and Term Currencies
Inter-bank Transactions
Key foreign-exchange terms:
• Bid—the rate at which traders buy foreign exchange
• Offer—the rate at which traders sell foreign exchange
• Spread—the difference between bid and offer rates
• American terms, or direct quote—the number of dollars per unit of foreign currency
• European terms, or indirect quote—the number of units of foreign currency per dollar
Base and Term Currencies:
When dealers quote currencies to their customers, they always quote the base currency (the denominator) first, followed by the terms currency (the numerator). A quote for USD/JPY (also shown as USDJPY = X) means the dollar is the base currency and the yen is the terms currency.
Inter-bank transactions are transactions between banks. Retail transactions, those between banks and companies or individuals, provide fewer foreign currency units per dollar than inter-bank transactions.
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The Forward Market
Forward Discounts-exist when the forward rate is less than the spot rate.
Forward Premiums-exist 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
The forward rate is the rate quoted for transactions that call for delivery after two business days.
An easy way to understand the difference between the forward rate and the spot rate for U.S. companies is to use currency quotes in American terms. If the forward rate for a foreign currency is less than the spot rate, then the foreign currency is selling at a forward discount. If the forward rate is greater than the spot rate, the foreign currency is selling at a forward premium. The premium percentage is annualized by multiplying the difference between the spot and forward rates by 12 months divided by the number of months forward.
An option is the right, but not the obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate. An option can be purchased OTC from a commercial or investment bank, or it can be purchased on an exchange. The option provides the company flexibility because it can walk away from the option if the strike price is not a good price. In the case of a forward contract, the cost is usually cheaper than the cost for an option, but the company cannot walk away from the contract. So a forward contract is cheaper but less flexible than an option.
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13. The Foreign Exchange Trading Process
When a company sells goods or services to a foreign customer and receives foreign currency, it needs to convert the foreign currency into the domestic currency. When importing, the company needs to convert domestic to foreign currency to pay the foreign supplier. This conversion usually takes place between the company and its bank.
Large MNEs go through their money center banks to settle foreign-exchange balances, but other firms use local banks or other financial institutions.
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Banks and Exchanges
The top banks in the inter-bank 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, futures, swaps).
• Conduct key market research.
Given the differing capabilities of banks, large companies may use several banks to deal in foreign exchange, selecting those that specialize in specific geographic areas, instruments, or currencies. In the past, for example, AT&T used Citibank for its broad geographic spread and wide coverage of different currencies, but it also used Deutsche Bank for euros, Swiss Bank Corporation for Swiss francs, NatWest Bank for British pounds, and Goldman Sachs for derivatives.
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Foreign-Exchange Trades: Top Commercial and Investment Banks, 2009 as Ranked by Overall Market Share
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16. Top Exchanges for Trading Foreign Exchange
Firms can also use securities exchanges for derivatives trade in foreign exchange.
CME Group
NASDAQ OMX
NYSE Liffe
The CME Group trades many different commodities. In terms of foreign exchange, it 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.
In July 2008, PHLX merged with NASDAQ OMX. With this merger, they created the third-largest options market in the United States. They also formed a new hybrid of trading, which involves traditional floor trading and online trading as well. Options were being offered by PHLX in the Australian dollar, the British pound, the Canadian dollar, the euro, the Japanese yen, and the Swiss franc. Futures were offered in British pounds and the euro. The London International Financial Futures and Options Exchange (LIFFE) was founded in 1992 to trade a variety of futures contracts and options. It was subsequently bought in 2002 by Euronext, then a European stock exchange based in Paris but with subsidiaries in other European countries. Beginning in 2003, the electronic platform where its derivatives products traded on member exchanges was known as LIFFE CONNECT. In 2007, Euronext merged with the New York Stock Exchange to create NYSE Euronext. The international derivatives business of NYSE Euronext is now handled by NYSE Liffe, using the LIFFE CONNECT platform developed before the merger between NYSE and Euronext. According to their corporate Web site, NYSE Liffe is the world’s second-largest derivatives exchange by value of transacted business.
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17. Future: Where are foreign exchange markets headed?
Restrictions to the free flow of goods and services should diminish
Technological developments cause foreign exchange trades to be executed more quickly and cheaply.
Internet trade will increase currency price transparency and increase the ease of trading, thus allowing more investors into the market.
The speed at which transactions are processed and information is transmitted globally will certainly lead to greater efficiencies and more opportunities for foreign-exchange trading. The impact on companies is that costs of trading foreign exchange should come down, and companies should have faster access to more currencies.
Capital controls still impact foreign investment, but they will continue to become less of a factor for trade in goods and services.
The growth of Internet trades in currency will take away some of the market share of dealers and allow more entrants into the foreign exchange market.
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18. How Companies Use Foreign Exchange
Cash Flow Aspects of Imports and Exports
Commercial Bills of Exchange
Letters of Credit
Other Financial Flows
Speculation
Arbitrage
When a company must move money to pay for purchases or receives money from sales, it has options as to the documents it can use, the currency of denomination, and the degree of protection it can ask for.
With a draft or commercial bill of exchange, one party directs another party to make payment.
A sight draft requires payment to be made when it is presented. A time draft permits payment to be made after the date when it is presented.
A letter of credit obligates the buyer’s bank to honor a draft presented to it and assume payment; a credit relationship exists between the importer and the importer’s bank.
With a confirmed letter of credit, the exporter has the guarantee of an additional bank—sometimes in the exporter’s home country, sometimes in a third country. It rarely happens that the exporter establishes the confirming relationship. For the L/C to be valid, all of the conditions described in the documents must be adhered to. For example, if the L/C states that the goods will be shipped in five packages, it will not be valid if they are shipped in four or six packages. It is important to understand the conditions of the documents.
Companies also deal in foreign exchange for other transactions, such as the receipt or payment of dividends or the receipt or payment of loans and interest.
Speculation is the buying or selling of a commodity, in this case foreign currency, that has both an element of risk and the chance of great profit. For example, an investor could buy euros in anticipation that the euro will strengthen against other currencies. If it strengthens, the investor earns a profit; if it weakens, the investor incurs a loss. Speculators are important in the foreign-exchange market because they spot trends and try to take advantage of them. They can create demand for a currency by purchasing it in the market, or they can create a supply of the currency by selling it in the market.
Arbitrage is the buying and selling of foreign currencies at a profit due to price discrepancies.
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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