PART FOUR
WORLD FINANCIAL ENVIRONMENT
International Business
Chapter Nine
Global Foreign Exchange and
Capital Markets
Chapter Objectives
• To learn the fundamentals of foreign exchange
• To identify the major characteristics of the foreign
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•
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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
To show how companies make payment for international
transactions
9-2
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 of
one country into that of another country]
9-3
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]
9-4
Fig. 9.1: Average Daily Volume in
World Foreign Exchange Markets,
1989-2004
9-5
Currency Distribution of Global
Foreign Exchange Market Activity
CURRENCY
U.S. Dollar
Euro
Japanese Yen
Pound Sterling
Swiss Franc
All others
April April April April April April
1989 1992 1995 1998 2001 2004
90 82 83 87 90 89
—
—
—
—
38 37
27 23 24 21 23 20
15 14 10 11 13 17
10
9
7
7
6
6
31 32 39 44 30 31
Source: Bank for International Settlements, Central BankSurvey of Foreign Exchange and Derivatives Market Activity, 2004.
9-6
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%]
9-7
Fig. 9.2: Geographical Distribution
of Global Foreign Exchange Market
Activity, April 2004
9-8
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 $1),
and then use currency C to buy currency B.]
9-9
Fig. 9.3: The Circadian Rhythms of
the Foreign Exchange Market
9-10
Map 9.1: International Time Zones
and the Single World Market
9-11
Foreign Exchange Terms and
Conventions
• Bid: the price at which a trader is willing to buy a
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•
•
•
foreign currency
Offer: the price at which a trader is willing to sell
a foreign currency
Spread: the difference between the bid and the
offer rates, i.e., the trader’s profit
American terms: the U.S. point of view, i.e., the
number of U.S. dollars per unit of foreign currency
European terms (indirect quote): the number of
units of foreign currency per U.S. dollar
[continued]
9-12
• A quote in American terms (US$/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.
9-13
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
9-14
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 transaction, 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]
9-15
• 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
9-16
Foreign Exchange Markets:
Thursday, April 28, 2005
COUNTRY
US$ EQUIVALENT
THUR WED
Brazil (Real)
.3917
Canada (Dollar)
.7991
India (Rupee)
.02291
Japan (Yen)
.009430
Russia (Ruble)
.03597
South Africa (Rand)
.1630
Switzerland (Franc)
.8383
U.K. (Pound)
1.9068
Special Drawing Right 1.5135
Euro
1.2895
.3972
.8004
.02288
.009445
.03607
.1646
.8390
1.9059
1.5121
1.2933
CURRENCY PER US$
THUR WED
2.5530
1.2514
43.649
106.04
27.801
6.1350
1.1929
.5244
.6607
.7755
2.5176
1.2494
43.706
105.88
27.724
6.0753
1.1919
.5247
.6613
.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.
9-17
Exchange-based vs. Over-theCounter Fx Instruments
Contract Specs.
Regulation
Type of market
Transparency
Short margin req.
Anonymous orders
Mark positions daily
Audit trail
Participants
EXCHANGE-BASED
(OPTIONS & FUTURES)
OTC
(FORWARD CONTRACTS)
Standard + Custom
SEC
Open outcry, auction
Yes
Yes
Yes
Yes
Complete trail
Public cust. +
corp. & inst. users
Custom
Self
Dealer
No
No
No
No
No
Corp. & inst. users
Source: The Philadelphia Stock Exchange.
9-18
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]
9-19
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:
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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.
9-20
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:
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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
9-21
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
9-22
Fig. 9.4: Structure of Foreign
Exchange Markets
9-23
Fig. 9.5: Foreign Exchange
Transactions
9-24
The Over-the-Counter Market:
Commercial and Investment Banks
Top banks in the interbank fx markets are so
ranked because of their ability to:
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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
9-25
Top OTC and Commercial and
Investment Banks: Fx Trades
TRADING BANK
ESTIMATED BEST IN
BEST IN
BEST IN
BEST IN
MKT.SHARE LONDON NEW YORK EURO/US$ US$/YEN
1. Deutsche Bank
2. UBS Warburg
3. Citigroup
4. HSBC
5. Barclays
6. JP Morgan
7. ABN Amro
8. Merrill Lynch
9. Goldman Sachs
10.Morgan Stanley
19.75%
11.61%
7.33%
6.64%
6.41%
5.38%
4.57%
4.45%
4.38%
4.20%
2
5
3
1
4
7
9
—
8
—
3
4
1
5
—
2
7
—
8
9
1
4
3
2
7
5
6
—
10
—
4
3
1
2
7
5
6
—
10
—
Source: “2005 Euromoney Foreign Exchange Poll,” Euromoney (May 2005).
9-26
U.S. Securities Exchanges
U.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.
9-27
Global Capital Markets:
Eurocurrencies
• Eurocurrency: any currency banked outside its
country of origin
• Eurocurrency market: an offshore, wholesale
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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.
9-28
Major Sources of Eurocurrencies
• Foreign governments or individuals who want to
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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
9-29
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
9-30
Eurocurrency Borrowing
• Eurocredit: a type of loan or line of credit that
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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.]
9-31
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.
9-32
Global Capital Markets:
Equity Securities
• Private placement: an investment by a venture
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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.
9-33
Map 9.2: Market Capitalization,
2001 (US$ Bil.)
9-34
Fig. 9.6: Growth of Emerging Stock
Markets
9-35
Global Capital Markets:
The Euroequity Market
• Euroequity 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 exchanges
A major source of competition to the world’s traditional
stock exchanges is the electronic trading of stocks
through companies such as E*Trade.
[continued]
9-36
• American Depository Receipt (ADR): a nego-
•
tiable certificate issued by a U.S. bank that
represents underlying shares of stock of a
foreign corporation held in trust at a custodial
bank in a foreign country
In addition to ADRs, there are:
– global depository receipts
– European depository receipts
Depository receipts are traded like stocks, with each
receipt representing some number of shares of an
underlying stock.
9-37
Implications/Conclusions
• Approximately U.S. $1.2 trillion in foreign
exchange is traded each day.
• The major institutions that trade foreign
exchange are the large commercial and
investment banks (over-the-counter) and
securities exchanges.
[continued]
9-38
• The U.S. dollar is the most widely traded
•
currency in the world, but London represents
the main foreign exchange market in the
world.
Some players buy and sell foreign exchange
to settle trade transactions, some for
purposes of foreign direct investment, others
for purposes of portfolio investment, and still
others for arbitrage and speculation.
9-39