International Financial Environment

Foreign Exchange: Basic Concepts

Foreign exchange (Fx): money denominated in the currency of another nation or group of nations

[a financial instrument issued by a foreign country]

Exchange rate: the price of one currency expressed in terms another currency

[the number of units of a given currency needed to buy one unit of another currency]

Foreign exchange market: banks and currency exchanges that buy and sell foreign currencies and other exchange instruments

[a market for converting the currency ofone country into that of another country]

The Foreign Exchange Market: Major Segments

• Over-the-counter (OTC) market: commercial and investment banks

[most foreign exchange activity occurs here]

• Exchange-traded market: specialized securities exchanges where particular types of foreign-exchange instruments are traded

[instruments such as futures and options are exchange-traded]

Fig. 9.1: Average Daily Volume in World Foreign Exchange Markets, 1989-2004

The U.S. dollar is the most widely traded currency in the world because it serves as:

• 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

The most frequently traded currency pairs are:- the U.S. dollar/euro [28%]- the U.S. dollar/yen [17%]

Fig. 9.2: Geographical Distribution of Global Foreign Exchange Market Activity, April 2004

Location of the Foreign Exchange Market

• London is the largest foreign exchange market (followed by New York, Tokyo, and Singapore) because of its strategic location between Asia and the Americas.

• Market activity first heightens when Europe and Asia are open and again when Europe and the United States are open.

• Cross-trading: using the U.S. dollar as a vehicle currency for trades between two other currencies– Cross rate: the exchange rate between two non-U.S. dollar

currencies that is computed from the exchange rate of each currency in relation to the U.S. dollar [Use currency A to buy currency C (US $1), and then use currency C to buy

currency B.]

Fig. 9.3: The Circadian Rhythms of the Foreign Exchange Market

Map 9.1: International Time Zones and the Single World Market

Foreign Exchange Terms and Conventions

• Bid: the price at which a trader is willing to buy a foreign currency

• Offer: the price at which a trader is willing to sell a foreign currency

• Spread: the difference between the bid and the offer rates, i.e., the trader’s profit

• American terms: the U.S. point of view, i.e., the number of U.S. dollars per unit of foreign currency

• European terms (indirect quote): the number of units of foreign currency per U.S. dollar

[continued]

• A quote in American terms (US$/Fx) is always the reciprocal of a quote in European terms (Fx/US$).

$1.00/¥.009430 ¥106.04/$1.00

• Base currency: the quoted, underlying, or fixed currency

• Traders always quote the base currency (the denominator) first, followed by the terms currency (the

numerator).

• An example:Dollar-yen quote: dollar = base, yen = terms

Oct. 10, 2004 April 28, 2005 ¥110.96/$1.00 ¥106.04/$1.00

The dollar (base) weakened; the yen (terms) strengthened.

Types of Foreign Exchange Markets• Spot market: the market in which foreign exchange

transactions occur “on the spot,” i.e., for delivery within two business days following the date of agreement to trade– Spot rate: the rate quoted for transactions that require

immediate delivery, i.e. within two days• Forward market: the market in which foreign exchange

transactions occur at a set rate for delivery beyond two business days following the date of agreement to trade– Forward rate: a contractually established exchange rate

between a foreign exchange trader and the trader’s client for delivery of foreign currency on a specified date

forward discount: the forward rate is less than the spot rate forward premium: the forward rate is higher than the spot rate

Forward/Future Instruments• Forward contract: a contract between a firm or

individual and a bank to deliver foreign currency at a specific exchange rate on a future date

• Outright forward: a forward contract that is not connected to a spot transaction, i.e., a contact to deliver foreign currency beyond two days following the date of agreement at the forward rate

• Fx swap: a simultaneous spot and forward trans-action, i.e., one currency is swapped for another on one date and then swapped back on a future date

• Currency swap: the exchange of principal and interest payments via interest-bearing OTC financial instruments (e.g., bonds) [continued]

• Futures contract: an agreement between two parties to buy or sell a given currency at a given (negotiated) price on a particular future date, as specified in a standardized contact to all participants in that currency futures exchange [not as flexible as a forward contract]

• Option: an instrument traded both OTC and on exchanges that gives the purchaser the right (but not the obligation) to buy or sell a certain amount of foreign currency at a specified exchange rate within a specified amount of time [more expensive but also more flexible than a forward contract] – Strike price: the exchange rate specified in the option, i.e., the

exercise price – Premium: the fee paid to the writer of the option

Foreign Exchange Markets: Thursday, April 28, 2005

US$ EQUIVALENT CURRENCY PER US$

COUNTRY THUR WED THUR WEDBrazil (Real) .3917 .3972 2.5530 2.5176Canada (Dollar) .7991 .8004 1.2514 1.2494India (Rupee) .02291 .02288 43.649 43.706Japan (Yen) .009430 .009445 106.04 105.88Russia (Ruble) .03597 .03607 27.801 27.724South Africa (Rand) .1630 .1646 6.1350 6.0753Switzerland (Franc) .8383 .8390 1.1929 1.1919U.K. (Pound) 1.9068 1.9059 .5244 .5247Special Drawing Right 1.5135 1.5121 .6607 .6613Euro 1.2895 1.2933 .7755 .7732

Special Drawing Rights (SDRs) are based on exchange rates for the US dollar, the euro, the Japanese yen,

and the British pound.

Sources: International Monetary Fund; Wall Street Journal, 2005.

