PART FOUR WORLD FINANCIAL ENVIRONMENT CHAPTER NINE GLOBAL FOREIGN EXCHANGE AND CAPITAL MARKETS

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 To show how companies make payment for international transactions

CHAPTER OVERVIEW
The foreign-exchange market consists of all those players who buy and sell foreignexchange instruments for business, speculative, or personal purposes. Primarily, foreign exchange is used to settle international trade, licensing, and investment transactions. Chapter 9 explains in detail basic concepts (such as rates, instruments, and convertibility) and explores the major characteristics of the foreign-exchange markets. The chapter includes a discussion of the foreign-exchange trading process that focuses on both the over-the-counter and the exchange-traded markets, i.e., banks, securities exchanges, electronic brokerages, and the respective roles they play. The chapter concludes with a discussion of global capital markets, including Eurocurrencies, international bonds, and equity markets.

CHAPTER OUTLINE
OPENING CASE: Western Union This case describes Western Unions international money transfer services and the increasing competition the company is facing from banks. Western Union has been particularly successful in attracting business from Mexican emigrants in the United States who send part of their paycheck home to support their families. Western Union charges relatively high fees and uses its own exchange rates that are usually significantly lower than the market rate. Banks have been introducing their own money transfer services, many with lower fees and better exchange rates than Western Union. Due to many Mexicans distrust of banks, however, Western Union continues to enjoy large profit margins and a large market share in the money transfer business.

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TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Nine and select those you find most useful for enhancing your lecture and class discussion. For additional visual summaries of key chapter points, also review the figures, tables and maps in the text. I. INTRODUCTION Foreign exchange is money denominated in the currency of another nation or group of nations, i.e., it is a financial instrument issued by countries other than ones own. An exchange rate is the price of one currency expressed in terms of another, i.e., the number of units of one currency needed to buy a unit of another. II. MAJOR CHARACTERISTICS OF THE FOREIGN-EXCHANGE MARKET The foreign-exchange market consists of the different players who buy and sell foreign currencies and other exchange instruments. Their combined activities affect the supply of and demand for currencies. The market is comprised of two major segments. The over-the-counter market (OTC) includes commercial banks, investment banks, and other financial institutionsthis is where most foreignexchange activity occurs. The exchange-traded market includes certain securities exchanges (e.g., the Chicago Mercantile Exchange and the Philadelphia Stock Exchange) where particular types of foreign-exchange instruments (such as futures and options) are traded. A. A Brief Description of Foreign-Exchange Instruments Several types of foreign exchange instruments are available for trading. In addition, several types of transactions may occur. Spot transactions involve the exchange of currency on the spot, or technically, transactions that are settled within two business days after the date of agreement to trade. The spot rate is the exchange rate quoted for transactions that require the immediate delivery of foreign currency, i.e., within two business days. Outright forward transactions involve the exchange of currencies beyond two days following the date of agreement at a set rate known as the forward rate. In an FX swap (a simultaneous spot and forward transaction), one currency is swapped for another on one date and then swapped back on a future date. In fact, the same currency is bought and sold simultaneously, but delivery occurs at two different times. FX swaps account for nearly 45 percent of all foreign-exchange transactions. In addition to the traditional instruments, several other ways now exist with which to participate in the foreign-exchange market. Currency swaps deal with interest-bearing financial instruments (such as bonds) and involve the exchange of principal and interest payments. An option is a foreign-exchange instrument that guarantees the purchaser the right (but does not impose an obligation) to buy or sell a certain amount of foreign currency at a set exchange rate within a specified amount of time. A futures contract is a foreign-exchange instrument that specifies an exchange rate, an amount, and a maturity date in advance of the exchange of the currencies, i.e., it is an agreement to buy or sell a particular currency at a particular price on a particular future date. 100

