Part Four

World Financial Environment

Chapter Nine
Global Foreign-Exchange Markets

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Chapter’s 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 describe how the foreign exchange market
works
• To examine the different institutions that deal in
foreign exchange
• To understand why companies deal in foreign
exchange

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Foreign Exchange
• Foreign exchange is money denominated in the
currency of another nation or group of nations
• The market in which these transactions take place
is the foreign-exchange market.
• The exchange rate is the price of a currency

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The Foreign Exchange
• The Bank for International Settlements divides the
foreign exchange market into reporting dealers
(also known as dealer banks or money center
banks), other financial institutions, and nonfinancial
institutions.
• Dealers can trade currency by telephone or
electronically, especially through Reuters, EBS, or
Bloomberg
• The foreign exchange market is divided into the
over-the-counter market (OTC) and the exchange-
traded market
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Some Traditional Foreign Exchange
Instruments   
• Spot transactions involve the exchange of currency
on the second day after the date on which the two
dealers agree to the transaction
• Outright forward transactions involve the exchange
of currency three or more days after the date on
which the dealers agree to the transaction
• An FX swap is a simultaneous spot and forward
transaction

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Foreign Exchange Derivatives
• Currency swaps deal more with interest-bearing
financial instruments (such as a bond), and they
involve the exchange of principal and interest
payments.
• Options are the right but not the obligation to
trade foreign currency in the future.
• A futures contract is an agreement between two
parties to buy or sell a particular currency at a
particular price on a particular future date.

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Some Aspects
Of The Foreign Exchange Market
• Approximately $3.2 trillion in foreign exchange is
traded every day.
• The US dollar is the most widely traded currency in
the world (on one side of 86% of all transactions)
• London is the main foreign exchange market in the
world

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Why the US dollar is the most widely
traded currency
• 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.

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The Spot Market
• Foreign exchange dealers quote bid (buy) and offer
(sell) rates on foreign exchange
• If the quote is in American terms, the dealer quotes
the foreign currency as the number of dollars and
cents per unit of the foreign currency
• If the quote is in European terms, the dealer quotes
the number of units of the foreign currency per
dollar
• The numerator is called the “terms currency” and
the denominator the “base currency.”
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The Forward Market
• If the foreign currency in a forward contract is
expected to strengthen in the future (the dollar
equivalent of the foreign currency is higher in the
forward market than in the spot market), the
currency is selling at a premium. If the opposite is
true, it is selling at a discount
• An option is the right, but not the obligation, to
trade foreign currency in the future
• Options can be traded OTC or on an exchange

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Futures
• A foreign currency future is an exchange-traded
instrument that guarantees a future price for the
trading of foreign exchange, but the contracts are
for a specific amount and specific maturity date

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The Foreign Exchange Trading Process

• Companies work with foreign exchange dealers to

trade currency
• Dealers also work with each other and can trade
currency through:
• voice brokers
• electronic brokerage services
• directly with other bank dealers
• Internet trades of foreign exchange are becoming
more significant

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How Companies Use Foreign Exchange

• The major institutions that trade foreign exchange

are the large commercial and investment banks
and securities exchanges
• Commercial and investment banks deal in a variety
of different currencies all over the world
• The CME Group and the Philadelphia Stock
Exchange trade currency futures and options

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How Companies Use Foreign Exchange

• Companies use foreign exchange to settle

transactions involving the imports and exports of
goods and services, for foreign investments, and to
earn money through arbitrage or speculation

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