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 Union’s 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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INTRODUCTION Foreign exchange is money denominated in the currency of another nation or group of nations. an amount. the number of units of one currency needed to buy a unit of another....e.TEACHING TIPS: Carefully review the PowerPoint slides for Chapter Nine and select those you find most useful for enhancing your lecture and class discussion. it is an agreement to buy or sell a particular currency at a particular price on a particular future date. In addition to the traditional instruments. In an FX swap (a simultaneous spot and forward transaction). In fact. it is a financial instrument issued by countries other than one’s own. FX swaps account for nearly 45 percent of all foreign-exchange transactions. within two business days. The exchange-traded market includes certain securities exchanges (e. 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. A futures contract is a foreign-exchange instrument that specifies an exchange rate. several other ways now exist with which to participate in the foreign-exchange market. i. but delivery occurs at two different times. the Chicago Mercantile Exchange and the Philadelphia Stock Exchange) where particular types of foreign-exchange instruments (such as futures and options) are traded. several types of transactions may occur.e. i. II.. A. one currency is swapped for another on one date and then swapped back on a future date. For additional visual summaries of key chapter points. tables and maps in the text. Currency swaps deal with interest-bearing financial instruments (such as bonds) and involve the exchange of principal and interest payments. 100 . Their combined activities affect the supply of and demand for currencies. investment banks. 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. I. In addition. The over-the-counter market (OTC) includes commercial banks. i. A Brief Description of Foreign-Exchange Instruments Several types of foreign exchange instruments are available for trading. Spot transactions involve the exchange of currency “on the spot. 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.e.. the same currency is bought and sold simultaneously. The market is comprised of two major segments. An exchange rate is the price of one currency expressed in terms of another. and a maturity date in advance of the exchange of the currencies. The spot rate is the exchange rate quoted for transactions that require the immediate delivery of foreign currency. and other financial institutions—this is where most foreignexchange activity occurs. also review the figures.” or technically. transactions that are settled within two business days after the date of agreement to trade.e. i.g.

DOES GEOGRAPHY MATTER? Foreign-Exchange Trades Even though the U. the heaviest volumes of trade are concentrated in the hours when Asia and Europe are open or when Europe and the U. The spread is the difference between the bid and offer rates. for example. III. The Spot Market The spot market consists of players who conduct those foreign-exchange transactions that occur “on the spot. 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. dollar is the most widely traded currency in the world.” or technically. usually used by wealthy individuals and institutions. 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.S. Also. Nonetheless. the largest foreign exchange market is in the United Kingdom.. prices tend to be better when markets are active and liquid.S. The U. Despite the fact that the currency market is a 24 hour market. The Size. London. 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. it is the profit margin of the 101 .B. dollar remains the most important currency in the foreignexchange market.S. the offer is the rate at which traders sell foreign exchange.S. comprising one side (buy or sell) of 89 percent of all foreign currency transactions worldwide in 2004. some trading centers outside the U. 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. are very important in the global currency trade.3). The bid is the rate at which traders buy foreign exchange. are open (see Figure 9. Foreign-exchange traders always quote a bid (buy) and offer (sell) rate. which is strategically situated between Asia and the Americas. This increase more than reversed the decline seen from 1998 to 2001. within two business days following the date of agreement to trade.e. i. MAJOR FOREIGN-EXCHANGE INSTRUMENTS A. followed by the United States.S. which is allowed to use aggressive trading strategies unavailable to mutual funds). Japan and Singapore.