B. The Size, Composition and Location of the Foreign-Exchange Market The Bank for International Settlements (BIS) estimated in 2004 that $1.9 trillion in foreign exchange was traded each day. This increase more than reversed the decline seen from 1998 to 2001. This reversal is likely due to the growing importance of foreign exchange as an alternative asset and the larger emphasis on hedge fund (a fund, usually used by wealthy individuals and institutions, which is allowed to use aggressive trading strategies unavailable to mutual funds). The U.S. dollar remains the most important currency in the foreignexchange market, comprising one side (buy or sell) of 89 percent of all foreign currency transactions worldwide in 2004. This is because the dollar: is an investment currency in many markets is held as a reserve currency by many central banks is a transaction currency in many international commodity markets serves as an invoice currency in many contracts is often used as an intervention currency when foreign monetary authorities wish to influence their own exchange rates. Nonetheless, the largest foreign exchange market is in the United Kingdom, which is strategically situated between Asia and the Americas, followed by the United States, Japan and Singapore. DOES GEOGRAPHY MATTER? Foreign-Exchange Trades Even though the U.S. dollar is the most widely traded currency in the world, some trading centers outside the U.S. are very important in the global currency trade. London, for example, is a major trading center because it is close to the major capital markets in Europe and is in a time zone that straddles the other major markets in Asia and the U.S. Despite the fact that the currency market is a 24 hour market, the heaviest volumes of trade are concentrated in the hours when Asia and Europe are open or when Europe and the U.S. are open (see Figure 9.3). Also, prices tend to be better when markets are active and liquid.

III. MAJOR FOREIGN-EXCHANGE INSTRUMENTS A. The Spot Market The spot market consists of players who conduct those foreign-exchange transactions that occur on the spot, or technically, within two business days following the date of agreement to trade. Foreign-exchange traders always quote a bid (buy) and offer (sell) rate. The bid is the rate at which traders buy foreign exchange; the offer is the rate at which traders sell foreign exchange. The spread is the difference between the bid and offer rates, i.e., it is the profit margin of the 101

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trade. Exchanges can be quoted in American terms, i.e., a dollar-direct quote that gives the value in dollars of a unit of foreign currency, or European terms, i.e., an indirect quote that gives the value in foreign currency of one U.S. dollar. The base currency, or the denominator, is the quoted, underlying, or fixed currency; the terms currency is the numerator. Most large newspapers quote exchange rates daily, listing both spot and forward rates. The spot rates listed are usually the selling rates for interbank transactions (transactions between banks) of $1 million or more. The Forward Market The forward market consists of those players who conduct foreign-exchange transactions that occur at a set rate beyond two business days following the date of agreement to trade. The forward rate is the rate quoted today for the future delivery of a foreign currency. A forward contract is entered into whereby the customer agrees to buy (or sell) over the counter a specified amount of a specific currency at a specified price on a specific date in the future. The difference between the spot and forward rates is either the forward discount (the forward rate, i.e., the future delivery price, is lower than the spot rate) or the forward premium (the forward rate is higher than the spot rate). Options An option is a foreign-exchange instrument that guarantees the right, but does not impose an obligation, to buy or sell a foreign currency within a certain time period or on a specific date at a specific exchange rate (called the strike price). Options can be purchased over the counter from a commercial or investment bank or on an exchange. The writer of the option will charge a fee, known as the premium. An option is more flexible, but also more expensive, than a forward contract. Futures A foreign currency future resembles a forward contract because it specifies an exchange rate sometime in advance of the actual exchange of the currency. However, a future is traded on an exchange, not OTC. While a forward contract is tailored to the amount and time frame the customer needs, futures contracts have preset amounts and maturity dates. The futures contract is less valuable to a firm than a forward contract, but it may be useful for small transactions or speculation. Foreign-Exchange Convertibility Hard currencies are those that governments allow both residents and nonresidents to purchase in unlimited amounts, i.e., currencies freely traded and accepted in international business. Hard currencies are fully convertible, relatively stable and tend to be comparatively strong. Soft (weak) currencies are not fully convertible and tend to be the currencies of developing countries. To conserve scarce foreign exchange, governments may impose exchange restrictions on individuals and/or companies. Under a multiple exchange-rate system the government sets different rates for different types of transactions. If the government imposes an advance import deposit, importers will be required to make a deposit with the central bank, often for as long as one year, to cover the full price of the products being sourced from abroad. With quantity controls, the government limits the amount of foreign currency that can be used