Exchange-based vs. Over-the-Counter Fx Instruments

EXCHANGE-BASED OTC(OPTIONS & FUTURES) (FORWARD CONTRACTS)

Contract Specs. Standard + Custom CustomRegulation SEC SelfType of market Open outcry, auction DealerTransparency Yes NoShort margin req. Yes NoAnonymous orders Yes NoMark positions daily Yes NoAudit trail Complete trail NoParticipants Public cust. + Corp. & inst. users

corp. & inst. usersSource: The Philadelphia Stock Exchange.

Foreign Exchange Convertibility

Convertibility: the ability of residents and nonresidents to purchase foreign currency with a given (domestic) currency without government restrictions

External convertibility: the ability of non- residents to purchase foreign currency with a given currency without government limitations

Nonconvertibility: the inability of residents and nonresidents to convert a given currency into foreign currency because of government limitations

[continued]

Fully convertible currencies are those that govern-ments allow both residents and nonresidents to purchase in unlimited amounts, i.e., they are freely traded and accepted by central banks.

Hard currencies are fully convertible, relatively stable, and tend to be comparatively strong. Soft (weak) currencies are not fully convertible.

A government may control the convertibility of its currency through:– licensing– a multiple exchange rate system– advance import deposits– quantity controls

Currency controls add to the cost of doing business and thus serve as serious impediments to trade and investment.

The Uses of Foreign Exchange

• The role of commercial banks:– buy and sell foreign exchange– serve as vehicles for payments between domestic and

foreign customers– lend money in foreign denominations

• Business purposes:– settlement of international business transactions– hedging [risk reduction through loss protection]– speculation [currency trading on expectations of future prices]– arbitrage [risk-free profit based on price differentials]

• interest arbitrage

The Fx Trading Process• To settle foreign exchange balances, companies may work

through:– local banks– commercial and investment banks (OTC market)– securities exchange brokers

Banks deal with each other in the interbank market, primarily through foreign-exchange brokers.

Brokers are specialist intermediaries who facilitate transactions in the interbank market by matching the best bid and offer quotes.

• Banks’ fx dealers can trade foreign exchange: – directly with other dealers – through voice brokers – through electronic brokerage systems

Fig. 9.4: Structure of Foreign Exchange Markets

Fig. 9.5: Foreign Exchange Transactions

The Over-the-Counter Market: Commercial and Investment Banks

Top banks in the interbank fx markets are so ranked because of their ability to:• trade in specific market locations• handle major currencies • handle major cross trades• deal in specific currencies• handle derivatives (forwards, options, futures,

swaps)• conduct key market research

U.S. Securities ExchangesU.S. exchanges where fx instruments (primarily options

and futures) are traded include:• Chicago Mercantile Exchange (CME): offers futures and

futures options contracts in more than a dozen foreign currencies

• Philadelphia Stock Exchange (PHLX): the only U.S. exchange that trades foreign currency options; lists six dollar-based standardized currency options contracts

Although options cost more than futures, large firms prefer options because of their greater flexibility and convenience.

Global Capital Markets: Eurocurrencies

• Eurocurrency: any currency banked outside its country of origin

• Eurocurrency market: an offshore, wholesale currency market [started with the deposit of U.S. dollars in London banks]

• Eurodollars: dollars banked outside of the United States, i.e., a certificate of deposit in dollars in a bank located outside of the U.S. (constitute 65-80% of the Eurocurrency market)

Eurocurrencies are also known as offshore currencies, while currencies banked within their country of origin are known as onshore currencies.

Major Sources of Eurocurrencies

• Foreign governments or individuals who want to hold dollars outside of the United States

• MNEs that have cash in excess of current needs• European banks with foreign currency in excess of

current needs• Countries such as Germany, Japan, and Taiwan that

have large balance-of-trade surpluses held as reserves

Demand for Eurocurrencies

• Demand for Eurocurrencies reflects:– greater convenience– increased security– lower rates and thus higher yields

• Demand for Eurocurrencies comes from:– sovereign governments– supranational agencies (e.g., the World Bank)– firms and individuals

Eurocurrency Borrowing

• Eurocredit: a type of loan or line of credit that matures in one to five years

• Syndication: the process of pooling the specific resources of several banks in order to spread the risks associated with large loans

• London Inter-bank Offered Rate (LIBOR): reflects the interest rate London banks charge one another for short-term Eurocurrency loans

[Traditional loans are made at a certain percentage above the LIBOR.]

Global Capital Markets: International Bonds

• Foreign bonds: sold outside of the borrower’s home country but denominated in the currency of the country of issue

• Eurobonds: sold in countries other than the one in whose currency the bond is denominated; usually underwritten by a syndicate of banks from different countries; typically sold over-the-counter

• Global bond: registered in different national markets according to the registration requirements of each market; traded simultaneously in numerous capital markets

Eurobonds may have currency options which allow the creditor to demand repayment in one of several currencies, thus reducing the exchange risk.

Global Capital Markets: Equity Securities

• Private placement: an investment by a venture capitalist or other private party in exchange for stock

• Market capitalization: the total number of shares listed times the market price per share

• The three largest markets in the world are New York, Tokyo, and London.

• The growth of emerging stock markets has been very sensitive to global economic conditions and events.

Map 9.2: Market Capitalization, 2001 (US$ Bil.)

Fig. 9.6: Growth of Emerging Stock Markets

Global Capital Markets: The Euro equity Market

• Euro equity market: shares sold outside the boundaries of the issuing firm’s home country; issuing stock simultaneously in two or more countries in order to attract capital from a wider variety of shareholders

• Global share offering: the simultaneous offering of actual shares on different stock exchangesA major source of competition to the world’s traditional stock exchanges is the electronic trading of stocks through companies such as E*Trade.