International Business

Chapter Nine
The Foreign-Exchange Market

9-1
 Chapter Objectives
 Learn the fundamentals of foreign
exchange
 Identify major characteristics of the
foreign-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
9-2
 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
 Exchange rate: the price of a particular
currency relative to another
9-3
 Characteristics of the Foreign-
Exchange Market

 Over-the-counter (OTC) market

• Commercial banks
• Investment banks
 Exchanged-traded market
• Securities exchanges
• Foreign-exchange instruments
 Exchange-traded futures
 Exchange-traded options

9-4
 Foreign-Exchange Instruments
 Spot transactions: involve the exchange of
currency the second day after the date on
which the two foreign-exchange traders
agree
 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
 Foreign-Exchange Instruments
Others

 Currency swaps
 Options
 Futures

9-5
 Key Foreign-Exchange Terms
 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
Trading

9-7
 Significance of Foreign-Exchange
Trading

 $1,200,000,000 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
market
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
Foreign-Exchange Convertibility
 Fully convertible currencies are those that
the government allows both residents and
nonresidents to purchase in unlimited
amounts
 “Hard currencies” are fully convertible
 “Soft currencies” (or weak currencies) are
not fully convertible
• Typically from developing countries
• Known as exotic currencies

9-10
Business Use of Foreign-Exchange
 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
Foreign-Exchange Market
Activity

9-12
Market Rhythms

9-13
Foreign-Exchange Structure

9-14
 Choosing a Foreign-Exchange
Trader
 Capability to handle major currencies
 Capability to handle major cross-trades
 Capability to handle specific currencies
 Capability to handle derivatives (forwards,
swaps, and options)
 Capability to engage in research
 Ranking in specific locations
 Large international banks will use multiple
foreign-exchange traders depending upon
their expertise in particular areas
9-15
Foreign Exchange Markets Overview
 Foreign exchange (FX) markets - markets in
which cash flows from the sale of products or
assets denominated in a foreign currency are
transacted
 Foreign exchange rate - the price at which one
currency can be exchanged for another currency
 Foreign exchange risk - risk that cash flows will
vary as the actual amount of U.S. 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
 Background and History of Foreign
Exchange Markets
 Bretton Woods Agreement (1944-1977) - called
for exchange rate of one currency for another to
be fixed around a specific rate with government
intervention - led to some currencies being
overvalued and some undervalued
 Smithsonian Agreement (1971) - major countries
allowed the dollar to be devalued and boundaries
of exchange rate could fluctuate
 Smithsonian Agreement II (1973) - exchange
rate boundaries eliminated altogether, free-
floating exchange rate
 Foreign Exchange Transactions
Spot
Spot foreign
foreign exchange
exchange transaction:
transaction:
00 11 22 33mo
mo

Exchange
ExchangeRate
RateAgreed/Paid
Agreed/Paid ++ Currency
CurrencyDelivered
Deliveredby
by
between
betweenBuyer
Buyerand
andSeller
Seller Seller
Sellerto
toBuyer
Buyer

Forward
Forward exchange
exchange transaction
transaction
00 11 22 33mo
mo

Exchange
ExchangeRate
RateAgreed
Agreed Buyer
BuyerPays
PaysForward
ForwardPrice
Price
between
betweenBuyer
Buyerand
andSeller
Seller Seller
SellerDelivers
Deliverscurrency
currency
 Hedging with Forwards
Transactional steps when FI hedges its FX risk by
immediately selling one-year sterling loan proceeds in
forward FX market
1. U.S.bank sells $100 M for pounds at spot exchange rate today
and receives $100 M/1.6 = £ 62.5 M
2. Bank then lends the £ 62.5 M to British customer at 15% for one
year
3. Bank sells expected P & I proceeds from the sterling loan
forward for dollars at today’s forward rate for one year
4. British borrower repays P & I in £ 71.875 M
5. Bank delivers the sterling to buyer of one-year forward contract
and receives $111.406 M
Role of FIs in Foreign Exchange Transactions

 Net exposure - a FIs overall foreign exchange exposure

in any given currency
 Net long (short) in a currency - a position of holding
more (fewer) assets than liabilities in a given currency
 Four trading activities
• purchase/sale of foreign currencies for trade transactions
• purchase/sale of foreign currencies for investment
• purchase/sale of foreign currencies for hedging
• purchase/sale of foreign currencies for speculating
Liabilities to and Claims on Foreigners Reported
by Banks in U.S., Payable in Foreign Currencies ($M)

120000
120000
100000
100000
80000
80000
60000
60000
40000
40000
20000
20000
00
1993
1993 1994
1994 1995
1995 1996
1996 1997
1997 1998
1998 1999
1999

Banks'
Banks'liabilities
liabilities
Banks' claims
Banks' claims
Claims
Claimsofofbanks'
banks'domestic
domesticcustomers
customers
 Purchasing Power Parity
The
The theory
theory explaining
explaining the
the change
change in in foreign
foreign currency
currency
exchange
exchange rates
rates as
as inflation
inflation rates
rates in
in the
the countries
countries change
change

iUS
iUS == IP
IPUSUS ++ RIR
RIRUSUS
and:
and:
iFi == IP
IPFF ++ RIR
RIRFF
F
where:
where:
iUS
iUS == Interest
Interestrate
rateininthe
theUnited
UnitedStates
States
iFi == Interest
Interestrate
rateininFrance
France
F

then:
then:
iUS
iUS -- iFiF == IP
IPUSUS -- IP
IPFF
 Interest Rate Parity
The
The theory
theory that
that the
the domestic
domestic interest
interest rate
rate should
should equal
equal
the
the foreign
foreign interest
interest rate
rate minus
minus the
the expected
expected appreciation
appreciation
of
of the
the domestic
domestic currency
currency

11 ++ iUSt (1/St)t)  (1
iUSt == (1/S iUKt))  FFt t
(1 ++ iUKt
where:
where:
11++iUSt
iUSt == 11plus
plusthe
theinterest
interestrate
rateon
onaaU.S.
U.S.investment
investment
maturing
maturingatattime
timett
11++iUKt
iUKt == 11plus
plusthe
theinterest
interestrate
rateon
onaaU.K.
U.K.investment
investment
maturing
maturingatattime
timett
SSt == S/L
S/Lspot
spotexchange
exchangeraterateat
attime
timett
t
FFt == S/L
S/Lforward
forwardexchange
exchangerate
rateatattime
timett
t
 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 foreign
trade in goods and services, net investment
income, and gifts, grants, or aid given to
other countries
 Capital accounts - the section of the balance
of payment table that summarizes capital
flows into and out of a country