© 2001 Prentice Hall 9-1 International Business by Daniels and Radebaugh Chapter 9 The Foreign-Exchange Market
Jan 15, 2016
© 2001 Prentice Hall 9-1
International Businessby
Daniels and Radebaugh
Chapter 9The Foreign-ExchangeMarket
© 2001 Prentice Hall 9-2
ObjectivesTo learn the fundamentals of foreign exchangeTo 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 exchangeTo describe how the foreign-exchange market worksTo examine the different institutions that deal in foreign
exchange
© 2001 Prentice Hall 9-3
IntroductionFundamental 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
instrumentsExchange 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 Hall 9-4
Foreign-Exchange InstrumentsSpot 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 transactionCurrency 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 Hall 9-5
The Foreign-Exchange MarketSize 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 ratesLondon—the biggest market for foreign exchange
© 2001 Prentice Hall 9-6
1,190
1,500
590
820
0
200
400
600
800
1000
1200
1400
1600
U.S
. dol
lars
(bi
llio
ns)
1989 1992 1995 1998
Average Daily Volume in World Foreign-Exchange Markets, 1989–1998
Years
© 2001 Prentice Hall 9-7
$350.90
$78.60
$81.70
$94.30
$148.60
$637.30
$139
$451.20
United States Hong Kong Switzerland Germany
Japan United Kingdom Singapore Others
Average Daily Volume of Foreign-Exchange Transactions
© 2001 Prentice Hall 9-8Hours
0
5000
10000
15000
20000
25000
30000
35000
40000
45000
100 300 500 700 900 1100 1300 1500 1700 1900 2100 2300
Ele
ctro
nic
co
nve
rsat
ion
s/ho
ur
Peak
Average
Circadian Rhythms of the FX Market
© 2001 Prentice Hall 9-9
Key Foreign-Exchange Terms for the Spot MarketBid—price at which traders are willing to buy foreign currencyOffer—price at which traders are willing to sell foreign currencySpread—difference between bid and offer price
• Profit margin for the traderDirect 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 Hall 9-10
The Forward MarketMost 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
OptionsOption—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 Hall 9-11
FuturesFutures 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 ConvertibilityFully convertible currencies—government permits both
residents and nonresidents to purchase in unlimited amountsHard currency—currencies that are fully convertible
• Relatively stable and strongSoft currencies—currencies that are not fully convertible
• Typically currencies of developing countriesNonresident convertibility—foreigners can convert their
currency into the local currency and can convert back into their currency
© 2001 Prentice Hall 9-12
Governmental Restrictions on Foreign-Exchange ConvertibilityRestrictions 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 Hall 9-13
How Companies Use Foreign ExchangeMost 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 countriesSpeculation—buying or selling foreign currency has both risk
and high profit potential
© 2001 Prentice Hall 9-14
Foreign-Exchange Trading ProcessCompanies work through their local banks to settle foreign-
exchange balances• Commercial banks in major money centers became
intermediaries for small banksMost 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 Hall 9-15
Foreign-ExchangeBroker
OTCInterbank
Market
Major Banks(spot and forward
transactions)
SecuritiesBroker
SecuritiesBrokerSecurities Exchange
Client buys marks with $ U.S.
Client buys $ U.S. with marks
CME(futures)
PSE(options)
Structure of Foreign-Exchange Markets
© 2001 Prentice Hall 9-16
VoiceBrokers
Foreign-Exchange Dealers
Reuters EBS
MNE
Internet
AutomatedBrokers
Direct toInterbank
Counterparty
Foreign-Exchange Transactions
© 2001 Prentice Hall 9-17
Commercial and Investment BanksGreatest 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 Hall 9-18
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 Amro10. Merrill Lynch
EstimatedMarket Share %
7.757.12
7.09
6.444.864.394.003.753.373.27
Best InLondon
13
2 6=
6=10=
4
Best InNew York
12
3
5=104
7
5=
Best InTrading
Euro/Dollar
21
3
7
6
549
Best InTrading
Euro/Dollar
13
2
6
4
5
8
Top OTC Commercial and Investment Banks inForeign-Exchange Trades
© 2001 Prentice Hall 9-19
Chicago Mercantile Exchange (CME)A not-for-proft corporation owned by its membersCreated 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
futuresPHLX growing faster than the CME