International Business by Daniels and Radebaugh Chapter 9

International Business by Daniels and Radebaugh Chapter 9 The Foreign-Exchange Market 1

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 exchange 2

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 3

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 4

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 foreign exchange 5

Average Daily Volume in World Foreign-Exchange Markets, 1989– 1998 U. S. dollars (billions) 1600 1, 500 1400 1, 190 1200 1000 820 800 600 590 400 200 0 1989 1992 1995 1998 Years 6

Average Daily Volume of Foreign-Exchange Transactions $350. 90 $451. 20 $78. 60 $81. 70 $139 $94. 30 $148. 60 $637. 30 United States Hong Kong Switzerland Germany Japan United Kingdom Singapore Others 7

Circadian Rhythms of the FX Market Electronic conversations/hour 45000 40000 Peak 35000 Average 30000 25000 20000 15000 10000 5000 0 100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300 Hours 8

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 9

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 foreign currency is less than the spot rate • Forward premium—the forward rate 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 10

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 11

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 foreign travel Currency controls increase the cost of international business and reduce overall international trade 12

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 13

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 14

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

Foreign-Exchange Transactions MNE Foreign-Exchange Dealers Voice Brokers Automated Brokers Reuters Internet Direct to Interbank Counterparty EBS 16

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 17

Top OTC Commercial and Investment Banks in Foreign-Exchange Trades Best In Estimated Bank Market Share % London 1. Citibank/Salomon Smith Barney 1 7. 75 2. Deutsche Bank 3 7. 12 3. Chase Manhattan Bank 2 7. 09 4. Warburg Dillon Read 6= 6. 44 5. Goldman Sachs 4. 86 6. Bank of America 6= 4. 39 7. JP Morgan 10= 4. 00 8. HSBC 4 3. 75 9. ABN Amro 3. 37 10. Merrill Lynch 3. 27 Best In New York Best In Trading Euro/Dollar 1 2 2 1 1 3 3 3 2 5= 10 4 7 6 6 4 7 5 4 9 5 5= 8 18

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 19