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for a given transaction. Such currency controls significantly add to the cost of doing business and can serve as serious impediments to trade. IV. HOW COMPANIES USE FOREIGN EXCHANGE The most obvious use of foreign exchange is for the settlement of international business transactions, i.e., trade, licensing, and investment activities. Profit-seekers may engage in arbitrage, i.e., they may purchase foreign currency on one market for immediate resale on another market (in a different country) in order to profit from a price discrepancy. Interest arbitrage involves investing in debt instruments (such as bonds) in different countries in order to maximize profits by capturing interest-rate and exchange-rate differentials. Speculation involves buying (or selling) a currency based on the expectation it will gain (or lose) in strength against other currencies. Although speculation offers the chance to profit, it also contains an element of risk. The Parker Discretionary FX Index, which measures the performance of 17 currency managers worldwide, finished with a negative return in 2004the first negative return in 19 years. V. THE FOREIGN-EXCHANGE TRADING PROCESS When a firm needs foreign exchange, it typically goes to its commercial bank. If the bank is large enough, it may have its own foreign-exchange traders. A smaller bank, dealing either on its own account or for a client, can trade foreign exchange directly with another bank or through a foreign exchange broker, who matches the best bid and offer quotes of interbank traders. The Bank for International Settlements (BIS) based in Basel, Switzerland (effectively the central banks central bank), estimates there are about 1,200 dealer institutions worldwide that comprise the foreignexchange market. Of these, approximately 100 to 200 are market markers and, of this group, only a select few are major players. A. Commercial and Investment Banks At one time, only big money center banks could deal in foreign exchange. Now, with the advent of electronic trading, smaller regional banks can hook up to Reuters and Bloomberg and deal directly in the interbank market. In spite of these developments, the greatest volume of foreign-exchange activity still takes place with the big banks. Commercial banks and other financial institutions comprise the over-the-counter market (OTC). This is where most foreignexchange activity occurs. Top banks in the interbank market are so ranked because of their abilities to: trade in specific market locations handle major currencies engage in cross-trades deal in specific currencies handle derivatives (forwards, options, futures, and swaps) conduct key market research. Other factors often mentioned are market share by size and region, advisory services, price, quote speed, credit rating, liquidity, back office/settlement, strategic advice, trade recommendations, out-of-hours service/night desk, systems technology, innovation, risk appraisal, and e-commerce capabilities. A large firm may use more than one bank to conduct its foreign-exchange dealings, given their particular strategic capabilities. In addition to the OTC market, there 103