While a forward contract is tailored to the amount and time frame the customer needs. futures contracts have preset amounts and maturity dates. However. or European terms. i. 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.B.S. The forward rate is the rate quoted today for the future delivery of a foreign currency.e. To conserve scarce foreign exchange. D.. i. a dollar-direct quote that gives the value in dollars of a unit of foreign currency. underlying. Foreign-Exchange Convertibility Hard currencies are those that governments allow both residents and nonresidents to purchase in unlimited amounts. Under a multiple exchange-rate system the government sets different rates for different types of transactions. is the quoted. dollar. the government limits the amount of foreign currency that can be used 102 . Most large newspapers quote exchange rates daily. 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).e. an indirect quote that gives the value in foreign currency of one U. not OTC. but it may be useful for small transactions or speculation. Exchanges can be quoted in American terms. The writer of the option will charge a fee. i. Options An option is a foreign-exchange instrument that guarantees the right. Options can be purchased over the counter from a commercial or investment bank or on an exchange. listing both spot and forward rates. importers will be required to make a deposit with the central bank. The difference between the spot and forward rates is either the forward discount (the forward rate.e. but does not impose an obligation. The futures contract is less valuable to a firm than a forward contract. C. The spot rates listed are usually the selling rates for interbank transactions (transactions between banks) of $1 million or more. a future is traded on an exchange. With quantity controls. often for as long as one year. Soft (weak) currencies are not fully convertible and tend to be the currencies of developing countries... currencies freely traded and accepted in international business. An option is more flexible. 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. but also more expensive. Hard currencies are fully convertible. known as the premium. the future delivery price. 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. to cover the full price of the products being sourced from abroad. relatively stable and tend to be comparatively strong. E.e. or the denominator. or fixed currency. trade.. If the government imposes an advance import deposit. The base currency. i. governments may impose exchange restrictions on individuals and/or companies. the terms currency is the numerator. than a forward contract. is lower than the spot rate) or the forward premium (the forward rate is higher than the spot rate).

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

A major advantage of the Eurodollar market is that. VI. large firms prefer options because of their greater flexibility and convenience. International Bonds: Foreign. The Eurocurrency market is completely unregulated. and Global The international bond market can be divided into foreign bonds. Syndications. Eurocurrencies The Eurocurrency market is an important source of debt financing form MNEs. Eurobonds. B. Although options cost more than futures. Japan. Foreign bonds are sold outside of the borrower’s country but are denominated in the currency of the country of issue. since it is an offshore market. Loans are traditionally made at a certain percentage above the London Inter-Bank Offered Rate (LIBOR). A Eurocredit is any loan. or other instrument with a one to five year maturity. 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. 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. then. The Philadelphia Stock Exchange (PHLX) is the only exchange in the United States that trades foreign-currency options.are a number of exchanges where particular types of foreign-exchange instruments (such as futures and options) are traded. central banks. A Eurodollar. A. The Eurocurrency market is a wholesale market where major players such as governments. The Eurocurrency market consists of short-term borrowing (maturities less than one year) and medium-term borrowing. also a form of Eurocredit. 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. which is the deposit rate that applies to interbank loans within London. is a certificate of deposit in dollars in a bank outside of the United States. Euro. it is not regulated by the Federal Reserve Board. 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. It lists six dollar-based standardized currency options contracts. and public sector corporations make large transactions. line of credit. GLOBAL CAPITAL MARKETS This section looks at the role of foreign debt and equity markets in moving currency from one country to another. Other Eurocurrencies are likewise not regulated by the major regulatory bodies in their respective home countries. are situations in which several banks pool resources to extend credit to a borrower and spread the risk. and global bonds. A Eurobond is usually 104 . but they could be held in any bank outside the United States. Most Eurodollar CDs are held in London. A Eurocurrency is any currency that is banked outside its country of origin.

