International Business

Chapter Nine The Foreign-Exchange Market Foreign-


Chapter Objectives 

Learn the fundamentals of foreign exchange Identify major characteristics of the foreignforeign-exchange market and how governments control the flow of currencies across national borders Understand why companies deal in foreign exchange Describe how foreign exchange markets work Examine different institutions that deal in foreign exchange

Foreign Exchange Terms  Foreign exchange: money denominated in the currency of another nation or group of nations ‡ Transactions of foreign currencies take place in foreign exchange markets ‡ Cash ‡ Credit ‡ Bank deposits ‡ Other short-term claims short-  Exchange rate: the price of a particular currency relative to another 9-3 .

Characteristics of the ForeignForeignExchange Market  Over-theOver-the-counter (OTC) market ‡ Commercial banks ‡ Investment banks  ExchangedExchanged-traded market ‡ Securities exchanges ‡ Foreign-exchange instruments Foreign  ExchangeExchange-traded futures ExchangeExchange-traded options 9-4 .

ForeignForeign-Exchange Instruments    Spot transactions: involve the exchange of currency the second day after the date on which the two foreign-exchange traders foreignagree Outright forward transactions: involve the exchange of currency 3 or more days after the date the traders agree FX swap: involves a swap of one currency for another and then swapped back on a future date 9-5 .

ForeignForeign-Exchange Instruments Others    Currency swaps Options Futures 9-5 .

Key Foreign-Exchange Terms Foreign      Bid: the rate at which traders buy foreign currency Offer: the rate at which traders sell foreign exchange Spread: the difference between bid and offer rates. the profit margin for the trader American terms: the number of dollars per unit of foreign currency European terms: the number of units of foreign currency per dollar Option: the right but not the obligation to trade for a foreign currency at a specific exchange rate 9-6 .

Trends in Foreign-Exchange ForeignTrading 9-7 .

200.000.Significance of Foreign-Exchange ForeignTrading     $1.000 in foreign exchange is traded every day US dollar is most widely traded US is involved in 90% of all transactions London is the main foreign-exchange foreignmarket 9-8 .

Reasons Why US Dollar is Most Widely Traded      It is an investment currency in many capital markets It is a reserve currency held by many central banks It is a transaction currency in many international commodity markets It is an invoice currency in many contracts It is an intervention currency employed by monetary authorities in market operations to influence their own exchange rates 9-9 .

ForeignForeign-Exchange Convertibility    Fully convertible currencies are those that the government allows both residents and nonresidents to purchase in unlimited amounts ³Hard currencies´ are fully convertible ³Soft currencies´ (or weak currencies) are not fully convertible ‡ Typically from developing countries ‡ Known as exotic currencies 9-10 .

Business Use of Foreign-Exchange Foreign   Arbitrage: the purchase of foreign currency on one market for immediate resale on another marker to profit from a price discrepancy Interest arbitrage: the investing in debt instruments. such as bonds. in different countries Speculation: the buying and selling of a commodity ‡ Risk ‡ Profit 9-11 .

ForeignForeign-Exchange Market Activity 9-12 .

Market Rhythms 9-13 .

ForeignForeign-Exchange Structure 9-14 .

and options) Capability to engage in research Ranking in specific locations Large international banks will use multiple foreignforeign-exchange traders depending upon their expertise in particular areas 9-15 .Choosing a Foreign-Exchange ForeignTrader        Capability to handle major currencies Capability to handle major cross-trades crossCapability to handle specific currencies Capability to handle derivatives (forwards. swaps.

markets in which cash flows from the sale of products or assets denominated in a foreign currency are transacted Foreign exchange rate . dollars received on a foreign investment changes due to a change in foreign exchange rates Currency depreciation/appreciation .when a country s currency falls/rises in value relative to other currencies .the price at which one currency can be exchanged for another currency Foreign exchange risk .S.risk that cash flows will vary as the actual amount of U.Foreign Exchange Markets Overview     Foreign exchange (FX) markets .

major countries allowed the dollar to be devalued and boundaries of exchange rate could fluctuate Smithsonian Agreement II (1973) . free-floating freeexchange rate .led to some currencies being overvalued and some undervalued Smithsonian Agreement (1971) .exchange rate boundaries eliminated altogether.Background and History of Foreign Exchange Markets    Bretton Woods Agreement (1944-1977) .called (1944for exchange rate of one currency for another to be fixed around a specific rate with government intervention .

Foreign Exchange Transactions Spot foreign exchange transaction: 0 1 2 3 mo Exchange Rate Agreed/Paid + Currency Delivered by between Buyer and Seller Seller to Buyer Forward exchange transaction 0 1 2 Buyer Pays Forward Price Seller Delivers currency 3 mo Exchange Rate Agreed between Buyer and Seller .

U.S.5 M to British customer at 15% for one year Bank sells expected P & I proceeds from the sterling loan forward for dollars at today s forward rate for one year British borrower repays P & I in £ 71.Hedging with Forwards Transactional steps when FI hedges its FX risk by immediately selling one-year sterling loan proceeds in oneforward FX market 1. sells $100 M for pounds at spot exchange rate today and receives $100 M/1.6 = £ 62.406 M .5 M Bank then lends the £ 62. 5.875 M Bank delivers the sterling to buyer of one-year forward contract oneand receives $111. 3. 4.

a FIs overall foreign exchange exposure in any given currency Net long (short) in a currency .Role of FIs in Foreign Exchange Transactions    Net exposure .a position of holding more (fewer) assets than liabilities in a given currency Four trading activities purchase/sale of foreign currencies for purchase/sale of foreign currencies for purchase/sale of foreign currencies for purchase/sale of foreign currencies for trade transactions investment hedging speculating .

.Liabilities to and Claims on Foreigners Reported by Banks in U.S. Payable in Foreign Currencies ($M) 120000 100000 80000 60000 40000 20000 0 1993 1994 1995 1996 1997 1998 1999 Banks' liabilities Banks' claims Claims of banks' domestic customers .

IPF .iF = IPUS .Purchasing Power Parity The theory explaining the change in foreign currency exchange rates as inflation rates in the countries change iUS = IPUS + RIRUS and: iF = IPF + RIRF where: iUS = Interest rate in the United States iF = Interest rate in France then: iUS .

Interest Rate Parity The theory that the domestic interest rate should equal the foreign interest rate minus the expected appreciation of the domestic currency 1 + iUSt = (1/St) v (1 + iUKt) v Ft where: 1 + iUSt = 1 plus the interest rate on a U.K. investment maturing at time t 1 + iUKt = 1 plus the interest rate on a U.S. investment maturing at time t St = S/L spot exchange rate at time t Ft = S/L forward exchange rate at time t .

net investment income.the section of the balance of payment table that summarizes foreign trade in goods and services. grants.Balance of Payment Accounts    Balance of payment accounts .summary of all transactions between citizens of two countries Current account .the section of the balance of payment table that summarizes capital flows into and out of a country . or aid given to other countries Capital accounts . and gifts.

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