are a number of exchanges where particular types of foreign-exchange instruments (such as futures and options) are traded. The Chicago Mercantile Exchange (CME) offers futures and futures options contracts (contracts that are options on futures contracts, rather than options on foreign exchange per se) in more than a dozen foreign currencies. The Philadelphia Stock Exchange (PHLX) is the only exchange in the United States that trades foreign-currency options. It 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. VI. GLOBAL CAPITAL MARKETS This section looks at the role of foreign debt and equity markets in moving currency from one country to another. A. Eurocurrencies The Eurocurrency market is an important source of debt financing form MNEs. A Eurocurrency is any currency that is banked outside its country of origin. A Eurodollar, then, is a certificate of deposit in dollars in a bank outside of the United States. Most Eurodollar CDs are held in London, but they could be held in any bank outside the United States. A major advantage of the Eurodollar market is that, since it is an offshore market, it is not regulated by the Federal Reserve Board. Other Eurocurrencies are likewise not regulated by the major regulatory bodies in their respective home countries. The major sources of Eurocurrencies are: Foreign governments or individuals who want to hold dollars outside of the United States Multinational enterprises 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 balanceof-trade surpluses held as reserves The Eurocurrency market exists partly for reasons of convenience and security and partly because of cheaper lending rates for the borrower and a better yield for the lender. The Eurocurrency market is a wholesale market where major players such as governments, central banks, and public sector corporations make large transactions. The Eurocurrency market consists of short-term borrowing (maturities less than one year) and medium-term borrowing. A Eurocredit is any loan, line of credit, or other instrument with a one to five year maturity. Syndications, also a form of Eurocredit, are situations in which several banks pool resources to extend credit to a borrower and spread the risk. Loans are traditionally made at a certain percentage above the London Inter-Bank Offered Rate (LIBOR), which is the deposit rate that applies to interbank loans within London. The amount of the interest rate above LIBOR that a borrower is charged depends on the credit worthiness of the customer, but is usually less than it would be in the domestic market. The Eurocurrency market is completely unregulated. B. International Bonds: Foreign, Euro, and Global The international bond market can be divided into foreign bonds, Eurobonds, and global bonds. Foreign bonds are sold outside of the borrowers country but are denominated in the currency of the country of issue. A Eurobond is usually 104

underwritten (placed in the market for the borrower) by a syndicate of banks from different countries and sold in a currency other than that of the country of issue. The global bond, introduced by the World Bank in 1989, is a combination of a domestic bond and a Eurobondthat is, it must be registered in each national market according to that markets registration requirements. It is also issued simultaneously in several markets, usually those in Asia, Europe, and North America. C. Equity Securities and the Euroequity Market Another source of financing is equity securities, where an investor takes an ownership position in return for shares of stock in the company and the potential for capital gains and/or dividends. Firms can gain access to capital through private placements with wealthy individuals or venture capitalists. Another source of demand for private placements is the corporate restructuring market in Europe. Companies can also access the equity-capital market by listing their shares publicly on a stock exchange, either in their home country or in another country. The size of stock markets can be compared on the basis of market capitalization (the total number of shares of stock listed times the market price per share). The five biggest stock exchanges in the world are the New York Stock Exchange, NASDAQ, Tokyo Stock Exchange, London Stock Exchange, and Euronext. The growth of emerging stock markets was quite erratic in the 1990s. In recent years, however, emerging markets have grown more rapidly. Another significant development in the past decade is the creation of the Euroequity market, the market for shares sold outside the boundaries of the issuing countrys home country. Hundreds of companies worldwide have issued stock simultaneously in two or more countries in order to attract more capital from a wider variety of shareholders. Recently, however, several companies have reduced the number of exchanges on which their stocks are listed. Investors are finding that the best price for their stocks is usually in their home market. Despite these trends, there are still 460 foreign companies listed on the New York Stock Exchange, more than triple the number listed in 1993. The most popular way for a Euroequity to get a listing in the United States is to issue an American Depositary Receipt (ADR)a negotiable certificate issued by a U.S. bank in the United States to represent the underlying shares of a foreign corporations stock held in trust at a custodian bank in the foreign country. Some ADRs will list for the same price in the home country and foreign country exchange, but some companies list for different prices in different countries. Another major development in international equity markets is electronic trading. Companies such as E*Trade and Charles Schwab & Company are now doing business in Europe and competing with local e-trade companies. POINTCOUNTERPOINT: Speculation in Capital Markets POINT: Currency speculation is not illegal, nor is it necessarily bad. Speculators are merely trying to make a profit by trading based on market trends. Currency speculation allows investors to diversify their portfolios from traditional stocks and bonds, which are themselves forms of speculative investment.