is a combination of a domestic bond and a Eurobond—that is. The growth of emerging stock markets was quite erratic in the 1990s. Another source of demand for private placements is the corporate restructuring market in Europe. however. London Stock Exchange. Investors are finding that the best price for their stocks is usually in their home market. In recent years. 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. Companies can also access the equity-capital market by listing their shares publicly on a stock exchange. Currency speculation allows investors to diversify their portfolios from traditional stocks and bonds. Recently. but some companies list for different prices in different countries. nor is it necessarily bad. The five biggest stock exchanges in the world are the New York Stock Exchange. more than triple the number listed in 1993. there are still 460 foreign companies listed on the New York Stock Exchange. emerging markets have grown more rapidly. Equity Securities and the Euroequity Market Another source of financing is equity securities. Companies such as E*Trade and Charles Schwab & Company are now doing business in Europe and competing with local e-trade companies. C. Another significant development in the past decade is the creation of the Euroequity market. several companies have reduced the number of exchanges on which their stocks are listed.S. Speculators are merely trying to make a profit by trading based on market trends. it must be registered in each national market according to that market’s registration requirements. Some ADRs will list for the same price in the home country and foreign country exchange. introduced by the World Bank in 1989. The global bond. Despite these trends. however. Firms can gain access to capital through private placements with wealthy individuals or venture capitalists. 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). either in their home country or in another country. which are themselves forms of speculative investment. 105 . Another major development in international equity markets is electronic trading. It is also issued simultaneously in several markets. and Euronext. usually those in Asia.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. POINT—COUNTERPOINT: Speculation in Capital Markets POINT: Currency speculation is not illegal. 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. Tokyo Stock Exchange. and North America. Europe. 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. bank in the United States to represent the underlying shares of a foreign corporation’s stock held in trust at a custodian bank in the foreign country. the market for shares sold outside the boundaries of the issuing country’s home country. NASDAQ.

The country’s economy has recovered well since 2002. 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. 1995 earthquake in Kobe. Companies’ costs of trading foreign exchange should come down and they should gain faster access to more currencies. to make money illegally or contrary to company policy. 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. In 2001. Argentina experienced a tremendous financial that led to losses of $1. Japanese stocks plunged and Leeson had to come up with cash to cover the margin call. After a loss in 1998. After the January 17. putting the company into bankruptcy. or should HSBC continue to be reserved in its operations in Argentina? 106 . but HSBC has been reluctant to invest more in Argentina. Since the collapse of Barings. so I did not provide them with the revision. a 28-year-old trader for British bank Barings PLC was chief trader for the bank in Singapore.000 offices in 81 countries. whether in foreign exchange or securities.COUNTERPOINT: There are plenty of opportunities for a trader. The growth of Internet trades in currency will take away some of the market share of dealers and allow more entrants in the foreign—exchange market. 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.1 billion for HSBC. yet the occurrence of and potential for negative outcomes from rogue trading continue to exist. the company earned a healthy profit in 1999 and expected growth rates of 100% or more. 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. With lax internal controls. HSBC Holdings plc is a London based global banking and insurance enterprise with over 7. Government exchange restrictions should diminish as currency markets are liberalized. Is now the time for increased investment. Leeson was able to make numerous questionable and illegal transactions to illicitly generate the cash needed to cover his positions. As the euro continues to solidify its position in Europe. HSBC entered Argentina in 1997 through an acquisition. Nicholas Leeson. however. measures have been put into place in banks to prohibit such consequences. These actions resulted in huge losses in excess of $1 billion for Barings.

When Argentine banks were pressured to buy government bonds.S. thus further draining the economy. The IMF and Argentina did finally agree to terms. dollar. Federal Reserve. the IMF refused saying that Argentina would have to restructure its banking system. The declining peso helped exporters to be more competitive but made the prices of imported goods increase faster than the prices of domestic goods. HSBC should be very reluctant to issue any more dollar denominated loans. Brazil. fiscal policy. both the Argentine government and many private companies found it difficult to pay their debts. 3. if the government requires that dollar denominated loans issued by HSBC and other banks in the past be allowed to be repaid in Pesos. however. Also. The company should monitor the government’s actions carefully. particularly its actions regarding the repayment of foreign debt. Also. and Argentina’s interest rates were determined by the U. Although the situation appears to be stabilized. and both are working to establish a long term relationship. a bank run ensued. Argentina’s main trading partner. Concurrently. the Argentine peso was trading at about 27 cents to the dollar. but then was difficult to negotiate with when Argentina had trouble repaying those loans. the currency board was abandoned.S. dollar. Following the government’s default on its debt. Interest rates payments went primarily to overseas investors. it is still potentially volatile. the government’s ability to respond to external shocks was severely reduced. 4.S. When world commodity prices declined. Argentina’s exchange-rate and monetary policies were determined de facto by the United States. the U. 2. 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. 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. In effect. and the peso was allowed to float against the dollar. strengthened against other currencies. WEB CONNECTION 107 . Eventually the IMF did grant loans to Argentina. What has been Argentina’s experience with the IMF? Has the IMF been helpful or not? Argentina has had a somewhat tumultuous relationship with the IMF.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. while public spending increased. and exchange rate policy. Initially when the country sought help from the IMF. and hence the Argentine peso. As deflation set in. devalued its currency. companies with dollar denominated debt were badly hurt as the cost to repay that debt escalated rapidly. Tax revenues fell. In the latter half of 2002.

p. 307 foreign exchange market. 316 option. 329 ADDITIONAL EXERCISES: The Foreign-Exchange Market Exercise 9. 319 speculation. 307 spot transactions. p. p. p. _________________________ CHAPTER TERMINOLOGY: foreign exchange. p. 307 spot rate. 318 advance import deposit. p. p. p. p. p.prenhall. Be sure to refer your students to the online study guide. p. p. 311 offer. 312 forward rate. 326 Euroequity. p.com/daniels for additional information and links relating to the topics presented in Chapter Nine. How were the transactions reported on their statements? Were they charged processing fees? 108 . 318 interest arbitrage. as well as the Internet exercises for Chapter Nine. p. p. 319 Chicago Mercantile Exchange (CME). Then ask students to describe their experiences using credit cards and ATM cards in particular foreign countries. 316 forward premium. 322 Philadelphia Stock Exchange. 328 American Depositary Receipt (ADR). p. 311 spread. p.307 exchange rate. 316 multiple exchange rate system. 324 Eurobond. 323 Eurodollar. 323 Eurocredit. p. 311 interbank. 311 direct quote. p. p. p. p. Many students will have had experience with foreign currency conversion. 311 base currency. p. 316 soft currencies. p.Teaching Tip: Visit www. p. 325 market capitalization. 323 Eurocurrency. p. 325 global bond. p. p. p. 311 European terms. p. 308 options. p. p. 308 futures contract. 316 weak currencies. p. p.1. 318 arbitrage. 311 terms currency. p. p. 308 hedge funds. 316 hard currencies. in hotels and banks and on the street. p. 307 over-the-counter market. 311 indirect quote. p. p.307 currency swaps. 315 forward discount. 322 Eurocurrency market. p. p. p. 323 London Inter-Bank Offered Rate (LIBOR). 311 American terms. 318 quality controls. 307 outright forward. p. p. p. 308 bid. p. 323 syndication. p. 324 foreign bonds. Ask them to describe the differences they have encountered in rates quoted at the airport. p. p. 307 FX swap.

S. however. More than 150 currencies exist today. Chile’s currency is pegged to the U.. Use the forward rates to engage the students in a discussion as to which currencies appear to be stronger.g. Should the CFO do anything to hedge against possible fluctuations in the dollar/euro exchange rate? If so. conversion calculators. should those currencies necessarily be tied to regional economic blocs? Exercise 9. forward rates.forex-markets. Ask students to debate the potential for additional regional currencies such as the EURO. Some countries share a common currency (e. etc.com or an information site like finance.S. Explain to students where to find foreign exchange rates. Explore the possible underlying reasons for a given currency’s strength or weakness. If they support the concept. while certain countries peg their currencies to others (e.yahoo.Exercise 9. and other research and information tools available for foreign exchange.5. what? If not. maintain their own independent currencies. Have the students assume the role of CFO of a mid-sized U. Many nations.3.com/currency and demonstrate the charting. why not? Exercise 9. Exercise 9. 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.g.2. Take copies of the most recent editions of The Wall Street Journal and the Financial Times to class. 109 . dollar). Select the home countries of various students in your class.. company that exports to Europe. those that participate in the EURO). cross rates. commodity prices.4. Go to a trading Web site like www.

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