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COUNTERPOINT: There are plenty of opportunities for a trader, whether in foreign exchange or securities, to make money illegally or contrary to company policy. Nicholas Leeson, a 28-year-old trader for British bank Barings PLC was chief trader for the bank in Singapore. Leeson had no checks and balances on his trading and made big bets on stock index futures assuming that the Tokyo stock market would rise. After the January 17, 1995 earthquake in Kobe, Japanese stocks plunged and Leeson had to come up with cash to cover the margin call. With lax internal controls, Leeson was able to make numerous questionable and illegal transactions to illicitly generate the cash needed to cover his positions. These actions resulted in huge losses in excess of $1 billion for Barings, putting the company into bankruptcy. Since the collapse of Barings, measures have been put into place in banks to prohibit such consequences, yet the occurrence of and potential for negative outcomes from rogue trading continue to exist. LOOKING TO THE FUTURE: The Future of Foreign Exchange and Global Capital Markets The speed at which transactions are processed and information is transmitted globally will continue to lead to greater efficiencies and more opportunities in foreign exchange markets. Companies costs of trading foreign exchange should come down and they should gain faster access to more currencies. Government exchange restrictions should diminish as currency markets are liberalized. As the euro continues to solidify its position in Europe, it will reduce exchange-rate volatility and should lead to the euro taking some of the pressure off the dollar so that it is no longer the only major vehicle currency in the world. The growth of Internet trades in currency will take away some of the market share of dealers and allow more entrants in the foreignexchange market.

CLOSING CASE: HSBC and the Peso Crisis in Argentina None of the closing cases in the last version of the manual had any summary paragraph, so I did not provide them with the revision. HSBC Holdings plc is a London based global banking and insurance enterprise with over 7,000 offices in 81 countries. HSBC entered Argentina in 1997 through an acquisition. After a loss in 1998, the company earned a healthy profit in 1999 and expected growth rates of 100% or more. In 2001, however, Argentina experienced a tremendous financial that led to losses of $1.1 billion for HSBC. The countrys economy has recovered well since 2002, but HSBC has been reluctant to invest more in Argentina. Is now the time for increased investment, or should HSBC continue to be reserved in its operations in Argentina?

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Questions 1. What are the major factors that caused the peso to fall in value against the dollar? What has the government done to reverse the recession? When the Convertibility Law pegged the Argentine peso 1:1 with the U.S. dollar, the governments ability to respond to external shocks was severely reduced. In effect, Argentinas exchange-rate and monetary policies were determined de facto by the United States, and Argentinas interest rates were determined by the U.S. Federal Reserve. When world commodity prices declined, the U.S. dollar, and hence the Argentine peso, strengthened against other currencies. Concurrently, Argentinas main trading partner, Brazil, devalued its currency. As deflation set in, both the Argentine government and many private companies found it difficult to pay their debts. Tax revenues fell, while public spending increased. Interest rates payments went primarily to overseas investors, thus further draining the economy. When Argentine banks were pressured to buy government bonds, a bank run ensued. Following the governments default on its debt, the currency board was abandoned, and the peso was allowed to float against the dollar. In the latter half of 2002, the Argentine peso was trading at about 27 cents to the dollar. What has been Argentinas experience with the IMF? Has the IMF been helpful or not? Argentina has had a somewhat tumultuous relationship with the IMF. Initially when the country sought help from the IMF, the IMF refused saying that Argentina would have to restructure its banking system, fiscal policy, and exchange rate policy. Eventually the IMF did grant loans to Argentina, but then was difficult to negotiate with when Argentina had trouble repaying those loans. The IMF and Argentina did finally agree to terms, however, and both are working to establish a long term relationship. How has the fall in the value of the peso affected business opportunities for companies doing business in Argentina and in exporting and importing? The biggest effect of the fall in the value of the peso for companies doing business in Argentina was hyperinflation. Also, companies with dollar denominated debt were badly hurt as the cost to repay that debt escalated rapidly. The declining peso helped exporters to be more competitive but made the prices of imported goods increase faster than the prices of domestic goods. Should HSBC invest more money in its operations in Argentina? What factors should they monitor as they make their decision? HSBC should continue to be cautious in its approach to increased investment in Argentina. Although the situation appears to be stabilized, it is still potentially volatile. The company should monitor the governments actions carefully, particularly its actions regarding the repayment of foreign debt. Also, if the government requires that dollar denominated loans issued by HSBC and other banks in the past be allowed to be repaid in Pesos, HSBC should be very reluctant to issue any more dollar denominated loans.

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WEB CONNECTION 107

Teaching Tip: Visit www.prenhall.com/daniels for additional information and links relating to the topics presented in Chapter Nine. Be sure to refer your students to the online study guide, as well as the Internet exercises for Chapter Nine. _________________________ CHAPTER TERMINOLOGY: foreign exchange, p.307 exchange rate, p. 307 foreign exchange market, p. 307 spot transactions, p. 307 spot rate, p. 307 outright forward, p. 307 FX swap, p. 307 over-the-counter market, p.307 currency swaps, p. 308 options, p. 308 futures contract, p. 308 hedge funds, p. 308 bid, p. 311 offer, p. 311 spread, p. 311 direct quote, p. 311 American terms, p. 311 European terms, p. 311 indirect quote, p. 311 base currency, p. 311 terms currency, p. 311 interbank, p. 312 forward rate, p. 315 forward discount, p. 316 forward premium, p. 316 option, p. 316 hard currencies, p. 316 soft currencies, p. 316 weak currencies, p. 316 multiple exchange rate system, p. 318 advance import deposit, p. 318 arbitrage, p. 318 quality controls, p. 318 interest arbitrage, p. 319 speculation, p. 319 Chicago Mercantile Exchange (CME), p. 322 Philadelphia Stock Exchange, p. 322 Eurocurrency market, p. 323 Eurocurrency, p. 323 Eurodollar, p. 323 Eurocredit, p. 323 syndication, p. 323 London Inter-Bank Offered Rate (LIBOR), p. 324 foreign bonds, p. 324 Eurobond, p. 325 global bond, p. 325 market capitalization, p. 326 Euroequity, p. 328 American Depositary Receipt (ADR), p. 329

ADDITIONAL EXERCISES: The Foreign-Exchange Market Exercise 9.1. Many students will have had experience with foreign currency conversion. Ask them to describe the differences they have encountered in rates quoted at the airport, in hotels and banks and on the street. Then ask students to describe their experiences using credit cards and ATM cards in particular foreign countries. How were the transactions reported on their statements? Were they charged processing fees?

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Exercise 9.2. Take copies of the most recent editions of The Wall Street Journal and the Financial Times to class. Explain to students where to find foreign exchange rates, forward rates, cross rates, commodity prices, etc. Select the home countries of various students in your class. Use the forward rates to engage the students in a discussion as to which currencies appear to be stronger. Explore the possible underlying reasons for a given currencys strength or weakness. Exercise 9.3. More than 150 currencies exist today. Some countries share a common currency (e.g., those that participate in the EURO), while certain countries peg their currencies to others (e.g., Chiles currency is pegged to the U.S. dollar). Many nations, however, maintain their own independent currencies. Ask students to debate the potential for additional regional currencies such as the EURO. If they support the concept, should those currencies necessarily be tied to regional economic blocs? Exercise 9.4. Have the students assume the role of CFO of a mid-sized U.S. company that exports to Europe. The company has received a contract to supply components to a European manufacturer with an agreed upon sales price of 4 million due in 90 days. Should the CFO do anything to hedge against possible fluctuations in the dollar/euro exchange rate? If so, what? If not, why not? Exercise 9.5. Go to a trading Web site like www.forex-markets.com or an information site like finance.yahoo.com/currency and demonstrate the charting, conversion calculators, and other research and information tools available for foreign exchange.

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